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

Particularly true for a diversified portfolio of stocks

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

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

Required Rate of Return =Rf +Risk premium

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

Rf =Real Rate of Return +Inflation premium

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

Nominal Rf must contain premium for expected inflation

The risk premium

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

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

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

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:

reinvesting income

adjusting portfolio to maintain asset allocation criteria

  • maintain risk-level of portfolio

Index funds

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

No attempt made to forecast market movements and act accordingly

No attempt to select under- or overvalued securities

Low costs to operate, low turnover

  • Reasons why indexing works (Malkiel)
  • Securities market extremely efficient
  • Cost efficient
  • Avoids heavy trading expenses
  • Tax advantage
  • 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.)

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

Selections part of a diversified portfolio

  • Use of fundamental analysis
  • Use of technical analysis

Majority of investment advice geared to selection of stocks

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

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

 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

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

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

Classification of Sectors:

Large-group classifications

Cyclical

Growth

Value

Four broad sectors:

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)

 consumer durable stocks

  • Cars, washers, dryers, computers,

capital goods stocks

  • Manufacturing equipment, precision machinery

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

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

Success depends on the amount of brokerage commissions and taxes paid

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:

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

If markets efficient, prices reflect fair economic value

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

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

Approaches to Stock Selection

Technical analysis

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

Prices assumed to move in trends that persist

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

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

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

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

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

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?

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

  • Momentum Strategies

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

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

Short-run approach

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

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

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

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

Value stocks feature cheap assets and strong balance sheets

Top-down approach

First, analyze the overall economy and conditions in security markets

Economy/Market Analysis

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

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

Investors cannot go very well against market trends

If markets move strongly, most stocks are carried along

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

economy significantly affects what happens to various industries

Second, analyze the industry within which a particular company operates

Industry Analysis

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

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

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

Company Analysis

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

Close relationship between earnings per share and share prices

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

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

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