COMMON STOCKS: ANALYSIS &
STRATEGY
Structuring a Stock Portfolio : The Objective
The four main portfolio objectives are stability
of principal, income, growth of income, and
capital appreciation.
In a world with taxes, one dollar in capital
gains is worth more than one dollar in
income.
The overriding investment objective is utility
maximization.
Structuring a Stock Portfolio : Asset Allocation
An asset class refers to a broad category of
investments.
Domestic equities, foreign equities, bonds,
and cash are four widely used asset classes.
Allocating total portfolio wealth to various
asset classes such as stocks, bonds and
cash equivalents is asset allocation.
Structuring a Stock Portfolio : Asset Allocation
Asset allocation: the most Important
decision
Investors failure or success depends
upon asset allocation.
Structuring a Stock Portfolio : Asset Allocation
Portfolio
attitude
toward risk
need for
return
individual choice
stocks
bonds
real
estate
ASSET
CLASSES
cash foreign
equities
asset class mix
realized
return
and risk
with the
passage
of time
investment results
Structuring a Stock Portfolio :
Active vs. Passive Management
A strategy of passive management is one in
which, once established, the portfolio is
largely left alone.
An active management policy, in contrast, is
one in which the composition of the portfolio
is dynamic.
Buy and Hold Strategy
With a passive buy and hold strategy
(a naive strategy), investors simply
select their investments and hang on
to them.
Constant Mix Strategy:
Always maintain a fix percentage of risky
assets in your portfolio.
Buy and Hold , Constant Mix Strategy
A buy and hold strategy does well If the
market is in upward trend.
in Constant Mix Strategy the
appreciating assets are sold off ( i.e.
profits are taken to buy other assets)
so as to maintain the same percentage
of risky assets in portfolio.
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Buy and Hold , Constant Mix Strategy
In a downward market trend buy and
hold strategy dont do well.
Constant Mix Strategy is forced to
maintain the same percentage of risky
assets during downtrend hence
constant mix strategy is worst off in a
bear market.
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The performance of Buy and Hold
Strategy during a oscillating market is
flat.
Constant mix strategy does quite well
in a oscillating market. In a oscillating
market
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The Costs of Revision
There are costs to revising a portfolio.
Trading fees : Historically, stock commissions
are a function of the number of shares and the
dollar amount involved.
Even relatively simple portfolio revisions take up
management time.
Selling securities can involve tax implications.
Window dressing refers to largely cosmetic
portfolio changes made near the end of a
reporting period.
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Portfolio Rebalancing
Rebalancing a portfolio is the process of
periodically adjusting the portfolio so that
certain original conditions of the portfolio are
maintained.
In a constant proportion portfolio,
adjustments are made so as to maintain the
relative weighting of the portfolio components
as their price change.
A constant beta rebalancing scheme seeks to
maintain beta at a prespecified level. This
method is not commonly used now.
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Portfolio Rebalancing
Indexing : Some funds seek to mirror the
performance of a market index
Dollar cost averaging : The idea is to invest a
fixed amount on a regular interval into the
same security, regardless of current market
conditions.
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Index Funds
Using index funds, the pools of mutual &
pension funds assets are designed to duplicate
as precisely as possible the performance of
come market index.
It may consist of all the stocks in a wellknown market average (e.g. S&P 500)
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Index Funds
Expenses are kept to a minimum
Research costs
Portfolio managers fees
Brokerage commissions
No sales or exit charges
Total operating expenses are extremely low
(about 0.20%)
Tax efficiency
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Index Funds
Kinds of portfolios
The Index Trust Portfolio
Extended Market Portfolio
The Total Stock Market Portfolio
The Value Portfolio
The Growth Portfolio
The Total International Portfolio
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Index Funds
According to a recent survey ending 2000,
indexing funds outperformed comparable
actively managed equity funds
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Active approach
Investors use valuation models to value and
select stocks. They assume or expect the
benefits to be greater than the costs
Advantages
Superior analytical and judgment skills
Superior information
Willingness to take risk
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Active approach
Despite the EMH, investor focus on the high
potential rewards and they are confident to
achieve these rewards even if others cant do
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Active Management Strategy
Most common technique of investing involving:
Security Selection
The Importance of Stock Selection
Role of Sell-side and Buy-side Analysts
Sector Rotation
Indirect investing un sectors
Industry momentum and sector investing
Market Timing
Rational Markets and Active Strategies
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Security Selection
The most traditional and popular strategy,
which offers superior return-risk
characteristics
Stocks are typically selected using
fundamental as well as technical security
analysis
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Security Selection
A key feature of the investment environment is
the uncertainty influencing investment
decisions, which persuades the investors to
adopt stock diversification
Significance
Focus of advisory services
Increase in cross-sectional variation of returns
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Sector Rotation
An active strategy, similar to stock selection is
group or sector rotation
This strategy involves shifting sector weights
in the portfolio in order to take advantage of
those sectors that are expected to do relatively
better and reduce for relatively worse sectors
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Sector Rotation
Broader classifications
Interest-sensitive stocks
Consumer-durable stocks
Capital goods stocks
Defensive stocks
Each of the above are expected to perform
differently during the various phases of the
business and credit cycles
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Market Timing
Entering the market in good timings and being
out of the stock market at the bad times
When equities are expected to do well, timers shift
from money market to common stock and vice
versa
market timing strategy pay more brokerage
commissions and taxes as compared to buy and
hold strategy
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Market Timing
switching between stocks and cash-equivalents
over a long period, a successful timer could
enhance returns, but the timer needed to be
right seven times out of ten (Sharpe, 1975)
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Approaches for Analyzing and
Selecting Stocks
Technical Analysis
A form of security analysis that attempts to
forecast price changes based on historical price
and volume trends.
