Why Equity Investing?

Stocks Over the Long Run

Compounding is an important term used in investing and it refers to the way gains are accumulated on investments. When an investment averages a 10 percent gain over a period of time the gains build upon themselves, or you essentially earn a higher return through increased money from previous returns. For example, say a 10 percent gain on an initial investment of $100 in the first period is a $10 return. But a 10 percent return in the second year on the beginning investment in that period of $110 (due to the prior period’s gain of $10) leads to a gain of $11. If you stretch this over many years (which we hopefully have left in our lives) then a few percentage points of return between investment types makes a huge difference.


From historical data provided by financial data firm Morningstar’s 2015 Ibbotson Yearbook we can see the compounded annual return rates across several investment types. These returns represent what investors would have received if in 1926 (when this data began to be gathered) they invested $1 in stocks of large-sized companies, long-term debt issued by companies, Treasury debt of long, intermediate, and short maturities, and a measure of general price increases over that time period. The returns are a compounded average accounting for all interest and dividends received being reinvested in more shares or bonds. This is not a picture of actual price movement of each asset (as prices were very volatile over the period and didn’t follow these patterns), but rather the change in the size of your initial investment through investing in each type of asset beginning in 1926.

Since 1926 through the end of 2014 stocks of large-sized U.S. companies have averaged a 10.1 percent annual compounded return through capital gains (a rise in their share prices) and dividends (quarterly cash payments, which were reinvested in more shares). In the same period, longer-term corporate bonds returned 6.1 percent annually. Over this significant time horizon, which contained historical events as dramatically bad as the Great Depression and World II, this 4 percent annual asset price differential received by investing in equities as opposed to fixed income would have created $5,316.85 in stock value versus and an ending bond value of $189.76! The long-term benefits received with taking on more risk with stocks speak for themselves! The returns for taking an additional risk by investing in small company stocks were even higher over this period providing a 12.2 percent annual return.

But, to be honest, the recent past has been a brutally tough period for stock investors. Combining the technology bubble in 2000 (which led to overpriced stock prices and preceded a minor recession beginning in early 2001) and the most recent housing bubble and financial meltdown (which led to the longest and deepest recession since the Great Depression) has led to weaker than average historical returns for stocks.

 

The S&P 500 is a popular index that tracks stock prices for the 500 of the largest U.S. companies. The index does not account for dividends paid to investors which effectively understating actual returns by about 2-3 percent each year. This also removes the compounded return investors receive by using their dividend payments to buy more shares of stock.

This is to suggest that stocks over the short term are more volatile yet over longer holding periods their returns tend to outperform fixed income. The single worst equity return in a calendar year was -43 percent in 1931. Yet if we look at 20-year holding periods ranging from over the past 86 year period in the Ibbotson Yearbook data the lowest 20-year return for large company stocks was +3.11 percent (the best was 17.88 percent). If you stretch your holding period to 30 years then the lowest annual return moves to 8.5 percent (the best being 13.7 percent)!

This goes to show that over the longer time horizons that equity returns tend to revert to their long-term averages as the various economic cycles balance out with higher returns prevailing over losing years. Over this period 65 years out of 89 provided positive equity returns (73 percent), but over longer holding periods stock investors are rewarded for taking this short-term risk through longer-term higher returns. However, attempting to time when exactly the market will rise in the short run is perilous as many individual investors time the market incorrectly and sell after a decline and fail to buy before a market rise. This problem is solved by staying invested through all market cycles.

In the short-term, our economy and economies worldwide face tough issues like high unemployment, tight lending conditions, weak demand for goods and services, and an uncertain solution to politically important items like entitlement reform and deficit reduction.

In the long-term stocks will be driven by the “long-term bets” which we covered in the equity overview section: A company’s continued growth and success seen in their ability to reach new customers across the globe, their use of technology to improve the efficiency of their operations and to develop innovative new products, the continued growth of the global economy, and the success of globalization and capitalism.

Don’t let the negative portrayals of the current economy cloud the long-term view of the world. Make investments now, and continue to invest in equities over many years to participate in the long-term exponential growth of your investments! Focus on the long-term and invest accordingly.

Breaking Down a Stock: Details of a Stock in Plain-English

There is an ocean of information available in regards to each stock, and at times it can be overwhelming. Hundreds of different economic indicators and news items guide stock prices over the short-term as traders place bets on near-term results of a company and the economy overall. Deep analysis is done on every aspect of a company’s current health and models of their future health, and you can see how it seems there are hundreds of financial experts on media outlets on both sides of every argument pertaining to a company’s near-term picture (that’s why CNBC has 30 people talking at the same time and it just ends up “rabble rabble rabble blah blah blah” as everyone argues counterpoints at the same time).

Thankfully young professional investors don’t have to focus on a lot of this. We will go through a lot of basic information provided on a stock since it is useful to know, but since we are placing long-term bets and not focused on predicting the near-term future (which is nearly impossible) then much of this analysis doesn’t pertain to our investment decisions. We have already seen the argument for investing in stocks over the long-run, so we will stick with that and let everything else run its course!

We are going to take the ocean of information provided about a stock and summarize it into three points to explain what drives the price of a stock. Add these to our long-term bets that we mentioned in the previous section that describes what drives a company’s success in the long-run, and we have enough of a picture to explain a stock price!

Dividend Stream:

Remember how a company generally looks at all the money it earns after paying interest to bondholders and paying taxes (net income), decides what it needs to keep to reinvest in new projects, and sends the rest off as a dividend payment to shareholders. When a company begins paying a dividend this represents a cash flow to the shareholder, and generally, under stable economic conditions, financial professionals can model this stream of cash for many years into the future based on many assumptions about the company’s business and economic conditions.

Without providing the detail on the math used to place a value on a stream of future dividends or how to actually model them, we will just break down three inputs in the equation:

1. Current dividend: In theory, if the company is paying a dividend now then the stock should be more valuable all other things equal. The bigger the better. Firms that don’t currently pay a dividend are likely companies that are growing quickly and need to keep the cash to reinvest in their business instead of paying it to shareholders. Once their growth slows they will likely begin paying dividends at some point in the future, and this is when the stream of money to the shareholders begins to be modeled.

2. Company risk: All else equal – the less risky a company is the better. If a company is currently paying a big dividend but they are involved in a very risky business (and their net income has been historically very volatile) then you can’t be assured that this dividend will continue forever. However, for a company in a very stable business there is less risk involved and thus a better chance of stockholders getting this dividend. If a risky company finds a way to lower their risk (ie due to a new product patent, or they signed long-term business contracts) then with that lower risk profile their share price should rise.

3. Company growth: Perhaps the most important and price-sensitive variable is the company’s growth. If a company is able to consistently deliver growth in their earnings then they will be able to continue to pass more money to shareholders. A company that pays a huge dividend now but that is unlikely to find steady growth in the future is not as attractive as a company who might pay a lower dividend now but has much more promising prospects to deliver long-term growth.

Company Buyout Prospects:

Small investors will usually focus on dividends as the source of their cash flow on their investment. But larger institutional investors and also companies themselves constantly analyze other companies and their ability to generate cash and earnings to see if they would be an attractive target for a takeover (thus the overall cash flow of the smaller company would become theirs should they purchase the smaller firm).

A company that is able to generate a lot of cash in their regular course of business by making money without having to continually spend a lot of money to keep the business going (known as positive cash flow) is a very attractive company for other firms. If a company in a similar line of business sees a smaller firm with these characteristics and other higher growth opportunities then they could acquire the company by buying all of the outstanding stock of a company.

However, they must offer a hefty premium to convince the smaller company to accept their offer. A company that wants to acquire another company has historically on average paid about a 30 percent premium to the current share price of the smaller firm in order to get them to agree to the deal. Investors look for companies that could be a target for a takeover due to the potential for an immediate sizable return. Therefore your company’s stock value will be higher if they generate solid cash-flow, have high growth prospects, and set themselves up to be purchased by other companies and large investors.

Relative Valuation:

The third main driver of a stock price is its relative valuation – or the price of a company compared to other similar companies in the same industry.

A common measure of a company’s value is their “price to earnings” or “P/E” ratio … seen as their current stock price divided by how much money they are expected to earn next year per share of stock outstanding. As of June 2016, this ratio on average for large U.S. companies was about 16:1 – or stocks were priced at $16 for every $1 the company is expected to make per share over the next year. So, if a company earned $3 million and they had 1 million shares of stock then they earned $3 per share. So, the average market ratio would suggest this company should have their shares priced at $48 (16 x $3).

