COLUMBIATHREADNEEDLE.COM

OCTOBER 2015

INVESTOR GUIDE EQUITIES

COLUMBIATHREADNEEDLE.COM

PLEASE READ THIS IMPORTANT INFORMATION.This brochure is a guide and does not cover all the factors that go into making an investment decision. We have included within the guide some examples of the tools an investment manager may use when picking stocks. It does not aim to cover all of the tools that will be used to make the decision to purchase a stock. Columbia Threadneedle Investments is unable to provide financial advice and nothing in this guide should be interpreted as advice. If you are unsure about anything you should speak to a financial adviser. For details of one in your area please go to www.unbiased.co.uk - please note that we do not endorse this website or the advisers found on it.

The material in this brochure is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

To help your understanding of specific terms used in this guide we have included a glossary on page 11.

CONTENTS01 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

02 Types of return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

03 What does the company do? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

04 Finances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

05 What could go wrong? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

06 What is it worth? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

07 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

08 Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

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Investor Guide to Equities

Equities, also known as shares, give investors a stake in a company. If the company does well the value of the shares may rise and you may be able to sell them at a profit. However, they may also fall, making them a high-risk asset. Shareholders are also entitled to share in any profits made by a company, which are usually distributed in the form of a dividend payment. In this guide we look at what active managers look for when selecting stocks for their portfolios.

01 INTRODUCTION

Companies are an important part of modern society. Many of us work for one; almost all of us use them in some way for the products and services that we consume in our daily lives. Millions of people also own shares in companies as investments – either in their pensions or in other vehicles such as life policies and ISAs. For centuries, entrepreneurs have been setting up companies as a way of bringing their ideas to the market. In the process of developing these ideas, companies often require financial help. At the same time, in other parts of the economy there are entities – such as local authorities, pension funds and private investors – with capital that they wish to put to work.

The fund management industry helps to connect companies in need of capital to investors who can supply it. Fund managers allocate capital in ways that are designed to earn a healthy return for their clients, and buying shares in companies is one method of doing this. In return for an initial injection of capital

to help companies undertake activities such as building factories, buying supplies or hiring staff, investors take part ownership of the company. This entitles them to a share of future profits as well as any increase in the value of the company.

So what makes a good company? The answer depends on your perspective. What looks like a good company from a consumer’s point of view might not be so attractive from an investor’s stand point. It is also important to distinguish between a good company and a good investment, as they are not always the same. A Rolls-Royce may be an excellent car but if it is for sale for £2m, it is not a good investment. Conversely, at £2,000 it may be a fantastic investment. So, as well as identifying the characteristics that make a company “good” – such as strong management, solid finances and desirable products – we also have to decide whether it will be a good investment by valuing it.

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Investor Guide to Equities

In looking at companies as potential investments, fund managers try to ascertain what kind of returns they might generate. These returns can come from two main sources:

1. Capital growthAll companies’ share prices fluctuate and an investor can make money by gaining from increases in a company’s share price. Companies normally have a limited number of shares and, if lots of people want to own those shares, the laws of demand and supply suggest that the share price will rise. Conversely, poor quality companies that nobody wants to own are likely to see their share prices fall. Fund managers want to own companies whose shares are likely to rise faster than the overall stock market.

2. DividendsFor many investors, generating income is an important goal. Some companies pay part of their profits out to investors in the form of regular dividends, and fund managers will be looking to calculate the value of these future payments when assessing companies for a portfolio.

The balance between growth and income stocks will depend on the objectives of the fund. For example, smaller companies typically pay out lower dividends or no dividends at all. This is because they are often at an earlier stage of development and will wish to invest all of their profits in new equipment, staff or research. Conversely, more mature companies or businesses operating in industries with highly predictable revenues may well pay out higher dividends.

At the same time, investors’ needs vary depending on their lifestyle and risk appetite. Many younger investors are more interested in generating capital growth, while more mature investors may prefer to take an income from their funds. To meet these needs, investment companies typically offer a range of funds, and populate those funds with the appropriate mix of either growth or income stocks or both.

PORTFOLIO CONSTRUCTIONIn addition to the kind of returns that a company is likely to offer, fund managers will also consider other factors such as volatility and liquidity. For most portfolios, it is prudent to limit overall volatility by spreading investments across the market or by combining companies that are likely to react differently to changes in the market. It is also sensible to ensure that the bulk of the portfolio is invested in highly liquid stocks that can be sold quickly and cheaply if required. The ability to balance these considerations is a key part of a fund manager’s skill.

