Financial Education

The weak form of the efficient market hypothesis assumes that current stock prices fully reflect all security market information. Security market information includes historical price and volume data, as well as other market-generated information such as odd-lot trades and short interest.

If the weak-form EMH holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

The two most common types of orders that can be placed when buying a security are market orders and limit orders.

Market orders are executed promptly at the best available price, which in the case of a buy order is the lowest price a prospective seller is willing to accept. If the buyer wants more shares than the lowest asking party is offering, the remaining shares would be sold to the next-lowest ask price and so on until all shares requested were purchased.

For example, a buyer places a market order for 10,000 shares of stock X. The lowest ask price is offering 5,000 shares at $100 and these are filled. The next lowest ask price is for 3,000 shares at $100.25 and these are filled. The third-lowest ask price is for 5,000 shares at $100.50 and 2,000 of these are filled to complete the order. The effective purchase price is ((5,000 X 100) + (3,000 X 100.25) + (2,000 X 100.50))/10,000 = $100.175

Market orders emphasize prompt execution, and in return result in accepting some uncertainty as to the actual execution price.

Limit orders are instructions to accept only those prices that are better than a designated limit, including a time (end of day, good-til-canceled, etc) at which the order will expire.

For example, the buyer above may specify that the order has a $100.25 limit price. In that case, 5,000 shares would be executed at $100 and 3,000 at $100.25. The others would remain on order until a prospective seller was willing to accept $100.25 or less. The average price at execution would be ((5,000 X 100) + (3,000 X 100.25))/8,000 = $100.09375. If the remaining 2000 shares were executed at $100.25 the effective price would be ((5,000 X 100) + (5,000 X 100.25))/10,000 = 100.125.

Limit orders emphasize price at the expense of uncertainty as to whether the order will be filled in entirety.

Investors typically think of buying stocks that they believe will go up, and selling those (holding no position) in those they believe have poor prospects. Short selling takes this one step further, allowing an investor to have a negative position in a stock they believe will go down in value.

A short sale is accomplished by selling stock that was borrowed from another investor. In exchange for this privilege, the short seller must pay interest on the borrowed stock, as well as any dividends paid by the stock while it is sold short. At an unspecified future point, the short seller buys back the stock and returns it to the original investor.

Short sales are profitable if the stock declines in value while the seller is short, and lose money if the stock increases in value.

In the November/December 2007 Financial Analysts Jounal Fama and French break down the returns historically delivered by growth and value stocks into dividends and three components of capital gain: growth in book value, primarily through retained earnings; convergence in price/book ratios due to mean reversion in profitability and expected returns; and the general upward drift in P/B ratios experienced over the last century.

For value stocks, the capital gains arise primarily from convergence. P/B reverts to the mean (increases) and many of the companies that were cheap due to lack of profitability become more profitable.

For growth stocks, the growth in book value is the primary positive factor for returns and convergence is a negative one.

Drift has had a negligible effect on average returns, regardless of the growth or value profile.

Many investors seek to exploit temporary market inefficiencies by buying a security they believe is underpriced and shorting a similar security they believe is overpriced. This is designed to limit fundamental risk, or the chance that bad news will hurt the investment. Since many types of news will affect all companies in the industry, shorting a competitor can cushion the risk. However, no two securities are a perfect match. For example, the trader who buys Citibank and shorts Bank of America runs the risk that a piece of negative news will hit Citigroup exclusively.

The dividend discount model and other discounted cash flow approached define the value of a stock as a function of the current cash flow, growth and a required rate of return. Normally these models are used to derive a valuation, which is then compared to the current stock price to determine whether the stock is “overvalued” or “undervalued.” The determination will be affected by the assumptions made regarding required return and growth.

An alternative is to reverse the model and use the current stock price to determine the average assumptions being implicitly made by investors. For example, consider a stock with a $20.00 current share price and $1.00 in expected annual dividends. The consensus long-term growth estimate is 6%, and the investor believes this growth rate reflects the typical belief of market participants.

Since the Gordon growth model defines Value = D1/(r-g) we can substitute what is known to solve for the required return r. $20.00 = $1.00/(r – 0.06) and r = 0.11 or 11%. This market-implied r can further be compared to a required return calculated using a formula such as the Capital Asset Pricing Model. If the market-implied return is higher than the CAPM required return it may indicate that the stock is undervalued (will earn a higher return than is “efficient.”)

Bottom up investing describes investors who focus on company-specific fundamentals to build a portfolio rather than on macroeconomic indicators or themes. Bottom-up investors look at a company’s revenue, earnings, cash flow and product development to determine the best opportunities for investment. The focus is on the individual company’s prospects rather than an overall outlook for the stock market or economy.  Typically bottom-up investors will start by screening the investment universe for a desirable trait (such as a low P/E multiple) to identify candidates for further analysis. Finally, the best companies will be chosen from that list.

Many bottom-up investors will combine their research with a top-down approach. For example, they may focus on the best stocks in the sectors most likely to benefit from global trends or conform to certain sector weights to balance risks.

Theoretical asset valuation models such as the Capital Asset Pricing Model and Arbitrage Pricing Theory do not always work in practice. In 2002 the telecom bubble was beginning to burst, and the bonds for heavily leveraged telecom companies started to signal financial distress, with yields to maturity (YTM) rising to 20% or more. At the same time, equity analysts were frequently valuing the stocks on the basis of the CAPM and a cost of equity of perhaps 15%.

Since equity holders have a residual claim equity investors are assumed to demand a higher return than bondholders. Therefore, a 15% required equity return when bonds are yielding 20% does not make economic sense. Instead, the results of the CAPM model could have been checked against the bond YTM and adjusted to reflect a risk premium to the same company’s publicly traded bonds.

Historical equity to bond premia have been 3-4%, though investors may want to use a higher premium in times of financial distress.

Originally stated by Grinold and Kahn (2001), the Fundamental Law of Active Management states that the information ratio (IR) is equal to the information coefficient (IC) multiplied by the square root of breadth (defined as the number of active decisions taken per year.) The information coefficient represents the investor’s knowledge about a given investment.

The law indicates that low-turnover strategies must be more accurate about a given investment in order to produce the same information ratio as a high-turnover strategy.

Traditional investment strategies are known as long-only, meaning they cannot sell stock they do not yet own (short-selling.) Such portfolios add value by performing better than a benchmark portfolio with similar characteristics.

A long-short portfolio should maximize the advantage of skilled investors, because they can profit both by buying stocks that will do well and selling short those that will not. If the long and short positions completely offset each other, the portfolio is said to be market neutral. In other words, it should not be affected by bull or bear markets, but only by the manager’s skill.

Since there are numerous risks related to short selling, many long-short portfolios constrain such risks by using pair trades. In a paired trade, one stock is bought and a similar stock (same industry, for example) is sold short. In this way, the bet is solely based on stock selection skill rather than industry performance. Even with this pairing in effect, however, the investment can lose significant amounts of money if the wrong stock does well.