Stock Investment Investor
2.0 Literature Review
This research deals with stock selection techniques. A successful share selection is one which adds a few percentage points to your investment returns- year in and year out. An investor may diversify his investment between shares selected by different ‘successful’ method. Therefore, the review of related studies firstly tries to depict the different techniques that exist for stock selection followed by considering their advantages and limitations.
2.1 Diversification
Interest rates, government decisions, market expectations, global and economic conditions are factors which affect the financial markets. Many of these factors are unpredictable and beyond our control. This is why diversification is essential.
“Diversification is the process of investing in a portfolio across different asset classes in varying proportions depending on an investor’s time horizon, risk tolerance and goals” (Thornburg Investment Management (2007)).
An investor will be better off when the assets in which he has invested are less correlated with each other. Geoff Considine (2006) agrees that the more the assets are correlated with each other, the riskier is the portfolio.
Many studies have been conducted on the benefits of diversification. Learned (2002) asserts that diversification diminishes positive skewness may even create negative skewness and boost kurtosis, that is, there is a trade-off between reduced probability of loss and profit possibility. He also agrees that better opportunities for diversification are obtained through style investment than by judgment diversification.
The number of assets that a diversified portfolio should consist is an issue that has been discussed extensively in the finance literature for more than 30 years. However, the ultimate number of assets in a portfolio has not yet been discovered. Learned (2002) believe that the number of assets in a portfolio depends on the types and individual characteristics of the assets into consideration, country under study, the level of transaction costs and the market conditions.
2.2 Issues to be considered in stock selection
There are many issues which need to be taken into consideration when making a selecting in stocks. Most of the issues affecting the selection of stocks depend on micro and macro economic factors.
2.2.1 Micro economic factors
An investor has to know his risk tolerance, his goals and the time he has at his disposal to achieve those goals before making an investment on the stock exchange. If an investor is risk-averse, he will not want to invest in risky assets. He will prefer to invest in assets that will guarantee him a return. Markowitz (1952) asserts that investors have the tendency to be risk averse and thus their investment dollars are spread among many assets so as to diversify risks
Fundamental traders tend to apply more to long-term stock investment approach meanwhile the reverse holds for technical investors (Moube and Jannach 2002). This coincides with the findings of Greenwald, Khan, Sonlin and Van Biema (2002) who found that long-term investors are basically fundamentalists, whereas investors investing for short-term apply technical or a combination of both fundamental and technical analysis. Therefore, the selection of stocks will depend on the time horizon of the investor.
2.2.2 Macro economic factor
Stock prices are affected by factors which are beyond the firm level. These are known as macro economic factors. If an economy is in a recession, most businesses will suffer. However, some companies may suffer more than others. These economic cycles are more or less followed by stock prices.
Exchange rates, inflation, interest rate and liquidity are factors which affect the stock prices. Moube and Jannach (2002) affirm that the development of stock prices is affected directly by exchange rates. They also found that when there is a fall in interest rate, it becomes cheaper and easier for businesses to finance projects. Therefore, higher earnings will be obtained due to lower cost of interest. Furthermore, increase in market liquidity which has not been controlled will fuel inflation. A high rate of inflation generally has a bad impact on the price of stocks.
2.3.1.1 Discounted Cash Flow (DCF)
Assets (securities) can be valued by using the discounted cash flow method (DCF). Valuation of asset is done by using the future cash flows produced by the asset. Cash flows can be in terms of interest payments received from investment in bonds or dividend payments obtained from investment in shares.
2.3.1.2 Dividend Discount Model (DDM)
The value of an ordinary share can be calculated by discounting the dividends which are expected to be obtained from the ordinary shares. For discounting purposes, the Rate of return of projects that have similar risk level as the ordinary share will be used.
The expected return of all the shares in the market can also be calculated and all the shares are ranked accordingly. Shares which are ranked at the top of the expected return list are supposed to be bought and those at the bottom are expected to be sold. Goldstein et al. (1991) agree that the DDM has the advantage of being flexible.
However, in reality, there are certain problems which arise when applying the discounted method for share valuation. A shareholder does not know for sure the amount of dividend he will receive in the future. Therefore, dividend figures should be estimated for a specific time period. Moreover, shares do not have a fixed lifetime and thus, the shareholder is entitled to receive virtually unlimited stream of dividends. Hence, in some cases, prediction of dividend payments should be made over long periods so as to obtain the valuation of ordinary share.
2.3.2 Earnings
Earnings are perhaps the most single studied number in a company’s financial statement. They represent the bottom-line accounting measure of firm performance. A firm’s earnings number represents an accounting measure of the change in the value of the firm to common equity shareholders during a period. The corporate earnings are a crucial factor in the elaboration of investor’s anticipations and hence it is also important for the valuation of stock.
Equity shareholders obtain a lot of information from earnings numbers about current and expected future probability of the business. Earnings will in return give further information about the firm’s current and expected future dividends. Share price can also be calculated as the present value of future expected dividends to shareholders.
2.3.2.1 Price Earnings Ratio (P/E) Model
P/E ratio was introduced by Graham and Dodd in 1934 in the finance literature as a benchmark for the valuation of equity. Financial investors and market makers make use of the level of P/E to know when to buy and sell stocks. It is a tool which has been able to produce above-market returns in the long run. It is termed as value investing. Value investing is to invest in stocks with low prices and excellent accounting performance criteria such as cash flows, book value to asset, dividends and share capital.
Basu (1977), Jaffe, Keim and Westerfield (1989), Fama and French (1992) found that stock with low P/E ratios generate higher returns than that of high P/E ratios. Beaver and Morse (1978) did their research to know whether earnings growth is an indicator of P/E and found that P/E is affected more by dissimilarities in accounting methods instead of growth or risk.
Lakonishok et al. (1994) concluded that low E/P ratios ( high earnings growth related to glamour stocks) are less overestimated than stock with low cash flow to price ratio.
Kyriazis, Diacogiannis (2002) carried out their research on Athens Stock Exchange and found that future return is highly connected with high dividend yields and low P/E ratio, regardless of risks taken. They also point out that in boom markets, both low market value and book to market ratios earn higher returns but at the expense of higher risks. Therefore stocks with low market value and book to market ratios should be avoided during period of market recession.
2.3.2.2 Returns around earnings announcement
This strategy avoids the joint-hypothesis problem. The main idea behind this technique is to hold stocks that are about to benefit from high earnings announcement returns. Similarly, stocks that are about to undergo low announcement returns should be avoided.
Baker, Litou, Watchter, Wurgler (2004) discovered that managers do have some stock-picking skills when this method is used. The stocks which have been bought do significantly better at future earnings announcement, and vice-versa with stocks that are being sold. Graham and Dodd (1934) are in favor of buying stocks that sell at low multiples of earnings (that is, price-to-earnings ratio).
2.3.2.3 Value investing
Value investing was first recognized by Graham and Dodd in the mid-30s as an effective method to investing. Under this approach stocks are rated as being inexpensive or costly.
A value fund is normally searching for undervalued companies, that is, companies whose share price does not give a true value of the company when things like assets, debt and profitability are examined (Graham and Dodd (1930)). The P/E ratio of those company are usually lower than average. It is presumed by the fund that the investor will know the true value of the company at some point in time and the share price will increase as a result.
Studies have shown that undervalued shares tend to outperform the market average while overvalued shares have underperformed the market. Therefore value investors tend to buy stocks that seem under priced by fundamental analysis in hope they will rise eventually. Moube and Jannach (2002) affirm that value stocks have the tendency to have slower and more stable earnings growth rates; earnings are more predictable, which normally makes them less volatile.
C.H.Browne, W.H.Browne, Spears establish that the empirical research which has been used in their investment process has shown that stocks containing combinations of value-related investment characteristics have performed better than the average low P/E and low price/ book value stock. They believe that value-oriented stocks with great investment characteristics are liable to beat the returns from cash over the long run.
Lucas, Dijk and Kloek (2001) conclude that in particular, value stocks outperformed growth stocks historically and small capitalization stock had greater annual returns than large capitalization stock.
Senchack and Martin(1987) had shown that low PSR stocks tended to outperform high PSR stocks but that low PER stocks dominated low PSR stocks on both an absolute and risk-adjusted basis.
Fama and French (1996) assert that in years of high inflation, low interest rates and recovery years, small companies and ‘value shares’ tend to do well. But they do badly in period of low inflation.
Several studies have shown that fairly uncomplicated value strategies outperform the overall market in most countries. Piotroski (2000) argues that over most reasonable time periods, most of the stocks included in the value portfolio actually underperform the market. This shows that the simple multiples used to recognize value stocks are not able to make a distinction between the true value stocks and those that appear cheap.
2.3.2.4 Growth Investing
Growth investors are concerned with a company’s future growth potential, that is, they for companies which have above growth characteristics (Mayo 2000). Therefore investors invest in companies whose future prospects are seen to be above average.
