The exclusive focus of stock pickers is to select individual stocks. This
type of manager falls into three camps: value managers, growth managers, and
core managers.
 Value Managers
Value managers try to find companies trading at less than their "intrinsic
value", the price the underlying company is worth. In other words, they try
to by the stock as cheaply as possible. In buying stocks as cheaply as
possible, they hope to outperform in the long term, as their undervalued stocks
return to higher valuation levels. They also believe that when they make
mistakes, they have a more limited downside, since they paid a cheap price for
the stock to start with.
Value managers use financial analysis to calculate yardsticks of a stock's
worth. A classic value manager would focus on: a low "P/E ratio" or
price-to-earnings ratio (market price divided by earnings) which indicates that
the stock is cheaply valued compared to earnings; a low "price-to-book"
ratio (market price divided by accounting book value) which indicates that the
stock is cheap compared to its historical accounting value; and a high dividend
yield (dividend divided by market price) which shows that the stock pays a high
cash yield on its price.
 Growth Managers
Growth managers invest in the stocks of companies with rapidly growing
sales and earnings. They believe that the stock price of this type of
company will increase quickly as well, reflecting the strong growth of these
companies. They do not focus on the valuation of these companies, preferring to
examine their industries, management and growth potential. In aggregate, they
think that the strong growth of these stocks will outweigh their valuations over
a longer period of time. Obviously, growth managers focus on industries with
strong growth such as technology and computer companies. The recent growth of
the Internet has made Internet companies such as Yahoo! and Netscape favourites
of growth investors.
 Core Managers or "Closet
Indexers"
Core managers or "closet indexers" focus on security
selection, but try to maintain the same weightings as the index that they are
compared to. They use the same valuation techniques as value and growth
managers, but they don't want to make their portfolios appreciably different
from the index or other managers.
There are a couple of reasons for this. The most important is relative
performance. Relative performance means how a manager looks versus the market
index they are compared to. Managers generally try to beat the index they are
being compared to. If the manager's portfolio is very different from the index,
the manager will perform quite differently. If the manager's performance is
good, then there is little problem. When the manager under performs, the clients
are not very happy or patient. So managers keep their portfolios similar to the
index or other managers, expecting to be not to different from the index or
other managers.
The other reason is that clients, sales representatives and consultants want
their manager's performance to be similar to the index or other managers. Client
often don't want the best performance, but "conservative" management,
meaning performance fairly similar to published performance statistics.
Financial sales representatives want their clients to be happy and explaining
wide performance differentials between client performance and published market
and performance statistics takes a lot of time. Consultants want the manager's
performance to be similar to the index they are being measured against because
they have done "asset planning" studies which are based on the
performance of that index.
This means that there is a large group, perhaps the majority of managers,
who try to construct portfolios that will perform similarly to indexes and other
managers. These core or "closet index" managers will pick the best
stocks from an industry grouping. For example, if there are twenty-five stocks
in an industry group that is 20% of the market index, the manager might select
the best four at a 5% weight. Since most stocks in an industry tend to track
each other in performance, the manager will have much the same performance in
this portion of her portfolio as the index. By implementing this strategy for
the significant industry groups in an index, the manager will obtain very
similar performance to the index. Hopefully, by using financial analysis and
valuation techniques to choose the best stocks from the index groups, the
manager will outperform the index by a reasonable margin. |