RAMME G O R P D URED CP STRUCT

S E I T I K EQU

U

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We think in decades, not years Our investment approach is rooted in the view that there are no short cuts to success. We choose companies that we believe are undervalued by the market and we have the patience to hold these positions, sometimes for more than a decade. We also constantly look for any opportunities to increase our holdings to maximise returns. Which may explain why we’ve been acknowledged as the best-performing and most consistent fund house of the last decade up to July 2013 by FE Trustnet1. Find out more about our long term approach at invescoperpetual.co.uk/uk or call 0800 028 2121. Success comes through long term thinking

This ad is for Professional Clients only and is not for consumer use. 1Source: FE Trustnet, 18 July 2013. The study of fund houses that manage at least 30 funds across the majority of IMA sectors, with at least 15 of those having a 10-year track record, showed that Invesco Perpetual had the greatest proportion of its funds in the 1st and 2nd quartile of their respective IMA sectors over 3, 5 and 10 years. The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Past performance is not a guide to future returns. Where Invesco Perpetual has expressed views and opinions, these may change. Invesco Perpetual is a business name of Invesco Asset Management Limited. Authorised and regulated by the Financial Conduct Authority. CPDS 15.12.14

To take the test go to bit.ly/UK-equities-test

UK equities

3 WELCOME TO NEW MODEL ADVISER®’S STRUCTURED CPD PROGRAMME, DESIGNED TO HELP YOU STAY ON TOP OF YOUR TRAINING REQUIREMENTS. Readers participating in the programme can claim one hour towards the CII/PFS/IFP CPD scheme for each module completed. Individual modules will publish with New Model Adviser® magazine and at www.citywire.co.uk/newmodel-adviser/cpd, and will cover a range of investment sectors, themes and asset classes as well as broader financial planning issues. Each module is designed so you can spend around 45 minutes reading when convenient and 15 minutes on the online test (at bit.ly/ UK-equities-test). If you pass with

70% or over, you will get an hour of structured CPD. We have asked industry specialists to write on their areas of expertise and hope you find the topics engaging, insightful and valuable. We always welcome feedback and there is an opportunity to register any views on this CPD experience after completing the online test. This module looks at UK equities, examining the history of the asset class, how the market has developed and how investors can gain exposure. We have also canvassed a selection of advisers to get their views on

investing in UK equities and how they employ this asset class in their clients’ portfolios.

CONTENTS The history and development of the UK equity market

4

Investing in UK equities

13

How advisers are using UK equities

22

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UK equities

To take the test go to bit.ly/UK-equities-test

4 The history and development of the UK equity market From reading this chapter, you will be able to: some of the history and • Outline development of the UK stock market

• Describe how UK equities function • List and explain the major UK equity indices some of the ways UK equities • Understand are valued

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This chapter explores the history, development and structure of the UK stock market. It gives an overview of the main UK equity indices and provides an insight into how equities are valued.

UK equities

5 When John Castaing started issuing a list of stock and commodity prices from the homely surroundings of Jonathan’s Coffee-House in Change Alley, he was laying the foundations for what would become known as the London Stock Exchange (LSE). More than 300 years have passed since those inauspicious first steps – believed to be the earliest evidence of organised trading in marketable securities in London. Today, the LSE stands as one of the oldest and most respected exchanges in the world. Not that everything has been smooth sailing since. Over the course of three centuries, there has been a devastating fire that wiped out most of the coffee shops, numerous wars, market crashes and other significant events, such as deregulation of the market. A look through the history books highlights some of the most important years, such as 1761, when a group of 150 stockbrokers formed a club at Jonathan’s to buy and sell shares.

Twelve years later, this group had a home in a building in Sweeting’s Lane that featured a dealing room on the ground floor and, of course, a coffee room above. It soon became known as The Stock Exchange. By the early 1800s, it was decided to reopen the business under a formal membership subscription basis. This gave birth to the first regulated exchange in London, while a move into a new building in Capel Court came the following year. The following century saw the first codified rule book created, as well as regional exchanges opening in Manchester and Liverpool. The Stock Exchange was rebuilt in 1854, and 22 years later, a new Deed of Settlement came into force. In 1972, the Queen opened the Stock Exchange’s new office block that boasted 26 storeys and a 23,000 sq ft trading floor. The following year, female members were admitted to the market for the first time. Major changes were afoot by the 1980s,

with the deregulation of the market, known as the Big Bang. Among the raft of changes introduced was trading moving from being conducted face to face on a market floor to via computers and telephones. As well as the Exchange becoming a private limited company, ownership of member firms by an outside corporation was allowed, all firms becoming broker-dealers were now able to operate in a dual capacity, while minimum scales of commission were abolished. In 1991, the governing Council of London Stock Exchange was replaced with a Board of Directors, drawn from the Exchange’s executive, customer and user base. Around the same time, the trading name became ‘The London Stock Exchange’. The past 20 years have seen the launch of Alternative Investment Market (AIM) – the international market for growing companies – as well as a move to a new headquarters on Paternoster Square, close to St Paul’s

