Security Analysis of Equities

Prof. Mohammed Elgammal

Outlines

  • Fundamental Analysis Technical Analysis
  • EMH
  • Market Anomalies
  • Active and Passive Management

Fundamental Analysis

  • Compare market price with “correct” price Determine “correct” price by using models
  • Ratio analysis
  • Gordon’s growth model
  • Market model
  • Capital asset pricing model
  • Cap M Model << to determine the expected return and if you have BETA
    R= P+ – P+ -1 / P+ -1
check with historical values to see if past values of the share price are correct

Technical Analysis

Study past share price movements to identify a pattern

Chartists

Economic analysis:

  •  Global economy – political risks, exchange rates, etc
  •  Domestic economy – GDP, employment, inflation, interest rates, budget deficit, consumer sentiment, etc
  •  Supply / demand shocks – government spend, tax rates, oil prices, foreign export demand, etc
  •  Government policy – fiscal policy, monetary policy, supply-­‐side policies
  • Business cycles – economic indicators
All decisions depend on expected cash flows for the firms, as market as a whole are not doing well e.g. middle east crises, government spendings. if the government does not spend it sends a signal that they might increase unemployment and investment in infrastructure.
 Industry analysis: 
  1.  Defining an industry
  2.  Sensitivity to the business cycle – types of good and service sold
  3.  Industry life cycles – stage of business development and sensitivity to economy
  4.  Industry structure and performance , competitive strategy and profitability (Porter’s five forces)

Firm-­‐specific analysis:

  • Financial statement analysis Future cash flows generated
  • Dividends
  • Profits
  • Liabilities

Technical analysis

  • Concentrate on recurrent and predictable patterns in share prices
  • Does not discount the importance of new information on future prospects of the firm
  • BUT, if prices respond slowly enough the analyst can identify a trend that may be exploited during an adjustment period
  • Such trends have been found to exist in equities, bonds, currencies, commodities, and other classes of financial assets

analysis believe that past events will happen again, this approach tries to identify a trend in a period of time because there is a delay in data coming in and out of the market and because of this delay it could be possible to beat the market.

Dow Theory

Charles Dow is widely regarded as the grandfather of most technical analysis, the market is affected by:

  • Primary trend – the long-­‐term movement of prices, lasting for several months or years
  • Secondary / intermediate trend – caused by short-­‐term deviations of prices from the underlying trend line.Such deviations are eliminated via corrections when prices revert back to the trend value
  • Minor trends – daily fluctuations of little importance
There also tends to be a positive relationship between a trend and the volume of shares traded

The primary trend

Intermediate trend

Head and shoulders topping pattern:

Head and shoulders topping pattern:

  •  A head and shoulders pattern typically appears after an upward primary market trend
  •  By early February the neckline has been set at the previous low from mid-­‐December
  •  High trading volume in the decline of the right shoulder and low volume in the formation of the head are taken as signals of the pattern
  •  Once the neckline is broken the price is expected to further decline by the difference between the top of the head and the neckline

Trend/Tram Lines

  • The support trend line is formed when a share price decreases and rebounds at a pivot point that aligns with at least two previous support pivot points
  • A resistance trend line is formed when a share security price increases and then rebounds at a pivot point that aligns with at least two previous resistance pivot points

Moving average trading rules

  • Simple moving average trading rules are built on the basis of taking the arithmetic average of the share price over a specified number of days:
  • The market price is higher than the moving average price, so there is a momentum for it to further increase in the near future
  • The market price is lower than the moving average price therefore the trend is for the market price to reduce in the near future
As the price is lower then the moving average then sell

Efficient Market Hypotheses

Information efficiency

Identified by Fama in 1960’s

  • Three forms
  • Weak form
  • Semi-­‐strong form Strong form

Efficient Markets Hypothesis (EMH):

  •  The market price of a security reflects ‘all available information’ about the stock
  •  The expected return on the security is related to its risk
  •  So you can not make any abnormal returns in the long run.

Assumptions of EMH

There are a large number of profit-­‐maximizing market participants who, independently of one another, analyze and value stocks

New information on securities comes to the market in a random fashion

Profit maximizing investors adjust security prices rapidly to reflect the effect of new information

Random Walk

The outcome of the EMH is that share prices should follow a ‘random walk’

  •  Current prices reflect all available information
  •  Changes in prices occur in response to new information, which is random and unpredictable
  •  Under the random walk hypothesis, the best prediction for tomorrow price is today price.

