Approaches to Equity Analysis

Equity analysis involves a lot of technical and in-depth analysis of the expected behaviour of the risk and returns with respect to a security. An individual investor may undertake the security analysis himself or may depend upon the professional analysis of others.

Approaches to equity analysis can be classified into two groups:

(i) Active or Primary Approach 

Active approach involves studying the individual securities and then selecting the specific securities for investment. An investor may want to improve upon the performance and earn a higher return than the market. This approach assumes that the investor has more information than the other participants and he can earn more than others. Thus, an investor likes to identify and pick up undervalued equity investment and, attempts to ‘beat the market’. He may identify high growth shares which are expected to show higher growth than other shares. 

For equity investors, this process means conducting a detailed and thorough analysis of a company’s business model, its prospects, and its financial situation. This analysis may involve meeting with company management and interviewing them about their strategy and the prospects of the company. Many financial advisers around the  world recommend actively managed investments for significant portions of their clients’ portfolios. Active management includes mutual funds and exchange-traded funds, as well as portfolios of stocks, bonds and other holdings managed by financial advisers. The benefits that are seen are:

  1.  Flexibility; because active managers are not required to hold specific stocks or bonds.
  2. Hedging; the ability to use short sales, put options, and other strategies to insure against losses.
  3. Risk management; the ability to get out of specific holdings or market sectors when risks get too large.
  4. Tax management; including strategies tailored to the individual investor, like selling money-losing investments to offset taxes on winners.

(ii)  Passive or Secondary Approach 

In the past couple of decades, index-style investing has become the strategy of  choice for millions of investors who are satisfied by duplicating market returns instead of trying to beat them. This approach attempts to go with the market and to ‘buy the market’. The investor likes to invest in such a way so as to earn as much as the market as a whole is earning. He may not devote time for equity analysis. Among the benefits of passive investing are: 

  1. Good transparency; because investors know at all times what stocks or bonds an indexed investment contains.
  2. Tax efficiency; because the index fund’s buy-and-hold style does not trigger large annual capital gains tax.

There can be two ways to this approach: 

First is ‘Buy and Hold Approach’ wherein an investor may make investment in some selected shares and hold the investments for some time. By holding the investment, the investor would be able to save on the transaction cost (brokerage on sales/purchase of shares), etc. Such a passive approach may or may not bring as much net return to the investor as available from active approach (which involves lot of costs like research, etc.). Sometimes, adjustments may be made in the ‘buy and hold’ approach to suit the change in risk preference of the investor. 

The other one is ‘Index Fund Approach’ wherein an index fund is basically a mutual fund that invests its corpus in those equity shares which form the benchmark index. For instance, Sensex is the benchmark for index fund scheme of Tata Mutual Fund. Thus, an investor buying the units of Tata Mutual Fund, is actually investing in 30 shares of Sensex in the same proportion as they are included in the Sensex. The return from his investment will be as much as from Sensex. However, it may be  noted that there are different index funds available and an investor has to carefully select a particular benchmark. 

Members of both camps perennially argue that their way is unequivocally the best. Proponents of active management argue that good active managers can outperform the benchmark and, therefore, more than cover their costs and thus deliver  net benefit to investors. Conversely, proponents of passive management argue that the difficulty of identifying superior investments is such that it is not worth paying higher costs for that effort and that passive management will deliver higher net-of-costs returns over the longer term. Yet, when used in tandem, the two methods can work together in ways that deliver the best of both worlds while compensating for the downsides of each.



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