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UK equities

6 Cathedral, and a merger with Borsa Italiana, creating the London Stock Exchange Group. HOW DOES THE LSE WORK? Today, the London Stock Exchange plays a crucial role in global capital markets. Offering a wide choice of routes to market for UK and international businesses, it is home to more than 2,600 companies from 60 countries across the globe. It is easy to understand why companies are drawn to the LSE’s Main Market, which is widely recognised as being the most international – and well-located – place for trading equity, debt and other securities. Listing on a stock exchange is particularly attractive when a company wants to raise a substantial amount of money. After applying to join an exchange, it must go through

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an official approval process and satisfy various legal and financial requirements. Once approval is granted, a company’s shares can be offered to investors, who can be anyone from individuals to fund management groups and institutions, such as pension funds and life assurers. The share prices will then be quoted every day on the exchange. An admission to the stock exchange enables a firm to not only access a pool of capital, but also enjoy the benefits of a higher profile. The fact that the market operates under a framework of regulation and corporate governance also gives it credence in the eyes of investors. Unsurprisingly, this makes it popular. In fact, the combined market capitalisation of companies on the Main Market is estimated to

be in excess of £3.7 trillion. There are around 40 sectors containing companies of all types and hailing from countries across the globe. According to official statistics, in excess of £366 billion has been raised through new and further issues by Main Market companies over the past decade. This capital has helped support companies through tough times and given them the stimulus to grow. DEFINING EQUITIES UK equities may be subject to countless column inches and theories, but are essentially straightforward. In their broadest sense, they simply enable you to buy into a company and enjoy part-ownership – a ‘share’ of that business. Buying a share is effectively a vote of confidence in a company. The

UK equities

7 investor is saying they expect it to do well in the future and are keen to be a part of its success. If they are right, of course, then the value of their shareholding could end up soaring. Having part-ownership also means investors get privileged access, such as entrance to annual meetings, where they can vote on important matters, such as the company’s accounts, the appointment of directors and their remuneration packages. Shareholders will also be consulted ahead of significant events, such as buying or selling parts of the company, or when the company decides it needs to raise fresh capital to develop existing business interests or begin an expansion plan. COMPANIES ON THE MARKET Being listed in London does not necessarily mean a company is

based in the UK. Many stocks are headquartered overseas, earn revenues across the world and are listed in the UK because they want to be on the LSE. Of course, there are also plenty of more UK-focused companies. Many of these will be found in the AIM for growing firms, although it will also depend on their area of business expertise. When you consider there are almost 3,000 companies listed, it is easy to understand these will vary enormously. Even though the smallest are still substantial by most standards, being valued at up to £1 million, the largest are worth more than £90 billion. These valuations are calculated by multiplying the number of shares in issue by the share price. For example, if a company has issued 1,000 shares

and each one is worth 200p, then its so-called market capitalisation will be £2,000. If the share price rises to 250p, the market cap goes up to £2,500. If, however, it slumps to 100p a share, the capitalisation would fall to £1,000. There are numerous reasons why a stock price might fluctuate and we will come to that later. As well as different sizes, companies will also operate in a variety of sectors. Even a cursory glance at listed companies will reveal everything from housebuilders and retailers to mining and pharmaceutical giants. Just about every field imaginable will be represented. The largest companies – as defined by their market capitalisations – are known as large caps and can generally be found in the FTSE 100. This is a list of the biggest companies on the

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UK equities

8 index, which are also often referred to as blue chips. Broadly speaking, these are the most popular and regularly traded companies. This means they are far more liquid than smaller names. On the next tier down are the mid caps, normally operating on the FTSE 250 index, followed by the small saps and the AIM businesses. HOW ELSE ARE COMPANIES DIVIDED? The sheer volume of stocks on the market means stockbrokers and analysts have had to devise other ways of grouping similar companies together. As a result, they have come up with a number of terms that are used as definitions. For example, defensive stocks are referred to as those likely to perform well when the economic environment

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Sector breakdown of FTSE 100 and FTSE All-Share FTSE 100

Source: FTSE (as end October 2014) FTSE All-Share

Number of companies

Weight (%)

Number of companies

Weight (%)

