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Industrial and Financial Economics Master Thesis No. 2002: 43 MUTUAL FUNDS AND CORPORATE STOCK SELECTION EMPIRICAL RESEARCH AMONG AUSTRIAN, BRITISH AND SWEDISH EQUITY FUND MANAGERS Armand Collins Fotsing Moube & Michael Franz Jannach Graduate Business School School of Economics and Commercial Laws Göteborg University ISSN X Printed by Elanders Novum AB Abstract The objective of this study is to identify the stock valuation and selection systems applied by European equity fund managers when selecting ordinary shares. It also includes examining the most significant micro and macroeconomic factors as well as economic indicators when investing in common shares. Additionally we present and review academic principles of corporate stock valuation and selection in order to provide background and tools helpful for prudent investment decision We conducted a survey among ten European equity fund managers across Austria, Great Britain and Sweden. The results indicate that no single stock valuation method is applied in isolation. The combination of available approaches is the option in use with respect to the fund objective. The most important factors or indicators when selecting ordinary shares are: the firm s financial situation, the shareholder value policy, the business climate index, the firm s expected earnings, the sales development and future demand trends. We also found evidence that qualitative business assessment is essential in corporate stock and firm valuation. Therefore, we argue that more efforts should be directed into this valuation area.. Key words: Corporate stock selection, corporate stock valuation, equity analysis, equity valuation, corporate stock investment, fund managers and stock analysis, investing in corporate stocks.. III Acknowledgements First we would like to thank our tutor, Professor Göran Bergendahl, for his academic assistance, and for challenging and helping us to bring our work to a higher academic level. We would also like to thank the management of PENS Investment, which has been a major part of inspiration and a great source of support.. We especially want to thank our respective families for their overall support; this thesis would not have been the same without them. Last but not least we extend our appreciation to those fund managers that have sacrificed their valuable time for interviews and questionnaires. Your time and knowledge have been of high value to us personally and for the completion of this study. Göteborg, the 8 th December 2002 Armand Collins Fotsing Moube Michael Jannach. IV Table of Contents. TABLE OF CONTENTS... V TABLES... VIII FIGURES...IX 1 INTRODUCTION BACKGROUND PROBLEM DISCUSSION PURPOSE OF THE STUDY POTENTIAL CONTRIBUTIONS OF THE STUDY SCOPE AND LIMITATIONS DATA AND METHODOLOGY RESEARCH APPROACH RESEARCH PROCEDURE DATA COLLECTION Data Collection Method Data Collection Process Choice of Respondents RESEARCH EVALUATION Validity Reliability INVESTING IN CORPORATE STOCKS CORPORATE STOCKS Equity and Business Funding Corporate Stock Live Cycle V 3.1.3 The Attractions and Risk of Stock Investment Why Have Shares Performed So Well ECONOMICS AND MARKET RATIONALITY Stock Market Efficiency DETERMINANTS OF CORPORATE STOCK RETURNS STOCK VALUATION AND ANALYSIS INVESTMENT STRATEGIES TECHNICAL ANALYSIS The Dow Theory Charts Trend Analysis Gaps Moving Averages Chart Formations Trend Acknowledgement Formations Other Technical Indicators Mood Indicators FUNDAMENTAL ANALYSIS Investment Approach, Technique, and Style The Process of Bottom Up Investment Financial Ratios Analysis Business Valuation Models Qualitative Business Valuation Top Down Investment LITERATURE REVIEW ON CORPORATE STOCK ANALYSIS MUTUAL FUNDS TYPES OF MUTUAL FUNDS EQUITY FUNDS EQUITY FUNDS AND MARKET INDEXES...79 VI 5.4 FUND MANAGERS AND BEATING THE MARKET ADVANTAGES AND DISADVANTAGES OF STOCK INVESTMENT CHOICES ANALYSIS AND RESULTS STOCK VALUATION AND SELECTION METHOD Investment Philosophy Time horizon, Investment Strategy and - Approach FACTORS, INDICATORS AND VALUATION CONCEPTS Financial Ratio Analysis Discounted Cash Flow Analysis Qualitative Business Valuation Analysis of the geographical Region and Sector Technical and Mood Indicators Other Important Factors SUMMARY OF THE FINDINGS AND CONCLUSION MAIN EMPIRICAL FINDINGS CONCLUSIONS RECOMMENDATIONS CORPORATE STOCK SELECTION QUALITATIVE BUSINESS VALUATION REFERENCES...I APPENDIX 1- SEARCH STRINGS...VII APPENDIX 2 COVER LETTER TO FUND MANAGERS IN ... VIII APPENDIX 3 - STRUCTURED TELEPHONE INTERVIEW OR QUESTIONNAIRE...IX APPENDIX 4 SURVEY RESULTS... XIII APPENDIX 5 CORPORATE STOCK ANALYSIS AS IN THE LITERATURE...XVII VII Tables TABLE 4.1: Business valuation models and their prime of application TABLE 5.1: Advantages & disadvantages of the three basic stock investments TABLE 6.1: Stock valuation and selection method TABLE 6.2: Result stock valuation and selection method TABLE 6.3: Combination of stock valuation and selection