Week 10 Flashcards
Perfectly efficient markets would make it
Perfectly efficient markets would make it impossible to identify mispriced stocks using public information such as published financial reports
– Implies that we can’t use public info to ‘buy low and sell high’ because any price reaction to the info happens instantaneously
Perfectly Efficient Market
Unlikely to exist in equilibrium
If perfect efficiency exists at a point in time, there would be no incentive for people conduct such research
– Market would ‘slip away’ from efficiency, creating incentive for research
• More likely that the market is ‘close’ to efficient, as per following slide
People who are able to read, analyse and understand the implications of the new info for the asset’s future returns more swiftly than others may be able to ‘buy low and sell high’
• Why doesn’t everyone do this?
– Barriers to entry: innate ability, financial and opportunity costs of formal education, practical experience etc
– Trading profits may be viewed as a return on an individual’s investment in developing their human capital
Even if the market is very close to being efficient,
there is potential value to fundamental analysis (at least for the people who are the very best at it).
•
fundamental analysis may assist in
assessing whether a security is consistent with risk preferences / intended investment horizon
There is evidence that suggests that markets fail
Several studies, including Bernard and Thomas (1989, 1990) find evidence that suggests that markets fail to fully impound the implication of changes in current quarterly earnings for subsequent quarterly earnings
‘Post Earnings Announcement Drift’
Markets Failure to fully recognise positive autocorrelation with next quarter earnings, negative autocorrelation with 4 th quarter earnings
Does the relative amount of accruals and CFO within firms’ net profit affect the persistence of earnings (i.e. the extent to which the current level of earnings persists into the future)
Limitation
Accruals require more subjective judgement, and there is greater uncertainty as to whether an associated cash flow will EVER occur
Does the relative amount of accruals and CFO within firms’ net profit affect the persistence of earnings (i.e. the extent to which the current level of earnings persists into the future)
current period earnings which are similar in magnitude to current CFO are more likely to persist next year, relative to current earnings which are very different to current CFO
If the amount of accruals implied by a firm’s profits and CFOs does affect earnings persistence, do stock prices efficiently impound this information?
What is assumed
Given that the data underpinning Sloan’s findings are/were public info, and also the existence of anecdotal evidence that analysts consider the relation b/w Profit and CFO when valuing firms, one would expect that the greater persistence of cash flows is reflected in stock prices, and thus cannot be used to ‘beat the market’
Sloan tested the market pricing of accruals and cash flows several ways
This includes
Constructing a ‘hedge portfolio’ which includes a positive investment in firms with very high CFO relative to Net Profit and a equivalent negative investment in firms with v. High Accruals relative to Net Profit
– This zero net investment portfolio should earn a zero return if market is efficient
What did sloan’s study show in terms of market pricing
regardless of the method by which Sloan controlled for ‘normal’ market returns, a strategy of ‘buying’ firms with high CFO relative to Profit, and ‘selling’ those with high ‘Accruals’ relative to Profit earned positive returns
– Most of the return comes from the apparent mis-pricing of high accrual firms (row above ‘hedge’)
DRS(2008) broke down sources of firms profit by using an alternate ROE breakdowns to decompose income into the following ‘components’:
ACCRUALS + (ΔCASH + DISTRIBUTIONS TO EQUITY + DISTRIBUTIONS TO DEBT)
DRS(2008) thus decomposed income into the following ‘components’:
– ACCRUALS + (ΔCASH + DISTRIBUTIONS TO EQUITY + DISTRIBUTIONS TO DEBT)
– Are each of those components equally persistent over time?,
ACCRUALS and ΔCASH have similar persistence, and each much less likely to persist than DIST to EQUITY
DRS(2008) Findings
• 1) ACCRUALS and ΔCASH have similar persistence, and each much less likely to persist than DIST to EQUITY
Explain
where annual earnings and distributions to equity and debt are very similar, those earnings are more likely to persist than occurs when firms earnings differ greatly from the amount distributed to equity holders.
