Canadian Securities Chapter 13 PDF

CANADIAN SECURITIES Chapter 13 Fundamental and Technical Analysis Agenda Methods of Equity Analysis Compare and contrast fundamental and technical analysis. Fundamental Macroeconomic Analysis Describe how the three macroeconomic factors affect investor expectations and t...

CANADIAN SECURITIES Chapter 13 Fundamental and Technical Analysis Agenda Methods of Equity Analysis Compare and contrast fundamental and technical analysis. Fundamental Macroeconomic Analysis Describe how the three macroeconomic factors affect investor expectations and the price of securities. Fundamental Industry Analysis Explain how industries are classified and how industry classifications impact a company’s stock valuation. Technical Analysis Describe the tools used in technical analysis. Learning Objectives 1.1 Differentiate between fundamental and technical analysis. 1.2 Compare the three theories developed to explain the behaviour of stock markets. 1.3 Identify the fundamental macroeconomic factors that affect the capital markets. 1.4 Analyze industries with respect to their stage of growth, competitive forces and characteristics. 1.5 Calculate the P/E ratio of a stock using the Dividend Discount Model (DDM). (Next Week) 1.6 Assess the value of technical analysis in forecasting price movements in the equity markets. Introduction To make investment recommendations, you must have an understanding of how to analyze and interpret the information available to you (Fundamental and technical analysis) A great deal of information is available to help investors and their advisors make investment decisions. Resources include: - market and economic data - stock charts - industry and company characteristics - financial statistical data All this information can add clarity and perspective to the investment-making process, but the sheer amount can be overwhelming. CHAPTER 13 Methods of Equity Analysis Two Methods Fundamental Analysis: a method of assessing the short-, medium-, and long-range prospects of different industries and companies to shed light on security prices. an attempt to measure the intrinsic or fundamental value of a security. Technical Analysis: the study of historical stock prices and stock market behaviour to predict future prices and behaviour. Comparing Fundamental and Technical Analysis The main difference between technical and fundamental analysis is the subject of study. The technical analyst studies the effects of supply and demand, which are reflected in price and volume. The fundamental analyst, on the other hand, studies the causes of price movements. Both types of analysts might come to the same conclusion based on very different observations. Fundamental Analysis What is analyzed? Capital Market Conditions Economic Conditions Industry Conditions Company Conditions Fundamental analysts study everything that can affect a security’s value! The most important factor affecting a security’s price is the actual or expected profitability of the issuer The ultimate goal is to compare the intrinsic value against a security’s current price so that you can determine whether the security is overvalued or undervalued Technical Analysis What is analyzed? Past Price Movements & Patterns Quantitative Analysis Market Sentiment Price & Trading Cycles Technical analysts attempt to understand the market sentiment behind the trend in a stock’s price instead of its fundamental attributes! Technical analysts believe that, by studying the “price action” of the market, they will have better insights into the emotions and psychology of investors. Technical analysts contend that, because most investors fail to learn from their mistakes, identifiable patterns exist, and therefore future prices/signals can be predicted based on past activity Market Theories Three theories help to explain the behaviour of stock markets: the efficient market hypothesis, the random walk theory the rational expectations hypothesis. All three theories suggest that stock markets are efficient and that a stock’s price is therefore the best available estimate of its true value Essentially this implies investors cannot consistently ‘beat’ the market! Market Theories – Efficient Market Hypothesis Assumption Profit-seeking investors in the marketplace react quickly to the release of information. When new information about a stock appears, investors reassess the intrinsic value of the stock and adjust their estimation of its price accordingly Conclusion A stock’s price fully reflects all available information and represents the best estimate of the stock’s true value. Market Theories – Efficient Market Hypothesis Weak Form assumes that all past market information is fully reflected in current prices. With this form, technical analysis is considered to have little or no value. Semi-Strong From assumes that all publicly available information is fully reflected in current prices. With this form, both fundamental analysis and technical analysis have little or no value. Those who subscribe to this version of the theory believe that only information that is not readily available to the public can help investors boost their returns to a performance level above that of the general market Strong From assumes that all information is fully reflected in current