Cleary/Jones
Investments: Analysis and Management, Second Canadian Edition
CHAPTER 14 Common Stocks: Analysis and Strategy REVIEW QUESTIONS 14-1.
The market has a major impact on the average stock. For a well-diversified portfolio, which has little or no nonsystematic risk (attributable to individual company factors), the market is the dominant influence on the portfolio, explaining most of the variation in its returns. Since most mutual funds are very well diversified, they will tend to move very much like the market.
14-2.
The required rate of return for Bombardier is the minimum expected rate of return necessary to induce investors to purchase Bombardier shares. The required rate of return takes into account the opportunity cost involved of investing in a particular stock with a given level of risk. In the case of Bombardier, an investor can justify purchasing shares if he or she can expect to earn a level of return that will adequately compensate for the risk involved as measured by the beta coefficient of the stock.
14-3.
The two components of the required rate of return are: (1) (2)
the risk-free rate of return – available to all investors by buying riskfree assets (Treasury bills). the risk premium – compensation for the particular risk of an asset. The larger the risk, the larger the risk premium.
14-4.
The shape of the trade-off between the required rate of return and risk is upward sloping because the relationship is formulated on an ex-ante basis. That is, investors purchase assets to hold based on their expectations of the future. Ex-post, for relatively short periods, this relationship can, and does, slope downward.
14-5.
Passive investment strategies are based on the proposition that an investor does not possess either the knowledge or the ability to outperform the market as a whole. These strategies simply seek to do as well as the market. Passive strategies are related to the concept of efficient markets.
14-6.
The evidence on market timing suggests that there is little evidence of many investors doing this successfully on a consistent basis. The evidence from mutual funds is particularly persuasive in this regard.
14-7.
The two traditional approaches to analyzing and selecting common stocks are fundamental analysis and technical analysis.
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Cleary/Jones
Investments: Analysis and Management, Second Canadian Edition
Fundamental analysis uses the fundamental accounting and related data of the firm ― sales, earnings, financing, and so forth ― to estimate the intrinsic value of a company. Technical analysis uses the past price and volume data for a company or the market as a whole in an attempt to forecast future price directions. 14-8.
The recommended framework for fundamental analysis is market/economy first, industry second, and company third. This is a top-down approach because it starts with the economy/market first and works down to the individual company.
14-9.
The top-down approach is consistent with the discussion of the impact of the market on the typical stock, and in particular the typical well-diversified portfolio. If the market is expected to go down, most stocks can also be expected to decline, and it would not be desirable to be assuming long positions at such a time. Thus, it makes sense to analyze the market first, before considering either particular industries or particular companies.
14-10.
Fundamental analysis is based on the premise that any security has an intrinsic value (its true value as estimated by an investor). This value is a function of the firm’s underlying variables, which combine to produce an expected return and an accompanying risk.
14-11.
Technical analysis is based on the belief that the value of a stock is primarily a function of supply and demand conditions. If the demand (buyers) for a particular stock is greater than the supply (sellers) of the stock, the price will rise. If supply is greater than demand, the stock price will fall.
14-12.
Technical analysis is inconsistent with the Efficient Market Hypothesis (EMH) because technical analysis relies on past volume and price data to determine the value of a stock. Since the Weak Form of the EMH states that stock prices already reflect all past price and volume data, this means that technical analysis is inconsistent with the EMH.
14-13.
Common stock investors recognize that returns will be quite variable on a year-to-year basis. One has only to examine the historical stock market data given in the text to verify this. Nevertheless, owning common stocks is a prudent thing to do because of their larger returns. Diversification is an absolute essential, which helps to reduce the risk. Also, owning stocks over a long period helps to reduce the risk in the sense that a portfolio does not have to be liquidated during bear market periods. Based on the historical evidence, it would not be prudent to own a portfolio of fixed-income securities over a long period of time because of the much lower returns of the securities, (and ending wealth), particularly on an inflation-adjusted basis.
