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  1. 1. Business Finance 824 I. INTRODUCTION A. Stock market returns, etc. • Assuming a constant payout, the return on the market is determined by three factors: growth in earnings, changes in valuation, and the dividend yield o Recall the dividend discount formula: P = [E0 * (1 + g) * payout] / (r-g) Rearrange the above equation to solve for r: P = [E0 * (1 + g) * payout] / (r-g) P / [E0 * (1 + g) * payout] = 1 / (r-g) [E0 * (1 + g) * payout] / P = r – g r = E1 * payout / P + g  E1 * payout / P = D1 / P = the dividend yield; the return on the stock absent growth in earnings and changes in valuation  E1 / P (or the inverse in P / E1) = the value of the stock based on earnings alone; movements in this ratio can result in positive stock returns even if the stock does not pay a dividend and earnings growth is absent  Changes in the equity risk premium impact valuations  Changes in interest rates (based on inflation, etc.) impact valuations  Changes in the economy, sector, industry, business and financial fundamentals of a company impact valuations  G = growth in earnings per share; the return on a stock absent changes in valuation and dividends o The key to outperforming the market is to accurately forecast the above factors for each stock (or at least 51% of the stocks) • The probability of outperforming the market is inversely related to the absolute return on the market (“Questioning the Theory of Relativity”, Exhibit 4, Morgan Stanley) o Why? • There is a wide variance in returns to different investment styles (see chart) • Generally, the rising tide lifts all ships (see chart) Introduction 1
  2. 2. Business Finance 824 • Volatility—high or low? (“It Has Been the Most Volatile of Times and the Least Volatile of Times”, Prudential Securities, and “Charting the Course”, May 25, 2001, Bear, Stearns & Co. Inc.)) o Monthly (figures 1-2) versus daily (figures 3-4) returns  Monthly volatility is low versus the 1930s  Daily volatility is high, which is normal around recessions and directional changes in the market o Why has daily volatility picked up?  More noise  High valuations—a small change in expectations can cause large movements in stock prices o High volatility is good for informed investors (can capitalize on movements in stocks) and is positive because of increased liquidity • Calendar anomalies (“Calendar Anomalies: Abnormal Returns at Calendar Turning Points”, Financial Analysts Journal) o January effect  There is a higher return and risk premium in January; best for small stocks  Rationale(s):  Tax-loss selling  Window dressing  Bonuses invested o Turn-of-the-month effect (figure A)  The first few days of the month account fully for the positive return of the stock market  The first few days average a return of 0.118%/day versus 0.015%/day for all days  Rationale(s):  Monthly rebalancing; investors may reinvest dividends at this time  Higher month-end cash flows, such as salaries  Timing of EPS announcements—tend to announce good earnings earlier than bad earnings Introduction 2
  3. 3. Business Finance 824 o Day-of-the-week effect (figure B)  Good performance on Friday’s and down on Monday (the only down day)  This phenomenon also exists in other markets and is stronger for small capitalization stocks  Rationale(s):  Only a few rationales and most are easily refuted  Cover shorts on Friday so one can have “peace of mind” over the weekend  Investors “throw in the towel” after a weekend of reflection  Bad news is announced after the close of the market on Friday o Holiday effect (figure C)  The average pre-holiday return is much higher than other days of the year  The pre-holiday returns average 0.365%/day versus 0.026%/day of other days, and 35% of the rise of the stock market can be attributed to these eight days  This phenomenon is stronger for small capitalization stocks  Rationale(s):  Short covering because of happy euphoria o Time-of-day effect (figure D)  Prices rise in the first 45 minutes, the rest of the day the market is essentially flat, and then stock rise the last 15 minutes (all of the days are up except Monday)  Rationale(s):  Closing prices are special—used for performance evaluation  Opening prices are determined by market call, unlike continuous trading for the rest of the day  There is a rush to beat the close to buy (after watching the market all day) • The markets best months follow immediately after market corrections (“The Market’s Best Months”, The Journal of Portfolio Management) o 66 corrections from 1948-1994 (566 months) (exhibit 1) o 35 of the strongest 41 months are within 4 months (238 subsets) of a correction— cannot be chance (319.1 million to one) o Best returns one month after correction (exhibit 2) o The gains following intermediate and major corrections are more sustained (exhibit 3) o This is great information for investors but, unfortunately, it is hard to know when a correction is actually over Introduction 3
