ANALYZING EQUITIES

PRESENTED BY:
ATO BARNES
SEM INTERNATIONAL ASSOCIATES

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Chapter 6

ANALYZING EQUITIES
Economy, Industry, and Company Analysis
– The starting point for all fundamental analysis

Analyzing the Economy

Profitability of all companies,depends on the overall

performance of the economy
The overall performance of the economy is measured by the
GROSS DOMESTIC PRODUCT (GDP).
The GDP is the result of the interaction of government
policies and external factors.

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ANALYZING EQUITY
SECURITIES
Two categories of government policies:
(1)Fiscal:- establishes government revenue and
expenditure
(2)Monetary: -determines the liquidity of the
economy through money supply. Also determines
level of interest rates.
(3)Projections for government expenditure,
inflation and GDP are always made in each year’s
annual budget

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 Analyzing Equity Securities

Economic Variables and Share Prices

(Michael Keran’s Model)

 Policy variables affect total spending (Y)
which in Combination with the tax rate tc
affects corporate earnings. As investors change
their expectations of corporate earnings,
share prices respond, with high earnings
expectations leading to share price increases
and vice-versa.

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Economic Variables and Share Prices

2. The policy variables affect total spending which in

combination with the economy's potential output
Y* and past changes in prices determine current
changes in prices (P). Y and P determine current
changes in real output (X). Changes in X and P
generate expectations about inflation and real
growth which in turn affects interest rates. Interest
rates have a negative effect on share prices. As
taxes rise, investors raise the rates of return that
they require, causing share prices to fall.

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 Analyzing Equity Securities

Industry Analysis

 An investor should determine which industry will

perform better in the short- and long-term.
 Industries are dynamic
 A comprehensive industry analysis will contain at least
the following three elements:
      Analysis of the industry in terms of their stage in the
life cycle. The analysis provides an indication of the
industry's health and current position –. Implications of
the pioneering, expansion, and stabilization (maturity),
and decline stages for the investor?

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Industry Analysis

     Evaluation of the industry in relation to major

macroeconomic variables
• Implications of “Cyclical” ,“Counter Cyclical”,
“Interest Sensitive”, and “Non-interest Sensitive”
industries for the investor?
      A qualitative analysis of industry characteristics.
• Historical performance (Sales and profitability)
• Competition (Porter’s 5 force Model)
• Government effects (regulations and taxes)
• Structural changes of the industry

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 Analyzing Equity Securities

Summary of Industry Analysis

In the short-run (e.g. 1 year), industry analysis

should assist in identifying which industries will
produce high earnings, which industries will have
high P/E ratios. The short-run analysis is usually
based on expectations about macroeconomic
variables such as interest rates and GDP growth.

Long-run investors would usually be more interested

in the industry life cycle and the qualitative factors
that affect the long-run strength of an industry.

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 Analyzing Equity Securities

Company Analysis

• Company analysis identifies the strengths and

weaknesses of a company.
• Other things being equal, a strong company
would command a higher price-earnings ratio
than a weak company.
• Therefore, it is necessary to evaluate the long
term 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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Technical Analysis –
Underlying Assumptions
Values, and thus, prices are determined by
supply and demand.
Supply and demand is driven by both rational
and irrational behaviour
Security prices move in trends that persist for
long periods of time.
While the cause for changes in supply and
demand are difficult to determine, the actual
shifts in supply and demand can be observed
in market price behaviour.
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Differences Among Fundamental,
Technical, and the Efficient Market
Analysts
Fundamental Analysts believe that a
security’s 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
forecast value changes by analyzing
earnings data and publicly available data.
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Differences Among Fundamental,
Technical, and the Efficient Market
Analysts
The major challenges to technical analysis
is the efficient market hypothesis.
Efficient analysts feel all available
information is impounded in the current
security price. That past technical
relationship may not be repeated. That
technical rules require too much subjective
interpretation, and decision variables
changes over time.
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Differences Among Fundamental,
Technical, and the Efficient Market
Analysts
 The difference between fundamental analysts, technical
analyst and efficient market analysts is the speed at which
these analyst believe news is impounded into prices.
 Fundamentalists, through research, look for changes in
the basis of value, which eventually leads to changes in
the supply and demand for the shares. Technicians look
for evidence of changes in supply and demand through
market signals and indicators. Efficient market followers
say all this looking is a hopeless and profitless exercise
since prices will change instantaneously to information
changes.

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Advantages of Technical Analyst

It’s 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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Challenges to Technical Trading
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, the
market would self-destruct. This is called
self-fulfilling prophecy.
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Challenges to Technical Trading
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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Technical Rules

 Technicians tend to take one of two views when

analyzing general market rules:
– The contrarian view – contrary-opinion technicians
feel 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 that
technicians had better “jump on the bandwagon”
while there is still time.

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Technical Rules

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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 Analyzing Equity Securities
TECHNICAL ANALYSIS (cont’d)

ANALYSIS OF AGGREGATE MARKET

1. The DOW Theory
– Primary Moves: broad based market movement lasting for several years.
BULL market – upward primary move, in which successive market rallies
tend to penetrate previous highs: BEAR market – downward 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.
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
 Analyzing Equity Securities
TECHNICAL ANALYSIS (cont’d)

ANALYSIS OF INDIVIDUAL SHARES

 Volume
 Odd-Lot Index
 Cumulative Offers-to-Bids
 Technical indicators, graphs, charts, for individual shares

 “Head and Shoulders” patterns: These are time series graphs of market
index to share price ratio that indicate end of rallies.
 “Support and Resistance” patterns/level – This is a time series graph of
market index that indicates new and ending rallies.
 Analyzing Equity Securities

TECHNICAL ANALYSIS (cont’d)

Demerits of Technical Analysis:

1. Failed to outperform simple buy and hold

strategy
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
Introduction
 Concerns assessing the performance of a portfolio and hence a
portfolio manager
 A performance measurement system should address two concerns:
– How did the manager perform after adjusting for the risk
associated with the active portfolio strategy employed?
– How did the manager achieve the reported return? Was the
stated strategy followed?

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 Performance Evaluation

Benchmarks for Evaluating Performance

Market Indices
GSE All-Share Index
Databank Stock Index

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Generic-Investment Style
Indices
Generic-Investment Style Indices
Measures performance of various investment
styles, and compared with published style indexes
Style classification: large value, large growth,
small value, small growth
P/B ratio used to classify stocks as value or
growth stocks
Growth oriented managers concerned about
earnings growth; value oriented managers
concerned about price movement
Value stocks are cheap stocks (low P/B ratio)

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Normal Portfolio

Normal Portfolios
Customized benchmark that includes all of
the securities from which a manager
normally chooses, weighted as the
manager would weight them.

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 Performance Evaluation

Single Index Measures of Portfolio

Performance
A good measure of performance considers both
risk and return. Two common measures of
portfolio performance that considers both risk
and return are:
1. The Reward-to-Variability Ratio (the Sharpe
Index)

Rp  R f
SI 
 p

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 Treynor Index

2. The Reward-to-Volatility Measure (the Treynor

Index)
Rp  R f
TI 
p

• Recall: Standard deviation or variance measures

total risk, but beta measures systematic risk
• Note: Both SI and TI measure excess return over the
risk-free rate to risk

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 Performance Evaluation

Single Index Measures of Portfolio Performance

(cont’d)
Illustration:- Calculation of Sharpe and Treynor Indices

PORTFOLIO
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 28
 Performance Evaluation

Equity Performance Attribution Models

These models seek to explain the sources of equity

portfolio return in terms of three actions of portfolio
managers, viz:

1. Timing short term factor trends

2. Market timing
3. Security analysis

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Equity Performance Attribution Models

The equity performance attribution attribution analysis

is done with the view to determining:

1. The sources of return

2. Whether the short-term factor timing is
statistically significant
3. Whether the market timing is statistically
significant
4. Whether the security analysis is statistically
significant

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