Share Trading Assignment

Introduction

This project is about whether or not an investor with only publicly available information is able to “beat the market”. We have £100,000 which we can invest in the stock market however this amount must be split into two portfolios. Each portfolio will be made up of investments chosen through theories and strategies which come from either the fundamental analysis or technical analysis approaches. Fundamental analysis is method which looks at fundamental information such as competitive advantage, earnings growth, market share and quality of management to indicate a security’s future value.

Technical analysis is the other basic trading technique which relies on statistical methods and data charts to detect and predict current and future trends. The Efficient Market Hypothesis is an investment theory that states that the stock market cannot be “beaten” as the stock market has a level of efficiency which causes existing share prices to integrate all the information which is available and relevant to making decisions on investments.

According to the Efficient Market Hypothesis, it is impossible for investors to ascertain undervalued stocks from overvalued stocks as stocks always trade at their fair value on the stock exchange without much fluctuation. This assignment is about testing this theory by applying the fundamental analysis and technical analysis techniques to try to outperform the stock market. The Efficient Market Hypothesis is composed of three progressively stronger forms:

Weak form
Semi-strong form
Strong form

We traded on the FTSE All Share index for four months to try to make a profit which is greater than the percentage change of the market. Over the time that I was trading for this assignment, the FTSE All-Share Index grew by 7.85%. To beat the market the investments in both portfolios would have to make a total percentage gain of over this market change which they did. Overall, both portfolios produced a gain of £20,194.03, which is 20.22% increase from the investment which means that I did beat the market.

Method

Fundamental analysis is a method of evaluating securities by trying to gain an understanding and measuring the intrinsic or fundamental value of the company. This means that you must analyse the entirety of the company; both tangible and intangible factors must be taken into account. By studying all aspects of a stock option fundamental analysis can show you securities which have been mispriced under their fair value which if bought and held for a short time will return a profit when the stocks are re-priced once other investors become aware of this information. Technical analysis, on the other hand, does not try to measure a company’s share’s fair value.

Alternatively, this type of analysis uses charts and data to find patterns which can be used to predict future activity. Technical analysts are not concerned with whether stocks are undervalued, but instead exclusively use historical data to see how the market or individual security’s price might move in the future. Research into the weak form of the Efficient Market Hypothesis seems to reject the effectiveness of this approach. ¬¬¬¬For the fundamental analysis approach two methods were used to choose companies in which to invest.

The first method was to look at news articles online and invest in companies which would seemingly perform positively on the stock market once share prices reflected this information. The company’s financial position was disregarded in this decision as this is not relevant to the new information which would presumably improve the company’s earnings and returns and so on. Once I had invested in a security I kept a close watch on news, either online or in broadsheet newspapers such as the Financial Times, coming in about the company so that the stocks could be sold for a return before the market reacted unfavourably towards new information.

For example, one of the companies in the fundamental portfolio is Rolls Royce Holdings PLC which on 9th November 2012 announced expectations of growth after signing a deal with the US military. Following this news, I invested in the security as the price would presumably rise once knowledge of this information had spread. On the other hand, the second method which was used for the fundamental analysis was to look at companies entirely in the context of their financial position; particularly at assets, revenue growth and dividend pay-out over the last three years.

Part of this method, companies with low P/E ratios were chosen because Basu (2012) commented that “past P/E ratios are indicators of the future investment performance of a security” and that “low P/E securities will tend to outperform high P/E stocks”. These stocks were then held in the portfolio until the end of the fourth month to theoretically gain a profit when they were sold towards the end of January. Royal Dutch Shell PLC was a security which was chosen through this type of analysis.

Royal Dutch Shell’s company accounts show that it is in a strong position in its sector, latest reported profits were high and income was predicted to be healthy. All the companies chosen, like Royal Dutch Shell PLC, had good performance indicators in the company accounts as is explained in the appendix. There are many convincing strategies that can be used for technical analysis but the approaches chosen for this project are Momentum Investing and the Small Firm Effect. Using the momentum investing strategy, focus was put on the six-month period before the investment period for this assignment started, over which “winners” and “losers” were determined, and a four-month investment period, over which “winners” were held unless their price began falling, in which case “losers” were sold short.

This method was set out in a study by Griffin, Ji and Martin (2003) where they found that in an economic decline, price momentum strategies earned positive returns in 35 out of 40 markets. Campbell, Lo and MacKinlay also found that “there is a shorter-run weak tendency toward momentum, for stock prices to continue moving in the same direction”. A security in the technical analysis portfolio which is an example of this strategy is Topps Tiles PLC. Topps Tiles PLC show a steady increase in share price between May and October which, assuming this strategy is effective, should continue rising over the next months.

For the second technical analysis method, firms were selected on the basis of the Small Firm Effect. A study by Stoll & Whaley (1983) showed that “investors can earn risk-adjusted excess returns after transaction costs by holding small firms for relatively short holding periods.” Also, the results of research done by Banz (1981) showed that “in the period from 1936-1975; the common stock of small firms had, on average, higher risk-adjusted returns than the common stock of large firms”.

As the securities will only be held and sold over a maximum period of four months this method should be able to make positive returns through this method based on these results. To utilise this method, companies which had a market capitalisation which was in the bottom tenth percentile of the industry sector were chosen. Trinity Mirror PLC had one of the smallest market capitalisations (£184.89m) in its sector which is why it was chosen for the technical analysis portfolio.

Results

Overall both fundamental and technical approaches yielded respectable results returning a 20.22% profit on the original £100,000 investment. The market increased by 7.85% while each portfolio produced gains of 23.38% and 17.05% respectively. Both portfolios beat the market by a sizable amount; the fundamental strategies beat the market by 15.53% and technical techniques beat the market by 9.20%. The fundamental analysis technique outperformed the technical approach by a margin of 6.33%.

