Equities are shares of fractional ownership of a company. Shareholders have a claim on either the returns that the company generates during operations, or any residual claim on the company assets in the event of the company’s liquidation (this happens after all debts are paid).
“Listed Equities” are listed on a stock exchange once a company goes public. Equities are initially offered to the public market through an IPO (initial public offering). Then, trading takes place on the secondary market through stock exchanges or over-the-counter.
- Shareholders own a part of the company (while bondholders, in contrast, are owed a debt by the company).
- Equities have the potential to provide income through dividends and capital gains if the company’s share price increases.
- Shareholders in a public company do not manage the company, but they have certain rights.
- Different classes of shares carry different rights, such as the right to receive dividends and to vote at shareholder meetings.
- Limited liability, which means that the rights and obligations of a company are not the rights and obligations of its stockholders. “Shareholders in a public company do not manage the company, but they have certain rights.”
Types of Equity
Common Shares: These shares are generally what comes to mind when people talk about buying equities. The shareholder has the right to vote on certain matters in running the company, and is entitled to a share of company profits via dividend payments or capital appreciation.
Preferred Shares: These shares combine both properties of equity and debt. In the company’s capital structure, preferred shares have priority over common shares in the payment of dividends and upon liquidation. Both preferred and common shares, however, are subordinate to debts. Preferred shareholders do not usually have voting rights.
Convertible Preferred Shares: These are a type of preferred share that have a feature enabling investors to turn them into common shares after a certain period of time or a certain date.
Common Ways of Categorizing Equity
By Size (Market Capitalization)
A company’s “market cap” is the total market value of all its outstanding shares (number of shares x price per share). Companies can be classified into the following categories according to market cap.
- Mega Cap: greater than $200B
- Large-cap: greater than $10 billion of outstanding shares
- Mid-cap: $2 billion to $10 billion of outstanding shares
- Small-cap: less than $2 billion of outstanding shares
- Micro-cap: One type of small cap stock (“micro-cap,” at $50 million to $300 million) that typically trades at a relatively low price (below $5 per share) and has lower liquidity and higher risk. If a company has 20 million shares outstanding and a share price of $4 per share, then its market cap is 20 million x $4 = $80 million. It is a micro-cap company.
Depending on the stage of the business cycle, different industries or sectors perform better than others. For example, in a downturn, low-end retailers may earn more revenue than luxury goods retailers.
- Domestic Equities: Stocks that are traded on stock exchanges in the same country as the investor.
- International Equities: Stocks of companies external to the investors’ domestic market.
By Market Classification
- Developed Market Equities: These equities offer a high degree of stability and ease of capital inflows/outflows. Examples include the United States, United Kingdom and Canada.
- Emerging Market Equities: Those of less developed major nations like Brazil, Russia, India and China. These markets enjoy high economy growth rates, and can offer higher potential profits for local companies. However, equities in these markets tend to be more volatile and therefore are seen as higher risk investments.
- Frontier Market Equities: Those of a subset of emerging markets. These are sometimes referred to as “pre-emerging” markets, such as Kazakhstan, Sri Lanka and Vietnam. Investors in frontier market equities typically seek high potential returns, but must also tolerate the high risk exposure that the investments in these markets carry.
Basics of Equity Investing
- Bid-Ask and Spread: The difference between the bid price and the ask price is called the bid-ask spread. The bid price is the maximum price that buyers are willing to pay. The ask price is the minimum price that sellers are willing to receive.
When there is a higher demand or supply of a stock, where there are many buyers and sellers, the stock is more liquid and as a result has a smaller bid-ask spread.
- Market Order: An order to buy/sell at the current best available market price (at the time the order is placed). For example, an investor submits a market order to buy 100 shares of a technology stock, which currently trades at $150. The Order will be executed immediately at $150 a share.
- Limit Order: An order to buy/sell at maximum/minimum prices set by investors. For example, an investor submits a limit order to buy 100 shares of a technology stock at $140. The order ensures that the investor pays at most $140 for all 100 shares, but the order might not be fully executed if there is less than 100 shares available at $140 or below.
- Stop Order (or Stop Loss): Is an order that will be executed only when the stock price reaches the stop price set by investors. Once the stock price is reached, the order becomes a market order. For example, an investor submits a stop order to sell 100 shares of a technology stock at $160. Once the stock price reaches $160, the order becomes a market order. All 100 shares will then be sold at best available market price, which is not guaranteed to be $160 or above.
