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Why Analyze a Security?
This chapter covers the origin and evolution of security analysis. The herd psychology and gamesmanship that are endemic to the securities market are discussed, along with modern valuation approaches.
The systematic analysis in place at the time was centered in bond-rating agencies and legal appraisals. Moody's Investors Service and Standard & Poor's began assigning credit ratings to bonds in the early 1900s. The two agencies based their ratings almost entirely on the bond's collateral protection and the issuer's historical track record, giving short shrift to qualitative indicators such as the issuer's future prospects and management depth. Dominated by railroad and utility bonds, the rating agencies' methodology lacked transferability to other industries and the equity markets. In-depth evaluations of corporate shares were found in legal appraisals, which were required for estate tax calculations, complicated reorganization plans, and contested takeover bids. Like credit ratings, these appraisals suffered from an overdependence on historical data at the expense of a careful consideration of future prospects.
Graham and Dodd suggested that certain common stocks were prudent investments, if investors took the time to analyze them properly. Many finance professors and businesspeople were surprised at this notion, thinking the two academics were brave to make such a recommendation. Only five years earlier, the stock market had suffered a terrible crash, signaling the beginning of a wrenching economic depression causing massive business failures and huge job losses.
By today's standards, the market drop of 1929 is hard to comprehend. On Monday, October 28, 1929, the Dow Jones Industrial Average fell 12.8 percent and an additional 11.7 percent on Tuesday. The two-day drop of 23 percent followed a decline that began on September 3, when the industrial average peaked at 381.17, and then declined 21.6 percent in the weeks preceding the Crash. Although the market staged modest recoveries in 1930 and 1931, the October 1929 drop presaged a gut-wrenching descent in stock prices, which wasn't complete until February 1933. Over the 3½-year period, the Dow dropped by 87 percent. A prolonged rally boosted the average 288 percent (to 194.40) by March 1937, only for stock prices to collapse 47 percent by April 1938. The index didn't reach its 1929 high until November 1954, 25 years later.
At the time of the publication of Security Analysis, equity prices had doubled from 1933's terrible bottom, but they were only 26 percent of the 1929 high. Shaken by the volatile performance of equities, the public's view of the stock market in 1934 was still a caricature of the 1920s, when common stocks were speculative. Not only was there a dearth of conservative analysis, but the market was afflicted with insider trading, unethical "story stock" pitches, and unscrupulous brokers. For two educators to promote a scholarly approach was radical indeed.
The publication of Security Analysis coincided with the formation of the Securities and Exchange Commission (SEC). Designed to prevent a repeat of the 1920s' abuses, the SEC was given broad regulatory powers over a wide range of market activities. It required corporate issuers to disclose all material information and to provide regular public earnings reports. This new information provided a major impetus to the security analysis profession. Previously, companies were cavalier about providing information to the public. Analysts, as a result, operated from half truths and incomplete data. With the regulators' charge of full disclosure for publicly traded corpora-tions, practitioners had access to more raw material than ever before. Added to the company-specific data was the storehouse of economic, mar-ket, and industry material available for study. It soon became clear that successful analysts needed to allocate their time and resources efficiently among various sources of information to produce the best results.
If the analyst acts on his conclusion and buys Random Corp. stock at $4 per share, he has no assurance that the price will reach the $8 to $10 range. The broad market might decline without warning or Random Corp. might suffer an unexpected business setback. These variables can restrict the stock from reaching appraised value. Over time, however, the analyst believes that betting on such large differences provides superior investment results.
In the first instance, perhaps the investor's research uncovered a hidden real estate value on the company's balance sheet. The general public is unaware of this fact. As soon as others acknowledge the extra value, the stock price should increase. In the second situation, the investor may assume more corporate growth than the market assumes. Should the investor's prediction come true, the stock price should increase accordingly. Perhaps 250,000 people follow the markets full time, so there are plenty of differing views. Even small segments of investors with conflicting opinions can cause significant trading activity in a stock.
It is not unusual that professionals using similar methods of analysis come up with valuations that differ by 10 to 15 percent. These small percentages are sufficiently large to cause active trading. As discussed later, the popular valuation techniques require a certain amount of judgment in sifting information and applying numerical analysis, so reasonable people can easily derive slightly dissimilar values for the same security. As these differences become more profound, the price of a given stock becomes more volatile, and divergent valuations do battle in the marketplace. Today, this price volatility is evident in many high-tech stocks. The prospects of the underlying businesses are hard to appraise, even for experienced professionals.
At any given time, the price behavior of certain individual stocks and selected market sectors is governed by forces that defy a studied analysis. Key elements influencing equity values in these instances are the emotions of the investors themselves. Market participants are human beings, after all, and are subject to the same impulses as anyone. Many emotions affect their decision-making process, but two sentiments have the most lasting impact: fear and greed. Investors in general are scared of losing money, and all are anxious to make more profits. These feelings become accentuated in the professional investor community, whose members are caught up in the treadmill of maintaining good short-term performance.
Of the two emotions, fear is by far the stronger, as evidenced by stock prices, which fall faster than they go up. Afraid of losing money, people demonstrate a classic herd psychology on hearing bad news, and rush to sell a stock before the next investor. Stocks can drop 20 to 30 percent in price on a single day, even when the new information is less than striking. In the crash of 1987, the Dow Jones Index fell 23 percent in one day on no real news. Buying frenzies, in contrast, take place over longer stretches of time, such as weeks or months. Exceptions include the shares of takeover candidates and initial public offerings.
True takeover stocks are identified by a definitive offer from a respectable bidder. Because the offers typically involve a substantial control premium, investors rush in to acquire the takeover candidate's shares at a price slightly below the offer, thus immediately boosting the company's market valve. Occurring as frequently as real bids are rumored bids. Speculators act on takeover rumors by inflating a stock's price in anticipation of a premium-priced control offer.
All these factors play a role in the next hard-to-analyze security— the initial public offering (IPO). Many IPOs rise sharply in price during their first few days of trading, such as Etoys, an Internet retailer of children's toys. Etoys went public in May 1999, at $20 per share, and jumped 280 percent to $76 per share on its first day of trading. Within three weeks, the stock was selling for $85. Unlike an existing issue, an IPO has no trading history, so the underwriters setting the offering price make an educated guess as to its value. At times, this guess is conservative and the price rises accordingly. More frequently, the lead underwriters "lowball" the IPO price to ensure that the offering is fully sold, protecting themselves from their moral obligation to buy back shares from unsatisfied investors if the price were to fall steeply.
