What are the criteria for initial consideration of a stock? Are screens used to flag potential stocks? Are top-down factors—first focusing on the economy or industry and then looking for the stock—a consideration, or is a bottom-up approach used, focusing exclusively on individual companies?
Funds that use different initial screens will end up with quite different portfolios, even if they share similar philosophies.
For instance, Fund A is led by a very growth-oriented, bottom-up fund manager:
"The most important thing we look for is a company whose earnings are currently growing well in excess of 20% per quarter. That's the primary tool. The second is to look for companies that are not only growing rapidly, but appear to be accelerating."
This selection process is a bottom-up approach that singles out growth and, not surprisingly, gives the fund a heavy bias toward technology stocks, a factor that is made quite clear in this fund's prospectus.
Fund B manager describes a top-down, value-and-growth approach that selects stocks from "sunrise industries"—industries that are growing. In other words, first the industry is selected based on growth prospects, and then individual stocks are selected from the industry.
Contrast that with another growth-and-value fund, whose manager uses a bottom-up approach:
"We look for two basic things: The stocks that we will buy must have a price-earnings ratio that is less than that of the S&P 500 and earnings growth prospects over the next several years that are superior to the earnings growth prospects of the S&P 500. What we're trying to do is buy above-average earnings growth at a discount."
Not all managers screen a large universe of stocks. For example, there is the "story" selection approach used by Peter Lynch, who made his investment fame managing Fidelity's Magellan Fund. Mr. Lynch selected stocks based on well-grounded expectations concerning the firm's growth prospects, derived from the company's "story"—the story being what it is that the company is going to do, or what it is that is going to happen, to bring about the desired results.
All of these portfolio managers have produced good long-term performance records, but their portfolios look quite different.
What "conditioning" or secondary characteristics do you look for?
A portfolio manager's initial criteria for selection will turn up a list of potential stocks, but there will be losers as well as winners. A good portfolio manager will have conditioning screens or other stock characteristics that attempt to weed out the kinds of losers that tend to turn up as a result of his initial criteria.
Good secondary screens are an indication that the portfolio manager is aware of the potential pitfalls of his approach, and, of course, it notifies you of those potential pitfalls, as well.
For the most part, these secondary screens are pretty standard, but they should be consistent with the initial selection criteria. For instance, one growth and income fund invests in conservative dividend-yielding companies, and so the portfolio manager looks for companies with a healthy balance sheet and a commitment to paying the dividend.
Another manager uses primary screens that search for value—low price-earnings ratios, low price-to-book ratios, and high dividend yields. But this fund seeks mispriced stocks, not those that deserve low multiples, so the manager also looks for companies with a high return on equity and that are market leaders, with the best profit margins, product lines or service in their industry.
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