02 TYPES OF RETURN

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Investor Guide to Equities

Different companies perform well in different conditions, and the kind of business that a company is engaged in is absolutely key to its share price performance. When a company is listed on a stock exchange it is classified into one of a number of industries or sectors. These include areas such as mining, retailing and utilities. The fortunes of the companies in each of these sectors are driven by different factors.

For example, a mining company may do very well when the price of the commodity that it is mining goes up, as this is likely to feed through to higher sales and bigger profits. Meanwhile, a retailer will prosper when consumer sentiment is positive, unemployment and interest rates are low and people feel like spending money. For a utility company, demand tends to be more stable – people drink water throughout the economic cycle. So-called “non-cyclical” areas like this might be more appealing when economic growth is weaker and “cyclical” areas that are exposed to the economy appear less attractive.

So, the kind of business is an important consideration and fund managers will alter the mix of industries in a portfolio to suit the prevailing economic and market conditions.

PRODUCT DEVELOPMENTMost companies will wish to build a range of well-established products that they can sell to a variety of customers. However, businesses cannot afford to stand still. In most industries competition is fierce and, in order to be a leading player, it is necessary to invest time and effort in developing new products.

A good example here is the pharmaceutical sector. This is a relatively non-cyclical industry, as illness unfortunately occurs irrespective of economic conditions. However, better and more effective drugs command a significant price premium and new drugs are usually protected by a strict patent framework that is enforced globally.

Thus, companies with the vision and expertise to develop ground-breaking new treatments can generate high levels of profit from them. For this reason, pharmaceutical companies spend a lot of time updating investors on products under development. Conversely, companies whose patents are approaching expiry, and which have not invested in developing new drugs to drive future profits, are likely to be shunned by investors because they have limited future growth potential.

The aim of good product development in any sector is to combine established products with more novel introductions in order to ensure that consumer needs continue to be met. This should allow the company to generate healthy revenues. Thus, product development is one of the key considerations for an investor.

PROFITS VS REVENUESBuilding a strong set of products and keeping it up to date is vital if a company is to generate sales. However, revenues are no good if it costs the company more to make and market a product than it can sell it for. The profit margin is the difference between the cost of bringing a product to market and the price received for it. Margins can vary widely between companies and products and can be a crucial driver of investment decisions.

Companies seek to grow their profit margins by controlling costs and increasing revenues. Costs come in many forms, including raw materials, labour, transport and storage as well as sales commission and advertising and promotional spend.

03 WHAT DOES THE COMPANY DO?

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Investor Guide to Equities

Striking the right balance between revenues and costs can dramatically affect profits. For example, consider three rival companies making mobile phones:

Although Company C makes the most desirable product and is able to sell it for a higher price, it has much higher costs and is actually making a loss on each unit sold. This is not a sustainable recipe for long-term success and would prompt some serious questions from investors.

THE IMPORTANCE OF END MARKETSManagers will also seek to understand where a company’s profits are coming from. Many companies operate internationally and factors such as economic growth and the regulatory framework in various markets can affect the money to be made from international operations. In addition, currency effects can have a significant impact on costs and profits from overseas. Thus, understanding the geographical breakdown of a company’s business is a crucial part of the investment decision, as it provides insights into how regional developments are likely to feed through to profits.

MEET THE MANAGEMENTDeciding how much to spend on product development; which markets to sell into; where to source materials, etc can significantly affect the success of a business and its appeal as an investment. These decisions are made by the company’s senior management and, for this reason, it is important for fund managers to meet a company’s management team regularly in order to interrogate them on their progress and plans. Indeed, an experienced fund manager will have a good knowledge of the best company executives and, as people move around industries, it is sometimes possible to spot opportunities where a new team can invigorate a previously unprofitable business.

Company A Company B Company C

Retail price of phone £100 £110 £120

Cost of production £50 £57 £75

Sales commission £15 £20 £25

Advertising costs £9 £5 £18

Transport costs £2 £3 £3

Margin £24 £25 -£1

This is an illustrative example.

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Investor Guide to Equities

Understanding the products, end markets and quality of management are key steps to making an informed investment decision, but the company finances are of equal importance. Shareholders are relatively low in the pecking order if a company runs into financial difficulty, so it is vital to understand what kind of financial footing a company stands on in order to be able to ascertain its long-term prospects. Fund managers analyse the three key financial statements to gauge a company’s finances:

1. PROFIT AND LOSS ACCOUNTThe profit and loss account (commonly shortened to “P&L”) is an accounting statement that reflects any sales made and costs incurred by a company over a set period of time. In other words, it will show how the company is converting its previous investments in stock, equipment and other forms of capital into wealth. It also indicates how the ability to generate wealth is changing over time.