When underwriters get their publicity machines working and an IPO becomes "hot," the herd psychology infects investors, who then scramble over one another to buy in anticipation of a large price jump. At this point, a dedicated evaluation of the IPO has little merit. For a hot deal, equity buyers operate by game theory— what's the other guy thinking and what's he going to pay for this issue? Others use momentum investing logic: I must buy the stock because others are buying it.
As the following examples illustrate, some investors bring this dynamic into the realm of game theory and attempt to influence the market's thought processes:
A large part of a stock's price is set by expectations of its future growth in earnings. While a competent study of the past frequently provides the basis for an earnings projection, even the most talented analyst has a limited ability to predict the growth rate of a given company for years ahead. This implies that a major portion of any analyst's valuation is the product of educated guessing. As with similar vocations, many conclusions look terribly wrong with 20Ð 20 hindsight. Sometimes the actual earnings of a company come in substantially lower than forecast data, and the stock price drops accordingly. An analyst who recommended the stock has made a mistake, but level-headed investors, realizing the field's limitations, don't demand perfection. Rather, excellence can be achieved by partial success. In baseball, a .300 hitter "fails" 7 out of 10 times at bat, yet he is among the best. For security analysts, the grading process is more complicated than baseball, but a professional who is right 60 to 70 percent of the time is considered exceptional. Luck plays a role in compiling this kind of track record, but over time the importance of chance diminishes in favor of analytical skill.
Graham and Dodd summarized the analyst's requirements many years ago in Security Analysis:
Although the "similar stock/ similar price" supposition is easy to describe and makes sense, proving this theory and other basic tenets of security analysis in a scientific manner is difficult. In a true science such as physics, observations are repeated in a laboratory environment to verify their accuracy (e. g., a ball is dropped in a vacuum 100 times to confirm the pull of gravity). Security analysis theories, in contrast, are subject to the vagaries of the stock market, which has far too many uncontrolled variables to provide the appropriate conditions for a truly scientific test.
Even the "similar supermarket" example is hard to prove scientifically. Finding two publicly traded supermarket chains with identical financial results is impossible, and most chains have significant differences in market conditions, business operations, and managerial styles. Even with two firms that resemble each other in financial and business attributes, the scientific method is problematic. Much of a company's value is represented by its future potential to generate earnings, as opposed to its present condition and past history. Determining a consensus view of a company's future is accurately described as educated guesswork, rather than scientific deduction.
Despite the drawback of injecting scientific methods into the stock market, investors and finance professors keep trying. Certain of their theories have been proven academically, while others have a commonsense appeal that heightens their acceptance. For example, most professionals consider the next two hypotheses to be valid:
Under the intrinsic value method, future dividends are derived from earnings forecasts and then discounted to the present, thereby establishing a present value for the stock. If the stock is trading at a price lower than this calculation, it is a "buy"; if the market price is higher then the intrinsic value, the stock is a "sell."
For most businesspeople, the intrinsic value approach (discounted cash flow) is their first introduction to security analysis since it is the approach emphasized by business schools and most valuation books. The intrinsic value concept makes economic sense and is theoretically sound, but in the real world its applicability is limited. No professional investor places much weight on projections extending past two or three years, and dividend discount rates are hard to pinpoint. Furthermore, even devoted advocates of this technique are hesitant to promote its use for analyses involving (1) growth companies that don't pay dividends; (2) established companies that are consistent money losers; and (3) complex companies that are liquidation or restructuring candidates.
The relative value approach considers intrinsic values too difficult to determine, owing to the arguments over hard-to-make projections and controversial discount rates. Instead, various valuation parameters of a given publicly traded stock, such as its P/ E, price/ book and price/ sales ratios, are compared with the stocks of companies in the same industry. If the value ratio of the stock being evaluated is substantially lower than its peer group, and if there is no justifiable reason for the discrepancy, the relative value approach views the stock as a buy. Stock valuations are therefore made in a manner similar to many other asset appraisals. In real estate, the value of a house is established by comparing the target house to nearby houses that have sold recently. The relative value approach is attractive to analysts because it takes most of the guesswork out of relying on future projections and discount rates. Its weaknesses stem from three factors. First, few publicly traded companies have exact comparables, leaving a lot of room for subjectivity in the appraisal. Second, investors are in the market to make money in absolute terms, whereas the relative value method focuses on relativeperformance. Suppose an entire industry is the subject of speculative interest, and its share prices crash when expected operating results fail to materialize. The relative value picks fall 20 percent, but the industry's decline is 30 percent. The successful relative value investor is losing less money than other investors committed to the industry, but he's still losing money. Third, relative value places a heavy emphasis on contrasting the historical operating results of similar businesses, when future prospects are critical. "Driving by looking in the rearview mirror" is a perilous investment tactic.
The acquisition value approach suggests that a publicly traded stock should never trade at less than 70 to 75 percent of its worth to a sophisticated and well-financed third party. The analyst evaluates industry acquisition prices compared with the relevant company, and he tests its feasibility as a leveraged buyout or liquidation candidate. If the stock trades at less than 70 percent of its acquisition value, it is probably a buy. By relying on "comparable company" data, the acquisition value approach suffers from the same weaknesses as the relative value method, with the further proviso that comparable public mergers and acquisitions (M& A) deals are rare in many situations. The leveraged buyout (LBO) and liquidation techniques are dependable, but they apply only to a select group of manufacturing and service industries.
The fourth approach, technical analysis, has a wide following but it lacks the broad institutional acceptance of the first three approaches. Often referred to as Wall Street's version of "voodoo economics," technical analysis is concerned solely with the price and volume trading patterns of a stock. This valuation technique does not consider a company's operating history, its earning potential, or other microeconomic factors as relevant to the valuation process. Rather, the technician believes that trading patterns reflect all logical and emotional forces affecting a stock price. An analysis of these patterns, usually in conjunction with industry and market trading indicators, provides predictive trends that enable the technician to forecast stock prices.
