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COMMON STOCKS: ANALYSIS AND STRATEGY CHAPTER 14 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

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COMMON STOCKS: ANALYSIS AND STRATEGY

CHAPTER 14

• 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

• 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

• 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

• 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)

• 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

• 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.

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

• 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

• Active Strategy #2 in the stock price- 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

Sector Rotation (cont.) in the stock price

• 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)

Active Strategy #3 in the stock price- 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

Passive Strategies in the stock price

• 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

• Passive Strategy #1 - Buy and Hold in the stock price

• 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

• e.g. i60’s, SPDR’s, Diamonds

Frameworks for Fundamental Analysis in the stock price

• 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

• 2) Top-Down Analysis in the stock price

• 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