007 Stocks, Shares Equities

Chapter 7 of 'There are no grown ups'

Equity ownership is ownership of an underlying ‘thing’, which might be a house, a building, a company, a vehicle, or almost any other asset. That thing might be owned just by you, or part-owned (shared) by you and someone else, or by lots of other people.

If you own a house, you own 100% of the equity. If you share ownership of a house with one other person (eg your husband or wife) and you have equal shares, you each own 50% of the equity (in some cases you might hold 100% in common, but let’s leave that to one side for the property/family lawyers to discuss). If your grandparents left their home to you and their nine other grand children, then you, and they, would each own 10% of the house.

If you own 100% of something, you only need papers to show that it is yours (eg the title deeds to a house). When you share owing a house with 1 person, or with 9 other people, just knowing that you have equal shares, and having all the relevant names on the ownership papers is probably enough. You don’t each need a bit of paper to say ‘I own 1/10th, or 10% of the house’. But what happens if one of the 10 marry, and their 1/10th becomes owned half by them, and half by their husband/wife? You then have 9 people who each own 1/10th (10%) and 2 who each own 1/20th (5%), and it probably becomes simpler to divide the ownership into eg 100 ‘shares’ each worth 1%.

The main reasons for dividing the ownership of a house, or a business, into 100 (or 1,000, or 1,000,000 or 1,000,000,000) shares are

A)    It makes administration simpler, especially when the multiple part-owners do not all have equal shares

B)    It is a step towards making it easier to buy/sell a fractional interest in the house/business. Going back to the example of the house given by grandparents to their 10 grandchildren. If some of the grandchildren want to sell, and others do not, rather than have an argument, they could divide the house into 10 shares, and allow each owner to sell or keep their own share.  The house probably yields a benefit/return to its owners. EITHER each gets to live in it for 36 1/2 days a year (perhaps this works if it is a great place for holidays) OR the house is rented out and each owner gets 1/10th of the rent (less costs).  Each share of 1/10^th of the whole is a potentially attractive asset, whether as a time share, or as a stream of rental income.

In the sixteenth, seventeenth and eighteenth centuary, when large scale trade revolved around ships cargoes, it would involve buying goods in a distant land, loading them onto the ship, sailing for several months, landing in eg London, and selling the cargo at what the captain / shipping company hoped would be a profit. The venture required money to be ‘tied up’ for several months, and involved lots of risks: the ship might sink or be stolen by pirates: the hull might leak causing the cargo to perish, or lots of other ships might have chosen the same cargo, creating a glut of supply in London and forcing prices down.

Both individual entrepreneurial captains, and trading companies would finance voyages by selling interests in their cargoes.  As cargoes were carried in ships bottoms (hulls), investing in maritime trade was called bottomry.  An investor/speculator might buy a 1/40^th share in a voyage.  In return for putting up initial cash to help finance the trip, they would get 1/40^th of the proceeds of selling the cargo.  If the voyage was a success, these proceeds would be greater than the initial investment.  Given the risk of total loss, investors with enough money to buy more than a single 1/40^th share, were usually best spreading their investments eg buying 1/40^th of 10 different ventures(voyages), rather than 10/40ths of a single voyage.  In ‘The Merchant of Venice’, Shakespere’s hero Antonio says ‘My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate Upon the fortune of this present year, Therefore my merchandise makes me not sad.’.  The wisdom of diversification is ancient.

When dealing with shipping and bottomry, an investor might buy a 1/40^th share.  When investing in a publicly traded company, you might be buying ‘common stock’ representing a billionth share.  But, whether one talks of stocks, or shares, the underlying position of an ‘equity investor’ is that they tend to risk the whole of their investment.  A lender advancing money to a business/person may have ‘collateral’ (eg a building) that, in the event of default, can limit the loss.  An equity investor has no such guarentees, they become part-owners of the business.  If the business makes a profit, they get to share in it, but if it makes a loss, they are the last in line for any cash.  In the worst case scenario where a business fails, and its assets (if any) are sold off, the cash must first be used to repay creditors (eg Banks who have lent it money, or anyone that holds its bonds), and staff must be paid any redundancy money due.  Only if there is anything left after paying all its obligations, will the owners (equity investors) be given anything.  It is not unusual for a failing business to not have enough money to pay all its creditors: if the company has debts of $100m, but disposing of its assets yields only $50m, then bond holders will probably only be repaid 50 cents in the dollar, and equity investors will get nothing.

The reason for accepting the possibility of total capital loss which comes with equity investment, is that the upside is also unlimited.  If you invest in a bond, your best case scenario is that you will be paid the defined interest payments and the eventual principal repayment.  If you buy part of a business, and that business flourishes, your upside can be vast.  If you bought Amazon in late 2001, after the dot com bubble had burst, you might have paid $8 per share, which makes the $3,000 of July 2020 look quite attractive.  In the long term, owning a good business also provides some insurance against inflation.  Even when inflation does not help the business in the short term, if it survives and prospers, the value of its returns should more than exceed the inflation.  However, most new businesses close their doors within a year or two of starting.  And, of those that don’t, employing people other than their founder/owner is the preserve of few.

Understanding equity investments requires an understanding of the underlying business:  balance sheets, Profit & Loss, the difference between business expenditure that is just a cost of keeping the doors open (eg office rent), and expenditure that creates something with value for the future (eg building an office or developing a new product / brand).  You don’t need an MBA to understand these things, but this book is not the place to deal with complex business analysis.

Lets look at a very simple business that does not need complex branding, marketing, or intricate financial structuring / controls:  A business that owns a 5 bedroom house worth £1,000,000. The business is controlled by a Director who is paid a salary which is set at 10% of the (pre salary) profits of the company. The business can make money by renting out its asset.

The initial strategic choice made by the Director is whether to let the house.  Let’s say that it can be let for £5,000 per month.  This gives £60,000 pa revenue

Costs might include

This would give a profit, before Directors pay, of £54,500

The post tax profit of £39,240 represents 3.924% of the £1,000,000 capital value.

The company could pay out all, or some, of the £39,240 as a dividend to its owners (shareholders).  Or it could keep the money in the company.  If it keeps the money then the shareholders own a business whose assets are:

If the business ownership is divided into 1,000 shares, each representing an underlying £10,000.00 at the start of the year, then by the end of the year, each share represents £10,392.40.  But that does not necessarily mean that the shares can be bought / sold for £10,000.00 at the start of the year, or £10,392.40 at the end of the year.  £10,000.00 and £10,392.40 are the balance sheet values per share at the start and end of the year, but shares almost never trade for exactly their balance sheet value.  The legendary Graham & Dodd made their name in the 1950s by buying shares for less than their underlying balance sheet value.  Corporate raiders like Sir James Goldsmith, Carl Ican, and Lord Hanson, in the 1970s & 80s made billions by buying whole companies when their shares were trading for less than their balance sheet values.  Both Graham & Dodd’s passive investment in parts of companies, and Sir James Goldsmith’s hands on buying of whole companies, made them fortunes because the assets of the companies could be sold off for more than the company itself had cost.  It is asif the shares of the company in our example were trading for £6,500.  Graham & Dodd would point out that buyers of such shares could spend £6,500 and acquire assets worth £10,000.00 to £10,392.40, Sir James Goldsmith would buy perhaps 10% of the company at £6,500 per share, then announce a takeover bid, offering £7,250 per share for the other 90% of the company.  If successful, he would own the whole company for £717,500, and could then sell the house and pocket £1,000,000.

While some unfashionable markets like Japan present opportunities to buy shares for under their balance sheet (‘book’)[1] value, a decade of QE in Europe and the USA has left precious few such bargains in the quoted stocks of the developed western world.    It is far more usual to find stocks that trade for many times their book value.  Consider Twitter, a company that looses money, but which is worth Over $20 billion.  Well publicised success stories, like Amazon & Google have lead to people being prepared to pay vast sums for companies which they hope will dominate / revolutionise the future.  Sometimes the mere presence of a ‘big name’ CEO or chairman will cause investors to pay a premium in the expectation that the star in the driving seat will achieve superior performance for shareholders.  Of course, all too often, such stars secure amazingly lucrative deals which guarantee them vast wealth whether or not the company flourishes.

Whether you are considering buying the whole business, like Sir James Goldsmith, or a fraction of it, like a Graham & Dodd passive investor (which is what most of us are, most of the time), it is probably a good idea to know

• What it does (eg owns/develops property in the case of British Land, extracts/refines/retails oil/gas in the case of Royal Dutch Shell, makes/brands/markets soap powder & consumer products in the case of Proctor & Gamble, etc)
• The underlying business model: eg in the case of Channel, for its No5 scent selling for $150, it may be: The perfume itself costs $2, Packaging $20, Marketing & advertising $30, distribution $8, Retailer mark-up $50, profit $40.  Which means that it is NOT primarily a perfume manufacturing operation, but a branding, marketing, packaging & (as it is typically sold to consumers by third party retailors) a sales-channel management operation.
• How much money it is making (or loosing), and whether these profits (losses) are rising or falling
• The prospects for future profitability. Some companies may be making a lot of money because they happened to be quite fortunate / foresighted and were ‘in the right place at the right time’: if a year is far more rainy than usual, an umbrella specialist (whether a manufacturer or a retailer) may do very well, but their ‘good year’ is not necessarily the start of a trend unless the weather has changed for the long term (ie future years will not go back to ‘normal’) AND they have a competitive edge that makes it difficult for other companies to serve the market (if lots of businesses and/or entrepreneurs think that rainy years are here to stay, what is stopping them going into the umbrella business; if the answer is ‘very little’ then the increased competition may be a bigger negative than the increased rain is a positive)
• Whether the management seems to run the business to benefit shareholders (as opposed to just themselves)

These things will lead you to think

EITHER ‘I would be interested in owning (part of) that business if the price was suitable’ (however good the business, do you really want to buy if it is priced at $100 Trillion?)

OR ‘That business is not of interest’.   There are lots of good reasons for avoiding a company, including:

• Because I don’t understand what it does and so can’t make an informed choice without spending more time on research than I am prepared to commit
• Because I don’t think that future profits will be high enough
• Because it is in a sector I don’t want to own (arms, tobacco, intensive farming, logging of the Amazon rainforest),
• Because the management are running the company for their own aggrandisement and are not for the benefit of its owners (ie the shareholders)

The last factor is often a good reason to avoid buying part of a business, but, where the management practice is egregious enough, it could be a very good reason for someone to buy the whole company and to kick out the old management.  The 1980s blockbuster ‘Barbarians at the Gate’ describes the junk-bond financed buyout of RJR Nabisco.  Robert J Reynolds was a tobacco business (it owned, among other things, the Winston & Salem brands popular in the USA), run largely for the benefit of its management. A company, other than one in the aviation business, having a corporate jet is typically a sign that management are pampering themselves.  Warren Buffett calls his own jet ‘the indefensibe’; it may be that for Buffet (who draws a salary of $100k per year, when he could easily draw more than $100m if he wanted[2]) the jet is a cost effective way to allow him to achieve more with his time, but there are few Chairmen or Chief Executives of his calibre. Robert J Reynolds did not simply have a corporate jet for its CEO, or a couple of jets, it had a fleet of 26 them for which it built its own terminal at Atlanta airport!