Growth investors make investment in stock with high P/E ratio. It can be noted from studies that growth investors are not concerned about the price or cost of obtaining a stock but are more concerned with the prospects for growing a company’s earnings. Long term earnings potential that are higher than the market expectations are expected from growth stocks (Moube and Jannach2002).
2.3.2.5 Blend- style Investment / GARP(Growth At Reasonable Price)
A blend fund is simply using a combination of value and growth styles to choose stocks. Growth and GARP investors definitely study companies that are anticipated to persist growing in the future years. Growth projections beyond those of other companies within the same industry are welcome by GARP investors - but only to a point. Because of their concern for growth, GARP investors also enjoy the P/E ratio valuation metric because, it tells how the earnings compare to the share price.
GARP investors select stocks that consist of neither purely value nor growth characteristics but a combination of both. GARP investors like high and increasing ROE and low P/E and P/B ratio. The PEG ratio may very well be the most important metric to any GARP investor, as it basically gauges the balance between a stock's growth potential and its value.
Several empirical studies show a methodical relationship between stock characteristics (size, earning yield, dividend yield, etc.) and stock returns. Researches have shown that stocks with high earnings yield produce higher returns make use of univariate measures (such as E/P or B/P) to classify stocks into value or growth stocks. Ahmed and Nanda (2000) showed that value and growth strategy can complement each other instead of being mutually exclusive.
GARP might sound like the ideal approach, but combining growth and value investing isn't as simple as it sounds. If you don't master both strategies, you could find yourself buying mediocre rather than good GARP stocks. But as many great investors such as Peter Lynch himself have proven, the returns are undeniably worth the time it takes to study the GARP strategies.
“Value stocks tend to have slower and more stable earnings growth rates; earnings are more predictable, which generally makes them less volatile. In contrast growth stocks are expected to have long-term earnings potential that are higher than the market's expectations” (Moube and Jannach (2002)). Hence how much an investor will invest in value or growth depends on his risk tolerance and investment purpose. In the short term investors move more or less towards growth or value stock depending on the particular market conditions. For example, when the market is depreciating some investors favor value stocks so as to prevent excessive losses and to obtain steady income. However the difficult aspect is to forecast when the market is going to move towards growth or value style investment.
2.3.3 Dividends
Dividends are a spendable return on one’s investment and its payment represents a most fundamental signal of value in the stock market. One of the surest ways to confirm a company’s profitability may be dividend, since dividends can arise only from the reality of earnings. There is substantial evidence which suggest that investors interpret dividends as conveying value relevant information.
2.3.3.1 Dividend based stock picking
Dividend can play an important role in one’s investment decision. High dividend yields indicate a sign of cheap stock. A number of yield-based stock picking strategies have surfaced over the past 20 years and the claims made for these techniques have usually been highly inflated.
The ‘Dow 10’ or ‘Dogs of the Dow’ ranks the stock in the Dow Jones Industrial Average by dividend yield and same number of the 10 stocks with the highest yield at the start of each year is bought. The theory behind this strategy is that the 10 ‘dog’ stocks are out of flavor for the moment only, but will recover in the future. These stocks have the quality of being cheap together with belonging to well-established companies that are not likely to close down. The strategy involves selling the Dogs after a year and reinvestment in the new dogs for the coming year.
2.3.3.2 Dividend announcement
Empirically, a positive association between stock price changes and dividend changes around dividend announcement dates has been well documented (Aharony and Swary (1980), Asquith and Mullins (1983), Brickley (1983) ).
Studies have shown that dividends are informative about future earnings. Penham (1983) found that earnings forecasts incorporating information about dividend have greater accuracy in predicting future earnings than models either incorporating earnings or management forecast information alone. Hand and Landsman (1999) showed that dividend changes are positively related to future abnormal earnings after controlling for current abnormal earning.
Modigliani and Miller (1961) suggest that dividends convey information about future cash flows when informational asymmetry exists.
2.3.4.1 Fundamental analysis
The above analysis is normally thought of as a long term strategy. Greenwald, Kahn, Sonkin, and van Biema (2002) assert that long-term investors are basically fundamentalists. Under fundamental analysis, the intrinsic value of a company’s stock is calculated. For the calculation of the latter, the Discounted Cash Flow technique (DCF) is used. Using this technique (DCF), all the future profits of a company are discounted to account for the time value of money and are added together to know the worth of a company.
Fundamental analysis is concerned with the study of the overall economy condition as well as financial condition and management of the company. Fundamentalists believe that the underlying value of a company and its potential growth is reflected in its stock price (Yang and Satchell 2003).
