COMMON STOCKS: ANALYSIS AND STRATEGY

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COMMON STOCKS ANALYSIS AND STRATEGY

• CHAPTER 14

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Required Return

• key feature in analyzing stocks and making
  investment
• decisions is the required return
• defined as the expected return necessary to make
  investing in
• a security worthwhile to an investor
• Required Return Risk Free Rate Risk Premium
• where
• Risk Free Rate Real rate of Return Inflation
• all three factors (risk premium, real rate,
  inflation) can vary
• and affect required returns and therefore stock
  prices

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Required Return

• Typically, one of several standard models is used
  to estimate the required return, based on K KRF
  Risk Premium
• Very common approach, CAPM
• K KRF Beta(E(RM) KRF)
• Often, CAPM may give an answer that does not seem
  correct (maybe a required return of 2 - who
  would invest in a stock for that?) so other
  methods sometimes used

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Required Return

• IF CAPM does not make sense, some analysts base
  the discount rate on the yield on the firms
  bonds
• K yield on bonds 3-4 risk premium
• No theoretical justification for this, just a
  simple back of the envelope calculation

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Required Return

• More advanced models (probably covered these in
  other courses)
• Arbitrage Pricing Theory
• Fama-French Three Factor Model (this model is
  gaining in popularity, data for US easy to get,
  harder to find for Canada)

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Strategies for Stock Investing

• Two main types of strategy
• 1) Active Strategy
• 2) Passive Strategy
• A passive strategy is consistent with a belief
  in efficient markets
• an active strategy may make sense for investors
  who do not believe markets are efficient

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Types of Active Strategies

• 1) Security Selection
• 2) Sector Rotation
• 3) Market Timing
• security selection tries to pick the best stocks
  to invest in
• sector rotation tries to pick the best
  industries to invest in
• market timing tries to pick the best times to
  invest in the market
• In any active strategy, the investor must
  believe that they have some advantage over other
  investors.

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Active Strategy 1- Security Selection

• perform some type of analysis to pick which
  stocks are undervalued (buy them) or overvalued
  (sell them)
• Primary role of stock analysts is security
  selection.
• forecast stock returns
• based on fundamental analysis
• info. from financial statements, discussions
  with management of firm, any other sources they
  can get
• emphasis is on forecasting earnings per share as
  part of valuation process

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• if analysts revise forecasts, there is typically
  a reaction in the stock price
• analysts (at least respected ones) can be
  influential
• stocks which have forecast revised up (down)
  tend to give excess positive (negative) returns
  after the revision
• analysts may have some ability (on average) to
  forecast correctly
• however, studies show analysts tend to be
  over-optimistic on average
• analysts tend to revise forecast sequentially
  rather than all at once

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Active Strategy 2- Sector Rotation

• certain sectors or industries tend to do better
  during
• different parts of the business cycle
• sector rotation assess current economic
  conditions and decide which industry or sector
  will perform the best
• typically invest in a portfolio of stocks from
  within the chosen sector
• diversified within the sector
• protected against firm specific risk, but
  exposed to risk from sector as a whole

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Sector Rotation (cont.)

• rather than specific industries, often done
  based on
• broad sectors (e.g Interest Rate Sensitive,
  Consumer Durables, Capital Goods, Defensive
  Stocks)
• or even based on very broad sectors (e.g.
  cyclical vs defensive)

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Active Strategy 3- Market Timing

• also known as tactical asset allocation
• switch investments between stocks, bonds and
  cash equivalents (e.g. money market) depending on
  which is expected to perform the best
• try to be in the stock market when it goes up
  and out of the market when it goes down
• Danger being out of market during key upswings
  can reduce long term returns significantly
• many people think market timing is extremely
  hard to do

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Passive Strategies

• believe that you cant beat the market in the
  long run
• belief in efficient markets
• Main Idea
• avoid transaction costs and reduce time spent
• managing the portfolio
• costs and time will not lead to higher returns
• consistent with using strategic asset allocation
  (chose allocation and stick with it for long term

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• Passive Strategy 1 - Buy and Hold
• chose appropriate stocks
• simply hold those stocks
• involves little trading, therefore few
  transaction costs
• Passive Strategy 2 - Indexing
• chose a stock index (e.g. TSX Composite, SP/TSX
  60, SP 500)
• buy the stocks in the index, or a portfolio of
  stocks which as closely as possible mimics the
  index
• does not try to outperform the market, tries to
  perform the same as the market
• avoids costs and effort of research
• Index funds
• Exchange traded funds (ETFs)
• e.g. i60s, SPDRs, Diamonds

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Frameworks for Fundamental Analysis

• 1) Bottom-Up Analysis
• choose firm and concentrate on detailed analysis
  of it
• emphasis on estimating earnings and growth
• Sometimes firms broken down into
• Value Stocks
• undervalued stocks
• low P\E ratios
• strong balance sheets and income statements
• Growth Stocks
• high growth potential
• high P\E ratios

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• 2) Top-Down Analysis
• start with analysis of economy and market
  overall
• is it a good time to invest in market?
• Then do industry analysis
• which industries will perform the best?
• Then analyze individual stocks
• after deciding economy is good, and
• deciding which industry to invest in, decide
• which firm(s) are the best in that industry
• often concentrate on forecasting earnings
• (based on first two steps as well as firm
• analysis) since strong link between earnings,
• dividends and value