Oil and gas

6

16.27

23

13.97

Chemicals

1

0.37

7

0.64

Basic resources

8

8.06

24

6.91

Construction and materials

1

0.62

14

0.78

Industrial goods and services

17

6.46

101

8.83

Automobiles and parts

1

0.31

1

0.26

Food and beverages

4

5.54

16

4.97

Personal/household goods

6

10.1

21

9.15

Healthcare

4

9.65

19

8.46

Retail

8

2.98

37

3.38

Media

5

3.28

25

3.23

Travel and leisure

7

2.96

35

3.76

Telecoms

2

5.12

8

4.55

Utilities

5

4.6

8

4.05

Banks

5

13.88

7

11.42

Insurance

10

6.3

24

5.83

Real estate

4

1.45

45

2.57

Financial services

5

1.07

208

5.86

Technology

2

0.98

22

1.38

UK equities

9 is unfriendly. When the backdrop is depressing, these will be the names that can usually be relied on to continue delivering returns. Generally, these firms will be operating in areas less affected by cutbacks in consumer spending, such as utilities, pharmaceuticals, food and tobacco. All have been proven to be areas that maintain decent sales in tough times. Some stocks are considered cyclical. These perform better when the prevailing environment is good, but can come under pressure when things turn sour. Operating more towards the luxury end of the business world, they include retailers, travel and leisure. WHAT ARE THE MAIN INDICES? The FTSE Group is an independent organisation that creates and manages indices of shares on which companies are listed. The most famous of these indices is the aforementioned FTSE 100 of leading names,

although there are plenty of others. This index first started in 1984, with a base level of 1000 points. This figure will rise and fall in accordance with the share price performance of its constituent companies. For example, when they are soaring – as they were in the late 1990s – it stood at close to 7,000 points. Every quarter the companies in the FTSE 100 are analysed. Underperformance can result in a company falling out of the list and being replaced by another whose shares had done considerably better over the period in question. Everyone from stockbroking firms to media commentators traditionally use the FTSE 100 as the barometer of stockmarket performance. This means it is regularly quoted alongside the US S&P 500 and Japan’s Nikkei. The other indices include the FTSE 250 – made up of the 250 largest listed companies – and the FTSE All-Share, which includes

virtually all the companies on the Exchange. Investors who want broad exposure to any of these indices can buy ‘tracker’ funds for the purpose. WHAT AFFECTS SHARE PRICES? A wide variety of issues can influence share prices, but these can be broadly boiled down to company-specific factors and the wider economic environment. Top of the list will be a company’s financial results. These are published twice a year and provide a detailed look at how a company has been performing and its future prospects. In addition, listed firms have to provide biannual trading updates, which serve to update the market as to how the company is doing and particular positives or negatives. The reaction to these financial figures and statements is usually responsible for the most significant share price movements. Also influential are company plans. For example, companies are required to notify

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UK equities

10 the market of any events that may have an influence on its share price. These factors can include takeover bids received or the launch of a new product. All such news is shared via a regulatory news feed – known as the Regulatory Information Service (RIS) – and will be scrutinised every day by market watchers and investors. Reaction to news announced will have a bearing on the share price. Share prices can also be moved in unofficial ways. Articles in newspapers that either reveal information that the company is yet to make public or something that will have a major impact on its trading environment, such as problems with a rival business, can also have an influence. If a company is performing well, and is expected to continue to do well, this is likely to be reflected in its

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Annualised performance of FTSE indices (%)

Source: FTSE

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

FTSE 100

11.2

20.8

14.4

7.4

-28.3

27.3

12.6

-2.2

10

18.7

FTSE 250

22.9

30.2

30.2

-2.5

-38.2

50.6

27.4

-10.1

26.1

32.3

FTSE Small-Cap

14

22.4

20.6

-10.5

-43.9

54.3

19.5

-12.5

27.8

32.8

FTSE All-Share

12.8

22

16.8

5.3

-29.9

30.1

14.5

-3.5

12.3

20.8

FTSE Fledgling

23.1

21.6

19.2

-6.5

-39.4

79.8

21.8

-12.6

19.8

39

share price. As share prices tend to be forward-looking, they will rise on the likelihood of good prospects and fall if the future looks bleak. ECONOMIC ISSUES The wider environment also affects share prices. For example, when economic conditions are favourable – and are expected to continue in that way – investors tend to feel

optimistic and more willing to spend their money. As a result, companies are more likely to perform well and deliver strong profits when the economic climate is benign. This means there is a better chance of companies paying rising dividends. In turn, this will create more demand for their shares and prices will rise. Conversely, if the economic climate