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Cleary/Jones
Investments: Analysis and Management, Second Canadian Edition
14-14. The ownership of foreign stocks is a natural and important part of the diversification process as well as the process of seeking the best returns possible, given the risk involved. Investors must operate in an international environment in today’s world. The fact that Japanese stock prices dropped drastically simply means that for new investors a significant opportunity has presented itself. All stock markets are risky, but all offer a chance for large returns. 14-15.
There are many financial assets and, therefore, many different required rates of return. Within a particular asset category such as common stocks, there are many required rates of return. The levels of required rates of return change over time.
14-16.
Since the market has a beta of 1.0 by definition, the required rate of return is simply the expected rate of return on the market.
14-17.
Three active strategies for common stocks include: (1)
Stock selection – searching for undervalued or overvalued stocks.
(2)
Sector rotation – shifting the sector weights in a portfolio to take advantage of those sectors expected to do relatively better and avoid those expected to do relatively worse.
(3)
Market timing – the attempt to earn excess returns by varying the percentage of portfolio assets in equity securities.
14-18.
In evaluating common stocks, security analysts rely on presentations from top management of companies, annual reports, and annual information reports that must be filed with the appropriate regulatory bodies (such as the Ontario Securities Commission).
14-19.
The cross-sectional variation in common stocks is large. In a given year, there is a wide range in performance of stocks. Investors who can confine stock selection to the stocks in the highest quartile in a given year would largely avoid losing years. However, about 25 per cent of the time even the best stocks would have lost money. Cross-sectional variation of returns has been increasing steadily over the decades.
14-20.
Sector rotation is an active strategy that involves shifting sector weights in the portfolio in order to take advantage of those sectors that are expected to do relatively better, and avoiding or de-emphasizing those sectors that are expected to do relatively worse. Investors using this strategy are betting that particular sectors will repeat their price performance relative to the current phase of the business and credit cycle.
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Cleary/Jones
Investments: Analysis and Management, Second Canadian Edition
The key to effective strategies involving sector rotation is an accurate assessment of current economic conditions. 14-21.
The Efficient Market Hypothesis has to do with the adjustment of stock prices to new information. If the market is efficient, stock prices adjust quickly, and (on balance) accurately, to new information. This hypothesis has obvious implications for the strategies and approaches discussed in this chapter.
14-22.
The implications of the EMH to both stock selectors and market timers are that they are unlikely to be successful unless they have access to information others do not have or they have superior ability and skill. If the market is efficient, prices currently reflect all available information.
14-23.
The advantage of the top-down approach is that it begins by looking at the overall economy first, and since 80 to 90 per cent of the return on a portfolio is determined by the asset allocation decision, this is a good way to begin your analysis. The disadvantage of the top-down approach is that if you make the wrong forecast of the overall economy, you may be heavily invested in the stock market at the wrong time.
14-24.
The advantage of the bottom-up approach is that an in-depth analysis of a company can be made with this approach. The disadvantage of the bottom-up approach is that the condition of the overall economy is neglected, and if the economy moves in the wrong direction, the price of your stock could still go down even though it might well be a good quality stock.
14-25.
Strategic asset allocation could be classified as a “buy-low, sell-high” strategy because you rebalance to maintain a long term strategic asset mix (e.g., 50% bonds, 50% stocks). For example, if price of bonds rises so that portfolio is 60% bonds, 40% of stocks, you would sell bonds (which have increased in price relative to stocks) and buy stocks (which have decreased in value relative to bonds).
14-26.
1. Buy + hold – buy shares, etc. and form a portfolio, and maintain it with few changes 2. Buy Index Mutual Funds – purchase units in Index funds that mimic a desired index such as the S&P/TSX composite Index or the SCM Universe Bond Index. 3. Buy Index Participation Units (i.e., Exchange –Traded Funds) – these funds hold shares in an underlying index, such as the S&P/TSX 60 Index, and charge low MERs.
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Cleary/Jones
Investments: Analysis and Management, Second Canadian Edition
14-27.
D
14-28.
D
14-29.
E (RM) – RF = 6, 11 – RF = 6, Real RF = 5 –3 = 2%
CFA PRACTICE QUESTIONS 1.
C
This statement is the basis for “bottom-up” analysis.
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Cleary/Jones
Investments: Analysis and Management, Second Canadian Edition
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