Considerations When Purchasing Individual Equities
First, investors should note that equity IPO investments (bought in primary market) are subject to higher risks than equities traded on secondary markets (due to a lack of historical track record and increased volatility).
There are several factors to consider when looking at a single stock: company’s financial statements, the current projects the company has undertaken, the company’s business model, the current business environment and volatility of the market, to name a few.
Investors should also be mindful of the management team of the company, whether or not the team has a strong track record, and how effective are they in running the company. One should always be cautious of over concentration and the risks associated with investing heavily in one stock.
And last but not least, Investors should use sound judgment in the fair value of the company.
Building an Equity Portfolio
Prior to constructing a portfolio, investors should understand their ability to take on risk over the short- and long-term based on their current financial position; their level of appetite for risk and what are their expected future financial needs and investment objectives.
When choosing equities to invest in, consider diversifying. It is advisable to choose companies in different industries/ sectors (e.g. Technology, Consumer Discretionary, Energy) and geographic markets (U.S., Emerging Markets).
When building an equity portfolio, investors should understand their expected return, and whether their portfolios are able to meet their expected returns. What is the amount of risk they will bear to meet the expected return? Can they sustain the volatilities that the portfolios may display?
Here are some of the benefits and risks that investors should consider ahead of investing.
- Capital Growth: If a company increases revenue and earnings, its value rises and this will tend to be reflected in its share price. Owning shares with a rising value allows investors to grow their wealth.
- Dividend Income: Investors could potentially earn dividends, which is the distribution to shareholders of a portion of a company’s earnings. Conservative investors may seek shares that provide stable dividend streams but little in capital appreciation. The payment of dividends is not mandatory.
- Diversification: Investors may not want to be too reliant on other asset classes, like bonds or currencies. Diversification can happen by geography, size, industry sector or other criteria.
- Flexibility and Liquidity: It can be easy and relatively cheap to buy/sell shares. Investors have a large degree of control over when to enter, exit or rebalance equity positions.
- Transparency: Equities are commonly listed on stock exchanges, which provide a methodical and organized system of trading. The price of any stock is set by supply and demand.
- Market Risk: Risk that arises from the overall market condition, local economy, inflation, political environment, and performance of other asset classes (bonds, commodities, etc.). For example, stock prices rise with better-than expected economic data such as gross domestic product (GDP) growth.
- Idiosyncratic Risk: Risk that is specific to a security and has little correlation with market risk. This risk could be diversified as it is not systemic. For example, a company’s stock price will drop if the company is reported to engage in fraud activities or be involved in material litigations.
- Liquidity Risk: Risk associated with the possibility that investors are not able to get out of positions when needed. For example, in the face of a market sell-off, an investor tries to sell a security that everyone else also wants to sell, but there are not enough buyers in the market.
- Foreign Exchange Risk: Risk that arises from fluctuations in foreign exchange rate, which could impact the value of a particular investment when converted to local currency.
|Blue-Chip||Typically the leaders in their industry with a proven record of earnings and dividends.|
|Growth||Stocks with high expectation of growth in earnings, though often low dividend payout. These types of stocks usually have a high price-to-earnings ratio.|
|Income||Companies (such as utility companies) that are more mature with high dividend payouts.|
|Value||Stocks that tend to sell at a low price-to-earnings ratio. They are usually undervalued by the market because they are in a sector that is currently out of favor.|
|Emerging||Growth Typically, they are new companies with little, if any, earnings and an unproven track record.|
|Cyclical||Stocks whose performance fluctuates with the business cycle (e.g., automobile, travel, etc).|
|Countercyclical||Stocks that are generally resistant to changes in the economic cycle (e.g. utility companies or drug manufacturers).|
|Sector||Stocks that represent a segment of the economy, or industry-specific companies (e.g., airline companies, technology stocks and gold stocks).|
|Speculative||Stocks that are considered high risk. These companies tend to fluctuate a great deal in price or have a positive track record or earnings.|
|Special Situation||Companies that may be involved in an event that will affect their earnings, such as a merger, restructuring or bankruptcy.|
|Stock Split||A corporate action in which a company’s existing shares are divided into multiple shares. The market value of the total number of shares (market capitalization) remains the same.|