Archive for the 'Fundamental Analysis' Category

Business Cycles in the Economy

The typical business cycle can last as long as 10 years or more. It is typically represented by several stages.

In the recovery stage, there is still a large gap between output and capacity. Bond yields are bottoming and stocks often surge. Taking risk (cyclical and risky stocks, high yield bonds) tends to offer above-average rewards.

In the early upswing, the economy experiences robust growth without causing inflation because output is still below capacity. As the capacity utilization improves, so does profitability. Short rates begin to rise, though long-term rates remain stable.

In the later stages of the upswing, the output gap closes and overheating becomes a danger. Inflation can pick up, resulting in rising interest rates and stock market volatility.

In a slowdown, the slowing economy becomes sensitive to potential shocks. Interest rates are peaking, and interest-sensitive stocks tend to perform well.

In a recession, declining GDP leads to falling short-term interest rates and bond yields. The stock market bottoms out and often starts to rise well ahead of the business cycle recovery.

Posted on 18th December 2008
Under: Asset Allocation, Fundamental Analysis, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Model Uncertainty and Input Uncertainty

Model uncertainty is the risk that a selected model is inappropriate or incorrect for the purpose used.

Input uncertainty relates to whether the inputs fed to a model are accurate.

Input and model uncertainties make it difficult to evaluate potential inefficiencies or market anomalies.

Posted on 18th September 2008
Under: Active Management, Fundamental Analysis, Industry Analysis, Institutional Investing, Portfolio Management | No Comments »

Global Industry Analysis

Companies that operate in global industries are subject to influences from both their country of domicile and their industry. As a result, both country analysis and global industry analysis are typically needed.

Country analysis can include not just the country of domicile, but also the major end markets in which a company operates. In each significant country market, analysts and economists typically monitor a wide range of economic, social and political variables. These can include:

  • Expected real and nominal growth
  • Monetary and fiscal policy
  • Investment climate
  • Business cycle stage
  • Long-term sustainable growth
  • Competitiveness
  • Factors affecting employment and wages
  • Social and political environment

Business cycles across countries are not fully synchronized, so some countries may recover or enter recession sooner than others. However, as markets become more globally integrated international business cycles tend to converge.

To estimate long-term sustainable growth, there are two primary competing theories.

  • Neoclassical growth theory assumes that the marginal productivity of capital declines as more capital is added.
  • Endogenous growth theory assumes that technological advances and improved labor force education can result in efficiency gains. These can prevent the decline in marginal productivity of capital.

As industries become more global, the country factors are also becoming less significant. Industry factors to consider include:

  • Demand analysis – how is the global market for the company’s products and services growing?
  • Value creation – Where on the supply chain is value created? Are there advantages to size, scale or scope? Is there a productivity learning curve in the industry?
  • Industry life cycle – is the industry a pioneer, accelerating growth, mature, stable or decelerating industry?
  • What is the industry’s competitive structure?
  • What is the competitive advantage pursued by each industry participant?

Posted on 25th August 2008
Under: Economic Analysis, Fundamental Analysis, Industry Analysis | No Comments »

Patterns in Analysts’ Long-term Earnings Forecasts

It is generally accepted that more accurate earnings forecasts by analysts should result in superior investment performance. In the Winter 2007 Journal of Investing Fortin, Gilkeson and Michelson examine three hypotheses to determine what factors may be advance indicators of superior forecast accuracy.

Hypothesis 1 is that more frequent forecast updates represent greater analyst effort and indicate greater accuracy. No support is found for this hypothesis.

Hypothesis 2 is that (a) greater changes in successive estimates result in more accurate forecasts and (b) given a tendency toward optimism, a decrease in estimates is a stronger indicator than a similar-size increase. Tests of this hypothesis find no support and even that larger changes suggest greater error and may be a signal of higher uncertainty, regardless of direction.

Hypothesis 3 is that (a) the magnitude of the change in earnings relative to last year’s earnings indicates greater accuracy and (b) a decrease is a stronger indicator than a similar magnitude increase. They find that larger changes lead to less accuracy, but that forecast declines lead to greater accuracy.

The authors conclude that investors should avoid following recommendations of analysts who frequently revise estimates and who change forecasts by significant amounts. However, they suggest that analysts forecasting earnings declines are worth noting.

Posted on 8th August 2008
Under: Fundamental Analysis, Investing in Stocks, Research | No Comments »

Asset Fire Sales in Equity Markets

When mutual funds experience large investor outflows, they must often quickly reduce their holdings to return funds to investors. Such forced liquidation can lead to asset sales at “fire sale” prices. In the November 2007 Journal of Financial Economics, Coval and Stafford show that mutual funds do not allow for the risk of such events, and that such flows are predictable – resulting in an incentive to front run the funds.

Funds in the highest and lowest deciles ranked by performance and prior outflows predictably face large inflows and outflows in subsequent periods. Investors can anticipate such flows by buying or selling the largest fund holdings ahead of the cash flows and reversing the position afterward.

