Security Analysis - Does it Matter?
Wall Street has scores of analysts, strategists and portfolio managers hired to do one thing: beat the market. Analysts are hired to find undervalued stocks. Strategists are hired to predict the direction of the market and various sectors. Portfolio managers are hired to put it all together and outperform their benchmark, usually measured as the S&P 500. Granted, there are many studies and disputes raging on the performance of equity mutual funds, but it is safe to assume that about 75% of equity mutual funds underperform the S&P 500. With these kinds of stats, individual investors would surely be better off simply investing in an index fund rather than attempting to beat the market. But that wouldn't be any fun, would it? After all, half the fun is actually doing the analysis.
The added value of analysis is in the eye of the beholder. A fundamental analyst believes that analyzing strategy, management, product, financial stats and many other readily and not-so-readily quantifiable numbers will help choose stocks that will outperform the market. They are also likely to believe that there is little or no value in analyzing past prices and that technical analysts would be better off star gazing. Star gazing! Hmmmmph. The technical analyst believes that the chart, volume, momentum and an array of funny and not-so-funny indicators hold the keys to superior performance. In addition, the technician might add that fundamentals are hogwash pure and simple. There is good news though. The battle between fundamental analysis and technical analysis has been settled by the Random Walk theory. The Random Walkers (no relation to Jeff Walker of the Walker Market Letter!) believe that both are useless as is any attempt to try and outwit the market.
So whom do we believe? Is fundamental analysis worth the time and effort? Are technicians a bunch of quacks? Or is it all a lesson in futility? First, it will help to look at the efficient market hypothesis and see where the fundamentalists, technicians and Random Walkers stand on the question of market efficiency. After we have explored this area, we will then take a closer look at the random walk theory, fundamental analysis and technical analysis.

Are Markets Efficient?
The question concerning the value of analysis begins with the debate on market efficiency. Just what is represented by the current price of a security? Is a security's current price an accurate reflection of its fair value? Or, do anomalies exist that allow traders and investors the opportunity to beat the market by finding undervalued or overvalued securities?




Aswath Damodaran, of the Stern Business School at NYU, defines an efficient market as one where the market price is an unbiased estimate of the true value of the investment. Fair enough, but it is not quite that simple. In an efficient market, the current price of a security fully reflects all available information and is the fair value. "All" because the price is the sum value of all views (bullish, bearish or otherwise) held by market participants. It is the fair value because the market agreed on a price to buy and sell the security. As new information becomes available, the market assimilates the information by adjusting the security's price up (buying) and down (selling). In an efficient market, deviations above and below fair value are possible, but these deviations are considered to be random. Over the long run, the price should accurately reflect fair value.
The hypothesis further asserts that if markets are efficient, then it should be virtually impossible to outperform the market on a sustained basis. Even though deviations will occur and there will be periods when securities are over- or undervalued, these anomalies will disappear as quickly as they appeared, thus making it almost impossible to profit from them.
From experience, most of us would agree that the market is not perfectly efficient. Anomalies do exist and there are investors and traders that outperform the market. Therefore, there are varying degrees of market efficiency, which have been broken down into three levels. These three levels also happen to correspond to the beliefs of the fundamentalists, technicians and random walkers.

Strong-form: Technicians
The strong-form of market efficiency theorizes that the current price reflects all information available. It does not matter if this information is available to the public or privy to top management; if it exists at all, then it is already reflected in the current price. Because all possible information is already reflected in the price, investors and traders will not be able to find or exploit inefficiencies based on fundamental information. Generally, pure technical analysts believe that the markets are strong-form efficient and all information is reflected in the price.

Semi-Strong Form: Random Walkers (academics)
The semi-strong form of market efficiency theorizes that the current price reflects all readily available information. This information will likely include annual reports, SEC filings, earnings reports, announcements and other relevant information that can be readily gathered. However, there is other information not readily available to the public that is not fully reflected in the price. This could be information held by insiders, competitors, contractors, suppliers or regulators, among others. Anomalies exist when information is withheld from the public and the only way to profit is by using information not yet known to the public. This is sometimes called insider trading. Once this information becomes public knowledge, prices adjust instantaneously and it is virtually impossible to profit from such news. Academics and Random Walkers believe that the markets are semi-strong efficient. Prices reflect public information and it is virtually impossible to profit from this information.
Why do academics believe it is not possible to profit from efficient markets? There is an old joke among economists that relates to market efficiency. Two economists are walking down the street and one spots a $20 bill lying on the ground. He turns to the other economist and says, "Look, a $20 bill". The other economist looks at him in disbelief and answers, "If it were a real $20 bill, someone would have already picked it up". Academics feel that if a security is selling for 10 and one year from now it will be worth 20, what is to keep it from going to 20, or at least 18 immediately? If it were really worth 20 in one year, the price would reflect this today.

