Advance Business Finance

10 Pages   |   2,294 Words
Table of Contents
Introduction. 2
Efficient Market Hypothesis. 2
Problems with Efficient Market Hypothesis. 2
Information Asymmetry. 3
Rational Behavior. 3
Investment Techniques. 3
Technical Analysis Portfolio. 3
Fundamental Analysis Portfolio. 4
I.       Risk Tolerance. 5
II.      Analysis of the Companies. 5
III.         P/E Ratio. 5
IV.         Revenue and Earnings Growth. 5
Assumptions. 6
Findings. 6
Conclusion. 7
References. 8
 
 

Introduction

The purpose of the assignment is to check the veracity of the claims of Efficient Market Hypothesis. A notional amount of 100,000 GBP will be divided equally between two portfolios in equal sizes. One portfolio of stocks will be selected through fundamental analysis while the other portfolio will be selected through technical analysis. 50,000 GBP will be invested in each portfolio and stocks selected through both technical and fundamental analysis will be traded for four months. At the end of four months investment period, investment returns from both the portfolios will be compared to each other and the market return. Efficient market hypothesis claims that stocks selected through both fundamental analysis and technical analysis cannot beat the market return. Therefore, if efficient market hypothesis holds practically, returns from both the fundamental portfolio and technical portfolio should be less than the market return.
 

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Efficient Market Hypothesis (EMH)

Efficient market hypothesis states that the stocks trade at their true intrinsic value and it is not possible for investors to beat the market by buying stocks that are undervalued and sell stocks that are overvalued. One of the most important assumptions underlying the theory is that investors are rational, and their decisions are not affected by behavioral biases. Citing this highly unrealistic assumption, majority of the critics has declared the theory to be ineffective and impractical. Efficient market hypothesis also assumes that there are no trading costs associated with buying and selling of shares; there is no information asymmetry among investors and cost of credit is the same for all investors. Although all the theories have some underlying unrealistic assumptions but almost all the assumptions and claims of efficient market hypothesis have been challenged by the experts.
In reality, most of the postulates of efficient market hypothesis seem unrealistic, at least in the short run (Balenovich, 2003, pp. 1-17). This is because efficient market hypothesis seems too simplistic to be applied 100% in practical life due to some unrealistic underlying assumptions.

Problems with Efficient Market Hypothesis

Although a lot of questions have been raised on the credibility of EMH, following two are most controversial assumptions underlying the theory.

Information Asymmetry

EMH states that there is no cost associated with acquiring new information and all the new information is readily available to all the investors without any discrimination (Connie, 2008, pp. 1-65). Even for semi-strong EMH, this postulate of EMH has to hold true. However, in reality it is quite obvious that new information that is pertinent to investment decisions is most of the times costly, depending upon the quality of the information.

Rational Behavior

EMH states that all investors respond to the same situation in a same way because all the investors in the market are rational. In the recent past, there has been a lot of debate about behavioral finance, and it has been agreed upon by most of the experts that decisions taken by human beings vary from person to person based on their behavioral aspects (Hsu, 2007, pp. 6-23). So, the claims of efficient market hypothesis regarding the rationality of all investors are quite inaccurate (Oberlechner, 2011, pp. 25-55).

Investment Techniques

The two techniques used for selecting stocks for the notional investment are the following:

Technical Analysis Portfolio

The prediction or estimation of future prices using historical data of share prices for a particular company can be called as stock selection through technical analysis. Although, technical analysis has not been hailed as an accurate method for estimating stock prices, the method has been used extensively by financial experts all over the world (Penman, 2001, pp. 109-154). Although, technical analysis has failed to accurately predict the future movements of stock market, it does provide some indication of price movements in future. Theoretically, it is impossible to earn above average returns using solely technical analysis if efficient market is assumed to be true (Oberlechner, 2011, pp. 25-55).
Selection of stocks for investment in technical analysis portfolio was done based on historical prices. Historical returns of stocks for different companies listed on FTSE-100 index were computed, and companies with significant positive returns were shortlisted because in technical analysis, it is assumed that past return data provides an indication for future return data. In order to keep the analysis simple, it was assumed that all the shares were held by the investor for full four months period and then sold in the end. Based on technical analysis, following ten companies were selected for the purpose of investment in technical portfolio.
  • TUI Travel
Historical 8-months Return: 25.5%
  • Barclays
Historical 8-months Return: 6.03%
  • Vodafone
Historical 8-months Return: 4.43%
  • Unilever
Historical 8-months Return: 6.31%
  • Prudential Plc
Historical 8-months Return: 21.75%
  • SABMILLER plc
Historical 8-months Return: 20.80%
  • Schroders
Historical 8-months Return: 7.09%
  • Smiths Group
Historical 8-months Return: 12.63%
  • United Utilities Limited
Historical 8-months Return: 18.08%
  • Rexam
Historical 8-months Return: 20.58%

Fundamental Analysis Portfolio

In fundamental analysis, as opposed to technical analysis, the investor tries to find the intrinsic value of shares of a company by doing in depth study of all economic, financial, quantitative and qualitative aspects associated with the company being analyzed (Wang and Mamaysky, 2000, pp. 115-165). Basically, fundamental analysis deals with anything that can even remotely affect the stock price of a company (Sakr, 2012, pp. 117-123). Therefore, all factors affecting the share price of the company, ranging from macroeconomic factors to firm specific factors are studied in fundamental analysis of the company.
For the purpose of stock selection, following four aspects and criteria have to be kept in mind by the investor. The first one refers to technical analysis for stock selection while the last three are a part of fundamental analysis for stock selection.

I.Risk Tolerance

The purpose of the investment and stock selection is to beat the market rather than trying to maximize the turn. Therefore, those companies are selected for which demand of the products is quite inelastic because there is no need to take a lot of risk.

II.Analysis of the Companies

All the factors that are relevant to the stock price movement of the companies should be taken into account. So, in addition to historical price data, industry practices and all firm specific factors were also considered.

III.P/E Ratio

P/E ratio gives an indication of the growth potential of the near future. A higher P/E ratio corresponds to a higher growth in the earnings of the company. For fundamental analysis portfolio, only the companies with reasonably high P/E ratios were selected. P/E ratio analysis is a very important tool for selecting undervalued stocks and rejecting overvalued (Yingzi, 2009, pp. 519-544).

IV.Revenue and Earnings Growth

Past financial statement data and quarterly reports were used for all the companies to check the growth of revenue and earnings in the past. Revenue and earnings growth gives an indication to profitability potential of the company in the near future (Spanos and Pittis, 2001, pp. 187-220).
For the purpose of this assignment, following ten companies were selected from FTSE all share index for investing approximately 50,000 GBP in fundamental analysis portfolio.
  1. Lloylds Banking Group
  2. Aberdeen Asset Management
  3. Anglo American
  4. Standard Life
  5. Royal Bank of Scotland
  6. Shire
  7. Tullow Oil
  8. Rio Tinto
  9. Xstrata
  10. Anglo American

Assumptions

Since this is a notional investment and not a real empirical test for Efficient Market Hypothesis, a lot of simplifying assumptions have to be made. Some of the most important assumptions are as follows:
  • Companies for both portfolios, fundamental and technical, have been selected from the list of FTSE 100. In order to make the outcome of the analysis realistic, real stock return values for all the companies have been used instead of using estimates for future returns. Four months return data, from 1st September 2012 to 31st December 2012, has been used for all the companies in both the portfolios. However, criteria for the selection of companies in both the portfolios were completely different.
  • In order to keep the analysis simple, no share was bought or sold during the for four months investment horizon. Shares are assumed to be bought on 1st September 2012 at the prevalent price and then later on sold on 31st December 2012 on current price.
  • Closing prices have been used for stocks of all the companies. These prices are adjusted for stock splits and dividends.

