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JANE SMITH’S INVESTMENT DECISION

THE UNDERSTANDING OF EFFICIENT MARKET THEORY

Presented By:Abhishek Ranjan

D. ArvindDeepesh Tyagi

Dhruv GuptaMohd. Saqib kalam

Nipun Singla

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A QUICK LOOK AT.. FUNDAMENTAL ANALYSIS

The Security Analyst or prospective investor is primarily interested in analyzing factors such as:

Economic Influences Industry Factors Pertinent company Information such as –

Product demand, earnings, dividends and management.

In order to calculate an intrinsic value for the firm’s securities.

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A QUICK..TECHNICAL ANALYSIS

The Technical Analyst or Chartist can discern patterns in price or volume movements and by observing & studying the past behavior patterns of given stocks, they can predict the future price movements in these stocks.

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CAN A SERIES OF HISTORICAL PRICES OR RATES OF RETURN BE AN AID IN PREDICTING FUTURE STOCK PRICES OR RATES OF RETURN EVERY TIME?

An article in Forbes reported the reported the result of a study shows over the period of 1973-90 the average error made by Security Analysts in Forecasting was 40%.

From 1985-90 it was 52%.

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THE EFFICIENT MARKET THEORY

The Efficient Market Hypothesis (EMH) deals with Informational efficiency, which is a measure of how quickly & accurately the market reacts to new Information.

It believes in Past prices do not matter, future ones do.

EMH is one of the most important paradigm in Finance.

A discussion of fair pricing inevitably leads to the Efficient Market Hypothesis.

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DEGREES OF INFORMATIONAL EFFICIENCY

Strong Form

Semi-Strong

Weak Form

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WEAK FORM EFFICIENCY

The least restrictive form of the EMH.

It states that future stock prices cannot be predicted by analyzing prices from the past. In other words charts are of no use in predicting future prices.

It says a stock arrived at its current price is irrelevant, the only thing that matters is current price.

It states that the current stock price fully reflects any information contained in the past series of stock prices.

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SEMI STRONG FORM EFFICIENCY

Semi Strong form takes the Information set a step ahead & include all publicly available information.

In addition to past stock prices, corporate reports, corporate announcements, information related to corporate dividend policy, forthcoming stock splits & so on. As soon as this information becomes publicly available, it is absorbed & reflected in stock prices.

It says Public Information will not yield consistently superior returns to Analysts.

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STRONG FORM EFFICIENCY

The most extreme version of the EMH.

It states Security Prices fully reflect all public & private information.

Tests of the trading of Specialists on the floor of stock exchanges and test of Profitability of insider trading suggest that the possibility of excess profits exists for these two very special groups of Investors.

Since both of these trading are illegal that means the excess returns are not possible even in this form.

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EMPIRICAL TESTS OF WEAK FORM

Serial correlation tests Runs tests Filter tests Distribution patterns

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SERIAL CORRELATION TEST

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RUN TESTS

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FILTER TEST

If the daily closing price of a security moves up at least X% , buy the security until its price moves down at least X% from a subsequent high, at which time simultaneously sell and go short. The short position should be maintained until the price rises at least X% above a subsequent low, at which time cover and buy.

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DISTRIBUTION PATTERNS

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EMPIRICAL TESTS OF THE SEMISTRONG FORM

Fama, Fisher, Jensen, and Roll Study- Speed of the market’s reaction to a firm’s announcement of a stock split and the accompanying information with respect to a change in dividend policy.

The Conclusion- The Market was efficient with respect to its reaction to information on the stock split and with reaction content of stock splits vis-à-vis changes in dividend policy. Ball and Brown Test- Examination of stock price movement of companies that experienced “good” earnings reports as opposed to the stock price movements of companies, that experienced “bad” earnings reports.

The Conclusion- a) A “good” earnings report reported higher EPS than the forecasts and “bad” earnings reports, just vice versa.

b) The Companies with “good” earnings reports experienced increases in their stock prices and those with “bad” earnings reports, a decline.

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OTHER TESTS

Joy, Litzenberger, and McEnally stock price earnings report Test- The Impact of quarterly earnings announcements on the stock price adjustment mechanism.

The Conclusion- The favourable information contained in published quarterly earnings reports was not instantaneously reflected in stock prices. Basu’s Price Earning Multiple Test- Whether low P/E stocks tended to outperform stocks with high P/E ratios?

The Conclusion- The low P/E portfolios experienced superior returns relative to the market and high P/E portfolios performed in inferior manner, relative to the overall market. The Size Effect Test- Whether smaller firms experience larger returns than the larger firms experienced over the same time period?

The Conclusion- Yes. They did provide larger returns.