Rather than seeing shares as parts of a business, lots of people instead, see shares as things whose price fluctuates, and which can make them money if you ‘buy low & sell high’, this was the approach taken by the legendary Jesse Livermore and detailed in his book ‘Reminiscences of a stock operator’.  It is also the approach taken by many quantitative  /  ‘technical’  fund managers.  “Greater Fool theory” is the unusually catchy name used by economists to justify over-paying for assets: it can be rational to pay more than something is inherently worth, if you expect that someone else will soon be prepared to pay you even more for it.  And, of course, defining ‘inherent value’ can be difficult.  The pricing of assets is not an objective matter, it relies as much on psychology as on anything else.  Greed and fear are the dominant emotions driving buying and selling decisions and, while technology and businesses change, human nature does not.  It may well be that certain patterns in the movement of prices have predictive value because they put investors in a particular psychological position that they then react to in a particular way.  A ‘Head and shoulders’ pattern of prices going up a little, down a little, up a lot, down a lot, up a little, down a little, may have predictive value.  The strongest indicator I have found that it does is Richard Dennis’s experiment with ‘Turtles’.  He took 23 people without trading experience, gave them a formula to follow, and stepped back to see what would happen.  The rookies were like newborn turtles hatching on the beach, and needing to get to the sea without being eaten by the seagulls.  If success in trading was down to luck, there would be a normal distribution of winners and losers among the 23.   There was not, so there is probably something in this approach, but I dont understadn it, so I wish good fortune on those professionals that make money this way, but wont use it myself: it is probably not the best approach for someone with a job outside fund management / trading, as it relies on pretty constant monitoring of prices, and on a mental strength capable of handing big losses without going ‘on tilt’.

I find it astonishing that financial journalists looking at a business typically focus on share price & share price movements.   Whenever I see an article with a little summary box detailing “share price”, “52wk high”, “52wk low”, I am wary: if the article then does not mention total market capitalisation, or the historic & projected profitability of the business, I have difficulty seeing much value in the coverage.  I suppose one could be commenting on a change in market sentiment towards the company that is not based on changed business performance, but some publications that purport to offer serious analysis betray a lack of gravity when they focus more on share price than on fundamentals.  If one company has 500 million shares, each valued at £1, and another has 100 million shares each valued at £5, is there any significance in the different share prices?  Is the £500 million capitalisation (the same for both) not what matters?

Thinking about a company on a per-share basis can be a great way to ‘make it real’ for those of us whose minds are not naturally attuned to thinking in nine, ten, or eleven digit sums.  

What can go wrong investing in stocks?

This is a vast subject.  ‘The Intelligent Investor’ by Ben Graham, is a great book, and well worth reading (or listening to, it is available as an audiobook).   Its key message is “Don’t buy bad companies, and don’t overpay for good companies’.  Why then does it run to more than six hundred pages?  Because, while the concept is simple, following it is not easy.  The human brain developed to respond to situations in ways that improved the chances of surviving (ie being one of the fortunate ones that reached the age of 30) when mankind evolved on the planes of Africa. Fight or flight responses are ingrained in us, but they are not the best ways to manage our own balancing of greed & fear, let alone responding to price signals coming from the herd behaviour of other market participants responding to their own greed and fear.  It is all very well, and generally correct, to say ‘Be fearful when others are greedy, and greedy when others are fearful’, but that does not make it easy to follow the advice when faced with a crash & headlines predicting perpetual doom, or to sit on the side uninvested during a time of over exuberant valuations when everyone is talking about how they are making a fortune by quitting their jobs & day trading / backing ‘hot new issues’.  ‘The Intelligent Investor’ spends much of its time describing seemingly clever investment approaches that end up not working.  It is a rigorous study.  The three examples below are not; they are mere thumbnail sketches; anecdotal and incomplete, they are hardly more than a few of the ways I have managed to lose money.