prices, including both publicly available and insider information. In other words, no single investor has information that provides an advantage over any other investor. Efficient Market Hypothesis - Application Generally speaking: Investors who believe in the efficient market hypothesis, particularly the strong form, favour a passive investment approach. They are likely to follow a buy-and-hold strategy or invest in market indexes and exchange-traded funds. Investors who reject the hypothesis are likely to use a more active approach, which involves more buying and selling in an attempt to beat the stock market’s average returns. Market Theories – Random Walk Theory Assumption New information concerning a stock is disseminated randomly over time. Price changes are therefore random and bear no relation to previous prices. Profit-seeking investors in the marketplace react quickly to the release of information. When new information about a stock appears, investors reassess the intrinsic value of the stock and adjust their estimation of its price accordingly Conclusion Past price changes contain no useful information because any developments affecting the company have already been reflected in the current price of the stock. Market Theories – Rational Expectations Theory Assumption People are rational and have access to all necessary information. People use information intelligently in their own self interests and make intelligent decisions after weighing all available information. Conclusion Past mistakes can be avoided by using available information to anticipate change. Market Theories - Inefficiencies Many studies have been conducted over the years to test the three stock market theories. Some evidence supports the theories, whereas other evidence supports capital market inefficiencies. Those inefficiencies may occur for any of the following reasons: New information is not available to everyone at the same time. Investors do not react in the same way to the same information. Not everyone can make accurate forecasts and correct valuation decisions. Mass investor psychology and greed may at times cause investors to act irrationally. CHAPTER 13 Fundamental Macroeconomic Analysis Top-down Analysis World Economy Domestic Economy Industry Sector Company Macroeconomic Factors The macroeconomic factors affecting investor expectations (and, therefore, the price of securities) can be grouped into three categories: fiscal policy impacts monetary policy impacts Inflationary impacts Macroeconomic Factors - Considerations Unpredictable events can affect the economy and the prices of securities either favorably or unfavorably. Such events might include international crises such as war (consider COVID19) unexpected election results regulatory changes technological innovation debt defaults dramatic changes in the prices of important agricultural, metal, and energy commodities can affect the prices of securities. Macroeconomic Factors – Fiscal Policy Tax Changes By changing tax levels, governments can alter the spending power of individuals and businesses. When governments increase sales or personal income tax levels, people have less disposable income, which curtails their spending. A reduction in tax levels has the opposite effect. Corporations are similarly affected by tax changes. Higher taxes on profits generally reduce the amount businesses can pay out in dividends or spend on expansion. On the other hand, a reduction in corporate taxes gives companies an incentive to expand. Macroeconomic Factors – Fiscal Policy Government Spending On the simplest level, an increase in government spending stimulates the economy in the short run, whereas a spending cutback has the opposite effect. Conversely, tax increases lower consumer spending and business profitability, whereas tax cuts boost profits and common share prices. This type of expansionary fiscal policy of tax cuts and spending initiatives can help to spur the economy. Fiscal policies can also be designed to achieve government policy goals. For example, the dividend tax credit and the exemption from tax of a portion of capital gains were designed to encourage greater share ownership of Canadian companies by Canadians.. Savings by individuals are encouraged through measures such as registered retirement savings plans and tax-free savings accounts. Such policies increase the availability of cash for investments, thereby increasing the demand for securities. Macroeconomic Factors – Fiscal Policy Government Debt Higher levels of government debt have a tendency to restrict both fiscal and monetary policy options. Fiscal and monetary decisions affect the overall level of interest rates, the rate of economic growth, and the rate of corporate profit growth. All these factors affect the valuation of stocks. Macroeconomic Factors – Monetary Policy The primary role of the Bank of Canada (the Bank) is to promote Canada’s economic and financial welfare, which it does through monetary policy. The Bank achieves this by attempting to preserve the value of the Canadian dollar by keeping inflation low, stable, and predictable. During periods of economic expansion, demand for credit grows (i.e., bank loans for individuals and businesses) and the prices for goods and services generally rise thus creating inflationary pressures. If the Bank believes these pressures are having a negative impact they can try to restrain the growth rate of money and credit by raising short term interest rates. On the other hand, if the economy appears to be slowing down, the Bank may increase the money supply and the availability of credit by reducing short-term interest rates. Changes in monetary policy affect both interest rates and corporate profits, which are the two most important factors affecting the prices of securities. Macroeconomic Factors – Inflation Inflation creates widespread uncertainty and undermines confidence in the future. These factors tend to result in higher interest rates, lower corporate profits, and lower price-earnings multiples. Inflation leads to higher inventory and labour costs for manufacturers. To maintain their profitability, manufacturers generally try to pass these higher costs on to consumers in the form of higher prices. But higher costs cannot be passed on indefinitely; buyers eventually resist. The resulting squeeze on corporate profits is reflected in lower common share prices. CHAPTER 13 Fundamental Industry Analysis Industry Analysis - Classification Industry and company profitability has more to do with the structure of the industry than with the products or services it sells. Industry structure results from the strategies that companies pursue relative to their competition. Companies pursue the strategies they feel will give them a sustainable competitive advantage and lead to long term growth. Pricing strategies and company cost structures affect not just long-term growth, but also the volatility of sales and earnings. For this reason, industry structure affects a company’s stock valuation. Industry Classification – Product or Service A natural way to classify an industry is by the product or service it produces; This common classification system is used by investment dealers to define the coverage universe of their equity analysts. Standard & Poor’s (S&P) and Morgan Stanley Capital International (MSCI), two well known providers of equity indexes, have developed a comprehensive industry and sector classification system known as the Global Industry Classification Standard (GICS). S&P and MSCI assign every company within their indexes to one of 163 subindustries. Each sub-industry belongs to one of 74 industries that are apportioned into 25 industry groups and then into 11 sectors.  Industry Classification – Sectors and Industry Groups Based on the Global Industry Classification Standard Sector Industry Groups Communication Services Telecommunication Services, Media and Entertainment Consumer Discretionary Auto and Components, Cons. Durables and Apparel, Cons. Services, Cons.Discretionary Distribution and Retail Consumer Staples Consumer Stapes Distribution and Retail, Food, Beverage, and Tobacco, Household and Personal Products Energy Energy Financials Banks, Financial Services, Insurance Health Care Health Care Equipment and Services, Pharmaceuticals, Biotechnology, and Life Sciences Industrials Capital Goods, Commercial and Professional Services, Transportation Information Tech Software and Services, Technology Hardware and Equipment, Semiconductors and Semiconductor Equipment Materials Materials Real Estate Equity Real Estate Investment Trusts (REITs) Real Estate Management and Development Utilities Utilities Industry Classification - Lifecycle In theory, all industries exhibit a life cycle characterized by four stages: Maturity Growth Decline Emerging However, the length of each stage varies from industry to industry and from company to company. Determining where an industry is in its life cycle is an important factor in the valuation process. Throughout that life cycle, sales volume at a company in the industry grows or declines. Therefore, each stage in the cycle affects the relationship between the firm’s pricing strategies and its unit cost structure.  Lifecycle Classification - Emerging New industries are continually developing to provide products and services that meet society’s changing needs and demands. These industries are known as emerging growth industries. Emerging growth industries, and companies within them, tend to share certain financial characteristics: They are unprofitable at first, although future prospects may be promising. Large start-up investments may even lead to negative cash flows. It is sometimes impossible to predict which companies will ultimately survive in a new industry. Emerging growth industries are not always directly accessible to equity investors, especially if privately owned companies dominate the industry, or if the new product or service is only one activity of a diversified corporation.  Lifecycle Classification - Growth A growth industry is one in which sales and earnings are consistently expanding at a faster rate than in most other industries. Companies in these industries are called growth companies, and their common shares are called growth stocks. A growth company should have an above-average rate of earnings on invested capital over a period of several years. The company should also be able to continue to achieve similar or better earnings on additional invested capital. It should show increasing sales in terms of both dollars and units, coupled with a firm control of costs. During the growth period, companies that survive experience increased consumer awareness, lower costs of production, increased competition, rising demand, and growth in profits. Cash flow may or may not remain negative. Growth stocks typically maintain above-average growth over several years, and growth is expected to continue. These companies generally do not pay out large dividends because their growth is often financed through retained earnings. Growth companies therefore tend to exhibit high price-to-earnings ratios and low dividend yields.  Growth stocks vs Value stocks Growth stocks typically maintain above-average growth over several years, and growth is expected to continue and tend to exhibit high price-to-earnings ratios and low dividend yields Amazon.Com Inc (AMZN) – Amazon continues to add features, open new markets and take customers from other retail-oriented companies. The 2018 trailing P/E of 263 reflects this astounding growth potential, compared to the SP-500 trailing P/E of 24.6 Shopify (SHOP) – During the COVID19 period, Shopify became Canada’s larges company (by market valuation), superseding RBC. The P/E ratio was “infinite” since Shopify had negative earnings (TTM ROE = -5.15%) , as of May 2020 A value stock trades at a price below where it appears it should be based on its financial status and technical trading indicators. It may have high dividend payout ratios or low financial ratios such as price-to-book or price-earnings ratios. For example: a stock has is valued at $20/share (P/E ratio of 10) based on DDM but it is currently trading at $15 with a P/E ratio of 7.5.  Lifecycle Classification - Mature Mature industries usually experience slower, more stable growth in sales and earnings that more closely matches the overall rate of economic growth. Both earnings and cash flow tend to be positive. Within the same industry, it is more difficult to identify differences in products between companies. For this reason, price competition increases, profit margins usually fall, and some companies expand into new businesses with better growth prospects. During recessions, stable growth companies usually demonstrate a decline in earnings that is less than that of the average company. Companies in the mature stage usually have sufficient financial resources to weather difficult economic conditions.  Lifecycle Classification – Declining As industries move from the mature/stable to the declining stage, they tend to stop growing and begin to decline. Declining industries produce products for which demand has declined because of changes in technology, an inability to compete on price, or changes in consumer tastes. Cash flow may be large, because there is no need to invest in new plant and equipment. At the same time, profits may be low.  Industry Classification – Competitive Forces In his book Competitive Strategy: Techniques for Analyzing Industries and Competitors (Free Press, 1980), Michael Porter described five basic competitive forces that determine the attractiveness of an industry. According to Porter, those five factors can drastically alter the future growth and valuation of companies within the industry. Threat of New Entry - The ease of entry for new competitors to that industry Compeditive Rivalry - The degree of competition between existing firms Threat of Substitutes - The potential for pressure from substitute products Barging Power (buyers) - The extent to which buyers of the product or service can put pressure on the company to lower prices Barging Power (suppliers) - The extent to which suppliers can put pressure on the company to pay more for the resources they supply  Industry Classification – Competitive Forces The ease of entry for new competitors to that Companies choose to enter an industry 1. Threat of new entry industry depending on the amount of capital required, opportunities to achieve economies of scale, the existence of established distribution channels, regulatory factors and product differences. 2. Competitive rivalry The degree of competition between existing This factor depends on the number of firms competitors, their relative strength, the rate of industry growth, and the extent to which products are unique (rather than simply ordinary commodities). 3. Threat of substitutes The potential for pressure from substitute Other industries may produce similar products products that compete with the industry’s products. 4. Bargaining power of buyers The extent to which buyers of the product or The degree of influence depends largely on service can put pressure on the company to lower buyers’ sensitivity to price. prices 5. Bargaining power of suppliers The extent to which suppliers can put pressure on The costs of suppliers’ raw materials or inputs the company to pay more for the resources they affect profit margins or product quality. supply  Industry Classification – Economic Cycle Industries can be broadly classified according to how they react to the cyclical nature of the economy. Three typical classifications are cyclical, defensive, and speculative. Portfolio managers may structure their portfolios based on these broad classifications, or may used tactical asset allocation strategies to find alpha depending on their analysis of the economic cycle  Economic Cycle – Cyclical Industries Cyclical Industries are industries that are sensitive to economic cycles and moves in step with them, such as automobiles, housing, and steel industries which prosper in times of economic growth and stagnate in times of recession. Most cyclical S&P/TSX Composite Index companies are large international exporters of commodities such as lumber, base metals (e.g., copper and nickel), or oil. These industries are sensitive to global economic conditions, swings in the prices of international commodities markets, and changes in the level of the Canadian dollar. When business conditions are improving, earnings tend to rise dramatically. In general, cyclical industries fall into three main groups: Commodity basic cyclical, such as forest products, base metals, and chemicals Industrial cyclical, such as transportation, capital goods, and basic industries (steel and building materials) Consumer cyclical, such as merchandising and automobile industries  Economic Cycle – Defensive Industries Defensive industries have a relatively stable return on investor equity and tend to do relatively well during recessions. The term blue-chip denotes shares of top investment-quality companies, which maintain earnings and dividends through good times and bad. This record usually reflects a dominant market position, strong internal financing, and effective management. Many investors consider shares of the major Canadian banks to be blue-chip industries; however, bank stock prices are typically sensitive to changes in interest rates. The shares of utility companies (gas, water, electricity) are also considered defensive, blue-chip stocks given their ability to generate consistent earnings over most economic cycles. However, utility stocks that carry large amounts of debt tend to be sensitive to interest rates.  Economic Cycle – Speculative Industries All investment in common shares is speculative to some degree because of the risk of ever-changing stock market values. However, the term speculative industry usually applies to industries in which risk and uncertainty are unusually high because analysts lack definitive information. Shares in these companies are called speculative shares. The term speculative can also describe any company, even a large one, whose shares are treated as speculative. For example, shares of growth companies can be bid up to high multiples of estimated earnings per share as investors anticipate continuing exceptional growth. If, for any reason, investors begin to doubt these expectations, the price of the stock will fall. Example: Stock XYZ in Industry A has an average EPS and a P/E of 100 based on estimates of expanded growth however, the average P/E ratio for Industry A is 50. In other words, based on the speculation of expanding future growth, investors are willing to pay 2x as much per dollar of earning for Stock XYZ. If the speculating does not pan out, the P/E ratio and (and share price) might fall, possibly closer to the industry average or lower! Emerging industries are often considered speculative. CHAPTER 13 Technical Analysis  Technical Analysis Technical analysis is the process of analyzing historical market action in an effort to determine probable future price trends. Technical analysts view the range of data studied by fundamental analysts as too massive and unmanageable to pinpoint price movements with any real precision. Instead, they focus on the market itself, whether it is the commodity, equity, interest rate, or foreign exchange market. They study, and plot on charts, the past and present movements of prices, the volume of trading, and statistical indicators. In the case of equity markets, they track the number of stocks advancing and declining. The purpose of these activities is to identify recurrent and predictable patterns that can be used to predict future price moves  Technical Analysis Market action includes three primary sources of information: price, volume, and time. Technical analysis is based on the following three assumptions involving these sources of information: 1) All influences on market action are automatically accounted for or discounted in price activity. 2) Prices move in trends, and those trends tend to persist for relatively long periods of time. 3) The future repeats the past Technical analysts believe that markets essentially reflect investor psychology and that the behaviour of investors tends to repeat itself. Investors tend to fluctuate between pessimism, fear, and panic on one side, and optimism, greed, and euphoria on the other. By comparing current investor behaviour as reflected through market action with comparable historical market behaviour, the analysts attempt to make predictions. Even if history does not repeat itself exactly, we can still learn a lot from the past, they believe.  