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WHAT RWM SAYS Previous price changes or changes in return are useless in predicting future price or return changes. Using historical price-change information, to predict future prices, would be an unsuccessful endeavor. Says that the successive price changes are independent. Prices at any time, will on the average, reflect the intrinsic value of the security. If at all a stock’s price deviates from its intrinsic value, because of evaluation of available information differently by investors or have different insights into future prospects of the firm, professional investors and astute non professionals, will seize upon the short-term or random deviations from the intrinsic value, and through their active buying and selling, will force the price back to its equilibrium position.

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WHAT RWM DOESN’T SAY The RWM says nothing about relative price movements (i.e.) about selecting securities that may or may not perform better than other securities. It says nothing about decomposing price movements into such factors as market, industry or firm factors. These trends provide no basis for forecasting the future. Discussions about a competitive market, instantaneous adjustments to new information, knowledgeable market participants and easy access to markets are all, not part of the random-walk model.

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RANDOM WALK MODELThe term random walk was first introduced by Karl Pearson in 1905.

A random walk, sometimes denoted RW, is a mathematical formalization of a trajectory that consists of taking successive random steps.  For example, the path traced by a molecule as it travels in a liquid or a gas, the price of a fluctuating stock and the financial status of a gambler can all be modeled as random walks.

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RANDOM WALK MODEL CONTD..

Random walk model says that previous price changes or changes in return are useless in predicting future price or return changes.

In short, this is the idea that stocks take a random and unpredictable path.

concept that stock price movements do not follow any pattern or trend.

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ANOMALIES

Anomalies are unexplained empirical results that contradict the EMH. The Small firm effect. The “Incredible” January Effect. P/E Effect. Day of the Week (Monday Effect).

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THE SMALL FIRM EFFECT

The small firm effect recognizes that investing in small firms(those with low capitalization ) seems to ,on average ,provide superior risk-adjusted returns.

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THE “INCREDIBLE” JANUARY EFFECT

Another well-known anomaly is called the January effect.

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LOW THE P/E EFFECT

Stocks with low PE ratio provide higher returns than stock with higher PEs.

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THE MONDAY EFFECT

A theory that states returns on the stock market on Mondays will follow the prevailing trend from the previous Friday.

If the market was up on Friday, it would also up on Monday and vice versa.

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OVERVIEW OF GROWTH VS VALUE INVESTING: WHATS THE DIFFERENCE

The stock market can be divided into two types of stocks, value and growth. Value stocks are "bargain" or out-of-favor stocks that are inexpensive relative to company earnings or assets. Growth stocks represent companies with rapidly expanding earnings growth.

 •To determine whether a stock fits in the growth or the value camp, investment managers analyze earnings and assets relative to the stock's current price.

• High-speed earnings growth typically indicates a growth stock.• A stock priced low relative to company assets or earnings is

regarded as a value stock.•Growth investors search for stocks with the potential for above-average earnings and earnings growth rates. These companies tend to be market leaders and innovators, and their stocks often can produce above-average returns.•Value investors typically search for stocks with relatively low price multiples and high dividends.

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CHARACTERISTICS OF GROWTH AND VALUE STOCKS

“BUY LOW,SELL HIGH”

“BUY HIGH,SELL HIGHER”

Value stocks•Low or no sales growth•Little corporate debt•Below-average earnings growth•Low price/earnings and price/book ratios

a

Growth stocks

• Sales growth greater than competitors

• Debt incurred for expansion• Above0average earnings

growth• High price to earning and

price tob book ratios

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GROWTH INVESTORS

More apt to subscribe to the "efficient market hypothesis" which maintains that the current market price of a stock reflects all the currently "knowable" information about a company and, so, is the most reasonable price for that stock at that given point in time.

Seek to enjoy their rewards by participating in what the growth of the underlying company imparts to the growth of the price of its stock.

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PROS N CONS

 Pros: Potential for incredible returns in a short period of time

Cons:

Hot stock tips, rumors, hype, and market hysteria are not reliable sources of information to act upon

Failure to relate the stock price to the company value leads to purchasing overvalued stocks

Safety net is low or non-existent Market downturns hit growth stocks far harder than value

stocks Potential for total loss

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VALUE INVESTORS

put more weight on their judgments about the extent to which they think a stock is mispriced in the marketplace.

. If a stock is underpriced, it is a good buy; if it is overpriced, it is a good sell. They seek to enjoy their rewards by buying stocks that are depressed because their companies are going through periods of difficulty;

riding their prices upward, if, when, and as such companies recover from those difficulties; and selling them when their price objectives are reached.