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1.     Confusing a company with a sector.  This is a particular risk with early stage investments in exciting new areas of technology.   Today we look at Google, Facebook, and eBay, and think what amazing businesses they are.   But, before Google there was Yahoo, before it altaVista, and lycos.  Before Facebook there was friendsreunited.  Before eBay there was QxL.  The pioneers of the age of the motor car included Alvis, Vanden Plas, and Humber, as well as Ford & Benz.  It is very easy to get carried away with the vision of how a technology or a product can change the world, and, from that, to assume that there must be a fortune to be made for the pioneers creating that future, or, worse still, to assume that the pioneers will own the sector, and so value the business asif it is the sector .  History is littered with brilliant first movers that were out-competed by later entrants to the market.   Nor is it plain sailing for the late entrant that becomes dominant: In computing, IBM may have ‘owned’ the mainframe age, and the early parts of the PC revolution, but the PC age came to be dominated by Microsoft, which then failed to dominate a mobile age that came to be defined by Apple & others (although Microsoft is now, once again, super-profitable with its subscription pricing of Word / Excel / Outlook: however ubiquitous smartphones have become, even young people have to sit at a desktop/laptop computer for much of their work).

2.    Assuming that good management, and a great product, amount to a formula for success.  A very bright friend of mine had a publishing business, he noticed that when he went to printers to get prices for jobs, most quotations would be at similar prices, but sometimes there would be a noticeably cheaper price offered.  The cheapness was explained EITHER by human error – an estimator had messed up and quoted a price at which the printer would end up loosing money OR by the fact that the estimator had come up with a better way of running the job, which allowed cheaper delivery.   Further investigation and some modelling showed that, for a typical print shop, with the usual variety of kit, there could be literally thousands of possible ways of running a job, and the optimal way could be affected by even small changes in the number of copies to be printed, or the thickness of the paper to be used.   He commissioned some very bright programmers to build an engine that could instantly provide accurate estimates and workflow/configuration details.  There was a compelling case for printers to sack their error-prone and expensive human estimators, and use the new tool to do their estimating.  I was one of the investors in the software company that developed the tool and brought it to market.  The tool’s creation involved applying considerably more intellectual firepower to the subject of print estimation than had ever been applied before, the tool worked, and it allowed printers to cut their costs.  It should have been a winning proposition, but it was a commercial failure, because the print market was in terminal decline.  Materials that would previously have been printed were being published as websites.  Lots of everyday print jobs that would once have been bread and butter jobs for small printers, such a business cards & letterheads, started to be served by specialist printers that sold online and worked from standard price lists rather than bespoke estimates.  Having a great product is not enough, you also need the target market to have enough customers with the resources and inclination to buy it.  This was a modern version of building a better canal in the mid nineteenth centuary: at that time canals were the commercial arteries of the UK, they carried the raw materials (coal, iron ore, etc), and the finished products of the industrial revolution.  But the invention of the steam locomotive revolutionized the freight sector, however good a canal might be, in most cases, it would not be able to compete with a railway.

3.    Backing businesses in a competitive market, that have high sunk costs, but low marginal costs of delivery.  The problem here is that, once the big infrastructure investment has been made, when sales start to slow, there is a tendency to cut prices, and the logical floor to prices is the marginal cost of delivery.  If you are running an aeroplane from London to New York, and having an extra passenger costs you £30 (for the food, seat cleaning, trivial extra fuel cost to carry an extra say 100kg of person plus baggage, etc), then you are better off filling that seat for £31 + Taxes, than having it empty.  But you cant make money at that price.

4.    For a short term investment, ignoring dividend timing & when stocks move from ‘cum div’ to ex div’.   This may seem like a small technicality, but I remember a French banker loosing c£250,000 when selling a FTSE-100 index put (see the chapter on derivatives for an explanation of Put options) because he didn't notice that the expiration date was the day that lots of stocks in the index moved from ‘cum-div’ (ie the buyer of the stock gets the dividend due to be paid from profits already made)  to ex-div (ie while the buyer gets the stock, they will not get the already-declared dividend that is due to be paid imminently; the seller keeps the dividend).  If the declared dividend is c3% of the stock price, the day the stock goes ‘ex dividend’, the price will usually fall by more than 2% (possibly due to the different tax rates that apply to capital gains and dividend income, the price fall is typically less than the dividend, c3/4 of the dividend is typical)

