There are two basic styles of stock managers: Active and Passive.
- Active Management: Active Managers are active players in the stock market. Their goal is to “beat” the market by actively seeking securities that will “add value” to their portfolio through increased dividend yield and price appreciation. The axiom of “buy low, sell high” fits this type of manager. The active manager’s goal is to generate higher returns for the investment portfolio. Active managers are supposed to make your DC Plan grow faster than the Market.
- Passive Management: Passive managers do not attempt to beat the market. They attempt to match the return of a broad market index. The Dow Jones Industrial Average (DJIA), the S&P 500, Russell 3000 Indices are standard passive market indices (see Manager Evaluation below).
Equity (Stock) Management Styles
Just as there are many characteristics associated with stock selection, there are managers who specialize in a specific asset management category. Managers are very creative when it comes to their names. However, they basically fall into the following management styles.
Growth Managers identify companies with above average to high growth prospects. These managers pick stocks with higher Price to Earnings Ratios (also known as P\E ratios). They will grow higher in valuations and higher in profitability. Managers in this style place emphasis on stocks that will grow rapidly in value.
Value Managers identify companies that are undervalued. These managers pick stocks that have low P\E ratios, low Price to Book Valuation and low-sales price ratio – but high in dividend yields. Value managers concern themselves with discounted pricing (they want low pricing) as a part of their buying strategy.
Top-Down Sector Rotator Managers use a systematic approach to stock selection by doing an economic forecast and analysis on such things as the political climate, interest rates and the employment outlook of the U.S. economy. They look for industries that will perform well in a particular forecasted economy and seek companies within that industry that will be more profitable than others.
Bottom-Up Sector Rotator Managers are the opposite of the top down rotational approach. These managers use specialized software programs to filter out companies that do not meet their specific buy/sell criteria. These managers use such things as potential market size, sales/earnings, and a good balance sheet with strong cash flows that show the company will gain market share as it grows.
Depending on their independent analysis, top down and bottom up managers will rotate from one sector to the next to get the highest returns possible.
Quantitative Managers (called quants), use quantitative analysis as a tool for evaluating stock market investing. These managers use complex mathematical and statistical computer modeling as a screen for making stock selections. Examples of its screening includes analyzing financial ratios (earnings per share), discounted cash flows, option pricing, and performance evaluation. The statistical data provides them with buy, sell and hold positions on securities so they can generate above average returns.
Technical Managers use trends and chart lines in their analysis of stock price movements and stock selection. These managers use graphical analysis in determining the direction of the market. They buy securities based on an up-trend analysis or sell securities based on a down-trend analysis of the market.
Capitalization and Capitalization Managers
What is Capitalization?
Capitalization is defined as the market share price of a company, multiplied by its issues of outstanding shares. Example: Let’s estimate AC computers. AC computers has 900,000,000 outstanding shares issued, and the market price is $540.00 per share.
Therefore, their market capitalization is $486,000,000,000. In English: 900 million shares times $540 dollars per share equals $486 billion dollars. Mathematically, 900,000,000 X
$540.00 = $486,000,000,000. Thus, AC computers has a market capitalization of $486 billion. This is a “Large Cap” stock.
Just as we have growth, value and core companies, we categorize companies into segments called large, medium and small capitalization markets.
Large Capitalization (Large Cap) Stocks are companies that have stock valuations of
$10 billion or more. The term “Large Cap” is an abbreviation of the term “Large Market Capitalization”.
Medium-Capitalization (Mid Cap) Stocks are companies that have valuations between
$2 billion and $10 billion. The term “Mid Cap” is an abbreviation of the term “Medium Market Capitalization”.
Small Capitalization (Small Cap) Stocks are companies that have valuations between
$300 million and $2 billion. The term “Small Cap” is an abbreviation of the term “Small Market Capitalization.”
Capitalization changes on a daily basis, but for the most part, highly capitalized companies always stay in and around the top of their capital markets. The same can be said for oil companies, high tech companies or automotive companies that dominate their markets. You can go to your local library or go onto the Internet and look up large, medium and small cap companies.
Large Capitalization Managers: Invest only in companies that have valuations of $10 billion or more. These managers invest in the largest companies in the world and are dominate in their industry.
Mid-Capitalization Managers: Invest only in companies that have valuations between $2 billion and $10 billion. This value can change over time, especially when an established company is growing.
Small Capitalization Managers: Invest only in companies that have valuations between $300 million and $2 billion. Small Cap stocks tend to be more volatile. Their valuation will change rapidly and often, depending on how well their products perform in the market.
All money managers must be evaluated (they get graded too!) to see how well they are managing your funds. The most common method is to compare their Rates of Returns (ROR) to some kind of index. This index is called a Benchmark. An index like the Dow Jones Industrial Average (DJIA), the S&P 500, Russell 3000 Indices or a hybrid index is compared to a manager’s unique style. In some cases, a manager will have to use a custom index to compare its performance. Example: if a manager is investing in a Socially Responsible Fund, an index is created to measure how well the manager compares to it. If the manager is an active manager, they will be required to beat the returns of that index by a quantifiable figure (Example: 2%) above the index return.
This quantifiable figure is called a Bogey. An active manager should beat meet or beat its bogey against its established benchmark. For example: the return of a small-cap fund can be compared to the Russell 2000. The manager will be required to beat this benchmark by a given percentage (200 basis points or 2%) above the Russell 2000 Index’s rate of return for small-cap funds. If an active manager is on a performance-based fee, they must meet or beat their bogey. If they do not, they will not earn any incentive fee. This type of arrangement creates a win-win situation for you and the manager. If the manager outperforms the index by its bogey, they are making money, and everyone gets paid.
If the manager is a passive manager, their goal will be to generate returns that match that particular index. If the manager under-performs that index, their ability to manage your portfolio should be questioned.