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Stock Investment Strategy and Value Analysis

Value Analysis of Share Prices

Share price is determined by supply and demand of a company’s shares
Expectation of bad company performance causes investors to sell their shares, increasing supply and reducing the price
Similarly expectation of good company performance increased demand and leads to an  increase in share price
What causes the shifts in demand and supply of a company’s securities on the secondary market?
Three approaches taken in analysing this question
–      1. Fundamental analysis – bottom up
–      2. Fundamental analysis – top down
–      3. Technical analysis

Fundamental Analysis – Bottom Up

Focuses on ratios and other measures of the firm’s financial characteristics and performance
Considers such factors as
–      Capital structure
–      Liquidity
–      Debt servicing
–      Profitability
–      Share price
–      Risk

Fundamental Analysis – Top Down

Focuses on the factors of the overall economic that would impact upon the performance of the various firms and sectors
Considers such factors as
–      International economies
–      Exchange rates
–      Domestic economy
ð  Interest rates, growth rate, balance of payments, inflation, wage growth
International economies
–      The higher the growth rate in the rest of the world, the greater will be the demand for exports
–      The sectors which benefit from international growth depends upon the source of the growth
–      Growth could be driven by
ð  Increased consumer demand
ð  Increased business investment in capital equipment
Exchange rates
–      Affects the domestic currency profit of exporters that quote their prices in foreign currency
–      A strengthening of the domestic currency makes these firms worse off, as the domestic value of the exports is now less
–      Exchange rates also affect firm indirectly (devaluation of currency increases costs of imports, thereby increasing inflations)
Interest rates
–      Has both a direct and indirect impact upon firm value
–      Direct effect on profitability
ð  Represents the cost of debt finance for borrowers and the return for finance providers
–      Indirect effect on profitability
ð  Rise in interest rates may indicate a slowing of economic activity
ð  Future reduction in profitability

Growth of an economy
–      Generally, greater domestic growth leads to increased profitability of domestic firms
–      However, high growth rates may be accompanied by
ð  (a). Deterioration in balance of payments
ð  (b). Increase in inflationary pressures
ð  (c). Pressure on wages
–      The presence of any of these factors may lead to a reduction in firm profitability

(a)    Current account and balance of payments
If current account is in deficit, then there is a need to borrow foreign currency
Some export income is diverted to service this debt
Indirect effect on firm profitability
–      Government may slow down the economy to help control the debt (ie reduce growth, increase interest rates)

(b)    Inflationary pressures
Effect of inflation on firm profitability
Tax treatment of inflation
–      Makes historical-based depreciation allowances inappropriate
–      Combined with higher replacement costs leads to an overstatement of after-tax profit
Inventory
–      ‘Inflated’ selling price of inventory creates and illusion of inventory profits
effect of government policies designed to combat inflation

(c)    Wages growth
Increase in wages growth raises the amount of business profit used for salaries
This will impact most heavily on those firms that are highly labour intensive

Technical Analysis

Explains and forecasts share prices on the basis of past price behaviour
Assumes that markets are dominated at certain times by a mass psychology, from which regular patterns can be determined
Two main forecasting models
–      Moving average (MA)
–      Charting
Moving Average Models (MA)
–      Smooths out a series facilitating the identification of trends in the series
–      Calculation of MA
ð  Assuming a 5-day moving average
ð  The MA is calculated by taking the average of the price series for the preceding 5 days
–      Trading rules
ð  Buy when the price series cuts the moving MA from below
ð  Buy when the MA series is rising strongly and the price series cuts or touches the MA from above after only a few observations
ð  Sell when the MA flattens or declines and price series cuts the MA from above
ð  Sell when the MA is in decline and the price series cuts or touches the MA from below
–      Typically for daily price series both 10-day (short-term) and 30 day (medium-term) moving averages are calculated
–      Weighted moving averages
ð  The most recent information is given the greatest weight
Charting
–      Investigate the patterns in price charts
–      Several techniques
ð  Trends
ð  Support and resistance
ð  Continuation patterns
ð  Reversal patterns
Charting – trends
–      Trends are regular movements in share prices
–      Three types of trends
ð  Uptrend line: lower points of rising price series
ð  Downtrend line: higher points of falling price series
ð  Sideways trend
–      Critical issue is determining when the trend is going to change
Charting – support and resistance
–      Support levels: where there is sufficient demand to halt further price falls
–      Resistance levels: where there is sufficient supply to halt further price increases
–      “strong levels”, historical support and resistance
–      “weak levels”, support and resistance based on recent activity
Charting – continuation patterns
–      Often occur within trends and do not signal a change in the trend
–      Two types
ð  Triangles, composed of a series of price fluctuations, each smaller than it’s predecessor
ð  Flags and  Pennants, form during a sharp rise in prices, trading volume then reduces and the increases suddenly to take prices sharply higher
Charting – Reversal patterns
–      Occurs after a major market move
–      Results in a ‘head and shoulders’ patter
–      H/S consists of 3 successive rallies and reactions
ð  Left shoulder, formed by volume-strong rally on up trend, followed by reduced –volume reaction
ð  Head, second rally increases price before reaction moves price back to previous low
ð  Right shoulder, final rally marked by reduced volume indicating price weakness

Program Trading
Refers to buy and sell strategies generated by computer programs
Programs range between
–      Simple buy/sell based on moving averages
–      Complex monitoring of both derivatives and share markets for the purpose of wither hedging or speculating
Program trading increased the speed at which prices change

Randon Walk and EMH
Random walk
–      Share price is assumed to be formed by investor’s expectations of future cash flows (intrinsic value)
–      Price will change in response to new information, since information arrives in a random fashion, stock prices will adjust in a random fashion
–      Each observation in the (price) series is assumed to be independent of the previous price
–      There is an equal probability that the next price will move, up down or remain unchanged

Efficient market hypothesis  (EMH)
–      EMH proposes that markets are informational efficient if prices adjust immediately to new information
–      Three forms
ð  Weak form: historic price data reflected in share price
ð  Semi-strong form: all publicly available information is reflected in share price
ð  Strong: public and private information is fully reflected in share price