4-Slides - Fundamental Analysis (1) (1)

8/3/2019 4-Slides - Fundamental Analysis (1) (1)

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FUNDAMENTAL ANALYSIS

Part I

1SA: Fundamental Analysis (1)


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SA: Fundamental Analysis (1) 3

Consider the Following News Headlines(FT.Com)

UK inflation eases but rate rise still likely

UK economy shrinks in third quarter

Tokyo stocks edge up as yen strengthens

Eurozone growth fails to impress ECB

Opec cuts output but prices fall

Barclays names new finance chief

Do they mean anything to security analysts?
http://www.ft.com/cms/s/22155d60-5db7-11db-82d4-0000779e2340.htmlhttp://www.ft.com/cms/s/0/69fbf964-bf1a-11de-a696-00144feab49a.htmlhttp://www.ft.com/cms/s/0acbaabe-5e67-11db-afac-0000779e2340.htmlhttp://www.ft.com/cms/s/cea6579a-61e1-11db-af3e-0000779e2340.htmlhttp://www.ft.com/cms/s/cea6579a-61e1-11db-af3e-0000779e2340.htmlhttp://www.ft.com/cms/s/f39b6284-6024-11db-b929-0000779e2340.htmlhttp://www.ft.com/cms/s/362b6a90-5daa-11db-82d4-0000779e2340.htmlhttp://www.ft.com/cms/s/362b6a90-5daa-11db-82d4-0000779e2340.htmlhttp://www.ft.com/cms/s/f39b6284-6024-11db-b929-0000779e2340.htmlhttp://www.ft.com/cms/s/f39b6284-6024-11db-b929-0000779e2340.htmlhttp://www.ft.com/cms/s/f39b6284-6024-11db-b929-0000779e2340.htmlhttp://www.ft.com/cms/s/cea6579a-61e1-11db-af3e-0000779e2340.htmlhttp://www.ft.com/cms/s/cea6579a-61e1-11db-af3e-0000779e2340.htmlhttp://www.ft.com/cms/s/cea6579a-61e1-11db-af3e-0000779e2340.htmlhttp://www.ft.com/cms/s/0acbaabe-5e67-11db-afac-0000779e2340.htmlhttp://www.ft.com/cms/s/0/69fbf964-bf1a-11de-a696-00144feab49a.htmlhttp://www.ft.com/cms/s/22155d60-5db7-11db-82d4-0000779e2340.html


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What determines the price of a security?

0

1

Then:1

t

t

t

CP

r

Let us define:P = price of a share

C = expected cash flow

r = required rate of return

It shows that P is associated with:

C (positively)

r (inversely)

0

CP

rIf C and r are constant in perpetuity then:


Any factor that affects C or r is relevant for valuation.


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Valuation and Investment

Fundamental analysis is based on:

Firm has an Intrinsic Value

Intrinsic value = f(underlying factors)

Trading strategies:

Buy if Intrinsic Value > Market Value

Sell if Intrinsic Value < Market Value



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Economy/Market Analysis

Security markets reflect what is expected to go on in an economy Reilly and Brown (2003, p. 407)

We discuss association of stock prices with:

Global Economy

The Domestic Macro economy and Business Cycles

Empirical Evidence on Macroeconomic factors and Stock returns.


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Firms export prospect, international competition & profit made abroadare affected by global economy. Consequently, firms cash-flows are

affected.

There are considerable variations in economic performance of various

countries. The lack of perfect correlation in economic conditions of

various countries offers an opportunity for international businessdiversification which help reduce the volatility in cash-flows.

Global Economy



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Stocks normally trade between 8 to 20 times of earnings.

Broad stock market conditions (returns) and aggregate earnings trend

together.

Firms earnings are affected by countrys economic conditions.

Therefore, forecasting aggregate earnings and stock market conditionsrequires assessing the economy.

Domestic Macro economy



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Domestic Macro economy

Economic growth and Business cycles

Interest rates

Inflation

Monetary growth (money supply)

Fiscal policy and budget deficit



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Economic growth and its stages affects company performance.

Business cycle represents recurring pattern of recession and recovery.

Peaks and troughs are transition points.

Cyclical industries (durables, capital goods etc.) tend to outperform others

immediately after trough.

Defensive industries (food, pharmaceutical, utilities etc.) are less sensitive

to stages of business cycles.

Economic Growth and Business Cycles


Extracted from Reilly and Brown (2006), see p. 464 for their original source.


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Business cycles and security trading:

If you could identify the stage of a business cycle you can identify what

type of companies are likely to generate higher returns.

Your assessment of business cycle should be more reliable than those of

others to outperform the market.

Business cycle is difficult to predict. You should examine various indexes

of economic indicators (for example gross domestic product, industrial

production, rates of interest, inflation, employment, etc.).

Economic Growth and Business Cycles



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Role of Macroeconomic factors:

Empirical Evidence

Macroeconomic factors and stock returns

Discount rate (interest rate) changes and stock returns

Inflation and stock returns

Monetary growth and stock returns


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Economic Factors and Stock returns

Fama and French (1989)report that:

Expected excess returns on bonds and stocks move together.

Variables that are commonly used in measuring default and term premiums

in bond returns can also track the variations in stock returns.

Expected returns are related to long-term business conditions that span

several business cycles.

Returns predicted by the dividend yield and the default spread are high

(low) at times of weak (strong) business conditions.

Cheung and Ng (1998) show evidence of long run co-movements between

national stock market indexes and country specific aggregate real economic

activities (the real oil price, real consumption, real money, and real output).



