Financial Advice for Australians - Free finance tips and reporting by a Financial Adviser

Introduction

It has started already. The market has tanked and all the experts have started telling us how we might go about finding the shares that will be the biggest winners over the next 12 months.

While all share market fund managers and investment professionals have their own style of investing, they generally fall into two main groups: those who are looking to pick investments or asset classes that grow in value, and those who are looking for assets that give superior returns to say bonds or cash. It helps if we (as investors) have an idea of how the different styles will affect growth and returns. It also helps if we understand what limits and constraints act on certain styles of investing and how much scope fund managers have to avoid them.

Regardless of the different style used, all fund managers have the same goal: to get good returns. Why? Because funds management is just like all good commercial businesses: achieve better returns for your investors than your competitors and more people will invest with you, the business will grow and you'll make more profit.

Let's explain the different styles

Value investing or investing in a value fund
As the name implies, value investing means buying or investing in assets that are undervalued.

The measures used to determine if shares are undervalued may vary but they generally involve identifying shares that are trading at low Price to Earnings (PE) multiples compared to similar companies, or are underpriced for numerous other reasons. They could be trading at a discount to their asset value.

This style of investing is credited to Benjamin Graham. Graham has written many books on how and where to 'find value' but his most famous student, Warren Buffet, has always described the investment style as "finding an outstanding company at a sensible price." I think ANZ is a good example. The share price today is almost 50% less than it was 6 months ago. Where do you think it will be in 18 months time? Do you think it will do better than the cash rate of around 8%? In other words if the share price of ANZ is now $15.50 do you think it will be worth more than $16.70 in 12 months (or 8%)? I suspect it may be more than that by October.

Growth investing or investing in a growth fund
Again as the term implies growth investing is a style that seeks to pick an asset that has greater potential for future growth and earnings than it currently shows. This style of investing looks for shares that are expected to grow at an above average rate and give good capital gains over time, with less regard to earnings (as the share grows in value so will the earnings). This anticipated growth could be because of its technology, processes or another advantage over its competitor.

These 2 styles are often seen as opposed but the hybrid of value and growth investing is what's known as GARP (Growth at Reasonable Price) or when cheap meets good growth potential. Is it now sounding a little contrived? Well it is. Yes they both want the same, the price of the share to increase. It's just the methodology that's used to come to the conclusion to buy.

Interestingly, history has shown that value funds outperform growth funds over time.

Contrarian investing or not following the herd
This is related to doing the opposite of the crowd. The idea behind contrarian investing is if there is wide spread pessimism, as there is now, that pessimism can lead to shares being driven down much further than is justified which creates buying opportunities. Conversely some shares are often overhyped which can lead prices to be inflated well above their true value. In this case the contrarian would be selling. This can apply to individual shares or to whole sectors, e.g. media stocks or mining stocks. Which one would you see as a better buying opportunity at the moment?

Momentum investing or buying high and selling higher
This is as it sounds, using market momentum to invest. Momentum managers look for trends in shares movements. Are they tending higher or lower? If a share has been increasing over a 3 month period then it tends to continue, and a momentum manager will buy. Conversely if a share has been falling over the same period a momentum manager will tend to sell.

What about index funds?
These funds buy shares that make up the index. Before we look at some of the pitfalls let's examine what the S&P/ASX200 actually is.

The S&P/ASX200 was launched in April 2000 and coincided with Standard and Poor's taking over the index business that was run by the Australian Stock Exchange. The index is made up of the top 200 companies in Australia (just as the S&P 500 of the US is the top 500 companies in the US).

In Australia this index is made up of 200 companies with over $200 billion combined capital value and represents around 80% of the Australian equity market.

So if you are invested in an index fund you are simply buying the shares that make up the index. So if BHP represents 14% of the index then 14% of your money is in BHP. The same applies if Westpac is 3.5% of the market and so on. So it's very representative of the Australian stockmarket as a whole. Now fund managers measure their performance as how well they do above the index. So if the whole index performs at 12% for the year and your actively managed fund does well and achieves 17% then you have outperformed the index by 5%. Simple!

Yes it is but what is extraordinary here is we all know that all shares can't all be performing at the same time, so not all 200 companies in the ASX/S&P 200 will be going up in unison. Different economic conditions and cycles clearly favour certain industries. For example, mining shares may be going gangbusters while financials and media stocks are underperforming terribly. But if you are the fund manager of an index fund you really have no choice but to invest in them all, as long as they are in the top 200. If a share does badly it actually reduces its percentage of the index which means as a fund manger you would have to sell some of the shares. This is called reweighting and tends to force the price down further.

Let's take BHP as an example: if its price goes up and it now represents 14.5% of the index rather than 14% the fund manager must buy more BHP to match the percentage. This is why even though all the research and economic data may tell us not to buy a share, if you're in an index fund you own that dog whatever it may be. You are over diversified and unless the rising tide floats all boats index funds are not going to be the top performers.

This is why I don't like index funds. Little skill and research is needed. If a good fund manager and his or her research team can't cherry pick the stocks that are going to do well and those that aren't, considering all the info at their finger tips, then what are they doing? Good fund managers should always be able to outperform the index or you're perfectly right to ask what value they're adding.

What are the other indices?
Other indices on the ASX include the S&P/ASX300, the 100, 50, 20, the MidCap 50, and the All Australian 50. All these indices form part of the Australian stock market, obviously with some overlap. Finally we have the All Ordinaries index which is the top 500 companies listed on the exchange.

So where does all this leave us?

In summary all fund managers are trying to buy shares that will grow and increase in value over time. They use different techniques to try and identify the shares that will give their investors superior returns over time so that they stay invested. If you invest via an index fund I guarantee you will end up holding shares you wouldn't choose to buy yourself so go for a more active investment style and invest with a fund manager who is out there looking for the best stocks.
Don't invest in index funds!

Financial Advice for Australians - Free finance tips and reporting by Financial Adviser Venn Williams

What are the different styles of investing?

Introduction

Let's explain the different styles

So where does all this leave us?

Article originally published in August 2008.

Venn Williams - Halogen Pty Ltd