Bargain issue

The Holy Grail for followers of value investing. The term has a general meaning indicating good value in an ordinary share. However, through the writing of Benjamin Graham, it also has a specific meaning which was successfully applied by Graham and continues to be used by orthodox value investors, although usually with some modifications. These allow for the fact that stock markets are now generally more highly valued than when Graham was working from the 1930s to the 1970s.

The specific meaning of a bargain issue is when a company's ordinary shares sell in the market for less than the per share book value of current assets after deducting all other claims on the business. In other words, take a company's current assets (inventories, debtors, cash) and deduct not only the current liabilities (creditors, short-term borrowings) but also the long-term borrowings and any other allowances. The net result is that the shares of such companies sell for less than the value of net current assets with any fixed assets thrown in for nothing. Graham found that buying a selection of such shares across a variety of industries invariably produced good investment returns.

Balanced fund

A mutual fund that invests in a combination of ordinary share and bonds (including government debt). As such, it has a wide spread of assets and could be considered medium risk, in contrast to funds that are invested wholly in equities (high risk) and wholly in bonds (low risk). The consequence of this should be that the investment return of a balanced fund will be pedestrian compared with an equity fund during a bull market, but will do well during a bear market.

Alpha

A term borrowed from statistics which is used to show how much of the investment performance of a stock or portfolio of stocks is independent of the stock market in which they trade.

• Within a simplified pricing model used to identify those portfolios of investments that deliver the best combination of risk and return, alpha is used to describe the expected return from a security or a portfolio assuming that the return from the market is zero. Thus in this model the expected return for, say, an ordinary share would be its alpha plus the market return leveraged by the share's sensitivity to market returns (its beta). Here both alpha and beta are estimated based on comparison of the historical returns of the share and the market (see also single index model).

• In measuring portfolio performance, alpha is used to define to what extent a portfolio has done better or worse than it should have done, given the amount of risk it held. If it is accepted that a portfolio's performance will (simply speaking) depend on market returns times the portfolio's sensitivity to the market, then alpha quantifies the extent to which the portfolio's return varies from its expected return. Thus it measures the extent to which the manager adds or erodes value.

Arbitrage pricing theory (APT)

A theory which aims to estimate returns and, by implication, the correct prices of investments. Intellectually, it is an extension of the capital asset pricing model. It says that the CAP-M is inadequate because it assumes that only one factor - the market - determines the price of an investment, whereas common sense tells us that several factors will have a major impact on its price in the long term. Put those factors into a model and you are making progress.

Thus arbitrage pricing theory (APT) defines expected returns on, say, an ordinary share as the risk-free rate of return plus the sum of the share's sensitivity to various independent factors. (Here sensitivity, as with the CAP-M, is defined by the share's BETA.) The problem is to identify which factors to choose. This difficulty is compounded by academic studies which have come up with varying conclusions about the number and identity of the key factors, although benchmarks for interest rates, inflation, industrial activity and exchange rates loom large in tests.

In practice, the aim of using APT would be simultaneously to buy and sell a range of shares whose sensitivity to the chosen factors was such that a profit could be made while all exposure to the effect of the key variables and all capital outlay were canceled out. To the extent that APT assumes that markets always seek equilibrium, it says that the market would rapidly price away such arbitrage profits.

Alternatively, a portfolio could be chosen which could be expected to outperform the market if there were unexpected changes in one or more key factors used in the model, say industrial activity and interest rates. As such, however, that would be doing little more than betting on changes in industrial production and interest rates and would not have much to do with minimizing risk for a given return. Resolving problems such as these means that APT gives greater cause for thought to academics than to investors.