Chapter Highlights

• • We now start to pull together what we learned in Volume

look at t he 'bigger' picture.
• • The focus of Chapt er 13 is funda men t al and technical anal ,
t he economy and in dust ry.
• • Th e focus of Chapter 14 is company analysis and the use of
financial ratios.
• • Th e object ive: utilizing t he t ools of invest ment analysis for better
security select ion decisions.
Types of Analysis

• Fundamental Analysis
• Assesses the short-, medium-, and long-range prospects of
different industries and companies.
• Looks at everything and anything to best determine how
securities' prices will change.

Technical Analysis
• Focu ses on the stock market itself.
• Uses charts and patterns of past stock price behaviour to predict
future price movements.
Capital Market Theories

• Efficient Market Hypothesis

• • The market price of a security fully reflects all available
information and therefore it is d ifficult, if not impossible, to
consistently outperform the market.
• • It also assumes that a stock's price cannot remain in
disequilibrium or be improperly priced for very long.
Capital Market Theories

• Implications
• 1. If markets are efficient then an investor should spend less time
analyzing stocks and more time on reducing taxes and transaction costs.
• 2. The only way to increase returns is to invest in a portfolio of higher- --=~
risk securities.
• 3. If the market is efficient, one cannot use fundamental analysis to
determine if a stock is undervalued or overvalued.
• However:
• Not all investors receive new information at the same time, nor process it
at the same rate, nor interpret the data in the same light.
Capital Market Theories

• Random Walk Theory

• • New information is disseminated randomly over time.
• • Price changes are random; bear no relation to past price
changes.
• What are the implications for investors?
Capital Market Theories
• Implications:
• Technical analysis is not useful.
• However:lf the market is less than perfect, the absorption of new
information may be gra~al, thus producing gradual shifts in deman
and supply patterns, which can be recognized using technical analysis.
Capital Market Theories

• Rational Expectations Hypothesis

• Based on the assumption that people are rational and make
intelligent economic decisions after weighing all available
information .
• 1. Given two securities of equal risk, a rational investor will always
choose the one with the highest return .
• 2. Given two securities w ith the same rate of return, the investor
always chooses the one with the lower amount of risk.
Capital Market Theories

• Implications:
• • If investors act in a rational manner then current prices are correctly
priced.
• • This being the case then a small investor can do just as well as a larg
investor.
• Past mistakes can be avoided using available information to anticipate
change
• Counter Arguments:
• • Investors are not always totally rational in their choices or
expectations.
• • Psychological factors (such as fear and greed) may drive the market or
individual stock prices.
Which Theory is Correct?
• • It is generally believed that the market is not 100% efficient.
• • Given that new information is not always received and process
at the same time and that psychological motives may influence som
stock or market prices - technical analysis has its place.
• • While past performance is not ind icative of future performance
because of random events, over time stronger companies usually
perform better than weaker compan ies. Hence, there is a need for
fundamental analysis of industries and companies.
• • Interest rates, and economic variables do influence individual
and industry stock prices. So fundamental macroeconomic analysis
and the understanding of the underlying factorsis requ ired .
Fundamental Macroeconomic Analysis

• Fiscal Policy Impact

• • Taxation
•- Impact of changes to taxes
•- Time lags
• • Government Spending
•- Impact on aggregate spending
• • Government Debt
•- Impact on fiscal and monetary policy options
Fundamental Macroeconomic Analysis

• Monetary Policy Impact

• • Interest Rates
• • The bbnd Market
• • The Yield Curve
• • Flow of Funds
• • Inflation
Company/Industry Life Cycle
• • Emerging Growth Industry
• • Growth Industry
• • Mature Industry
• • Declining

• What are the features/characteristics of each?

Company/Industry Life Cycle

• • Emerging Growth Industries

• negative cash flows
• • privately owned or controlled
• • high risk of business failure

• Growth Industries
• • high growth in sales and earn ings
• • competition increasing
• • most financing is from retained earnings
Company/Industry Life Cycle

• • Emerging Growth Industries

• negative cash flows
• • privately owned or controlled
• • high risk of business fai lure

• Growth Industries
• • high growth in sales and earn ings
• • competition increasing
• • most financing is from retained earnings
Company/Industry Life Cycle (cont'd)

• Mature Industries
• • slower growth with intense competition
• • profit margins decline, but earnings remain positive
• • revenues sustained by customer loyalty
• Declining Industries
• • competition from new products or technology
• • growth is minimal
• • cash flows are initially good as little is spent on expanding plant
and equipment but are expected to decline over time
Porters five forces model

..
Classification of industries by economic
cycle
• Cyclical
• Defensive
• Speculative
Assumptions
• Prices reflect every thing

.
• Prices ~ .,n tren ds
move

• Future repeats itself

Technical Analysis

• Assumptions
• • Market value is determined solely by the interaction of supply
and demand .
• • Supply and demand are governed by numerous factors, both
rational and irrational.
• • Disregarding minor fluctuations in the market, stock prices tend
to move in trends which persist for an appreciable length of time.
Technical Analysis of the Market
• • Uses past data to pred ict the future- the future repeats the
pa st .
• • Looks for recurring patterns- prices move in trends.
• • Based on the prem ise that the market is its own best forecaste "". .,......
• • Looks at stock market index or average and the vo lume of shares
traded .
Technical Analysis
• Chart Analysis
• Support and Resistance
• Reversal Patterns (Head and shoulder)- Inverse head and shoulder downsid
breakout (in top formation ) and head and shoulder bottom formationupsid
breakout (in downw ard formation )
• Continuation pattern - Symmetrical triangle
• Quantitative Analysis
• Moving average
• Sentiment indicators - Used by con t rarians
• Cycle analysis
Price Patterns
• • Analysts use price patterns to indicate reversals and
continuations of trends .
• • Support and resistance levels are very useful.
• • Support Level:

.........................................................' ..........................
Support and Resistance level
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Reversal patterns
Head & Shoulders
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Bottom Head & Shoulders buy s,gnol when pnce breaks up

through neckline
Head and shoulder
Continuation pattern
Continuations are pauses 1n pnce charts , typically sideways
movements
E.g. Symmetrical Triangle:

·····
····· ····· .......

...
········· ·····
····· ··········
Moving average

Sell Signal - sell when stock price b1eaks through moving average
from above
Moving averages
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Other Indicators
• Sentiment
•- focus on investor expectations
• Cycle Analysis
• - direction
• - peaks & troughs
• - short or long term
Conclusion
• • At any point in t ime, a stock is worth what investors are willing
pay for it .
• • To some the prevailing market price may be too high, to others t--.-,x
may appear as a bargain .
• • While valuation models play an important role in the investment
process, there is abso lutely no ass urance that the actual outcome will
be even remotely similar to the forecasted behaviour.