Investing in Equities The Basic Schools of Thought

Active Investing
Growth Investing Value Investing

Passive Investing
Growth Investing Value Investing

Acitve Investing
The investment decisions of an asset manager are designed to outperform a benchmark index He tries to uncover situtiation, which the market has not fully appreciated (trying to outperform, he essentially uses market inefficiencies) The investments can be long or short investments, merger arbitrages, option writing etc.

Passive Investing
The asset manager makes only a few portfolio decisions (like in which markets or in which styles he wants to be invested in) The portfolios themselves replicate indexes (like the S&P 500, DAX, Russell 2000 or indexes specially designed for the need of the investor) The portfoilio is only changed, if the components of the index change Passive investing is based on the efficient market hypothesis, stating that equilibrium market prices fully reflect all available information.

Basic outline of the universe of stock exchange traded equities

Shares
Common shares Preferred shares

REITs
mutual fund for real estate investments

Exchange Traded Trusts

are used to handle royalty interests

Master Limited Partnerships

no income tax on the corporation level - quarterly distributions to investors required

Practical implication for fund/asset managers

most of the non pure equity instruments have higher dividend yields, but some legal restrictions may apply

Overview of the worldwide universe of stocks

Today we have about 45.000 equity instruments traded worldwide. About half of it has a market cap below $ 50 Mio and/or are traded on OTC exchanges (like the Pink Sheet Stocks in the US). So our investable universe consists of about 22.000 stocks. In the Americas and in Europe stocks can be traded freely with no restrictions (with some minor exemptions in Turkey). In Asia thing are quite different. Japan is a free market, but in most other countries restrictions apply. You might need special clearing procedures or a local clearing account, special permissions to trade, special reporting duties etc. (Examples: India, China, South Korea, Thailand). In some cases like in China you might not be allowed to trade special share classes (like the Chinese A or B shares). On the opposite side Hong Kong listed shares can be traded freely like Japanese shares.

Acitve Investing

The Concept of Value and Growth Investing

The basic concept of value investing is to buy cheap companies. Growth investing seeks to buy companies that have a high growth potential, especially an earnings growth potential. These two principal investmement styles seem to be cyclical in nature by themselves. In the late nineties growth investing (i.e. technology and biotecs) did very well. They were followed by years where value investors generally did better. Warren Buffet, the godfather of all value investors, does not like to distinguish between value and growth investing he talks more about the instrinsic value of a company. Intrinsic value is the discounted value of all future distributions. How do we measure cheap and how do we measure growth and is there a way to determine the intrinsic value?

The Value Drivers

Price/Earnings (P/E ratio) Price/Book Price/Sales Price/Cash Flow Dividend Yield

Growth drivers
Earnings Growth Rate Earning Momentum Sales Growth Operating Margin Growth

What about:
Return on Equity? Earning Surprises? Analysts Earnings and Sales Growth forecasts and revisions? Earnings Stability? Long Term Earnings Growth? Return on Assets?

Earnings
At the end of the day, its earnings that matter. Why?

The Most important Growth Drivers

Earnings Growth
Sustained earnings growth period to period There are a number of different earnings that can be used (earnings before taxes, earnings after taxes, EBIT, EBITDA, earnings before or after extraordinary items, GAAP or non GAAP earnings etc.). What earnings are used in a model depends what you want to express. Financial analysts normally use corporate profits before extraordinary items either after taxes (US) or before taxes (Europe) as a standard. Excluding the tax component makes companies more comparable over different countries.

Positive Earnings Revision

When analysts indicate that business is even better than anticipated

Positive Earnings Surprises

Announced corporate earnings that are higher than the analysts expected Because of the conservative nature of analysts estimates companies have a tendancy to deliver better results that the analysts are expecting. Nevertheless it indicates that business is doing better than anticipated. This gives rooms for upside surprises to follow in the next reporting period. Analysts are notoriously cautious because they dont want to be accused of pushing a stock. So they have to be really impressed by a company to raise their estimates (negative examples where Tyco, Enron and the whole tech bubble in 1999 and 2000). The more analysts cover a stock the better is the quality of the estimates. Beware of stocks with only 1 analyst covering the stock.

Earnings Momentum
Earnings that are accelerating period over period Companies that grow earnings faster every period are better growth companies than the ones where earnings growth decelerates.

Increased Sales
Continuous rapid sales growth of a companys products If a company is able to continuously come up with rising sales period to comparable period it indicates that they are growing their business. If you dont increase sales, you still can increase probability but only for a limited time period. (General example is the period out of a recession). But there is no sustained earnings growth without top line growth.

Expanding Operating Margins

Corporate profit margins are expanding Operating margin is defined as: Sales (direct costs + overhead) measured in % of net sales or simply: operating profit/net sales A comparison of the operating profit margins period over period shows whether the profit margin is expanding or not. A companys profit margin will increase if their products are in high demand and the competition is low.

Strong Cash Flow

Ability of a company to generate free cash flow after expenses (which is the cost of doing business and the upkeep and maintenance needed to stay in business). It is simply how much cash a company earned in a certain period after paying for all their expenses and investments. If a company works profitable but spends more than they earn on capital expenditures, their (free) cash flow is negative. The degree to which a company is cash flow positive or cash flow negative is an indication of their financial independence. As the absolute amount of free cash flow does not say much if you want to compare a company to others, it is a good idea to calculate a per share value.

High Return on Equity (High overall corporate profitability)

Return on Equity is a measure of profitability. It is calculated by dividing the earnings per share by the book value per share. The higher the number is the more profitable a company is and the more return management is providing for the shareholders. A rule of thumb says that the more dominant a company in its industry is, the higher the return on equity. But be careful: the absolute return on equity is highly dependent from the industry sector a company works in. Capital intensive industries like the steel industry tend to deliver lower return on equity than low capital intensive industries like the service industry. So a meaningful comparison of the degree of profitability is only possible among companies of the same industry.

What is so special about these growth drivers?

Earnings Revisions
Changing minds lead to changing prices.

Earnings Surprise
Stocks with positive earnings surprises are the superstars of the growth stock world Earnings surprises tend to persist!!!!

Sales Growth
Sales Growth is also one of the most important drivers (Top Line Growth)

Operating Margin Growth

Rising profit margins indicate, that a company is dominating its market (=pricing power) and/or has a new major product.

Free Cash Flow

Free Cash Flow gives a company a lot of freedom in their decision making As the absolute amount of free cash flow does not say much if you want to compare a company to others, it is a good idea to calculate a per share value.

Summary
Historical Operating margin growth, Free Cash Flow and Earning momentum have the highest influence of the outperformance of a stock versus the overall market. Sales growth has the least influence. But the importance of the various growth drivers can shift quite dramatically in various market phases like in 1999 or 2008.

It is necessary to keep an eye on all the variables defining growth. Depending on the market, these factors will be more or less important in various market phases. In phases of a booming economy earnings momentum and earnings growth will be more important that cash flow. But the latter will be much more important in times of a financial crisis like in 2008. Why?