– The persistence of distributions to DEBT is similar to ACCRUALS and ΔCASH
DRS(2008) thus decomposed income into the following ‘components’:
– ACCRUALS + (ΔCASH + DISTRIBUTIONS TO EQUITY + DISTRIBUTIONS TO DEBT)
If there are differences in persistence, does the market correctly price those differences
Most of the market mispricing relates to the ACCRUALS and ΔCASH components. These components represent the earnings retained in the business.
– Results suggest that the market over-estimates the return available on re-invested earnings,
– May imply that investors overestimate the persistence of historic ROE when BVE is growing strongly.
Not all people accept Sloan’s (and later) results as evidence of mis-pricing
Why
As is the case with many theoretical trading strategies, an accrual based strategy implies the ability to short-sell firms that tend to be a) small and b) have illiquid equity securities
– If you actually traded on the strategy, your demand would affect the price transacted and thus the returns to the strategy
Steps in the Overall Investment Advisory Process
– (1) Establish Investor’s Objective – (2) form expectations re future returns and risks of individual securities
– (3) use (2) to make investment decisions consistent with (1)
Steps in the Overall Investment Advisory Process
– (1) Establish Investor’s Objective – (2) form expectations re future returns and risks of individual securities
– (3) use (2) to make investment decisions consistent with (1)
If we are writing a report for many potential clients, it may be hard to establish their objectives
– So, we
– So, we do 2) assuming a moderate level of risk aversion, but provide plenty of detail regarding expected riskiness in the short and long-term
Analysts’ investment reports must consider (or at least acknowledge) the objectives of investors
Why
of the investors known or assumed to rely on the report •
Investor objectives are highly idiosyncratic and must be matched with the appropriate investment. •
For example, individuals vary in terms of their: – risk tolerance – tax exposure – stage of life – other assets held etc
Sell-Side Analysts
What do they work for
work for investment banks, brokerage houses (or brokerage arms of other institutions), specialist research firms (to sell info to investment or broker firms or large companies)
Sell side analysts
– Sell or otherwise provide their equity research to investors
Sell side analyst incentive
Analysts working for brokerage firms may have incentive to encourage share trading by their firm’s clients
• Incentive for positive bias?
– Major incentive is to identify mis-priced stocks
Buy-Side Analysts
Work for
Work for institutional investors (e.g. Mutual funds / unit trusts/Super funds
work for those who buy investments
Buy-Side Analysts
Role
Provide investment advice to their employing firm, who then use this to offer products customised to investor clienteles
Buy-Side Analysts
They still are interested in
Still interested in identifying mis-priced securities, but also considers the suitability of the security for particular investment funds:
– High Growth fund
– Income (Dividend paying) generating fund
– Index Fund (a fund designed to track a particular mkt index)
End Investors
They vary in
They may
Different risk profiles, investment horizons, tax status, existing portfolio etc will influence suitability of any particular equity security to that investor
• May conduct security analysis themself • Or:
– Acquire research from sell-side analyst source
– Invest in fund with characteristics suited to their objectives
What does an Analyst do each day?
- Selection of candidates to analyze
- Inferring market expectations
- Develop/refine our own expectations
- Develop Investment Recommendation with supporting forecasts, discussion of strategic risks, investment horizon etc.
What does an Analyst do each day?
Inferring market expectation
Identifying potentially mispriced securities requires a comparison of the analysts expectations with those of the market
Selection of Candidates to Analyse
Analysts tend to concentrate their coverage by
Analysts tend to concentrate their coverage by industry/sector
– Specialisation allows for knowledge spill- overs (what you learn from analysing a firm is relevant to analysing that firm’s competitors), economises on general research time/costs
Selection of candidates
Buy-side analysts choice of firms to cover will also be constrained by
the types of mutual funds offered by their employer (e.g. Growth, income, value etc)
Selection of candidates
Others first
first screen firms based on some indicator of potential mispricing (e.g. Firms that have received positive revisions in earnings forecasts), and then analyse these firms in depth
Inferring Market Expectations
we could infer market expectations about short-term or long-term growth in earnings if we know
Current price – Current cost of equity
• And have information or informed beliefs regarding either long-term profits or short- run profits
Develop Our Own Expectations
Using our original forecasts, refined by our initial valuation and our examination of differences between our expectations and those of the market, develop our final forecasts.