Posted on 7th July 2008
Under: Active Management, Fundamental Analysis, Institutional Investing, Investing in Stocks, Investment Returns, Research | No Comments »

Where is the Value Premium?

The value premium refers to the well-documented outperformance of value stocks (those with high book value relative to market value) over gorwth stocks (those with high market-book ratios.) This outperformance is not explained by systematic Beta as defined in the CAPM, though it does represent one of the three/four factors used in the Fama-French model.

In the March/April 2008 Financial Analysts Journal, Phalippou finds that the value premium is driven by stocks with low institutional ownership – a group that represents just 7% of the total stock market capitalization. Since individual investors may be less sophisticated than institutional investors, such stocks may have a higher tendency to be mispriced. The low institutional ownership may also signal that the mispricing opportunities are difficult to arbitrage.

Posted on 3rd July 2008
Under: Active Management, Fundamental Analysis, Institutional Investing, Investing in Stocks, Investment Returns, Security Selection, Valuation | No Comments »

Are Markets Strong Form Efficient?

In a strong-form efficient market no group of investors should be able to generate excess risk-adjusted returns. Technical analysis, fundamental analysis, and even inside information will provide little value once the information is known.

Tests of the strong form efficient market hypothesis have generally examined the performance of four groups of investors.

  1. Corporate insiders
  2. Stock exchange specialists
  3. Security analysts
  4. Professional money managers

Studies of insider buying and selling have provided mixed support for the EMH. At one time, insiders and public investors following insider trades experienced excess risk adjusted returns. However, more recent studies have indicated that public traders can no longer profit after adjusting for transaction costs.

Stock exchange specialists have monopolistic access to certain market data such as unfilled limit orders. Data suggests that specialists are able to earn excess risk-adjusted returns due to their access to this data.

There is some evidence that certain analysts may possess superior information, and that following the recommendations of these analysts may permit excess returns. Often these anomalies appear to be incorporated, which would support the EMH. For example, the Value Line timeliness rating was considered enigmatic as it appeared to consistently predict returns. However, changes in rating are now incorporated in stock prices within a day or two, and transaction costs may limit any usefulness of the anomaly.

In general, tests of professional investors have supported the EMH. On average, such investors do not enjoy superior risk-adjusted returns.

Posted on 28th June 2008
Under: Active Management, Fundamental Analysis, Institutional Investing, Investing in Stocks, Investment Returns, Passive Management, Research | No Comments »

Efficient Market Hypothesis: Strong Form

The strong-form efficient market hypothesis assumes that stock prices reflect all information, whether public or private. As such, it encompasses both the weak-form EMH and the semistrong-form EMH. If a market is strong form efficient, it is also weak- and semistrong-form efficient.

In a strong-form efficient market no group of investors should be able to generate excess risk-adjusted returns. Technical analysis, fundamental analysis, and even inside information will provide little value once the information is known.

In essence, the strong form efficient market assumes a perfect market in which all information is cost-free and universally available to all market participants simultaneously.

Posted on 23rd June 2008
Under: Active Management, Fundamental Analysis, Investing in Stocks, Investment Returns, Portfolio Management, Technical Analysis | No Comments »

Credit Rating and the Momentum Anomaly

The momentum anomaly refers to the fact that a strategy of buying past winners and selling past losers produces returns that are not explained by the Capital Asset Pricing Model framework. Proponents of the efficient market hypothesis (EMH) attribute the momentum anomaly to risk factors that are not captured in Beta, while opponents point to the anomaly as evidence against the EMH.

In the October 2007 Journal of Finance, Avromov et. al. find that the influence of momentum is limited to a small sample (4% of market capitalization) of companies with high credit risk. This study offers support to the efficient market hypothesis and the argument that the excess returns are attributable to a risk factor (in this case, credit quality.)

Posted on 5th June 2008
Under: Fundamental Analysis, Investing in Stocks, Investment Returns, Momentum Strategies, Performance Measurement, Research | No Comments »

Dilutive and Antidilutive Securities

When a company has issued securities that can be exchanged for common shares, converting the securities into common shares would potentially dilute the ownership stake of existing shareholders. When calculating earnings per share, companies must consider the potential dilution.

For securities that pay a dividend or periodic interest payment, the after-tax payments would be added back to earnings (since those payments would no longer be necessary if the securities were converted.) Then, the number of shares into which the securities are converted is added to the shares outstanding.

Diluted EPS = (Earnings + After tax payments on convertible securities)/(Shares outstanding plus shares issued on conversion)

In some cases, securities would be antidilutive, or increase earnings per share if they were assumed to be converted. Such securities are not included in the diluted EPS calculation, as it is intended to represent the maximum possible dilution.

Posted on 2nd June 2008
Under: Accounting, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks | No Comments »