Types of Analysing Techniques Used by Financial Advisers in Evaluating Securities - Essay Example

Stock Trading Contents Introduction---------------------------------------------------------------------------------3 2. Fundamental analysis---------------------------------------------------------------------3 2.1 Selection of securities-------------------------------------------------------------------4 2.2 Illustration on results--------------------------------------------------------------------5 3. Technical analysis-------------------------------------------------------------------------6 3.1 Selection of securities-------------------------------------------------------------------6 3.2 Illustration on results--------------------------------------------------------------------7 4. Reflection on analysis--------------------------------------------------------------------7 5. Conclusion---------------------------------------------------------------------------------8 6. References----------------------------------------------------------------------------------9 7. Appendices---------------------------------------------------------------------------------10 1. Introduction Stock market is to provide investors platform in selecting different investment tools, thus assessing risk and return for each security is crucial for financial advisers. According to Brealey (2003), stock market generally follows a “random walk” movement, where security price cannot be predicted. And base on this fact, the developed efficient-market hypothesis argued that in an efficient market, no one can make gain on buying and selling stocks in a predictable way. (Brealey, 2003) However, there is hardly any stock market has been classified as efficient market. UK stock market has been widely recognised as semi-strong efficient market, where security price can be predicted by using historical information and growing trend. Therefore, this makes financial adviser useful in advising investors to invest certain portfolio aimed on making gain. There are generally two types of analysing techniques used by financial advisers in evaluating securities, which are commonly known as: fundamental analysis and technical analysis. By evaluating two sets of security portfolios, this study is to assess the usefulness and accuracy of these two types of evaluation tools. However, due to lack of analysing experience and information limitation, this study might not be able to provide the most comprehensive mechanism of these two analysing tools. But reflection shall be given to illustrate the usefulness and limitations of these two methods by assessing the results of two portfolios. 2. Fundamental analysis Fundamental analysis is widely known as the technique that analyses a company’s operational performance figures such as revenue, profitability, growth trend etc. According to Grahame (2008), fundamental analysis involves analysing a firm’s financial statements, health of its operation, market competition, industrial climate, and the macro-economy performance. (Grahame and Dodd, 2008) Grahame and Dodd (2008) have summarised fundamental analysis into three levels: Economic level, industry level, and company level. And based on these different levels of conditions, the following part will illustrate how these securities have been selected, and their overall performance deduced as a result of fundamental analysis based selection. 2.1 Selection of securities First of all, the economic condition in the UK started showing that the UK’s economy is recovering during the year 2014, despite the summer decline in the retail sector. According to Financial Time’s trend analysis (Figure 1), UK’s retail sale volume is growing rapidly in the year 2014, despite some fluctuations. Overall, the growing trend is quite positive for the year 2015. That is why most securities in the fundamental portfolio were from retail industry, such as Sainsbury, ASOS, Ted baker, William Hill, Next, and JD Sports. Due to the rise of online retailing, Royal Mail is also considered to be on a growing trend with regards to the retail industry. Furthermore, due to the holiday season expected in due course of the year, the hospitality industry is also predicted to be among growth leaders such as Easy Jet and Whitbread. Therefore, this portfolio was mainly formed by the retail and hospitality industry where the consumers’ purchasing power can directly be reflected. Figure 1 UK retail sales volumes Adapted from (FT, 2014) Having stated the economy and industry level by selecting these firms, company related factors, which are the most important indicators were taken into consideration. The core performance indicators in a company reflect on their past five years’ revenue, profitability, and dividend policies. Having assessed the overall economic and industrial conditions, the companies’ economic performance have also been carefully assessed. As it can be seen from appendix 1 – 10, the key indicators that were taken into consideration are: Revenue, profitability, and dividend policy trends in the last five years. All the selected companies have been steadfast and performed positively in the last five years. Therefore, it can be deduced that the securities of these companies will reflect their performance. However, it can be noted that the three months investment is still quite limited in making gains from these securities, as fundamental analysis aimed at making gains for a longer term. 2.2 Illustration on results Aimed at minimizing transaction costs, the one-off buying strategy was applied, which involved purchasing all securities on 16-Oct-2014, and selling them on 16-Jan-2015, thus maximizing time efficiency. Having invested in the fundamental portfolio for the last three months, results have shown that the investment outcome was extremely good. Having gained net 5954 GBP by investing 50033 GBP, the return was calculated to be 11.9%. Most securities have grown except the only non-retail and non-hospitality related company – Rolls-Royce. The top 3 growth leaders are ASOS (40.7%), Ted Baker (20.8%), and Whitbread (16.7%). The fascinating return rate from this portfolio has significantly proven that the usefulness of using fundamental analysis as an important analysing tool in stock analysis. However, having examined the security prices of these ten companies in the past five years; it was noted that their prices were not always good during these steady and positive growing five years. If allowing the selection of the same portfolio in another time of the year, or same time in other years, results could be significantly different. Perhaps it was just the good time to buy in. Taking into consideration the technical analysis in these securities, most of them will not be selected due to poor prior performance. Therefore, the high return rate on this portfolio does not necessarily reflect their real growth during these three months. 