UK equities

11



VALUING UK EQUITIES While analysing equities is part and parcel of fund manager fees, it is useful to have some understanding of how businesses are valued as it ultimately dictates what returns they will provide. Forbes Magazine has listed these key valuation metrics: Price-earnings ratio (P/E): Calculated by dividing earnings per share by the stock price, this number reveals how many years’ worth of profits you are paying for a stock. Price-earnings growth (PEG) ratio: The PEG ratio attempts to measure how much of a discount or premium you are paying for growth. The calculation is to divide the P/E by the long-term annualised percentage growth rate of earnings, ideally the next five years’ worth. A result of less than 1.0 implies the market is not fully valuing the prospects for future growth. Price-to-sales: Similar to the P/E, price-sales divides the market capitalisation of a stock by total sales over the past 12 months instead of earnings. Because there are times when cyclical companies have no earnings, the price-sales multiple can be a better indicator of a company’s relative value than P/E. Price-cashflow: This measure is obtained by dividing the market value by operating cashflow over the

prior 12 months. It strips out items like amortisation and depreciation from earnings and focuses on cash generated by the business. Price-to-book: This tells you how much you are paying for every pound of assets owned by the company, calculated by dividing the market capitalisation by the difference between total assets and total liabilities. The idea is to approximate how much money you could put your hands on if you shut down the business and sold off everything. As with most price multiple metrics, price-to-book is best used by comparing present multiples with historical averages. Debt-to-equity ratio: Debt-equity ratio is a measure of financial leverage, telling you the percentage of a company’s assets financed by debt. The formula is to divide total debt (or just long-term debt) by shareholder’s equity, two items both found on the balance sheet. Return on equity: ROE measures a company’s efficiency at generating profits from money invested in the company, and is derived by dividing net income by shareholder’s equity. When comparing competing investments, stocks with higher ROE demonstrate they can produce more profit from each pound of equity and, all else equal, should be considered the superior choice.

Return on assets: Similar to return on equity, return on assets is a measure of management effectiveness obtained by dividing net income by total assets. A company with a higher ROA is usually preferable to one with a lower ROA, since it shows the ability to grow profits more efficiently from a given base of assets. Profit margin: This shows how much a company earns from each pound of sales and is arrived at by dividing profit by sales. The number you get depends on the kind of profit you choose. Gross profit, which is sales minus cost of sales, is the simplest measure. Operating profit is gross profit less overhead items, and net profit (income) is what is left after paying taxes. Dividend payout ratio: If you are looking for yield from your equities, a fat dividend yield can appear quite enticing, especially in a low interest rate environment. The danger of a high yield is that it can be unsustainable, and when eventually cut, you do not only lose out on the income, but the share price will often take a hit. The dividend payout ratio is computed by dividing earnings per share by annual dividends per share. Gearing: This compares the amount of money in shareholders’ funds with a company’s external liabilities. High gearing, therefore, would be riskier, although this might be explained away by a company needing high levels of debt to finance its growth.

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UK equities

12 is more challenging, customers are less likely to part with their cash and this can make investors feel nervous. They will understandably worry that the profits of the company they have invested in are likely to suffer. This translates into less demand for the shares – or even shares being sold off – and a subsequent price drop. Of course, these fears may be without merit, which is why robust, strong companies can suffer share price falls. This can also happen in reverse: for instance, companies may have a lacklustre underlying business, but still benefit from a rising market. However, it is generally accepted that markets tend to reward robust, well-managed companies over the longer term. When you go from a long period of strong growth to a more volatile environment, in which growth is likely to remain below trend for some time, it

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refocuses the attention of investors on to these fundamental qualities. Two particular types of indicators have become vital barometers for discerning investors. First, there are those analysing business sentiment, such as purchasing managers’ indices, which are produced from surveys of conditions and what is happening at an individual company level. Second, there are studies that reveal how closely expectations resemble the reality. These are the surprise indicators and look at whether the data has been better or worse than consensus over a certain period. Both of these indicators help to build up an economic picture.

•

The history and development of the UK equity market You should now be able to: some of the history and • Outline development of the UK stock market

• Describe how UK equities function • List and explain the major UK equity indices some of the ways UK equities • Understand are valued

To take the test go to bit.ly/UK-equities-test

UK equities

13 Investing in UK equities From reading this chapter, you will be able to: the benefits of investing in UK • Outline equities via a fund the pros and cons of passively • Describe investing in UK equities

Within financial circles, it is generally acknowledged investing in equities is the best way of delivering long-term returns. Over the years, various studies have shown equities usually outperform other popular asset classes, such as government bonds, corporate bonds and property.

the different types of UK equity • Explain funds available how UK equities can help in the • Understand search for income

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UK equities

14 Everyone needs to accept investing in equities will not be without risk: history is littered with periods of poor performance and dramatic share price falls. However, shares still provide the best chance of success over a 10 to 20-year time horizon. Anyone that wants to put their money into equities will face the question whether to buy individual shares or opt for a fund. While both routes provide exposure to companies, they vary enormously when it comes to risk and potential levels of return. Buying individual shares will only give an investor exposure to a particular company, which is obviously riskier, but comes with the potential to make higher returns. A fund, meanwhile, provides diversification with the caveat of limiting the upside you can enjoy