Two Groups of Strategies Used:
1. Momentum and Contrarians Strategies
2. Moving Average and Trading Range Breakout
Strategies
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Technical Analysis
Momentum and Contrarians Strategies
examine the returns over a time period just
ended to identify
momentum investors who seek out stocks
recently rising in price for purchase; falling
for sale
contrarians who follow the opposite strategy
of most investors (base their strategy on
the overreaction theory)
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Technical Analysis
Moving Average and Trading Range
Breakout Strategies
MOVING AVERAGE STRATEGY:
calculate a moving average over the last 200 days of
closing prices
dividend todays closing price into the moving average
(SHORT-TO-LONG RATIO)
if short-to-long ratio is greater than 1, buy
if ratio is less than 1, sell.
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Technical Analysis
Moving Average and Trading Range
Breakout Strategies
TRADING RANGE BREAKOUT STRATEGY:
high and low prices for past 200 trading days are
identified
if todays close is greater than the high = buy!
if todays close is less than the low = sell!
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Fundamental Analysis
Fundamental Analysis: the study of stocks
value using basic financial data of corporations
such as earnings, sales, risks of firms and so
forth.
Approaches to Fundamental Analysis:
Bottom-up Approach
Top-down Approach
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Bottom-up Approach
Approach to fundamental analysis that focuses
directly on a companys fundamentals.
Attempts to estimate prospects in the
following order:
The firm
The Industry
The economy
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Bottom-up Approach
The emphasis of bottom-up approach is to find
out the companies with good long term growth
perspectives, and making accurate earnings
estimates. Bottom-up approach is categorizes
into:
Value Investing
Growth Investing
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The Value Approach to Investing
A value investor believes that securities
should be purchased only when the
underlying fundamentals (macroeconomic
information, industry news, and a firms
financial statements) justify the purchase.
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The Growth Approach to Investing
Growth investors seek steadily growing
companies. There are two factions:
Information traders are in a hurry; they
believe information differentials in the
marketplace can be profitably exploited.
True growth investors are more willing to
wait, but they share the belief that good
investment managers can earn above-average
returns for their clients.
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The Growth Approach to Investing
Growth investors seek steadily growing
companies. There are two factions:
Information traders are in a hurry; they
believe information differentials in the
marketplace can be profitably exploited.
True growth investors are more willing to
wait, but they share the belief that good
investment managers can earn above-average
returns for their clients.
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The Growth Approach to Investing
Growth investors seek steadily growing
companies. There are two factions:
Information traders are in a hurry; they
believe information differentials in the
marketplace can be profitably exploited.
True growth investors are more willing to
wait, but they share the belief that good
investment managers can earn above-average
returns for their clients.
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The Value vs. Growth Investing
Value Stocks and Growth Stocks: How to
Tell by Looking
No precise definition exists.
Classification by Morningstar Mutual
Funds:
relative
relative
price to book + price-earnings
ratio
ratio
1.75
2.25
otherwise
- value
- growth
- blend
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Top-down Approach to Fundamental
Analysis
TOP-DOWN APPROACH attempts to forecast in the
following order
1. economic activity
2. industry performance
3. firms performance
The analyst first considers conditions in
the overall economy (market risk),
then determines which industries are the
most attractive in light of the economic conditions (using
Porters competitive strategy analysis framework, for
example),
and finally identifies the most attractive
companies within the attractive industries
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