Analysis Of The Stock Market Using Quantitative Approach Finance Essay - Free Essay Example

Sample details Pages: 8 Words: 2539 Downloads: 1 Date added: 2017/06/26 Category Finance Essay Type Research paper Did you like this example? Quantitative finance started in the U.S. in the 1930s as some astute investors began using mathematical formulas to price stocks and bonds. Harry Markowitzs 1952 Ph.D. Don’t waste time! Our writers will create an original "Analysis Of The Stock Market Using Quantitative Approach Finance Essay" essay for you Create order thesis Portfolio Selection was one of the first papers to formally adapt mathematical concepts to finance. Markowitz formalized a notion of mean return and covariances for common stocks which allowed him to quantify the concept of diversification in a market. He showed how to compute the mean return and variance for a given portfolio and argued that investors should hold only those portfolios whose variance is minimal among all portfolios with a given mean return. Although the language of finance now involves Ito calculus, minimization of risk in a quantifiable manner underlies much of the modern theory. In 1969 Robert Merton introduced stochastic calculus into the study of finance. Merton was motivated by the desire to understand how prices are set in financial markets, which is the classical economics question of equilibrium, and in later papers he used the machinery of stochastic calculus to begin investigation of this issue. At the same time as Mertons work and with Mertons as sistance, Fischer Black and Myron Scholes were developing their option pricing formula, which led to winning the 1997 Nobel Prize in Economics. It provided a solution for a practical problem, that of finding a fair price for a European call option, i.e., the right to buy one share of a given stock at a specified price and time. Such options are frequently purchased by investors as a risk-hedging device. In 1981, Harrison and Pliska used the general theory of continuous-time stochastic processes to put the Black-Scholes option pricing formula on a solid theoretical basis, and as a result, showed how to price numerous other derivative securities. 2.0 Fundamentals of Quantitative Analysis Definition: Quantitative analysis is a process of disseminating financial data in order to make valid projections regarding the future performance of a corporation or market. Quantitative analysis of stocks is done purely based on numbers. In this type of analysis, the price trend of the stock is analyzed based on historical data using complex mathematical calculations and statistical modeling techniques. Quantitative Analyst: A quantitative analyst is a person who works in the financial markets developing and implementing mathematical models to assist the activities of traders and risk managers within investment banks, hedge funds and other financial institutions. Throughout the industry, such professionals are known as quants. Although the original quants were concerned with risk management and derivatives pricing, the meaning of the term has expanded over time to include those individuals involved in almost any application of mathematics in finance. An example is statistical arbitrage. Differentiated Features: The quantitative analysis of stock is very different from fundamental analysis of stocks. Fundamental analysis considers the business, growth prospects and effectiveness of management to determine the value of the stock while quantitative analysis discounts all these factors. The analyst who believes in this technique think that all the above mentioned factors are very subjective and do not portray the exact picture since everyone can interpret these numbers in a different manner. The analysts who believe in quantitative analysis of stocks do not take into consideration the effectiveness of management, business or economy while doing this analysis. Quantitative analysis may also involve such characteristics as company liabilities, sales figures, trading trends, and alike. Unlike qualitative analysis, which may consider more uncertain factors like the quality of management, branding, and intrinsic value, quantitative analysis looks only at me asurable facets. Thus, technical analysis, which employs mathematical models, would be considered part of quantitative analysis. A person who performs quantitative analysis is referred to as hybrid stock analyzed. This is because, he/she is characterized by the attributes of both fundamental and technical analyzed. Purpose: The purpose of quantitative analysis is to employ quantifiable attributes of a particular company in order to determine its securitys or markets value. To do so, quantitative analysis practitioners gather and analyze data such as income statements, company assets, market share, and earnings records. 3.0 Techniques Used in Quantitative Analysis Quantitative analysis in general is simply a way of measuring things. In quantitative analysis of stock, the behavior of a stock is analyzed using complex mathematical and statistical modeling equations. For analysts who specialize in quantitative analysis of a stock, the business or the management mean nothing to them. There is no regard for underlying business at all. All they look for are the numbers. For quantitative analysis, the number crunching is done through advanced computers now days. These people who do this are also called as quants. These quants will do analysis based on complex formula and will decide on sell versus buy option purely based on these equations and numbers. Some of the major considerations while doing quantitative analysis of stock are: Company size First thing which the investors look at is the size of the company. This is usually done in term of capitalization or cap in short. Broadly, the companies are divided into various caps depending upon their market. These are micro cap, small cap, mid cap and large cap. Smaller the cap, riskier is the company since it can go bankrupt very easily. But smaller companies have the chances to grow radically as well. Broadly, the guidelines of distinguishing these caps are: Large cap Tk. 1000 million or more. Mid cap Tk. 500 million to Tk. 1000 million. Small cap -Tk. 250 million to Tk. 500 million. Micro cap Tk. 250 million or less. Criteria based or screen based investing Some analysts use a filter or criteria to select the company which they want to trade on. These criteria are based on quantitative factors. Again this is done using computers since the selection is done pretty fast. Momentum of the company can also be used as a deciding factor. Some companies are just doing well for a few quarters in a row which make people believe that company is in good shape. These companies usually outperform other companies in short run and everyone would like to buy stock of this company. Another interesting topic in quantitative analysis is something called as CANSLIM. CANSLIM is a system pioneered by William J. ONeil that is a hybrid of quantitative analysis and technical analysis. CANSLIM has an interesting acronym. C and A stand for current and annual earnings; N - stands for new (new product or new market); S L stands for small cap and large volumes; I - stands for institutional ownership; and M stands for market momentum. All these aforementioned factors are used to decide buy or sell of a company. 4.0 Modus Operandi of Quantitative Analysis 4.1 Quantitative analysis with respect to trading equities generally includes the following research topics: Annual Reports Financial Statements (Earnings, Revenues, Etc.) Publicly Available Data General Economic Data General Econometric Data 4.2 Quantitative analysis with respect to funds involves evaluating statistical analysis of the trading managers track record. These include: A. Return Analysis Compounded average rate of return Percentage of positive months Consistency Length of Track Record B. Risk Analysis Volatility Measures Standard Deviation Monthly Standard Deviation Annual Standard Deviation Combined upside and downside standard deviation Downside Deviation only Sortino Ratio Drawdowns Maximum Drawdown Depth of Drawdowns Frequency of Drawdowns Time in any given Drawdown Recovery from a Drawdown Reward to Risk Average Return Divided by Maximum Drawdown (Total Return Minus Risk Free Rate of Return)/(The Total of All Drawdowns) (Average Return)/(Maximum Drawdown) Sharpe Ratio: (Average Rate of Return Minus Risk Free Rate of Return)/(Annual Standard Deviation) Treynor Ratio: : (Average Rate of Return Minus Risk Free Rate of Return)/(Degree of systematic Risk-ÃÆ'Ã… ½Ãƒâ€šÃ‚ ²) Reward to Assets Under Management Evaluating all of the above measures as a manager increases assets under management The average rate of return since the manager first had 50% of their current assets under management. 5.0 Qualitative Analysis of Stock as Input to Quantitative Analysis of Stock Subjective, non-statistical oriented analysis generally comes before Quantitative Analysis. Qualitative research is one of the two major approaches to research methodology in social sciences. Qualitative research involves an in-depth understanding of human behavior and the reasons that govern human behavior. Unlike quantitative research, qualitative research relies on reasons behind various aspects of behavior. Simply put, it investigates the why and how of decision making, as compared to what, where, and when of quantitative research. Hence, the need is for smaller but focused samples rather than large random samples, which qualitative research categorizes data into patterns as the primary basis for organizing and reporting results. Unlike quantitative research, which relies exclusively on the analysis of numerical or quantifiable data, data for qualitative research comes in many mediums, including text, sound, still images, and moving images. This sort of analysis is the most im portant for the following reasons: Stock market is in transition from poor form of efficient market to semi-strong form of efficient market; Most of the investors have inadequate knowledge of stock market; Most of the investors take investment decision on the basis of information being aired over the sky of the stock market without judgement; Most of the investors are willing to make capital gain; Most of the investors, especially small investors are vulnerable to stock market gambling/crisis originated from any source. Non-statistical Qualitative analysis generally explores the following: Sustainable competitive advantage Quality Experience of Management Employee Morale Loyalty Industry Competitors Strength of Research Development Cyclicality of the Industry Actions towards Investors interests Ability to achieve economies of scale General labor relations Quality and Positioning of Products Quality and Positioning of Services 6.0 Quantitative Analysis-Selection of Security to Buy or Sell An investor or Fund Manager can create An Equity Desk- a set of some stocks which has the potential to grow at a good pace over a period of time. This analysis is an attempt to rank the selected stocks and help an investor decide which among the lot is the best and the worst stock to invest at the current market prices. Basically, this is a quantitative analysis of a set of stocks, based purely on their fundamentals. The TED methodology can be used on any portfolio to determine the best and the worst. The study has taken 11 blue chip stocks for analysis as follows: All the 11 stocks will be analyzed based on P/E Ratio Return on Equity Last 4 years CAGR Sales Growth Last 4 Years CAGR Profit Growth Market Cap P/BV Ratio Debt to Equity Ratio Dividend Yield Last 4 Years CAGR dividend per share growth Dividend Payout Ratio Basically, we will be looking at parameters typically used by both growth and value investors. Ranking Methodology: All the 11 stocks are ranked based on each parameter say P/E Ratio to begin with. A stock with the lowest P/E Ratio gets the highest 11 points, while a stock with the highest P/E Ratio gets the lowest 1 point. Similarly, for other parameters like ROE, market-cap etc, each stock is awarded between 1 point and 11 points depending on where it stands compared to each other. The scores are added at the end, and the stocks are ranked from 1 to 11. Flaw in the Methodology: Looks into the past rather than the future to rank the stocks. ROUND NUMBER 1 THE P/E RATIO Obviously, lower the P/E ratio, the better. Since there are 11 stocks in the portfolio, the stock with the lowest P/E Ratio gets 11 points while the stock with the highest P/E ratio gets 1 point. Company Name P/E Ratio Points Earned 1. AX 11.67 11 2. BX 13.57 10 3. CX 19.29 9 4. DX 19.94 8 5. EX 20.46 7 6. FX 28.94 6 7. GX 29.56 5 8. HX 30.41 4 9. IX 40.23 3 10. JX 43.12 2 11. KX 55.12 1 AX is the cheapest stock of the lot and hence gets rewarded with the maximum 11 points. Meanwhile, KX had a loss making quarter recently, and hence its P/E is extremely high. It is appropriately penalized with just 1 point awarded to it in this round. The rest of the stocks get 10, 9, 8 etc points in descending order based on their current P/E. ROUND NO. 2 RETURN ON EQUITY Higher the ROE, better is the stock for investment. The stock with the highest ROE gets 11 points and the stock with the lowest ROE gets 1 point in this round. Company Name ROE Points Earned 1. BX 94.68 11 2. IX 45.00 10 3. DX 43.01 9 4. FX 39.99 8 5. AX 34.58 7 6. JX 34.55 6 7. CX 24.88 5 8. GX 18.59 4 9. EX 15.46 3 10. HX 13.71 2 11. KX 13.36 1 To find out the stock with the best combination of low P/E and high ROE, we add the points earned by each stock in the P/E round and the ROE round. Company Name P/E Ratio ROE Total Points Earned Ranking 1. BX 10 11 21 I 2. IX 3 10 13 VI 3. DX 8 9 17 III 4. FX 6 8 14 IV 5. AX 11 7 18 II 6. JX 2 6 8 IX 7. CX 9 5 14 V 8. GX 5 4 9 VIII 9. E X 7 3 10 VII 10. HX 4 2 6 X 11. KX 1 1 2 XI For now, the best stock to buy is BX and the worst to own now is KX. But the contest is not over yet. We add the scores earned by each stock in market cap, sales growth, profit growth, debt equity ratio and other rounds. ROUND NO. 3 THE MARKET CAP It is almost always better from capital appreciation point of view to invest in stocks with low market cap. So, in this round, the lowest market cap stock gets the maximum while the stock with the highest market cap to get just 1 point. Expect the GX twins to be hit hard in this round. Company Name Market Cap (TK.in Million) Points Earned 1. BX 513 11 2. CX 914 10 3. FX 1249 9 4. IX 2015 8 5. DX 3960 7 6. AX 6850 6 7. KX 8870 5 8. EX 10000 4 9. JX 12500 3 10. GX 30,000 2 11. HX 60,000 1 ROUND NO. 4 LAST 4 YEAR SALES CAGR Sales growth rates are as important as profit growth rates, if not more. If a stock has a scorching bottom line growth and a dull top line growth, it probably implies that the going might not last long. Bottom line growing faster than top line can happen because of improving margins, for example. But there is only a limit up to which you can increase margins after that, the bottom line growth will align with the top line growth. So in this round, we reward companies with high top line growth and take away points from companies with lower sales growth rates. Company Name 4 year Sales CAGR in % Points Earned 1. EX 87.91 11 2. IX 72.88 10 3. HX 37.88 9 4. FX 35.92 8 5. JX 33.36 7 6. GX 27.69 6 7. AX 24.37 5 8. DX 21.92 4 9. KX 21.00 3 10. BX 18.60 2 11. CX 15.88 1 ROUND NO. 5 LAST 4 YEARS PROFIT CAGR Company Name 4 year Profit CAGR in % Points Earned 1. IX 96.8 11 2. BX 73.21 10 3. EX 71.61 9 4. AX 48.89 8 5. DX 44.8 7 6. CX 38.95 6 7. HX 35.68 5 8. JX 35.57 4 9. FX 31.89 3 10. GX 22.45 2 11. KX 3.47 1 Now we add the scores again after 5 Rounds -Combination of Best Five Quantitative Parameters Company Name P/E Ratio ROE Market Cap 4 year Sales CAGR in % 4 year Profit CAGR in % Total Points Earned Ranking 1. BX 10 11 11 2 10 44 I 2. IX 3 10 8 10 11 42 II 3. DX 8 9 7 4 7 35 IV 4. FX 6 8 9 8 3 34 V 5. AX 11 7 6 5 8 37 III 6. JX 2 6 3 7 4 22 IX 7. CX 9 5 10 1 6 31 VII 8. GX 5 4 2 6 2 19 X 9. EX 7 3 4 11 9 34 V 10. HX 4 2 1 9 5 21 VIII 11. KX 1 1 5 3 1 11 XI ANALYSIS: BX tops each of the 5 rounds except for the rather crucial sales growth round. Although IX looks expensive, it still seems to be among the best stock to buy if we consider the above 5 parameters. KX had an extraordinary expense (write off) in the last period of study. This methodology punishes such a company, because at the end of the day, the market looks at the numbers on the table. Only the perfect companies are rewarded with higher rankings. The contest isnt over yet 5 more rounds to go, before we decide on the winners and the losers.