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from rocketing single stocks. Let’s take a look at both disciplines. INVESTING IN UK SHARES UK shares provide two types of return: annual income and longer-term capital growth. Which option is the most suitable will obviously depend on an investor’s objectives as well as their attitude to risk. Most of the income on shares is provided in the form of dividends, normally paid twice a year, which are regarded as rewards to shareholders for their support. In most cases, dividends are paid when the company is in good financial shape and has cash to spare. When a company’s profits are rising, there is more chance of dividends increasing, as the company is likely to have a surplus of cash after allocating a percentage towards research and

development. The most generous dividend-paying stocks are regarded as income stocks. Growth companies, meanwhile, are generally involved in substantial investment programmes that will stand them in good stead for the years to come. Firms that are at an early stage of development often fit into this category. Profits made will be ploughed back into the business and if the company’s ambitious projects succeed, its share price will substantially increase over time, providing long-term capital growth to investors. A potential benefit of investing in individual shares is hefty exposure to the next Microsoft at a very early stage. However, the downside is the risk involved. As well as the costs, you will not have much diversification: pinning all your hopes on a handful of shares

UK equities

15 leaves you vulnerable to problems these companies may encounter. Developments in share ownership There have been tremendous advances in share ownership over the past quarter of a century, thanks largely to technology. These have made the whole process of managing a portfolio of shares quicker, cheaper and more efficient. Although shareholders can still opt to receive the paper certificates that were sent out as proof of ownership, individual investors can now choose to set up nominee accounts, which allow them to sidestep a lot of the administration and paperwork. Stockbrokers will set up nominee accounts and hold shares on behalf of their investors. While remaining the legal owners of the shares, they will receive dividend payments from

the stockbroker as opposed to the company itself. Nominee accounts have helped share trading as transactions are carried out electronically without the need for documents to be posted. As well as cutting down the costs involved, it also makes the entire process more efficient. How to pick shares Investment needs and risk appetite will dictate the type of stocks to which they are attracted. For example, those wanting regular, rising dividends are likely to be drawn towards income stocks, which are generally the more stable and reliable names. Those who are less reliant on income, but are focused on building a nest egg for the future, will be more attracted to growth stocks, especially if they are further away

from retirement and are willing to embrace riskier names in the hope of generating bumper returns. Those who are saving for a particular purpose, such as funding their child’s path through university, meanwhile, may be more risk averse. In this case, they will probably put their faith in large, unexciting companies that can be relied on to deliver steady returns. INVESTING IN UK EQUITY FUNDS A safer alternative to individual shares is to buy an investment fund. For most people, this will be a sensible option as a manager will be making the key decisions on their behalf – based on their knowledge and expertise – and monitoring the shares on a regular basis. UK equity funds allow investors to diversify their assets as well as get

CPD PROGRAMME

UK equities

16

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Passive and active management Choosing between active and passive vehicles is a key decision for investors. While both approaches are equally capable of making and losing money, there are factors to consider that will have a bearing on which is likely to be the most suitable for a particular investor’s needs. These include how much cash the investor has to put away, the length of time they are willing to tie up the money, and their attitude to risk. Passive – or ‘tracker’ funds – broadly mirror the construction and



KEY POINT

exposure to different companies and sectors. The value of funds will fluctuate depending on the performance of the stocks in which it invests. At the end of October 2014, there was more than £210 billion invested in UK equity funds, according to Investment Management Association (IMA) figures, with UK All Companies being the largest IMA sector. There is no shortage of funds from which to choose, with a basic split between those seeking income and growth, for example. A more fundamental split is between passive and actively managed portfolios. While the former will just follow a particular market, such as the FTSE 100, managers of active funds will trade assets to generate the best possible returns.

performance of specific stock market indices, rather than trying to beat them. Active managers, meanwhile, buy stocks they believe will exceed market expectations. Passive products have been around for 30 years and there is one following virtually every global stock market index these days: UK equity investors of course, will typically buy products tracking the FTSE 100, although the choice widens as the passive industry continues to develop and innovate. Index replication is achieved by

A key argument in favour of trackers is that many active managers end up underperforming their chosen index... ...however, if active managers get their calls right, they can earn bumper returns.

UK equities

17 either buying every stock in the index in proportion to its weight, or using financial instruments, such as derivatives – which are contracts between two parties – to achieve a similar result. As trackers reflect the fortunes of a particular index, they will benefit if it rises and stumble if it falls, without being able to do much in response to either scenario. A key argument in favour of them is that many active managers end up underperforming their chosen index. However, if they get the calls right, they can earn bumper returns, so managers who outperform consistently are priceless. As might be expected given the local market bias of many investors, many of the most popular active managers in the UK over recent years invest in UK equities. FOLLOW THE FUND, NOT THE MANAGER In general, the track record of a particular manager is more important than the

performance of a fund as it could have had numerous people at the helm: the strong returns a fund has delivered may have been due to a previous manager rather than the incumbent. While past performance is no guarantee of future success, these figures should be taken into account as part of the due diligence process. It is useful to know, for example, the conditions in which a manager has done well – or badly – over the past decade. If you are looking at a particular UK equity fund, meanwhile, see who has been in charge over various periods. It is also worth analysing whether periods of strong or weak performance can be attributed to particular factors, such as economic issues, investment style or a change of manager. A manager’s departure can have devastating consequences. For example, in the late 1990s, the Solus Special Situations fund was a star portfolio under the leadership of Nigel Thomas and a leading light of the competitive UK All