Suppose a stock price fluctuates in a small range over a period of months, after it has made a big upward move. This behavior is called a "consolidation" pattern because the stock is consolidating its previous gain. If the stock price breaks through the top end of this range, this is a buy signal, because technical theory says it is poised for another run-up, after which the price will stabilize again. Numerous investors and academics have tested this and other technical theories and concluded that there is no evidence to support these claims. Nevertheless, Wall Street is one place where perception easily becomes reality. Since thousands of investors believe in technical analysis, market participants are sensitive to technical opinions in evaluating stock prices. Reports of security analysts often include charts outlining the trading activity of the stock in question, and I have observed that most professional money managers use such charts as one ingredient in buy/ sell decisions.
Both approaches require a sophisticated knowledge of the market's inner workings and an experienced hand in equity trading. They are best employed by professional traders and stock promoters, who participate in the securities markets on a full-time basis and are thus in a position to react quickly to the sharp price movements endemic to these investment strategies.
Conventional security analysis is sometimes characterized as the art of "buying low, and selling high." Momentum investing, in contrast, is frequently referred to as "buying high, and selling higher," because its adherents look to buy shares which are rising quickly in price. Momentum investors pay close attention to trading trends and give short shrift to the underlying company's sales or earnings; and thus, they represent a subset of the technical community. Having played a major role in many share price run-ups, they are a key source of market volatility, often through automated program trading. Such trading is initiated by a series of signals such as an upward 90-day moving price average, a large positive net cash flow into a stock, or a big jump in trading volume.
The market anticipation approach acknowledges that most stocks are fairly valued by security analysts using the intrinsic value, relative value, and acquisition value methods. At some future point, however, the consensus view on any given stock's earnings power or business risk changes, providing impetus to a higher (or lower) stock price. A typical pronouncement from a market anticipation analyst might be, "The Starbucks shares will increase in value as the market realizes the reduced volatility of the company's earning stream." Such conclusions carry little analytical weight and are most effective when repeated loudly and continually, thus echoing "the squeaky wheel gets the grease" tactic used by promoters in any business. Despite the speculative nature of this approach, even the most rigorous disciples of security analysis are cognizant of the sometimes relentless drumbeating of "market anticipation" investors, who are trying desperately to influence the consensus decision on a stock's value. Their influence has been strong in certain cases and has been observed in the rise and fall of numerous "high flyer" stocks, the peak prices of which defy rational explanation. How else does one explain the rocketlike rise of Amazon. com from $40 per share to $180 in nine months in 1998, the precipitous drop of Dispatch Management from $30 to $3 in the first four months of 1999, or the lightning round trip of Books-a-Million, which rose from $2½ in August 1998 to $46 in October 1998, and then declined to $7 by June 1999?
Despite its lack of exactitude, security analysis provides careful investors with sufficient tools to recognize pricing anomalies in the market, and then to benefit from them by making the appropriate buy/ sell decision. These evaluation tools provide the pricing anchors from which a rational decision can be reached, and they include the intrinsic value, relative value, and acquisition value methods. Technical analysis, a popular stock-picking technique based on trading patterns, is often used as a complement to these approaches.
Because so much of a typical share's value is based on hard-to-predict future results, the stock market is fertile ground for unscrupulous promoters who exaggerate the prospects of investments in which they have a financial interest. The rumor mongering and tub thumping of these players sometimes has the desired effect of inflating the price of a stock. This impact is transitory, and share prices generally return to a modest valuation range in which reasonable people achieve a consensus. Within this band, however, investors still face uncertainty, and so investment selection remains a challenging activity.
Security Analysis on Wall Street: A Comprehensive Guide to Today's Valuation Methods / Edition 1 available in Paperback
Security Analysis on Wall Street: A Comprehensive Guide to Today's Valuation Methods / Edition 1
by Jeffrey C. Hooke
Jeffrey C. Hooke
- ISBN-10:
- 0471362476
- ISBN-13:
- 9780471362470
- Pub. Date:
- 09/03/1999
- Publisher:
- Wiley
Security Analysis on Wall Street: A Comprehensive Guide to Today's Valuation Methods / Edition 1
by Jeffrey C. Hooke
Jeffrey C. Hooke
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Overview
Security Analysis on Wall Street The principles of investing have always been simple: buy low, sell high. The information needed to make these potentially lucrative decisions, however, is often hard to find, difficult to decipher, and not always reliable. This authoritative new book is the essential reference for students who want to learn the rational, rigorous analysis that is still the most successful way to evaluate securities. Security Analysis on Wall Street explains how the values of common stocks are really determined in today's marketplace and takes a comprehensive look at the entire security evaluation process, as well as the major valuation techniques currently being used by Wall Street professionals. Beginning with an overview of the environment in which stocks are issued, researched, bought, and sold, Hooke examines the roles of the various players, the rules of the markets, and the activities surrounding initial public offerings. He then probes the intricacies of analyzing and reporting on securities with proven methods for evaluating the merits of a stock. This sophisticated yet straightforward system teaches students how to assess profitable firms; understand marginal performers, leveraged buyouts, and corporate takeovers; and-most importantly-to break down different analyses and get the big answers: Is the security fairly valued, and why or why not? "A welcome successor to Graham and Dodd's Security Analysis." -Barron's
Product Details
| ISBN-13: | 9780471362470 |
|---|---|
| Publisher: | Wiley |
| Publication date: | 09/03/1999 |
| Series: | Wiley Frontiers in Finance Series |
| Edition description: | University Edition |
| Pages: | 512 |
| Product dimensions: | 7.05(w) x 10.26(h) x 1.33(d) |
About the Author
JEFFREY C. HOOKE is a Managing Director at Hooke Associates, LLC, a valuation firm, and FOCUS, LLC, an investment bank. He was formerly director of Emerging Markets Partnership, a $5 billion fund focusing on emerging markets,, principal investment officer of the World Bank Group, and an investment banker with Lehman Brothers and Schroder Wertheim. Hooke is also the author of M&A: A Practical Guide to Doing the Deal and Emerging Markets: A Practical Guide for Corporations, Lenders, and Investors, both from Wiley.Visit www.wiley.com/go/hooke
Read an Excerpt
Note: The Figures and/or Tables mentioned in this sample chapter do not appear on the Web. Chapter 1
Why Analyze a Security?
This chapter covers the origin and evolution of security analysis. The herd psychology and gamesmanship that are endemic to the securities market are discussed, along with modern valuation approaches.