5.    Not understanding how the company makes its money (ie the actual business that it is in).  You might think that this is ‘obvious’, but the ‘obvious’ answer may well be wrong.  Mark McCormack whose IMG revolutionized the way professional sportspeople and sports are managed/marketed, talks of the CEO of Rolex being asked ‘How is the watch business?’ only to reply ‘I am not in the watch business, I am in the luxury business’.  There are lots of areas of insurance where, historically, insurers have had overheads & claim costs that equal or exceed the insurance premiums received: they have made their money from the fact that they get the premium up front and don't have to pay claims until months or years later, and during that time they have invested the money and made profits[4].  N Taleb observes that most Restaurants are not enterprises that try to make money by selling you food, but, rather, sell food at close to cost in the hope that, while eating, you will buy expensive alcoholic drinks (with a 200-300+% markup and, unlike food, requiring little by way of costly preparation, risk of unused stocks spoiling, etc).   I am told by several local retailers, and in particular our local toy shop, that they usually loose money from January to November: more than 100% of their annual profits come from 1^st-24^th December.  As Uber manages to loose money even in markets where it is well established, many people have suggested its owners will only make money when self-driving cars allow it to avoid the tiresome business of paying its drivers.  If you don't know the game that the business is trying to play, your investor’s role as ‘scorer’ is impossible: when a football player picks up the ball and runs, is this good play (Rugby football, american football), or a foul (association football)?

6.    Believing that, during the initial stages of looking at a market/sector, you have identified a ‘once in a lifetime opportunity’.  In my late teens and early 20s I often thought I had come across such things, before I realized that ‘once in a lifetime opportunities’ crop up a couple of times a year.  If you are relatively new to an area[5],  is what seems like a great deal/opportunity really that great.  The area already has its own professionals and, if they are not buying, it could be because they have looked at it and understand something you don't, rather because  they don't know that the possible deal exists.     One of the saddest things I see in my local high street is small independent shops/restaurants opening with a flurry of energy (and often  unnecessarily high investment in refurbishment) by a proprietor who thinks that they have a great idea that meets a demonstrable local need, only for the enterprise to close and, a few months later, for someone else to try again with a remarkably similar offering:  the footfall may be there, the demographics may be propitious, but, when a building has recently housed two upscale gastro fish and chip restaurants, and both have failed, what are the odds that a your new venture will succeed if it is another upscale gastro fish and chip restaurant[6]?

If it all seems like too much effort, you may want to consider just buying the index, or an index fund.  See ‘the Joys and Limits of The Index’

[1]

[2] As Berkshire Hathaway has a market capitalisation of >US$500Bn, the typical hedge fund charging structure of 2% would mean that, even without performance fees, Buffet and his partner, Charlie Munger, would get US$10Bn per year in fees.  So the $100m figure really is an underestimate!

[3] Further details of the colourful BCCI can be found in the 1992 book ‘A Full Service Bank: How BCCI Stole Billions Around the World’ by James Ring Adams and, Douglas Frantz

[4] My understanding here is decades old.  How the business model has responded to post 2009 QE, Zero Interest Rate Policy & Negative Interest Rate Policy, is another matter.  The point remains that one should understand a business in order to make rational investment choices about it.

[5] By ‘relatively new’ I mean that you lack the experience of those that have worked in / studied the sector/country for a few decades

[6] The site at 170 Upper Richmond Road West, London SW14 was occupied by Fish!Kitchen (expanding from their original and still successful site in Borough market), then, when that closed, Kerbisher & Malt (adding to their empire started North of the River in Brook Green) took on the site.  On Kerbisher’s demise, 2019 saw ‘What the Fish’ adding to their Hammersmith & Chiswick outlets, and I wish them well