COMMON STOCKS: ANALYSIS AND STRATEGY

1. COMMON STOCKS: ANALYSIS AND STRATEGY CHAPTER 14

2. 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

3. 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

4. Required Return • IF CAPM does not make sense, some analysts base the discount rate on the yield on the firm’s bonds K = yield on bonds + 3%-4% risk premium • No theoretical justification for this, just a simple “back of the envelope” calculation

5. 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)

6. 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

7. 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.

8. 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

9. 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

10. 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

11. 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)

12. 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

13. Passive Strategies • believe that you can’t “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

14. 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, S&P/TSX 60, S&P 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 (ETF’s) • e.g. i60’s, SPDR’s, Diamonds

15. 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

16. 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