Why Price is Right
May 11, 2012
Brian K. Evans may work out of an office overlooking the Pacific Ocean, but that Left Coast location may just give him the chance to, as Apple's semantically incorrect advertising used to proclaim, think different.
Which is why his index-based e exchange-traded Madrona funds do not use market capitalization as the basic value for evaluating the worth of stocks or other securities they hold.
Size is what drives most, if not all, other index funds. Market cap is supposed to encapsulate the wide range of market participants' evaluations of the prospects going forward for a given name.
But, for Evans, share price is what matters. His domestic stock fund looks at each stock as an individual stock. With earnings of its own to be evaluated on its own. With analysts estimates of future earnings to be taken in and weighed.
And that's what Madrona's automated, rules-based stock fund does. Yes, it's an actively managed fund, part of that tiny, but growing segment of the exchange-traded fund business.
But there is no intuition or gut calling involved. That's the rules-based part.
The fund takes the Standard & Poor's 500 and pulls in 7,500 analysts estimates on the earnings of those stocks for the next five years. Then it calculates the present value of those earnings and compares that projected value to the current share price, to determine if that price under- or over-values the firm's prospects.
The most undervalued firms automatically, by direct calculation, float to the top. The most overvalued stocks drop to the bottom. Companies which are projected to lose money over the next five years or to even see declining profits are simply culled from consideration altogether.
This means the fund winds up with a forward-looking, profit-based set of stocks that it can recalibrate at will. Right now, that's every three months.
And, thanks to what is starting to be called Big Data, he can sit in his office overlooking the ocean and simply let the system do his work. Like a quantitative trader, he figured out in advance how he wants his fund to work.
Now he just lets his system do its work, on behalf of his clients.
In effect, he is a passive manager of an actively managed fund.
And, if price is the right way to value stocks, he'll end up a winner, as will his customers.