A FOCUS ON FUNDAMENTAL ANALYSIS
Given the significance attached to fundamental analysis in the question- naire survey, analysts and fund managers were also asked to describe their decision-making process when deciding to buy, hold or sell equities of foreign firms. This was in order to gain a more detailed understanding of decision-making processes within the fundamental analysis approach.
For analysts, and as found in prior research into domestic equity ana- lysis (e.g., Arnold and Moizer, 1984), decision making was varied, ranging from systematic to subjective and judgmental. For example, Analyst 3 (a European telecoms companies analyst) stated that he conducts a system- atic analysis using discounted cash flow and multiples, such as enterprise value to earnings before interest, taxation, depreciation and amortisation (EV/EBITDA) to arrive at a valuation (where EV represents enterprise value, given by market value of equity, plus market value of debt, less the company’s cash balance). This valuation is then compared with other companies in the sector. If the value is 10% above the share price, it is re- commended as a ‘buy’ and if it is 10% lower, it is recommended as a ‘sell’.
However, Analyst 3 noted that this approach is used more in the telecoms sector, indicating, in line with Barker (1999) that the valuation models used may be dependent on the industry or sector of the company being analysed.
At the other end of the continuum, Analyst 6 (a European pharmaceuticals companies analyst) stated that his process is not formalised, pointing out that fundamental analysis ‘is not a methodological series of instruction’.
The technique used by Analyst 6 essentially involves examining relative performance over the following six months, using valuation ratios such as P/E or EV/EBITDA against leading US and European competitors, while also allowing for country variations in multiples. Analyst 5 also pointed out that the fundamental analysis approach varied between different firms.
Consistent with the findings in the previous sections of analysts moving away from country-based specialism, intra-sector comparisons of ratios and performance were prevalent in sell-side analysts’ techniques, and sector- based factors clearly underpinned the basis of analysis.
Examination of fund managers’ decision making revealed a multi-stage process involving other members of the institution. The first stage of the investment decision lies with a senior asset allocation committee, which allocates funds to the key regions of Europe, the US, Asia and Japan and other emerging markets, on the basis of economic variables, with reference to a global index, such as MSCIR (Morgan Stanley Capital International).
Following this allocation, most fund managers progress to a ‘screening’
stage in their investment process, which involves the initial selection of companies that meet certain criteria. These companies are subsequently subjected to more rigorous analysis. This screening stage would not form part of sell-side analysts’ techniques, as they are devoted to a relatively small number of companies in a specific industry. Transnational fund managers, on the other hand, often have hundreds of potential investee companies in their ‘universe’, and thus have to find a means of discriminating between them in the initial stages in order to reduce the number of companies to a manageable figure.
The screens used by fund managers take one of two forms. The first involves discriminating on a purely quantitative basis, using a combination of factors such as company size, performance or valuation multiples such as EV/EBITDA or P/E. The second is a ‘thematic’ approach, where fund managers, either themselves or through analysts’ research, identify themes, then ascertain how these themes will affect specific companies. In some instances, this thematic approach was necessitated by the absence of the data required for a systematic quantitative screening.
Fundamental analysis of individual companies follows this screening process. This involves an assessment of company management and strategy, a detailed analysis of financial statements and a questioning of local analysts.
Thus, the approach taken by fund managers was characterised as ‘bottom-up within top-down’, that is, at the individual fund manager level, the analysis is company specific and bottom up, yet this analysis follows an earlier asset allocation stage. The ultimate investment decision is then made in consultation with other members of the regional ‘desk’ or team, who offer additional insights and knowledge.
It appears, therefore, that the use of top-down analysis has probably been understated, at least at the institutional level. This is because the ques- tionnaire focused on the use of top-down at the individual fund manager level; here it was not perceived as useful. At the institutional level, how- ever, top-down appears to be more prevalent, and is therefore effectively used alongside fundamental analysis, although at opposite ends of the in- vestment decision. This also helps to explain the results of Bhushan and Lessard (1992), who found that fund managers perceive both top-down and bottom-up analysis techniques to be useful.
The interviews also included questions on the ratios used in company analysis, in order to ascertain whether differences exist between transna- tional analysis and domestic analysis. In domestic analysis, the P/E ratio is a dominant valuation ratio (Arnold and Moizer, 1984 and Pikeet al.,1993).
However, international accounting differences represent a significant obs- tacle to the comparison of P/E ratios. Interestingly, fund managers and an- alysts involved in transnational analysis have devised a way of mitigating the effects of international accounting differences, by effectively ‘moving up’ the income statement. In particular, the EV/EBITDA ratio was referred to specifically by the majority of analysts and fund managers.
Numerous comments exemplify why this ratio is so valuable in transna- tional analysis. Fund Manager 12, for example, used P/E only as a tertiary indicator; he examined EV/EBITDA to strip out accounting differences, as ‘there is no need to go through the accounts if you go up earnings far enough’. Similarly, Fund Manager 13 stated that:
EV/EBITDA is used because of accounting differences in the treatment of debt, tax and depreciation, so backing up [the profit and loss account] this far gives you a better feeling of operational profitability and what is coming through in terms of that.
Fund Manager 9 commented that she uses EV/EBITDA because it is more suitable in transnational analysis, and can be used for comparing
‘apples with apples’. She also pointed out that this ratio is more popular in transnational analysis due to the time involved in adjusting accounts.
Similarly, Fund Manager 11 commented that country differences are not too much of a problem because:
What you tend to do is use a ratio that gives you a better basis for cross-border comparisons, i.e., EV/EBITDA.
Overall, the number of analysts and fund managers stating they used EV/EBITDA exceeded those who stated they relied on P/E ratios by 20%
(18 to 15), despite recent research indicating that P/E is, in general, the most dominant valuation ratio (Fernandez, 2001).