1. Common Stock Valuation Chapter 9
Lecture 18
Common Stock Valuation
Chapter 9

2. Efficient Market Hypothesis (EMH)
Efficient market hypothesis suggests that complete information is available to investors.
Investor price securities according to that information.
Hence all securities are always fairly priced.

3. EMH and Investment strategy
The theory implies that a passive strategy will bring results as an active strategy of investment.
EMH says no matter how active an investor is, he cannot beat the market i.e. he will not find a security that will offer higher returns than the whole market.

4. EMH suggests Passive Strategy
Passive strategy means an investor does not actively change the stocks in his portfolio on daily or weekly basis.
Investor simply follows the buy-and-hold strategy.
Passive investors accept that current market price is the best estimate of security value.

5. Options in a Passive Strategy
A passive investor can simply follow the buy-and-hold strategy or investing in an index portfolio.
Buy and hold:
Minimize transaction costs
Eliminates search costs
Saves time
However, initial selection should be made.
Investor must decide to reinvest income or not to invest, and to adjust for risk or not.

6. Options in a Passive Strategy
Many mutual funds can be described as passive equity investments.
These portfolios are designed to have risk and return characteristics similar to a market index
An index fund is an unmanaged mutual fund that designed in a way to replicate market index:
Once included, securities are not changed too frequently.
Research costs, and other costs are minimum.
Run by a small staff.

7. Research Study on Index Funds
Burton Malkiel, an economist professor makes a case for index fund.
On average, the typical actively managed fund underperforms the index by about two percentages points a year.
He explains:
Security markets are highly efficient
Index is cost efficient
Trading cost saving up to 1 percent
Tax advantage, deferring capital gains and thus lower taxes

8. Active strategy
All of the valuation techniques we use involve an active approach.
Investors seek undervalued stocks and try to outperform the market
They assume that benefits of active strategy will be greater than the costs.

9. Active strategy
If an investor is applying active strategy, he assumes that:
He has some advantage over others, in terms of :
superior analytical skills
proprietary information
ability and willingness to do what others do not or cannot do

10. Active Strategy - Kinds
There are numerous active strategies, the most prominent are:
Security Selection
Sector Rotation
Market Timing

11. 1. Security Selection
The most popular form active strategy is selection of stocks offering superior return-risk combination.
Many investors believe that they have the ability to identify the under-valued stocks.
For security selection, all of the standard steps in portfolio development are taken, e.g.
Calculating risk and return combinations of securities.
Combining such stocks that can offer greater advantage of diversification.

12. 1. Security Selection
Investors have the option to analyze stocks themselves or rely on the recommendations of analysts.
Can we rely on analysts recommendations for stock selection?

13. Analysts Dilemma
Analysts may face pressure from company’s management not to recommend sale.
One study shows that two-thirds of analysts felt that a negative recommendation on a company would severely impact their access to the company’s management.
Analysts also face pressure from their firms who seek to be underwriters or advisors to the companies being analyzed.

14. Analyst’s Reports Typical analysts reports contains:
Description of the company’s business
Analysts view about the future performance
Earnings estimates
Price estimates
Recommendation to buy, sell, or hold
The most important part of the report is forecasted earning, however these forecasts are often too optimistic.
A researcher found 44% average error on annual basis in the analyst forecasts when they were compared to actual earnings.

15. Importance of Stock Selection
There are always cross-sectional variations in returns of different industries at different time periods.
One study shows that there was consistent spread in the performance of stocks in upper quartile and performance of stock in the lower quartile.

16. Importance of Stock Selection
Another study by Mcenally and Todd for the period 1946 to 1989 found that investors who successfully confined stock selection in the highest quartile would have largely avoided losing years, and even the bad years showed modest losses
Conversely for the bottom quartile, results were negative about 55 percent of the time.
The implication of these results suggests that for those who do attempt to pick stocks, the rewards can be very high but the risk is also high.

17. 2. Sector Rotation
Sector means group of stocks that have some common features, like growth stocks, income stocks, interest sensitive stocks etc.
An investor can follow an active strategy by changing weights of sectors in the portfolio.
If a sector is expected to perform well, its weight can be increased and reduce the weights of those that are expected to perform worse.

18. 2. Sector Rotation
When economic conditions change, these stocks perform or react differently.
For example, Pakistani cement industry is highly levered, firms that have flexible interest rates will be adversely affected by increase in interest rates.
But stocks in oil industry will be affected less by increase in interest rates as they are cash rich firms.
In defensive stocks, companies of food production, soft drinks, pharmaceuticals etc are included; these companies are less affected in business downturns.

19. Indirect Investing in Sectors
Investor can pursue the sector investing approach using mutual funds.
An investment company may offer a number of mutual funds that have focused investment in specific sector.
Risk and return are usually large with sector funds.
Sector funds are popular with momentum traders.
Momentum means that if a stock performs well or worse, it will continue for some time period to perform well or worse.

20. Indirect Investing in Sectors
Research has uncovered an intermediate (3 to 12 months) momentum in U.S. stocks.
This suggests that strong or weak industry performance is followed by strong or weak performance over a period of time.

21. 3. Market Timing
One form of active strategy is to actively change the percentage of portfolio assets.
Market timers invest all of their funds in equities when stock market is performing well, and invest in risk free asset when the market is performing poorly.
They invest in high beta stock when the market is bullish, and invest in lower beta stock when the bullish trend cools down.
Empirically, there is less evidence in support of timing the market.
Sharpe says that an investor can increase return by timing the market but the investor has to be right 7 times out of 10.

22. 3. Market Timing Commission costs may be high.
If an investor misses some important months of trading, his returns may decrease considerably.
A study shows the following information:
Return on S&P500( ) = 14.8%
Take out the ten best days = 10.2%
Take out the 20 best day = 7.3%
Take out the 30 best days = 4.8%
Take out the 40 best days = 2.5%

23. Which Strategy? Passive or Active
Each strategy has its pros and cons.
It depends upon the investor belief about the market functioning.
If he thinks that markets are efficient, then passive otherwise active.