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PROS N CONS

 The fundamental goal of value investing is, quite simply, to buy a stock when it is low and sell when it is high

Pros: Reduces risk of under performing by choosing

investments which have a built in “safety net” “Hot” stock tips, hype, and mass hysteria do not

affect the decisions a value investor makes Cons: The potential returns for value investing are

smaller than those of growth investing

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WHEN TO BUY : ALTHOUGH THESE SECTORS ARE ON OPPOSITE ENDS OF THE SPECTRUM, INVESTORS MAY BE JUSTIFIED IN PURCHASING EITHER, DEPENDING ON ECONOMIC AND MARKET CONDITIONS

REASON TO BUY

Market prices tied to business valuation/earnings – high correlation between price and earnings, relatively stable P/E

Above average earnings growth (in industry or market as a whole)

High certainty/visibility in earnings growth

REASON TO AVOID

Prices divergent from business valuation – low correlation between price and earnings, highly volatile P/E

There is no growth - Relatively slow economic growth/recession

Low certainty/stability in earnings growth

GROWTH STOCK

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REASON TO BUY

Market prices have come down significantly and oversold issues are starting back up

Overall economic or corporate growth appears to be slowing

Certain out of favor securities may be selling for less than value of their assets (i.e. get the business for free)

REASON TO AVOID

There is no value (entire market is overvalued)

Price appreciation for value so shallow that much better returns for minimally increased risk are possible

VALUE STOCK

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PRICE TO EARNING RATIO:

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as: Market Value per Share

Earnings per Share (EPS)

Low for value stock high for growth stock

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PRICE TO BOOK RATIO

A ratio used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share. 

Also known as the "price-equity ratio". 

Calculated as:

 

LOW FOR VALUE STOCK HIGH FOR GROWTH STOCK

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PRICE TO SALES RATIO:

A ratio for valuing a stock relative to its own past performance, other companies or the market itself. Price to sales is calculated by dividing a stock's current price by its revenue per share for the trailing 12 months:

LOW FOR VALUE STOCK HIGH FOR GROWTH STOCK

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DIVIDEND YIELD:

A financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock. Dividend yield is calculated as follows:

High for value stock low for growth stock

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 CHART OF COMPARISON:

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 CONCLUSION:

Which strategy shows the better returns depends, in part, upon the periods over which they are compared.

It has, however, been my impression, over the past several decades, that "value" investing has received the more hype.

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ACTIVE AND PASSIVE INVESTING

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ACTIVE INVESTING

• Look to make profit from price fluctuations that occurs over a short period.

• Believes market is inefficient and so undervalued to be purchased and overvalued stocks to be sell short.

• Try to outsmart market timing. If bull to enter the stock, purchase and if bear than sell.

• Use different factors like P/E ratio, short positions, option writing.

• Gives better results but risk involved much higher.

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PASSIVE INVESTING

• Intention of holding the investment for a long term.

• Involves limited ongoing selling or buying of stocks.

• Invest in the portfolio which is well diversified.

• Believes that markets are well efficient and that the securities market price is the best available estimate of the correct prices.

• Risk less but return also less.• Examples- Purchase of mutual funds or ETF

that are indexed.

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PASSIVE INVESTING STRATEGIES

Index Investing A type of mutual fund with a portfolio constructed

to match or track market market index.Buy and Hold Strategy Investors have broadly diversified portfolios which

minimizes unsystematic risks. Stocks held for a long period

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TO BE CONTD.. Transaction cost and money spent to obtain

information are minimized DRIPS as a Passive Strategy It is reinvesting of the dividends.Valuation Informed Indexing It is a new concept developed by Rob Bennett.

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JANE SMITH’S INVESTMENT DECISION

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SUPER GOLD VERSUS TSE 300 STOCK PERFORMANCE

Day Super Gold TSE(toronto stock exchange) 300

Monday -0.5% -0.5%

Tuesday -0.2% -0.2%

Wednesday 0.5% 1.2%

Thursday 0.2% -0.2%

Friday 0.3% -0.4%

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BUILDCO INC. FINANCIAL INFORMATION

Buildco % versus Industry

% versus TSE 300

Assets($m) $1,200 140% 70%

Long term debt($m)

150 89% 55%

Debt to equity 0.25 35% 52%

Dividend yield 1.20% 85% 61%

Dividend payout ratio

15% 82% 43%

Beta 1.21 132% 121%

Return on equity

13.50% 67% 107%

Price to earnings

18.5% 115% 88%

Price to book 3.3 126% 140%

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TO BE CONTD..

Buildco Industry TSE 300(actual)

1 Year Earnings Growth -30.50% 5.8% 6.4%

1 Year Stock Return 2.20% 12.8% 21.1%

5 Year Earnings Growth 425% 172.0% 226%

5 Year Stock Return 185% 88.5% 180%

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THANK YOU