These are crucial considerations for shareholders as, in return for the capital they have injected into the business, they wish to receive a share of any wealth created in the form of share price appreciation and dividends.

2. CASH FLOW STATEMENTNo company can survive without cash – indeed, cash is often described as the lifeblood of companies. Like the P&L, the cash flow statement describes a period of time, but the crucial difference is that it shows the actual movements of cash into and out of the business.

For example, a company might sell a product before its financial year-end but not actually receive payment until the following period. The sale would be reflected in the P&L account for year one but would not appear in the cash flow statement until year two.

Different businesses have very different cash flow characteristics. Supermarkets have excellent cash flow, as there is typically no lag between selling goods and receiving payment. On the other hand, companies involved in infrastructure projects such as building hospitals for the government may have a very different experience. They may sign a lucrative contract in one year but not receive full payment until well into the future. In the meantime, they will still need cash to fund their ongoing operations.

No matter how good a company’s products are, running out of cash can be a terminal problem. As such, ensuring good cash flow is arguably the number one priority of company management and the cash flow statement is the key tool used by potential investors to assess corporate health and the long-term viability of businesses.

04 FINANCES

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Investor Guide to Equities

3. BALANCE SHEETUnlike the P&L and the cash flow statement, the balance sheet gives a snapshot of a company’s finances at a specific date. It contains details of all the company’s assets, capital and liabilities. Assets are the things that are of value to a company, including its premises, equipment, cash, investments, stock and patents. Capital is the money put into the business by its owners. Liabilities are the claims made by other entities against the business, including debts and unpaid bills.

As its name suggests, investors use the balance sheet to assess the balance between what a company owns and what it owes. In tough economic times fund managers will tend to favour companies with high levels of cash on their balance sheets, as this cash provides a buffer against lower sales or higher costs of servicing debt. Having cash on the balance sheet also allows companies to take advantage of opportunities to expand by taking over their rivals without having to raise additional capital.

In times of economic expansion, companies may be encouraged to have less cash and more debt, as there may be greater opportunities to expand into new areas and the cost of debt is likely to be lower. Managing the level of debt on the balance sheet is a key ingredient of maximising shareholder value.

The three key accounting statements may look rather dry to the layman, but each one provides a different and complementary view of a company’s financial position. As a result, each is used extensively by fund managers in assessing the prospects and financial strength of businesses.

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Investor Guide to Equities

nn Reputational risk – BP’s problems in the Gulf of Mexico in 2010 provide an excellent example of how a company’s reputation can be affected by its operations. Most businesses involve some form of risk and the oil industry is certainly no exception. Companies like BP invest immense amounts of money in order to extract oil from increasingly hostile locations while minimising environmental risk. Note the word “minimising”, for the risk of machinery malfunctioning can never be completely removed. BP’s share price fell savagely after the disaster – indeed, it fell by far more than most estimates of the likely financial cost to the company. The difference is the cost to BP’s reputation, as measured by its potentially reduced ability to do business in the US in the future.

nn Regulatory risk – most industries are subject to some form of regulation and changes in the rules governing businesses can significantly impact investors’ assessments of the returns that they can expect to receive. For example, the recent financial crisis has led to expectations of much tighter regulation of the financial services industry. Investors have concluded that this will limit financial companies’ ability to generate profits. Analysing the likelihood of tighter regulation and attempting to put a price on companies’ ability to make money in the future is a conundrum that is taxing fund managers across the world.

The statements that we have just outlined help to quantify the financial risks and opportunities that companies face. However, there are other risks that could affect the value of companies.

We highlight two other key risks here by way of example:

05 WHAT COULD GO WRONG?

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Investor Guide to Equities

We have looked at the different kinds of companies, how they make their money and the risks that they face. Pulling all of this together, fund managers need to make rational decisions about what different companies are worth. To do this, they use a variety of measures.

On a very basic level, the share price should give some indication. However, shares are issued at different prices, in different currencies and at different times, so making direct comparisons between companies on this basis alone is of little use. Fund managers get round this by looking at ratios of the share price to other financial metrics. Among the most popular are:

nn Price to earnings (“PE”) ratio. This divides a company’s share price by the earnings that the company is likely to generate per share. For example, if a company’s share price is £100, it is expected to generate total earnings of £1,000,000 and it has 100,000 shares, the earnings per share is £1,000,000 ÷ 100,000 = £10 per share. And therefore, the PE ratio is £100 ÷ £10 = 10. The company is said to be on a PE ratio of 10 times earnings. Because share prices are a means of valuing future cash flows, higher earnings per share should lead to a higher share price. Thus, dividing one by the other should allow a more valid comparison of value between two similar companies, with a lower ratio implying better value.

