How investments work - shares 2

Last time we looked at Steve Wood and his timber business. We saw how shares can you lose you all your money when a business becomes insolvent. We also saw how you can make money through dividends, which are how companies usually distribute profits. Finally we looked at how the share price goes up if dividends go up over the long term. As long as the company you are invested in makes profits and those profits keep going up you will do well, you will enjoy the dividends each year and at a later date you will be able to sell your shares for a higher price than you paid for them.

Investing in shares is not complicated if you take a long term view. You need to be looking at the company’s profitability both now and in the future. That means looking at what affects profitability.

Let’s start by looking at what affects a company’s profits.

In very simple terms profit is what arises when you manage to sell goods or services for more money than they cost you. In simple terms again, turnover less costs = profit. Anything which reduces your expenses as a business is good for profit as long as it doesn’t lead to you reducing your turnover! And anything that increases your turnover as a business without significant increases in expenses will improve your profit.

Let’s look at some examples. Airlines have big overheads with the high cost of buying planes and buying vast amounts of fuel. Some estimates put the cost per hour at $10,500 dollars in fuel costs for an Airbus 320. If you can buy planes that are more fuel efficient you will be able to reduce the fuel costs and therefore increase profits. That is just good business sense. But say you’re running an insurance company and you cut expenses by making your customer service team redundant, that may be bad for business. It could lead to unhappy customers, loss of reputation, fewer customers and eventually lower turnover and lower profits. I know – I watched this happen first hand over the last twenty years!

Increasing turnover without massive increases in expenses is often harder than cutting costs because the business needs to grow its market. An example of a company that did this very well was Colgate-Palmolive, when China opened up they went in. A market of over 1 billion people who value clean teeth, bright smiles and think red is a very lucky colour. As the Chinese market developed from agricultural dependency and modernised, a lot of people had a little more money to spend. One of the few new products they could afford was western toothpaste. Colgate with its red packaging only needed to increase its sales and marketing teams and increase production to meet demand. Did it work? Well since 1994 its share price has gone from $7 to over $70.

There is a saying in investment “It is better to be in a bad stock in the right sector than the best stock in a bad sector”. What that means is, if you invested in say the best performing airline and oil prices rocket you will struggle to as well than if you invested in say a poorly run semiconductor manufacturer just as the price of copper, silicon and other raw materials collapsed. (They are essential in making semi-conductors). So as well as looking at the company you need to look at the market it operates in and look for themes that will affect your investment.

Here is a list to consider,

· Water purification

· Transport

· Fossil fuels

· Car manufacturer

· Pharmaceuticals

· Robotics

· Banking

· Airlines

· Holiday companies

· Food production

Some of these areas are going to suffer in the next thirty years. Others are going to be around for a very long time to come. Car manufacturers who make diesel cars are likely to face a tough time, those who make hybrids and electric alternatives are going to do better. That doesn’t mean that you rush out and buy Tesla shares by the way. Food production is a stable market for the next generation and beyond although food tastes do change. Pharmaceuticals is an area that we are going to need for many decades ahead, there are plenty of illnesses and conditions that need treatments and solutions. Fossil fuels may be safe for a few years ahead but may not exist in fifty years from now. Banking is changing but people are still going to need to save and borrow, how they interact may move from bricks to clicks though. Holidays are unlikely to disappear any time soon but how we holiday is changing. For instance, AirBnB and bucket shop airlines have had a good run but many cities around the world are tightening up on AirBnB properties.

If you think you can pick a share and make money then you probably don’t need to listen to this podcast. For the rest of us, and yes that does include me, picking individual shares is not a skill we have. You need analysts, researchers and up to date information. That comes at a hefty price in professional fees. Without it, you will be making educated guesses at best. In the US there is a report each year for the last 25 years comparing the success of professional and amateur investors against market benchmarks called the Dalbar report . It shows that amateurs underperform significantly and consistently.

Warren Buffet has been described as the most successful investor in history and is often quoted by fund managers and financial advisers. He said in the New York Times[i]:

"Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497."

What is he saying? Essentially in the long term, share values will rise because the economy will expand. In the short term there are setbacks, recessions, crises, wars; but in the long run they don’t last forever.

In the same article he said,

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now.”

So if the greatest investor in the recorded history of the world doesn’t know what is going on in the short term, but thinks that in the long term the value of shares will rise, it is well worth listening.

Shares and interest rates

We’ve seen with the other assets that we’ve looked at that they’re keenly linked to interest rates. To some extent the same is true for shares. Let’s go back to the FTSE 100, those big name companies, and assume that the dividends they pay provide a return of 3.0% of their current share price. If interest rates on deposits suddenly shot up to 12% a year would that impact on share prices? It certainly would. Investors would receive four times as much income from deposits and the income from shares would look less attractive. In that situation you would expect the price of shares to fall until the market found its new level because people would sell. In reverse, if the FTSE 100 companies continue to increase their profits (and dividends), say doubling their pay-outs, then the yield from the dividend would go up to 6%. If interest rates don’t change, then you would expect to see the share price go up because shares would be, relatively, more attractive to investors and they would buy them.

If only life were that simple!

In reality markets don’t react directly to movements in interest rates. There is a trend over the very long term (see the graph below).The reason for that is that movements in interest rates affect companies in different ways. Banks for example tend to do better when interest rates rise because their margins increase. Conversely companies with large debt will pay more for it when rates rise and that is a straight hit on their bottom line.

In reality it takes a long time for a company to double its profits, which means it takes time to see the growth in the share price and dividend. Similarly, it takes time for interest rates to go up significantly generally they don’t jump up by several percentage points in a single day.

Don’t be obsessed with trying to predict what will happen in the short term to interest rates or any other factor that affects share prices. It will lead you to start speculating!

Long term value = smart investing

[i] Warren Buffet, Op-Ed contribution. [online] Available at:

<http://www.nytimes.com/2008/10/17/opinion/17buffett.html?_r=0>

{Accessed 5 January 2015]