A Scientist in a Strange Land. Norman Rothery

Transcription

1 A Scientist in a Strange Land Norman Rothery York University Jan Norman Rothery

2 Abstract Interested in making a small fortune on Bay street without squeegeeing your way to riches? To help graduate students avoid living a life on the street I will start by reviewing some of the basics. Questions such as, What the heck is a stock anyway?' and How can I avoid being crushed by the mutual fund vise?' will be addressed. I will then move on to discuss several investment strategies that range from the modestly successful to those that allow for rapid capital depreciation. Regrettably, options pricing under generalized-autoregressive-conditionalheteroskedasticity models will not be discussed and the issue of making money from nothing will be left to the next Bank of Quebec speaker. Alternate Abstract A sure way to make a small fortune on Wall Street.

3 Conclusion Start with a large fortune!

4 A Brief History of Canadian Investments Superior returns are obtained in the stock market. Important Caveat: Past performance is not necessarily indicative of future performance. This is also referred to as the Achilleas heel of investing.

5 What is Stock Anyway? Definition: The capital that a corporation raises through the sale of shares entitling the holder to dividends and other rights of ownership. Alternately, a certificate that shows such ownership. The Black Box Model Input The Company s Fundamentals Number of Shares Output Stock Price or Price per Share Dividends or Yield

6 Some of the Fundamentals Number of Shares The number of shares that a company has sold to investors. Usually each share entitles an owner to an equal portion of the company. Earnings Per Share (EPS) The amount of money the company makes after all deductions (i.e. cost of production, cost of sales, taxes, etc.) divided by the number of shares. Price Earnings Ratio (P/E) Price per Share divided by the current EPS. Perhaps the most common stock statistic. Low P/Es are generally favorable and high P/Es less so. Book Value Per Share (BPS) Approximately the amount of money that the company is worth if all of its components were sold off on a per share basis. Price to Book Ratio (P/B) Price per Share divided BPS.

7 The Output Dividends A company may pay out a portion of its earnings to its shareholders as a dividend. Typically dividends are paid once a quarter and are a small fraction of the company s earnings per share. Yield The yield of a stock is simply the annual dividend rate per share divided by the stock s price per share. It is often used when comparing a stock to fixed rate securities such as GICs or bonds. Price per Share One of the more interesting characteristics of a stock. For publicly traded companies it is set by current market conditions. That is by how much someone else is willing to pay for it at auction. The auction typically happens by public (or electronic) outcry on the floor of a stock exchange.

8 The Academic View of Stock Prices Most academic work is based on the Efficient Market Hypothesis. "An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value." Eugene F. Fama, "Random Walks in Stock Market Prices," Financial Analysts Journal, September/October 1965 (reprinted January-February 1995) Practitioners usually vigorously dispute the Efficient Market Hypothesis.

9 Efficient Markets and Random Walks An offshoot of the Efficient Market Hypothesis makes the claim that a stock s price can be best described by a random walk (i.e. geometric Brownian motion). One path shows that taken by the shares of the Bank of Nova Scotia (BNS) starting on January The other was generated by a computer using a series of random walks. Try to figure out which is which!

10 Efficient & Rational Efficient and rational markets also lead, via some dense mathematics, to the Capital-Asset Pricing Model (CAPM) which basically states that an investor is rewarded for taking on more risk. CAPM can also be inverted to determine the theoretical price of a stock. A typical proxy for the Risk Free Rate is determined by that of U.S. Treasury Bills. Beta is a measure of market risk and a Beta of one is usually based on the variance of the S&P 500.

11 Does Theory Work? How About the Fundamentals A number of other studies have looked at the historical record (30+ years) and strongly indicate that the Efficient Market Hypothesis is weak in a number of areas. P/E: P/B: High P/E stocks underperform the market. Low P/E stocks outperform the market. High P/B stocks underperform the market. Low P/B stocks outperform the market.

12 Oh Bother, What about Funds? Why bother dealing with specific stocks when some nice folk from the Bank will make your investments for you? The small fee they charge is called the Management Expense Ratio (MER) and for Canadian Stock Funds it averages a smooth 2.1%.

13 Do Funds Outperform If funds outperform the market by more than their MER then most people would be happy to pay it. Regrettably most funds tend to underperform the market... Canadian equity mutual fund managers are able to provide a yearly performance boost of 0.67% but it is eaten up by the average 2.11% in MER.

14 Buying the Market The goal that many professional money managers fail to attain is surprisingly easy for the individual investor. Many stock exchanges have created index stocks to facilitate futures and options traders. These index stocks are actually trusts that buy all of the stocks in a particular index (say the TSE 35 or the Dow) in the correct proportion. They track the index remarkably well with an equivalent MER of about 0.05%. The index stocks can be purchased just like any other stock and unlike funds can be sold at any time. Some Index Stocks: Symbol Exchange Index it Tracks TIP TSE The TSE 35 HIP TSE The TSE 100 DIA AMEX The Dow 30 SPY AMEX The S&P 500 Many other international and emerging market index stocks are traded on the AMEX (American Stock Exchange). A large number of mutual funds have jumped on the indexing bandwagon. Most charge ridiculous MERs with many in excess of 1%. Tread carefully before purchasing any of them!

