28 Aug 2019

Anyone who cares to investigate can discover that the equities that you probably own directly or through your pension scheme are equitable only with each other. Benjamin Graham, the so-called father of modern investing, called them “common shares” which is a better clue.

When a company is wound up this typically means that it has run out of money and run out of people who will lend or give it more cash. Equities represent any surplus assets that are left when all other creditors have been paid off.

Every other creditor ranks above the owners of the common shares. First are secured creditors like banks or bondholders who have lent money on fixed terms. If the company defaults on those terms it can be forced into formal insolvency, though sometimes the secured creditors will accept equity in return for a further cash injection, if they judge that their best chance of getting their money back in the end is to keep the business going. In those circumstances they will be issued shares on such favourable terms that existing equity investors are diluted to the point of worthlessness. This is happening now in the case of Thomas Cook.

After secured creditors have been paid in full, anything left goes to so-called preferential creditors, including employees, and then to the luckless trade creditors and HMRC. You can infer that common shareholders will usually be completely wiped out.

Unsurprisingly, people who invest in equities very rarely think about the risk of insolvency and losing all their money. We all dream of the day when the theoretical value of those surplus assets explodes upwards. Bond holders may get their money plus interest back but as Benjamin Graham pointed out many decades ago, common stocks have “a far better record than bonds over the long term past”. It has widely been accepted as a fact that equities are the answer for a long term investor.

Cautious share owners look for sustainable dividends that can rise as the company grows; the more optimistic hope for rising share prices as well. Those are the two elements that drive the long-term performance of common stocks observed by Graham. But stock market investors are looking down rather than up these days.

Here are five companies that recently raised their dividends and their current dividend yields:

Royal Mail – yields 7.8%
Halfords – 11.1%
J Sainsbury – 6.1%
Imperial Brands – 9.2%
GVC Holdings – 6.1%

Here are six companies that have maintained their dividend payouts:

BT – 9.2%
Greene King – 5.9%
TP ICAP – 6.0%
Stagecoach – 6.1%
Kingfisher – 5.6%
Shoe Zone – 6.0%

And two companies that have “rebased” (i.e. cut) their dividends to allegedly sustainable levels:

Centrica – 7.7%
William Hill – 5.3%

The common characteristic of these common stocks is that the stock market is sceptical (in some cases highly sceptical) about their ability to keep paying those dividends.

I have views, which are truthfully irrelevant, and quite possibly wrong, about whether the market is correct on each company. The important point is that the market tells us what investors believe. And it seems to me that what the market believes is that the companies are technically below investment grade.

Companies that are not regarded as financially sound enough to borrow money from sensible, risk-averse counterparties will usually have low credit ratings. When they issue debt it carries a high interest rate and the resulting paper, if tradeable, is colloquially known as a junk bond. An index of selected European high yield bonds measures their current collective yield at 2.86%. If these are junk bonds, then the companies I listed above are trading as junk equities.

A number of commentators have recently noted that there have been a number of takeovers of UK-listed companies by foreigners this year. I can confirm this as my portfolio has already been the beneficiary of four bids and it’s still August. The most recent was Greene King which appears (pre-bid) in the list of companies above (compiled a few days before the bid). The others are Dairy Crest (covered here a few weeks before the announcement), EI Group and KCOM.

Perhaps one person’s jaundiced eye sees junk where another sees compelling value?

Some people have blamed opportunistic raiders taking advantage of Brexit-induced sterling weakness. I doubt whether this is a decisive factor though of course it doesn’t hurt. Either way, it is irrelevant. Moreover, as I have written before, it could be that foreigners looking through unemotional eyes judge that the value of sterling and sterling assets is likely to appreciate, if bloody Brexit ever happens.

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