Introduction to ActivePortfolio Management

Equity Style Spectrum

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Deep Value

Value GARP

Index

Growth

Management Styles

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Traditionally: Fundamental

An investment approach that relies on detailed company specific research to identify buy/sell candidates

Quantitative An investment approach that relies on “models”

(involving forecasting financial metrics using mathematical and statistical techniques) to identify buy/sell candidates

Decision Making ProcessFundamental vs. Quantitative

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Fundamental− Decisions based on human judgment− Applied depth and breath of knowledge to a narrow set

of investment opportunities− Company visits may be important in the investment

process− Intellectual capital of managers very important− Portfolio results less easily back-tested and replicated

Hard to test the investment strategy because it cannot be quantified

Decision Making ProcessDiscretionary vs Quantitative

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Quantitative− Based on objective rules: Relationship between

inputs (fundamental or technical/statistical factors) and expected return are formalized in a model

− Applied narrow set of information to broad set of investment opportunities

− More easily back-tested and replicated (if you know the model)

− Intellectual capital of managers less important

Overall Process

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Investment Process

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Investment universe− Dictated by strategy mandate. Examples: U.S. small

cap., global value, international growth Focus list

− Narrow down the universe and perform in-depth research on stocks on the focus list

Portfolio construction− Optimal weight of each stock in the final portfolio, risk

management

Discretionary Managers

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Team-based majority voting Approach Fundamental research Active corporate interview program

Quantitative Managers

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Example: LSV Asset Management Use both statistical and fundamental inputs Management process: see handout

Basic Investment Strategies

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Top-down Bottom-up Value Growth GARP Market cap International

Top-down Strategy

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Start with forecast of the economy: GDP growth, interest rates, exchange rates, capital flows, employment growth….etc.

Then select industries that will prosper in the forecasted economic environment

Then select companies in the chosen industries, based on financial analysis

Asset allocation funds are examples of top-down strategy− Portfolio weights of two (or more) asset classes vary

over time, depending on market conditions

Bottom-up Strategy

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Focus on the financial characteristics of individual companies− Start with preliminary screening based on financial

analysis, e.g., dividend yield > 2.5%, P/B < 2.5x, consistent sales growth ….etc.

− More in-depth company analysis of the stocks left in the universe after screening

− Managers with a specific mandate, e.g., value, growth, income…etc. tend to be bottom-up managers

Value Investing

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− Choosing companies for which analysis reveals unrecognized value

− Value stocks tend to have:• High dividend yield• Low P/B, P/E, and P/cash flow

− Company experienced profits and stock price decline

− Stock underpriced by the market relative to its long-term fundamentals

Value Investing

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Which?

Long-term earnings potential?

Profits and stockprice decline

Did investors over-react to short-term negative events?

Investment decision

Value Investing (Cont’d)

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Graham and Dodd’s 1934 classic, Security Analysis, published during the Great Depression− Warren Buffet was a student of Ben Graham at

Columbia UniversityBut old ratios no longer apply in today’s market (e.g.,

P/B < 2/3x). Multiples fluctuate (S&P 500’s average is about 2x in 2012)

Value trap: low price stock value stock Momentum factor is important here

Value Investing

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Discretionary/fundamental For example, in “The Warren Buffett Way” by

Hagstrom (2005): Business tenets (Is the business idea sound?) Management tenets (Is management competent?) Financial tenets (ROE, profit margin, debt … etc.) Value tenets (PV of cash flow)

Quantitative LSV (uses both fundamental and statistical inputs)

Growth Investing

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Picking companies that are considered to have above average growth prospects− Higher than average valuation (P/B, P/E, P/cash flow)− Pay little or no dividend; excess cash used to finance

expansion• Investors expect superior rate of stock price

appreciation, rather than dividend yield − Expected to generate above-average sales and

earnings growth relative to its industry, or the overall market

− Representative sectors: health care and technology

Growth Investing

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PM’s view

Consensus view

Sto

ck’s

For

war

d E

arni

ngs

Gro

wth

Investment opportunity

Another way of thinking about growth investing

Value vs Growth

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Historically, value tends to outperform growth Positive value premium over the long term

Time-series

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Mkt-Rf SMB HML Rf1999 20.58 15.29 -33.95 4.692000 -16.93 -1.28 39.45 5.882001 -15.12 18.5 18.69 3.862002 -22.47 3.45 10.41 1.632003 32.12 27.72 5.04 1.022004 11.81 4.96 9.8 1.192005 4.34 -2.2 9.0 2.982006 11.39 0.24 14.22 4.812007 2.65 -8.32 -12.3 4.672008 -39.99 3.88 0.94 1.692009 31.52 8.6 -5.65 0.092010 17.78 13.52 -3.26 0.112011 -0.94 -6.03 -6.58 0.04

Growth vs Value

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Source: Dimensional Funds

Value vs. Growth

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Style Cycles and Geography

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TSX Weights by Market Cap

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As of September 2012

Energy 26.31%Materials 19.20%Industrials 5.93%Cons Disc 4.44%Cons Staples 3.05%Health Care 1.95%Financials 30.77%Info Tech 1.20%Telecom Svc 5.26%Utilities 1.91%

GARP

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Growth at a reasonable price Looking for growth but also reasonable valuation Popularized by Peter Lynch of Fidelity’s Magellan

Fund (1977-1990) PEG ratio 1

Blend

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Canadian stock market not large enough to have a deep value or uniquely high growth portfolio

Equity funds can be a blended fund (mix of value and growth stocks)

Market Cap

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Specialize in a particular size U.S. dollars (pre-2008 Q4):

− Large cap: > $10 billion− Mid cap: $2 - $10 billion− Small cap: $300 million - $2 billion− Micro cap: $50 - $300 million− Nano cap: Under $50 million

Size premium – preference for small-mid cap tilt? If passive, can pick a small-mid cap ETF

If active, may argue that this is the segment of the market where manager can exploit inefficiencies

International

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Benchmarks: EAFE (for developed markets), MSCI All Country World (for global markets)

Country selection weakening as a source of alpha and diversification

Economies and stock markets are increasingly globally integrated

New direction: sector selection Sector calls made independent of geography

Global sector ETFs

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Examples:

10 Global SectorsiShares S&P Global Materials Sector Index Fund (MXI) iShares S&P Global Consumers Staples Sector Index Fund (KXI) iShares S&P Global Consumer Discretionary Sector Index Fund (RXI)

iShares S&P Global Energy Sector Index Fund (IXC) iShares S&P Global Financials Sector Index Fund (IXG) iShares S&P Global Healthcare Sector Index Fund (IXJ) iShares S&P Global Industrials Sector Index Fund (EXI) iShares S&P Global Technology Sector Index Fund (IXN) iShares S&P Global Utilities Sector Index Fund (JXI) iShares S&P Global Telecommunications Sector Index Fund (IXP)

Currency Overlay

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Managing currency risk of international portfolio separately. Equity manager’s job not affected

Can be active currency bets, or passive hedge To hedge or not to hedge

Impact of Currency

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