Some investors analyze securities to reduce the risk and chance aspects of investing. They need the confidence supplied by their own work. Others seek value where others haven't looked. They're on a treasure hunt. Still others have fiduciary reasons. Without documentation to justify an investment decision, clients can sue them for malpractice, should investment perfor-mance waver. Many investors analyze shares for the thrill of the game. They enjoy pitting their investment acumen against other professionals.
Security analysis is a field of study for the evaluation of securities in a rational way. By performing a rigorous analysis of the factors affecting a stock's price, security analysts seek to find equities that present a good value relative to other investments. In doing such work, professional analysts refute the efficient market theory, which suggests that a monkey throwing darts at the Wall Street Journal will, over time, have a performance record equal to the most experienced money manager. In fact, the proliferation of security analysis techniques as well as advances in regulation and information f low contributes to the market's transparency. Nevertheless, on a regular basis, pricing inefficiencies occur. An astute observer takes advantage of the discrepancies.
THE ORIGINS OF SECURITY ANALYSIS
Benjamin Graham and David Dodd made the business of analyzing investments into a profession. With the publication of their book, Security Analysis, in 1934, they offered investors a logical and systematic way to evaluate the many securities competing for investment dollars. Until then, methodical and reasoned analysis was in short supply on Wall Street. The markets were dominated by speculation. Stocks were frequently purchased on the basis of hype and rumor, with little business justification. Even when the company in question was a solid operation with a consistent track record, participants failed to apply quantitative measures to their purchases. General Motors was a good company whether its stock was trading at 10´ or 30´ earnings, but was it a good investment at 30´ earnings, relative to other equities or the bond market? Investors lacked the skills to answer this question. Security Analysis endeavored to provide these skills.The systematic analysis in place at the time was centered in bond-rating agencies and legal appraisals. Moody's Investors Service and Standard & Poor's began assigning credit ratings to bonds in the early 1900s. The two agencies based their ratings almost entirely on the bond's collateral protection and the issuer's historical track record, giving short shrift to qualitative indicators such as the issuer's future prospects and management depth. Dominated by railroad and utility bonds, the rating agencies' methodology lacked transferability to other industries and the equity markets. In-depth evaluations of corporate shares were found in legal appraisals, which were required for estate tax calculations, complicated reorganization plans, and contested takeover bids. Like credit ratings, these appraisals suffered from an overdependence on historical data at the expense of a careful consideration of future prospects.
Graham and Dodd suggested that certain common stocks were prudent investments, if investors took the time to analyze them properly. Many finance professors and businesspeople were surprised at this notion, thinking the two academics were brave to make such a recommendation. Only five years earlier, the stock market had suffered a terrible crash, signaling the beginning of a wrenching economic depression causing massive business failures and huge job losses.
By today's standards, the market drop of 1929 is hard to comprehend. On Monday, October 28, 1929, the Dow Jones Industrial Average fell 12.8 percent and an additional 11.7 percent on Tuesday. The two-day drop of 23 percent followed a decline that began on September 3, when the industrial average peaked at 381.17, and then declined 21.6 percent in the weeks preceding the Crash. Although the market staged modest recoveries in 1930 and 1931, the October 1929 drop presaged a gut-wrenching descent in stock prices, which wasn't complete until February 1933. Over the 3½-year period, the Dow dropped by 87 percent. A prolonged rally boosted the average 288 percent (to 194.40) by March 1937, only for stock prices to collapse 47 percent by April 1938. The index didn't reach its 1929 high until November 1954, 25 years later.
At the time of the publication of Security Analysis, equity prices had doubled from 1933's terrible bottom, but they were only 26 percent of the 1929 high. Shaken by the volatile performance of equities, the public's view of the stock market in 1934 was still a caricature of the 1920s, when common stocks were speculative. Not only was there a dearth of conservative analysis, but the market was afflicted with insider trading, unethical "story stock" pitches, and unscrupulous brokers. For two educators to promote a scholarly approach was radical indeed.
The publication of Security Analysis coincided with the formation of the Securities and Exchange Commission (SEC). Designed to prevent a repeat of the 1920s' abuses, the SEC was given broad regulatory powers over a wide range of market activities. It required corporate issuers to disclose all material information and to provide regular public earnings reports. This new information provided a major impetus to the security analysis profession. Previously, companies were cavalier about providing information to the public. Analysts, as a result, operated from half truths and incomplete data. With the regulators' charge of full disclosure for publicly traded corpora-tions, practitioners had access to more raw material than ever before. Added to the company-specific data was the storehouse of economic, mar-ket, and industry material available for study. It soon became clear that successful analysts needed to allocate their time and resources efficiently among various sources of information to produce the best results.
NO PROFIT GUARANTEE
It is important to remember that security analysis doesn't presume an absolute value for a given stock, nor does it guarantee the investor a profit. After undertaking the effort to study a security, an analyst derives a range of value, since the many variables involved reduce the element of uncertainty. After an investigation, suppose the analyst concludes that Random Corp. stock is worth $8 to $10 per share. This conclusion isn't worth much if the stock is trading at $9, but it is certainly valuable if the stock is trading at $4, far below the range, or at $20, which is far above. In such cases, the difference between the conclusion and the market prompts an investment decision, either buy or sell .If the analyst acts on his conclusion and buys Random Corp. stock at $4 per share, he has no assurance that the price will reach the $8 to $10 range. The broad market might decline without warning or Random Corp. might suffer an unexpected business setback. These variables can restrict the stock from reaching appraised value. Over time, however, the analyst believes that betting on such large differences provides superior investment results.
DAY-TO-DAY TRADING AND SECURITY ANALYSIS
For the most part, participants in the stock market behave rationally. Day-to-day trading in most stocks causes few major price changes, and large interday differentials can usually be explained by the introduction of new information. Small price discrepancies are often attributable to a few professionals having a somewhat different interpretation of the same set of facts. An investor may believe a stock's price will change because either (1) the market will conform to his opinion of the stock's value over time, or (2) the future of the underlying business will unfold as he anticipates.In the first instance, perhaps the investor's research uncovered a hidden real estate value on the company's balance sheet. The general public is unaware of this fact. As soon as others acknowledge the extra value, the stock price should increase. In the second situation, the investor may assume more corporate growth than the market assumes. Should the investor's prediction come true, the stock price should increase accordingly. Perhaps 250,000 people follow the markets full time, so there are plenty of differing views. Even small segments of investors with conflicting opinions can cause significant trading activity in a stock.
It is not unusual that professionals using similar methods of analysis come up with valuations that differ by 10 to 15 percent. These small percentages are sufficiently large to cause active trading. As discussed later, the popular valuation techniques require a certain amount of judgment in sifting information and applying numerical analysis, so reasonable people can easily derive slightly dissimilar values for the same security. As these differences become more profound, the price of a given stock becomes more volatile, and divergent valuations do battle in the marketplace. Today, this price volatility is evident in many high-tech stocks. The prospects of the underlying businesses are hard to appraise, even for experienced professionals.
HERD PSYCHOLOGY AND SECURITY ANALYSIS
Ideally, a security analyst studies the known facts of a business, considers its prospects, and prepares a careful evaluation. From this effort, a buy or sell recommendation is derived for the company's shares. This valuation model, while intrinsically sensible, understates the need to temper a rational study with due regard for the vagaries of the stock market.At any given time, the price behavior of certain individual stocks and selected market sectors is governed by forces that defy a studied analysis. Key elements influencing equity values in these instances are the emotions of the investors themselves. Market participants are human beings, after all, and are subject to the same impulses as anyone. Many emotions affect their decision-making process, but two sentiments have the most lasting impact: fear and greed. Investors in general are scared of losing money, and all are anxious to make more profits. These feelings become accentuated in the professional investor community, whose members are caught up in the treadmill of maintaining good short-term performance.
Of the two emotions, fear is by far the stronger, as evidenced by stock prices, which fall faster than they go up. Afraid of losing money, people demonstrate a classic herd psychology on hearing bad news, and rush to sell a stock before the next investor. Stocks can drop 20 to 30 percent in price on a single day, even when the new information is less than striking. In the crash of 1987, the Dow Jones Index fell 23 percent in one day on no real news. Buying frenzies, in contrast, take place over longer stretches of time, such as weeks or months. Exceptions include the shares of takeover candidates and initial public offerings.
True takeover stocks are identified by a definitive offer from a respectable bidder. Because the offers typically involve a substantial control premium, investors rush in to acquire the takeover candidate's shares at a price slightly below the offer, thus immediately boosting the company's market valve. Occurring as frequently as real bids are rumored bids. Speculators act on takeover rumors by inflating a stock's price in anticipation of a premium-priced control offer.
All these factors play a role in the next hard-to-analyze security— the initial public offering (IPO). Many IPOs rise sharply in price during their first few days of trading, such as Etoys, an Internet retailer of children's toys. Etoys went public in May 1999, at $20 per share, and jumped 280 percent to $76 per share on its first day of trading. Within three weeks, the stock was selling for $85. Unlike an existing issue, an IPO has no trading history, so the underwriters setting the offering price make an educated guess as to its value. At times, this guess is conservative and the price rises accordingly. More frequently, the lead underwriters "lowball" the IPO price to ensure that the offering is fully sold, protecting themselves from their moral obligation to buy back shares from unsatisfied investors if the price were to fall steeply.
When underwriters get their publicity machines working and an IPO becomes "hot," the herd psychology infects investors, who then scramble over one another to buy in anticipation of a large price jump. At this point, a dedicated evaluation of the IPO has little merit. For a hot deal, equity buyers operate by game theory— what's the other guy thinking and what's he going to pay for this issue? Others use momentum investing logic: I must buy the stock because others are buying it.
MOMENTUM INVESTORS
Extremely influential in short-term pricing moves, momentum investors predict individual stock values based on trading patterns that have happened repeatedly, either in the relevant stock or in similar situations. Thus, if they notice the beginning of a downward price trend, they sell the stock in anticipation of the pattern reaching completion. Naturally, the selling pattern is a self-fulfilling prophecy as other momentum investors are motivated by the increased activity and follow suit. Often lumped together with emotional investors by the media, momentum players attempt to take advantage of the common belief that stocks move in discernible patterns. Two of Wall Street's oldest expressions, "You can't fight the tape" and "You can't buck the trend," are evidence of the futility of injecting a security analysis bias into any price move driven by emotional and momentum factors. The herd instinct that is set off by such behavior contributed to several market crashes in the past. As a result, the federal government prohibits computerized program trading, which activates on the observance of such trends, if market indices drop too much. Right now, the "circuit breaker" kicks in with a 350-point decline in the Dow Jones Average, as it did on October 27, 1997, when the Dow Industrials Average dropped 554 points.GAME THEORY AND SECURITY ANALYSIS
The average portfolio manager does not have a controlling position in his shareholdings. Public corporations are owned by numerous equity investors, perhaps numbering in the thousands. With this diversity of ownership, the portfolio manager's return in a given stock, or in the general market, is dependent on the behavior of rival investors. If the manager holds onto a stock because he thinks its a good investment, while others are selling because they think the opposite, he loses in the short run. Future results of the company may bear out his original analysis, but in the present he looks bad. This is a dangerous situation in the investment industry, which tends to measure results quarter by quarter rather than year by year. For this reason, knowing how others think and react to events is critical to success.As the following examples illustrate, some investors bring this dynamic into the realm of game theory and attempt to influence the market's thought processes:
- False Takeover. An investor with a reputation for hostile takeovers acquires a position in a company's shares. He files a public notice or leaks his interest to the rumor mill. As other investors react to a potential takeover, they buy the stock and its price increases. In this case, the takeover artist has no intention of bidding for the company. He sells his shares into the buying activity sparked by his original interest, thus realizing a quick profit from speculative expectations. Clinton Morrison, an analyst at John Kinnard & Co., remarks, "It's called a self-fulfilling prophecy. You advertise your position and then you sell into it."
- Phony Promotion. A key market player, such as a large fund manager, indicates his strong interest in a certain industry sector, such as cable television. As other investors follow the fund manager's direction by purchasing cable TV stocks, the manager busily unloads his own holdings into the trading strength. One large fund manager was criticized in 1995 for advocating technology stocks in public, when his fund was selling them in private.
