History of Fundamental Analysis As A Trading Mechanism

History of Fundamental Analysis As A Trading Mechanism

https://www.ukessays.com/dissertation/
The history of fundamental analysis as a trading mechanism began with Benjamin Graham in 1928. Graham published his first book,
Security Analysis in 1934. This book defined the framework of Value Investment and is now in its fifth edition.
Since that time, a great deal of research focused on specific fundamental measures as key determinants of a securities future price. The
concept of efficiency is central to finance. Mainly, in an efficient financial market an asset price should be the best possible estimate of
its economic value.

1.2 Definition
A financial market is efficient when widely available information to participant is reflected in stock prices.

1.3 FORMS OF EFFICIENT MARKET

There are three forms of market efficiency; the weak form, semi-strong form and strong form.

Weak Form: Stock prices reflect all of the information contained in past stock prices. The inference drawn from this is that you cannot
consistently profit by spotting trends and patterns in stock prices.

Semi-strong Form: Stock prices all of publicly available information (including company accounts, industry data etc.). This simply
implies you cannot consistently profit by analysing company accounts and other public data.

Strong Form: Stock prices reflect all information (including information known only to company insiders. The insinuation is that no one
can earn excess returns by stock picking, even people with inside information.

However, this dissertation will concentrate more on using fundamental analysis to disprove the efficient market hypothesis which assets
that stock markets impounds all publicly available information about a company into stock prices in an instantaneous and unbiased
manner. The implication of this assertion is that publicly available information such as financial statement figures cannot be used to detect
mispriced securities; any investment strategy designed on the basis of published financial information should not prove profitable.
However, in contrast to this argument, fundamental analysts believe that the markets may misprice securities and that it is possible to
make an informed financial projections using financial statement information to earn an abnormal returns.

According to Fama (1970) he established the efficient market model after it has been tested and found supported by different wider
markets and this became widely in use by financial communities, applied economist and financial economist. The weak forms of the
efficient market hypothesis is strongly supported by evidence and the result follow and consistent with random walk model, while the
strong form test is strongly supported by the efficient market hypothesis Fama, Fisher, Jensen and Roll (1969) found that the real time
information such as the time of stock split, the future information on future dividend is fully reflected in this price
Grossman and Stigliz 1980 argues that if the market efficiency theory hypothesis govern the way price respond to information, then
Institutional investors and security analyst who engage in equity research will not arrive at any meaningful conclusion and the whole
research will be a complete waste of time and resources. To mention but a few other argument includes the market anomalies: such as
the post earning drifts, value versus growth and small cap stocks anomalies.

According to Ball and Brown (1968), even after earnings are announced, cumulative abnormal returns for stocks with unexpected positive
(negative) earnings surprise continue to drift upwards (downwards). This anomaly is known as Post Earnings Announcement Drift
(PEAD). Foster, Olson and Shevlin (1984) noted that sixty days prior to an earnings announcement, combining a long position in stocks
with unexpected earnings in the highest decile with a short position in stocks in the lowest decile generates an abnormal return of 25%
p.a. before accounting for transaction cost, which confirms the existence of the PEAD anomaly.
Many other researchers who have argued in favour of fundamentals analysis includes: Basu (1977) studied the relationship between price-
earning (P/E) ratios and excess returns, and was the first to uncover evidence that appeared to oppose the efficient market hypothesis
(EMH). Basu concluded that there was an information content present in publicly available P/E ratios, and portfolios built from low P/E
stocks earned excess returns even after adjusting for risk. Banz in 1981, did analysis on monthly returns over the period 1931-1975 on
listed shares on the New York stock exchange. Over this interval, he observed that the fifty smallest outperformed the largest by an
average of one percentage point per month. He observed a size effect, and concluded that there was a relationship between market
capitalization of a firm, and its returns, even after adjusting for risk. Also In 1981, Reinganum confirmed that data on firm size could be
used to create portfolios that earn excess returns.

Further fundamental anomalies were discovered, such as the book-to-market effect described by Rosenberg et al. (1984), which found
that stocks with a high book-to-market value yielded higher long-term returns. Fama and French (1992) surveyed the above styles of
anomaly detection, and concluded that if asset pricing is rational, then size and ratio of book to market value must be proxies for risk.
 History of Fundamental Analysis As A Trading Mechanism

Lakonishok et al in 1994 evidence in the US by considering a time horizon up to five years found a wide range of value strategies (based
on sales growth, book-to-market, cash flow, earnings, etc) all produced higher returns, and refuted Fama and French's claims that these
value strategies are fundamentally riskier. In 1995, Fama and French responded to Lakonishok by stating that size and book-to-market
equity are proxies for sensitivity to risk factors in returns. Their results also suggest that there is a size factor in fundamentals that might
lead to a size related factor in returns. Later, Fama and French (1998) studied returns on market, value and growth portfolios for the US
and 12 major EAFE countries (Europe, Australia and the Far East). They found that value stocks tend to have higher returns than growth
stocks, and conclude that these returns are explained by a one-state variable Intertemporal Capital and Asset Pricing Model (ICAPM) (or
a two-factor APT), that explains returns with the global market return and a risk factor for relative distress.
Frankel and Lee also in 1998 estimate firms fundamental values (V), using I/B/E/S consensus forecasts, and a residual income model.
They find V is highly correlated with stock price, and that V/P is a good predictor of long term returns. Piotroski focused on high book
to market securities, and shows that the mean return earned by a high book-to-market investor can achieve a return of at least 7.5%
annually. Piotroski 2000 also studied a number of different fundamental ratios and criteria with similar outcomes, and notes that returns
are concentrated in small and medium size companies, companies with low share turnover, and firms with low analyst following.

