Tutorial 5 Forecasting Share Price Movements

Question 2
A funds manager is considering investment opportunities in
China, Hong Kong and Japan. Data indicate the rate of economic
growth over the past year as:

China 9.5%
Hong Kong 5.75%
Japan 2.25%

Based on these data, the funds manager concludes that the

significantly stronger economic growth in China represents much
higher potential investment returns in the form of capital growth
on share investments. Critically analyse this conclusion.

Firstly, the data is historic, so an investor needs to recognise that future

performance may be different.

China is a large exporter to major international economies. There is a

need to consider the impact of lower economic growth in USA and Europe
on future export growth in China.

There is a need to consider the various sources of the economic growth in

these countries. The growth may be driven by increased consumer
demand or by a surge in business investment in capital equipment.

Stronger economic growth should be expected to improve the

performance of companies contributing to that growth, however there is a
need to ascertain whether high economic growth is sustainable.
Unsustainable growth over the medium-to-longer term may have
significant negative impacts, including:

A deterioration in the balance of payments current account

An increase in inflationary pressures
Upward pressure on wages
An eventual depreciation of the exchange rate
A rise in interest rates
An inevitable downturn in economic activity and the business cycle

The investor needs to consider the impact of the higher economic

performance on relative exchange rates.

Essentially, the investor needs to know what is driving the economic

growth and whether it is sustainable.

Question 3
The board of directors of BHP Billiton Limited is concerned about
changes in the exchange rate between the Australian dollar and
the US dollar. Analyse this situation and discuss the main impacts
a change in exchange rates might have on the performance of
BHP Billiton Limited and its share price.

A corporation, such as BHP Billiton, that is an importer or exporter of

goods or services will usually enter into contracts denominated in a
foreign currency If export contracts are price in USD, the level of
profitability could be affected by foreign exchange risk

An appreciation of the exchange rate of a local currency against the USD

will result in lower profits from increased export sales than if the change
rate had remained constant. This occurs because the exporter will need to
convert its USD income back into the local currency at the higher
exchange rate.

A depreciation of the local currency will increase the profits on existing

contracts. Also, it will lower the relative cost of exports and thus make
them more price competitive, with the potential for increased sales. A
depreciation in the local currency will, over time, push up the price of
imports, and therefore add to the cost of living and put upward pressure
on the rate of inflation. The flow-on effects of the currency change may
result in the workforce seeking to maintain its standard of living by
demanding wages increases, thus pushing up business costs.

The central bank may attempt to dampen the inflationary impact of the
weakening currency by tightening monetary policy through an increase in
short-term interest rates. Increased interest rates, which resulted from
exchange rate movements, will slow economic growth. Future profits
would be squeezed from both increased costs and higher interest rates.

Question 5
Evans and Partners is an investment advisory firm that provides
specialist investment advice to its private clients. As part of the
investment decision process, the senior investment analysts firm
apply the bottom-up approach to the fundamental analysis of
share prices. This approach focuses on the analysis of accounting
ratios and other performance measures.

a) Explain why Evans and Partners will use this type of

analysis.

Evans and Partners will use the fundamental analysis bottom-up approach
to consider micro facts that indicate a firms financial, operational and
management performance. The approach focuses on accounting ratios
and other measures of a firms performance.

Accounting ratios are measures of a companys financial and management

performance, strength and efficiency. An investor will calculate and
compare the ratios of companies in the same industry and consider
selecting the shares of companies with the strongest ratios for inclusion in
an investment portfolio.
An investor should consider the bottom-up approach within the context of
the top-down approach.

b) Identify and discuss six different accounting ratios that

should be included in a bottom-up approach model.

The size different accounting rations that should be included in a bottom-

up approach model are:

Current ratio the ratio of current assets to current liabilities

Liquid ratio the ratio of current assets, less inventory, to current
liabilities, less bank overdraft
Interest cover ratio the number of times a firms financial
commitments are covered by earnings
Earnings before income tax (EBIT) to total funds ratio the profits of
a firm before allowing for interest expense and tax payments
divided by shareholders funds and borrowings
EBIT to long-term funds ratio the EBIT divided by total funds less
short-term debt
Return on equity the net income of a firm divided by shareholders
funds
c) Identify and discuss three other performance measures that
may be used.

Three other performance measures that may be used are:

Earnings per share (EPS) earnings attributable to an ordinary share

Price earnings ratio the current share price divided by the EPS
Price to net tangible assets ratio the current share price relative to
the firms net tangible assets

Question 7
An investor is evaluating the use of the bottom-up approach and
the top-down approach to fundamental analysis. The investor
wants to use the approach that will best enable them to structure
a diversified share portfolio that will achieve specified income
returns and capital gains. Which approach do you recommend the
investor adopt?

Fundamental analysis requires the adoption of both the top-down

approach and the bottom-up approach.