- Story Stocks. A professional investor establishes a significant position in a little-known company. Using financial publicists, stock newsletters, and aggressive brokers, he weaves a story behind the scenes about the company's unrecognized earnings potential. Although the analysis is sketchy, the growth story is entertaining. Carlton Lutts, editor of the Cabot Market Letter, summarized such game theory dynamics well. "A stock, like love, thrives on romance and dies on statistics." As the drumbeating becomes louder and louder, a cross section of investors takes notice. They buy in and the price climbs. When the professional's profit objective is reached, he bails out of his position and winds down the publicity machine. Shortly thereafter, the stock price collapses. This strategy is most effective with early-stage companies and technology firms. Their business prospects are difficult to analyze, making fanciful forecasts hard to dispute. Sometimes, just the rumor of an important investor is enough. In December 1996, Zitel Corp. shares rose from $22-7/8 per share to $72-7/8 per share on rumors that George Soros was amassing a position. When his firm publicly denied the reports on December 30, Zitel's stock price dropped 43 percent, or 31 points, in minutes.
In each of the preceding situations, the outcome of a competitive move by one investor depends on the reactions of his rivals, much like a good chess game. A seemingly irrational reaction by competitors may make a fine strategy unsuccessful. What happens if a professional feeds the takeover rumor mill and no one buys? The risk of the game is that his competitors won't act as expected. This risk decreases if he commands a visible leadership role in the market and has a strong public relations operation. Former Goldman, Sachs strategist, Leon Cooperman, for example, has the qualifications to be a top game player at his new firm, Omega Advisors. Of course, selection of the target stock must be made carefully. Competitors may see through a promoter's strategy or simply ignore the new information presented to them.
THE PREMISE OF SECURITY ANALYSIS
Practicing security analysts acknowledge the impact of human emotions, herd behavior, and game theory on stock prices, and they factor these elements into their investment conclusions. Generally, these are short-term influences, and sooner or later, most share prices reflect a rational view of underlying economic values. This rational view is far from absolute. Investment evaluation is not an exact science, and reasonable people examining the same facts are bound to have differences. Over the long haul, an analytical approach toward stock selection offers superior results, as occasional instances of price irrationality provide obvious opportunities. Maintaining a valuation discipline in emotional markets is one of the analyst's hardest challenges. Few people want to face the ridicule of going against the crowd by sticking to accepted standards, even though equity investors invariably return to normal measures of determining value after periodic infatuations with untested themes. These notions of rationality and consistency form the bedrock of the security analysis profession.A large part of a stock's price is set by expectations of its future growth in earnings. While a competent study of the past frequently provides the basis for an earnings projection, even the most talented analyst has a limited ability to predict the growth rate of a given company for years ahead. This implies that a major portion of any analyst's valuation is the product of educated guessing. As with similar vocations, many conclusions look terribly wrong with 20Ð 20 hindsight. Sometimes the actual earnings of a company come in substantially lower than forecast data, and the stock price drops accordingly. An analyst who recommended the stock has made a mistake, but level-headed investors, realizing the field's limitations, don't demand perfection. Rather, excellence can be achieved by partial success. In baseball, a .300 hitter "fails" 7 out of 10 times at bat, yet he is among the best. For security analysts, the grading process is more complicated than baseball, but a professional who is right 60 to 70 percent of the time is considered exceptional. Luck plays a role in compiling this kind of track record, but over time the importance of chance diminishes in favor of analytical skill.
Graham and Dodd summarized the analyst's requirements many years ago in Security Analysis:
To do these jobs credibly the analyst needs a wide equipment. He must understand security forms, corporate accounting, the basic elements that make for the success or failure of various kinds of businesses, the general workings not only of our total economy but also of its major segments, and finally the characteristic fluctuations of our security markets. He must be able to dig for facts, to evaluate them critically, and to apply his conclusions with good judgment and a fair amount of imagination. He must be able to resist human nature itself sufficiently to mistrust his own feelings when they are part of mass psychology. He must have courage commensurate with his competence.
SCIENTIFIC METHOD
According to serious practitioners, security analysis is a quasi-science, like medicine or economics. Its systematized knowledge has been derived from the observance of decades of stock market data and the application of common sense. The field's basic tenets have thus been tested by the use of the scientific method, which calls for carrying out three basic steps to reach a conclusion. Exhibit 1-3 summarizes the scientific method alongside its application in the securities market. Two supermarket stocks can serve as an example. Suppose the respective shares of Safeway and Kroger, two national chains, have the key financial characteristics shown in Exhibit 1Ð 4. Safeway's stock is trading at 15 times earnings. Given the similarity, what should be the P/ E multiple of Kroger's stock? All things being equal, Kroger shares should have a 15 P/ E multiple, meaning a $30 price (i. e., 15 P/ E ´ $2 EPS = $30). If the Kroger shares are trading at $25, the stock is a buy because it should eventually reach the $30 price. In practice, analysts take this $30 theoretical value as a starting point. They then study the future prospects of each company. Certain factors may justify the $25 value, despite the apparent similarities.Although the "similar stock/ similar price" supposition is easy to describe and makes sense, proving this theory and other basic tenets of security analysis in a scientific manner is difficult. In a true science such as physics, observations are repeated in a laboratory environment to verify their accuracy (e. g., a ball is dropped in a vacuum 100 times to confirm the pull of gravity). Security analysis theories, in contrast, are subject to the vagaries of the stock market, which has far too many uncontrolled variables to provide the appropriate conditions for a truly scientific test.
Even the "similar supermarket" example is hard to prove scientifically. Finding two publicly traded supermarket chains with identical financial results is impossible, and most chains have significant differences in market conditions, business operations, and managerial styles. Even with two firms that resemble each other in financial and business attributes, the scientific method is problematic. Much of a company's value is represented by its future potential to generate earnings, as opposed to its present condition and past history. Determining a consensus view of a company's future is accurately described as educated guesswork, rather than scientific deduction.
Despite the drawback of injecting scientific methods into the stock market, investors and finance professors keep trying. Certain of their theories have been proven academically, while others have a commonsense appeal that heightens their acceptance. For example, most professionals consider the next two hypotheses to be valid:
True—Companies with low interest coverage ratios go bankrupt more frequently than those with high interest coverage ratios.
True—Companies with high P/ E ratios have better growth records than those with low P/ E ratios.
A combination of academic proofs, commonsense ideas, and intuitive beliefs supports these and other notions of security analysis. The systematic application of these concepts has evolved into a rational discipline, which one studies like other quasi-scientific fields such as medicine, economics, or sociology.
