CFA L3

 

Value-Based Approaches Benjamin Graham is regarded as the father of value investing. Along with David Dodd, he wrote the book Security Analysis (1934), which laid the basic framework for value investing. Graham posited that buying earnings and assets relatively inexpensively afforded a “margin of safety” necessary for prudent investing. Consistent with that idea, value-based approaches aim to buy stocks that are trading at a significant discount to their estimated intrinsic value. Value investors typically focus on companies with attractive valuation metrics, reflected in low earnings (or asset) multiples. In their view, investors’ sometimes irrational behavior can make stocks trade below the intrinsic value based on company fundamentals. Such opportunities may arise due to a variety of behavioral biases and often reflect investors’ overreaction to negative news. Various styles of value-based investing are sometimes distinguished; for example, “relative value” investors purchase stocks on valuation multiples that are high relative to historical levels but that compare favorably to those of the peer group. Relative Value Investors who pursue a relative value strategy evaluate companies by comparing their value indicators (e.g., P/E or P/B multiples) to the average valuation of companies in the same industry sector with the aim of identifying stocks that offer value relative to their sector peers. As different sectors face different market structures and different competitive and regulatory conditions, average sector multiples vary. Exhibit 2 lists the key financial ratios for sectors in the Hang Seng Index on the last trading day of 2016. The average P/E for companies in the energy sector is almost five times the average P/E for those in real estate. 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 usually recognize that in addition to the simple comparison of a company’s multiple to that of the sector, one needs a good understanding of why the valuation is what it is. A premium or discount to the industry may well be justified by the company’s fundamentals. Contrarian Investing Contrarian investors purchase and sell shares against prevailing market sentiment. Their investment strategy is to go against the crowd by buying poorly performing stocks at valuations they find attractive and then selling them at a later time, following what they expect to be a recovery in the share price. Companies in which contrarian managers invest are frequently depressed cyclical stocks with low or even negative earnings or low dividend payments. Contrarians expect these stocks to rebound once the company’s earnings have turned around, resulting in substantial price appreciation. Contrarian investors often point to research in behavioral finance suggesting that investors tend to overweight recent trends and to follow the crowd in making investment decisions. A contrarian investor attempts to determine whether the valuation of an individual company, industry, or entire market is irrational—that is, undervalued or overvalued at any time—and whether that irrationality represents an exploitable mispricing of shares. Accordingly, contrarian investors tend to go against the crowd. Both contrarian investors and value investors who do not describe their style as contrarian aim to buy shares at a discount to their intrinsic value. The primary difference between the two is that non-contrarian value investors rely on fundamental metrics to make their assessments, while contrarian investors rely more on market sentiment and sharp price movements (such as 52-week high and low prices as sell and buy prices) to make their decisions. High-Quality Value Some value-based strategies give valuation close attention but place at least equal emphasis on financial strength and demonstrated profitability. For example, one such investment discipline requires a record of consistent earnings power, above-average return on equity, financial strength, and exemplary management. There is no widely accepted label for this value style, the refinement of which is often associated with investor Warren Buffett.2 Income Investing The income investing approach focuses on shares that offer relatively high dividend yields and positive dividend growth rates. Several rationales for this approach have been offered. One argument is that a secure, high dividend yield tends to put a floor under the share price in the case of companies that are expected to maintain such a dividend. Another argument points to empirical studies that demonstrate the higher returns to equities with these characteristics and their greater ability to withstand market declines. Deep-Value Investing A value investor with a deep-value orientation focuses on undervalued companies that are available at extremely low valuation relative to their assets (e.g., low P/B). Such companies are often those in financial distress. The rationale is that market interest in such securities may be limited, increasing the chance of informational inefficiencies. The deep-value investor’s special area of expertise may lie in reorganizations or related legislation, providing a better position from which to assess the likelihood of company recovery