  4. 4. Business Finance 824 • Avoid the noise (“Helter Skelter”, PaineWebber) o Market leadership changes  The headlines reverse daily  Few stocks outperform the index for several months in a row  All stocks outperform the index during at least one month each year • Breadth of market (“The Start of a New Bull Market”, Prudential Securities) o The advance/decline line  A true measurement of the health of a market rally  The net difference of the total number of advancing issues and the total number of declining stocks (a cumulative measure) o Dictionary definition of breadth: “Freedom from narrowness or restraint; liberality; size in general; extent; broad or general effect due to subordination of details or non essentials”. o The generals and their armies  The generals are the big, well-known stocks, and the armies are the rest of the stocks  To wage a successful war the generals need their armies; if there are no armies then eventually the generals will have to retreat  This is exactly what happened during the bubble and the burst o The A/D is reversing its decline (figure 6)  In April of 1998 the A/D line peaked, the next 23 months the A/D fell while the DJIA and S&P 500 rose 30%+, NASDAQ was up 150%  The A/D line has been rising since the burst in early 2000, despite the fact that the market averages are down  In 2001 (through June) 64.6% of the stocks in the S&P 500 have outperformed the index, compared to 45% in a normal year (“Quantitative Viewpoint: Success in the 1st Half Simply Meant Avoiding Tech”, Jul 10, 2001, table 2, Merrill Lynch)  Is a rising A/D line good or bad for the active manager? It is good because:  Even many growth investors pay attention to valuations  Most managers own many stocks (they diversify their portfolios)  Most sophisticated investors are somewhat rationale Introduction 4
  5. 5. Business Finance 824 B. Investor behavior • Behavioral Finance (“Behavioral Idiosyncrasies and How They May Affect Investment Decisions”, AAII Journal) o Human nature sometimes causes investors to veer from rational decisions  Fundamentals + X = performance, where X is human nature (behavior) o Frame of reference  People are more risk-averse when facing a gain and more risk-seeking when facing a loss  Example page 14  Participants asked to choose between sure gain of $800 or 85% chance of $1000 and 15% chance of nothing ♣ The second option is better mathematically ♣ People chose the first option  Participants asked to choose between sure loss of $800 or 85% chance of losing $1000 and 15% of losing nothing ♣ The first option is better mathematically ♣ People chose the second option o Aversion to regret  People tend to hold on to their losing investments  People tend to regret action more than inaction  Example page 14 ♣ Investor A owns MF A and considers switching to B, but fails to do so ♣ Investor B owns MF B at the beginning of the period but immediately switches to A ♣ MF B outperforms A during the period ♣ Investor B is much more unhappy (i.e. more regret) than investor A o Pride of ownership  There is a tendency for investors to place a higher value on what they own than the overall market  The result is that sellers typically want more for an item than the market will pay  In portfolio management, managers often focus more time on the issues that they own than in other issues, in their benchmark, that they do not own Introduction 5
  6. 6. Business Finance 824 o Herd mentalities  Refers to the tendency of people to think and act the same way (and be susceptible to fashions, fads and peer pressure)  Explains the market movement of late 1999 and early 2000, and the decline of technology stocks after that period  Herd eliminates feeling of regret—if one loses he/she is comforted by the fact that others are too  Explains the unexplainable movements in the market • Investor sentiment (“Investor Sentiment and Stock Returns”, AIMR) o Changes in the level of sentiment of individual investors and Wall Street strategists are negatively correlated with future stock returns (figure 1) o There is a positive relationship between S&P 500 returns and future changes in the sentiment of individual investors and newsletter writers (figure 2) o Individual investors act on their changes in sentiment, but not forcefully (figure 3) o The implication is that individuals/strategists are normally wrong in their sentiment, so we should not get caught up in the emotions of the market • Weather and returns (“Blame the Weather for Poor Returns”, November 2001, Traders) o Study published by finance professors at OSU o The study suggests that stock market returns can be linked to whether the sun shines or not • The authors studies daily returns on leading stock exchanges in 26 countries from 1982-1997 • The looked at average cloud cover from 6 a.m. to 4 p.m. and its relationship to stock returns • They found that the daily difference in return from a completely overcast day to a sunny day is nine basis points (0.088%) or an annualized excess return of 24.8% o The article implies that the role of psychology (people are happy on sunny days) can impact performance • “There is nothing so dangerous as the pursuit of a rational investment policy in an irrational world”. – John Maynard Keynes Introduction 6
  7. 7. Business Finance 824 C. Types of stocks/investors • Morningstar boxes ( o The boxes VALUATION Value Blend Growth Large SIZE Mid Small o Are the boxes adequate? Probably not. (“A Matter of Style: Fund Categories Prepare for a New Look”, The Wall Street Journal) • Characteristic Value (and small) Growth (and large) D. Types of analysis • Fundamental analysis (“Starting the Analysis”, Security Analysis on Wall Street) o Most of the class will be focused on fundamental analysis, whereby analysts use information concerning the current and prospective profitability of a company to access the fair market value of a stock Introduction 7
  8. 8. Business Finance 824 o Top-down versus bottom-up analysis (exhibit 5-7) (page 75) (with changes) (see course outline) Ethics Economics : Capital Markets : Style Analysis : Sector/Industry Analysis : Company Analysis : Trading : Performance Evaluation o Dividing the responsibility (exhibit 5-3) (see course outline)  One has a better opportunity to outperform with specialization  The areas are not as distinct as the table indicates o Importance and difficulty (see course outline)  All areas are important and difficult  The most important/difficult areas are to the left o Examples (exhibit 5-1 (Campbell Soup), 5-5 (Homebuilding Company), and 5-6 (Coke)) • Technical analysis o Technical analysis involves the examination of past data such as prices and the volume of trading to estimate future valuations of stocks o Chart reading is an art, not a science o If enough people believe in technical analysis then it will work; more people are utilizing it today o Assumptions:  Value is determined by interaction of supply and demand Introduction 8
  9. 9. Business Finance 824  Supply and demand are governed by rational and irrational factors, including variables relied on by the fundamental analysts as well as opinions, moods and guesses (the irrational factors is “X” in the equation fundamentals + X = performance)  Disregarding minor fluctuations, the prices of individual securities and the overall market tend to move in trends, which persist for appreciable lengths of time  Prevailing trends change in reaction to shifts in supply and demand, and these shifts, no matter why they occur, can be detected sooner or later in the action of the market itself o Advantages:  Not heavily dependent on financial statements  Technicians need only to identify new trends (quickly based on only prices and volume), whereas fundamental analysts must process information quickly on an array of factors  They can call attention (by unusual volume or price) to something happening in the company  Charts offer a means of confirming (or rejecting) what is learned in fundamental analysis (charts can help one recognize the time to buy and when the market finally identifies a stock as a good buy—fundamental analysis may indicate that a stock is cheap, but it still takes a while for the market to appreciate the stock) o Do charts tell a story? (“How Charts Help You Spot Buy & Sell Signals in the Stock Market”, Trendline)  As few as three points may suggest the presence of a trend  An uptrend/downtrend is drawn by connecting the lower/upper points of stock movement (figure 1) ♣ Draw:  Channels are grooves or ducts through which prices move as they zigzag along a trend line (figure 2) ♣ Draw: Introduction 9
  10. 10. Business Finance 824  The longer a stock has been on a trend the stronger the trend (trends based on weekly or monthly charts are stronger than ones based on daily prices)  Pull back effect refers to what commonly happens when a stock breaks an established trend (figure 3) ♣ Draw: ♣ Why?  Volume can help to confirm a trend  The higher the volume the more confidence in a trend and support/resistance levels  During a normal uptrend/downtrend volume is high/high when prices are rising/falling from the trend line and low/low when prices are falling/rising back to the trend line  Changes in volume often warn of a reversal in the trend before it happens  Variations of the straight-line trend  A curved trend line can occur if momentum of an advance or decline suddenly increases (figure 4) ♣ Draw:  Internal trend line (figure 5) ♣ Draw: Introduction 10