3. Technical analysis Technical analysis is often considered to be a technique that makes investing decisions by taking a stock market’s historical performance. According to Murphy (1999), in a semi-strong efficient stock market, security prices can be predicted according to their trends. There are many theories and methodologies that can be used to explain such predictable movements in stock market, such as return reversal theory and momentum theory. (Murphy, 1999) Due to the limitation of length in this study, these two theories are the only theories applied and explained in technical analysis. Many authors such as De Bondt and Thaler (1985) believe that “Shares that had given the worst returns over a three-year period out-performed the market by an average of 19.6 percent in the next 36 months.” (De Bondt and Thaler, 1984) This is the return reversal theory, which indicates that a share price which has been under-valued for long term will be back on track after certain period. A quite opposite theory called momentum theory indicates that shares that constantly grow will carry on growth for a certain period of time. According to Jegadeesh and Titman (1993), “Selects shares on their past six-month returns and holds them for six months, realises a compounded return above the market of 12.01 per cent per year on average”. (Jegadeesh and Titman, 1993). This theory explains why a security’s constant growth in the past shall deliver positive return in the following year. Based on these two theories, the following part will explain how the technical portfolio has been selected and how it generates return. 3.1 Selection of securities Regardless of the industry or company’s performance, all ten securities in the technical portfolio have been selected according to their price trend previews. To illustrate the usefulness of return reversal theory, Debenhams, Diageo and GSK have been selected due to their relatively poor performance. The length of the poor performance varies from one to another, without entirely meeting the “three years worst return.” These three securities have all performed badly around the last two years. On the other hand, Domino’s, Cranswick, Easy Jet, National Grid, Royal Bank of Scotland, and Unilever have been selected to assess the usefulness of momentum theory. According to these securities’ preview market performance, they have more or less achieved constant growth in the last two years. 3.2 Illustration on results Having invested in these ten securities for two months since November 2014, the returns do not seem to be impressive. According to the total net gain of 407 GBP out of 49981 GBP, the return rate is only at 0.8%. Cranswick, GSK, National Grid, and Royal Bank of Scotland have negative return, while the highest growth leader, Unilever, only achieved 7.2% growth. Overall, the technical portfolio has only achieved a 0.8% return rate. Results have proven that neither the return reversal theory nor momentum theory can effectively explain the mechanism of stock growth in technical analysis. 4. Reflection on analysis By utilising both fundamental and technical analysis methodologies, the selected two portfolios with twenty securities have generated an overall return of 6.35%. Within two portfolios, fundamental portfolio has out-formed technical portfolio significantly. From a writer’s point of view, both fundamental and technical analysis methods have their limitations, regardless of their poor or outstanding performance during these three months. Learning can be summarized into the following categories: 1. Fundamental analysis lacks vision on security’s true market performance, such as over-valued, under-valued or short-selling activities. Despite this, the method has explained how cash is generated from a company’s healthy running. Security pricing does not only reflect the publicly available information such as performance, but it may also reflect other information such as insider trading activities. 2. Technical analysis lacks consideration of a company’s true performance, such as cash generation ability and dividends policy. While some securities are growth led securities, and others might be dividend led securities, where investors rely on these securities heavily on their attractive dividends. As a result, dividend’s date shall impact significantly on security price. 3. A three-month investment period is too short to carry out a methodology assessment on fundamental and technical analysis methods. The return rate could be different if extra time is given. Since the selling date of 16-Jan-2015, some securities in the portfolios have already started completely reverse movement. 4. Combing Fundamental and Technical analysis methods would generate smoother and better outcomes. However, this does not mean that the combined analysis portfolio will definitely beat the portfolio return in this study, as the stock market is generally following a random walk. 5. Conclusion Having analysed both portfolios, writer found that neither fundamental nor technical analysis can provide constant better return for long run, despite fundamental portfolio has significantly beaten the technical portfolio. The finding of this study is that fundamental and technical analysis methods can be complementary methods to each other to provide a more comprehensive vision of the selected security. The return reversal and momentum theory are not proven to be work efficiently in this study might due to the limited length of holding period (only two months) of security. Nevertheless, the stock market is too large to be manipulated or predicted without professional information, thus some theories can be only well used by professional and experienced financial advisers. Although there are a few internationally recognised well performed stock trader/investor such as Warren Buffett and George Soros, writer still believe that without unique information from professional source, ordinary investors cannot simply beat the market by using fundamental or technical analysis techniques, which has illustrated the market random walk theory. 6. References Brealey M., (2003), Corporate Financing and the six lessons of market efficiency, The McGraw-Hill De Bondt W. F. M., and Thaler R., (1984), Does the Stock Market Overreact? The Journal of Finance, Vol. 40, No. 3 FT, (2014), UK economy, http://www.ft.com/cms/s/0/b5e05af2-5a90-11e4-b449-00144feab7de.html#axzz3PHCXOqRO Retrieved on 17/01/2015 Grahame B., Dodd D., (2008), Security analysis, 6th Edition, McGraw-Hill Jegadeesh N., and Titman S., (1993), Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency: Implications for Stock Market Efficiency, The Journal of Finance, Vol. 48, No. 1 Murphy J., (1999), Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications, New York Institute of Finance 7. Appendices Appendix 1 Fundamental figures of Easy Jet Appendix 2 Fundamental figures of Whitbread Appendix 3 Fundamental figures of Sainsbury Appendix 4 Fundamental figures of Rolls-Royce Appendix 5 Fundamental figures of ASOS Appendix 6 Fundamental figures of Royal Mail Appendix 7 Fundamental figures of Ted Baker Appendix 8 Fundamental figures of William Hill Appendix 9 Fundamental figures of Next Appendix 10 Fundamental figures of JD Sports Appendix 11 Technical chart of Associated British Food Appendix 12 Technical chart of Cranswick Appendix 13 Technical chart of Debenhams Appendix 14 Technical chart of Diageo Appendix 15 Technical chart of Dominos Pizza Appendix 16 Technical chart of Easy Jet Appendix 17 Technical chart of GlaxoSmithKline Appendix 18 Technical chart of National Grid Appendix 19 Technical chart of Royal Bank of Scotland Appendix 20 Technical chart of Unilever (All appendices were adapted from London Stock Exchange website) Read More