This ratio will vary greatly across companies – generally with older and slower growing companies having P/E ratios below average, and younger and faster-growing companies having ratios above the average. But if two companies are very similar in that they have the same earnings, same growth prospects, and the same risk involved with their business … and one company is priced much more expensively (say with a P/E ratio of 20) and the other company is priced lower (say with a P/E ratio of 10) then investors will in theory buy the lower priced company and drive their share price higher and sell the expensive company which drives that share price lower.

Stock Information Basics:

Here we won’t try to teach you how to pick a stock, but rather explain what are all the data associated with a stock quote from a major news outlet. Some sites provide varying information, but these main categories should exist in almost all of them:

Example Company

(NYSE: XX) The first potion is the stock exchange on which the company trades. In this case, the New York Stock Exchange. “XX” is known as the “ticker”… or the symbol under which the company trades. You will use this symbol whenever you want to buy or sell shares of Example Company. Every stock on an exchange has their own unique “ticker”.

Last Trade: 60.07 The price where the shares last exchanged hands from seller to buyer
Trade Time: 2:53PM EDT When the last trade occurred. U.S. stock markets are open from 9:30 to 4:00 EST weekdays excluding certain holidays
Change: 0.68 (1.12 percent) Where the shares last traded compared to where they closed trading yesterday
Prev Close: 60.75 Where shares stopped trading during the previous trading session
Open: 60.55 Where shares began trading at the beginning of this session. Prices can move when markets are not open due to trading on other exchanges and “after hours” trading
Bid: 60.07 x 200 Bid refers to buy – and this is where someone is offering to buy shares. They want to buy 200 shares at $60.07 each
Ask: 60.08 x 5200 Ask refers to sell – and this is where a seller is offering to sell 5,200 shares at $60.08 each. When the bid and ask prices meet, a trade takes place. A highly liquid, or frequently traded stock like XX will have a very narrow spread between the bid and ask price

 

Day’s Range: 59.85 – 60.63 This shows the range in prices the shares have traded at in this trading session
52wk Range: 39.37 – 64.58 These are the low/high closing prices of the stock in the past year
Volume: 5,624,800 Volume refers to how many shares have traded in this session. Over 5.6 million!
Avg Vol (3m): 14,277,100 However 5.6 million is low compared to the 14.3 million shares of this stock that normally trade each day based on the average of the last three months
Market Cap: 170.48B Market capitalization (market cap) is a frequently used term to tell the value of the company. It takes total shares outstanding and multiplies that by the current share price. Combined, all stock shares at this date were currently collectively worth over $170 billion!
P/E (ttm): 14.61 P/E is a common ratio that describes the value of a share of stock. It divides the current price of the stock by how much money the company earned per share over the last twelve months. This ratio can also be stated based on the expected earnings over the next twelve months (showing the value of a share while factoring in next year’s expected earnings growth). “ttm” here suggests trailing twelve months, so it is based on what the company earned last year.
EPS (ttm): 4.11 Earnings per share – all the money the company made last year divided by how many shares of stock currently exist
Div & Yield: 1.93 (3.20 percent) This shows the dividends paid per each share of stock to shareholders. The yield takes this annual dividend amount ($1.93) and divides that by the current price of the stock ($60). Dividends here are quoted as the annual total while they are paid each quarter (every three months) … so each shareholder gets $0.4825 per each share they own every three months. Dividends are subject to change at any time – up or down – but in healthy economies, they will generally rise slowly.

Company Financial Statements:

Without getting into too much unnecessary detail here we just wanted to briefly go over three critical pieces of information that provide a picture of the health of every company, and thus their stock as well. All companies that issue shares to the public must report their financial health to the Securities and Exchange Commission (SEC) every 3 months as well as an in-depth annual report so investors have a clear picture of how the company is performing. You will encounter these three statements and will likely read the professional analysis of them that breaks down how a company is performing.

  • Income Statement: This statement shows over the three month period (or annual period if provided in the annual report) how much revenue the company received, what their costs were, and how much money was left as profit for shareholders. Comparing this report to previous statements could show whether sales are increasing attractively, expenses are growing too fast, and how much money is left as earnings to shareholders over time.
  • Balance Sheet: The balance sheet takes a “snapshot” of the company at the end of the three month period and shows what the company owns (assets), what they owe (liabilities), and how much the company is worth (shareholders equity … also calculated as assets minus liabilities). A company with low levels of cash and high levels of debt coming due (in the form of their bonds maturing) could lead them into bankruptcy if they are unable to find money to pay these obligations.
  • Cash Flow Statement: “Cash is King” is a frequently used nerdy term used in financial jibber-jabber, but it is important that a company has cash available to pay off their debt and invest in new projects. This statement shows the sources (inflows) and uses (outflows) of cash over the three-month or annual period. If a company is not generating cash in the normal course of their business then they might have to borrow more money to pay bondholders or invest in new projects.

