Investment decisions are a crucial part of the financial world, and equity investors employ a myriad of techniques at process the necessary information for making these decisions. These techniques are often personalized, with each analyst favoring certain methods based on their experience and judgment. The strategies employed can be broadly categorized into two types, depending on the investment discipline specifics: bottom-up and top-down.
Bottom-Up Strategies
In the field of investment strategies, bottom-up strategies hold a significant place. These strategies are a method of asset selection that begins with data at the individual asset and company level. This includes factors such as price momentum and profitability. Quantitative investors who use a bottom-up approach utilize computer power to apply their models to this asset- and company-level information, with the added requirement that the information be quantifiable.
Application in Fundamental Investing
Fundamental investing employs bottom-up strategies, starting with thorough analyses of individual companies before considering broader sector or market conditions. The efficacy of this approach depends on the analyst’s deep knowledge of a company’s industry, products, business strategy, leadership, and financial health. By evaluating a company’s intrinsic value and comparing it to its market price, analysts pinpoint undervalued or overvalued stocks. This method allows for the identification of companies that are performing well despite a declining industry or finding struggling companies within thriving sectors. Critical factors for assessment include the company’s business model, brand, competitive edge, management quality, and governance, with valuations based on discounted cash flows or earnings-related market multiples.
Business Model
- A business model outlines a company’s strategy for operating and making profits, as seen in Amazon’s online retail approach.
- The value proposition explains the unique advantages offered to customers, demonstrated by Tesla’s high-performance electric vehicles.
- Operational flow describes the processes involved in creating value, encompassing everything from design to sales.
- The value chain details the activities a company undertakes to bring a product or service to market, exemplified by Starbucks from sourcing to retail.
- Branding strategy and target market segment define how a company positions itself in the market and who it aims to serve, like Nike’s focus on athletes and fitness enthusiasts.
- The business model also covers how a company generates revenue and maintains profit margins, critical for assessing its competitive edge and sustainability, as illustrated by Netflix’s subscription fees.
- Corporate branding conveys a company’s identity to the market and its promise to customers, affecting brand equity and allowing for pricing strategies that can lead to higher profit margins, such as Apple’s ability to command price premiums.
Competitive advantages
A competitive advantage is a unique factor that allows a company to outperform its competitors in terms of the return it generates on its capital. This can be due to various reasons such as access to natural resources, superior technology, innovation, skilled personnel, corporate reputation, brand strength, high entry barriers, exclusive distribution rights, and superior product or customer support. For instance, Apple Inc.’s innovative technology and strong brand reputation give it a competitive advantage over other tech companies. For value investors, it is vital to understand the sustainability of the company’s competitive position when assessing the prospects for recovery.
Company Management
Effective company management is crucial for increasing shareholder value through strategic resource and capital allocation. Leadership with a long-term vision, like Jeff Bezos at Amazon, significantly contributes to sustained growth. Analyzing financial metrics such as ROI, ROE, and earnings growth helps gauge management’s impact on value. Additionally, qualitative evaluations of management’s alignment with shareholder interests, competency, stability, talent retention, and ESG factor management are essential. Insider transactions, like Elon Musk’s Tesla share purchases, indicate management’s confidence in future prospects.
These assessments are vital for projecting earnings, cash flows, and assessing risks, leading to accurate company valuation. Valuation methods include discounted cash flow, dividend models, or relative valuation, using P/E, P/B, and EV/EBITDA ratios. Identifying discrepancies between intrinsic value and market price relies on analyst confidence in their estimates versus market expectations. Investment strategies, classified as either value or growth-based, leverage these analyses.
Value-based approaches
Value-based approaches to investing are a cornerstone of the investment world, with roots tracing back to the work of Benjamin Graham, often hailed as the father of value investing. Alongside David Dodd, Graham penned the seminal work, Security Analysis, in 1934, laying the groundwork for value investing. The core tenet of this approach is the pursuit of stocks trading significantly below their estimated intrinsic value, thereby offering a “margin of safety” for the investor. This approach typically targets companies with appealing valuation metrics, often reflected in low earnings or asset multiples.
Value investors operate on the belief that stocks can occasionally trade below their intrinsic value due to irrational behavior by investors. This can often be a result of overreaction to negative news or various behavioral biases. There are different styles of value-based investing, one of which is “relative value” investing. This involves buying stocks with high valuation multiples relative to historical levels, but that are favorable compared to the peer group.
Relative Value
Investors who adhere to a relative value strategy compare the value indicators of companies, such as Price-to-Earnings (P/E) or Price-to-Book (P/B) multiples, to the average valuation of companies in the same industry sector. The objective is to identify stocks that offer value relative to their sector peers. It’s crucial to understand that different sectors have unique market structures and face varying competitive and regulatory conditions, which can cause average sector multiples to fluctuate.
For instance, consider the average P/E for companies in the energy sector is almost five times the average P/E for those in real estate. Therefore, a consumer staples company trading on a P/E of 12 would appear undervalued relative to its sector, while a real estate company trading on the same P/E multiple of 12 would appear overvalued relative to its sector. Investors need to understand why the valuation is what it is, as a premium or discount to the industry may be justified by the company’s fundamentals.
