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Chapter 11Chapter 11Charles P. Jones, Investments: Analysis and Charles P. Jones, Investments: Analysis and

Management,Management,Ninth Edition, John Wiley & SonsNinth Edition, John Wiley & Sons

Prepared byPrepared byG.D. Koppenhaver, Iowa State UniversityG.D. Koppenhaver, Iowa State University

Common Stocks: Common Stocks: Analysis and StrategyAnalysis and Strategy

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Impact of the MarketImpact of the Market

Pervasive and dominantPervasive and dominant The single most important risk The single most important risk

affecting the price movement of affecting the price movement of common stockscommon stocks– Particularly true for a diversified Particularly true for a diversified

portfolio of stocks portfolio of stocks Accounts for 90% of the variability in a Accounts for 90% of the variability in a

diversified portfolio’s returndiversified portfolio’s return Investors buying foreign stocks face Investors buying foreign stocks face

the same situationthe same situation

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Required Rate of ReturnRequired Rate of Return

Minimum expected rate of return Minimum expected rate of return needed to induce investmentneeded to induce investment– Given risk, a security must offer some Given risk, a security must offer some

minimum expected return to persuade minimum expected return to persuade purchasepurchase

– Required RoR = RF + Risk premiumRequired RoR = RF + Risk premium– Investors expect the risk free rate as Investors expect the risk free rate as

well as a risk premium to compensate well as a risk premium to compensate for the additional risk assumedfor the additional risk assumed

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AB

C

kM

kRF

0 1.0 2.00.5 1.5

SML

BetaM

E(R)

Security Market LineSecurity Market Line

Beta = 1.0 implies Beta = 1.0 implies as risky as marketas risky as market

Securities A and B Securities A and B are more risky than are more risky than the marketthe market– Beta >1.0Beta >1.0

Security C is less Security C is less risky than the risky than the marketmarket– Beta <1.0Beta <1.0

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Understanding the Required Understanding the Required Rate of ReturnRate of Return

Risk-free rateRisk-free rate RF =Real RoR +Inflation premiumRF =Real RoR +Inflation premium

– Real rate of return is basic exchange Real rate of return is basic exchange rate in the economyrate in the economy

– Nominal RF must contain premium for Nominal RF must contain premium for expected inflationexpected inflation

The risk premium The risk premium – Reflects all uncertainty in the asset Reflects all uncertainty in the asset

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Passive Stock StrategiesPassive Stock Strategies

Natural outcome of a belief in Natural outcome of a belief in efficient markets efficient markets – No active strategy should be able to No active strategy should be able to

beat the market on a risk adjusted basisbeat the market on a risk adjusted basis Emphasis is on minimizing Emphasis is on minimizing

transaction costs and time spent in transaction costs and time spent in managing the portfoliomanaging the portfolio– Expected benefits from active trading or Expected benefits from active trading or

analysis less than the costsanalysis less than the costs

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Passive Stock StrategiesPassive Stock Strategies

Buy-and-hold strategyBuy-and-hold strategy– Belief that active management will incur Belief that active management will incur

transaction costs and involve inevitable transaction costs and involve inevitable mistakesmistakes

– Important initial selection needs to be Important initial selection needs to be mademade

– Functions to perform: reinvesting Functions to perform: reinvesting income and adjusting to changes in risk income and adjusting to changes in risk tolerancetolerance

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Passive Stock StrategiesPassive Stock Strategies

Index fundsIndex funds– Mutual funds designed to duplicate the Mutual funds designed to duplicate the

performance of some market indexperformance of some market index– No attempt made to forecast market No attempt made to forecast market

movements and act accordinglymovements and act accordingly– No attempt to select under- or No attempt to select under- or

overvalued securitiesovervalued securities– Low costs to operate, low turnoverLow costs to operate, low turnover

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Active Stock StrategiesActive Stock Strategies

Assumes the investor possesses Assumes the investor possesses some advantage relative to other some advantage relative to other market participantsmarket participants– Most investors favor this approach Most investors favor this approach

despite evidence about efficient marketsdespite evidence about efficient markets Identification of individual stocks as Identification of individual stocks as

offering superior return-risk tradeoffoffering superior return-risk tradeoff– Selections part of a diversified portfolioSelections part of a diversified portfolio

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Active Stock StrategiesActive Stock Strategies

Majority of investment advice geared Majority of investment advice geared to selection of stocksto selection of stocks– Value Line Investment SurveyValue Line Investment Survey

Security analyst’s job is to forecast Security analyst’s job is to forecast stock returnsstock returns– Estimates provided by analystsEstimates provided by analysts

expected change in earnings per share, expected change in earnings per share, expected return on equity, and industry expected return on equity, and industry outlookoutlook

– Recommendations: Buy, Hold, or SellRecommendations: Buy, Hold, or Sell

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Sector RotationSector Rotation

Similar to stock selection, involves Similar to stock selection, involves shifting sector weights in the portfolio shifting sector weights in the portfolio – Benefit from sectors expected to perform Benefit from sectors expected to perform

relatively well and de-emphasize sectors relatively well and de-emphasize sectors expected to perform poorlyexpected to perform poorly

Four broad sectors:Four broad sectors:– Interest-sensitive stocks, consumer Interest-sensitive stocks, consumer

durable stocks, capital goods stocks, and durable stocks, capital goods stocks, and defensive stocksdefensive stocks

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Market TimingMarket Timing

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

expected to riseexpected to rise Success depends on the amount of Success depends on the amount of

brokerage commissions and taxes paidbrokerage commissions and taxes paid– Can investors regularly time the market to Can investors regularly time the market to

provide positive risk-adjusted returns?provide positive risk-adjusted returns?