Stock Market Breakdown:

So we’ve gone through many of the specific terms and descriptors about an individual stock … so now we’re moving on to describe measures of the total stock market (Oh boy, oh boy sounds fun! Hang in there and keep learning … you could wind up a millionaire one day because you did.)

The popular press quotes several indices which measure the broad movement of the prices of stocks. Remember, these indices do not reflect the returns received by stock investors in the forms of dividends … they only account for the changes in prices of the underlying stocks within the index. Three of these indices are frequently used, but there are literally hundreds of others that track movement in a specific type of company or that look at international stocks. Here are the main three you should know:

  • Dow Jones Industrial Average (DJIA):
    This is probably the most popular measure of stock prices, but not the best. This measure follows 30 of the largest companies in the U.S., and its movement is based on how each of the underlying 30 stocks did during that day. It is known as a “price-weighted” index – where the companies with the largest share price have the biggest impact on the index. This is misleading since it doesn’t track the true value of the stocks (known as market capitalization = share price x shares outstanding) but rather is based only on the price of the stock. (Whoop that knowledge out at happy hour and impress some friends!!!)
  • NASDAQ:
    The NASDAQ is primarily known as the main stock exchange (alongside the New York Stock Exchange), but they also issue an index that shows the movement of the 3,000+ stocks that trade on the NASDAQ exchange. This is a value-weighted index – so the companies that are worth the most (high market cap) and their respective price movement have the most impact on the index. Due to the high number of technology and smaller firms that trade on the NASDAQ, this index is generally seen as a barometer for the price movement in growth and technology companies.
  • Standard and Poors 500 (S&P 500):
    The S&P 500 is a much better measure of total stock market movement since it includes about 500 of the largest companies in the U.S. (compared to 30 for the DJIA), is a value-weighted index (so it tracks the true market value of companies and not their stock prices), and it covers all sectors of the economy (unlike the technology-heavy NASDAQ). The roughly 500 companies that are in this index are collectively worth about $19.3 Trillion (as of October 31, 2016), or roughly 80 percent of all the value of public stocks in the U.S.

Within the S&P 500 are 11 general categories of the economy under which every company falls. By looking at each sector’s weight in the S&P 500 index we can get a sense of what type of companies drive the U.S. economy. The companies you own shares of stock in should resemble these proportions since you want to be diversified across all sectors of the economy. That way if one type of industry performs poorly (but others perform well) then your stocks won’t be focused on the losing sector.

