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One of the issues a number of Australian investors are considering at the moment is how to efficiently and effectively invest in our share market at a time when many companies’ share prices are at near-record highs. For example, “income stocks” like CBA are highly sought after by investors both in Australia and offshore, as the lure of yield draws global attention to them. However, these high valuations give investors cause to question the efficacy of buying stocks at these levels – causing leading global stockbrokers like UBS to label CBA as the “most expensive large bank in world” last year (UBS Investment Research, Commonwealth Bank of Australia, 3Q13 Trading Update, May 2013). At times like these, then, investing based on fundamental analysis of the value of stocks rather than simply relying on how the market is valuing them is particularly important (after all, that’s what disciplined investors like Warren Buffett do all the time).
What is fundamental analysis?
Instead of buying an investment because others are doing so at the same time (which can lead to asset price bubbles), fundamental analysis looks at the economic value of assets in order to identify good value. Fundamental analysis was first advocated in the 1930’s by Ben Graham and David Dodd (often described as the fathers of modern investing), in their seminal study entitled Security Analysis.
Accessing fundamental value via ETFs?
One of the drawbacks of traditional index funds, which typically use indices constructed using the “market capitalisation” method, is that they are forced buyers of stocks at whatever the prevailing price is at the time of the rebalance of the index (which often occurs quarterly). Such forms of passive investment can be a very effective alternative compared to typically more expensive, higher turnover, actively managed funds. But what if we introduced fundamental analysis into the way the fund invests? The chart below illustrates the gap between the price that a stock may trade at, versus its fundamental (or fair) value:
In recent times, there have been a number of index methodologies developed which use factors other than market capitalisation to weight their constituents. One of the most popular and fastest growing of these has been developed by Research Affiliates, a globally renowned product development and research firm, whose methodologies underlie products with in excess of US$100bn under management. The Research Affiliates Fundamental Index® (RAFI) approach uses 4 fundamental factors to develop index weightings. These factors, namely, sales, cash flow, dividends and book value, are used to determine the ‘economic footprint’ of companies.
So an ETF tracking a fundamental index like QOZ can be a good tool for investors to consider when they are looking to invest efficiently in a rising share market, where share prices have diverged from ‘fair’ or ‘fundamental’ value.
Past performance is not an indicator of future performance.