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Literature Review Of The Stock Investment Process


The stock investment process looks considerably different depending on the investor’s belief about market efficiency. The discussion in the academic literature about whether the stock market is efficient or not is endless long and the conclusions differ.2 Based on the belief in the degree of market efficiency, two major investment theories emerged that still separate the financial community. On the one hand is fundamental analysis based on the idea of non-efficient markets and on the other hand modern portfolio theory (MPT) with a strong faith in market efficiency.

Fundamental Analysis

Fundamental analysis is an investment approach that uses existing economic information, such as historical financial statements or different fundamental information about a company, to make investment decisions. The principles of fundamental analysis were first outlined in the book ‘Security Analysis’ of Graham and Dodd (Graham and Dodd, 1934). Two approaches to fundamental analysis are widely used today: the ‘Top down’ and the ‘Bottom up’ approach. The idea behind the ‘Top down’ approach is to use all information available, including macroeconomic data, to make an investment decision. In general, fundamental analysts look first at the current macroeconomic conditions, because for them the decision to invest depends mainly on what stage of the business cycle the economy is heading and which industry is expected to perform well in the forecasted economic environment. Then analysts try to find the best companies in these industries. The stock selection process is based on the idea that the stock of the selected company must outperform its peers in the industry and the industry must outperform other industries. The top-down approach is widely accepted and followed on Wall-Street and well documented in investment textbooks. Investment strategies based on that approach include sector rotation (changes in the sector allocation based on changes in the economic environment) and style investing (the differentiation between value and growth stocks).

In contrast to the top-down approach, the ‘Bottom-up’ approach to fundamental analysis does not attempt to forecast the economic environment. It consists mainly of estimating the value of a stock and comparing it to its current market price. If a stock is significantly undervalued, it is considered a buying candidate independent of future market or macroeconomic conditions. The proponents of this approach try to find good companies that are selling at a low price in relation to their fundamentals. Mainly because academics feel uncomfortable ignoring some important available information, the bottom-up approach is less of a focus in textbooks and empirical research and therefore also known as the practical approach to investing.

Although we know of no academic study comparing the empirical validity of the top-down and bottom-up approach to fundamental analysis, it seems that the bottom-up approach produced the most profit for its followers (Buffet, 1984). Forecasting the economy has been proven to be a very difficult task that rarely produces satisfactory investment returns. The most common mistake in the top-down approach is however that investors focus on companies rather than on stocks. Investors must recognize that a good company is not necessarily a good investment. The stock selection process should always be based on a comparison between the intrinsic value of a stock and its current market price. Investors must thus determine whether a stock is under- or overvalued based on the fundamentals of the business. Only when value exceeds price by a high enough margin of safety should a stock be bought.?

Modern Portfolio Theory

Modern portfolio theory (MPT) is based on the idea of efficient markets. The underlying

philosophy of this investment theory is that all investors in the marketplace are intelligent, profit-oriented and are trying to find mispriced stocks. The large number of informed participants will ultimately drive a stock price to its intrinsic value and hence create an efficient market. In such an environment mis priced stocks would be detected immediately, the under- or overvaluation would disappear and no profit could be gained from using any form of investment analysis. In other words, the MPT states that all stocks are priced fairly and nobody can persistently outperform the market. Consequently, followers of this method of investing will try to reduce risk by diversification and costs by minimizing transaction fees and taxes. The 6 optimal investment strategy is the creation of an efficient portfolio based on covariance’s of all the stocks in the global marketplace. In praxis however, this strategy usually means investing in index funds.

As far as we know, modern portfolio theory (MPT), shows s detailed information about the proposes of how rational investors use diversification to optimize their portfolios. Also how a risky asset should be priced. What then should be an ideal pricing model based on MPT? The basic concepts of this theory are Markowitz diversification, the efficient frontier, capital asset pricing model, the alpha and beta coefficients, the capital market line (CML) and the securities market line (SML). [1] 

Empirical evidence

Book to Market (BTM)

For a number of years, there was a sizeable research by accountants and finance people trying to find stocks with a low BTM ratio earned lower returns than Stocks with a high BTM ratio. Moreover, Daniel et al (2001) find that BTM ratio has a weaker power to predict average Stock returns in the U.S. market than the Japanese stock market. They investigated the U.S. and Japanese stock markets from 1975 to 1997. Also Stattman (1980) find there are positive relationship between book-to-market ratio and average return for U.S. stocks. Nevertheless, Chen et al. (2007) find positive relation between book-to-market ratio and average return for the Chinese stock market. Wang and Iorio (2007) show that BTM ratio has sufficient power to explain stock returns, and that the conditional local betas and the global betas are not related to stock returns for the period 1994 through 2002 in Chinese stock market. Lams (2002) there are relationship between book to market ratio and stock return is positive for Hong Kong Stock Exchange for the period July 1984–June 1997.