Restructuring and Distressed Investing While the restructuring and distressed investment strategies are more commonly observed in the distressed-debt space, some equity investors specialize in these disciplines. Opportunities in restructuring and distressed investing are generally counter cyclical relative to the overall economy or to the business cycle of a particular sector. A weak economy generates increased incidence of companies facing financial distress. When a company is having difficulty meeting its short-term liabilities, it will often propose to restructure its financial obligations or change its capital structure. Restructuring investors seek to purchase the debt or equity of companies in distress. A distressed company that goes through restructuring may still have valuable assets, distribution channels, or patents that make it an attractive acquisition target. Restructuring investing is often done before an expected bankruptcy or during the bankruptcy process. The goal of restructuring investing is to gain control or substantial influence over a company in distress at a large discount and then restructure it to restore a large part of its intrinsic value. Effective investment in a distressed company depends on skill and expertise in identifying companies whose situation is better than the market believes it to be. Distressed investors assume that either the company will survive or there will be sufficient assets remaining upon liquidation to generate an appropriate return on investment. Special Situations The “special situations” investment style focuses on the identification and exploitation of mispricings that may arise as a result of corporate events such as divestitures or spinoffs of assets or divisions or mergers with other entities. In the opinion of many investors such situations represent short-term opportunities to exploit mispricing that result from such special situations. According to Greenblatt (2010), investors often overlook companies that are in such special situations as restructuring (involving asset disposals or spinoffs) and mergers, which may create opportunities to add value through active investing. To take advantage of such opportunities, 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 faster than the overall market, as measured by revenues, earnings, or cash flow. 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) 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. 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.

TOP-DOWN STRATEGIES analyze top-down active strategies, including their rationale and associated processes As the name suggests, in contrast to bottom-up strategies, top-down strategies use an investment process that begins at a top or macro level. Instead of focusing on individual company- and asset-level variables in making investment decisions, top-down portfolio managers study variables affecting many companies, such as the macroeconomic environment, demographic trends, and government policies. These managers often use instruments such as futures contracts, ETFs, swaps, and custom baskets of individual stocks to capture macro dynamics and generate portfolio return. Some bottom-up stock pickers also incorporate top-down analysis as part of their process for arriving at investment decisions. A typical method of incorporating both top-down macroeconomic and bottom-up fundamental processes is to have the portfolio strategist set the target country and sector weights. Portfolio managers then construct stock portfolios that are consistent with these preset weights. Country and Geographic Allocation to Equities Investors using country allocation strategies form their portfolios by investing in different geographic regions depending on their assessment of the regions’ prospects. For example, the manager may have a preference for a particular region and may establish a position in that region while limiting exposure to others. Managers of global equity funds may, for example, make a decision based on a tradeoff between the US equity market and the European equity market, or they may allocate among all investable country equity markets using futures or ETFs. Such strategies may also seek to track the overall supply and demand for equities in regions or countries by analyzing the aggregate volumes of share buybacks, investment fund flows, the volumes of initial public offerings, and secondary share issuance. The country or geographic allocation decision itself can be based on both top-down macroeconomic and bottom-up fundamental analysis. For example, just as economic data for a given country are available, the market valuation of a country can be calculated by aggregating all company earnings and market capitalization.

Sector and Industry Rotation Just as one can formulate a strategy that allocates to different countries or regions in an investment universe, one can also have a view on the expected returns of various sectors and industries across borders. Industries that are more integrated on a global basis—and therefore subject to global supply and demand dynamics—are more suitable to global sector allocation decisions. Examples of such industries include information technology and energy. On the other hand, sectors and industries that are more local in nature to individual countries are more suitable to sector allocation within a country. Examples of these industries are real estate and consumer staples. The availability of sector and industry ETFs greatly facilitates the implementation of sector and industry rotation strategies for those portfolio managers who cannot or do not wish to implement such strategies by investing in individual stocks. As with country and geographic allocation, both top-down macroeconomic and bottom-up fundamental variables can be used to predict sector/industry returns. Many bottom-up portfolio managers also add a top-down sector overlay to their portfolios.

