Analyzing and Managing Common Stocks

Chapter 11 Charles P. Jones, Investments: Analysis and Management, Tenth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University

11-1

Impact of the Market

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

Particularly true for a diversified portfolio of stocks

Accounts for 90% of the variability in a diversified portfolios return

Investors buying foreign stocks face the same situation

11-2

Required Rate of Return

Minimum expected rate of return needed to induce investment

Given risk, a security must offer some minimum expected return to persuade purchase Required RoR = RF + Risk premium Investors expect the risk free rate as well as a risk premium to compensate for the additional risk assumed

11-3

Security Market Line

SML E(R) kM A B C

Beta = 1.0 implies as risky as market Securities A and B are more risky than the market

kRF

Beta >1.0

0.5

1.0 1.5 BetaM

Security C is less risky than the 2.0 market

Beta <1.0
11-4

Understanding the Required Rate of Return

Risk-free rate RF =Real RoR +Inflation premium

Real rate of return is basic exchange rate in the economy Nominal RF must contain premium for expected inflation

The risk premium

Reflects all uncertainty in the asset

11-5

Passive Stock Strategies

Natural outcome of a belief in efficient markets

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

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

Expected benefits from active trading or analysis less than the costs

11-6

Passive Stock Strategies

Buy-and-hold strategy

Belief that active management will incur transaction costs and involve inevitable mistakes Important initial selection needs to be made Functions to perform: reinvesting income and adjusting to changes in risk tolerance

11-7

Passive Stock Strategies

Index funds

Mutual funds designed to duplicate the performance of some market index No attempt made to forecast market movements and act accordingly No attempt to select under- or overvalued securities Low costs to operate, low turnover

11-8

Active Stock Strategies

Assumes the investor possesses some advantage relative to other market participants

Most investors favor this approach despite evidence about efficient markets

Identification of individual stocks as offering superior return-risk tradeoff

Selections part of a diversified portfolio

11-9

Active Stock Strategies

Majority of investment advice geared to selection of stocks

Value Line Investment Survey

Security analysts job is to forecast stock returns

Estimates provided by analysts

expected change in earnings per share, expected return on equity, and industry outlook

Recommendations: Buy, Hold, or Sell

11-10

Sector Rotation

Similar to stock selection, involves shifting sector weights in the portfolio

Benefit from sectors expected to perform relatively well and de-emphasize sectors expected to perform poorly Interest-sensitive stocks, consumer durable stocks, capital goods stocks, and defensive stocks

Four broad sectors:

11-11

Market Timing

Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equity securities

Increase portfolio beta when the market is expected to rise

Success depends on the amount of brokerage commissions and taxes paid

Can investors regularly time the market to provide positive risk-adjusted returns?

11-12

Efficient Markets and Active Strategies

If EMH true:

Active strategies are unlikely to be successful over time after all costs If markets efficient, prices reflect fair economic value

EMH Proponents argue that little time should be devoted to security analysis

Time spent on reducing taxes, costs and maintaining chosen portfolio risk

11-13

Copyright 2006 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United states Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

11-14