According to Rosenberg et al. (1985)find that average returns in the are positively related to the ratio of a firm’s book value of common stock to its market value, BE/ME. Chan et al. (1991) also find a similar positive BE/ME and average returns relation in the Japan stock market. Chui and Wei (1998) examine the relationship between expected stock returns and, book-to-market equity, and size in five Pacific Basin emerging markets. They find that the relationship between average stock return and is weak for all five markets. But the book-to-market equity can explain the cross-sectional variation of expected returns in Hong Kong, Korea, and Malaysia, while the size effect is significant in all five markets except Taiwan.

FF (1998) provide international evidence on the value premium by observing that value stocks (high book-to-market equity) outperform growth stocks (low book-to-market equity) in 12 of 13 major markets during the 1975–1995 period and document the existence of an international size effect (with small stocks outperforming large stocks in 11 out of 16 markets). However, the risk-based explanation of FF has been challenged by Daniel and Titman (1997) who observe that it is firm characteristics rather than the covariance structure that explains the cross-sectional variation in average returns.

Drew and Veeraraghavan (2002) find that the multifactor model approach provides a parsimonious description of the cross-section of returns, with the relationship between firm size, book-to-market equity and average stock returns being robust for several Asian markets over the 1990s. To date there is no evidence on the explanatory power of these factors in the Chinese market. This paper therefore extends the literature into one of the most challenging international markets by investigating of the explanatory power of an overall market factor, firm size and book-to-market equity for equities listed on the Shanghai Stock Exchange.

Drew et al (2003) findings suggest that mean-variance efficient investors in China can select some combination of small and low book-to-market equity firms in addition to the market portfolio to generate superior risk-adjusted returns. Moreover, we find no evidence to support the view that seasonal effects explain the findings of the multifactor model. In summary, we find the market factor alone is not sufficient to describe the cross-section of average stock returns in China. Djajadikerta and Nartea (2005)The results suggest a statistically significant size effect but aweak abook to market effect in newzealand stock market for period 1994 to 2002

Price to Earnings (PE) Ratio

Price to Earnings (PE), this model is very easy and realistic and can be easily applied to corporate profits Historical. In addition, it can be used to measure the extent of cheap or expensive shares relative to other stocks.

Moreover, lam (2002) find the beta was not able to appear to explain the stocks return in the Nikkei Stock Exchange of Hong Kong in the period from 1984 to 1997. It seems that the three variables including the size, B / M and P/E ratio can be interpreted in cross-sectional changes in the Nikkei stock return during that period. Furthmore, Basu (1983), found that the impact of P/E ratio was not visible with respect to small capital stocks. In another research, Lewllen (2004) found that there was a weak relationship among the Stock Return and E/P for the period 1946 through 2002 in the companies listed in New York Stock Exchange.

As well as, Isa and Jin (2000), a weak relation among earning– per-price ratio and return stock for the Malaysian stock market, also there is significant size can have an impact on Malaysian stock returns. Sezgin (2010) find there is relationship among variables long-run and short-run. RE effects negatively on PE in long-run and DY ratio effects positively on PE in long-run, over the period 2000-2009 of ISE 100 index.

Ong et al (2010) This study observes the development of the Malaysian stock market index, the Kuala Lumpur Composite Index (KLCI) and its PE ratio between 1994 and 2010, a time period that involves notable financial crisis such as the 1997/98 Asian financial crisis and the global financial crisis of late. Although the notions that high levels of PE Ratio could have resulted in the fall of stock market returns in the Malaysia context is rejected in this study, the results show that PE ratio is still a useful predictor of the performance of KLCI. Moreover, Al-Mwalla et al (2010), Find there is long run equilibrium between dividend yield, P/E ratio, size and the return on the stocks of Jordanian companies. The sample of 24 companies listed in the Amman Bursa was selected. The annual average values for the suggested variables from 1980 to 2006 were calculated.

Campbell and Shiller (2001) find P/E is the mean return and provide evidence that valuation ratios are historically accurate in forecasting stock price changes. If the multiplier is the mean rate of return and takes on a value much higher or lower than average, mean regression means that prices in the future, profits, or both must be at least partially forecast able.