nn Price to book value (“P/BV”) ratio. This is a similar concept to the PE but, rather than using earnings per share, it uses the value of all the company’s assets minus its liabilities. Therefore, the P/BV ratio is more focused on what the company actually owns rather than an estimate of what it will earn in the future. Many “value investors” prefer to use this measure as they believe that it gives a truer and less volatile indication of what a company is worth.

nn Dividend yield. Companies that pay dividends can be compared using this measure, which is a ratio of the dividends paid to the share price. Thus, if the share price is £100 and the company pays a dividend of £5 per annum, the dividend yield is £5 ÷ £100 = 5%. If the share price stays stable and the company continues to pay the same dividend, this is the return you can expect to receive. If the share price goes up but the dividend stays the same, the dividend yield will fall. Income-seeking investors favour this measure as a way of comparing the appeal of different companies.

nn These measures – and others – are all useful for assessing value in different sectors and at different stages of the economic cycle. Like the financial statements outlined on pages 6 and 7, they represent different perspectives on a company’s value.

nn A fund manager’s skill lies in reconciling a company’s valuation with its future prospects. All participants in the market are constantly assessing these prospects, so the valuation is ultimately a function of the consensus view of the future. When a fund manager takes a different view of the future, he will conclude that the company valuation is either too high or too low. Either of these scenarios represents an investment opportunity.

06 WHAT IS IT WORTH?

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Investor Guide to Equities

In selecting stocks for a portfolio, fund managers seek to gain an in-depth understanding of how a company operates, how profitable it is and how strong its finances are. They then assess these fundamental factors in light of the company’s valuation relative to other investments, both in terms of the scope for share price gains and the likelihood of dividend growth.

The diverse nature of stock markets means that there are many different kinds of opportunities, from small companies to large and from cyclical businesses to those whose profits are not dependent on the economic outlook. By the same token, markets are always changing and this presents risks as well as new openings for companies to exploit.

Talented fund managers are able to consider all of these moving parts and use their experience and judgement to make high conviction calls on which investments offer the best potential for their clients.

At Columbia Threadneedle Investments our highly regarded team works together, debating and challenging consensus views to ensure that our best investment ideas are leveraged across portfolios. This approach has delivered excellent long-term performance, and we are confident that our clients will continue to benefit from this expertise in the future.

As always with any type of investment, please be aware that past performance is not a guide to future returns and that you may not get back your original investment. Columbia Threadneedle Investments is unable to provide investment advice so if you are unsure whether an investment is suitable for you, you should contact a financial adviser. For details on one in your area visit www.unbiased.co.uk - please note that we do not endorse this website or the advisers found on it.

07 SUMMARY

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Investor Guide to Equities

Balance sheet – accounting statement detailing a company’s assets and liabilities at a given point in time

Bottom line – another term for profit or loss (derived from the fact that this figure is shown on the bottom line of a company’s P&L account)

Capital – the total assets of a person or organisation minus their total liabilities

Capital growth – an investment return generated by changes in the price of a share

Cash flow statement – financial statement showing all the inflows and outflows of cash over a given period

Cyclical – company whose profits are relatively dependent on the pace of economic growth

Dividend – the regular payment of part of a company’s profits to its shareholders

Dividend yield – valuation measure defined as the dividend divided by the share price

Liquidity – the ease or difficulty with which an investment can be bought or sold

Margin – the difference between the cost of producing something and the revenue gained from selling it

Non-cyclical – company whose profits are relatively independent of the economic cycle

P&L – financial statement detailing the wealth created by a company’s activities over a given period

PE ratio – valuation measure defined as a company’s share price divided by its earnings per share

Price to book value – valuation measure defined as a company’s share price divided by the value of all its assets

Profit – the excess of cash generated by a business over the cash used during the period

Revenue – proceeds of a company’s sales

Sector – way of grouping companies according to the industry that they operate in

Top line – another term for a company’s revenues, or sales

Valuation – way of assessing the cheapness of company shares. Examples include price to earnings ratio and dividend yield

Volatility – the extent to which the value of an investment fluctuates over time

08 GLOSSARY

NOTES

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Investor Guide to Equities

Important information. The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. The research and analysis included in this document has been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. The mention of any specific shares or bonds should not be taken as a recommendation to deal. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Threadneedle Asset Management Limited. Registered in England and Wales, No. 573204. Registered Office: Cannon Place, 78 Cannon Street, London, EC4N 6AG. Authorised and regulated in the UK by the Financial Conduct Authority. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies. columbiathreadneedle.com Issued 10.15 | Valid to 04.16 | J24335

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