method TABLE 6.4: Most important factors and indicators. TABLE 6.5: Relative importance multiple comparison analysis and key ratios TABLE 6.6: Relative importance DCF models TABLE 6.7: Relative importance qualitative business valuation TABLE 6.8: Relative importance of geographical region and sector analysis TABLE 6.9: Relative importance technical indicators TABLE 6.10: Relative importance mood indicators TABLE 6.11: Other important factors.. VIII Figures FIGURE 2.1: The research process of the thesis FIGURE 4.1: Growth and value stock: periods of out performance FIGURE 4.2: Line chart depicting the S&P 500 index from FIGURE 4.3: Bar chart depicting the S&P 500 index from FIGURE 4.4: Candle stick chart depicting the S&P 500 index FIGURE 4.5: Increasing upper trend line FIGURE 4.6: Support and resistance level FIGURE 4.7: Upper and lower trading band FIGURE 4.8: S&P , with the 38 & 200 days simple moving average FIGURE 4.9: Chart Coca Cola stock indicating a head and shoulder formation FIGURE 4.10: Triangle and rectangle formation FIGURE 4.11: Timing indicator: buying and selling signals. FIGURE 4.12: Overview concepts of stock valuation and selection FIGURE 6.1: Results stock valuation and selection method FIGURE 6.2: Investment philosophy FIGURE 6.3: Time horizon, investment technique and investment approach FIGURE 6.4: Investment time horizon FIGURE 8.1: Corporate Stock Selection Approach. IX X 1 INTRODUCTION This chapter presents our motivation for choosing mutual funds and corporate stock selection as our area of interest; this is presented under the background. Next, the focus is directed towards the problem under consideration and the specification of the purpose of our study. The chapter ends up with details on scope and limitations as well as the potential contributions of the study. 1.1 Background The importance of the corporate stock market has generally increased during the last decades. 1 Many individuals invest large amounts into this type of financial market generally driven by the fact that over long time spans, corporate stocks have outperformed other investments by enormous margins, though one characteristic of the stock market is that it can fall as well as rise significantly in the short and middle term. The current bear market and a lot of other market falls have been painful to many investors who were unprepared for the possibility of such drops. However these falls have changed the attitude of many investors towards alternative stock investment instruments. One of these investment alternatives is the mutual fund. According to some business analysts, a mutual fund is one of the most profitable securities investment alternatives. They seem cost efficient and easy to invest in. Moreover, they appear to be easy to purchase, buy back, and are expected to be less risky than individual stocks. Anybody, no matter their age or income can invest in mutual funds on the premise that they present an easy and inexpensive way for an individual to capture the money that is to be made from stocks and bonds, without buying them directly. By pooling money together, individual investors can purchase stocks or bonds with lower trading costs i than if they tried to do it on there own. Yet the biggest 1 K. Spremann (2002) Finanzanalyse & Unternehmensbewertung, 2 nd Ed IMF Oldenbourg Wien, p.75 i A person or organization that trades large enough quantities of shares qualifies for preferential treatment and lower commissions. excerpt,00.pdf, advantage to mutual funds is diversification. i They are set up to buy many stocks, diversifying them in a predetermined category of investments (i.e.- growth companies, low-grade corporate bonds, international small companies). 2 Moreover, because of the professional management offered by the fund, one does not need to know everything about investing. The major responsibility of the potential investor is merely to choose a fund whose investment objective and risk level are suitable for them. The rest is the fund manager s task, to invest the pool of money in order to achieve the fund's specific objective. Based on the growing interest in mutual funds as an investment alternative in the last years, the volume of actively traded funds has increased in line with the demand. 2 Of course this does not stand without any drawbacks. There is a fee to be paid for the professional management carried out by the fund manager no matter whether the fund performs badly or well and additional fees for other related services offered by the fund company. In addition, mutual funds are set up in a way that they pursue preset objectives to which the potential shareholder has to comply. But, the bottom line is that on average, the S&P, DOW JONES and NASDAQ indexes that measure the performance of stocks, will nearly always, rise in the long term, so too or better will active managed funds perforrm. ii In an appreciating market, when the market index is rising a well diversified portfolio will track the index up. The reverse holds for a depreciating market situation. Therefore selecting the right stocks becomes more and more significant in order to prevent a severe decline in the portfolio with the depreciation of the overall market. The main task of an equity fund manager is i Mutual funds are composed of a diversified portfolio, according to investment style, geographical region, market segments etc. 2 http: ii The premise is that active managed funds can perform better than their relevant benchmark index 2 to invest the money collected from customers in profitable stocks in pursuit of the fund's specific objective. 