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Investing – a matter of style |
by David Tomlinson
Boosted by a strong international demand for commodities, the Australian share market has had another remarkable run in the last 12 months.
The ASX 200 Index rose 16 per cent in 2005 and 43 per cent over the past two years.
Investors in superannuation funds are also happy – double-digit returns for most diversified funds in both the last two years.
While Australia did well, others did even better.
Japan is on the mend and Japanese share prices rose almost 40 percent last year as the Japanese economy recovered from its long period of stagnation. By comparison, the US market moved only slightly, with the S&P 500 index up 4.7 per cent and the more often quoted Dow Jones index up just 0.9 per cent.
But where to from here? The newspapers are full of tips on what will do well this year with many experts saying careful stock selection in a fully priced market will be essential. They are probably right.
But this does raise a philosophical question about the efficiency of markets and what it means for investors. The stock market in particular is often held to be the most efficient market we’ve got apart perhaps from the currency markets.
To be efficient, investors must have instant knowledge of all the factors that affect share prices and these should be instantly built into share prices. If this is true then beating the market is just a matter of luck and over the longer term it would be impossible.
From a practical point of view, investors who believe in efficient markets would be better off investing in index funds that passively invest in stocks that reflect their importance in the index. If the All Ordinaries index rises by 10 per cent then an index fund tracking the All Ords would move by the same amount.
The advantage of index funds is that they are cheap to run and management fees are low. There is no need for expensive analysts and hefty broker fees as no research is required – all the information is reflected in the share price.
Indeed the Stock Exchange and the regulators are keen to see that markets are as efficient as possible and have introduced continuous disclosure rules for listed companies and established severe penalties for insider trading.
Even analyst and broker briefings by companies are now not on unless the information is also provided to the wider market.
If efficient markets exist then there is no need for analysts and researchers at all. But of course you only have to look at Warren Buffett and other investors who consistently outperform the market to know that efficient markets do not exist.
More efficient than they used to be perhaps, but still not quite there yet. For one thing many of the analysts and investors are not as good as they could be. It means that many receive information but do not realise its significance. In addition insider trading does exist although it is often difficult to prove.
Another reason for inefficiency is that many stocks are under-researched. This happens particularly with smaller companies where the major researchers just do not bother because they are too small for the major investors such as super funds.
Time considerations are also important. Many of the major investors are pressured to focus on short-term investment gains rather than picking investments where the returns will be delayed - for years in some cases.
So if markets are inefficient how do you go about picking the anomalies? There are a number of different ways, most of which work at some time or other.
One is the value approach favoured by investors such as US billionaire Warren Buffett, regarded as one of the most successful investors ever.
This is basically a bottom-up approach where analysts look in detail at all aspects of every company in which they invest. They look at management, profits, debt, markets and so on and then calculate what the share price should be. If it is cheaper than the current market price, they buy. In other words they are looking for value now, not what the shares might be worth in two or five years time.
It is a process of investing in stocks that have been misjudged or overlooked by the rest of the market.
The other major way is the top down approach.
This involves looking at the major trends in the world and local economies.
Is a recession imminent? What is happening in China and India that will affect world markets? Is US manufacturing doomed? Will the resources boom continue? Once these questions are answered, the analyst then goes looking for stocks that will benefit or lose from the trends.
This approach aims at being ahead of the market, virtually predicting future profitability of various market sectors.
Both strategies have done well in the past. The bottom-up approach avoided all the pain of the dot-com bust because it saw no value. The top-down investors who saw the revival of Japan have reaped the rewards of their research (and patience).
These approaches are difficult for small investors to take on their own. The solution for most is to invest in a managed fund of some sort – either a unit trust or a super fund and let the analysts do all the work.
Good fund managers detail the approach or style they take, so getting a mix is possible. Overall, the climate for investors over the next 12 months looks reasonably favourable.
However as always, expect the unexpected.
David Tomlinson is a freelance finance journalist.
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