  11. 11. Business Finance 824  A fan develops when a well-established trend line is broken, but prices continue to move in the same direction (figure 6) ♣ Draw:  Moving averages  Utilized to smooth prices  Created by adding the closing prices of a stock (for a given period) and dividing by that period to arrive at an average price  Eliminates minor fluctuations in prices  Technicians look at the slope of the moving average and how far above/ below a stock is from the averages (the stock should return to the average over time) ♣ Draw:  Support and resistance  The support/resistance level is that price at which one may expect a considerable increase in demand/supply for a stock ♣ Draw:  Normally a lot of volume around these levels  Example of how resistance/support forms (narrative on page 13-4) ♣ Resistance example: Suppose you bought a stock between $20 and $22/share. The stock drops to $16. Your first reaction is to hold on in hopes that you will eventually make a gain. If the stock remains depressed then you may begin to hope to just to recover your loss. So, if the stock starts to rise then your disposition to sell will grow stronger as the stock approaches your buy point. Thus, resistance/supply of stock for sale forms/grows around $20 to $22/share. ♣ Support example (see narrative)  Normally support and resistance are drawn as horizontal lines Introduction 11
  12. 12. Business Finance 824  Old support/resistance lines become new resistance/support lines when the stock breaks out of the congestion range (area of heavy turnover— figure 7) (figure 9) ♣ Draw:  The 50% rule  There is a tendency for support/resistance to develop when a stock retraces half of the ground won/lost in the last move  Example (figure 10) ♣ A stock moves from $20 to $60, then it falls and finds support at $40 ♣ Draw:  Other factors  Closing prices are normally more important than intraday (closing prices are reported in the paper) and round numbers are more common  No two charts are alike  Many stocks have personalities of their own  Stocks have jokingly been said to spend 2/3 of their time making up their minds what they will do and 1/3 of the time doing it  Not all events are written in the charts—there are bombshells (events such as war, proxy fights, mergers, new products, etc.) that charts cannot predict E. The analyst’s job • “Analyst’s Guidelines”, STRS Ohio o Performance (65%)—a lot of pressure to perform  Hopefully correct > ½ of the time  Versus the industry, not the S&P 500 o Communication to PMs (25%)  There are many forms  This requirement is more important at other firms  Team player Introduction 12
  13. 13. Business Finance 824  Timely  Analysis of facts, not a reporter o Skills and knowledge ranked by PMs (10%, 0% for senior analysts)  Read, read, read  Everyone is smart—MBA, CFA  Need knowledge, but skill is important to identify the catalysts  Travel to talk with management  Many styles of analysis  Independent job o Overall body of knowledge ranked by DOR (10% for senior analysts)  Assist others  Team player for department success • Buy-side versus sell-side o In simple terms, the buy-side are the investors (invest the money) and the sell-side is the brokers (sell ideas) o Buy-side analysts (“The 13 Laws of Buy-Side Analysis”, Scudder) 1. It’s the numbers, stupid (management and the sell-side like to paint a rosy picture, you must create your own financial models (and focus on cash flows and the balance sheet), the numbers are important even though accounting is boring) 2. The knowledge society is here to stay (most do not want to share knowledge, but all need it to make good decisions, information is power) 3. The market is talking to you (what is it saying to you? The market is efficient in the long-term) 4. Data smog is everywhere (there is too much information, how can you acquire it and make sense of it?) 5. Smart is over-rated, common sense is under-rated (everyone is smart in this field, you need to determine the three things that will make a stock work (i.e. the catalysts) 6. Leverage the street (i.e. the sell-side) (the sell-side covers less stocks than the buy-side so they will know more about the companies than people on the buy- side—utilize their knowledge) 7. Cash is king (too much focus on the income statement and not enough on the cash flow statement) Introduction 13