1.2 Problem Discussion Before planning an investigation, the researcher first recognizes a question or a problem to be studied. Although questions need not always to be derived from a theory, theories often guide researchers in predicting events or outcomes of research, which ultimately support or deny the explanation. In order to move our science beyond observation, we need to state our underlying problem in a proper manner. A central idea with active managed funds is that they ought to be efficient, and should perform better than market indexes by reason of professional management. Of course this idea is very much supported by mutual funds advocators. Though we recognize the advantage of this investment alternative in terms of diversification, expert management, liquidity and maybe straightforwardness, we would like to keep in mind that the potential mutual fund investor will also bear several costs associated with the services offered by the fund. The premise that professional investment managers are likely to outperform their respective benchmark index has induced us to look at the methods and concepts used or applied by these investment managers. We basically summarize these as systems i of corporate stock valuation and selection. The literature on stock selection distinguishes mainly two attitudes within the frame of corporate stock analysis namely fundamental and technical analysis. On the one hand, the fundamentalist is the one who ties to assess the basic value of the stock. He or she will come up with an intrinsic value to be compared with the market price of the targeted stock. If the market price were below the intrinsic value, the fundamentalist would buy the stock. If not, the i Systems of corporate stock valuation include the investment philosophy, the stock valuation and selection method and concept, and the investment strategy 3 fundamentalist would either sell the stock he already owned or wait for a better deal. On the other hand the trading decision of a technical analyst is solely based on his or her expectation about future stock price based on past stock prices and trading volumes. Given these divergent views on ordinary share concepts, we structure this study on mutual funds and stock valuation to provide answers the following research questions: (1) Which are the major systems of corporate stock valuation and selection according to academic theory? This research issue covers an extensive presentation and evaluation of the major concepts of corporate stock analysis as presented in the theoretical literature. This is fundamental in order to provide a theoretical foundation for the analysis. (2) Which of these systems do fund managers apply when selecting ordinary shares, and how do they apply the particular corporate stock valuation and selection systems? The research questions drive us into the relationship between fund managers and corporate stocks selection decisions. In other words, we intend to investigate from our survey sample to which extend they use the presented concepts to support their buy, hold or sell decision. In addition to the identification of these methods, we intend to look at the rationale behind the particular choice.. (3) Which are the most important market indicators, micro-macroeconomic factors considered when valuing and selecting ordinary stocks? A previous study on Finnish mutual fund managers by Kjellman and Granlund (1998) concludes that the firm s growth potential; management competence, expected P/E ratio and expected profit are the most important factors considered by fund managers before investing in an ordinary company s stock.. 4 In fact, going through the literature pertaining to the area of corporate stock valuation, reveals that whether technical analysts or fundamentalists, there will always be key factors or indicators to look at in order to estimate the value of an ordinary stock. Which are those factors and indicators according to our survey sample, and can these factors vary in relation to market sector and business cycle? 