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By M. Isi Eromosele
A stock market is an investment platform where risk cannot
be ignored.
In order to develop effective stock market portfolio
management strategies, it is important to first gain a good understanding of what factors
influence share price movements and to what extent.
Speculators monitor movements in economic indicators to
decide whether to buy or sell stocks, bonds, shares, commodities, foreign
currency and other instruments or goods traded in speculative markets.
In order for movements in economic indicators to be
monitored, one needs to have some historical data on the indicators to use as a
comparative base for new data. Different macroeconomic forces impact on each other
and ultimately influence share prices.
Having gained an understanding of the fundamental analysis
and technical analysis tools available for the investment portfolio
manager, these tools should be incorporated into the risk management strategies.
These strategies include consideration of the macroeconomic
factors likely to influence share prices, an analysis of which market sectors
are likely to benefit from the macroeconomic environment and selection criteria
for companies within those sectors.
These would be pro-active strategies to position the stock
market investment portfolio manager in a reduced risk starting block with
profit potential.
Buying and selling signals are addressed as part of the risk
management strategy, as it is important to
remove emotion from the decisions made. Due to the cyclical nature of the stock
market, timing of transactions cannot be ignored when developing these strategies.
Fundamental Analysis
The macroeconomic environment must be scanned to ascertain
whether conditions are favorable for an increase in the value of shares as a
whole. Thereafter, consideration should be given to how the forces in the macroeconomic
environment are likely to influence the different market sectors.
Once the sectors most likely to benefit have been identified,
companies within those sectors need to be evaluated on the basis of their
financial soundness with the use of financial ratios.
Macroeconomic Environment
It is important to ascertain in which phase of the business
cycle the economy is functioning, to gain insight into what is likely to happen
with factors such as production and sales, exports, imports, interest rates, and
inflation. These factors will all influence share prices because they impact on
company profits.
Factors influencing balance of payments should be researched
to enable the investment portfolio manager to anticipate changes in the balance
of payments, so as to evaluate currency stability or predict changes in
currency strength.
As a result of the varied impact on different market sectors,
the risk management strategies developed need to address the risk associated
with investing in a single market sector. Deciding that the companies selected
for the investment portfolio should be representative of two or more market
sectors can effect this.
It is important to ascertain which companies in the selected
sectors are fundamentally poised to benefit from activity in the economic
environment, and are most likely to show a positive movement in their share
prices.
Different levels of reaction can occur from different companies
in the same sector to influences on that sector. This may have been as a result
of the traders’ perceptions of how much each company would benefit based on
their fundamental position.
There is no relationship between market capitalization of
shares and risk, as well as no relationship between market capitalization and
trading frequency. Market capitalization will, therefore, not be considered as
an influence on liquidity or risk and, as a result will be excluded from the
selection criteria.
Price: Earnings (PE) Ratio
Price: Earnings (PE) ratio acts as a good indicator of the value
of a company’s shares. If the projected growth in earnings does not justify the
inflated PE ratio, then the shares are overpriced. If on the other hand a PE ratio
is deflated, it could mean that the shares are under-priced, or that the company
is perceived by investors to be in trouble.
Generally, a high PE ratio means high projected earnings for
the company in the future. A company with a high PE ratio will have to deliver
on the expectation, or its share price will drop.
A PE ratio of 40, for example, means that an investor would
have to wait 40 years to see a return on investment. Historically, a desirable
PE ratio is one that falls between 15 and 30. A company with a PE ratio of 30
has greater scope for a fall in the price of shares than a company with a PE
ratio of 9.
In developing risk management strategies for stock markets, PE
ratios should be used as a guide to the value of the companies’ shares. No
numerical boundaries need be selected for the PE ratio.
Risk Exposure
Beta is a measure of the volatility of a share in relation
to the volatility of the market as a whole. Beta gives the stock market
investment portfolio manager an indication of how much risk as a result of volatility
of the company’s shares they are exposing themselves to.
If a company has a beta of 5, for example, it has
historically moved in the same direction as the market, but with five times the
intensity. If the market surrenders 2 per cent of its value in one day, a company with a beta of 5 will
historically have surrendered 10 per cent of its value on the same day.
These values are calculated using weekly data over a three-year
period.
Return On Shareholders’ Funds
Return on shareholders’ funds is a ratio, which demonstrates
the percentage return that the company has generated on the shareholders’ funds
at its disposal. It serves as an indicator of profitability, which would result
in a profit opportunity for the stock market investment portfolio manager.
Developing A Watch List
Once the list of companies has been developed based on the
above-mentioned criteria, these shares can be monitored for buying signals. The
watch-list should be updated whenever new selection criteria information or new
economic data is available.
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control ©
2012 Oseme Group
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