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The Valuation of Security Analysis

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  • Alex Kane
  • Alan J. Marcus

Abstract

Active portfolio management is commonly partitioned into two types of activities: market timing, which requires forecasts of broad-based market movements, and security analysis, which requires the selection of individual stocks that are perceived to be underpriced by the market. Merton (1981) has provided an inciteful and easily-implemented means to place a value on market timing skills. In contrast, while a normative theory of stock selection was outlined long ago in Treynor and Black's (1973) work, no convenient means of valuing potential selection ability has yet been devised. We present a framework in which the value of a security analyst can be computed. We also treat market timing ability in this framework, and therefore can compare the relative values of each type of investment analysts. We find that stock selection is potentially extremely valuable, but that its value depends critically on the forecast interval, on the correlation structure of residual stock returns, and on the ability to engage in short sales. Finally, we show how to modify the value of selection for the important case in which analysts' forecasts of stocks' alphas are subject to error.

Suggested Citation

  • Alex Kane & Alan J. Marcus, 1986. "The Valuation of Security Analysis," NBER Working Papers 1958, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1958
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    References listed on IDEAS

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    1. William F. Sharpe, 1963. "A Simplified Model for Portfolio Analysis," Management Science, INFORMS, vol. 9(2), pages 277-293, January.
    2. Sharpe, William F., 1967. "Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 2(02), pages 76-84, June.
    3. Jensen, Michael C, 1969. "Risk, The Pricing of Capital Assets, and the Evaluation of Investment Portfolios," The Journal of Business, University of Chicago Press, vol. 42(2), pages 167-247, April.
    4. Roll, Richard & Ross, Stephen A, 1984. " A Critical Reexamination of the Empirical Evidence on the Arbitrage Pricing Theory: A Reply," Journal of Finance, American Finance Association, vol. 39(2), pages 347-350, June.
    5. Roll, Richard & Ross, Stephen A, 1980. " An Empirical Investigation of the Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 35(5), pages 1073-1103, December.
    6. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
    7. Admati, Anat R & Ross, Stephen A, 1985. "Measuring Investment Performance in a Rational Expectations Equilibrium Model," The Journal of Business, University of Chicago Press, vol. 58(1), pages 1-26, January.
    8. Dhrymes, Phoebus J & Friend, Irwin & Gultekin, N Bulent, 1984. " A Critical Reexamination of the Empirical Evidence on the Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 39(2), pages 323-346, June.
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