Weak-form: Fundamentalists
The weak-form of market efficiency theorizes that the current price does not reflect fair value and is only a reflection of past prices. Furthermore, the future price cannot be determined using past or current prices (sorry technical analysts). Fundamental analysts are champions of weak-form market efficiency and believe that the true value of a security can be ascertained through financial models using information readily available. The current price will not always reflect fair value and these models will help identify anomalies.

Which Form Exists in the Market Today?
Many in academia, including Gordon Gemmill of London City University Business School and Aswath Damodaran of NYU, believe that security prices are semi-strong efficient. Recall that semi-strong efficient implies that all public knowledge is reflected in the price and it is virtually impossible to exploit deviations from the true value based on public information. Only new information will affect the price. Judging from the reaction of many stocks to news events, there seems to be evidence to support this case. The flow of information has become faster with the internet and surprises are factored in instantly. Few will argue that a surprise, both positive and negative, can violently move the price of a security. A few examples include:

- After pre-announcing that earnings would come in below expectations on 6-Jan-00, Lucent fell from 73 to 53 in one day.



- After positive comments from an influential analyst on 23-Feb-00, AOL shot up 49 to 59 in 2 days.



- After reporting earnings that were below expectations on 15-Feb, Abercrombie and Fitch fell from 24 to 15.



Even though these are but a few examples, it is obvious that new information can move the price of a security. Many academics also argue that price movements are largely random and only influenced by the introduction of new information. Many academics do acknowledge that some drift exists in security prices, but never a trend. Random, are prices really random?

A Random Walk

A Random Walk Down Wall Street, written by Burton Malkiel in 1973, has become a classic in investment literature. Random walk theory jibes with the semi-strong efficient hypothesis in its assertion that it is impossible to outperform the market on a consistent basis. Malkiel puts both technical analysis and fundamental analysis to the test and reasons that both are largely a waste of time. In fact, he goes to great lengths to show that there is no proof to suggest that either can consistently outperform the market. Any success outperforming the market with technical analysis or fundamental analysis can be attributed to lady luck. If enough people try, some are bound to outperform the market, but most are still likely to underperform.



The basic random walk premise is that price movements are totally random. Judging from the chart, the price movements of Nemont Mining over this 5-month period would appear to be quite random. Prices have no memory, therefore past and present prices cannot be used to predict future prices (as implied in technical analysis). Prices move at random and adjust to new information as it comes available. The adjustment to this new information is so fast that it is impossible to profit from it. Furthermore, news and events are also random and trying to predict these (fundamental analysis) is also a lesson in futility.
Malkiel maintains that a buy and hold strategy is best and individuals should not attempt to time (or beat) the market. Attempts based on technical, fundamental or any other analysis are futile. Admittedly, he does have a point. Statistics have shown that the majority of equity mutual funds fail to outperform the market, as measured by the S&P 500. Investors can easily buy index-based securities with very low transactions costs.