In addition, Carlson et al (2002), find Statistical evidence of an upward shift in the average percentage of time Series P / E for the S & P 500 index. This structural break in the series mean P / E indicates that the new average price multiplier much higher than the historical long-run average price multiplier. And rules that detect excessive by comparing the current value of the absolute double historical averages may be misleading if the historical average P / E increased. Therefore Fama and French (1992),Shown to decrease the value of the stock price to the book, low P / E stocks outperformed the market significantly over the period 1963 -1990.

Basu (1977) Find that there is a relationship between my historical rates and the consequent risk stock market performance amended. Such a relationship is inconsistent with the efficient market hypothesis semi-strong form as they indicate that investors can employ PE ratios available to the public for the expected rates of return in the future. Based on these experimental studies, the paper seeks to explore the other side of the relationship between the public and the rates of stock performance: If you are high my precedes a decline in stock prices, and if the rates of BP can be a sign warning of the market bear the next.

Return on assets

Return on assets is indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets. [2] The Return on Assets is the profit generated from each dollar of assets. Generally, the higher the ROA, the more efficient the management is at generating profit. ROA varies between industries, so the best way is to compare with the company's past ROA of the ROA of a similar company.

In addition, Yao et al (2010) find a pervasive negative relation between asset growth and subsequent stock returns on the nine equity markets in Asia for the period from 1981 to 2007. In addition, Tudor (2008) finds there is no relationship between the return on assets with stock return, on the Romanian stock market for the period 2002 to 2008. Moreover, Mais (2005) performed research on effect of financial ratios, including NPM, ROA, ROE, DER, and EPS, on stock price of companies listed on Jakarta Islamic Index in 2004. The outcome of this research explains that statistically all variables except DER are significant and have positive impact on stock price.

Based on by Kennedy (2005) analyzed the effect of ROA, ROE, EPS, Profit Margin, Assets Turnover, DTA, and DER on stock return using samples of stocks from LQ 45 index in BEJ during period 2001-2002. This research finds out that TATO, ROA, EPS, and DER have positive effect, while ROE and DTA have negative effect, on stock return. However, all variables are statistically insignificant in influencing stock return.

Current ratio

The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies within the same industry.

Roswati (2007) studied the effect of CR, TATO, DER, ROE, EPS, and PBV on stock price of manufacturing industry with five sub-industries including retail, food and beverages, tobacco, automotive, and pharmacy. The result shows that the significant financial ratios in retail industry are ROE, EPS, and PBV; In food and beverages industry are EPS and PBV; In tobacco industry are CR, TATO, DER, EPS, and PBV; In automotive industry are DER, ROE, EPS, and PBV; while in pharmacy industry are CR, EPS, and PBV. In overall five industries, the influential financial ratios are TATO, DER<EPS, and PBV. Furthermore, this research shows that the variety of average stock prices can still be explained properly by financial ratios during 1-3 month period after the issuance of annual financial report.

Hamzah (2007) analyzed the correlation between financial ratios, including liquidity ratio (Current ratio),profitability ratio (Return on Investment), activity ratio (Total Assets Turnover), and solvability ratio (Debt to equity), and both capital gain (loss) and dividend in 135 manufacturing companies listed on Jakarta Stock Exchange.


Bodie (1976) find claims that there are two distinct ways to define stocks as a hedge against inflation. First, a stock is a hedge against inflation if it eliminates or at least reduces the possibility that the real rate of return on the security will fall below some specific floor value. Secondly, it is a hedge if and only if its real return is independent of the rate of inflation

Canova et al ( 1997) ,they find, analyze the Stock return ,long term structure, inflation and Real activity for US, Germany , Japan and UK and concluded that there were relationship with nominal stock returns are negatively significant to inflation only in the US and it didn't have correlated for other countries. Moreover, Cozier and Rahman (1988) Investigated in stock returns, inflation and real activity in Canada. First, using the rational expectations forecasting procedure, they degrade the Canadian series to the components of inflation, expected and unexpected. They said that there is a negative relationship among stock returns and inflation. Therefore, Beirne et al (2009) they are examine the market, Interest rate and Exchange rate risk effect on the financial Stock returns. To examine this fact they selected three sectors (Banking, Financial Services and Insurance) of 16 different countries including some European countries. They used fourvariate GARCH-M Model. Their variables were short-term debt (90 Day treasury Bills Rate) and 10- years Government bond yield for all the countries. Overall results showed that interest rate and exchange rate effects common in banking sector and financial services but in insurance sector interest rate and exchange rate have limited effect.

In addition, Boudhouch and Richarson (1993), they find data sets use, covering the period 1802 to 1990 of the United States from 1820 to 1988 and from Britain. Results obtained indicate a positive relationship between inflation and nominal stock returns on the long horizons.