Technical Analysis – Common Tools Chart Analysis - The use of charts (graphical representations of market action) Quantitative Analysis – The use market action statistics Sentiment Indicators - The observation and study of investor expectations Cycle Analysis – The use of the tools available to determine the market’s probable direction  Chart Analysis Chart analysis is the analysis of graphic representations of relevant market data. Charts offer a visual sense of where the market has been, which helps analysts project where it might be going. The most common type of chart is one that graphs the high, low, and close (or last trade) of a particular asset (such as a stock, market average, or commodity). Activity may be tracked hourly, daily, weekly, monthly, or even yearly. This type of chart, called a bar chart, often displays the volume of trading at the bottom. Other price charts, not discussed in this course, include candlestick charts, line charts, and point and figure charts  Chart Analysis – Support/Resistance A support level is the bottom price of the trading range for a security. It is the price at which most investors sense value and are willing to buy the security; therefore, demand begins to grow. Most existing holders (or potential short sellers) are unwilling to sell at this price; therefore, supply is low. As demand begins to exceed supply, prices tend to rise above support levels. A resistance level is the top price of the trading range, where most investors are willing to sell a security and most buyers are unwilling to buy it. At this point, supply exceeds demand and prices tend to fall. Chart Analysis – Support/Resistance Support Line Resistance line Support Line Resistance line Support Line  Chart Analysis – Patterns Chart formations reflect market participant behavioural patterns that tend to repeat themselves. They can indicate either a trend reversal (reversal pattern), or a pause in an existing trend (continuation pattern).  Chart Analysis – Reversal Patterns Reversal patterns are formations on charts that usually precede a sizeable advance or decline in stock prices. There are many types of reversal patterns, but probably the most frequently observed pattern is the head-and-shoulders formation. This formation can occur at either a market top, where it is called a head-and-shoulders top formation, or at a market bottom, where it is called either an inverse head-and-shoulders or a head-and-shoulders bottom formation. Chart Analysis – Reversal Patterns  Chart Analysis – Continuation Patterns Continuation patterns are pauses on price charts before the prevailing trend continues. They typically appear in the form of sideways price movements. These patterns are quite normal and healthy in a trending market and are referred to as a consolidation of an existing trend. Chart Analysis – Continuation Patterns  Quantitative Analysis Quantitative analysis is a form of technical analysis that relies on statistics and has thus been greatly enhanced by computer technology. One general category of quantitative analysis tools used to supplement chart analysis is the moving average. A moving average is simply a device for smoothing out fluctuating values in an individual stock or in the aggregate market as a whole. In doing so, either week-to-week or day-to-day, it shows long-term trends. By comparing current prices with the moving average line, you can see whether a change is signaled. ****A moving average is calculated by adding the closing prices for a stock over a predetermined period and dividing the total by the number of days or weeks in the period selected. You can follow the same procedure with a market index. Quantitative Analysis – Moving Average  Sentiment Indicators Sentiment indicators are a measure of investor expectations. Contrarian investors use these indicators to determine what the majority of investors expect prices to do in the future, so that they can move in the opposite direction. The contrarian believes, for example, that if the vast majority of investors expect prices to rise, then there probably is not enough buying power left to push prices much higher. The concept is well proven, but sentiment indicators should only be used as evidence to support other technical indicators. A number of services measure the extent to which market participants are bullish or bearish. If, for example, one of these services indicates that 80% of those surveyed are bullish, it may mean that the market is overbought and that caution is warranted, especially if other indicators provide similar evidence.  Cycle Analysis The tools described above can help you forecast the market’s probable direction and the probable extent of movement in that direction. Cycle analysis, on the other hand, can help you forecast when the market will start moving in a particular direction and when it will ultimately reach its peak or trough. The theory of cycle analysis is based on the assumption that cyclical forces drive price movements in the marketplace. Cycles can last for periods as short as a few days or as long as decades. There are four general categories of cycle lengths: Long-term (greater than two years) Seasonal (one year) Primary/intermediate (nine to 26 weeks) Trading (four weeks) Cycle analysis is complicated by the fact that, at any given point, a number of cycles may be operating. Cycle analysis is useful in identifying a time window when a market peak or trough is expected. However, when it comes to trading, you must supplement cycle analysis with other technical tools, such as trend analysis and chart formations. These tools and formations help confirm that a turn has indeed taken place and that you should take action. Cycle Analysis v v v QUESTIONS? Thank you