The security analyst when faced with the problem of a buy or sell decision must first evaluate the past performance of the security, and then coupled with his personal experience predict the future performance of the security and the relative market position. The amount of data available to him far exceeds his potential and therefore he has to base his predictions on several basic attributes and modify the results in the light of intuitive beliefs. While the process may be successful, its intuitive segments make the evaluation of errors and improvements of this technique very difficult, if not impossible.
Equity valuation is difficult in comparison to valuation of bonds and preference shares. This is because benefits are generally constant and reasonably certain. Equity on the other hand involves uncertainty. It is the size of the return and the degree of fluctuations, which in togetherness determine the values of the share of the investor. Therefore forecasting abilities of the analyst are more crucial in the equity analysis. In fact equity analysis is based on the notion that the stock market is not working efficiently. In other words active management is based on the notion that historical and current information is not fully and correctly reflected in the current price of the stock. Hence there exist stocks that are over valued and those that are under valued. The task of the equity manager is to decide which stocks are which and then invest accordingly. By contrast the equity manager who believes that the market is efficient tends to flow a passive strategy. With indexing being the most common form of equity strategy.
Active Equity Investment Styles
The primary style of active equity management style is top down and bottom up.
The manager who uses top down equity investment style begins with an overall economic environment and a forecast of its nearest outlook and makes a general asset allocation decision regarding the relative attractiveness of the various sectors of the financial markets (e.g. equity, bonds, real estate, bullion etc). The manager then analyses the stock market in an attempt to identify economic sectors and the industries that stand to gain or lose fro the managers economic forecast. After identifying attractive and unattractive sectors and industries, the top down manager finally selects the portfolio of individual stocks.
A manager who uses bottom up equity investment style de-emphasizes the significance of economic and market styles and focuses instead on the analysis of individual securities. Using financial analysis and computer screening techniques, the bottoms up manager seek out stocks that have certain characteristics that are deemed attractive (e.g. low price earning ratio, small capitalization, low analyst coverage etc.)