Companies sector. Statistics show that it delivered an astonishing bid-to-bid return of 355.07%, compared with the 96.99% average from January 1996, to the point where he relinquished control in February 2001. The following two years, however, were diabolical. From 5 March 2001 to 3 March 2003, it delivered a 57.55% loss, compared with the sector average of a 36.22% loss. While working in tough conditions in the wake of the bursting technology bubble, this meant that out of a list of 234 competitors, the fund sunk to 232nd place. For some groups, the exit of a star name can prompt dramatic action. In 2004, when Neil Pegrum decided to move to Cazenove less than 18 months after joining Insight Investment to launch the UK Dynamic fund, the company closed the fund. While the departure of a manager should trigger a re-evaluation of the holding, it does not automatically mean exiting the position.

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UK equities

18 After all, the investment house may find someone of equal – or, better still, higher – standing to take over. More groups are also starting to push the concept of investment teams, reacting against the ‘star manager’ culture that has dominated the UK fund market for more than a decade. TYPES OF FUNDS AVAILABLE The greater the risk taken, the greater the potential rewards. For example, you could plough all your money into fledgling US technology companies. Although many may go bust, you might end up backing the next Microsoft and make a fortune. While you cannot totally eliminate risk from your investments – and nor should you want to because it is needed for longer-term gains – it is possible to limit downside risk by paying attention

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to how you invest your money. Top of the list is diversification, which remains perhaps the strongest argument for collective investing, as losses suffered by some companies should be outweighed by gains elsewhere. The IMA divides funds into groups to enable comparison on a like-for-like basis. The aim is to help investors and advisers navigate their way around the universe of around 2,500 funds. For UK equity investors, the UK All Companies, UK Equity Income and UK Smaller Companies sectors are the key areas of focus, although it is important to understand the variety within those broad definitions. Within the income and smallcap sectors, for example, funds are broadly comparable based on their dividend focus or skew towards the smaller end of the market.

Even within the income sector, there have been arguments about investment styles, with some funds clearly seeking income, while others are more focused on total return. Meanwhile, UK All Companies is a much broader peer group and

While you cannot totally eliminate risk from your investments – and nor should you want to because it is needed for longer-term gains – it is possible to limit downside risk by paying attention to how you invest your money

UK equities

19

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TYPES OF UK EQUITY FUNDS Income investing focuses on dividend yield. Managers seek to provide a sustainable high yield by allocating to dividend-paying stocks. Some companies offer a high yield for a reason, however (the income stays steady while the share price declines), and most income managers look to avoid sacrificing quality for yield. That leads into the sphere of value or contrarian investing, where managers are seeking stocks that are out of favour, with the expectation that the stock price will correct upward. Academic evidence has shown this method to be particularly profitable, and it is the favoured approach of investment guru Warren Buffett. Funds following this approach are often called recovery or special situations. Finally, growth investing focuses on generating capital growth for clients. Companies that are able to grow their cashflow and, subsequently, their profits at a fast rate will generally generate capital gains. From an investor standpoint, such companies are usually smaller, younger and, therefore, higher risk. There are also funds investing according to the size of companies, with large, mid and small-cap vehicles available. As a general rule, larger companies will tend to be more stable and mature, so they will feature heavily in income-orientated funds. Mid and small caps, by contrast, are typically at an earlier stage in their life and should therefore have more in the way of growth to offer (although many will still pay dividends, as it is seen by the market as a general sign of corporate health).

should not simply be seen as a ‘growth’ sector. Across the more than 250 funds included, there are funds invested in large and mid-caps (funds focusing on smaller businesses have their own sector), plus a range of recovery, growth and special situations vehicles. Several funds called ‘focus’ or ‘alpha’ will also sit in this sector, which typically means they own a smaller number of stocks in an effort to generate strong performance. THE SEARCH FOR INCOME In the low-return world in which we live – where lacklustre rates of interest are on offer from high-street banks and building societies – people are turning towards stock markets to help them achieve a decent income. As mentioned previously, one option is to receive an income from

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UK equities

20 the payment of dividends by individual companies, or by opting for one of the funds in a sector such as IMA UK Equity Income, which gives exposure to a broad range of dividend payers. It can be tempting to buy companies that have the highest dividend yield – best defined as the dividend paid expressed as a percentage of a

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IMA SECTOR DEFINITIONS

Source: IMA

UK Equity Income Funds that invest at least 80% in UK equities and intend to achieve a historic yield on the distributable income in excess of 110% of the FTSE All-Share yield at the fund’s year end. UK All Companies Funds that invest at least 80% of their assets in UK equities which have primary objective of achieving capital growth. UK Smaller Companies Funds that invest at least 80% of their assets in UK equities of companies which form the bottom 10% by market capitalisation.

