The Valuation of Security Analysis

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. Robert Merton and others have provided an insightful and easily implemented means to place a value on market timing and fundamental analysis skills. While a normative theory of stock selection was outlined in 1973 by Jack Treynor and Fischer Black, no convenient means of valuing potential selection ability has yet been devised. In this article the authors present a framework for estimating the value of security analysis, be it by human or computer. They also treat market timing ability in this framework, and are therefore able to compare the relative values of each type of investment analysis. They 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, they show how to modify that value of selection for the important case in which analysts' forecasts of stocks' alphas are subject to error.