2.3.4.2 Technical Analysis
Technical analysis consists of analyzing statistics formed by market activity. It is also known as Chartism. It is a practice of predicting future price movements from the past price history and trading volumes.
Technical traders concentrate on the price and trading histories to produce pattern in price movement and to predict future activity. Its applications have long remained controversial in the economics and finance literature. It is concerned with the impact of the forces of demand and supply upon its price (Colin Nicholson (2000)).
Technical analysts can use several components like charts, Dow Theory, trend analysis, gaps, moving average, trend acknowledgement formations, mood indicators and many others to estimate share prices. Frankel and Froot (1990); Taylor and Allen (1990) have found that technical analysis has been extensively used among institutional and individual traders.
2.3.4.3 Residual Income Valuation (RIV) Approach
The value of a firm is normally calculated through the DDM. For the use of that technique, dividends have to be predicted until infinity and this is a daunting task as very often there are changes in dividend policies during the life-time of the firm. This makes it difficult to predict future dividends from currently observable dividends.
The RIV is a technique which uses currently observable information for valuation. The RIV has gained popularity from the work of Ohlson (1995) and Feltham and Ohlson (1995). Studies have shown that it is possible to earn abnormal stock returns when using the RIV approach to calculate the intrinsic value as the RIV consists of a complete value expression contrary to simple ratios like P/E ratios, P/B ratios and Dividend Yield.
Jamin (2005) implemented four different model specifications empirically in the RIV approach. Two of the models are simple specifications and the other two are linear information dynamic in the spirit of Ohlson (1995). He found that returns of undervalued portfolios for all model specifications are higher than returns for overvalued portfolios.
Soobaroyen, Tangur and Fowdar (2002) made use of the Ohlson’s (1991, 1995) valuation model to investigate the link between firm accounting numbers and market values. Using data from companies listed on the Stock Exchange of Mauritius, they strongly support the Ohlson model by providing evidence that residual earnings are only relevant when combined with book values.
Book value was found to have more relevance in valuing a firm shares than residual earnings. The incremental relevance of book values and residual earnings was respectively 45.2% and 23.5%. As was expected, the relative and incremental value relevance of earnings and book values in Mauritius exceeded those of Thailand and Taiwan applying relatively conservative accounting practices. However, despite Korea employing very conservative accounting practices, it was found by Graham and King (2000) that the value relevance was highest.
2.3.4.5 Qualitative analysis
This technique is one of the easiest strategies that can be used for stock selection and is also one of the most effective ways to assess potential investment.
Courtney Smith (2002) is of the opinion that the qualitative process is an important stock selection technique. Hamel and Prahald (1989) point out management and corporate culture are major factors of future success. Therefore, investors can ask the standard five Ws: who, where, what, when and why to evaluate the strength of management before investing in a particular company.
Another essential factor to take into account when examining a company’s qualitative factors is its product(s) or service(s). When an investor knows about the activities of the company, it becomes easier to know about the worth of his investment or else he will not be sure whether his stock will bring him a return or not.
Granatelli and Martin (1984) made an analysis of the performance of a portfolio which consisted of US stocks during the period 1975-1980. The stocks were supervised by chief executive officers (CEOs) who have won gold & silver awards. They found that well-managed firms portfolios outperform the market. Peter and Waterman (1982) shared the same opinion as Granatelli and Martin.
However, a detailed study done by Kolodny et al. (1989), by making use of Peter and Waterman framework, reached the conclusion that ex ante knowledge of excellent firm characteristics cannot be utilized to produce superior returns.
2.3.4.6 Indexation
An index is made up of stocks selected to represent a particular section of the market. Indexation consists of buying and holding shares in the largest company which guarantees a return like that of the market indices. Fredman and Wiles (1998) are of the opinion that market indicators have a vital role in mutual fund investing since they give the feel for the market behavior and help in the comparison of performance.
Index funds are always in line with the market as a whole. It is easy and no specific investment knowledge or ability is required. Also little management time and effort is required. There is no need to pay for information or investment advice. Shares are rarely sold and therefore brokerage costs are very low. Investors can diversify their holdings by investing in a group pf stocks instead of just one. If one stock is going down, it won’t hurt the overall fund too much. The poorly performing stock will be balanced out by others that are doing very well.
John Bogle (1998, 2002), founder of the Vanguard Group, persuasively affirms that index funds are the most reasonable investment choice for both individual and professional investors. Siegel (2002) and Malkiel (1999) also provide data to sustain indexing as a better equity investment approach.
