© 2000 John Petroff
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© 2000 John Petroff |
F- Shareholders and outside investors
Current shareholders and prospective purchasers of shares of a corporation are those for whom financial statements are primarily intended, along with auditor's opinion and other text describing company's financial position. In addition, shareholders are invited to attend general and extraordinary assemblies, vote at elections of board members and have access to corporate accounting data. As described in Chapter 1 Section 1D-1, more detailed financial information for the publicly traded securities is also on file at specialized government agencies, such as the Securities Exchange Commission in the United States, and a wealth of information appears in financial press.
Proportionately very few shareholders ever bother to read all the information that is available to them to evaluate companies they invested in. A possible exception is that of shareholders that hold a controlling interest in a given corporation (and these are looked at in next section). Nevertheless, analysis of information pertaining to events affecting companies takes place. It is substantial and very quick, witness the rapid price changes that take place when announcements are made of, say, a drop in annual earnings, a new product introduction or a merger bid. The market reacts in less than one hour, sometimes within minutes. As argued in Chapter 1 Section 1B, on the basis of evidence presented by the findings of Ball and Brown, price adjustments take place even before official announcements. This quick response confirms that financial markets are efficient, in the sense that they reflect new information that is made public. Some individuals must be doing the analysis, and others quickly use that knowledge in their decisions.
Analysts do not sit and wait for
new information about a specific company to emerge. In fact, trading
takes place even in stock of companies for which no new information
has been released, which seems contrary to the formulation of
stock pricing based on company specific measures of dividend and
required rate of return derived in Chapter
3 Section 3D. To understand why this occurs, let us look at
alternative strategies of those who invest in stocks. One can
distinguish three general approaches to the stock market:
- technical analysis approach,
- portfolio rebalancing,
- mispriced security picking.
See review questions Q-4F.1 through Q-4F.3.
1)- active trading based on technical analysis
For those who use technical analysis, trading in stocks is based on recent stock price trends and other information that signals that a given stock price will soon go up or down significantly. The name given to this approach comes from the need to use many "techniques" to catch anticipated price changes. Some of these techniques are outlined in Chapter 5 Section 5J. What is important to these chartists, as they are called because several techniques involves charts (including the most famous technique referred to as Dow theory), is to correctly assess changes in market demand and supply for given securities and the entire stock market. Watching the market and trading takes the entire working day (and more). There is no time to waste on studying what takes place inside individual companies: financial analysis is contrary to this approach. Yet, an initial reversal in stock price trend does not come from thin air. It must be started by someone who uses recent information to bid a price significantly different from going market prices.
See review questions Q-4F1.1 through Q-4F1.4.
See research assignment R-4.19.
The bulk of equity is owned by institutional or private investors who hold diversified portfolios. Trading occurs occasionally and as often as needed for the portfolio to offer an adequate rate of return compatible with the risk aversion or risk tolerance of the portfolio holder. When new information indicates that the return of a given stock has fallen off or the volatility of the stock has increased, the decision is made to sell that stock and replace it by one that offers the proper trade-off for the entire portfolio to retain its intended features. (Some amount of trading activity is taking place for personal reasons of investors: buying some additional shares from new savings, or selling part of the holding for new outlays. These trades affect the overall price formation little, although a personal saving and dissaving cycle is known to impact market trends.)
Modern portfolio theory (introduced in Chapter 2 Section E) suggests that holding a portfolio of 15 to 20 stocks will most likely generate a rate of return equal to the market average return, and a desired risk-return trade off can be achieved by either leveraging the portfolio account with borrowing (to increase return while taking on additional financial risk), or, on the contrary, placing some of the wealth in a secure investment such as a government issue (to reduce risk while accepting lower return). Many mutual fund managers that are required to follow a strictly conservative investment strategy and who have underperformed the market, are critical of portfolio theory because the theory makes them look bad. These mutual fund managers also know that methods to raise return and lower risk are available today for all investors in the form of small company stocks (that outperform large company stocks) and in derivatives (such as options and futures), but are barred from using these methods because of their additional risk and the mutual funds conservative mandates.
