This chapter introduces the relevant theories such as Efficient Market Hypothesis and Portfolio Theory and the main models used in this study such as Fundamental Valuation and Risk-Return calculations Models. Summarized introduction to each of the selected relevant previous studies and a brief overview of the research frontier are also provided.
Efficient Market Hypothesis (EMH)
This theory is selected because it is one of the basic theories in finance that stipulate that in ideal capital markets there is no way that an investor can identify value stocks that the other market participants have not identified. After additional researches in the field, the hypothesis is further expanded to included three characteristics that describe a capital market. In this study, the results and analysis shall be used to identify the characteristic of Stockholm stock markets according to the behaviours of a market that the EMH postulates.
EMH describes that prices of securities at any time fully reflect all available information. Depending on the nature of information asymmetry that market actors might face, it is divided into strong, semi-strong and weak forms of EMH. When explaining this sub-categorization of the hypothesis, Fama contends that it:
Will serve the useful purpose of allowing us to pinpoint the level of information at which the hypothesis breaks down. And we shall contend that there is no important evidence against the hypothesis in the weak and semi-strong form tests (i.e., prices seem to efficiently adjust to obviously publicly available information), and only limited evidence against the hypothesis in the strong form tests.10
The study tries to use this theory to understand and categorize the characteristics of the Stockholm stock markets. If the Stockholm stock markets are efficient then there would be no significant return on investments in value stocks that are above the market returns. If, however, value stocks out perform growth stocks it indicates that Stockholm stock markets are not efficient and thus which variants of EMH hypothesis is relevant shall be studied closely.
The weak form:
Weak efficiency – The price follow a random walk. This means that the price reflects all historical information. Investors cannot predict the future price by historical information.11 In other words, the weak form of EMH rejects the application of technical analysis.
The semi-strong form:
Semi-strong efficiency refers to the price reflected in all public information. Public information includes annual accounting reports, stock splits, new stock issues and the likes. One cannot predict a future price using all public information.12
The strong form:
Strong efficiency implies that the price is reflected in all public information and insider information. This means that investors cannot predict the future price of securities using all available information and insider information.13
Criticism Against EMH
Criticism has been raised against the EMH assertion that investors in the financial markets are rational. Behavioral Finance criticizes EMH by stating that it ignores the way investors make decisions which in turn affects the market. The basic assumption in Behavioral Finance is that people do not act rationally but rather irrationally when making complex decisions. It argues that people do not always interpret and perceive information correctly and therefore make miscalculations, regarding the future returns.14
In summary, there is a wealth of phenomena in Behavioral Finance that acts as counterarguments against the EMH, in terms of misinterpretation of information. It is said that people have too much confidence in their own abilities that makes them overestimate their knowledge. People make miscalculations because they take too much account of past experience and recent events to predict future occurrences.15 Furthermore, some believe that people are separating decisions that they rather should combine and that investors are too slow to absorb new information, which can lead to a misleading price of a share.16
People’s irrational behavior is the cornerstone of Behavioral Finance which is contrary to EMH argument. Despite the criticisms raised against EMH, the hypothesis remains as a basic assumption among economists and researchers that informs further studies.
Though this study is based on a posteriori results (realized results), the theory is selected because it explains how investment decisions are made, in the first place. Portfolio theory explains how investors can construct portfolios of assets that meet the level of their risk sensitivities and earn them maximum returns.
It describes how risky securities are priced by relating risk, systematic risk, and the level of expected returns. The ground assumption is that investors calculate the payoffs according to the risk level they are willing to bear when constructing either value or growth stocks.
An important effect of this is that the portfolio total risk can be reduced without producing a lower return. According to Ridder, you must therefore not « put all your eggs in one basket. » A portfolio should preferably consist of different securities to reduce risk.17
Portfolio Risk and Historical Rate of Return
Markowitz defines an investment risk in terms of the yield volatility, with the standard deviation as risk measure. The standard deviation calculated from the investment’s average deviation from the mean and expressed as a percentage, the same unit for the return. If returns are normally distributed, it shows an indication of the actual return relative to expected returns.18 The standard deviation is also the most important risk measure of price changes for a security in the financial analysis.19
To study the behaviour of the return of the two categories of portfolios that have been selected and to compare them with each other as well as with the market index, it is essential to compute the historical rate of return for value and growth stocks, and the OMXS 30 market index.
Risk-Free-Rate: the rate of return one gets by investing on short-term government securities. Due to assumed ability of the government to raise taxes and pay back its debt; these securities are treated as risk-free assets. The study takes historical data about Statsskuldväxlar 3 mån interest rates in computing the performances of the portfolios. Since the study calculates the rate of returns for all portfolios on yearly basis it would have been more appropriate to use the interest rate on government bond with one year maturity but it is not easily to find historical data on such Swedish government bonds.
Equity risk premium is the difference between the rate of return to risky stocks and the risk-free short-term government bonds. This is the reward that an investor gets by investing in risky stocks instead of investing in the risk free government bonds.
OMX Stockholm 30 Index (OMXS 30)
The study uses OMX Stockholm 30 Index. It is selected because it is made up of 30 most actively traded stocks in Stockholm Stock Exchange. Moreover, OMXS 30 is a market weighted index that is reviewed every two years.22 Historical data for OMXS 30 between 1996 and 2009 is collected and used to compare the performances of both value and growth portfolios against the Stockholm stock market during the study period.
This financial calculation is the most popular model for measuring risk-adjusted returns. The return of various portfolios must be risk-adjusted before they can be compared, since different portfolios have varying risks. The Sharpe ratio is a ratio used to calculate the risk-adjusted return on an investment and shows how much return per unit of total risk as the portfolio manager has performed.23
Since investors, according to portfolio theory, want to receive the highest return possible per measurement of risk, this method will be ideal for the purpose of this study.
If a portfolio shows a higher Sharpe ratio, it implies that it has attained a higher risk-adjusted return with a good balance between risk and return. This ratio is calculated by taking the portfolio’s return, subtracted by the risk free rate (3 month T-bill) divided by the portfolio’s standard deviation.24
The core of this study is to find out if value stocks outperform growth stocks with in the selected study period. Since all investments entail some degree of risk, the returns to those investments can not relatively be judged without taking into consideration those risks. The study is adjusts all returns to their risks and then tries to compare both value and growth stocks and see which one is giving a superior payoff than the other.
Valuation Models and Fundamental Analysis Models
Dividend discount models (DDM) and Constant-growth dividend discount model (CDDM) are two prominent measures for valuing securities. The DDM is used to get the present price of a security by discounting its dividend payout and future sale value by using this formula.
Specifically, fundamental analysis uses variables such as P/E , price-to-book value (P/BV), market-value-to-book-value (MV/BV), market capitalization, cash-flow-to-price (C/P), and dividend-to-price (Div/P) multiples together with the DDM to identify equities that are undervalued, called value stocks, by the market.
This model is discussed here in order to help the reader appreciate that in a real world investment decision making process, investors make a priori evaluations (expected returns) using these variables to identify value and growth stocks.
Using one variable of the fundamental evaluation model namely price-earning-multiple, the study constructs both value and growth stocks for the five buy and hold portfolio periods.
Table of contents :
1.2. Problem Discussion
1.3. Research Questions
2. THEORETICAL FRAMEWORK
2.1. Efficient Market Hypothesis (EMH)
2.2. Criticism Against EMH
2.3. Portfolio Theory
2.3.1. Portfolio Risk and Historical Rate of Return
2.3.2. OMX Stockholm 30 Index (OMXS 30)
2.3.3. Risk Adjustment
2.4. Valuation Models and Fundamental Analysis Models
2.5. Previous Researches
2.5.1. Oertmann- Study in three regions, 18 stock markets
2.5.2. Anderson and Brooks, Study of Long-Term Price-Earnings Ratio (UK)
2.5.3. Fama and French, the International Evidence.
2.5.4. The Value Premium by Lu Zhang
2.5.5. Summary of the Selected Previous Studies and the Research Frontiers
3.1. Methodological Approach
3.2. Quantitative Research
3.3. Data Collection and Portfolio Creation
3.4. Procedures and Steps Used in the Calculation of the Various Returns
3.7. Method Critic
4.1. Comparing Value and Growth Portfolio Holding Period Returns (HPR)
4.1.1. HPR vs. Market Index
4.2. Comparing Value and Growth Portfolio Mean Price Returns
4.2.1 Mean Price Return vs. Market Index
4.3. Comparing Value and Growth Portfolio Risk-Adjusted Returns
4.3.1. Risk-Adjusted Return vs. Market Index
4.4. Comparing Value and Growth Portfolio Returns and Change in GDP
4.4.1 Holding Period Return (HPR) and GDP
4.4.2 Mean Price Return and GDP
4.4.3 Risk-Adjusted Rate of Return and GDP
5.1. Analysis and Discussions
6. CONCLUSIONS and REMARKS
6.2. Shortcomings of the Study
6.4. Recommendations for Further Studies