Developing an Active Investment Strategy

Statistical Arbitrage

• Define the investment universe: An analyst defines a broad category for potential investments. For instance, they might consider European Union equities.
• Narrow down the scope: The next step is to narrow down the range of options to make it manageable. For example, if EU equities were the initial universe, the analyst might focus on a specific industry like Industrials. This specialization helps the activist team develop expertise and enables in-depth analysis as options become fewer and more specific.
• Analyze the firm and industry: The team examines the company's position compared to competitors, identifying strengths, weaknesses, opportunities, and threats. They might use frameworks like Porter's five forces and review financial statements.
• Forecast performance (Discounted Cash Flows): Once potential companies are chosen, analysts forecast performance using methods such as bottom-up or top-down analysis. This helps understand company prospects and track metrics for opportunities that target cost reduction.
• Conduct valuations: Valuations help identify undervalued firms and guide the turnaround process. Analysts assess whether earnings per share have increased and analyze the reasons behind success or failure.
• Build a portfolio with desired traits.
• Periodically rebalance the portfolio as necessary.

Pitfalls

Behavioral Biases: As covered in other chapters, behavioral biases pose a consistent threat to successful investing. The potential to misjudge investments is always present due to biases such as the illusion of control or availability bias. For activist investing, two specific dangers are the value trap and the growth trap.

Value Trap: Imagine shopping for a car and finding a make and model listed at a lower price than similar options. However, is the vehicle truly a good “investment”? It could be underpriced or have hidden defects. A value trap is an investment that seems cheap based on metrics such as Price to Earnings (P/E), Price to Cash Flow (P/CF), or Price to Book Value (P/B), but it's ultimately a poor choice.

The risk is that an apparently inexpensive stock underperforms after purchase. Like any purchase, proper research is essential to avoid falling into a value trap.

Growth Trap: Unlike a value trap, a growth trap initially appears promising from a growth perspective. It carries high valuation multiples (P/E, etc.), indicating future growth potential. However, the danger lies in overly optimistic growth projections that fail to materialize, leading to a decline in share price.

Question

Consider the case of a potential activist investment in “Advanced Tektonics,” a company that has developed a seismic prediction machine and received significant media coverage, along with aggressive growth expectations compared to similar firms. What is the most appropriate characterization of this firm?

1. A value traps.
2. Insufficient information.
3. A growth traps.

Solution

The correct answer is C.

The company, “Advanced Tektonics,” has received significant media coverage and has aggressive growth expectations compared to similar firms. This suggests that investors might be overly optimistic about the company's growth prospects. The term “growth trap” implies that the company's growth expectations may not be sustainable or could lead to disappointment if not met. This is a common term used to describe companies that may be overhyped or overvalued due to high growth expectations.

A is incorrect. A value trap is a situation where a company's stock appears to be undervalued based on traditional valuation metrics (such as low price-to-earnings ratio) but is actually declining in value because of fundamental issues. In the case of “Advanced Tektonics,” there is no information provided to suggest that the company is undervalued based on traditional value metrics, nor is there evidence of declining fundamentals.

B is incorrect. Insufficient information acknowledges that without more data or context, it is challenging to make a definitive characterization of the company. However, the passage provides some information that can be used to make an initial characterization.

Reading 25: Active Equity Investing: Strategies

Los 25 (g) Describe how fundamental active investment strategies are created