15 Stock Indices The TSE 35 is made up of the largest 35 stocks on the TSE. Large is defined by capitalization which is the number of shares of a company times the current price per share. The TSE 35 like many other indices is capitalization weighted so that bigger stocks form a greater percentage of the TSE 35. Name Symbol Price P/E P/B Yield Abitibi-Consolodated A % Alcan Aluminum AL % BCE BCE % Bank of Montreal BMO % Bank of Nova Scotia BNS % Barrick Gold ABX % Bombardier Cl.B BBD.B % CIBC CM % CN Railway CNR % Canadian Occidental Petroleum CXY % Canadian Pacific CP % Canadian Tire Cl.A CTR.A % Dofasco DFS % Imasco IMS % Inco N % Laidlaw LDM % MacMillan Bloedel MB % Magna Cl.A MG.A % Moore MCL % National Bank of Canada NA % Noranda NOR % Northern Telecom Networks NTL % Nova NCX % Petro Canada PCA % Placer Dome PDG % Renaissance Energy RES % Royal Bank of Canada RY % Seagram VO % Suncor Energy SU % Talisman Energy TLM % Teck Cl.B TEK.B % Thomson TOC % Toronto Dominion Bank TD % Transalta TA % Transcanada Pipeline TRP %

16 The Problems with Indexing

17 Stock Picking There are four main flavors of stock picking: Technical: Growth: Contrarian: Fundamental: Looks at price history and charts. Looks for growing companies. Looks to go against the crowd. Looks for good businesses at low prices. Technical stock picking is very popular with brokerages since it encourages active trading. It is not clear that any form of technical analysis works for the investor over the long term. Growth strategies are very popular have and have been quite successful recently. They are usually based on selecting stocks that are up the most from last year or by selecting companies that are expected to grow the fastest. There is some evidence that some carefully selected growth strategies work in the long run but many do not. Contrarian strategies are difficult to implement but a number have been shown to be very successful. Regrettably these successes are well known and now widely followed which makes it hard to go against the crowd. Fundamental strategies are very popular with the investment community and have been shown to be quite successful. These strategies are also referred to as value strategies since they go after beaten down stocks of solid companies.

18 Foolish Investing Foolish investing is a popular contrarian strategy in the U.S. and is just starting to catch on in Canada. Due to its popularity it is starting to provide less than stellar returns in the U.S.. Those who are following it in Canada should hope that it doesn t get very popular here! The basic approach (called the beating the TSE approach) : 1. Start with the TSE Sort the TSE 35 by Yield 3. Select the top 10 Yielding stocks 4. Buy equal cash amounts of each stock Back Testing over the period of 1988 to 1997 shows that this approach had an average annual return of 16.1% versus an annual return of 11.6% for the index itself. Variants of this basic approach have also been shown to perform well.

19 Fools & Lemmings "The moral seems to be that any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last." - Benjamin Graham One needs to look only as far back as the early 70s and the Nifty Fifty craze to illustrate this point. The Nifty Fifty were fifty of best growth blue chip stocks of the day. At the time they were called one-decision stocks since you bought them once and that ended your portfolio decisions. Stock P/E 1972 P/E 1980 P/E 1999 Sony Polaroid McDonald s Intl. Flavors Walt Disney Hewlett-Packard In the bear market of over half of the Nifty Fifty lost close to 84% of their peak value. Regrettably if you had purchased many of the Nifty Fifty at the top you would have had to wait until recent years to break even.

20 A Value Approach Graham s Defensive Selection: 2. Large Companies (i.e. TSE 35) 3. Current Assets > 2 x Current Liabilities 4. Some earnings in the last 10 years 5. Uninterrupted Dividends for 20 years 6. 1/3 increase in Earnings over the last 10 years 7. P/E x P/B < 22.5 The approach has the disadvantage that there will be very few stocks to chose from at any given time. As of January there are none in the TSE 35 nor in the DOW 30. However, value approaches have been shown to outperform. Graham Stocks in the TSE 300 Name Symbol Price P/E P/B Yield Graham Price Acktion ACK % Agrium AGU % Edperbrascan EBC.A % Ipsco IPS % Tesco TEO % 5.64

21 Concluding Tips General Tips: Avoid any investment that is advertised on TV Avoid high cost mutual funds Consider indexing as an alternate to funds Invest in stock Some Stock Picking Tips: Stick to the blue chips Stick with companies you know Trade as little as possible Consider Low P/E and P/B stocks Avoid IPOs or young companies. Do your own research and think for yourself Good Luck! Some Further Reading Novice: Learn To Earn, Peter Lynch One Up on Wall St, Peter Lynch A Fool and His Money, John Rothchild Intermediate: The Intelligent Investor, Benjamin Graham A Random Walk Down Wall St, Burton Malkiel What Works on Wall St, James O'Shaughnessy Web Resources: