Investment Analysis & Portfolio Management (FIN630) VU

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

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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Investment Analysis & Portfolio Management (FIN630) VU

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.

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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.

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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