Contrarian Investing
Contrarian investing challenges mainstream market trends, focusing on acquiring stocks of underperforming companies with the belief they will rebound. This approach typically targets cyclical stocks in downturns, characterized by low earnings or dividends, expecting price recovery as company fortunes improve. Notable examples include buying opportunities during market crises like the 2008 financial downturn, where contrarians would invest in undervalued high-quality stocks anticipating a market rebound.
Contrarians leverage behavioral finance insights, identifying overreactions to trends and herd behavior to find undervalued or overvalued stocks. For example, contrary to the herd mentality during the dot-com bubble, contrarians might have invested outside the over-hyped tech sector. While similar to value investing in seeking stocks below intrinsic value, contrarianism distinctively relies on market sentiment and significant price fluctuations, rather than strictly on fundamental analysis, to identify buying or selling opportunities.
High-Quality Value
High-quality value is a concept in investment that focuses on identifying stocks that are undervalued but have strong fundamentals. This approach is often associated with renowned investor Warren Buffett. The strategies under this concept include Value-Based Strategies, Income Investing, and Deep-Value Investing.
Income Investing
Income investing is an investment strategy that focuses on stocks that offer high dividend yields and positive dividend growth rates.
- This approach focuses on shares that offer high dividend yields. For example, AT&T Inc., with a dividend yield of 7.3% in 2020, would be a prime candidate for this strategy.
- It is argued that a secure, high dividend yield can support the share price of companies expected to maintain such a dividend. Companies like Procter & Gamble, known for their consistent dividend payouts, are often targeted by this strategy.
- Empirical studies suggest that equities with these characteristics offer higher returns and are more resilient during market declines. For instance, during the 2008 financial crisis, companies with high dividend yields like McDonald’s Corp. performed better than the broader market.
Deep-Value Investing
Deep-value investing is an investment strategy that focuses on extremely undervalued companies relative to their assets.
- Deep-value investors focus on undervalued companies that are available at extremely low valuation relative to their assets (e.g., low P/B). For example, a company like Ford Motor Co., with a P/B ratio of 1.2 in 2020, would be a prime candidate for this strategy.
- These companies are often in financial distress, which may limit market interest and increase the chance of informational inefficiencies. Companies like General Electric, which faced financial distress in recent years, are often targeted by this strategy.
- The deep-value investor’s expertise may lie in reorganizations or related legislation, providing a better position to assess the likelihood of company recovery. For instance, investors with expertise in bankruptcy law may have an edge in investing in companies like Hertz Global Holdings, which filed for bankruptcy in 2020.
Restructuring and Distressed Investing
Restructuring and distressed investing is a strategy that thrives in the distressed-debt market and among equity investors proficient in navigating financial distress. This approach becomes particularly viable during economic downturns or sector-specific declines, where the number of financially troubled companies rises.
During events like the 2008 financial crisis, companies unable to fulfill short-term obligations may opt for restructuring or capital structure adjustments. Investors in this domain focus on acquiring debt or equity in such distressed entities, driven by the potential value in the company’s assets, distribution networks, or intellectual property, despite their troubled circumstances.
Investments often occur in anticipation of or during bankruptcy proceedings, with the goal of purchasing control or a significant stake in a distressed company at a discount. The aim is to restructure the entity to recover much of its value.
The efficacy of distressed investing hinges on the investor’s ability to discern opportunities in companies that are undervalued by the market, operating under the belief in the company’s survival or the value of its assets in liquidation. This requires a deep understanding of the business’s intrinsic value and the market’s misperceptions.
Special Situations
The Special Situations Investment Style is a unique investment strategy that seeks to identify and capitalize on pricing discrepancies that may arise due to corporate events. These events could include divestitures, spinoffs of assets or divisions, or mergers with other entities. For instance, a company like Yahoo spinning off its stake in Alibaba could be a special situation. These situations often represent short-term opportunities to exploit mispricing. Investors often overlook companies in such special situations, which may create opportunities to add value through active investing. This type of investing requires specific knowledge of the industry and the company, as well as legal expertise.
Growth-Based Approaches
Growth-based investment approaches focus on companies that are expected to grow faster than their industry or the overall market, as measured by revenues, earnings, or cash flow. For example, a company like Amazon, which has consistently outperformed its industry in terms of revenue growth, would be a target for growth investors. Growth investors usually look for high-quality companies with consistent growth or companies with strong earnings momentum. Characteristics usually examined by growth investors include historical and estimated future growth of earnings or cash flows, underpinned by attributes such as a solid business model, cost control, and exemplary management able to execute long-term plans to achieve higher growth. Such companies typically feature above-average return on equity, a large part of which they retain and reinvest in funding future growth. Because growth companies may also have volatile earnings and cash flows going forward, the intrinsic values calculated by discounting expected future cash flows are subject to relatively high uncertainty. Compared to value-focused investors, growth-focused investors have a higher tolerance for above-average valuation multiples.