Weak form market efficiency

Share prices reflect all information that can be derived by examining past market trading data: past share prices; trading volume, etc.

έt represents new information hitting the market, and is assumed to be random.

  •  Tradingstrategiesthataimtoexploitinformationonpast share price data cannot be used to make abnormal levels of profits
  •  Abnormalreturnscanonlybeearnedwhere:

Investors have public or private information about the firm’s present / future performance

Can be expressed as: Pt = Pt-­‐1 + έt

Semi-strong form market efficiency

  • Stock prices reflect all publicly available information about the company
  • Past share price data; trading data; financial statements; forecasts of future firm, industry and economic conditions
  • Trading strategies that aim to exploit information on past share price data AND publicly available data cannot be used to make abnormal profits
  • Abnormalreturnscanonlybeearnedwhere:
  • Investorshaveprivateinformationaboutthecompany’spresent/ future performance
  • Can be expressed as: Ωt-­‐1 represents the publicy available information set at t-­‐1

Pt = Pt-­‐1|Ωt-­‐1 + έt

Strong form market efficiency

Stock prices reflect all available information relevant to the firm, including private information

Past share price data; trading data; financial statements; forecasts of future firm, industry and economic conditions; insider information

  •  Trading strategies that aim to exploit information on past share price data, publicly available data, AND privately held data cannot be used to make abnormal profits
  •  Abnormal returns cannot be earned based on any of the information highlighted above:
  •  Even company directors left unregulated to trade would not be able to make abnormal profits in their

own company’s shares

Evidence on the EMH

Strong-­‐form market efficiency:

  • Insiders (such as company directors) have been found to make profits when they trade in their own company’s securities which rejects the notion that financial markets are strong-­‐form efficient

Semi-­‐strong and weak form market efficiency:

  • MIXED evidence that technical trading rules (weak form) and fundamental (semi-­‐strong) trading strategies have been used to make abnormal returns in the past

EMH forms and abnormal return

Market anomalies

  •  Overall, current evidence suggests that financial markets are less than strong form efficient. Markets are generally taken to be semi-­‐strong efficient, but with some anomalies to this.
  •  Anomalies to the EMH suggest a form of market inefficiency:Mainly relate to the semi-­‐strong form of the EMHTheoretically allow investors to systematically earn abnormally high returns from trading

Types of anomalies:

  • Firm anomalies
  •  Small firms Vs Bigfirms
  •  Value firms Vs Growth firms
  •  Winners Vs Losers Market anomalies
    Seasonal anomaliesJanuary or April
  • Event anomalies << Dividend before or after
  • Accounting anomalies
  • Earning momentum: Firms with reporting unexpectedly high earnings outperform firms reporting unexpectedly low earnings.
  • Accruals : firms with relatively high (low) levels of accruals to total assets experience negative (positive) future abnormal returns.

Active or passive fund management?

Passive Investment Management:

  •  Buy-­‐and-­‐hold management strategy
  •  No attempt to outsmart financial markets
  •  Setting up a well-­‐diversified portfolio with no attempt to identify mispricing of securities

Active Investment Management:

  •  Bottom-­‐up type approach to portfolio selection
  •  Regular trading of assets based on perception of under or overvaluation in financial markets
research as shown that passive approach is expected to gain more in the long term

EMH and asset management:

If the (semi-­‐strong) EMH holds then there is no value to active investment management

  • Regular trading incurs high transaction costs
  • Implications of Market Efficiency
  • The market cannot CONSISTENTLY be beaten
  • Market has no memory
  • All shares are the same
  • Correct return for given level of risk
  • Share price is good indicator of the future

Implications for Financial Manager

  •  There are no financial illusions
  •  Shares will be correctly priced by the market, nobetter time to issue new shares
  •  Current share price reflects current public knowledge
  •  To increase value of company undertake +NPV projects

What Makes Markets Efficient

  •  Large number of analysts
  •  Availability of information
  •  Company reports
  •  Legal, accounting and stock market requirements
  •  Credit agencies
Financial press, TV, internet, etc.
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