The method of choosing securities based on new information in the news made the greatest profit making a total gain of £7725.24 which means the results from this strategy outperformed the market by 22.48%. It should be noted however that the majority of this gain was made from one security, Thomas Cook Group PLC, which earned £6919.20; roughly 90% of the profit for this strategy. The worst strategy was the technical method of momentum investing despite strong evidence that this should provide superior returns from past research.

This method was the only approach which underperformed when comparing its 4.31% gain to the All-Share index’s increase of 5.85%. Securities chosen on the basis of the Small Firm Theory produced a high return of £7442.06 which performed only slightly worse than the news method in the fundamental analysis portfolio.

This method gave earnings of 29.77% of the initial investment which means it topped the All-Share index’s change of 9.00% by a considerable amount. It should be pointed out however that once again one company made up the majority of this profit and two of the securities produced a loss, therefore this method may not be very reliable. The other fundamental analysis technique (using financial statements and key performance indicators) gave a 15.98% return which beat the markets 9.20% growth by 6.78%.

Conclusion

Fama (1970) defines an efficient market as “A market in which prices at any time “fully reflect” available information is called “efficient”.” The Efficient Market Hypothesis is composed of three progressively stronger forms: The weak form of the EMH states that historic prices, volumes and other market statistics do not provide any information that can be used to make accurate predictions of prices. This is because information arrives randomly and it is information that effects share price changes, therefore share price changes should be random and when they do occur they should change very quickly to their new fair value.

Most research suggests that most stock markets are weak form efficient. The EMH’s semi-strong form says that stock prices will always fully reflect all information available to the public and consequently their expectations about the future. This suggests that the market reacts very quickly to new information, and that old information cannot be used to earn a profit. Research and studies suggest that markets are somewhat efficient in this sense. The strong form says that prices completely reflect all information, no matter if it’s publicly available or not. According to this form of the EMH, even material, non-public information can’t be used to earn superior results.

Most research has found that stock markets are not efficient in this way. My results seem to disclaim the assumptions of the Efficient Market Hypothesis, that it is impossible for an investor to beat the market due to the level of efficiency which is present in the stock market which causes prices to reflect all available information. These findings are consistent with empirical analyses which have found numerous problems with the efficient market hypothesis. One such study is that of Basu (1997) who rejects EMH after his findings showed that the Value Investing strategy of choosing low P/E securities generally outperformed high P/E stocks.

This directly disproves the definition of EMH. Malkiel (2003) puts forward another valid argument for why stock markets must be inefficient when he says “the market cannot be perfectly efficient or there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices”. Much research has shown that well-developed capital markets, such the New York and London Stock Exchanges are mostly semi-strong efficient which should mean that a fundamental analysis approach should work ineffectively in selecting stocks which will rise in value. As the fundamental approach was my best performing portfolio, my results do not correlate with this statement however as I did not have a large sample size of securities in my portfolios this could be due to chance as this was a short term trading assignment.

The results of the technical analysis portfolio beat the market; however this was only due to the one security, Trinity Mirror PLC, which made up a considerable portion of the profits in this portfolio. The new percentage gain for the entire technical portfolio, factoring these profits out, would be 7.60% which would mean that I did not beat the market using these methods. This might provide some validity to the weak form efficiency part of the Efficient Market Hypothesis that says that historic data cannot give accurate estimates of future prices.

The poor performance of the other securities in this portfolio could also be attributable to other market anomalies such as seasonality. Seasonality could not be factored into the decision of selecting securities by only looking at the previous six months before trading. Therefore there was no way to predict how the market sector would behave over the Christmas period. To conclude, the results found throughout this project seem to contradict the efficient market hypothesis, therefore the market can be beaten with the right techniques however risk should always be the biggest consideration when investing.

References
Arnold, G. (2012). Corporate Financial Management. Pearson Education Limited. Banz, R. (1981). “The Relationship Between Return and Market Value of Common Stocks”. Journal of Finacial Economics, 3-18. Basu, S. (1977). “Investement Performance of Common Stocks in Relation to their Price-Earnings Ratio: A Test of the Efficient Market Hypothesis”. Journal of Finance, 663-682. Campbell, J., Lo, A., & MacKinlay, A. (1996). Econometrics of Financial Markets. Chan, L. K., Jegadeesh, N., & Lakonishok, J. (1996). “Momentum Strategies”. Journal of Finance, 1681-1713. Chelley-Steely, P., & Siganos, A. (2008). “Momentum Profits in Alternative Market Structures”. Working Paper. Fama, E. (1970). “Efficient Capital Markets: a Review of Theory and Empirical Work”. Journal of Finance, 383-417. Griffin, J., Ji, X., & Martin, J. (2003). “Global Momentum Strategies: A Portfolio Perspective”. Working Paper. Latif, M., Arshad, S., Fatima, M., & Farooq, S. (2011). “Market Efficiency, Market Anomalies, Causes, Evidence, and Some Behavioural Aspect of Market Anomalies. Research Journal of Finance and Accounting, 1-13. Lee, C., & Swaminathan, B. (2000). “Price Momentum and Trading Volume”. Journal of Finance, 2017-2069. Malkiel, B. (2003). “The Efficiet Market Hypothesis
and its Critics”. Journal of Economic Perspectives, 59-82. Shiller, R. (2005). Irrationl Exuberance. Princeton Univerity Press. Stoll, H., & Whaley, R. (1983). “Transaction Costs and the Small Firm Effect”. Jounal of Financial Economics, 3-12.