Fama (1981), Suggests that there is a negative relationship between stock returns and the level of inflation. There is negative relationship due to the existence of the relationship between inflation and output in the future. Expected economic downturn, in particular, since stock prices reflect corporate profits in the future, high inflation rates and lower stock prices. Moreover, Spyrou (2001), suggests that there is a negative relationship between stock market returns and inflation in Greece for the period 1990 to 1995. Nevertheless, Ioannides et al (2001) there is negative relationship between the inflation and stock return in Greece over the period 1985 - 2000.

Jaffe and Mandelker (1976) find a negative relationship between stock returns and inflation suggests that the stock market is not even a partial hedge against inflation. And a negative correlation implies that the investors, whose real name is wealth dwindle due to inflation can be expected to double by the end of this less-than-average return in the stock market.


Kolluri and Wahab (2007), find an inverse relationship between stock returns and inflation expectations during periods of low inflation rates only, while not disclosed the existence of a positive relationship during periods of high inflation. In combination, both systems from the results of high inflation and low indicate that the shares delivered a favorable inflation protection. They use the period between January 1970 and December 2004. Therefore, Kaul (1987) find an inverse relationship between stock returns and inflation expectations during periods of low inflation rates only, while not disclosed the existence of a positive relationship during periods of high inflation. In combination, both systems from the results of high inflation and low indicate that the shares delivered a favorable inflation protection.

In addition, Park and Ratti (2000), find Variation in rates of inflation in the future strengthen the uncertainty, and limited economic activity in the future. They can be explained by an inverse relationship between inflation and output in the future through: (a) the existence of a positive relationship between the level of inflation and inflation volatility, and (b) the existence of a negative relationship between volatility of inflation and real activity in the future. Predicted a decline in production in the future, in turn, lowers the current stock price lead to negative equity returns. And these effects are enhanced by greater economic uncertainty in times of high inflation rates, leading to increased risk premiums on equity used to discount the future cash flows, and thus lower stock prices and returns. In sum, given the existence of a positive relationship between the volatility of inflation and the level of expected inflation, and a negative relationship between stock returns and the volatility of inflation can cause a negative correlation between stock returns and expected inflation. Moreover, Jung et al (2007) find the effects of anticipated inflation and expected real stock returns for France, Germany, Italy and the United Kingdom. We find evidence that inflation is expected to affect stock returns in France, Italy and the United Kingdom; however, inflation is not expected. Unexpected interest rates also affect real stock returns in the three countries.

Alagidede (2009) Find the Fisher hypothesis for 6 African countries. Using OLS estimates we find positive relationship between inflation and stock returns in Kenya and Nigeria. However, instrumental variable estimates provide consistent results and confirms the validity of a generalized Fisher hypothesis in 3 markets: Kenya and Nigeria at the 12 month horizon, and Tunisia at 60 month horizon. This suggests that investors should expect stocks to be a good hedge against inflation over long horizons. Moreover, Choudhry (2006) find the relationship between stock returns and inflation in four high inflation (Latin and Central American) countries are: Argentina, Chile, Mexico and Venezuela. Compared with most previous research (which involves low rates of inflation) this article provides evidence of a positive relationship between stock market returns and current inflation. This result confirms that stock returns as a hedge against inflation. The results also showed that inflation last also affect the current rate of dividends.

Interest rate and exchange rate

Harvey (1993), Find the stock returns in emerging countries that can be very unpredictable and has to do with lower stock returns in developed countries. The emerging markets are less efficient than developed markets, and can get higher yield and therefore low risk arising from the market by listing shares in the portfolios of investors. Therefore, Zhou (1996), the relationship between interest rates and stock prices using regression analysis, he find that interest rates have a significant impact on stock returns, especially on the prospects for a long time, but was rejected the hypothesis that expected stock returns move one-for-one with ex Ante interest rates. In addition, you receive the results of long-term interest rates may explain a large part of the difference in the ratio of price to earnings, and is proposed to be associate with high volatility in the stock market to the high volatility in bond yields long-term and may be reached by changing the expectations of discount rates .