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company’s share price – especially as a number of companies are yielding in excess of 5% at the moment. However, this is dangerous, as the payment may not be sustainable. You will have to look at a company in more detail to get a clearer picture of what is on offer. Also, it is necessary to examine its dividend payment history to see what it has handed out to investors in the past. Companies perceived to be the most likely to continue paying dividends are those able to generate decent levels of free cashflow – that is effectively the amount of money they have at their disposal after paying all the various costs associated with their business activities. In many cases, these will be the blue-chip giants that have traditionally operated in areas such as tobacco, oil and pharmaceuticals. However, it is

still possible to enjoy healthy dividends from smaller companies as it all comes down to research. It is also worth bearing in mind that you can run into problems with the large and well-established dividend payers. Many of these came badly unstuck during the global credit crunch – especially banks, which struggled in the financial crisis of 2007/08 – while other prominent names, such as oil giant BP, have suffered problems that have also affected the level of income paid out. FUND CHARGES While much of investors’ focus will be on choosing the most suitable fund and manager, it is very easy to overlook something that can have a dramatic impact on the returns enjoyed: charges. It is vital not to underestimate their effects because charges levied by

UK equities

21 Companies perceived to be the most likely to continue paying dividends are those able to generate decent levels of free cashflow – that is effectively the amount of money they have at their disposal after paying all the various costs associated with their business activities.

fund management groups can wipe thousands of pounds off the value of investments. It is, therefore, crucial that investors know what they are being charged for and how much it is going to cost. The charges faced by investors are either initial or ongoing. The initial charges include entry fees, which can be up to 5% where levied, and exit charges, while ongoing include administration, operational expenses and investment management. On top of that are trading costs that occur when managers buy and sell holdings. In some cases, there are also performance fees, regarded as a way to reward the investment manager for superior returns or outperforming targets. However, these are charged by less than 100 out of around 2,500 UK-domiciled funds.

Investing in UK equities You should now be able to: the benefits of investing in UK • Outline equities via a fund the pros and cons of passively • Describe investing in UK equities the different types of UK equity • Explain funds available how UK equities can help in the • Understand search for income

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CPD PROGRAMME

UK equities

To take the test go to bit.ly/UK-equities-test

22 How advisers are using UK equities From reading this chapter, you will be able to: the potential role of UK equities • Understand in client portfolios potential issues with too much of a • Explain local bias in portfolios

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Independent advisers are enthusiastic users of UK equities, although how they employ this asset class in their client portfolios depends on the requirements and attitudes to risk of their clients.

UK equities

23 Geoff Penrice, chartered financial planner with Astute Financial Management, says all the firm’s portfolios have exposure to UK equity funds, with the proportion dependent on the level of risk. ‘This increases from 22% in a cautious portfolio to 70% in an adventurous portfolio, with around 42% in a balanced portfolio,’ he explains. ‘For diversification, around 40% of the equity exposure is in the UK, with a further 40% in developed markets and 10% in emerging.’ UK and developed equity exposure, meanwhile, is further subdivided with 60% in large cap, 20% in small cap and 20% in value. ‘The large-cap exposure gives medium to long-term growth and a yield of around 3.8%,’ he adds. ‘Small-cap and value funds have a higher potential for long-term growth, but greater volatility, and a lower yield of around 2%.’ Penrice, who also uses tracker funds to

access UK equities at a lower cost, says the main reason for investing in the local market is to provide medium to long-term growth, along with the potential for an increasing income. ‘We have a UK equity bias as most of our clients are UK-based and, therefore, investing in sterling reduces currency risk,’ he adds. ‘As part of a portfolio, they are mixed with other lowly correlated assets, such as fixed interest and property, to provide diversification and reduce the volatility of the portfolio. ‘ Elsewhere, Justin Modray, founder of Candid Financial Advice, uses a variety of active and passive UK equity funds to provide core stock market exposure. This is usually complemented by exposure to other stock markets and asset types to provide all-round balance. ‘Some UK equity funds can also be a good source of income thanks to attractive dividends,’ Modray says. ‘They also stand a

reasonable chance of delivering income and growth that keeps pace with inflation in the long term.’ He says some UK equity funds are orientated towards growth, some towards income, while others strive for a mix of the two. He points out that stock market exposure usually generates better returns than fixed interest or commercial property. ‘UK exposure is desirable as it removes currency risk for UK investors, albeit obviously not at the underlying company level,’ he adds. ‘The UK stock market is also a pretty reliable source of dividends versus overseas markets.’ Dennis Hall, chief executive officer of Yellowtail Financial Planning, uses UK equities as part of a long-term holding in the company’s model portfolios – but typically would not have more than 30% of the overall portfolio in this area of the market. In addition, holdings would be subdivided into large-cap, growth and value.