The top-down approach analyses macro variables including:

The rate of growth of major international economies

The rate of growth of the economy
The exchange rate between a domestic currency and the currencies
of major trading partners and competitors
Internet rate movements
 Developments in the current account of the balance of payments
Price rises, as measured by the rate of inflation
The rate of growth in wages and productivity
Government policy responses to developments in the above
variables

The bottom-up approach considers factors that reflect or will impact upon
the performance of individual corporations and their price, including:

Accounting ratios, typically over the past 3 to 5 years

A comparison of the performance indicators with other similar firms
in the same industry
Intelligence on changes in key management positions
Information on the corporate mission, corporate governance and
planned strategic directions of the company into the future

The top-down approach identifies economies and industries that may

provide profitable investment opportunities in the future, while the
bottom-up approach identifies specific corporations with the preferred
economies and industry sectors that may represent stocks to incorporate
in an investment portfolio. Both approaches should be used together.

Question 8
After graduating from university, you obtain a position as a junior
journalist with a local newspaper. A number of readers have made
requests for information about technical analysis. You know that
technical analysis seeks to forecast and explain share price and
share-market movements. In conceptual terms, write a short
article for the newspaper that explains how the technical analysis
approach to share price forecasting operates.

Technical analysis explains and forecasts movements in share prices on

the basis of the past behaviour of prices.

One underlying assumption of technical analysis is that markets are

dominated at certain times by a mass psychology, and that over time
regular patterns in share price movements are evident. As a share price
pattern begins to emerge, it is assumed that the historic pattern will re-
emerge in full; that is, the full pattern will unfold this time as it did in the
past. An emerging share price pattern formation is taken as being a
pointer to the path of the future share price series.

Chart patterns may be used to signal the timing of the adjustment in stock
prices and market trends. One of the major claims made by some
technical analysts is that they can pick the timing of market turning
points.
Question 13
The random walk hypothesis is analogous to the Brownian motion
model of physics, which describes how microscopic particles
bombarded by water molecules, for example, trace a random
haphazard pattern over time. Outline the main features of the
random walk model and discuss the appropriateness of the
analysis between share price movements and the random
movements of physical particles.

The random walk hypothesis contends that each observation in a time or

price series such as share prices is independent of the previous
observation. That is, the path of a series of share prices is random and
unpredictable. If the price of a share rises in one period, there is an equal
probability that in subsequent period, the price may rise, fall or remain
unchanged.

Each share is assumed to have an intrinsic value that is based on

investors expectations about the present value of the firms future net
cash flows. The price of the share reflects investors estimation of the
shares intrinsic value, and is based on the latest information available
and relevant to the companys current state and its future prospections.
Variations in the price of the share through time should only be in
response to changes in the relevant information that comes to the
attention of the market concerning the company.

Therefore, it is appropriate to state that the random walk hypothesis is

analogous to the Brownian motion model of physics.

Question 14
a) Briefly outline the main contentions of the efficient market
hypothesis. In your answer, discuss the contentions of the
efficient market hypothesis within the context of technical
analysis and fundamental analysis.

The efficient market hypothesis contends that markets are information-

efficient if share prices adjust virtually instantaneously to new information.
If this is the case, it should not be possible for an investor to make
abnormal profits through having superior information to that of the rest of
the market.

The efficient market hypothesis also denies that there is a chance of

making superior profits from employing the techniques of technical
analysis, since these techniques rely almost totally on the assumption that
past price patterns will repeat themselves.

The hypothesis also argues that employing fundamental analysis to share

valuation will not yield superior results for one investor or another. This is
because all of the information required in either approach should be
available to all market participants. However, there would seem to be an
obvious disparity between the ability of analysts to understand, evaluate
and interpret information that comes into the market. Further, there are a
large number of listed companies all generating, or impacted by, new
information and therefore it is not possible for all market analysts and
investors to absorb and act upon that information immediately.

b) How can the hypothesis be tested? In your response,

distinguish between the weak, semi-strong and strong forms
of efficiency.

The strength of the efficient market hypothesis is related to the level of

efficiency of the markets; that is, how quickly information is absorbed by
the market and reflected in the share price.

The weak form efficiency version of the hypothesis suggests that

successive changes in the price of shares are independent of one another.

The semi-strong form efficiency of the hypothesis contends that all

publicly available information regarding a company is fully reflected in the
price of a share.
The strong form efficiency of the hypothesis sates that all information,
including that which is publicly available and that which is available only
through private inquiries and research, will be reflected fully in the market
price of a share.

Question 15
Behavioural finance has gained in popularity as an alternative to
the efficient market hypothesis. With reference to the types of
decision-making behavioural finance attempts to incorporate into
its models of investor behaviour, explore the reasons for the
growing popularity of behavioural finance and prospect theory
relative to the orthodox expected utility model.
Behavioural finance attempts to extend our understanding of investor
behaviour, based on psychological principles of decision marking. The
focus of behavioural finance is to identify and recognise the importance of
cognitive factors that may shape investor behaviour and lead to a
divergence between actual share price and those that would be expected
to prevail in an efficient market.

The orthodox model of rational choice of expected utility states that

choice under risk and uncertainty can be depicted in terms of the
maximisation of an expected utility function. This implies that when
confronted with risky opportunities, people assess their opportunities and
make a choice by assessing the outcomes that are likely to be associated
with each opportunity and the probability that the outcome will occur. The
weight that each possible outcome has on the persons decision-making
process is its probability of occurrence.

The prospect theory depicts the decision maker as assessing different

risky opportunities or prospects on the basis of prospect value. The
decision maker assesses the value of each prospect and chooses the one
with the highest value.