Equities - Overview

Equities are perhaps the most liquid (can be easily traded) of all asset classes. They are the common stock of publicly listed companies. In essence they represent an ownership stake in a publicly listed company proportionate to the amout of shares held. Baring notable exceptions (IKEA, Mars Candies, Bechtel, Fidelity Investments, etc.) an overwhelming majority of world's top companies are public. The common stock (i.e. shares) of these companies are traded on various stock exchanges around the world. Although a primer on equities is too basic a topic for this blog, I think discussing it might still help some readers.

How does the shares come into existence? In a typical example, an entrepreneur (say Dhirubhai Ambani) comes up with a business idea and initially grows the business (Reliance Industries) with his own capital. After reaching a certain size most of these companies need a sizeable amount of capital to grow further. So the entrepreneurs (i.e. promoters) comes out with an IPO (public issue) allowing the general public to own a piece of the company and benefit from its future growth. During the initial stages, most public companies reinvest their profits back into the business for expansion purposes and after few years when they start generating excess profits the money is distributed back to the shareholders in the form of dividends.

At what prices do the shares trade on exchanges? Ideally the value of a company (also known as its intrinsic value) is equal to the present value of the future cash flows the company is expected to generate during its lifetime or alternatively it is the replacement cost of building an equivalent company. The problem is that it is very difficult to know these values with a high degree of accuracy because they depend on several factors (future demand of company's products, competition, interest rates, inflation, exchange rates, government policies, management smarts & honesty, etc.). So invariably the shares of a company trade at wide divergence to its instrinsic value based on investors perception of the value of these factors and the degree to which each factor affects the intrinsic value. Additionally the value of these factors keeps changing with time. Due to so many moving parts in the valuation equation, the share price of a company becomes quite volatile (atleast in the short-run). With prices being so volatile any wrong judgement call by an investor can lead to huge losses thus giving stock investing a connotation of gambling.

So how does one come out ahead in the stock investing game? Most people think the obvious answer is to form better insights on the plethora of variables that impact stock prices. Naturally they turn to watching CNBC as much as possible, devouring the business journals like WSJ (or Economic Times in India), reading a ton of stock posts at Yahoo Finance (or Moneycontrol) and forming an opinion about the numerous economic & financial indicators that the media throws at them. Over long term (i.e. 10+ years) the unfortunate ones drop out after suffering early losses, the reasonably smart ones (which includes a majority of investors) end up earning a return which equates to the growth rate of underlying companies profit they invest in minus the cost of playing the stock market game (i.e. brokerage & custodian charges, taxes, penalty for improperly timing their investments & investing disproportionately large sums to fiascos like Enron, Satyam & AOL-Time Warner at their peak prices). Only the incredibly LUCKY and very smart ones (< 1% of the investing population) end up multiplying their wealth several times more than reasonably smart ones (i.e. the majority). The media zealously portrays eloquent stories of these elite investors to sell more news which again breeds a new wave of aspirants for the brutal game I just explained.

I know I am again sounding like a broken record and I need to quickly tell you how a sensible investor can use the equities asset class to his/her advantage without expending a lot of effort. For that you will have to wait for the next post as we are out of time.

Asset Classes - The building blocks

Before we delve into the topic of Portfolio Management lets talk a bit about asset classes. They form the building blocks of a Portfolio. Examples of asset classes are equities, bonds, real estate (direct & indirect), commodities, precious metals (gold), private equity & venture capital. For an average (but sensible!) investor only three asset classes matter: equities, bonds & real estate (primarily indirect & direct only to the extent of personal home). I will state the reasons for this while discussing the characteristics of each of these asset classes in the next few posts.

Determining the right mix of asset classes in ones portfolio is called Asset Allocation. It is a very important part of Portfolio Management. If one were to define the essence of Portfolio Management then it would be all about Asset Allocation. According to some widely accepted academic research, sources of investment returns can be decomposed into 3 things:

• Asset Allocation: the mix of asset classes in a portfolio (e.g. 60% Stocks, 20% Real Estate & 20% Bonds or 20% US Stocks, 20% International Developed Stocks, 20% Emerging Market Stocks, 20% US REIT & 20% US Treasury Bonds)
• Market Timing: jumping into & out of an asset class with the anticipation of rise/fall in its value (e.g. trying to time the stock market)
• Securities Selection: cherry picking only a few securities within an asset class based on their attractiveness (e.g. picking winners like Infosys instead of going with large cap Indian IT stocks as a whole)

As per a famous empirical study by Gary Brinson (one of the most influential investment managers in the institutional investing landscape) & others, over 90% of the variance in returns between two portfolios can be explained by the difference in their asset allocation (e.g. if fund A generated higher returns than fund B, over 90% of that higher return can be attributed to fund A's investment in better performing asset classes). For a more detailed discussion on the importance of asset allocation please refer to two of my favorite books 'Unconventional Success' & 'The Intelligent Asset Allocator'. If you are on a time crunch, here is an hour long lecture by David Swensen on the topic.