Common Stocks: Analysis and Strategy
Chapter 11
Impact of the Market
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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
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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
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.)
 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
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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
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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
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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 aboveaverage 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
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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