Thursday, March 10, 2011

McMillan et al., Investments

Investments: Principles of Portfolio and Equity Analysis, coedited by Michael G. McMillan, Jerald E. Pinto, Wendy L. Pirie, and Gerhard Van de Venter (Wiley, 2011), was written for financial analysts as well as aspiring financial analysts. Part of the CFA Institute’s book series, it is a weighty tome of more than 600 pages. In twelve chapters it covers such topics as market organization and structure, security market indices, market efficiency, portfolio management, portfolio risk and return, portfolio planning and construction, equity securities, industry and company analysis, equity valuation, equity market valuation, and technical analysis. There is also a separate paperback workbook with problems and solutions.

I debated what to focus on in this post and finally decided to look at two methods for valuing equity markets. The assumption is that, whatever the short-term effects of momentum, “economic fundamentals will ultimately dictate secular equity market price trends.” (p. 470) (For those who read yesterday’s post, this assumption is in sync with the theory of Frydman and Goldberg.)

First is the neoclassical approach to growth accounting, which uses the Cobb-Douglas production function to “measure the contribution of different factors—usually broadly defined as capital and labor—to economic growth and, indirectly, to compute the rate of an economy’s technological progress.” In imprecise and non-mathematical terms, the percentage growth in real output (or GDP) can be decomposed into its components: growth in total factor productivity (a measure of the level of technology), growth in the capital stock, and growth in the labor output. Applying this model to the Chinese economy, the authors of the chapter suggest that Chinese economic growth will eventually moderate; nonetheless, they project a near-term growth rate of 9.25%. They arrive at this by adding total factor productivity of 2.5%, a growth in capital stock of 12% times a value of 0.5 for the output elasticity of capital—that is, 6%, and a labor force growth of 1.5% times a value of 0.5 for the output elasticity of labor—or 0.75%. An ultimately sustainable growth rate might be 4.25% [1.25% + (0.5 x 6%) + (0.5 X 0%)].

Second is the effort to calculate the forward justified P/E ratio for an equity market using the H-model. The H-model assumes that dividend growth rates will “decline in a linear fashion, over a finite horizon, toward an ultimately sustainable rate from the end of that horizon into perpetuity.” (p. 476) This model is most frequently used to value emerging markets because in mature developed equity markets “supernormal growth would not generally need to be modeled.” (p. 477) The current 19.1 forward P/E ratio for Chinese equities, the authors conclude, is not unreasonable. But “only those with a very optimistic long-term dividend growth rate forecast and/or a low required discount rate would find the Chinese market to have substantially better than average current attractiveness.” (p. 481)

These two methods are examples of top-down analysis, but many analysts proceed from the bottom up. “When engaged in fundamental securities analysis,” the authors write, “it can be wise to use both top-down and bottom-up forecasting. However, when we use both approaches, we often find ourselves in the situation of the person with two clocks, each displaying a different time. They may both be wrong, but they cannot both be right!” When the two methods lead to significantly different results, the analyst must go back to the drawing board. “After all, if forecasts cannot be consistent with each other, at least one of them cannot be consistent with underlying reality.” (p. 487)

But “in rare and significant instances,” they conclude, “we will find that carefully retracing the steps reveals a gap between the two forecast types that gives rise to significant market opportunities. In such instances, the process of reconciling the two types of forecasts creates instances where we differ significantly and correctly from the consensus.” (p. 487) For instance, in the early 2000s top-down forecasts were more subdued, and more correct. In the recent financial crisis bottom-up forecasts were more telling.

Investments: Principles of Portfolio and Equity Analysis is not light reading, but it covers material crucial to the work of financial analysts. It also provides insights for the independent investor who wants go beyond the basics. The workbook is a welcome addition.

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