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How discount rate might affect stock Price?

Change in discount rate (base rate of interest) by central bank reflects

central banks intention to influence business activities.

Cuts in discount rate, for example, lead to lower cost of capital (e.g. cost

of loan).

Lower interest rate encourages consumption, rather than savings, leading

to higher cash-flow of companies.

Both decrease in cost of capital (r) and/or increase in cash-flows (C) leadto increase in share price.

Therefore, discount rate and stock price should be inversely related.

Discount Rate Changes and Stock Price

0Recall that:

CP

r


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Empirical Evidence:

Jensen and Johnson (1995): Discount rate decreases are associated with

higher stock returns and lower variability while the increases are

associated with lower returns and higher variability.

Both bond and stock markets move prior to the announcement of discount

rate changes indicating anticipation.

Prather and Bertin (1999): Trading strategy based on directional reversals

in the pattern of discount rate changes outperforms a passive buy and hold

strategy.

Overall, discount rate and stock prices are inversely related.

Discount Rate Changes and Stock Price


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Inflation and Stock Returns

Common stocks are expected to hedge against inflation. Why?

Stocks represent a claim over real assets whose value is assumed toremain independent of changes in commodity price level.

Since the seminal work of Bodie (1976), this proposition has been examined

in the context of the Fisher hypothesis which suggests that:

R = nominal rate of interest

r = real rate of interest

P = rate of inflation

Fisher hypothesis, applied to stock market, predicts a positive one to one

relation between stock return and inflation.

Does empirical evidence support the prediction?

(1 )*(1 ) 1e e

R r P


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Consider: Return of a stockt = a + b*Inflationt

If stocks are a hedge against inflation in the regression of stock returns

against inflation the value of b should not be significantly different from 1.

Empirical studies can be categorised into three groups: Inflation announcement studies (usually daily data)

Short horizon studies (monthly or annual data)

Long-horizon and long-term analysis


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Inflation Announcement Studies: Examine the effects of announcements of inflation on stock returns.

Typical findings: inverse relation between inflation and stocks returns

(e.g. Paudyal, 1990; Amihud, 1996).

Why a negative relation?

Possible explanations include historical cost accounting and tax on

earnings.


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Short Horizon Studies:

Examine the relation using monthly or annual inflation and stock return

data covering 10-15 years.

Typical findings: no significant relation between stock returns and

inflation (e.g. Jaffe and Mandelker, 1976).

Long horizon studies:

Boudoukh and Richardson (1993) and Boudoukh et al. (1994) use a long-

holding period data.

Typical findings: a positive relation but elasticity of less than unity.


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Long-term (co-integration) analysis:

Anari and Kolari (2001): Positive and more than unit slope coefficient in

six countries.

Paudyal and Luintel (2006): Positive and more than unit slope coefficient

for the UK market. However, the rate of compensation vary across the

industries.

Why more than unity? Compensation for tax!

Conclusion:

Overall, the ability of common stocks to protect the investors from inflation is

rejected for short horizon while they hedge against inflation in the long run.


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To be continued next week!



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Essential Readings

Bodie, Z., A. Kane and A. J. Marcus, (2011), Investments and Portfolio

Management, McGraw-Hill, chapter 21.

Cheung, Y. W. and L. K. Ng (1998), International Evidence on the Stock

Market and Aggregate Economic Activity,Journal of Empirical Finance 5,

28196.

Fama, E. F. and K. R. French (1989), Business conditions and expectedreturns on stocks and bonds,Journal of Financial Economics 25, 23-49.

Luintel, K. and K. Paudyal (2006), Are common stocks a hedge against

inflation?,Journal of Financial Research 29, 1-19.

Prather, L., and W. J. Bertin (1999), Market Efficiency, Discount-Rate

Changes, and Stock Returns: A Long-Term Perspective,Journal of Economics

and Finance 23(1), pp. 56-63.

Reilly, F. K. and K. C. Brown (2006), Investment Analysis and Portfolio

Management, Thomson South-Western, Chapter: 12.



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Seminar questions

1. Discuss how the global economic conditions affect stock price of a firm.

2. Critically assess the implications of aggregate economic conditions on stock

markets.

3. Explain how the changes in discount rate affects the stock returns. Support

your answer with the help of empirical evidence documented in the

literature.

4. Fisher hypothesis, in its strict sense, predicts a positive homogeneous

relationship of degree one between stock return and inflation. Critically

assess the empirical validity of this statement.



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Additional Exercises

1. Analyse the relationship between stock returns and inflation in any 5

countries of your choice using monthly data. Data are available in

Datastream.

2. Stock returns and unemployment are inversely related. Examine the above

hypothesis using monthly data and comment on your results. Data on UK

unemployment rate can be downloaded from:

http://www.statistics.gov.uk/statbase/TSDSelection1.asp . Within the

website select: Labour market, Unemployment and inactivity, Claimant

count, Labour market statistics, Time series data claimant count and

vacancies, Claimant count: UK summary, BCJE claimant count rate - all - SA

(UK) %. Stock return indices are available from Datastream.

3. Investing on stocks of firms operating in high growth economies is notnecessarily a profitable venture. Comment.

http://www.statistics.gov.uk/statbase/TSDSelection1.asphttp://www.statistics.gov.uk/statbase/TSDSelection1.asphttp://www.statistics.gov.uk/statbase/TSDSelection1.asphttp://www.statistics.gov.uk/statbase/TSDSelection1.asp

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