SECURITY ANALYSIS TECHNIQUES
As discussed earlier, emotions and trend followers influence the values of companies, but an underlying discipline governs share prices. Over time, this discipline, which is founded in security analysis, tends to correct stock market excesses. Thus, if a "hot" stock such as Ionica Group, the telephone service provider, goes public at a valuation of $900 million although the company has few revenues and no earnings, inevitably the stock price come back to earth, as investors lose their fervor and evaluate the business in terms of its risk-adjusted potential. Elder Beerman was a good company but a speculative stock in 1998, when its initial public offering sold at $22 per share. One year later, it was still a good firm but a better equity value at $7 per share, which was more in line with the company's future prospects. Frequently, the life cycle of pricing excesses begins with a security being bid up to an irrational price by anticipation investors and momentum players, who are then battled by scientifically inclined investors. The latter argue for a realistic valuation based on time-honored value anchors, derived from the four valuation approaches set forth in Exhibit 1-5.BASIC VALUATION APPROACHES
Of the four principal approaches to security analysis, the first three intrinsic value, relative value, and acquisition value lend themselves to the scientific method. All three approaches forecast stock prices on the basis of historical economic, capital market, industry, and corporate statistics, which are then used to establish predictive trends for corporate operating results and share prices. The principal decision variables are earnings projections and comparable company values.Under the intrinsic value method, future dividends are derived from earnings forecasts and then discounted to the present, thereby establishing a present value for the stock. If the stock is trading at a price lower than this calculation, it is a "buy"; if the market price is higher then the intrinsic value, the stock is a "sell."
For most businesspeople, the intrinsic value approach (discounted cash flow) is their first introduction to security analysis since it is the approach emphasized by business schools and most valuation books. The intrinsic value concept makes economic sense and is theoretically sound, but in the real world its applicability is limited. No professional investor places much weight on projections extending past two or three years, and dividend discount rates are hard to pinpoint. Furthermore, even devoted advocates of this technique are hesitant to promote its use for analyses involving (1) growth companies that don't pay dividends; (2) established companies that are consistent money losers; and (3) complex companies that are liquidation or restructuring candidates.
The relative value approach considers intrinsic values too difficult to determine, owing to the arguments over hard-to-make projections and controversial discount rates. Instead, various valuation parameters of a given publicly traded stock, such as its P/ E, price/ book and price/ sales ratios, are compared with the stocks of companies in the same industry. If the value ratio of the stock being evaluated is substantially lower than its peer group, and if there is no justifiable reason for the discrepancy, the relative value approach views the stock as a buy. Stock valuations are therefore made in a manner similar to many other asset appraisals. In real estate, the value of a house is established by comparing the target house to nearby houses that have sold recently. The relative value approach is attractive to analysts because it takes most of the guesswork out of relying on future projections and discount rates. Its weaknesses stem from three factors. First, few publicly traded companies have exact comparables, leaving a lot of room for subjectivity in the appraisal. Second, investors are in the market to make money in absolute terms, whereas the relative value method focuses on relativeperformance. Suppose an entire industry is the subject of speculative interest, and its share prices crash when expected operating results fail to materialize. The relative value picks fall 20 percent, but the industry's decline is 30 percent. The successful relative value investor is losing less money than other investors committed to the industry, but he's still losing money. Third, relative value places a heavy emphasis on contrasting the historical operating results of similar businesses, when future prospects are critical. "Driving by looking in the rearview mirror" is a perilous investment tactic.
The acquisition value approach suggests that a publicly traded stock should never trade at less than 70 to 75 percent of its worth to a sophisticated and well-financed third party. The analyst evaluates industry acquisition prices compared with the relevant company, and he tests its feasibility as a leveraged buyout or liquidation candidate. If the stock trades at less than 70 percent of its acquisition value, it is probably a buy. By relying on "comparable company" data, the acquisition value approach suffers from the same weaknesses as the relative value method, with the further proviso that comparable public mergers and acquisitions (M& A) deals are rare in many situations. The leveraged buyout (LBO) and liquidation techniques are dependable, but they apply only to a select group of manufacturing and service industries.
The fourth approach, technical analysis, has a wide following but it lacks the broad institutional acceptance of the first three approaches. Often referred to as Wall Street's version of "voodoo economics," technical analysis is concerned solely with the price and volume trading patterns of a stock. This valuation technique does not consider a company's operating history, its earning potential, or other microeconomic factors as relevant to the valuation process. Rather, the technician believes that trading patterns reflect all logical and emotional forces affecting a stock price. An analysis of these patterns, usually in conjunction with industry and market trading indicators, provides predictive trends that enable the technician to forecast stock prices.
Suppose a stock price fluctuates in a small range over a period of months, after it has made a big upward move. This behavior is called a "consolidation" pattern because the stock is consolidating its previous gain. If the stock price breaks through the top end of this range, this is a buy signal, because technical theory says it is poised for another run-up, after which the price will stabilize again. Numerous investors and academics have tested this and other technical theories and concluded that there is no evidence to support these claims. Nevertheless, Wall Street is one place where perception easily becomes reality. Since thousands of investors believe in technical analysis, market participants are sensitive to technical opinions in evaluating stock prices. Reports of security analysts often include charts outlining the trading activity of the stock in question, and I have observed that most professional money managers use such charts as one ingredient in buy/ sell decisions.
OTHER VALUATION APPROACHES
Technical analysis represents a systemized body of knowledge and numerous books review its procedures. Nevertheless, it straddles the line between rational inquiry and educated speculation. Two common stock-picking approaches that fall into the speculative category are "momentum investing" and "market anticipation".Both approaches require a sophisticated knowledge of the market's inner workings and an experienced hand in equity trading. They are best employed by professional traders and stock promoters, who participate in the securities markets on a full-time basis and are thus in a position to react quickly to the sharp price movements endemic to these investment strategies.
Conventional security analysis is sometimes characterized as the art of "buying low, and selling high." Momentum investing, in contrast, is frequently referred to as "buying high, and selling higher," because its adherents look to buy shares which are rising quickly in price. Momentum investors pay close attention to trading trends and give short shrift to the underlying company's sales or earnings; and thus, they represent a subset of the technical community. Having played a major role in many share price run-ups, they are a key source of market volatility, often through automated program trading. Such trading is initiated by a series of signals such as an upward 90-day moving price average, a large positive net cash flow into a stock, or a big jump in trading volume.
