It is being said that you need to invest in active managed funds so that fund manager can pick undervalued stocks. However many people still lose lots of money. Here is the reason:

For an analyst to find an undervalued stock, they need to calculate the intrinsic value of the stock. To do this they first must find what is the required rate of return or the discount rate. The required rate of return is the risk free return + risk premium. Risk free return is easy to find – in Singapore context it will be the government treasury. For CPF investment, it will be the CPF-OA 2.5% floor rate. The problem is with the risk premium which is the additional return required above the risk free. So how to find this risk premium? A famous model is from using the Capital Asset Pricing Model (CAPM) which goes like this:

Required rate of return = Risk Free Rate + Beta x ( Market Return – Risk Free Rate).

The Market Return is the expected return that the market will give. The relevant market return can be the STI (if the fund concerned invests in Singapore stocks), it can be Nasdaq (if the fund invests in US technology firms) etc. As for beta, it is a magical value invented by the analyst (actually it is more complicated than this but I am not too far wrong by saying it is just a magical value).

Having calculated the Required rate of return or the discount rate (we call it k), you would than calculate the intrinsic value of the stock using various models. If the stock has been known to pay dividends and it is expected that the dividends will growth at constant rate (called g) and assuming the stock is still alive infinitely, we are told we can use the Dividend Discount Model (DDM) as follows:

Intrinsic value = Last year’s dividends x (1 + g) / (k – g)

So we get that magical intrinsic value. If the intrinsic value is higher than the existing share price, we say that stock is undervalued (thus we buy). If the stock is overvalued, we sell or short sell. To be more kiasu, they would give themselves a margin of safety meaning they will only buy the stock if the intrinsic value is lower than the share price by 40% (for example).

What do I think? It is just rubbish. Here are my reasons:

1. “k” which is the required rate of return will be negative when the Market Return is negative (like what is happening now), the discount rate becomes negative. Practically it means that the active managed fund will also go down the drain.
2. Secondly, the intrinsic value is highly sensitive to the (k-g) spread. Take for example if k=8% and g = 4%, the (k-g) spread is 4% and say the last year’s dividend is 1, than the intrinsic value 1*(1+4%)/4%=$26 per share. But let’s say the k=6%, than the intrinsic value = 1(1+4%)/(6%-4%)=$52!! Even a margin of safety of 40% is not enough! Who can tell what is the good value for k? K is merely the projected return of the Market. Who will know how much the market will perform? Also – who can be confident that g will be the same every year? Fortune teller will know of course.