Behind the Scenes of a Mutual Fund

Country Routes - August, 1997

With the increasing popularity of mutual funds over the last few years, many people have invested in them without doing a bit of their own homework. Do you understand how a typical mutual fund works? More importantly, the risks involved? (See my two part series on "Risk" or call me for a copy.)

What I want to describe in this article is how a value-investing style works. In this environment of escalating valuations, this style of investing becomes increasingly more important! It is a fundamental long-term style where research is VERY disciplined. You would not have found any Bre-X in these portfolios. Research starts with a simple screening process to whittle down approximately 20,000 global stocks using basic criteria for determining which of those stocks hold value.

From this large grouping, approximately 300-400 stocks from around the world will routinely stand out. To these companies each analyst will apply detailed financial analysis to determine whether they are undervalued. They examine company financials and project normalized earnings approximately seven years into the future and actually create pro forma balance sheets and income statements. Based on these projected earnings, if a company has a normalized price to earnings ratio that is low, it is eligible for addition to the value list from which stocks are chosen for portfolios. Before the stock can be added however, regular weekly meetings require a complete review of the recommended company. Because each analyst and portfolio manager has a vested interest in making sure the company is truly undervalued, there is some very lively discussion. The company in question is completely dissected to determine whether or not the research analyst's recommendation is valid. If the company survives this strutiny, it is added to the value list.

As you can see, this team approach means that the value of the management company as an organization is the entire team -- not any star manager or research analyst. This team approach is solidified by the fact that only stocks from the value list are available for addition to the portfolios that are arranged.

Now I hope you can see in the above abbreviated description, the importance in your selection of a mutual fund, since they vary as to their management styles. The value-investment system perhaps best known is the Benjamin Graham method. He is the American father of modern securities analysis. The late Mr. Graham favoured bargains. He looked for companies in which working capital per share -- what he called "the skin and bones value" -- was above the stock price. Total debt to equity should be less than one, which eliminates many stocks on the TSE & the American markets.

Where is value found today? Both in developed and developing markets. In Western Europe and Asia there are many small and mid-cap companies which have been overlooked by the marketplace and meet value investor's criteria. For larger companies, there is value in Thailand, Korea, Eastern Europe and the Indian subcontinent. However, it is important to remember that to maintain a diversified portfolio is part of the fund's mandate. This means that generally no more than 20% of a portfolio will ever be invested in one country or region; and that there will be no more than 30% of emerging market stocks in a broad- based portfolio.

What areas of the world are currently overvalued? Today we see markets in Japan and North America as being fully valued. In addition, many larger capitalization stocks of Western Europe also seem to be more fully valued. However, there is still value and opportunity in each of these regions in the small and mid- cap arena.

If you have any questions, please call Reg Borrow at (519) 855-6639. He is an Independent Financial Consultant with Regal Capital Planners Ltd.

Money Matters Index                                 Home Page

Created: Mon Sep 23 10:30:50 1996
Web Page designed and created by Champ Consulting Services, Georgetown, Ontario