Asprem (1989), find A positive relationship between stock returns and real activity using data from 10 European countries, as well as to find support for the money supply and interest rate and exchange rate variables. Nevertheless, Carrieri and Majerbi (2006) they find the pricing of exchange risk in emerging stock markets. It covers eight countries (Argentina, Brazil, Chile, Mexico, Greece, India, Korea, Thailand and Zimbabwe), and the collection of revenue on a monthly basis. Finally, the agent and the price of interest rate risk-free, and the common exchange risk factor important and significant marginal to the Governor of scale. Alam and Uddin (2009) they find the relationship among Interest rate and stock returns of developed and developing countries. To examine this they collect the monthly interest rate and Stock Exchange Index from January 1998 to March 2003 of fifteen countries and run the panel regression. Finally, they said that there is relationship among interest rate and stock returns is negative. Beirne et al (2009) examined the market, Interest rate and Exchange rate risk effect on the financial Stock returns. To examine this fact they selected three sectors (Banking, Financial Services and Insurance) of 16 different countries including some European countries. They use fourvariate GARCH-M Model. Their variables were short-term debt (90 Day treasury Bills Rate) and 10- years Government bond yield for all the countries. Overall results showed that interest rate and exchange rate effects common in banking sector and financial services but in insurance sector interest rate and exchange rate have limited effect.

Leon (2008) estimates the impact of interest rate on stock returns in Korea. For this purpose he took the weekly data on Korean Stock Price Index 200 (KOSPI) for the period of six years (1992-1998) as dependent variable and weekly Negotiable Certificates of Deposits (Korea NCD 91-Day yield) for the same time as independent variable and run the Generalized Autoregressive Conditional Heteroskedasticity (GARCH) and reported that the Conditional market return have a negative and significant relation with the interest rate. Moreover, Khababa (1998) find behavior of the stock price in the Saudi Stock Exchange is seeking to double the evidence in the form of efficiency and found that the market was not weak form efficient. He explained that the inefficiency may be due to delay in operations and high transaction costs, and the thinness of trading and liquidity in the market.

In addition, Lee (1997) the regressions using rolling three-year analysis of the relationship between the stock market and interest rates on short-term. Try to forecast excess return (ie the difference between stock market returns and risk-free interest rate on short-term) on the S & P 500 with the interest rate on short-term, but found that the relationship is not stable over time. Gradually changed from a negative to a large extent in any relationship, or even in spite of the positive relationship are slim. Jefferis and Okeahalam (2000) the Sample from South Africa, Botswana and Zimbabwe stock market, where the assumption of higher interest rates lead to lower stock prices through the effect of changing (interest bearing assets relative to become more attractive to share), an increase in the discount rate (and thus lower the present value of future returns expected), or Depressing effect on investment and hence on the expected future profits.

In addition , Arango (2002) find Some evidence on the relationship non-linear inverse between stock prices in the stock market of Bogota and the interest rate as measured by the interest rate on these loans between banks, which to some extent influenced by monetary policy. The simple fact in this market of high dependence of returns in short periods, these results does not support any efficiency in the major stock market in Colombia. Uddin and Alam (2007) fine Linear relationship between the share price, interest rate, stock price and changes in interest rates, and changes in share price and the interest rate, and changes in share price and changes in interest rate on the Dhaka Stock Exchange (DSE). For all cases, were included and the exclusion of outlier, and found that the interest rate has a significant negative relationship with share price and changes in interest rate has a significant negative relationship with changes in share price. The study shows various mixed results; this study tested a model random walk and examines the implications of the share price on the interest rate and changes in stock prices changes in interest rates, both in the time series and the team approach, for fifteen of the developed and developing countries. Hsing (2004) find VAR model is based structure, which allows determining the time and one of the several local variables such as, the gross real interest rate and exchange rate and stock market index, and finding that there is an inverse relationship between stock prices and interest rates.

In addition, Solnik (1987) find that the main reason is the poor quality of macroeconomic data used. Much of this data, he says, suffer from large measurement errors, while the other cannot be measured directly so. It is proposed to increase dividends as a substitute for macroeconomic data, considering that stock returns reflect the expected changes in future economic activity, which can be measured directly and accurately returns. He uses monthly data and quarterly for eight industrialized countries from 1973-1983 to study the relationship between differences in real return securities (RSR) and changes in real exchange rates (RER) and reports a negative correlation between the death of love and RER data monthly and quarterly through the sample space for him. However, using monthly data over the 1979-1983 sub-periods, and notes the existence of a weak positive relationship between the two variables.

Abdalla and Victor (1997) investigate interactions between exchange rates and stock returns in the emerging financial markets of India, Korea, Pakistan and the Philippines to establish the causal linkages between leading returns in the foreign exchange market and the stock market. The results show uni-directional causality from exchange rates to stock returns in all the sample countries, except for the Philippines. Soenen and Aggarwal (1989) find Re-evaluation of the sample Solnik 1980-1987 using data from eight industrial countries themselves; they report a positive relationship between stock returns and exchange rates for three countries and a negative relationship for five.


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