Question

Importance of prospective analysis

For years, two great armies of investors have done battle on Wall Street. In one camp stand growth investors, willing to pay dearly for companies they believe can generate big profits for years to come. In the other camp are value investors. They’ll buy only into companies with real assets and solid earnings in the here and now and at bargain prices. As yet, value investing is more a framework than a set of codified rules. It relies more on forecasting, even though Benjamin Graham and David Dodd, who laid the principles of value investing, frowned on forecasts. BusinessWeek (2004) reports: “When you look at the Russell 1000 Value and Russell 1000 Growth indexes, which are now 25 years old, value beats growth by three percentage points a year, on average. Economists . . . using their own indexes, show value beating growth by an average 2.6% a year over 75 years.”

Whether you use growth or value criteria, it’s more important to pay attention to the fundamentals of a company’s business than it is to set investment criteria based solely on ratios like price to earnings or PE to sales growth. Value investors’ descriptions of their investing styles are also varied. But if you listen closely, the bottom line is the same assessment of fundamentals. In the broadest terms, value investors are looking for companies that trade at less than their real value in the hope that the value is eventually recognized by other market players and reflected in higher stock prices.

To identify such latent value, investors need to examine companies’ fundamental business prospects. “You want a company where something is going to change, either externally, like a fundamental change in its industry, or internally, like a change in management,” says the portfolio manager of the Oppenheimer Value Fund. Prospective analysis is a central component of value investing. It relies on a sound understanding of the company’s fundamentals and its economic environment. From this base, forecasts of future performance are developed that provide the basis for valuation of stock price. Whichever investing philosophy we subscribe to, the message is clear: understand where the company’s business model and strategic plan are taking it.

Required

1. With reference to the case above, critically evaluate the relevance of prospective analysis in an investment setting.

Answer 1

Prospective analysis is a form of risk assessment. The purpose of risk assessment is to identify the hazards that may render the system incapable of fulfilling its purpose and – preferably – to calculate the probability that this may happen. The risk is usually defined as the combination of the probability of something happening and the severity or seriousness of the outcome

A fundamental value investor will have a deeper understanding of the company, know what the exact risks are and hence is in a better position to make a better investing decision

Just by playing on the growth theme, without looking at the fundamentals is not a very smart way of investing and will eventually give sub-optimal results

A mix of thematic investing where you cross growth on a basis of sound fundamental will cause real value discovery and might take in all the aspects of prospective investing