Common Stock: Analysis and Strategy

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Analyzing and Managing
Common Stocks
Chapter 11
Charles P. Jones, Investments: Analysis and
Management,
Tenth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University
11-1
Impact of the Market


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
11-2
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 RoR = RF + Risk premium
Investors expect the risk free rate as well
as a risk premium to compensate for the
additional risk assumed
11-3
Security Market Line
SML

E(R)
A
kM

B
kRF
C
Beta = 1.0 implies
as risky as market
Securities A and B
are more risky than
the market

Beta >1.0
Security C is less
risky than the
2.0 market

0
0.5
1.0 1.5
BetaM

Beta <1.0
11-4
Understanding the Required
Rate of Return


Risk-free rate
RF =Real RoR +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
11-5
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
Emphasis is on minimizing transaction
costs and time spent in managing the
portfolio

Expected benefits from active trading or
analysis less than the costs
11-6
Passive 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
11-7
Passive 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
11-8
Active Stock Strategies

Assumes the investor possesses some
advantage relative to other market
participants


Most investors favor this approach despite
evidence about efficient markets
Identification of individual stocks as
offering superior return-risk tradeoff

Selections part of a diversified portfolio
11-9
Active 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
11-10
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
Four broad sectors:

Interest-sensitive stocks, consumer durable
stocks, capital goods stocks, and defensive
stocks
11-11
Market Timing

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?
11-12
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

Time spent on reducing taxes, costs and
maintaining chosen portfolio risk
11-13
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11-14
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