Findings

The objective of the notional investment analysis was to do an empirical test to check the practicality of the claims of efficient market hypothesis. Efficient market hypothesis states that it is futile to expend resources for stock selection through fundamental analysis and technical analysis because all investors are rational and all the new information relevant to the investment is readily captured by the market and is reflected quickly in the share price. Therefore, it is impossible to beat the market through stock selection. However, the results of the analysis completely contradict all forms of efficient market hypothesis in the short run. The value of FTSE-100 index at the start of the investment horizon is 2996.54 GBP. After four months, at the end of the investment horizon, FTSE index value increases by a 3.13% to a 100 index value of 3093.41 GBP. For efficient market hypothesis to hold, returns for both the portfolios should be less than the return provided by the market index; hence, investment in market index should be the best option available to the investor. Practically this is not the case due to all the problems with the assumptions of EMH discussed above. Data in the spreadsheet shows that Technical analysis portfolio has given a return of 8.531% during the four months investment period. This corresponds to a 5.4% premium over the market. After deducting broker’s commission and stamp duty, the investor had invested 49,800 GBP in the technical analysis portfolio for four months. At the end of the investment period, the investment had grown to 54,048 GBP.
On the other hand, portfolio of ten companies selected through fundamental analysis has shown even more impressive result. The portfolio has shown a return of 15.832% for the four month investment period. Stocks for all ten companies were bought at the start of the investment period and then later on at the end of the investment period; all the shares were sold in the market at prevailing prices. At the start of the investment period, investor had invested approximately 49,800 GBP in the fundamental analysis portfolio. At the end of the investment period, the investment had grown by 15.832% to 57,684 GBP. Therefore, returns of both the portfolios were greater than the market return; hence it has been proved that it is possible to beat the market through careful stock selection.
When stock return data for both Technical and Fundamental Analysis are compared with each other, it can be seen that the performance of fundamental analysis portfolio is far better than that of technical analysis portfolio. This makes sense because a greater effort was done to select stocks of fundamental analysis portfolio and it involved a more costly and in-depth analysis of the companies being considered for the investment. On the other hand, stock selection for technical analysis was done on the basis of trends predicted by the historical prices.

Conclusion

Even though the findings of this analysis contradict in all the three forms of efficient market hypothesis, the theory in itself cannot e rejected completely because the investment was done just for four months period. Based on the results of this assignment, it can be safely said that efficient market hypothesis does not hold in the short term. A lot of evidence in support of efficient market hypothesis has been provided by the proponents of EMH to support their claim that strong form of EMH does hold in the long run. The results of the notional investment of 100,000 GBP cannot be used to reject these claims because the investment horizon was a very short i.e. four months.

References

Balenovich, D . (2003). A Theoretical Foundation for Technical Analysis. Journal of Technical Analysis. 3 (4), 1-17.
Connie, B. (2008). The Boundaries of Technical Analysis. Journal of Technical Analysis. 65 (3), 1-65.
Hsu, P. (2007). Testing the Predictive Ability of Technical Analysis Using A New Stepwise Test Without Data Snooping Bias. Journal of Finance. 3 (4), 6-23.
Oberlechner, T. (2011).Importance of Technical and Fundamental Analysis in the European Foreign Exchange Market. International Journal of Finance and Economics. 92 (4), 25-55.
Penman, S. (2001).Ratio Analysis and Equity Valuation; From Research to Practice. Review of Accounting Studies. 12 (6), 109-154.
Sakr, S. (2012). The Predictive Power of Fundamental Analysis in Terms of Stock Return and Future Profitability Performance in Egyptian Stock Market: Empirical Study. International Research Journal of Finance and Economics. 92 (4), 117-123.
Spanos, A and Pittis, N. (2001).On Modelling Speculative Prices: The Empirical Literature. Journal of Economic Surveys. 15 (2), 187-220.
Wang, J and Mamaysky, H. (2000). Foundations of Technical Analysis: Computational Algorithms, Statistical Inference, and Empirical Implementation. The Journal of Finance. 6 (4), 115-165.
Yingzi, z. (2009). Technical Analysis: An Asset Allocation Perspective on the Use of Moving Averages. Journal of Financial Economics. 10 (2), 519-544.

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