Analyzing Equities

8/8/2019 Analyzing Equities

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ANALYZING EQUITIES

PRESENTED BY:

ATO BARNES

SEM INTERNATIONAL ASSOCIATES


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ANALYZING EQUITIES

The starting point for all fundamental analysis

Chapter 6

Economy, Industry, and Company Analysis

Analyzing the Economy

Profitability of all companies,depends on the overallperformance of the economy

The overall performance of the economy is measured by theGROSS DOMESTIC PRODUCT (GDP).

The GDP is the result of the interaction of governmentpolicies and external factors.


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ANALYZING EQUITY

SECURITIESTwo categories of government policies:

(1)Fiscal:- establishes government revenue and

expenditure(2)Monetary: -determines the liquidity of the

economy through money supply. Also determineslevel of interest rates.

(3)Projections for government expenditure,inflation and GDP are always made in each yearsannual budget


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Policy variables affect total spending (Y)which in Combination with the tax ratetcaffects corporate earnings. As investors changetheir expectations of corporate earnings,share prices respond, with high earnings

expectations leading to share price increasesand vice-versa.

Economic VariablesandShare Prices

Analyzing Equity Securities

(MichaelKeransModel)


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Economic VariablesandShare Prices

2. The policy variables affect total spending whichin combination with the economy's potential

output Y* and past changes in prices determinecurrent changes in prices (P). Y and P determinecurrent changes in real output (X). Changes in Xand P generate expectations about inflation andreal growth which in turn affects interest rates.Interest rates have a negative effect on shareprices. As taxes rise, investors raise the rates ofreturn that they require, causing share prices tofall.


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Industry Analysis

Evaluation of the industry in relation to majormacroeconomic variables

Implications of Cyclical ,Counter Cyclical,Interest Sensitive, and Non-interest Sensitiveindustries for the investor?

A qualitative analysis of industry characteristics.

Historical performance (Sales and profitability)

Competition (Porters 5 force Model) Government effects (regulations and taxes)

Structural changes of the industry


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Summary ofIndustry Analysis

In the short-run (e.g. 1 year), industry analysisshould assist in identifying which industries will

produce high earnings, which industries will havehigh P/E ratios. The short-run analysis is usuallybased on expectations about macroeconomicvariables such as interest rates and GDP growth.

Long-run investors would usually be more interestedin the industry life cycle and the qualitative factorsthat affect the long-run strength of an industry.



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Company Analysis

Company analysis identifies the strengths andweaknesses of a company.

Other things being equal, a strong companywould command a higher price-earnings ratiothan a weak company.

Therefore, it is necessary to evaluate the longterm prospects of a company in terms of sales

and profitability. A basic understanding of financial statements is

therefore, essential to company analysis.



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TechnicalAnalysis

UnderlyingAssumptions Values, and thus, prices are determined by

supply and demand.

Supply and demand is driven by bothrational and irrational behaviour

Security prices move in trends that persistfor long periods of time.

While the cause for changes in supply anddemand are difficult to determine, theactual shifts in supply and demand can beobserved in market price behaviour.


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Differences AmongFundamental,

Technical,andthe EfficientMarket

Analysts

Fundamental Analysts believe that a

securitys price is determined by the supply

and demand for the underlying security

based on its economic fundamentals such

as expected return and risk.

Fundamentalists believe they can forecastvalue changes by analyzing earnings data

and publicly available data.


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Analysts

The major challenges to technical analysisis the efficient market hypothesis.

Efficient analysts feel all availableinformation is impounded in the currentsecurity price. That past technicalrelationship may not be repeated. That

technical rules require too much subjectiveinterpretation, and decision variableschanges over time.


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Analysts The difference between fundamental analysts,

technical analyst and efficient market analysts is

the speed at which these analyst believe news isimpounded into prices.

Fundamentalists, through research, look forchanges in the basis of value, which eventuallyleads to changes in the supply and demand for the

shares. Technicians look for evidence of changesin supply and demand through market signals andindicators. Efficient market followers say all thislooking is a hopeless and profitless exercise since

prices will change instantaneously to informationchan es.


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AdvantagesofTechnicalAnalyst

Its quick and easy

It does not involve messing with data and

adjusting for accounting problems

It incorporates psychological as well as

economic reasons behind price changes

It tells when to buy; not why investors are

buying


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Challengesto TechnicalTrading

Rules

The vast majority of studies have found

that prices do not move in trends based on

statistical tests of autocorrelation and runs.

That is, past price patterns may not be

repeated in the future.

If technical trading rules worked, themarket would self-destruct. This is called

self-fulfilling prophecy.


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Challengesto TechnicalTrading

Rules

If a technical trading proved to be

successful, others would copy it. As more

traders implement the strategy, its value

will be neutralized.

Interpreting the rules is too subjective and

the decision variables change over time.


