Bottom-up strategies

In equity investments, whether a manager follows a fundamental or quantitative approach, they can further be classified as bottom-up or top-down investors. Bottom-up strategists focus on individual company data, while top-down approaches start with macroeconomic factors that could impact multiple companies. Some analysts may blend aspects of both styles.

• Relative value: Seeks to buy undervalued companies compared to peers using metrics such as price to book, price to cash flow, and price to earnings.
• Contrarian investing: Goes against market sentiment, buying stocks that have dropped and shorting those that have recently risen.
• High-quality value: Considers competitive advantages and management quality in addition to valuation, aiming to buy solid companies at a discount.
• Income investing: Targets companies with high dividend yields and growth rates.
• Deep value investing: Involves distressed companies, buying at a discount to their asset value for potential profit through asset liquidation.
• Restructuring and distressed investing: Similar to deep value, but aims to enhance firm value by changing the capital structure.
• Special Situations: Focuses on corporate events like mergers temporarily impacting company value.

Value versus Growth-based Approaches

• Consistent long-term growth: Looks for companies with sustained growth over time.
• Short-term earnings momentum: Focuses on recent outperformers with expected trend continuation.
• GARP (growth at a reasonable price): Uses the PEG ratio (P/E divided by annual earnings growth) to balance share price and earnings growth for cost-effective growth investment.

$$
\text{PEG Ratio} =\frac {(P/E) }{\text{Annual Earnings Growth.}} $$

Where:

\(P/E\) = Price to earnings ratio.

This approach aims to minimize the price per share relative to the growth rate of the firm's earnings, thereby purchasing ‘cheaper’ growth.

Question

An investor examines recent 52-week moving averages and buys shares of companies that have dropped below their 52-week mark. This investing style is most aligned with which of the following?

1. Short-term earnings momentum.
2. Special situations.
3. Contrarian investing.

Solution

The correct answer is C.

Contrarian investing involves going against the prevailing market sentiment. In this case, buying shares of companies that have dropped below their 52-week moving averages means the investor is taking a contrarian approach by buying stocks that others may be selling due to recent poor performance. The investor is essentially betting that the market's negative sentiment is overdone, and the stock may rebound.

A is incorrect. This option is not aligned with the investor's approach. Short-term earnings momentum investing typically focuses on buying stocks of companies that have shown recent positive earnings momentum or strong earnings growth. It is a fundamentally driven strategy that emphasizes companies with improving financial performance.

B is incorrect. Special situations investing typically involves investing in companies during unique events, such as mergers, acquisitions, spin-offs, or other corporate actions. It's not directly related to the investor's approach of using moving averages to identify undervalued stocks.

Reading 25: Active Equity Investing: Strategies

Los 25 (b) Analyze bottom-up active strategies, including their rationale and associated processes