Volatility-Based Strategies Another category of top-down equity strategies is based on investors’ view on volatility and is usually implemented using derivative instruments. Those managers who believe they have the skill to predict future market volatility better than option-implied volatility (reflected, for example, in the VIX Index) can trade the VIX futures listed on the CBOE Futures Exchange (CFE), trade instruments such as index options, or enter into volatility swaps (or variance swaps). Let’s assume that an investor predicts a major market move, not anticipated by others, in the near term. The investor does not have an opinion on the direction of the move and only expects the index volatility to be high. The investor can use an index straddle strategy to capitalize on his or her view. Entering into an index straddle position involves the purchase of call and put options (on the same underlying index) with the same strike price and expiry date. The success of this long straddle strategy depends on whether or not volatility turns out to be higher than anticipated by the market; the strategy incurs losses when the market stays broadly flat. Exhibit 4 shows the payoff of such an index straddle strategy. The maximum loss of the long straddle is limited to the total call and put premiums paid.

Thematic Investment Strategies Thematic investing is another broad category of strategies. Thematic strategies can use broad macroeconomic, demographic, or political drivers, or bottom-up ideas on industries and sectors, to identify investment opportunities. Disruptive technologies, processes, and regulations; innovations; and economic cycles present investment opportunities and also pose challenges to existing companies. Investors constantly search for new and promising ideas or themes that will drive the market in the future. It is also important to determine whether any new trend is structural (and hence long-term) or short-term in nature. Structural changes can have long-lasting impacts on the way people behave or a market operates. For example, the development of smartphones and tablets and the move towards cloud computing are probably structural changes. On the other hand, a manager might attempt to identify companies with significant sales exposure to foreign countries as a way to benefit from short-term views on currency movements. The success of a structural thematic investment depends equally on the ability to take advantage of future trends and the ability to

avoid what will turn out to be merely fashionable for a limited time, unless the strategy specifically focuses on short-term trends. Further examples of thematic investment drivers include new technologies, mobile communication and computing devices, clean energy, fintech, and advances in medicine.

 

IMPLEMENTATION OF TOP-DOWN INVESTMENT STRATEGIES A global equity portfolio manager with special insights into particular countries or regions can tactically choose to overweight or underweight those countries or regions on a short-term basis. Once the country or region weights are determined by a top-down process, the portfolio can be constructed by selecting stocks in the relevant countries or regions. A portfolio manager with expertise in identifying drivers of sector or industry returns will establish a view on those drivers and will set weights for those sectors in a portfolio. For example, the performance of the energy sector is typically driven by the price of crude oil. The returns of the materials sector rest on forecasts for commodity prices. The consumer and industrials sectors require in-depth knowledge of the customer–supplier chains and a range of other dynamics. Once a view is established on the return and risk of each sector, a manager can then decide which industries to invest in and what weightings to assign to those industries relative to the benchmark. The significant growth of passive factor investing—sometimes marketed as “smart beta” products—has given portfolio managers more tools and flexibility for investing in different equity styles. Smart beta investment portfolios offer the benefits of passive strategies combined with some of the advantages of active ones. One can exploit the fact, for example, that high-quality stocks tend to perform well in recessions, or that cyclical deep-value companies are more likely to deliver superior returns in a more “risk-on” environment, in which the market becomes less risk-averse. For example, where the investment mandate permits, top-down managers can choose among different equity style ETFs and structured products to obtain risk exposures that are consistent with their views on different stages of the economic cycle or their views on market sentiment.

PORTFOLIO OVERLAYS Bottom-up fundamental strategies often lead to unintended macro (e.g., sector or country) risk exposures. However, bottom-up fundamental investors can incorporate some of the risk control benefits of top-down investment strategies via portfolio overlays. (A portfolio overlay is an array of derivative positions managed separately from the securities portfolio to achieve overall portfolio characteristics that are desired by the portfolio manager.) The fundamental investor’s sector weights, for example, may vary from the benchmark’s weights as a result of the stock selection process even though the investor did not intend to make sector bets. In that case, the investor may be able to adjust the sector weights to align with the benchmark’s weights via long and short positions in derivatives. In this way, top-down strategies can be effective in controlling risk exposures. Overlays can also be used to attempt to add active returns that are not correlated with those generated by the underlying portfolio strategy