INVESTMENTS:INVESTMENTS:Analysis and ManagementAnalysis and Management

Second Canadian EditionSecond Canadian Edition

W. Sean Cleary

Charles P. Jones

Chapter 14Chapter 14

Common Stock: Analysis Common Stock: Analysis and Strategyand Strategy

• Discuss the impact of the overall market on common stock investors.

• Explain the importance of the required rate of return.

• Distinguish between passive and active investment strategies.

• Differentiate between technical and fundamental analysis.

• Describe the bottom-up and top-down approaches in fundamental analysis.

Learning ObjectivesLearning Objectives

• Pervasive and dominant• The single most important risk affecting the

price movement of common stocks Particularly true for a diversified portfolio of

stocks • Accounts for 90% of the variability in a diversified

portfolio’s return

• Investors buying foreign stocks face the same situation

Impact of the MarketImpact of the Market

• 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 =

Risk-Free Rate + Risk Premium Investors expect the risk-free rate as well as a

risk premium to compensate for the additional risk assumed

Required Rate of ReturnRequired Rate of Return

• Risk-Free Rate =

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

Understanding the Required Rate Understanding the Required Rate of Returnof Return

• Natural outcome of a belief in efficient markets No active strategy should be able to beat the

market on a risk adjusted basis

• Emphasis is on minimizing transaction costs and time spent on managing the portfolio Expected benefits from active trading or analysis

less than the costs

Passive Stock StrategiesPassive Stock Strategies

• Buy-and-Hold Strategy Belief that active management will incur

transaction costs and involve inevitable mistakes

Important initial selection needs to be made Functions to perform: reinvesting income and

adjusting to changes in risk tolerance

Passive Stock StrategiesPassive Stock Strategies

• 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

Passive Stock StrategiesPassive Stock Strategies

• Units of these trusts hold shares of firms in market indices in proportion to their weights in the index

• Differences from traditional Index mutual funds:1. Traded throughout the day on exchanges2. Lower management fees 3. Lower portfolio turnover – reduces capital gains

income and taxes payable4. Permit short-selling5. May be purchased on margin

Exchange-Traded FundsExchange-Traded Funds

• Assumes the investor possesses some advantage relative to other market participants Most investors favour this approach despite

evidence about efficient markets

• Identification of individual stocks as offering superior return-risk tradeoff Selections part of a diversified portfolio

Active Stock StrategiesActive Stock Strategies

• Majority of investment advice geared to selection of stocks Value Line Investment Survey

• Security analyst’s job is to forecast stock returns Estimates provided by analysts

• Expected change in earnings per share, expected return on equity, and industry outlook

Recommendations: Buy, Hold, or Sell

Active Stock StrategiesActive Stock Strategies

• 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

• Four broad sectors: Interest-sensitive stocks, consumer durable

stocks, capital goods stocks, and defensive stocks

Sector RotationSector Rotation

• Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equity securities Increase portfolio beta when the market is

expected to rise

• Success depends on the amount of brokerage commissions and taxes paid Can investors regularly time the market to

provide positive risk-adjusted returns?

Market TimingMarket Timing

• Based on the ability to time the performance of the major financial asset categories

• Asset allocation techniques: Tactical asset allocation Strategic asset allocation Insured asset allocation Dynamic asset allocation Integrated asset allocation

Asset Allocation StrategiesAsset Allocation 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 Time spent on reducing taxes, costs and

maintaining chosen portfolio risk

Efficient Markets and Active Efficient Markets and Active StrategiesStrategies

• Technical analysis Refers to the method of forecasting changes in

security prices 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

Approaches to Stock SelectionApproaches to Stock Selection

• 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

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

Technical AnalysisTechnical Analysis

• Following the trend Price Momentum Earnings Momentum

Those that outperformed over the past 3 to 12

months likely to do well in the next 3 to 12 months

Momentum StrategiesMomentum Strategies

• Fundamental Analysis Assumes that any security (and the market as a

whole) has an intrinsic value as estimated by an investor

Intrinsic value compared to the current market price of the security

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

Approaches to Stock SelectionApproaches to Stock Selection

• Bottom-up approach 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

Framework for Fundamental Framework for Fundamental AnalysisAnalysis

• Top-down approach First, analyze the overall economy and

conditions in security markets Second, analyze the industry within which a

particular company operates Finally, analyze the company, which involves

the factors affecting the valuation models

Framework for Framework for Fundamental AnalysisFundamental 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 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/Market AnalysisEconomy/Market 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

Industry AnalysisIndustry Analysis

• Security analysts 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 Earnings are key to fundamental analysis

Company AnalysisCompany Analysis

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