Investment report
Includes: – Investment Recommendation
(BUY/HOLD/SELL)
– Supporting forecasts and valuations, with
- underlying assumptions
– Description of firm’s activities
– Discussion of Strategic Risks and Opportunities
Factors Associated with The Performance of Security Analysts
Some recent research indicates that these analysts’ recommendations
analysts’ recommendations typically outperform market index and risk benchmarks
– Research indicates that analysts play an important role in market efficiency.
Factors Associated with The Performance of Security Analysts
analysts’ recommendations typically outperform market index and risk benchmark
Sell side?
sell-side analysts have incentives to be overly optimistic with their forecasts and recommendations
Sell-Side Analysts, Biased Forecasts,
Incentives
What do studies show
Some studies find evidence of systematic optimistic bias in analysts output
Some studies find evidence of systematic optimistic bias in analysts output
How
Tendency to issue more positive recommendations
– Earnings forecasts ‘too high’
realised actual earnings are lower than the forecast level of earnings
Some studies find evidence of systematic optimistic bias in analysts output:
Earnings forecasts ‘too high’
Time of the year influence this
Forecasts issued earlier in the reporting year more optimistic, gradual become less optimistic as reporting date approaches
Possible Incentives for Bias
‘Information Hypothesis’ / ‘Management Relations Hypothesis’
Analysts may believe that issuing ‘positive’ forecasts for a particular firm will win them favour with that firm’s managers, and give them access to private info, particularly in the case of firms for which they have issued a sell recommendation
the provision of ‘private briefings’ to analysts is
Following the Regulation Fair Disclosure Act in the US (effective October 2000), the provision of ‘private briefings’ to analysts is illegal
Following the Regulation Fair Disclosure Act in the US (effective October 2000), the provision of ‘private briefings’ to analysts is illegal
In Australia
Australia, such behaviour has been proscribed for a long-time (ASX Guidance Note 8 etc) though some firms continue to be sanctioned for ignoring this requirement.
Subsequent research (Eames et al 2002) using pre-Reg FD data, but which controlled for the level of actual earnings being forecast, found:
– Forecasts are systematically optimistic when
recommendation = BUY – Forecasts are systematically pessimist when
recommendation = SELL – NOT CONSISTENT with INFO HYPOTHESIS
Bias in Analyst Forecasts and Recommendations
Trading incentives
Where sell-side analysts work for a firm that offers brokerage services (i.e. Brokerage houses or investment banks with a brokerage function), more optimistic recommendations / forecasts may encourage trading (and thus transaction fees)
– Any investor can act on a ‘buy’ recommendation
– Acting on a ‘sell’ recommendation requires either that you already own the stock, or are able to ‘short-sell’ that stock
Bias in Analyst Forecasts and Recommendations
Objectivity Illusion
behavioural tendency to unconsciously process information in a manner that supports one’s goal
Bias in Analyst Forecasts and Recommendations
Objectivity Illusion
Example
– If I’ve issued a BUY recommendation, I may process subsequent info (e.g. Relevant to future earnings) in a manner that biases my forecasts upwards
– If I’ve issued a SELL, the opposite may be true.
Analyst Incentives Surrounding Particular Events
Investment Banking Incentives
In addition to evidence of general optimism in analyst forecasts, the investment banking business of some analysts’ employers may provide incentives to bias recommendations/forecasts
Investment Banking Incentives
Optimistic recommendations / forecasts for a firm expected to need advisory services may:
– Increase the chance that the analysts’ employer actually wins the tender for the advisory services
– If they do get the deal, optimism might increase the chance that the transaction is executed successfully
Analyst Bias and Seasoned Equity Offerings
When a listed firm issues additional equity to the market,
it is common to engage an investment bank to:
– Advise on price / terms of issue and help
market the issue – Underwrite the issue (i.e. Agree to purchase any unsubscribed stock)
