Before talking about investing and different strategies that
exist, it is necessary to undertake a certain philosophy about how the market
functions, therefore bringing about some basic assumptions.
The Efficient Market Hypothesis
The efficient market theory was published in the 1970s by
Eugene Fama. It is a theory that states that all share prices at any given time
are the result of all available information. It makes the assumption that
people analyze information in the same way, that they are rational, that all
information is available to everyone at the same time, they react to it
instantaneously, and that there is an infinite number of investors who want to
sell or buy a given stock at any given time.
There are three levels of this academic theory. The first
version is called «Weak Form Efficiency» and asserts that all
information from the past is already included in the current price. This goes
against the tenets of technical analysis, because this says that future price
movements cannot be predicted based on past price fluctuation patterns.
The second version is called «Semi-Strong Form
Efficiency,» and it states information that can only be obtained from
insider trading can benefit investors with an edge in the market.
Finally, the third version is called «Strong Form
Efficiency» and states that all information about a stock is already
reflected in its price, and its impossible to gain an edge through fundamental
or technical analysis. Therefore, it is impossible to «beat» or
outperform the market over the long term.5
This paper's philosophy of the market
This paper will be written on the assumed rejection of this
hypothesis because due to the information that we have read, we do not believe
it to be true. Investors like Warren Buffett and Benjamin Graham have
consistently beaten the market over the long term as well as many others. This
brings to assume that the market is inefficient which leads us to three main
investment methodologies.
· Behavioral Finance
· Investing Based on Technical Analysis
· Investing Based on Fundamental Analysis
Details of Behavioral Finance are out of the scope of this
paper because it deals with psychological aspects and we have no background
with psychology. We do accept that numerous studies have been made that explain
market anomalies based on the lack of investor rationality, and we will use
that fact further in our paper.
5
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We also believe that investing based on technical factors
carries greater risk than what an average beginning investor may want to
undertake, therefore the details of investing based on technical analysis will
be excluded from the scope of this paper. In addition, the average investor
will not likely have an extensive knowledge of the mathematics and charting
needed to perform technical analysis with a certain range of confidence.
However, we do recognize that certain technical phenomena and combinations of
technical and fundamental factors may help to make rational decisions for
investors and we will discuss those in some details in our valuation and
strategy sections.
We will propose a strategy for investing based on fundamental
factors of companies behind the stock. From our research we have concluded that
people that have managed to successfully beat the market have been able to do
so in this manner. From our research, we firmly believe that by picking
companies with strong fundamentals, it is possible to outperform the market.
This leads us to a further breakdown of the Fundamental Analysis I nvestment
Methodology as follows.
· Income Investing
· Speculation
· Value Investing
· Growth Investing
Income Investing is based on finding companies with good
fundamentals that will pay a good amount of dividends. However, the most an
investor can obtain from dividends on average is about 5-6%, and dividends are
not guaranteed, so if a company is not doing well, they may cancel several
dividend payments. A missed dividend in one quarter can decrease the gains to
around 4%. In addition, the price of the company's stock could fluctuate which
would also affect the income of the investor. Therefore, we believe that the
risk of being invested in the stock market is too great for the small amount of
gains that the investor would receive compared to a savings bond. We recognize
that some investors would prefer this method because of its decreased
volatility compared to other investing methodologies, but we would like to
point out that income investing is out of the scope of this paper.
Speculation is a much more risky strategy than income
investing, as well as any of the other strategies mentioned above. "An
investment operation is one which, upon thorough analysis, promises safety of
principal and a satisfactory return. Operations not meeting these requirements
are speculative."6 We believe that speculation carries more risk
than a beginning investor would like to take on in addition to not having
enough experience to speculate. Therefore, speculation is out of scope of this
paper.
6 Benjamin Graham, Security Analysis(18)
Value investing, described further in this paper involves
finding undervalued companies with good fundamentals and holding onto them for
a long time. Benjamin Graham, considered to be the father of value investing
was successful in the market over the long term as well as several others who
followed this methodology. We will further focus on this methodology in order
to develop our strategy.
Growth Investing, also described further in this paper
focuses on finding companies with reasonable potential for growth in the long
term. Investors such as Philip Fisher used this methodology to become
successful in the market over the long term. We will apply this methodology as
well to the development of our strategy.
To summarize, our strategies and our theories will assume
that:
· The market is inefficient
· All information is not available to everyone at the same
time
· That investors do not react to information
instantaneously,
· That a large percentage of investors are irrational and
emotional because a large percentage of them are human7
· Investors Make Mistakes
· It is possible to outperform the market over the long
term.
· Stocks of companies with strong fundamental factors will
perform well in the long run
7 A certain percentage of investments are performed by computers
who process market information and react to it instantaneously based on pre-set
guidelines.
