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one-sided that the ef¬cient markets hypothesis gained widespread acceptance within the
academic community and had a major impact on the practicing community as well.
Evidence pointing to very ef¬cient securities markets comes in several forms:
• When information is announced publicly, the markets react very quickly.
• It is difficult to identify specific funds or analysts who have consistently generated
abnormally high returns.
• A number of studies suggest that stock prices reflect a rather sophisticated level of
fundamental analysis.
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While a large body of evidence consistent with ef¬ciency exists, recent years have
witnessed a re-examination of the once widely accepted thinking. A sampling of the re-
search includes the following:
• On the issue of the speed of stock price response to news, a number of studies sug-
gest that even though prices react quickly, the initial reaction tends to be incom-
plete.3
• A number of studies point to trading strategies that could have been used to outper-
form market averages.4
• Some related evidence”still subject to ongoing debate about its proper interpreta-
tion”suggests that, even though market prices reflect some relatively sophisticated
analyses, prices still do not fully reflect all the information that could be garnered
from publicly available financial statements.5
The controversy over the ef¬ciency of securities markets is unlikely to end soon.
However, there are some lessons that are accepted by most researchers. First, securities
markets not only re¬‚ect publicly available information, they also anticipate much of it
before it is released. The open question is what fraction of the response remains to be
impounded in price once the day of the public release comes to a close. Second, even in
most studies that suggest inef¬ciency, the degree of mispricing is relatively small for
large stocks.
Finally, even if some of the evidence is currently dif¬cult to align with the ef¬cient
markets hypothesis, it remains a useful benchmark (at a minimum) for thinking about
the behavior of security prices. The hypothesis will continue to play that role unless it
can be replaced by a more complete theory. Some researchers are developing theories
that encompass the existence of market agents who trade for inexplicable reasons, and
prices that differ from so-called “fundamental values,” even in equilibrium.


APPROACHES TO FUND MANAGEMENT
AND SECURITIES ANALYSIS
Approaches used in practice to manage funds and analyze securities are quite varied.
One dimension of variation is the extent to which the investments are actively or pas-
sively managed. Another variation is whether a quantitative or a traditional fundamental
approach is used. Security analysts also vary considerably in terms of whether they pro-
duce formal or informal valuations of the ¬rm.


Active Versus Passive Management
Active portfolio management relies heavily on security analysis to identify mispriced se-
curities. The passive portfolio manager serves as a price taker, avoiding the costs of se-
curity analysis and turnover while typically seeking to hold a portfolio designed to
match some overall market index or sector performance. Combined approaches are also
possible. For example, one may actively manage 20 percent of a fund balance while
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passively managing the remainder. The widespread growth of passively managed funds
in the U.S. over the past twenty years serves as testimony to many fund managers™ belief
that earning superior returns is a dif¬cult thing to do.


Quantitative Versus Traditional Fundamental Analysis
Actively managed funds must depend on some form of security analysis. Some funds
employ “technical analysis,” which attempts to predict stock price movements on the ba-
sis of market indicators (prior stock price movements, volume, etc.). In contrast, “fun-
damental analysis,” the primary approach to security analysis, attempts to evaluate the
current market price relative to projections of the ¬rm™s future earnings and cash-¬‚ow
generating potential. Fundamental analysis involves all the steps described in the previ-
ous chapters of this book: business strategy analysis, accounting analysis, ¬nancial anal-
ysis, and prospective analysis (forecasting and valuation).
In recent years, some analysts have supplemented traditional fundamental analysis,
which involves a substantial amount of subjective judgment, with more quantitative ap-
proaches. The quantitative approaches themselves are quite varied. Some involve simply
“screening” stocks on the basis of some set of factors, such as trends in analysts™ earn-
ings revisions, price-earnings ratios, price-book ratios, and so on. Whether such ap-
proaches are useful depends on the degree of market ef¬ciency relative to the screens.
Quantitative approaches can also involve implementation of some formal model to
predict future stock returns. Longstanding statistical techniques such as regression anal-
ysis and probit analysis can be used, as can more recently developed, computer-intensive
techniques such as neural network analysis. Again, the success of these approaches de-
pends on the degree of market ef¬ciency and whether the analysis can exploit informa-
tion in ways not otherwise available to market agents as a group.
Quantitative approaches play a more important role in security analysis today than
they did a decade or two ago. However, by and large, analysts still rely primarily on the
kind of fundamental analysis involving complex human judgments, as outlined in our
earlier chapters.