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TechnicalRules

Technicians tend to take one of two views when

analyzing general market rules:

The contrarian view contrary-opinion techniciansfeel that everybody else is stupid, so they had better do

the opposite of what investors are doing.

Follow the smart money view technicians feel that

smart investors know what they are doing, so thattechnicians had better jump on the bandwagon while

there is still time.


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TechnicalRules

A review of the contrarian viewpoint

Since contrarians feel that majority of

investors are always wrong, they wait to see

what the investing public is doing and do the

opposite. This approach comes from

greed/panic view of the investment process. A

wise contrary-opinion technician does the

opposite of what the general public does.


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TECHNICAL ANALYSIS(contd)

1. The DOW Theory

Primary Moves: broad based market movement lasting for several years.

BULL marketupward primary move, in which successive market rallies

tend to penetrate previous highs:BEAR marketdownward primary move, in

which successive market rallies fail to penetrate previous highs, and declines

penetrate previous lows. Secondary Moves: occurs within primary moves. Represents interruptions

lasting for several weeks or months. Leads to technical corrections when

market is adjusting to previous excesses.

Day-to-Day Moves: occur randomly around the primary and secondary moves.


ANALYSIS OFAGGREGATE MARKET

2. Technical Indicators for Aggregate Market

1. Advance-Decline Line

2. New Highs and Lows

3. Volume : A high volume is considered bullish

4. Cumulative Offers to Bid

5. Contrarian Opinion: Odd-Lot Index=Odd Lot Sales/Odd Lot Purchases


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Volume

Odd-Lot Index

Cumulative Offers-to-Bids Technical indicators, graphs, charts, for individual shares

Head and Shoulders patterns: These are time series graphs ofmarket

indextoshareprice ratiothat indicate endofrallies.

Support and Resistance patterns/level This is a time series graph of

marketindexthat indicates newandendingrallies.


ANALYSIS OF INDIVIDUAL SHARES


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Demerits of Technical Analysis:

1. Failed to outperform simple buy and holdstrategy

2. Tools of technical analysis (graphs, charts,

indicators) can be misinterpreted

3. Rule could be self-destructive if many analysts

use it.



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PERFORMANCE

EVALUATION

Concerns assessing the performance of a portfolio and

hence a portfolio manager

A performance measurement system should address twoconcerns:

How did the manager perform after adjusting for the

risk associated with the active portfolio strategyemployed?

How did the manager achieve the reported return?Was the stated strategy followed?

Introduction


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Benchmarksfor EvaluatingPerformance

Market Indices

GSE All-Share Index

Databank Stock Index

Performance Evaluation


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Generic-InvestmentStyle

IndicesGeneric-Investment Style Indices

Measures performance of various investmentstyles, and compared with published styleindexes

Style classification: large value, large growth,small value, small growth

P/B ratio used to classify stocks as value or

growth stocksGrowth oriented managers concerned aboutearnings growth; value oriented managersconcerned about price movement

Value stocks are cheap stocks (low P/B ratio)


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NormalPortfolio

Normal Portfolios

Customized benchmark that includes all of

the securities from which a managernormally chooses, weighted as themanager would weight them.


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Single IndexMeasuresofPortfolio

Performance

1. The Reward-to-Variability Ratio (the SharpeIndex)


A good measure of performance considers bothrisk and return. Two common measures ofportfolio performance that considers both riskand return are:

p

fp RRSIW

!


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Treynor Index

2. The Reward-to-Volatility Measure (the TreynorIndex)

p

fp RRTIF!

Recall: Standard deviation or variance measurestotal risk, but beta measures systematic risk

Note: BothSI and TI measure excess returnovertherisk-free rate torisk


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Single IndexMeasuresofPortfolio Performance

(contd)Illustration:- Calculation of Sharpe and Treynor Indices


PERIOD A B MARKET INDEX RISK FREE RATE

1 10.4 15.4 17 8.6

2 -15.3 -15.7 -19 10.3

3 20 23.4 12.3 11.5

4 26.1 23.2 20 11.9

5 32.1 28.5 20 12

6 -30.7 -28.6 25 11.2

7 26 25.6 17.4 12.5

8 15.9 18 21.5 13

9 21.5 24.7 23.9 13.1

10 -24.1 12 -9.8 9.5

MEAN 8.2 12.7 12.8 11.14

STD DEV 21.7 18.3 14.2 1.4

BETA 0.79 0.42 1

PORTFOLIO


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Equity Performance AttributionModels


1. Timing short term factor trends2. Market timing3. Security analysis

These models seek to explain the sources of equityportfolio return in terms of three actions of portfoliomanagers, viz:


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Equity Performance AttributionModels

The equity performance attribution attribution analysisis done with the view to determining:

1. The sources of return2. Whether the short-term factor timing is

statistically significant3. Whether the market timing is statistically

significant4. Whether the security analysis is statistically

significant

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Analyzing Equities

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