Chapter 11: Common Stocks: Analysis And Strategy CHAPTER OVERVIEW Chapter 11 completes a two-chapter sequence on the analysis, valuation, and management of common stocks the same sequence used earlier for bonds This chapter concentrates on issues important to the analysis and management of common stocks, given that the valuation of stocks was discussed in Chapter 10 Market efficiency is covered in Chapter 12 This arrangement allows us to efficiently cover common stocks by discussing valuation in Chapter 10, analysis and management in Chapter 11, and market efficiency in Chapter 12 This provides an in-depth discussion of common stocks that in many cases will suffice for an introductory course; that is, instructors may choose to forego Part V on security analysis, or cover it in less detail Students will be exposed to the basic terminology, ideas, and concepts involving common stocks by covering these three chapters Chapter 11 begins by analyzing common stocks in terms of the impact of the market on common stocks (obviously a major consideration) and in terms of the required rate of return for common stocks (a very important concept covered briefly in earlier chapters) Now that we are analyzing stocks in detail, a full discussion of these two key topics is extremely valuable Earlier chapters defined and briefly discussed systematic risk and beta, and we can now emphasize that all investors who plan to analyze and manage a portfolio of stocks must be keenly aware of market risk, both domestic and foreign In a similar manner, in Chapter 10, in order to concentrate on the techniques of valuation, we assumed that we knew the discount rate or required rate of return Here we consider it in detail because of its importance to any successful understanding of stocks Chapter 11 relates to themes developed in Chapter 19, where it is noted that investors often consider the investment decision as consisting of two steps, asset allocation and security selection We are assuming here that the asset allocation decision has been made 159 Following the comparable chapter in the bond sequence (Chapter 9), the discussion of how investors should approach the analysis and management of stocks is divided into the two major alternatives, passive strategies and active strategies This division is an effective and realistic way to organize this discussion, and once again allows the instructor flexibility in bringing up such topics as Efficient Markets The passive strategy discussion covers the buy-and-hold strategy and index funds The active strategy discussion covers the major alternatives investors have when pursuing an active approach security selection, sector rotation, and market timing This discussion is followed by a consideration of how Efficient Markets concepts affect active strategies, and opens up numerous possibilities for discussion The remainder of Chapter 11 organizes the analysis of stocks by outlining the approaches to analyzing and selecting stocks-the fundamental approach and the technical approach which, in effect, organizes the four chapter sequence on security analysis in Part V that follows Chapter 12 The last section of the chapter provides a framework for fundamental analysis, thereby organizing the first three chapters of the four-chapter sequence in Part V The recommended order for fundamental security analysis is market/economy, industry, and company analysis CHAPTER OBJECTIVES To concentrate only on the analysis and management of common stocks To describe some major concepts and issues that investors should understand when analyzing stocks To outline investors’ alternatives in terms of passive and active strategies To establish a framework for security analysis, which follows in Part V 160 MAJOR CHAPTER HEADINGS [Contents] Taking a Global Perspective [U S investors have been myopic] Analyzing Some Important Issues Involving Common Stocks The Impact of the Overall Market on Individual Stocks [the significance of market risk; international examples] The Required Rate of Return [what it is; components; risk and required rate of return] Building Stock Portfolios [the asset allocation decision; security selection] Passive Strategy [passive strategies seek to as well as the market] Buy-And-Hold Strategy [description] Index Funds [stock-index funds] The Active Strategy [assumes investor possesses some advantage relative to others] Security Selection [the importance of stock selection; the role of the security analyst; forecasting EPS; cross-sectional variation in common stocks] Sector Rotation [what it involves; examples; use of mutual funds to this] Market Timing [what is involved; evidence on likelihood of success] Rational Markets And Active Strategies [brief description of the EMH; implications to investors] Approaches For Analyzing And Selecting Stocks [framework] Technical Analysis [brief description; momentum strategies] Fundamental Analysis [brief description] Behavioral Finance Implications [brief summary] A Framework For Fundamental Analysis Bottom-Up Approach to Fundamental Analysis [definition; growth stocks vs value stocks] Top-Down Approach to Fundamental Analysis [definition; rationale for using it here; Economy/Market Analysis; Industry Analysis; Company Analysis] The Framework for Fundamental Analysis In Perspective [using a diagram to depict the process] POINTS TO NOTE ABOUT CHAPTER 11 Tables and Figures There are no tables in Chapter 11 Figure 11-1 plots the performance of Fidelity’s Magellan Fund, one of the two largest mutual funds in the United States, against the S&P 500 Index for a recent 9-year period The two track quite closely, illustrating the importance of the market on the performance of diversified portfolios Figure 11-2 shows the ex-ante trade-off between required rate of return and risk, as measured by beta This is always an important figure to stress to students The greater the expected risk, the greater the required rate of return Figure 11-3 shows the framework for fundamental analysis, setting the stage for the next three chapters (of four) in Part V on security analysis It indicates that in fundamental analysis investors must estimate the expected cash flows and the risk involved, using either the Dividend Discount Model or the P/E ratio model, and this should be done in the recommended order-market/economy first, industry second, company third Box 11-1 is an interesting discussion of security analysts, who occupy a key role in security analysis and the valuation of common stocks It illustrates that security analysts are often wrong with their recommendations In 2001 the popular press became much more critical of security analysts and their recommendations, including the “superstars” like Mary Meeker and Henry Blodgett It is important for students to understand that analysts have traditionally not issued many “sell” recommendations, at least using that word, and that they appear to have often been influenced by the investment banking side of their firm Because the firm wants to secure or keep a client’s investment banking business, the analyst for that firm may be influenced when issuing opinions about the client’s stock ANSWERS TO END OF CHAPTER QUESTIONS 11-1 The market has a major impact on the average stock For a well-diversified portfolio, which has little or