19-EquityPort Page 567 Friday, March 12, 2004 12:40 PM
Equity Portfolio Management 567before, prominent economic variables include changes in commodity
prices, interest rates, inflation, and economic productivity.
Additionally, the macroeconomic outlook approach to top-down
investing can be both quantitative and qualitative in nature. From the
former perspective, equity managers employ factor models in their top-
down attempt at generating abnormal returns (i.e., positive alpha). The
power of top-down factor models is that given the macroeconomic risk
measures and factor sensitivities, a portfolio’s risk exposure profile can be
quantified and controlled. In this way, it is possible to see why a portfolio
is likely to generate abnormally high or low returns in the marketplace.Bottom-Up Approaches to Active Investing
The “bottom-up” approach to active investing makes sense when
numerous pricing inefficiencies exist in the capital markets (or compo-
nents thereof). An investor who follows a bottom-up approach to
investing focuses either on (1) technical aspects of the market or (2) the
economic and financial analysis of individual companies, giving rela-
tively less weight to the significance of economic and market cycles.
The investor who pursues a bottom-up strategy based on certain
technical aspects of the market is said to be basing stock selection on
technical analysis. The primary research tool used for investing based
on economic and financial analysis of companies is called security anal-
ysis and falls into two categories, traditional fundamental analysis and
quantitative fundamental analysis.
Traditional fundamental analysis often begins with the financial state-
ments of a company in order to investigate its revenue, earnings, and cash
flow prospects, as well as its overall corporate debt burden.^8 Growth in
revenue, earnings, and cash flow on the income statement side and the rel-
ative magnitude of corporate leverage from current and anticipated bal-
ance sheets are frequently used by fundamental equity analysts in forming
an opinion of the investment merits of a particular company’s stock.
Specifically, the fundamental analyst attempts to determine the fair
market value (or the “intrinsic value”) of the stock, using, for example,
a price-to-earnings or price-to-book value multiplier. The estimated
“fair value” of the firm is then compared to the actual market price to
see if the stock is correctly priced in the capital market. “Cheap stocks,”
or potential buy opportunities, have a current market price below the(^8) Benjamin Graham and David Dodd developed the classical approach to equity se-
curities analysis. Their approach is explained in Security Analysis (New York:
McGraw-Hill, 1934). Notable investors who have successfully employed the tradi-
tional approach to equity security analysis include Warren Buffet of Berkshire Hath-
away, Inc. and Peter Lynch of Fidelity Management & Research Co.