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UK equities

24 ‘The UK market represents approximately 8% of world market cap, so it should at least have some representation at this level,’ he says. ‘As our clients live and spend in sterling, we increase the weighting over and above the geographic market cap, although it should also be remembered that around 70% of FTSE earnings comes from overseas activities.’ Yellowtail does not generally invest in income units, unless there is a specific income need. ‘Neither do we look for funds with an income bias, except for a small number of people who want to derive a natural equity dividend income stream,’ he adds. David Burren, managing director of Warwick Butchart Associates, describes the company as a heavy user of UK equity funds and says it has embraced most investment styles, including conviction and contrarian investing, over the years. ‘Through investing in the UK and companies we know and understand, and with corporate governance we mostly trust, we can gain very

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good access to markets, not only in the UK, but also overseas,’ he explains. Such companies also resonate with the firm’s clients. ‘These are names they know and will understand,’ he adds. ‘It is largely a wellresearched market and offers opportunities, as well as being pretty liquid.’ However, Burren accepts UK equities will not be for everybody. ‘The UK has produced good results and clients like it because it’s generally delivered what they have wanted over the longer term,’ he says. ‘However, we see clients whose risk profile means an asset class, such as UK equity funds, is not appropriate, as the volatility that should be part of this market is unsustainable.’ For most clients, UK equities form a very large part of their overall portfolios, says Jason Witcombe, director of Evolve Financial Planning. ‘We primarily use a FTSE All-Share tracker fund, rather than a FTSE 100, because we believe in following the widest possible index to give clients the most diversified exposure and access to as

As our clients live and spend in sterling, we increase the weighting over and above the geographic market cap, although it should also be remembered that around 70% of FTSE earnings comes from overseas activities Dennis Hall, Yellowtail Financial Planning

UK equities

25 many companies as possible,’ he adds. There are, he suggests, a number of reasons why such an asset allocation makes sense, with currency risk being one of the most significant. ‘The UK is also a pretty global market and a high percentage of its earnings comes from overseas,’ he adds. However, Andrew Merricks, head of investments at Skerritts, believes there is a fear some people could have far too much exposure to the UK, which might not be suitable in certain circumstances. ‘A lot of people invest in the UK because they are familiar with the names, and feel comfortable having the likes of Lloyds Bank, M&S and BP, but that is providing a bit of false comfort,’ he says. ‘I like the idea of treating us as just another part of Europe.’ Exposure to UK equities should at

least partly depend on the backdrop, he suggests, pointing out he has been reducing his own exposure over the recent months in anticipation of the market becoming anxious ahead of next year’s general election. ‘Markets do not like uncertainty and I think there will be uncertainty as we head towards May, which means it is not the time to be increasing UK exposure,’ he says. ‘My feeling is that the markets will react badly if Labour or a Labour coalition gets in because they quite like what the Tory coalition has been doing and we are recovering better than Europe.’

How advisers are using UK equities You should now be able to: the potential role of UK equities • Understand in client portfolios potential issues with too much of a • Explain local bias in portfolios

•

CPD PROGRAMME

UK equities

To take the test go to bit.ly/UK-equities-test

26 TEST To receive your full hour of structured CPD, go to: bit.ly/UK-equities-test and take the test online. If you get 70% or above, we will send you confirmation that you have successfully completed the module. Passing the test and claiming the hour of structured CPD confirms an individual’s technical knowledge, experience and ability to provide training to intermediate/ advanced level to the quality standards of the CII, PFS and IFP. For any feedback, please email: [email protected]

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We think in decades, not years Our investment approach is rooted in the view that there are no short cuts to success. We choose companies that we believe are undervalued by the market and we have the patience to hold these positions, sometimes for more than a decade. We also constantly look for any opportunities to increase our holdings to maximise returns. Which may explain why we’ve been acknowledged as the best-performing and most consistent fund house of the last decade up to July 2013 by FE Trustnet1. Find out more about our long term approach at invescoperpetual.co.uk/uk or call 0800 028 2121. Success comes through long term thinking

This ad is for Professional Clients only and is not for consumer use. 1Source: FE Trustnet, 18 July 2013. The study of fund houses that manage at least 30 funds across the majority of IMA sectors, with at least 15 of those having a 10-year track record, showed that Invesco Perpetual had the greatest proportion of its funds in the 1st and 2nd quartile of their respective IMA sectors over 3, 5 and 10 years. The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Past performance is not a guide to future returns. Where Invesco Perpetual has expressed views and opinions, these may change. Invesco Perpetual is a business name of Invesco Asset Management Limited. Authorised and regulated by the Financial Conduct Authority. CPDS 15.12.14