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    Seed Weekly - Characteristics of Winning Shares

    The May 2014 edition of the Bank Credit Analyst produced a very useful report, discussing some of the merits of active versus passive fund management.

    Firstly this is not an “either or” debate. While it is impossible for the average active fund manager to outperform a passive index after fees are taken into account, there will always be successful stock pickers that do systematically deviate from their benchmark and successfully outperform the market on an ongoing basis.

    An active manager is one that relies on analytical research, forecasts, and their own judgement in order to decide which portfolio to construct. Passive investors, on the other hand, tend to construct a portfolio close to a given index – typically a market cap weighted index.

    Active managers will find more success where prices deviate substantially from their fundamental fair values. Two areas where this is often found are the small cap and emerging market universe.

    The report defined characteristics of superior active managers and then went on to define certain characteristics of winning stocks as follows.

    Firstly, small cap shares (i.e. size characteristics) have been associated with alpha (typically defined as the excess return above a benchmark index). Since 1926 small cap stocks have outperformed large caps by an average of 2.8% per year.


    BCA notes that value stocks have also outperformed and when ranking stocks by price to book ratio, those with low ratios (i.e. value stocks) have outperformed those with high ratios by an average of 4.8% per annum.

    BCA found that other value metrics have also been useful in predicting relative returns for stocks globally. These are criteria such as low versus high price to earnings, low versus high price to cash flow and high versus low dividend yields.

    Value stocks tend to outperform more in market downturns and underperform when markets are up strongly, offering a partial hedge against market risk.


    When looking at price momentum, an investor must consider the time horizon. Evidence suggests that over a short term horizon of one month, momentum is negative so that stocks that performed well last month tend to underperform this month (price reversion).

    Over medium term periods of 2 to 12 months momentum turns positive so that past winners continue to outperform, turning negative again over one to five years.

    Some of the reasons for shares, which have done well over the last year, continuing to outperform can be ascribed to institutional investors scaling in and out of positions, the persistency of buying and selling over several months, especially for large cap shares, and also a case of equity prices not immediately reflecting new information about a company.

    While a traditional passive fund tracks an index that is constructed using a market cap weighting, the independent research from BCA indicates that it makes a lot more sense to construct a portfolio using value and momentum factors. Indeed, this is exactly how we have designed the Seed Equity Fund. A value portfolio, using the four value criteria noted above, is systematically constructed and then equally combined with a momentum portfolio using price and earnings momentum.

    The result is a Fund that has the attributes of an actively managed portfolio and the proven ability to outperform traditional indices over time, yet at a lower cost.

    Kind regards,

    Ian de Lange

    021 914 4966

    Permalink2014-05-27, 09:47:51, by Mike Email , Leave a comment
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