I lost my metaphor mojo somewhere back in June – but it’s back, it’s a new year, and I’m ready to roll with the food allegory.

So let’s talk about equity.

In journalistic lingo, any and all of the following words and phrases have something to do with it: shares, stocks, stakes, stock splits, dividends, IPOs, stock options, shareholders… There may be others – but my internet connection and I are having an argument as I type this – so sadly, that’s all I could come up with.

But the point is: when someone says “I have investments” – they’re generally talking about this particular type.

Which made it long-past-due that I post a background: what it is, why we like it, and a short word on market madness.

What is Equity?

Equity is just a nice word for “ownership”. Or, should I say, “partial ownership” – as that’s usually the way that we understand it. And if I was to venture a guess about where the word came from, I would say that it began in a time before limited liability companies, where all the owners were basically partners: each equally and severally liable for the debts of the company/partnership.

But today you only share in the company (and the liability for its debts!) relative to how much of a stake you have purchased.

If I could take us back a step though, I have a diagram (although it’s really not too complicated):

There are two ways of looking at a company:

  1. What it has (the assets: land, buildings, items to sell, money in the bank, etc) – being the red circle; and
  2. How it got what it has (that is, how did it raise the money to buy everything?) – being the green & black circle.

And it’s the second one, being the financing, that is the most interesting. Because either you borrowed the money from a lender (a bank, a bondholder, etc), or you raised the money from an investor (being a stockholder/shareholder). And in the above diagram, any borrowing is “debt” and is coloured black; and investor money is “equity”, and is green.

Both options raise money. But the difference between them illustrates an old adage: the higher the risk, the higher the return.

  • Lenders: get their money back before shareholders and are usually guaranteed payments; therefore, they only earn a fixed rate of interest (low risk = low return).
  • Shareholders: get their money back as and when the company feels like it, and will sometimes get a dividend. In theory, the only limit to a dividend distribution (in some ways: the shareholder version of “interest”) is the ability of the company to remain solvent* and liquid** after they pay it (high risk = high return).

In smaller companies, the shareholders are usually the family of a family-run business. But when businesses need plenty of money, they’ll approach the general public for financing. And that’s when you hear about Initial Public Offerings and Share Issues – when a company lists itself on an exchange, and invites investors to buy shares of equity, which the company can then use to buy new productive assets and increase profits:

But now that we have investors giving money to a company’s management to play with, we need to be asking ourselves…

So why Equity?

The conventional argument for equity is that it’s the investment with the most potential for growth. It’s high risk, which gets compensated for by high returns, as though the Universe inevitably operates on the “nothing ventured, nothing gained” principle. Largely though, I think the truth is more mundane. There are just some investments that are better at generating returns than others.

In his 2011 shareholders’ letter, Warren Buffett gives a listing of the different types of investment out there, and then says this about his favourite:

My own preference – and you knew this was coming: investment in productive assets

Why productive assets?

These assets should have the ability in inflationary times to deliver output that will retain its purchasing-power while requiring a minimum of new capital investment

Which means…?

Well, apart from meaning that Warren Buffett expects “inflationary times”, what it really means is that you want your money to be doing something.

When one buys gold or bonds, you do it expecting that other people’s fears about the economy will drive up the price of the assets, earning you a return. When you buy equity (or, at least, the equity of non-financial-services companies), you do it based on the company’s ability to take your money and produce something for people’s needs. And/or their greed.

I personally dislike using fear as a motivator. Not because I don’t think that it’s real – but because I prefer to bet on greed.

Markets have a tendency to be a function of fear and greed. And then it all looks a lot like this:

Too much greed → over confidence → pricing bubbles → warnings from someone nameworthy → overboard fear → crash → good time to buy → back to greed

Which brings me to this graph of the (inflation-adjusted) S&P 500***:

For argument’s sake, let’s simply say that the graph goes up when people are greedy, and down when people are fearful. What do we see happening in the long-term?

That’s why we do equity. And that’s why it’s the protein in your finance diet. It’s financial muscle; and to push the metaphor, it generally determines the strength of your portfolio to take you to the places you want to go.

Oh – and it also could also tell you that steroiding up your portfolio with fancy chemicals (AKA derivatives) can give you some really good short-term results**** – but it’s easy to get out of control. And then when crisis places stress on your body, you’re suddenly heart-attack-out in your prime.

And finally – you must be careful about where the protein comes from. Because the general rule of thumb ought to be: if it’s not well-done, it’ll be the first one to give you food poisoning.

*Solvent – owns more than it owes.

**Liquid – has enough cash on hand to settle anything it owes without having to sell off land, buildings and factory equipment.

***An index, being something like the combined average of the top 500 companies on the Dow Jones.

****Even if there are some unfortunate, ah, re-productive side-effects.