1.3 Purpose of the Study As the problem discussion outlines, this study has three main objectives: (1) To describe and review the major concepts and principles of corporate stock analysis with the aim to provide a background and tools to make prudent investment decisions. (2) To identify the valuation and selection systems applied by European equity fund managers. This objective includes exploring the rationale behind their choice as well as the relative importance and practical application of their valuation and selection systems. Finally (3), we will examine the most significant micro-macroeconomic factors and indicators when selecting an ordinary stock. This incorporates the examination of the relative importance of the valuation concept that particular factors and indicators belong to. After fulfilling our stated purposes the last step is to come up with a model on corporate stock selection model bringing the understanding from the literature study and the empirical survey together Potential Contributions of the Study As the title of the study states we investigate the area of fund managers and corporate stock analysis. So far there have not been many studies conducted in this area. A previous study on Finnish market identified the most important factors and methods when a Finish fund manager is selecting an ordinary share. This study goes several steps ahead; it considers (1) a review of the major theories in the field of corporate stock analysis, and investigates (2) how fund. 5 managers apply these particular systems. (3) Moreover this research examines the relative importance of the valuation concepts that particular factors and indicators belong to. Finally we attempt to design a model supported theoretical and empirical knowledge. Since we regard fund managers as competent institutional investors, i another major contribution of the thesis will be to provide practical and consistent principles and guidelines of corporate stock valuation and selection. An additional contribution of this empirical research is to identify factors and indicators that an investor should focus on when investing in European ordinary stocks. Moreover, the findings of this study could be used as input for further research, for example for developing concepts of stock valuation and selection to be tested on other kinds of institutional investors, or mutual funds from other countries. So far taking time and personnel constraints into account, the developed principles and guidelines could be applicable by any kind of stock market investor. On the whole, this thesis intends to make a valid contribution to the advancement of knowledge in the area of corporate stock analysis. 1.5 Scope and Limitations As stated before, the major objective of our thesis is to find out the best individual or combinations of corporate stock valuation and selection systems used by fund managers. This study does not establish any link between the performance of the fund and the stock selection process. We argue that it is difficult to determine whether superior performance is due to skills, luck or both. ii So far this study does not identify or explore issues of portfolio management, for example whether the selected stock fits into a specific i Institutional investor: A person or organization that trades large enough quantities of shares that the trades qualify for preferential treatment & lower commissions. They enjoy fewer protective regulations, are usually more knowledgeable & better able to protect themselves from risk, excerpt,00.pdf, ii A study carried out by Lipper Analytical Services Inc on 24 top equity funds from 1976 to 1996 with a time frame of 20 years, dividing the 20 years period into two decades, revealed that mutual funds with the best records over one decade have a definite tendency to gravitate gradually back down to mediocrity over the next decade 6 portfolio or how one should diversify their portfolio in order to reduce the total risk. Moreover this thesis focuses on equity funds since this type of mutual funds are most specialized in corporate stock investment consequently other types of mutual funds and their principles are left out of the study. The issue of market timing is from secondary importance, implying that this matter is treated to a limited extend. The study is further limited to Austrian, British and Swedish equity fund i managers. This limitation is mainly due to time, and financial constraints, but also to avoid an excessively heterogeneous survey population. The research is further limited to Austrian, British and Swedish funds, which invest merely in European equity. ii Since we regard Europe as an integrated economy, we assume some macroeconomic factors, such as unemployment or educational level (among other), as relatively homogenous within Europe, therefore likely insignificant in the case of this research. Hence comparing equity funds that invest in different macro economies would lead to disproportionate heterogeneous results regarding the relative significance of these factors. iii i We categorize a British fund manager, as one who is working in Great Britain, no matter where the mutual fund she is working for is registered. The same principle holds for Austrian & Swedish fund managers ii The underlying firms are locate
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