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Efficient Markets and Efficient Markets and Active StrategiesActive Strategies

If EMH true:If EMH true:– Active strategies are unlikely to be Active strategies are unlikely to be

successful over time after all costssuccessful over time after all costs– If markets efficient, prices reflect fair If markets efficient, prices reflect fair

economic valueeconomic value EMH Proponents argue that little time EMH Proponents argue that little time

should be devoted to security should be devoted to security analysisanalysis– Time spent on reducing taxes, costs and Time spent on reducing taxes, costs and

maintaining chosen portfolio riskmaintaining chosen portfolio risk

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Approaches to Stock Approaches to Stock SelectionSelection

Technical analysisTechnical analysis– Refers to the method of forecasting Refers to the method of forecasting

changes in security priceschanges in security prices– Prices assumed to move in trends that Prices assumed to move in trends that

persistpersist– Changes in trends result from changes Changes in trends result from changes

in supply and demand conditionsin supply and demand conditions– Old strategy that can be traced back to Old strategy that can be traced back to

the late nineteenth centurythe late nineteenth century

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Technical AnalysisTechnical Analysis

Not concerned with the underlying Not concerned with the underlying economic variables that affect a economic variables that affect a company or the marketcompany or the market– The causes for the demand and supply The causes for the demand and supply

conditions are not important conditions are not important Technicians use graphs and charts of Technicians use graphs and charts of

price changes, volume of trading price changes, volume of trading over time, and other indicatorsover time, and other indicators

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Approaches to Stock Approaches to Stock SelectionSelection

Fundamental AnalysisFundamental Analysis– Assumes that any security (and the Assumes that any security (and the

market as a whole) has an intrinsic market as a whole) has an intrinsic value as estimated by an investorvalue as estimated by an investor

– Intrinsic value compared to the current Intrinsic value compared to the current market price of the securitymarket price of the security

– Profits made by acting before the Profits made by acting before the market consensus reflects the correct market consensus reflects the correct informationinformation

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Fundamental AnalysisFundamental Analysis

Classic common stock selection Classic common stock selection strategies involve growth stocks and strategies involve growth stocks and value stocksvalue stocks– Growth stocks carry investor expectations Growth stocks carry investor expectations

of above-average future growth in of above-average future growth in earnings and above-average valuations earnings and above-average valuations as a result of high price/earnings ratioas a result of high price/earnings ratio

– Value stocks feature cheap assets and Value stocks feature cheap assets and strong balance sheetsstrong balance sheets

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Framework for Framework for Fundamental AnalysisFundamental Analysis

Top-down approachTop-down approach– First, analyze the overall economy and First, analyze the overall economy and

conditions in security marketsconditions in security markets– Second, analyze the industry within Second, analyze the industry within

which a particular company operateswhich a particular company operates– Finally, analyze the company, which Finally, analyze the company, which

involves the factors affecting the involves the factors affecting the valuation modelsvaluation models

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Economy/Market AnalysisEconomy/Market Analysis

Assess the state of the economy and the Assess the state of the economy and the outlook for variables such as corporate outlook for variables such as corporate profits and interest ratesprofits and interest rates– The status of economic activity has a major The status of economic activity has a major

impact on overall stock pricesimpact on overall stock prices– Investors cannot go against market trendsInvestors cannot go against market trends

If markets move strongly, most stocks are carried If markets move strongly, most stocks are carried alongalong

– 25% to 50% of variability in annual earnings 25% to 50% of variability in annual earnings attributable to the overall economyattributable to the overall economy

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Industry AnalysisIndustry Analysis

An industry factor is the second An industry factor is the second component, after overall market component, after overall market movements, affecting the variability movements, affecting the variability of stock returnsof stock returns– The degree of response to market The degree of response to market

movements can vary significantly across movements can vary significantly across industriesindustries

– The business cycle affects industries The business cycle affects industries differentlydifferently

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Company AnalysisCompany Analysis

Security analysts typically assigned Security analysts typically assigned specific industries but reports deal specific industries but reports deal with individual companieswith individual companies

Close relationship between earnings Close relationship between earnings per share and share pricesper share and share prices– Dividends are closely tied to earnings, Dividends are closely tied to earnings,

but not necessarily the current earningsbut not necessarily the current earnings– Earnings are key to fundamental Earnings are key to fundamental

analysisanalysis

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