Formal Versus Informal Valuation
Full-scale, formal valuations based on the methods described in Chapter 11 have be-
come more common, especially in recent years. However, less formal approaches are
also possible. For example, an analyst can compare his or her long-term earnings pro-
jection with the consensus forecast to generate a buy or sell recommendation. Alterna-
tively, an analyst might recommend a stock because his or her earnings forecast appears
relatively high in comparison to the current price. Another possible approach might be
labeled “marginalist.” This approach involves no attempt to value the ¬rm. The analyst
simply assumes that if he or she has unearthed favorable (unfavorable) information
believed not to be recognized by others, the stock should be bought (sold).
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Unlike many security analysts, investment bankers produce formal valuations as a
matter of course. Investment bankers, who estimate values for purposes of bringing a
private ¬rm to the public market, for evaluating a merger or buyout proposal, or for pur-
poses of periodic managerial review, must document their valuation in a way that can
readily be communicated to management and (if necessary) to the courts.


THE PROCESS OF A COMPREHENSIVE SECURITY ANALYSIS
Given the variety of approaches practiced in security analysis, it is impossible to sum-
marize all of them here. Instead, we brie¬‚y outline steps to be included in a comprehen-
sive security analysis. The amount of attention focused on any given step varies among
analysts.


Selection of Candidates for Analysis
No analyst can effectively investigate more than a small fraction of the securities on a
major exchange, and thus some approach to narrowing the focus must be employed.
Sell-side analysts are often organized within an investment house by industry or sector.
Thus, they tend to be constrained in their choices of ¬rms to follow. However, from the
perspective of a fund manager or an investment ¬rm as a whole, there is usually the free-
dom to focus on any ¬rm or sector.
As noted earlier, funds typically specialize in investing in stocks with certain risk pro-
¬les or characteristics (e.g., growth stocks, “value” stocks, technology stocks, cyclical
stocks). Managers of these types of funds seek to focus the energies of their analysts on
identifying stocks that ¬t their fund objective In addition, individual investors who seek
to maintain a well diversi¬ed portfolio without holding many stocks also need informa-
tion about the nature of a ¬rm™s risks.
An alternative approach to stock selection is to screen ¬rms on the basis of some hy-
pothesis about mispricing”perhaps with follow-up detailed analysis of stocks that meet
the speci¬ed criteria. For example, one fund managed by a large U.S. insurance com-
pany screens stocks on the basis of recent “earnings momentum,” as re¬‚ected in revi-
sions in the earnings projections of sell-side and buy-side analysts. Upward revisions
trigger investigations for possible purchase. The fund operates on the belief that earnings
momentum is a positive signal of future price movements. Another fund complements
the earnings momentum screen with one based on recent short-term stock price move-
ments, in the hopes of identifying earnings revisions not yet re¬‚ected in stock prices.


Key Analysis Questions
Depending on whether fund managers follow a strategy of targeting stocks with
speci¬c types of characteristics, or of screening stocks that appear to be mispriced,
the following types of questions are likely to be useful:
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• What is the risk profile of a firm? How volatile is its earnings stream and
stock price? What are the key possible bad outcomes in the future? What is
the upside potential? How closely linked are the firm™s risks to the health of
the overall economy? Are the risks largely diversifiable, or are they system-
atic?
• Does the firm possess the characteristics of a growth stock? What is the ex-
pected pattern of sales and earnings growth for the coming years? Is the firm
reinvesting most or all of its earnings?
• Does the firm match the characteristics desired by “income funds”? Is it a ma-
ture or maturing company, prepared to “harvest” profits and distribute them
in the form of high dividends?
• Is the firm a candidate for a “value fund”? Does it offer measures of earnings,
cash flow, and book value that are high relative to the price? What specific
screening rules can be implemented to identify misvalued stocks?



