What Is An Equity?

One of the areas that many of the next generation ask us for is insights into finance and help in gaining financial awareness and understanding. The team at Brooks Macdonald have provided us with an article and video on equity investing and in this first piece we look at what an equity is, look at the building blocks of equities, and look at some equity investment styles.

What Is An Equity?

If you look at a company, you can view it in terms of its assets and liabilities. In terms of assets, to take one example, a company might own a chain of supermarkets or department stores, and all the intellectual property and equipment that go with these. Against these assets, the company will also hold liabilities, which might be money to be paid out in rent for store space and warehouses, money owed to banks or other lenders, and so forth.

What is left over after all the liabilities have been paid, is what we call the equity of a company. It is the remainder of assets once all outgoing payment obligations have been met or accounted for.

If You Own An Equity, What Do You Get?

As an equity holder, you participate in the future growth of a company. You also (usually) acquire voting rights, which means that you may attend the company’s Annual General Meeting, and exercise your vote on the resolutions that come through from the company’s board. This could includes votes on, for example, directors’ remuneration, dividends, or any number or manner of different resolutions. Essentially, when things are going well, equity holders have some of the best exposure to that company.

There are typically two broad options for investing in companies (equities and bonds): bonds generally provide holders with a fixed amount of income per annum (hence their alternative descriptor “fixed income”), but equities are variable. As an equity holder, you do not know exactly what returns you will get in the future, or what dividends, or indeed what amount of capital growth: you participate in the fate of the company, alongside the other equity holders.

If the company struggles or performance badly, as an equity holder, this could mean in a worst-case scenario that you do not even make you money back. Equity investors are at the higher risk end of the corporate structure, and will be some of the first to feel the effect of a change in fortune for the company. If things continue to go badly then, over time, the debt or bond holders might be impacted too, but initially it will be equity holders who suffer the early effects.

An often-overlooked point is that if the company decides to issue more shares, equity holders automatically have the right to buy more of these shares. During the financial crisis, a lot of companies, and banks in particular, came to the market to raise fresh equity capital, which is a relatively cheap source of funding for them to implement and, unlike issuing bonds, does not involve commitment to repayments. However, new share issues have the potential to dilute the other share holdings. If, for example, a company has 100 shares in issue and then issues a further 100, there would now be 200 shares sharing in the fate of the company. As an initial equity investor (in the original 100), you have the right to buy into the new share issue these new to make sure that your overall holding is not diluted (which in this example would otherwise result in a 50% dilution).

Public Versus Private Companies

A public company is owned by a broad group of investors and is traded on what we call an exchange, such as the London Stock Exchange. This allows investors, both retail and institutional, to buy and sell shares in these companies. An exchange is effectively an intermediary between the buyers and the sellers, and the exchange will effectively match supply with demand. Brokers also use exchanges, and may be independent organisations or some of the major investment banks, looking either to sell or buy some of these equities.

A public listed company is usually at a relatively advanced stage of its lifecycle or is a company that is growing rapidly. Importantly, once shares in a company trade on an exchange, they become more liquid. A publicly traded company’s equity tends to be owned by external shareholders, which is the opposite of what you usually find with a private company. Corporate governance tends to be stronger and more transparent: a public company must abide by the rules and regulations necessary to list on an exchange. A public company board will have a combination of people who work for the company and independent, external members who are what we call “non-executive directors.” These non-executive directors provide an additional level of oversight to make sure that the company is not only in keeping with the rules of the exchange on which it is listed, but also that it is acting in the interests of its shareholders.

A private company, on the other hand, is not traded on an exchange. Private companies tend to be smaller than public companies, and to be more tightly controlled, by virtue of having a smaller number of shareholders. A private company might be, for example, a family owned business, and it might be structured in a similar way to a public company, albeit with a smaller number of shareholders, each with relatively large shareholdings. A private company is typically in the earlier stages of its lifecycle – this is different from when you see a company that has been bought by a private equity company. A private equity company is a company that looks to take relatively small companies or struggling companies, and build on them and restructure them as necessary in order to produce something that they can sell to the broader market through what is called an initial public offering, or an “IPO.”

As private companies tend to be in the earlier stage of their lifecycle, they may have less rigorous corporate governance; in order to list its equity on an exchange, a company must abide by certain rules and regulations relating in particular to corporate governance, and a private company might not yet meet these same standards.

Private company shares may be very illiquid, as the number of people buying and selling them is very small, compared to listed public companies. If you do hold shares in a private company and want to sell your holding, you will probably have to find a buyer yourself, or wait for an opportunity where the company will agree either to find a buyer or buy back your holding. This means that for private companies, you do not have what we call ‘price discovery’: for public companies, if you want to sell your shares, there will be enough parties buying and selling those shares on the exchange to give a pretty good idea of what the current price is. As private companies are not listed, the price at which you buy and sell is much less transparent, and harder to anticipate.

In return for the illiquidity, the early-stage position in the corporate lifecycle, and probably less transparent corporate governance, private company equity investors generally have the potential for a higher return, on account of the fact that they are taking on these higher levels of risk, in comparison to public company equity investors.

Liquidity

Liquidity is an expression for how easily any financial security can be bought or sold. Some examples of more illiquid (i.e. difficult to buy and sell) assets include property, physical assets such as factory equipment, and unlisted private company shares. At the other end of the liquidity scale, we see assets such as listed equities and bonds, and the most liquid asset is cash. When it comes to equities, the question of being listed on an exchange or being unlisted is a significant determinant of liquidity. Equities traded on an exchange, such as any of the large supermarkets, banks, department stores and tech companies, while not being as liquid as cash, are still relatively easy to buy and sell. Whereas a private company, particularly if it’s quite closely held, will probably be closer to the “illiquid” end of the scale – there may be only annual options to buy or sell that holding, or indeed there may be no opportunity at all to buy or sell until the company is brought to the market in an Initial Public Offering.

Equity Investment Styles

Within listed equities, there are still many different levels of liquidity, and there are different equity investment styles that may aim to capture some of this extra risk and reward potential, and others that aim to avoid it, depending on the particular fund and its investment mandate.

If you look at the ‘mega cap’ companies such as Apple, Exxon Mobil and Royal Dutch Shell, these are right at the top end of the liquidity scale for equities. They form large proportions of the major equity market indices and have a very large number of shares in issue. Moving a little bit further down the scale, you reach the ‘large cap’ companies, most of which are well-known household names such as Aviva, Morrison’s and Just Eat, which are still very liquid, despite not being as big as the ‘mega cap’ leaders.

Moving still further down the scale, you reach what are known as ‘medium cap’ and ‘small cap’ companies.

What is important to note here for purposes of liquidity is that although these companies are still listed equities, they are generally less popular with equity market analysts, and therefore less well-know. This means that despite being listed, they are probably not traded with the same frequency or in the same volumes as their larger counterparts, which means that they are less liquid. If you choose to invest in these areas of the equity market, you might have the opportunity of a higher return than for a mega-cap company, but you would also take on higher risks, including lower price transparency and lower liquidity.

Notes: – The value of your investments and the income from them may go down as well as up and neither is guaranteed. Investors could get back less than they invested. Past performance is not a reliable indicator of future results. Changes in exchange rates may have an adverse effect on the value of an investment. Changes in interest rates may also impact the value of fixed income investments. The value of your investment may be impacted if the issuers of underlying fixed income holdings default, or market perceptions of their credit risk change. There are additional risks associated with investments in emerging or developing markets. The information in this document does not constitute advice or a recommendation and investment decisions should not be made on the basis of it.