Source: Standards & Poors
  1. Information Technology (23.8 percent): Being the largest component of the S&P 500 index shows how powerful a part technology firms has become in our economy. But in the early 1990’s this sector had only about a 5 percent weighting on the index! During the technology bubble days of 1999-2000 this sector reached upwards of 30 percent of the index when technology firms were priced very unreasonably at the onset of the internet era. Companies in this sector range from software makers, hardware manufacturers, internet services firms, semiconductor makers, data storage firms, and many other technology service firms. These firms have seen remarkable growth in a relatively short time, and will likely continue to do so due to the continued improvements in technology.
  2. Financial Services (14.8 percent): Before the financial collapse this sector held a dominant lead over the IT sector as the largest in the index at well over 20 percent (perhaps a sign that things were getting a little out of control), but the struggles of many of these firms and the resulting drop in their share prices and market values dropped them to the #3 spot. Financial firms continue to adjust their businesses following the powerful recession in 2007-2009 and the resulting legislation and regulations issued thereafter.
  3. Health Care (13.8 percent): Health care leads a group of three sectors whose importance to this index (and thus also our economy) are very similar. The uncertainty of health care legislation and further reforms will likely persist, but these firms will continue to benefit from a growing population of old-folks in our country and around the world. Drug companies continue to invest in research and development of new medicines to replace their drugs that may be losing patent protection in the years ahead.
    Companies in this sector range from drug researchers and manufacturers, medical device makers, biotechnology firms, health insurers, and hospital operators.
  4. Consumer Discretionary (12.2 percent): This sector feeds off of one of America’s greatest strengths – our ability to buy crap we don’t need. Discretionary items contrast to staple items in that they are our purchases of items that we don’t need on a daily basis but that we like to have. This sector is also extremely mature and competitive and includes auto-makers, retailers, restaurants, and media firms. Companies in this sector are more susceptible to swings in the economy since when Americans lose their jobs or their income’s fall then they will likely forgo their $5 daily latte at Starbucks before they discontinue their staple purchases like milk and toilet paper.
  5. Industrials (10.3 percent): This sector may be easiest described by those firms that make heavy equipment, their suppliers, and the firms that move these goods. Examples would include defense companies, construction equipment makers, engine makers, residential homemakers, and shipping and railroad companies. The industrial and manufacturing sector has been on a steady decline in terms of overall importance to our economy over the past 30+ years with advances in technology and outsourcing, but the share of manufacturing’s importance to the U.S. economy has grown coming out of the recession as it has become relatively cheaper to make products in the U.S. instead of overseas. Many of these firms in the U.S. are old and have unionized workforces which can be unfavorable for stock investors due to their ability to negotiate high labor costs.
  6. Consumer Staples (8.2 percent): The role of consumer spending by Americans constitutes a huge role of total U.S. economic output – over 70 percent of total US economic activity is based on just Americans spending money on the stuff we consume and the services we use. The consumer staples sector is comprised of the companies that make and sell the staples of our lives, or the everyday products like packaged foods, household cleaning supplies, textiles, and the companies that distribute and sell these items (think of most of the stuff in Wal-Mart). This industry is considered “mature” since it is slower growing and there is much competition amongst firms. These firms have historically had more stable stock prices due to their strong and established businesses and large and stable dividend payments. Successful firms will be able to grow their sales by expanding internationally and into emerging markets where groups of people are just beginning to buy and use the goods we fat Americans have used for generations.
  7. Energy (6.1 percent): China recently passed the U.S. in terms of how much energy each country consumes after our country’s 100+ year place in front (but on a per-person basis we win as the most inefficient peoples of the world by a long shot). This sector includes the firms that explore, drill, refine, and distribute primarily oil, natural gas, and coal to feed the energy needs of ourselves and growing foreign economies. Improved technology has allowed these firms to more efficiently drill for oil at lower costs, drill more oil out of existing wells, and find new reserves in areas previously unreachable by drills. This increased supply, as well as ongoing pumping of oil by Middle Eastern countries, helped oil prices collapse beginning in 2015. The declining energy prices helped push down prices of these companies and dropped their weighting in the S&P 500 down to 7th place from 4th place in 2014.
  8. Materials (3.0 percent): This sector includes a wide variety of commodity-related businesses including chemical makers, miners of various metals and minerals, steel producers, and agriculture fertilizer and chemical companies. We previously mentioned that if you want exposure to commodities (whose prices rarely grow faster than the general rate of inflation) then over long time frames you will likely be better served by investing in companies involved with mining and selling those goods instead of the goods themselves. Companies that mine only a few commodities can be subject to volatility in the prices of the commodities they mine which makes share prices volatile as well.
  9. Utilities (2.9 percent): Companies that produce and distribute power comprise a small amount of the S&P 500 and are generally sought after by investors looking for a high dividend payment. Many utilities offer yields of over 5 percent since they do not offer promising long-term growth opportunities. Demand for power by big industrial consumers can fall during a recession, but with new sources of low-cost natural gas, these companies are able to produce power at a lower cost. These companies normally need political approval to raise prices which is very unfavorable for investors. Potential limits on carbon and other pollutants could impact these companies (like EPA rulings on coal-burning power plants) which will require them to source more energy from more expensive renewable sources.
  10. Real Estate (2.9 percent): The real estate sector and the related companies were previously categorized as financial companies until they were spun off into their own S&P 500 sector in 2016. The majority of companies in this sector are classified as Real Estate Investment Trusts (REITS) which are companies that own and operate real estate of many different types ranging from office buildings to warehouses to shopping malls etc.
  11. Telecommunications (2.1 percent): Another mature industry sector is the “telecom” sector which involves wired and wireless communications services. This is a very mature and competitive business whose stocks normally offer large dividends due to limited growth prospects.