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INVESTORS NOTEBOOK – How stock pick affects fund manager

By Reuben Alberto

STOCK selection or stock pick is one of the fundamental factors that affect the performance of a portfolio/fund manager.

-serif”>A portfolio comprising of poorly/randomly selected stocks will thus be expected to play second fiddle to the benchmark while that comprising of quality and research-oriented stocks will definitely give value to the investor.

It should, however, be noted that stock selection is based on a number of factors and the criteria to be used differ from one fund manager to another.

Generally speaking, stock selection is mainly governed by the belief/philosophy of the respective fund manager. For example, a fund manager can be considered to be either value-driven or growth-driven when it comes to stock selection.

In the former case, the fund manager will include in his portfolio, more of those stocks that he believes to be value stocks. The manager will take positions in the stocks on the belief that there is some value in the stock that is yet to be realised.

On the other hand, a growth-driven fund manager will be interested in those stocks that he fundamentally believes to have some growth potential and these will be long-term positions in most cases.

Value stocks – quite a number of factors come into play when the fund manager is looking for value stocks. These include fundamentals like the stock’s price earnings ratio (P/E), debt to equity ratio and the price compared against its book value. Usually, a stock that is trading at a low P/E ratio relative to that of the market is considered to be trading at a discount and thus has some upside potential in it.

A stock trading at a price that is closer to its book value is also viewed to be a value stock. Since the book value is historic, the market value of the stock will be expected to be higher and thus the manager will view any stock trading closer or below its book value as having some great potential to strengthen.

If a stock has a low debt to equity ratio then it means most of its operations are being financed through equity. This means the stock has a lower interest burden and thus most of its earnings will be allocated to shareholders. Such a stock will be viewed to be having some greater value to shareholders/investors when compared against the one that has a high debt to equity ratio;

Growth stocks – they are those stocks that show some growth potential as reflected by their high growth rates in terms of earnings and return on equity.

These stocks have a high level of debt financing as they are still in their growth stage and the borrowing will be meant to finance the expansion projects.

In coming up with a portfolio, decisions are made as to which stocks to take positions in, based on both the quantitative and qualitative techniques. Making investment decision based on the quantitative technique is more objective once a standard/target has been developed. In cases of equities, the fund manager may set the maximum P/E ratio, above which the stock can be considered to be expensive to be the market P/E.

A targeted rate of return on equities may also be set and the manager will pick only those counters that meet the required criteria. For bonds, the fund manager’s decisions may be based on factors like duration and yield variations.

On the other hand, the qualitative aspect of the whole process is much subjective since it will based on the views of certain individuals – experts.

This will encompass issues like the quality of management, the company’s competitive advantage (eg technology, monopoly, distribution) and the support the company is getting from its shareholders and management (these include share buybacks and insider trading).

A well-constructed portfolio consists of a research-oriented stock pick and will definitely give value and wealth to the investor in line with the set objectives as indicated in the investment policy statement of the fund.

In the following week we will consider the issue of share buybacks, why they are undertaken and their implications to the investor in general.

*Reuben Alberto is the general manager (investments) for Imperial Asset Management Company and can be contacted on ralberto@imperialasset.co.zw

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