Common Stocks: Analysis and Strategy



Common Stocks: Analysis and Strategy

Chapter 11

Impact of the Market

The single most important risk affecting the price movement of common stocks is the market

1 Particularly true for a diversified portfolio of stocks

1 In diversified portfolio, market risk accounts for 90% of the variability

Investors buying foreign stocks face the same issues on market risk of the foreign country

• i.e. Japanese stock prices drastically fell in the 90’s

• Overall market (Nikkei) peaked at end of 1989 at 39000 and

by mid-1992 had dropped to below 15000 --- 60% drop

• 1999 still around 13,000

Required Rate of Return

Minimum expected rate of return needed to induce investment

1 Given risk, a security must offer some minimum expected return to persuade purchase

2 Required Rate of Return =Rf +Risk premium

3 Investors expect the risk free rate as well as a risk premium to compensate for the additional risk assumed

Understanding the Required Rate of Return

Risk-free rate

2 Rf =Real Rate of Return +Inflation premium

1 Real rate of return is basic exchange rate in the economy

2 Nominal Rf must contain premium for expected inflation

The risk premium

1 Reflects all uncertainty in the asset

Level of interest rate changes:

SML

• Shifts due to changes in inflation

• Slope changes due to risk premium changes

Investment Decision

• Asset allocation

• Determine

• Asset classes investing in

• Percentage of portfolio to allocate to each asset class

• Security selection

Passive Stock Strategies

Natural outcome of a belief in efficient markets

1 No active strategy should be able to beat the market on a risk-adjusted basis

2 Passive strategies do not seek to outperform the market but to do as well as the market

2 Emphasis is on minimizing transaction costs and time spent in managing the portfolio because any expected benefits from active trading or analysis are less than the costs

• Passive Strategies:

Buy-and-hold strategy

Buys stocks and holds them until some time in the future to meet some objective

Belief that active management will incur transaction costs and involve inevitable mistakes

• Odean and Barber Study

• Of 60,000 investors from 1991-1996—avrg investor earned 15% while active traders averaged 10% return

Important initial selection needs to be made

Functions to perform over life of the portfolio:

5 reinvesting income

6 adjusting portfolio to maintain asset allocation criteria

• maintain risk-level of portfolio

Index funds

1 Mutual funds designed to duplicate the performance of some market index

2 No attempt made to forecast market movements and act accordingly

3 No attempt to select under- or overvalued securities

4 Low costs to operate, low turnover

• Reasons why indexing works (Malkiel)

• Securities market extremely efficient

• Cost efficient

• Avoids heavy trading expenses

• Tax advantage

o Low turnover and thus deferring realization of capital gains

Active Stock Strategies

Assumes the investor possesses some advantage relative to other market participants (superior analytical skills, judgment skills, superior information, etc.)

1 Most investors favor this approach despite evidence about efficient markets

• Individuals not required to own diversified portfolios and are typically not prohibited from short sales or margin trading

Security Selection

Identification of individual stocks as offering superior return-risk tradeoff

1 Selections part of a diversified portfolio

• Use of fundamental analysis

• Use of technical analysis

Majority of investment advice geared to selection of stocks

1 Value Line Investment Survey—largest investment advisory service

• Studies:

▪ Latane,Tuttle, & Jones

• Results—widely differing performance of stocks in a given year

▪ McEnally and Todd

• Results—during 1946-1989 period stocks in the highest quartile would have largely avoided losing years, those in the lower quatrterile-55% of the time results are negative

▪ Lynch

• Results: “small stocks make big moves…”

Security analyst’s job is to forecast stock returns

1 Estimates provided by analysts based upon presentations by top management of companies, 10-K reports, annual reports, etc.

1 Forecast expected change in earnings per share, expected return on equity, and industry outlook

• One of most important forecast is the earnings per share because of its linkage between expected earnings and stock price/returns

2 Recommendations by analysts: Buy, Hold, or Sell

• Rare to see sell recommendations but see buy, hold or speculative hold

• Reason for few sell recommendations ---pressure from the investment banking side and their customers to avoid see recommendations

• Sell recommendations result in an average 2-day decline of almost 5% and an additional 9% decline over the next 6 months

Sector Rotation

Similar to stock selection, involves shifting sector weights in the portfolio

1 Benefit from sectors expected to perform relatively well and de-emphasize sectors expected to perform poorly

Classification of Sectors:

3 Large-group classifications

4 Cyclical

5 Growth

6 Value

7 Four broad sectors:

1 Interest-sensitive stocks

• Housing, banks, finance companies, savings and loans, utilities, and residential construction firms

• Adversely impacted during high rates (usually occur at the latter stages of the business cycle)