Inferring Market Expectations
If the security analysis is conducted with an eye toward the identi¬cation of mispricing,
it must ultimately involve a comparison of the analyst™s expectations with those of “the
market.” One possibility is to view the observed stock price as the re¬‚ection of market
expectations and to compare the analyst™s own estimate of value with that price. How-
ever, a stock price is only a “summary statistic.” It is useful to have a more detailed idea
of the market™s expectations about a ¬rm™s future performance, expressed in terms of
sales, earnings, and other measures. For example, assume that an analyst has developed
potentially unrecognized information about near-term sales. Whether in fact the infor-
mation is unrecognized, and whether it indicates that a “buy” recommendation is appro-
priate, can be easily determined if the analyst knows the market consensus sales forecast.
Around the world, a number of agencies summarize analysts™ forecasts of sales and
earnings. Forecasts for the next year or two are commonly available, and for many ¬rms,
a “long-run” earnings growth projection is also available”typically for three to ¬ve
years. In the U.S., some agencies provide continuous on-line updates to such data, so
that if an analyst revises a forecast, that can be made known to fund managers and other
analysts within seconds.
As useful as analysts™ forecasts of sales and earnings are, they do not represent a com-
plete description of expectations about future performance, and there is no guarantee
that consensus analyst forecasts are the same as those re¬‚ected in market prices. Further,
¬nancial analysts typically forecast performance for only a few years, so that even if
these do re¬‚ect market expectations, it is helpful to understand what types of long-term
forecasts are re¬‚ected in stock prices. Armed with the model in Chapters 11 and 12 that
expressed price as a function of future cash ¬‚ows or earnings, an analyst can draw some
educated inferences about the expectations embedded in stock prices.
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For example, consider the valuation of IBM. On July 28, 1999, IBM™s stock price was
$126.25. At this time analysts were forecasting that the company™s earnings per share
would grow by 19 percent to $3.91 in 1999, by 15 percent to $4.51 in 2000, and by a
further 24 percent to $5.60 in 2001. However, analysts did not provide detailed forecasts
of earnings growth beyond 2001. What then are the market™s implicit assumptions about
the short-term and long-term earnings growth for IBM?
By altering the amounts for key value drivers and arriving at combinations that gen-
erate an estimated value equal to the observed market price, the analyst can infer what
the market might have been expecting for IBM in mid-1999. Table 13-1 summarizes the
combinations of earnings growth, book value growth, and cost of capital that generate
prices higher, lower, and at the market price. The lightly shaded cells represent combi-
nations of assumptions that are consistent with market prices close to the observed price
(in the range of $123 to $127).
IBM has an equity beta of 1.2. Given long-term government bond rates of 5 percent and
a market risk premium of 3“4 percent, IBM™s cost of equity capital probably lies between
8 percent and 10 percent. In addition, the company™s growth in book value has been rela-
tively stable at 4“6 percent for the last three years, which is close to the historical long-
term book value growth rate for the economy. A critical question for estimating the mar-
ket™s assessment of IBM™s performance is to estimate when its strong earnings growth will
conclude and revert to the same level as average ¬rms in the economy, historically around
4 percent. The analysis reported in Table 13-1 assumes that IBM™s superior earnings
growth persists for ¬ve years, until 2003, and then reverts to the economy average.

Table 13-1 Alternative Assumptions About Value Drivers for IBM,
Including Combinations Consistent with Observed Market Price of $26
Average annual earnings and book value growth, 1999 to 2003
....................................................................................................

Earnings growth Earnings growth = Earnings growth =
=15% 20% 25%
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Book Book Book Book Book Book
value value value value value value
growth = growth = growth = growth = growth = growth =
4% 6% 4% 6% 4% 6%
..............................................................................................................................................
Implied earnings per share
in 2003 $6.62 $6.62 $8.19 $8.19 $10.04 $10.04

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