FNCE 625 – Investment Analysis and Management

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 11

Common Stocks: Analysis and Strategy

Impact of the Overall Market

Pervasive and dominant

The single most important risk affecting the price movement of common stocks

Particularly true for a diversified portfolio of stocks

Can account for 90% or more of the variability in a well-diversified portfolio’s return

Investors buying foreign stocks face the same situation

Building a Portfolio

Two step decision process:

Asset Allocation

% of wealth allocated to various asset classes such as stocks, bonds, real estate, and cash

This decision is the main factor in determining the risk and return of the portfolio

Security Selection

Determining the individual securities in each asset class

Passive Stock Strategies 1

Natural outcome of belief in efficient markets

No active strategy should be able to beat the market on a risk-adjusted basis over time

Aim, to do as well as the market

Emphasis is on minimizing transaction costs and time spent in managing the portfolio

No attempt to time market or find undervalued stocks

Assume benefits from active trading are less than the costs

Passive Stock Strategies 2

Forms of passive investing:

Buy & hold: investor purchases securities and holds them to meet some future objective

Indexing: investor purchases fund designed to match performance of a broad portfolio

Mutual funds, E T Fs and E T Ns

Enhanced indexing: fund that represents an index with a slight variation

WisdomTree fundamentally-weighted funds

Passive Stock Strategies 3

Buy-and-hold strategy

Avoids the transactions costs and errors that accompany active management

Relatively tax efficient strategy

Initial portfolio selection needs to be made

Investors still must take some actions

Reinvesting portfolio income

Adjusting to changes in risk tolerance

Passive Stock Strategies 4

Index funds

Mutual funds designed to duplicate the performance of some market index

No attempt is made to forecast market movements and trade on forecast

No attempt to select under- or over-valued securities

Low costs to operate, low turnover, tax efficient

Passive Strategies, Index Funds

Historical returns show index funds generally outperform actively managed funds

Index funds are available in many forms

Available as E T Fs, E T Ns and mutual funds

Funds track broad indexes e.g., S&P 500 and Nasdaq 100

Funds track foreign indexes e.g., E A F E and Nikkei

Funds track strategies such as small cap, value, large cap, growth, etc.

Active Stock Strategies 1

Assumes the investor possesses some advantage relative to market participants

Superior information, analytical skills, ability to do what other investors cannot

Most investors favor this approach despite efficient markets support

Both the potential rewards and risks are large

Active Stock Strategies 2

Traditional strategy is to select individual stocks

Majority of investment advice geared to stock selection

Investors focus on E P S forecasts

Growth stocks and value stocks

Value stocks “cheap” relative to fundamentals

Growth stocks have strong prospects

Value investing takes long-term, sometimes contrarian approach

Active Stock Strategies 3

Security analysts forecast stock value

Sell-side analysts: reports used to “sell” idea

Buy-side analysts: employed by money management firms to generate reports

Research typically only available to employers

Estimates provided by analysts

Expected performance, earnings estimates, price targets

Recommendations: Buy, Hold, or Sell

Active Stock Strategies 4

Recommendation changes often affect stock prices

Analysts focus on forecasting earnings

Typically overly optimistic about long-term E P S

Analysts rarely recommend selling

Analysts generally good at analyzing industries

Good independent info sources available

Value Line Investment Survey, S&P’s Outlook, Morningstar

Active Stock Strategies 5

Number of Analyst Recommendations by Type for the S&P 500 Stocks

Sector Rotation

Involves shifting sector weights in the portfolio

Over-weight sectors expected to perform well, under-weight those expected to perform poorly

Four broad sectors:

Interest-sensitive, consumer durables, capital goods, and defensive stocks

Subject to greater risk than investing in overall market

Can be pursued with sector mutual funds, E T Fs

Market Timing

Market timers attempt to earn excess returns by varying % held in equities

Shift to cash when stocks expected to do poorly

Success depends on the amount of brokerage commissions and taxes paid

Research suggests market timing is risky

Investors may not be in market at critical times and may miss out on returns

Rational Markets and Active Strategies

If market is efficient, prices reflect fair value

Active strategies are unlikely to be successful over time after all costs

Market efficiency proponents argue that little time should be spent on security analysis

Spend time on reducing taxes/costs and maintaining chosen portfolio risk

Investor’s beliefs affect strategy implemented

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FNCE 625 – Investment Analysis and Management

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