no nonsystematic risk (attributable to individual company factors), the market is the dominant influence on the portfolio, explaining most of the variation in its returns Since most mutual funds are very diversified, they will tend to move very much like the market 11-2 Common stock investors recognize that returns will be quite variable on a year-to-year basis One has only to examine the S&P data given in the text to verify this Nevertheless, owning common stocks is a prudent thing to because of their larger returns Diversification is an absolute essential, which helps to reduce the risk Also, owning stocks over a long period helps to reduce the risk in the sense that a portfolio does not have to be liquidated during bear market periods Based on the historical evidence, it would not be prudent to own a portfolio of fixed-income securities over a long period of time because of their much lower returns (and ending wealth), particularly on an inflationadjusted basis 11-3 The ownership of foreign stocks is a natural, and important, part of the diversification process as well as the process of seeking the best returns possible, given the risk involved Investors must operate in an international environment in today’s world The fact that Japanese stock prices dropped drastically simply means that for new investors a significant opportunity exists The question, of course, has been when to buy For example, Japanese stocks rallied sharply in 1993 from the low point reached but also had problems after that time As of August, 2001, Japanese stocks were at a 17-year low All stock markets are risky, domestic and foreign 11.4 The required rate of return for IBM is the minimum expected rate of return necessary to induce investors to purchase IBM shares The required rate of return takes into account the opportunity cost involved of investing in a particular stock with a given level of risk In the case of IBM, an investor can justify purchasing shares if he or she can expect to earn a level of return that will adequately compensate for the risk involved as measured by the stock’s beta coefficient 11.5 The two components of the required rate of return are: • the risk-free rate of return available to all investors by buying risk-free assets • the risk premium compensation for the particular risk of an asset the larger the risk, the larger the risk premium 11-6 There are many financial assets and, therefore, many different required rates of return Within a particular asset category such as common stocks, there are many required rates of return The level of required rates changes over time 11-7 The shape of the tradeoff between the required rate of return and risk is upward sloping because the relationship is formulated on an ex-ante basis That is, investors purchase assets to hold based on their expectations of the future Ex post, for relatively short periods, this relationship can, and does, slope downward It does not, however, when long periods of time are considered for example, data since 1920 clearly shows that stocks return about twice what bonds return over long periods 11-8 Since the market has a beta of 1.0 by definition, the required rate of return is simply the expected rate of return on the market 11-9 Passive strategies are based on the proposition that an investor does not possess either the knowledge or the ability to outperform the market as a whole These strategies simply seek to as well as the market Passive strategies are related to the concept of efficient markets 11-10 Three active strategies for common stocks include: stock selection searching for undervalued or overvalued stocks sector rotation shifting the sector weights in a portfolio to take advantage of those sectors expected to relatively better and avoid those expected to relatively worse market timing the attempt to earn excess returns by varying the percentage of portfolio assets in equity securities 11-11 In evaluating common stocks, according to one study, security analysts rely on presentations from top management of companies, annual reports, and Form 10-K reports that the companies must file with the SEC 11-12 The cross-sectional variation in common stocks is large In a given year, there is a wide range in performance of stocks Investors who can confine stock selection to the stocks in the highest quartile in a given year would largely avoid losing years However, about 25 percent of the time even the best stocks would have lost money Crosssectional variation of returns has been increasing steadily over the decades 11-13 Sector rotation is an active strategy involving shifting sector weights in the portfolio in order to take advantage of those sectors that are expected to relatively better, and avoid or de-emphasize those sectors that are expected to relatively worse Investors using this strategy are betting that particular sectors will repeat their price performance relative to the current phase of the business and credit cycle The key to effective strategies involving sector rotation is an accurate assessment of current economic conditions 11-14 The evidence on market timing suggests that there is little evidence of many investors doing this successfully on a consistent basis The evidence from mutual funds is particularly persuasive in this regard 11-15 The Efficient Market Hypothesis has to with the adjustment of stock prices to new information If the market is efficient, stock prices adjust quickly, and on balance accurately, to new information This hypothesis has obvious implications for the strategies and approaches discussed in this chapter 11.16 The implications of the EMH to both stock selectors and market timers is that they are unlikely to be successful unless they have access to information others not have or they have superior ability and skill If the market is efficient, prices currently reflect all available information 11-17 The two traditional approaches to analyzing and selecting common stocks are fundamental analysis and technical analysis Fundamental analysis uses the fundamental accounting and related data of the firm sales, earnings, financing, and so forth to estimate the intrinsic value of a company Technical analysis uses the past price and volume data for a company or the market as a whole in an attempt to forecast the future price direction, and/or technical indicators 11-18 The recommended framework for fundamental analysis is market/economy first, industry second, and company third This is a top-down approach because it starts with the economy/market first and works down to the individual company 11-19 The top-down approach is consistent with the discussion about the impact of the market on the typical stock, and in particular the typical welldiversified portfolio If the market is expected to go down, most stocks also can be expected to decline, and it would not be desirable to be assuming long positions at such a time Thus, it makes sense to analyze the market first, before considering either particular industries or particular companies 11-20 Fundamental analysis is based on the premise that any security has an intrinsic value, or its true value as estimated by an investor This value is a function of the firm’s underlying variables, which combine to produce an expected return and an accompanying risk