2 consumer durable stocks

• Cars, washers, dryers, computers,

3 capital goods stocks

• Manufacturing equipment, precision machinery

4 defensive stocks

• food production, soft drinks, beer, pharmaceuticals

• not as badly hurt during the down side of the business cycle

Success depends on accurate assessment of current economic conditions

• Indirect investing through sector funds

• Roughly 500 sector funds in such sectors as Real Estate, utilities, health care, etc

• Popular with momentum traders

Market Timing

Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equity securities

1 Increase (decrease) portfolio beta when the market is expected to rise (fall)

Success depends on the amount of brokerage commissions and taxes paid

1 Can investors regularly time the market to provide positive risk-adjusted returns?

• Empirical Evidence based on mutual funds:

• Biggest risk of market-timing is that the investor will not be in the market at the critical times

• No evidence that funds were able to time market changes and change their risk level in response

• Veit and Cheney (82)

• Results: not able to successfully change risk levels based on timing strategies

• Chang and Lewellen ( 84)

• Results: little evidence of market timing success

• Henriksson (84)

• Results: little evidence of market timing success

Efficient Markets and Active Strategies

If EMH true:

1 Active strategies are unlikely to be successful over time after all costs

2 If markets efficient, prices reflect fair economic value

EMH Proponents argue that little time should be devoted to security analysis

1 More time spent on reducing taxes, costs and maintaining chosen portfolio risk

Approaches to Stock Selection

1 Technical analysis

1 Refers to the method of forecasting changes in security prices by identifying recurring stock price patterns

2 Prices assumed to move in trends that persist

3 Changes in trends result from changes in supply and demand conditions

4 Old strategy that can be traced back to the late nineteenth century

2 Value of a stock is primarily a function of supply and demand

3 Not concerned with the underlying economic variables that affect a company or the market

1 The causes for the demand and supply conditions are not important

4 Basic Question: Does excess demand or supply exist for a stock and can such a condition be detected by studying either the patterns of past price fluctuations or the movements of certain technical indicators or rules?

5 Technicians use graphs and charts of price changes, volume of trading over time, and other indicators

1 Momentum Strategies

6 Investing on the basis of recent movements in the price of a stock

7 Basic Premise: if a stock outperformed the market over some recent period, it is likely to continue to do so

8 Short-run approach

14 Value Line Investment Survey ranks stocks on both price and earning momentum

• Merrill Lynch Survey on fund managers’ styles found most popular style is momentum

Fundamental Analysis

Assumes that any security (and the market as a whole) has an intrinsic value as estimated by an investor

• Intrinsic value a function of a firm’s earnings, sales, risk, etc.

Intrinsic value compared to the current market price of the security (SML)

In equilibrium, the current market price of a security reflects the average of the intrinsic value estimates made by investors

Profits are made by acting before the market consensus reflects the correct information

Fundamental Approaches

1 Bottom-Up Approach

• Investors focus on a company’s basics or fundamentals

• Company’s products, its competitive position, and its financial status leads to company’s earnings potential, and ultimately its value

• Emphasis is on finding companies with good long-term growth prospects, and making accurate earning estimates

2 Classic common stock selection strategies involve growth stocks and value stocks

1 Growth stocks carry investor expectations of above-average future growth in earnings and above-average valuations as a result of high price/earnings ratio

2 Value stocks feature cheap assets and strong balance sheets

3 Top-down approach

First, analyze the overall economy and conditions in security markets

16 Economy/Market Analysis

1 Assess the state of the economy and the outlook for variables such as corporate profits and interest rates

1 The status of economic activity has a major impact on overall stock prices

2 Investors cannot go very well against market trends

1 If markets move strongly, most stocks are carried along

3 25% to 50% of variability in annual earnings attributable to the overall economy

4 economy significantly affects what happens to various industries

Second, analyze the industry within which a particular company operates

17 Industry Analysis

1 An industry factor is the second component, after overall market movements, affecting the variability of stock returns

1 The degree of response to market movements can vary significantly across industries

2 The business cycle affects industries differently

• Down-turn—heavy goods industries decline

• Inflationary periods---regulated industries that can not pass on costs may be hurt

Finally, analyze the company, which involves the factors affecting the valuation models

18 Company Analysis

1 Security analysts are typically assigned specific industries but reports deal with individual companies

2 Close relationship between earnings per share and share prices

1 Dividends are closely tied to earnings, but not necessarily the current earnings

2 Forecasting earnings and dividends is important in arriving at the current price (price based on expected stream of cash flows and required rate of return)

• Earnings are key to fundamental analysis

Behavioral Finance

1 Investment behavior based on belief that investors may act irrationally

• “Investor overreaction hypothesis”—investors overreact to events in a predictable manner, overvaluing the best alternatives and undervaluing the worst

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