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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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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 firm’s 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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  • 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 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


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    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)


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    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


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    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


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    • 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

      • Exchange traded funds (ETF’s)

        • e.g. i60’s, SPDR’s, Diamonds


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    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


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    • 2) Top-Down Analysis in the stock price

      • 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


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