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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
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
required return3
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
required return4
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
required return5
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)
strategies for stock investing
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
types of active strategies
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.
active strategy 1 security selection
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

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
active strategy 2 sector rotation
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
sector rotation cont
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)
active strategy 3 market timing
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
passive strategies
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

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
frameworks for fundamental analysis
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

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