COMMON STOCKS: ANALYSIS AND STRATEGY

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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

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 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 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 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
• 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
• 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

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