The process of active management

One approach is called top-down. This method emphasizes broad economic indicators, including:

• GDP growth – a sign of overall national economic strength.
• Debt-to-GDP – a country’s national debt expressed as a percentage of its GDP. A low ratio indicates solid fundamentals.
• Interest rates and inflation – central banks raise rates to control inflation; low rates indicate inflation’s under control, and that’s usually positive for equity investors.
• Unemployment rates – low unemployment rates suggest a strong economy.
• Consumer sentiment – an indicator of people’s perceptions of the state of the economy, as well as their own economic standing.
• Retail sales – strong numbers suggest consumer-oriented firms, and the overall economy, are performing well.
• Savings rates – low rates can signal a strained economy or too much consumption. The figure should be weighed against other data; when coupled with strong jobs growth, high spending rates just point to optimism.
• Household debt – high levels suggest consumers are in trouble.
• Manufacturing data and shipping volumes – high numbers indicate improving economic activity.
• Housing starts – new-home building drives demand for consumer goods and raw materials.
• Position in business cycle – It’s better to buy riskier assets, like non-blue-chip equities, when the economy’s expanding; when growth levels off or the economy starts to contract, gravitate towards less risky options like bonds.
• Overall stock market trends – these can provide insights into the performance of the overall economy.

Based on this data, managers determine which sectors to emphasize. For example, if the analysis indicates a weak outlook, a manager may give more weight to companies in defensive sectors like utilities and health care; which tend to remain fairly stable even when the economy slows because people rely on those services.

The opposite approach, called bottom-up, focuses on assessing fundamentals and valuations of individual companies.

Bottom-up managers look for companies with stocks priced below the firm’s true value. They make this assessment through a multi-step analysis of the company’s financial health. In the manger’s view, the market has temporarily misjudged the company’s worth and its stock will eventually climb to true value.

So, bottom-up analysts look to buy mispriced stocks now, with the aim of capitalizing on the upswing.

Identifying mispriced stocks requires detailed examination of a wide range of data. But with thousands companies to choose from, how do managers narrow the list?

Technology provides the first filter. Analysts use computer models to access and assess every available scrap of company information, including balance sheets and financial statements.

The models identify sound company fundamentals, and those deemed inadequate are eliminated.

Once the fund management team gets a potential buy list, it embarks on in-depth analysis of each firm. Typically, it takes an eight-person team one month to assess a single company.

Here are some things analysts and managers consider:

• Debt-to-EBITDA and debt-to-cash flow ratios, which should be below 2.5 times
• Companies should have sustainable competitive advantages – barriers to entry for competitors should be high due to the existing firm’s domination of the niche, or startup costs for competitors should be daunting
• Returns on invested capital (ROIC) are strong relative to industry benchmarks
• Annual reports; and, for U.S.-listed firms, quarterly and annual reports filed to the SEC
• Estimates of future ROIC
• Assessment of the management team:
  • What incentives are built into their compensation?
  • Are they compensated for improving long-haul returns on invested capital, or focusing on earnings growth over the short-term?
  • Are executives required to own significant stakes in their firm’s stock?
• Range of values analysis – identifying best case; base case; bear case; and worst case, which define when the stock is overvalued, undervalued, or at true value. Managers want undervalued stocks, so they buy in the bear case
• How does the company finance operations? Many fund managers prefer self-financing firms as opposed to those that borrow from banks
• Price metrics, including a stock’s drawdown characteristics. This refers to how acute the stock’s peak-to-trough movement is, and how often the stock shows dramatic drops
• Return on equity (ROE). Provides insight into a stock’s total return. For instance, if a company has an ROE of 10%, over time the firm’s total return will be close to 10%.
• Dividend yield and growth
• Net accruals
• Price-to-equity (P/E) ratios
• Price-to-book (P/B) ratios – compares the market price of the stock to its book value and provides insight into whether the stock is overvalued or undervalued.
• Free cash flow yield – a high ratio tells you the company is an efficient user of capital at a good price.

The analysis also goes beyond hard numbers.

An experienced manager takes a broad look at the company’s unique attributes. For example, does it have a robust range of product offerings, so if one flops the others will brace the fall?

To understand the added value of this approach, compare it to a passive option, in which the amount you buy of Company X typically depends on that firm’s size relative to others on the index.

But what if it’s undervalued? The passive investor will still hold the same amount of stock, whereas an active manager will purchase more of Company X than the index’s weighting. If the price finally climbs to what the manager perceives as its true value, this overweight position leads to greater returns.

The opposite also applies. An active manager should be able to spot companies with less-than-rosy outlooks and underweight holdings relative to index positions. That way, potential losses should be lower.

A good active manager will be on the lookout for stocks that have taken a hit. For instance, a stock trading at $53 falls in three weeks to $40. A surface analysis says this company should be avoided. But a skilled manager won’t write it off without examining the reasons for the decline. It might present an opportunity.

If the company’s products are becoming obsolete and it won’t adapt, a price drop probably reflects actual decline in value, and the manager will avoid it. But sometimes the market overreacts to short-term negative news while the firm’s fundamentals remain strong. A good manager screens out market noise.

While top-down and bottom-up approaches are technically opposites, they can be used together. Some mangers use top-down analysis as a starting point, looking at macroeconomic factors to choose which sectors or asset classes to overweight. Then they analyze fundamentals of each firm to drill down on buying decisions.

Another tool some mangers use is tactical allocation. Take the case of a fund with 70% allocated to equities, where 40% is in U.S. stocks, 40% in Canadian, and 20% in emerging markets. This is the strategic or neutral mix.

Based on an ongoing analysis of macroeconomic and fundamental data, a manager may judge that in the next six months Canadian equities will underperform, while U.S. and emerging market stocks will outperform.

That manager may temporarily shift allocations and put 50% U.S., 30% emerging markets, and only 20% Canadian. Once the rally runs its course, or the manager’s return target has been met, she’ll revert to the original strategic allocation.