The market anticipation approach acknowledges that most stocks are fairly valued by security analysts using the intrinsic value, relative value, and acquisition value methods. At some future point, however, the consensus view on any given stock's earnings power or business risk changes, providing impetus to a higher (or lower) stock price. A typical pronouncement from a market anticipation analyst might be, "The Starbucks shares will increase in value as the market realizes the reduced volatility of the company's earning stream." Such conclusions carry little analytical weight and are most effective when repeated loudly and continually, thus echoing "the squeaky wheel gets the grease" tactic used by promoters in any business. Despite the speculative nature of this approach, even the most rigorous disciples of security analysis are cognizant of the sometimes relentless drumbeating of "market anticipation" investors, who are trying desperately to influence the consensus decision on a stock's value. Their influence has been strong in certain cases and has been observed in the rise and fall of numerous "high flyer" stocks, the peak prices of which defy rational explanation. How else does one explain the rocketlike rise of Amazon. com from $40 per share to $180 in nine months in 1998, the precipitous drop of Dispatch Management from $30 to $3 in the first four months of 1999, or the lightning round trip of Books-a-Million, which rose from $2½ in August 1998 to $46 in October 1998, and then declined to $7 by June 1999?
SUMMARY
Security analysis is a field of study that maintains stocks can be valued in a methodical and sensible way. While acknowledging the stock market's periodic spasms of emotion and irrationality, it suggests that, sooner or later, the price of a security approaches its economic value, as determined by a reasonable person with the requisite background in business operations, economics, finance, and accounting. This value cannot be pinpointed definitively because security analysis is not a science. Its results depend on the surrounding environment, which constantly changes with new information regarding developments of the business in question. As a quasi-science, security analysis has its limitations yet it provides a reasonable framework for comparing and contrasting investment opportunities. As a result, security analysis is widely accepted in the institutional community and it is the primary means for justifying investment decisions.Despite its lack of exactitude, security analysis provides careful investors with sufficient tools to recognize pricing anomalies in the market, and then to benefit from them by making the appropriate buy/ sell decision. These evaluation tools provide the pricing anchors from which a rational decision can be reached, and they include the intrinsic value, relative value, and acquisition value methods. Technical analysis, a popular stock-picking technique based on trading patterns, is often used as a complement to these approaches.
Because so much of a typical share's value is based on hard-to-predict future results, the stock market is fertile ground for unscrupulous promoters who exaggerate the prospects of investments in which they have a financial interest. The rumor mongering and tub thumping of these players sometimes has the desired effect of inflating the price of a stock. This impact is transitory, and share prices generally return to a modest valuation range in which reasonable people achieve a consensus. Within this band, however, investors still face uncertainty, and so investment selection remains a challenging activity.
QUESTIONS AND SHORT PROBLEMS
1. How does the principal objective of security analysis (i. e., finding su-perior investment values) contradict the "efficient market" theory?2. How can a solid company with a strong operating record be a poor investment choice when compared to competing alternatives, such as other stocks or bonds? Why might companies with less stellar records represent better investment choices?
3. A security analyst determines that Incel Corp. stock is worth $20 per share. The current market price is now $15 per share, indicating a likely "buy" decision. Is the analyst guaranteed an eventual $5 per share profit? Why or why not?
4. Name the two emotions that have the most lasting impact on stock prices.
5. Why do underwriters like to price initial public offerings below the value dictated by their supply-and-demand estimates?
6. Which of the following expressions summarizes momentum trading: a. Buy high, sell low. b. You can't buck the trend. c. You have to do your homework. d. Stocks thrive on love and die on statistics.
7. The "story stock" technique is often used by promoters for high-tech issues. Why are high-tech companies suitable for this technique?
8. Which statements are relevant to security analysis? Circle all that apply: a. Emotions are short-to-intermediate term influences on stock prices. b. Over the long-term, security analysis offers above-average investment returns. c. Security analysis is a science, like chemistry or physics. d. Security analysis depends on rational behavior over the long-term.
9. Why is security analysis likened to "educated guesswork," even by its practitioners?
10. All things being equal, which of the two chemical stocks shown below should trade at the higher P/ E multiple?
11. List the four principal approaches to security analysis.
12. Which of the four approaches is almost totally dependent on the analyst's assessment of a company's future earnings potential?13. Why do "real life" practitioners tend to favor the "relative value" approach?
14. Is "momentum investing" similar to technical analysis?
Adopt-a-Company Exercises
A. To learn security analysis concepts in a practical way, each student (or a group of students) selects a company to follow during the semester. To ease the learning process, students select companies that are relatively easy to understand. The best companies for this purpose are companies that:
- Have a five-year history of sales and positive earnings;
- Offer a low-tech product or service;
- Have a debt to equity ratio of 1;1 or less;
- Are engaged in one industry only; and
- Have completed an IPO within the last five years.
B. Students have two weeks to identify their company for adoption. The instructor will approve the selections that meet the criteria, or provide alternative companies.
Table of Contents
Introduction Part I The Investing Environment 1 Why Analyze a Security? 2 Who Is Practicing Security Analysis? 3 Seeking a Level Playing Field 4 Other Sources of Information Part II Performing the Analysis and Writing the Research Report 5 Starting the Analysis 6 Industry Analysis 7 Company-Specific Analysis 8 Financial Statement Analysis of an Established Business 9 The Limitations of Accounting Data 10 Financial Analysis and Stock Characterization 11 Financial Projection Pointers Part III Valuation and the Investment Decision 12 Modern Approaches to Valuation 13 The Relative Value Approach 14 Valuing Marginal Performers 15 The Mergers and Acquisitions Market, Leveraged Buyouts, and Takeovers 16 Breakup Analysis 17 Recommended Investment Decision Part IV Special Cases 18 Cash Flow Stocks 19 Natural Resource Stocks 20 Financial Industry Stocks 21 Insurance Companies 22 Highly Speculative Stocks 23 Distressed Securities and Turnarounds 24 International Stocks 25 Emerging Markets: The Final Frontier Part V Summary 26 Closing Thoughts on Security Analysis IndexFrom the B&N Reads Blog
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