All in all, the market in its entirety behaves as modern portfolio theory suggests. Rebalancing comes after the fact, i.e., after stock prices have changed and affected the risk-return trade off, and not before. Investors in this group may use dividend yield or, most often, the price-to-earnings multiplier to compare companies. Institutional investors naturally have large analytical departments that pay attention (in the manner described in next subsection) to major changes that affect companies, such as large dividend increase, stock split, or introduction of a new product, and that pass the information on to account managers. But, the overall emphasis of the strategy is on the portfolio and not on complete financial analyses of every stock in the portfolio.
See review questions Q-4F2.1 through Q-4F2.4.
See research assignment R-4.20.
3)- mispriced securities
The third stock market approach is to identify shares of companies which sell at a price other than what company's sales and earnings performance and expectations suggest it should be. The premise of this approach is that the price of a share is the consensus of all those who participate in the market. Among them, few are those who take the time to obtain all the information about a given corporation and correctly project into the future the consequences of management stated strategies in light of observable competitive circumstances. The assumption that underlies this approach is that the value of a stock is incorrectly determined in the market because investors have access to publicly available information, but do not process some most recent crucial information correctly. It is similar to mispriced and turn-around situation bonds. Identifying small companies with fast growth or quick recovery potential is what all speculators dream of. But this approach is far from being applied only to companies in difficulty. On the contrary, most fundamental analysis is devoted to the largest and most reputable companies for the simple reason that that is where most trading takes place.
It would appear that this approach postulates that financial markets are not efficient (i.e. price may be wrong). It doesn't. It is new information that is not reflected in price, that an analyst uncovers. This new information will eventually be integrated into stock price as a sufficient number of decision makers interpret the information correctly (and those who interpret it incorrectly will absorb losses and even possibly drop out of trading activity).
As argued in Chapter 1 Section B, for any given company, there isn't one dollar price that anyone can calculate as the precise correct value. Pricing of stocks is a continuous and dynamic process starting from an existing consensus level (i.e. the latest trading price in the market) and determining whether various new elements of company strategy and market conditions contribute to lower or raise expectations of company performance. These elements are themselves difficult to quantify because they are always pertaining to the future and affect the company in many different ways, as will be apparent throughout chapters 8 to 15. A new product, an entry into a new region, an improvement in manufacturing, a change in legislation affecting the industry, a recruitment of an additional expert, are all examples of events that must be translated into a modification of financial performance. No company is likely to give exact forecasts of consequences of such events. A financial analyst must do that. The consequences of any event are also not in one direction. Take the introduction of a new product: that adds to sales: it also adds to risk, and it takes away valuable resources from tried and true activities. Most analysts may consider a new product introduction as a positive outlook, but some may not.
Brokerage firms, investment banks, large mutual funds, commercial banks and other financial intermediaries have a staff of highly paid financial analysts who specialize in the study of given industries or even just one individual corporation. This is fundamental analysis at its highest level. To select stocks, an analyst usually starts (in what is known as a top-down approach) from the most general, such as long term social trends and current state of the business cycle, moves to how aggregates affect industries, studies companies within industries, and then focuses on specific corporate decisions relating to market opportunities of a given company in the face of competitive threats. Once stocks are chosen, tracking is the word used to describe how an analyst follows every event that affects a company, and is conducted in a bottom-up approach. Corporations know how important the opinion of those financial analysts can be in affecting the price of their shares, and they often provide new information first to these analysts as a group. These financial analysts then send memos to account officers in their institutions informing them of the consequences of impending events. Account officers draw their own conclusions about the various report from the analysts and forthcoming stock price trends. Such knowledge can be profitable to account officer's clients in buying or selling stock. Trading will take place until a new consensus on the price of the stock is reached.
Chapters 8 through 15 present a rather complete scheme of what should be looked at by an analyst. The sequence in the chapters would be more alike a bottom-up approach. It is not necessarily the approach recommended. Simply, the pattern follows what most analyst study to what analysts study least: from the very immediate to the most distant future. This sequence would be appropriate for an analyst already familiar with the company, who wants to update his/her recommendation. To look for potential companies that could be mispriced the top-down approach is more commonly used initially.
One group of investors that has privileged information, are insiders. They are managers, major shareholders, auditors or brokers of the corporation. In the United States, the SEC requires insiders to report their trading activity in the corporation stock. This information is regularly published in the financial press and is read with care (as noted in Chapter 1 Section D-1).
See review questions Q-4F3.1 through Q-4F3.11.
See research assignments R-4.21 and R-4.22.
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