COMMON STOCK: ANALYSIS AND STRATEGY

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Investment Analysis & Portfolio Management (FIN630)

Lesson # 22

COMMON STOCK: ANALYSIS AND STRATEGY

The Passive Strategy:

A natural outcome of a belief in efficient markets is to employ some type of passive strategy

in owning and managing common stocks. If the market is highly efficient, impounding

information into prices quickly and on balance accurately, no active strategy should be able

to outperform the market on a risk-adjusted basis. The efficient market hypothesis (EMH)

has implications for fundamental analysis and technical analysis, both of which are active

strategies for selecting common stocks.

Passive strategies do not seek to outperform the market but simply to do as well as the

market. The emphasis is on minimizing transaction costs and time spent in managing the

portfolio, because any expected benefits from active trading or analysis are likely to be less

than the costs. Passive investors act as if the market is efficient and accept the consensus

estimates of return and risk, recognizing .current market price as the best estimate of a

security's value.

An investor can simply follow a buy-and-hold strategy for whatever portfolio of stocks is

owned. Alternatively, a very effective way to employ a passive strategy with common

stocks-is to invest in an indexed portfolio. We will consider each of these strategies in turn.

Buy-And-Hold Strategy:

A buy-and-hold strategy means exactly that an investor buys stocks and basically holds

them until some future time in order to meet some objective. The emphasis is on avoiding

transaction costs, additional search costs, and so forth. The investor believes that such a

strategy will, over some period; of time, produce results as good as alternatives that require

active management whereby some securities are deemed not satisfactory; sold, and replaced

with other securities. These alternatives incur transaction costs and involve inevitable

mistakes.

Notice that a buy-and-hold strategy is applicable to the investor's portfolio whatever

its composition. It may be large or small, and it may emphasize various types of stocks.

Also note that an important initial selection must be made to implement the strategy. The

investor must decide to buy stocks A, B, and C and hot X, Y, and Z.

It is important to recognize that the investor will, in fact, have to perform certain functions

while the buy-and-hold strategy is in existence. For example, any income generated by the

portfolio may be reinvested in other securities. Alternatively, a few stocks may do so well

that they dominate the total market value of the portfolio and reduce its diversification. If

the portfolio changes in such a way that it is no longer compatible with the investors risk

tolerance, adjustments may be required. The point is simply that even under such a strategy

investors must still take certain actions.

Index Funds:

An increasing amount of mutual fund and pensions fund assets can be described as passive

equity investments. These asset pools are designed to duplicate as precisely as possible the

performance of some market index. An index fund is an unmanaged fund designed to

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replicate as closely as possible (or practical) the performance of a specified index of market

activity.

A stock-index fund may consist of all the stocks in a well-known market average such as

the S&P 500- Index. No attempt is made to forecast market movements and act accordingly,

or to select under of overvalued securities. Expenses are kept to a minimum, including

research costs (security analysis), portfolio manager's fees and brokerage commissions.

Index funds can be run efficiently by a small staff.

1. The index Trust 500 portfolio consists of stocks selected to duplicate the S&P 500

and emphasizes large-capitalization stocks.

2. The. Extended Market Port/olio consists of a statistically selected sample of the

'Wilshire 4500 Index and of medium-and small-capitalization stocks.

3. The Total Stock Market Portfolio seeks to match the performance of all

(approximately 7000) publicly traded U.S. stocks.

4. The Small Capitalization Stock Port/olio seeks to match the performance of the

Russell 2000 Small Stock Index, consisting of 2000 small-capitalization stocks.

5. The Value Portfolio seeks to match the investment performance of the S&P/BARRA

Value Index, which consists of stocks selected from the S&P 500 Index with lower

than average ratios of market price to book value.

6. The Growth Portfolio seeks to match the investment performance of the S&P

500/BARRA Growth Index, which consists of stocks selected from the S&P 500

Index with higher than average ratios of market price to book value.

7. The Total International Portfolio covers 31 countries across Europe, the Pacific, and

emerging markets, and holds over 1500 stocks. The European Portfolio invests in

Europe's 14 largest markets, whereas the Pacific Portfolio invests in the six most

developed countries in the Pacific region. The Emerging Markets Portfolio invests in

14 of the most accessible markets in the less-developed countries.

The Active Strategy:

Most of the techniques discussed in this text involve an active approach to investing. In the

area of common stocks, the use of valuation models to value and select stocks indicates that

investors are analyzing and valuing stocks in an attempt to improve their performance

relative to some benchmark such as a market index. They assume or expect the benefits to

be greater than the costs.

Pursuit of an active strategy assumes that investors possess some advantage relative to other

market participants. Such advantages could include superior analytical or judgment skills,

superior information, or the ability or willingness to do what other investors, particularly

institutions, are unable to do. For example, many large institutional investors cannot lake

positions in very small companies, leaving this field for individual Furthermore, individuals'

are not required to own diversified portfolios and are not prohibited from short sales or

margin trading as are some institutions.

Most investors still favor an active approach to common stock selection and management

despite the accumulating evidence from efficient market studies and the published

performance results of institutional investors. The reason for this is obvious that the

potential rewards are very large, and many investors feel confident that they can achieve

such awards even if other investors cannot.

There are numerous active strategies involving common stocks. We consider the most

prominent ones below. Because of its importance, we then consider the implications of

market efficiency for these strategies.

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Sector Rotation:

An active strategy that is 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 avoid or deemphasize those sectors that are

expected to do relatively worse. Investors employing this strategy are betting that particular

sectors will repeat their price performance relative to the current phase of the business and

credit cycle.

An investor could think of larger groups as the relevant sectors, shifting between cyclical,

growth stocks, and value stocks. It is quite standard in sector analysis to divide common

stocks into four broad sectors: interest-sensitive stocks, consumer durable shocks, capital

goods stocks, and defensive stocks. Each of these sectors is expected to perform differently

during the various phases of the business and credit cycles. For example, interest-sensitive

stocks would be expected to be adversely impacted during periods of high interest rates, arid

such periods tend to occur at the latter stages of the business cycle. As interest rates decline,

the earnings of the companies in this sector banks, finance companies, savings and loans,

utilities, and residential construction firms should improve.

Defensive stocks deserve some explanation. Included here are companies in such

businesses as food production, soft drinks, beer, pharmaceuticals, and so forth that often are

not hurt as badly during1 the down side of the business cycle as are other companies,

because people will still purchase bread, milk, soft drinks, and so forth. As the economy

worsens and more problems are foreseen, investors may move into these stocks for

investment protection. These stocks often do well during the late phases of a business cycle.

Investors may view industries as sectors and act accordingly. For example, $ if interest rates

are expected to drop significantly, increased emphasis could be placed on the interest-

sensitive industries such as housing, banking, and the savings and loans. The defense

industry is a good example of an industry in recent years that has experienced wide

swings in performance over multiyear periods.

It is clear that effective strategies involving sector rotation depend heavily on an accurate

assessment or current economic conditions. A knowledge and understanding of the phases

of the business cycle are important, as is an understanding of political environments,

international linkages among economies and credit conditions both domestic and

international. Obviously, an insight into the expected performance of various industries

or sectors is also necessary.

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