UNDERSTANDING SECURITY VALUATIONS: A BRIEF OVERVIEW

3 April 2017


News of the financial markets grace our electronic media devices each and every day, and one thing that is certain is that there is volatility. Do you understand the intricacies of arriving at a price for a commodity, a security, a company, a Fund? Today’s blog explores some of the methods

A FIRSTLINE SECURITIES LIMITED BLOG BY: MAXINE KING

I visited Disney World for the first time, in mid-2016. With great apprehension and extreme uncertainty, I joined the line for my first ride (see above) and soon enough found out there was no turning back. The line was long and my anxiety mounted, culminating in a ride which started and ended, before I could say “Jack Robinson”. I could not help but think, as I clutched the sides of the roller coaster, practised deep breathing and  treated my eyes like a shutter, on that man-made mountain side, that I was crazy enough to pay for pain, uncertainty, and risk  and that this was the last ride I was taking in this week long stay at Disney. Like a masochist, I went back repeatedly, to experience the surges, the tumbles, the ups and the plummeting downs!

Many times we read of analogies of foreign stock and bond markets, to roller coaster rides. My experience at Disney explained the truism of that metaphor. Those of us who follow these markets by way of fundamentals or charts, have come to understand, whether it be via academia, experience or otherwise, that there is no right or wrong way to analyse the financial markets. Here in Trinidad and Tobago, as under developed as our market is, we recognise that there are sometimes “inexplicable” reasons for the buoyancy of our equities market, despite exogenous shocks and despite the intrinsic value of some of the securities in the index.

So how do analysts and other investors, value securities and companies to make investment decisions, in the midst of all the din, the nerve wracking, the unpredictability, the risk and volatility that come with the ride?

Methods of Valuation

There are different approaches, styles and belief systems, used by investors, which may or may not conflate, as outcomes and objectives and investment experiences differ. In fact, I recently read an interview with the CEO of a Canadian investment firm who was adamant that the basis of his investment strategy was what he termed “a business-owner mindset”, where operations and operational excellence, not financial engineering, determined the intrinsic value of his investment picks. That may well be viewed as a sub-set of fundamental analysis, and adds some colour to the myriad of investment approaches which exist.

Let us, nonetheless turn our attention to the more common investment approaches used, which include fundamental analyses, technical analyses, quantitative analysis and market sentiment, which is purely behavioural; all of which present an opposing view to the concept of the Efficient Market Hypothesis. (A view that asset prices always fully reflect all available public information and that investors are not able to predict asset returns with anything else other than risk measures).

What is Fundamental Analysis?

Fundamental analysis involves the use of macro-economic and micro-economic tools, to gain insights so as to arrive at the valuation of a security, a company or the market as a whole, within the context of its current price or market value.

Some of the macro-economic factors which are considered are:

  • Inflationary trends
  • Labour Force Statistics
  • Unemployment rates
  • Non-Farm Payroll statistics (USA)
  • Fiscal and monetary policy of the government
  • GDP trends and forecasts
  • Consumer Confidence Index
  • Savings, investments and foreign exchange trends
  • Socio-political issues
  • Regulatory issues
  • Industry/Sector trends and issues
  • Stock market performance


Micro-economic
factors include:

  • Financial Statement Analyses
  • Earnings performance
  • Ratio analyses {P/B, P/E, EPS, EBITDA, solvency tests, PEG)
  • Discounted cash flow (DCF) and Divided discount (DDM) Models
  • Management Team composition
  • Corporate Governance structure
  • Business Model, structure and operations
  • Consumer Confidence Index
  • Other qualitative factors such as: competitor analyses, peer analyses, new products and the like.

 

What is Technical Analysis?