Siegel (2002) and Malkiel (1999) supply data to support indexing as a better equity investment technique. At Thestreet.com, the advice from Beverly Goodman (2002) is: “Because it’s nearly impossible to beat the market, the benefits of index funds are obvious.” Braham (2003) refers to a recent study by Standard & Poor's (2003) which shows that the professionals’ luck is no better when it comes to picking small-capitalization stocks — only one-third of small-cap fund managers beat the S&P Small Cap 600 Index from 1997-2002.
However it has been found that index fund cannot outperform the market (Moube and Jonnach 2002). Index shares are traded on the exchanges & sometimes the market rice will fall below the actual value of the index. Empirical data has confirmed that adding value above index returns is not a simple task. Browne and Spears 2007 stipulate that more money can be made in 10-20 years if focus is made on stocks which have strong potential return characteristics instead of making an effort to structure portfolios whose yearly returns track an index closely.
2.3.4.7 Cluster Analysis
Variable sets are sorted accordingly to their degree of correlation under cluster analysis (Johnson and Witcher 1992). A number of clusters can be predetermined and then let the analysis itself categorize natural clusters. One of the benefits of using cluster analysis over other regression strategies is its classifying nature.
Using cluster analysis, it has been shown that stock from chosen companies of the Americas can be classified in relation to their degree of integration. When the stock clusters are identified, the informed investor can use the output to his benefit. He may search for same-return stock and choose to minimize risks or he may choose a cluster of same-risk stocks with high return.
Costa Jr, Cunha and Silva (2005) showed how an informed investor can profit by the use of cluster analysis when choosing stocks. To illustrate their case, they have made use of big companies stocks from North and South America.
2.3.4.8 Classification trees
Growth or value characteristics and technical analysis information are the factors on which the model relies. The method has been applied to estimate outperforming assets for the different sectors of the S&P500 index from January 2001 to July 2006. An out-of-sample back test was carried out by constructing equiweighted portfolios created by the outperforming assets and compared their performance relative to the index.
The performance of these portfolios is considerably higher to the indexes even if more detailed strategies than equal weighting can be implemented to develop the relative Sharpe ratios. Finally a test with a real investment has been performed in 2006, which seems to confirm the back testing results.
Albanis and Batchelor (2000) examine numerous linear and nonlinear classification techniques together with artificial neural networks and recursive partitioning methods to divide underperforming from outperforming assets. Classification trees have been used by Kao and Shumaker (1999) to enlighten relationships between macroeconomic variables and performance of timing strategies based on market size and style.
2.3.4.9 Sorting Model
This method consists of sorting securities into three or five portfolios (depending on the number of security on the market) at the end of each month based on the value attribute. The holding period may be one month or more and at the end of the holding period the portfolio is then rebalanced.
Achour, Harvey, Hapkins and Clive (1998, 1999) carried out a market by market analysis of the information in firm attributes for portfolio approaches. A number of standard attributes like book value to price, cash flow to price, earnings to price, dividends to price, earnings growth, revenue growth, debt/equity ratio, returns on equity and market capitalization have been examined so as to broaden the scope of examination in the formation of country portfolio. It was argued by the authors that country selection mechanism is very significant. Their analysis gives detailed information an the performance of different screening factors in both up and down markets so as to know which stocks to buy and which one to sell.
2.3.4.10 Corporate governance
One of the recurring topics in finance is the impact of a firm’s opinion on corporate and investment management. The term corporate governance and performance have many different interpretations. The term corporate governance can mean the relations of a company with its stakeholders or how far a company complies with the provisions of the best codes of practice.
There may be problems in defining what is ‘good’ or ‘bad’ corporate governance. McGuire et al..,(1988,1990) have shown that for both Britain and U.S. performance based on past accounting is very relevant to evaluators’ view of different measures (for example, financial soundness).
Chung, Eneroth and Schneeweis (1998, 1999) carried out an investigation on the relationship between firms’ published corporate reputation ranking and its equity market performance pre, post and during their survey period. They found that the firms which have been ranked higher in reputation outperform on a total equity return basis, firms which have been ranked lower in reputation. They also concluded that firms which are large usually have a higher corporate reputation ranking than firms which are small.
Melvin and Hirt (2004) consider that the active promotion of good corporate governance in investee companies increases shareholder value in the long term. McKinsey(2002) conducted a survey over 200 institutional investors and noted that 80% of the respondents favoured well-governed companies and would willingly pay a premium for such companies. It has been found by Millstein and McAvoy (1998) that over five years, well-governed companies outperformed by 7%.