  14. 14. Business Finance 824 8. Opportunity is everywhere (you can make money in all markets and in all stocks) 9. Thou shall not hedge, fudge, equivocate or obfuscate (you have no real friends on the sell-side, the sell-side is highly influenced by $s) 10. Don’t tell me what happened, tell me how it changes what you think will happen (one should analyze events to predict the future) 11. Admit when you are wrong (being 51% correct is good, a big mistake that investors make is holding onto losers too long) 12. Be precise, identify catalysts 13. Review laws and abide by them o Sell-side analysts (“The Role of Financial Analysts in Equity Markets”, AIMR) 1. Forecast EPS  Mediocre to bad, in spite of help from company management (company management is not that good at predicting their own results) 2. Recommend stocks  More buy recommendations than sell (neutral means sell) (one sell for every 15 buys)  Buy recommendations move stocks up 3% on average and sell recommendations move stocks down 5%, trends continue (page 10)  Analysts tend to recommend stocks after they have already begun to move up  Recommend because they are “really cheap” or because of news, with the latter much more popular 3. Sell new securities  Underwriting transactions are highly profitable for brokerage firms (IPOs earn 10-20 times as much per share as regular transactions)  The firms with the best analysts bring in the most banking business  Analysts with sell ratings do not receive banking business  The compensation of the sell-side analyst is tied to the banking business  Red flag—conflict of interest  Most brokerage firms’ analyst do a better job recommending “other people’s stocks”—Why?  Analysts are conflicted between long-term goal (telling the truth and being a great analyst) and generating a profit for the firm (and themselves) Introduction 14
  15. 15. Business Finance 824  If an analyst says sell, then it is probably what he/she really thinks, a buy recommendation is questionable  The circle ♣ Short-term: If an analyst is good he/she receives banking business ♣ Short-term: The analysts have to recommend the stocks with the banking business ♣ Long-term: The analysts will have bad performance because of biased recommendations ♣ Long-term: The analyst will not receive future banking business • Helpful hints (“Reflections on the Art of Securities Analysis”, Smith Barney, and “Five Common Decision Making Errors”, Credit Suisse First Boston) o Understand consensus expectations—it is all about expectations (one must beat expectations) o Stocks are often driven to extremes (e.g. 1999/2000) o Herd instinct prevails in the stock market (e.g. a behavioral finance topic) o Comfortable recommendations are often poor recommendations (with consumer staples you will probably not win big) o The market reacts quickly (unless you are a technician) so you need to predict it o No matter how sure you are, a negative/positive surprise can alter your expectations (it is hard to stay the course) o Recommendations should not be made in a vacuum, more than just company fundamentals affect the stock o Recommending a stock because it is cheap (without a catalyst) is often disastrous in the short-term (it often takes a while for a cheap stock to be recognized for its real value) o The most utilized valuation measure (P/E) is often the worst measure (P/E is often distorted by accounting manipulations, cycles, etc.) o Too many people do not have a well-thought-out sell philosophy (the sell philosophy is just as important as the buy) o You are going to be wrong (hopefully, less than 50% of the time) o If you recommend quality and are wrong, then investors are much more forgiving than if you recommend poor quality companies and fail (there is window dressing at the end of the quarter and year) o What is management’s stake in the companies? (you want management’s interest aligned with the investors) o Sunk costs are sunk, your reference point should be the present (you should ignore the original price paid for a stock) o Don’t anchor judgments on irrelevant information, including prices and past multiples (the past is only a guide) o Don’t be overconfident (you WILL get burned…sometime) o Don’t be overly influenced by how information is presented (be objective) o Don’t fall into the confirmation trap (try to find alternative arguments) Introduction 15
  16. 16. Business Finance 824 • Are sell-side recommendations any good? (“Is Wall Street Research Useful?”, AIMR) o The ratio of buy to sell recommendations is approximately 7 to 1 o The 3-day recommendation period returns are significant and as forecasted by the analysts o Post-recommendation returns are not mean reverting and are significant and in the direction forecasted (new buy recommendations continue up for the first month and new sell recommendations continue down for six months) o The market’s reaction to new sell recommendations is much more pronounced than the response to new buy recommendations (because sell recommendations are real!) o The market reaction associated with small-capitalization stocks is much greater than large-capitalization stocks, both in the recommendation period and post- recommendation period (because of liquidity, other?) o The analysts that are part of Institutional Investor All-American Research Team are better than other analysts F. Information gathering (see class notes) Introduction 16