Technical Analysis is the forecasting of the future price trends of a security, based on observation and examination of past price and volume market data.  This type of analysis usually involves the use of charts, and persons who use this approach are commonly known as “chartists’. “Chartists” do not care to know or understand the intrinsic value of the commodity or the security, and like the fundamentalists, display different styles and beliefs.  Some look for patterns in the statistical data and others look at the statistical indicators, some complete a plethora of calculations, all in an effort to predict price or market value changes. Some are driven more by experiential gut and sentiment, based on their interpretation of what the Charts tell them.

Technical Analysis may consist of a number of techniques, some of which include:

  • Implied Volatility tests
  • Technical Indicators and Oscillators such as MACD (Moving average Convergence Divergence), ADX (Directional Index), Money Flow Index and much more.
  • Correlation Analysis
  • Linear Regression Analysis
  • Observations of patterns and trends

What is Quantitative Analysis?

Quantitative Analysis, known as “Quant”, is the use of complex computer algorithms and mathematical models to quantify pricing and movements of securities, indices, and trading instruments, into mathematical equations. This approach relies heavily on computers to calculate security values, but completely ignores the role of humans and human sentiment in the decision making process. This approach is probably the youngest of all the methods used for valuations. This singular approach makes it difficult to forestall programming glitches which could adversely affect valuation outcomes and cause significant losses. It relies heavily on the technical skills of individuals to translate or mirror the market into mathematical formulae.

Investor Sentiment

This aspect of investing is probably one of the most researched areas within the realm of academia, as it focuses on behavioural finance and economics. Suffice it to say that there is ample empirical and other evidence to assert that most or all investment decisions are influenced by some degree of subjectivity. Subjective attributes, or feelings, such as moods or confidence levels, observations or predictions of the actions of other investors, or simply the application of years of experience, can all contribute to the sentimentality used by some investors. This seeming irrational behaviour, can be explained by personality traits, cultural norms, or simply by the specific needs and short term desires of such investors.

There is a view as well, that it is the unsophisticated investor who more often utilises sentiment to guide his/her investment actions, in fact making room for the professional investor or the contrarian investor, to benefit from the arbitrage opportunities that the un-savvy may have created. In this context, fundamental or technical analyses are considered esoterica to this type of investor.

A most conspicuous example of how investor sentiment can influence asset values was observed when the current President of the United States was elected. In two days, more than US$1 trillion was wiped out across the global bond market, where investors sold down and re-allocated their portfolios out of bonds into equities, simply on the basis of his pronouncements on infrastructure spending and job creation. Even more recent, is the immediate tumble seen on stock prices internationally, and on the dollar itself after Trump’s Bill to replace the Affordable Care Act was pulled.

 

CONCLUSION

Each one of the approaches identified above has its loyal group of users, who “stick to their knittings” that their preferred approach works best for them.  Undoubtedly, none of them are complete, or perfect enough to avoid or predict systemic events, with certainty. They are however, not mutually exclusive and can be used collaboratively to make investment decisions which may well turn out to be superior.

Here in Trinidad and Tobago, you will find that some of the techniques and approaches identified above are not applicable to your limited basket of investments, especially if they are domestic or cross-listed securities. If however, you wish to increase the diversity of your investments to include foreign investment instruments, you may well find that many more aspects of these approaches become applicable and relevant.

At Firstline, our investment perspectives are guided by the appetites of aspiring High Net Worth clients and Institutions, for whom we manage funds, under our Wealth Management and Asset Management Strategic Business Units. We understand the importance of research and the need for fundamental analyses, but in our midst, we also have the technical folk, who believe in their Charts! Guided by a mix of approaches and based on the collective experience and using our risk management basket of tools, we make investment decisions which are considered prudent in specific circumstances.

 

CLOSING THOUGHTS

Firstline Securities Limited offers comprehensive coverage of local and international markets with a bias for the energy sector. Firstline offers a number of unique opportunities to put surplus cash to work either as your asset manager or investment advisor. Please contact us for more details at info@nullfirstlinesecurities.com or at 868.628.1175. We can discuss your investment needs in detail and craft a portfolio that makes sense for you. We look forward to hearing from you!

 

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