Stock pickers use three approaches for finding the best equities. These different manager styles look at stocks beaten down in value, stocks of companies with rapidly growing sales and earnings while others try to maintain the same weighting as the index that they are being compared to.
Stock Pickers, Three Types of Stock Picking Investment Management
The exclusive focus of stock pickers is to select individual stocks. These type of managers fall into three camps: value managers, growth managers, and core managers.
Value managers are stock pickers who try to find companies trading at less than their “intrinsic value,” or the price the underlying company is worth. In other words, they try to buy the stock as cheaply as possible. In doing so, 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 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.
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 too 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.