GARP (Growth at a Reasonable Price)
GARP is a sub-discipline within growth investing. This approach is used by investors who seek out companies with above-average growth that trade at reasonable valuation multiples, and is often referred to as a hybrid of growth and value investing. For example, a company like Apple, which has shown consistent growth but also trades at a reasonable valuation, would be a target for GARP investors. Many investors who use GARP rely on the P/E-to-growth (PEG) ratio, calculated as the stock’s P/E divided by the expected earnings growth rate (in percentage terms), while also paying attention to variations in risk and duration of growth.
Practice Questions
Question 1: An investor is looking for a strategy that fits their risk tolerance, investment goals, and understanding of the market. They are aware that there are many techniques and methods available, each with its own strengths and weaknesses. Which of the following is the most important factor for the investor to consider when choosing an investment strategy?
- The popularity of the strategy
- The complexity of the strategy
- The suitability of the strategy to the investor’s personal circumstances
Answer: Choice C is correct.
The most important factor for an investor to consider when choosing an investment strategy is the suitability of the strategy to the investor’s personal circumstances. This includes the investor’s risk tolerance, investment goals, financial situation, and understanding of the market. An investment strategy should align with the investor’s objectives and risk tolerance, and it should be something that the investor understands and is comfortable with. The suitability of an investment strategy is crucial because it determines whether the strategy will help the investor achieve their financial goals and whether the investor will be able to stick with the strategy during market downturns. A strategy that is not suitable for an investor’s personal circumstances can lead to poor investment decisions and potential financial loss.
Choice A is incorrect. The popularity of an investment strategy is not a reliable indicator of its suitability for a particular investor. Just because a strategy is popular does not mean it is appropriate for all investors. Each investor has unique circumstances and needs, and what works for one investor may not work for another. Furthermore, popular strategies can become overused and less effective over time.
Choice B is incorrect. While the complexity of an investment strategy is a factor to consider, it is not the most important factor. A complex strategy may offer higher potential returns, but it also carries higher risk and requires a greater level of understanding and management. An investor should not choose a strategy solely based on its complexity, but rather on its suitability to their personal circumstances.
Question 2: A quantitative investor is using a bottom-up approach for asset selection. This method begins with data at the individual asset and company level, and requires the information to be quantifiable. After identifying individual companies, the investor uses economic and financial analysis to assess the intrinsic value of a company. In this scenario, which of the following statements best describes the possible findings of the investor’s analysis?
- The investor may find companies operating efficiently with good prospects even though the industry they belong to is deteriorating.
- The investor may find companies with poor prospects in otherwise healthy and prosperous industries.
- Both A and B are possible findings of the investor’s analysis.
Answer: Choice C is correct.
When using a bottom-up approach for asset selection, the investor focuses on the analysis of individual companies rather than the overall industry or economy. This approach allows the investor to identify companies that are operating efficiently and have good prospects, regardless of the industry they belong to. Therefore, it is possible for the investor to find companies that are performing well even in a deteriorating industry. This is because the performance of a company is not solely dependent on the industry it operates in, but also on its management, business model, competitive advantages, and other factors.
Similarly, the investor may also find companies with poor prospects in otherwise healthy and prosperous industries. This is because even in a thriving industry, not all companies will necessarily perform well. Some companies may have poor management, lack competitive advantages, or face other issues that negatively affect their prospects. Therefore, both A and B are possible findings of the investor’s analysis when using a bottom-up approach.
Choice A is incorrect. While it is true that the investor may find companies operating efficiently with good prospects in a deteriorating industry, this statement alone does not fully capture the possible findings of the investor’s analysis.
Choice B is incorrect. While it is true that the investor may find companies with poor prospects in otherwise healthy and prosperous industries, this statement alone does not fully capture the possible findings of the investor’s analysis.
Glossary:
- Discounted Cash Flow Model: A method used to estimate the value of an investment based on its expected future cash flows, adjusted for time value of money.
- Enterprise Value (EV): A comprehensive measure of a company’s total value, often considered more accurate than market capitalization as it includes debt, cash, and other factors.
- EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization; a key indicator of a company’s financial performance and ability to generate operational cash flow.
- Behavioral Finance: A field that combines psychological theory with conventional economics to explain why people make irrational financial decisions.
- Margin of Safety: The principle of purchasing securities when their market price is significantly below their intrinsic value to minimize downside risk.
- Value Investing: An investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.
- Contrarian Investing: A strategy that seeks to capitalize on widespread pessimism in the market by purchasing assets that are undervalued and selling when they are overvalued.
- Deep-Value Investing: An aggressive form of value investing that targets companies thought to be extremely undervalued as measured by various valuation metrics.
- Restructuring: The corporate process of reorganizing a company’s structure, operations, or finances with the goal of increasing profitability or efficiency.
- Distressed Investing: A form of investment strategy focused on companies in financial distress, typically by buying their debt at a discount or acquiring equity cheaply.
Portfolio Management Pathway Volume 1: Learning Module 2: Active Equity Investing: Strategies; LOS 2(b): Analyze bottom-up active strategies, including their rationale and associated processes