Should random walkers take a hike?
While there are some good points to be gleaned from the random walk theory, it appears to be a bit dated and does not accurately reflect the current investment climate.
Random walk theory was introduced over 25 years ago when institutions dominated the market. These institutions had superior access to resources and the individual was at the mercy of the large brokerage houses for quality research. With the advent of online trading, power and influence are shifting from the institutions to the individual. Resources are now widely available to all at minimal cost, if not free. Not only can individuals access information, but the internet ensures that everyone will receive it almost instantaneously. They also have access to real time data and can trade like the pros. With the availability of real time data and almost instant executions, individuals can act on information like never before.
As little as 5 years ago, transactions costs were high and figured into any investment or trading strategy. Again, with the advent of online trading, transactions costs have become minimal. This has increased the amount of trading volume and probably volatility. Higher volatility increases the possibility that anomalies will develop. With better trading resources and low commissions, more traders and investors than ever are able to capitalize on potential anomalies.
For obvious reasons, the Wall Street establishment is not thrilled about Random Walk theory. After all, Wall Street is in the business of analysis, strategy and money management. However, it is a fact that about 75% of equity mutual funds underperform the S&P 500 year after year. Some of this underperformance can be blamed on transactions cost and management fees. However, with the advent of index-linked securities, the onus will be on the money managers to figure out a way to outperform the market or lose business.
In truth, 75% of equity mutual funds underperforming is not as bad as it sounds. When the Random Walk theory was introduced in 1973, or even 15 years ago, around 90% of equity mutual funds underperformed the market. Since this number seems to have risen, it would appear that either stock picking is getting better or fees are getting smaller, or both. 15 years ago, the stock market and mutual funds were much more homogeneous. Even though there were tech stocks, they did not exert nearly as much influence. With the explosion of the Nasdaq, tech stocks play a much larger role in today's market. Internet stocks, which have also come to the forefront, did not even exist 15 years ago. With an increase in specialty mutual funds catering to tech and internet, the total number of mutual funds has proliferated over the last few years. With the increase in mutual funds has also come and increase in the diversity of such funds. There are funds for almost every sector, industry or index imaginable and investors have a wide array of choices. The more homogeneous mutual funds there are, the less chance there is to outperform. However, this specialization has created a hierarchy among mutual funds and helped to increase the percentage funds that outperform the S&P 500 from 10% to 25%.
History has proven that a buy and hold strategy outperforms most attempts to time the market in absolute returns. In risk-adjusted returns, the argument looses some of its credibility. Buy and hold may take the guesswork out of beating the market, but it does little to compensate for the risk associated with a continuous investment in the market. There is a direct correlation with risk and return: the higher the expected return, the higher the associated risk. A portfolio with a timing strategy that seeks to move into risk-free treasuries when a bear market is signaled (Dow Theory for example), significantly reduces the amount of risk associated with that portfolio.



The New York Times on 6-Sept-98, notes a study that was published in the Journal of Finance by Stephen Brown of New York University and William Goetzmann and Alok Kumar of Yale. The Dow theory system was tested against buy-and-hold for the period from 1929 to Sept-98. Over the 70-year period, the Dow theory system outperformed a buy-and-hold strategy by about 2% per year. In addition, the portfolio carried significantly less risk. If compared as risk-adjusted returns, the margin of outperformance would even be greater. Over the past 18 years, the Dow theory system has underperformed the market by about 2.6% per year. However, when adjusted for risk, the Dow theory system outperformed buy-and-hold over the past 18 years. Keep in mind that 18 years is not a long time in the history of the market.

A Non-Random Walk Down Wall Street
There is another school of thought that considers the markets efficient yet predictable. One of the leading proponents is Andrew Lo. Lo earned his Ph.D in economics at the University of Chicago and is currently a Professor of Finance at the Sloan School of Management at MIT. Lo is a bit of an odd ball among academics because of his beliefs regarding the efficient market hypothesis and his attraction to technical analysis. Lo and Mackinlay's book A Non-Random Walk Down Wall Street debunks many of the theories put forth in the 1973 classic with a similar name. (Remember that most academics subscribe to the random walk theory.) Lo's research concluded the following:



Financial markets are predictable to some degree, but far from being a symptom of inefficiency or irrationality, predictability is the oil that lubricates the gears of capitalism.

It is not only plausible that markets are efficient, but participants can also profit from efficient markets. However, Lo asserts that even though it is possible to outperform the markets, it requires ongoing research, continuous improvement and constant innovation. Beating the market does not come easy, nor is it something that is easy to maintain. Lo likens the pursuit of above-average returns to that of a company trying to maintain its competitive advantage. After introducing a hot new product, a company cannot just sit back and wait for the money to roll in. In order to remain above the competition, management must be flexible and look for ways to continuously improve and innovate. Otherwise the competition will overtake them. Money managers, traders and investors who find ways to outperform the market must also remain flexible and innovative. Just because a method works today, does not mean it will work tomorrow. In an interview with Technical Analysis of Stocks and Commodities, Lo sums it up by stating:
"The more creativity you bring to the investment process, the more rewarding it will be. The only way to maintain ongoing success, however, is to constantly innovate. That's much the same in all endeavors. The only way to continue making money, to continue growing and keeping your profit margins healthy, is to constantly come up with new ideas."

Conclusions

These rebuttals to random walk theory are not meant to suggest that the vast majority of individuals are going to suddenly start outperforming the market. Even though this may be true over the past 3 years, history suggests that it is not likely to be the case 10 years from now. In other words, history suggests that this is an anomaly and there will be a reversion to the mean. Nonetheless, the investment and trading landscape has changed drastically over the last 20 years, even over the last 5 years. Individuals have access to more information and tools, transactions costs are negligible, trades are executed almost instantaneously, equity mutual funds have improved their performance and the buy and hold strategy does not appear to be a profit maximizing strategy. It should come as no surprise that analysis can make a difference. The only question is which type: fundamental analysis, technical analysis or both?