In 2001 Aby et al. focus on using fundamentals to screen stocks for value. Also in 2001 Aby et al. concentrated on four fundamental
conditions, namely, single valued P/E's; Market price less than Book Value; established track record of return (established by ROE), and
dividend payout ratio. The authors conclude that when the four criteria are used to screen stocks, quality investments seem to result. It is
interesting to note that in earlier work, the authors had simply focused on shares with low P/E and a market price below book value, and
concluded this filtering method did not produce satisfactory returns.

1.2 Contributions
Fundamental Analysis provides a framework for modelling the financial technicalities of a company. Primarily, it aids in the development
of company or industry specific models, and provides a means of evaluating the performance of a given company in terms of those
models. A considerable contribution of the fundamental models is that they provide for the calculation of a number of financial ratios.
These ratios are then used to assess the financial health of a company, and to compare directly to the ratios for different companies for
alternative investment decision.
There is a long established tradition of attempting to use these fundamental ratios as predictors of a companies future share price.
Primarily, this started with the work of Benjamin Graham in 1928, and forms the heart of an investment philosophy known as 'Value
Investing'. Value investors believe that the market does not price securities accurately, and that the true price of a security, its 'intrinsic'
value, only rarely coincides with the market price. The trading manner of value investors is to determine the intrinsic value of a security,
and acquire the security as long as the intrinsic value is above the price the market will sell at but according to the conventional definition,
a value investor is one who invest in low price book value or low price-earnings ratios stocks while the generic definition defines it as
one who pays a price which is less than the value of the assets in place of a firm. For example firms with high E/P, D/P or B/P ratios earns
positive capital asset pricing model (CAPM) – adjusted abnormal returns.

However, on the contrast growth investor focuses on the potential of a company with much less emphasis on its present price. They invest
on company that are trading higher than their current intrinsic worth in anticipation that the company intrinsic worth will grow and exceed
the current valuation

1.5 Structure
One important issue, the subject of this dissertation, is to apply fundamental analysis to two UK listed insurance companies namely :
Beazley Group Plc and Hardy Underwriting as a case study to investigate how detailed the financial statement information can be used
to implement an active investment strategy with the hope of making abnormal returns. The remainder of the dissertation proceeds as
follows: Section II provides a brief review of the relevant literature on various market anomalies such as post earning drift, value and
growth anomalies and small cap anomalies. Section III describes the methodology by explaining relevant descriptive financial ratios and
valuation dynamics procedure. The analysis of the result is explained in Section IV. The last section offers the conclusion.

2.0 Literature Review and Theoretical Frame Work

The semi-strong form efficient market hypothesis developed by Fama in 1970 assumes that security prices respond quickly to new
information such as earnings announcement. But research has observed an apparent delay in share price response to earnings information
(Richard, 2004). According to Ball and Brown (1968), even after earnings are announced, cumulative abnormal returns for stocks with
unexpected positive (negative) earnings surprise continue to drift upwards (downwards). This anomaly is known as Post Earnings
Announcement Drift (PEAD). Foster, Olson and Shevlin (1984) noted that sixty days prior to an earnings announcement, combining a
long position in stocks with unexpected earnings in the highest decile with a short position in stocks in the lowest decile generates an
abnormal return of 25% p.a. before accounting for transaction cost, which confirms the existence of the PEAD anomaly.

Various competing hypotheses try to explain the PEAD phenomenon. One school of thought attributes the phenomenon to ‘delayed
response' due to investors' failure to appreciate the full implication of earnings announcement and high transaction costs that restrain
immediate response to earnings news. Another school of thought suggests that there is misspecification in the Capital Asset Pricing Model
(CAPM) because the model fails to adjust returns for risk and thus, the abnormal return is a compensation for bearing risk not captured
in the CAPM (Ball et al 1988 in Bernard and Thomas, 1989).
 History of Fundamental Analysis As A Trading Mechanism

2.1.0 Evidence of Post Earnings Announcement Drift

US Evidence
The most widely accepted study of PEAD is that of Bernard and Thomas (1989). They empirically test competing explanations of PEAD
in the US using a sample of quarterly earnings announcements for firms listed on NYSE/AMEX, covering the period from 1974 to 1986.
The sampling criteria and the methodology are consistent with the models used by Foster et al. (1984) which are based on standardised
unexpected earnings (SUE) i.e. unexpected earnings scaled by their standard deviation. The SUE model allows for a better comparison
among firms because it accounts for earnings announcements at different points in time. Additionally, this model prevents firms with
more volatile earnings from unduly biasing the result. Firms are ranked in deciles according to SUE compared to their distribution in the
previous quarter and assigned to ten portfolios where the tenth portfolio consists of firms with the highest ranking of SUE. The results of
Bernard and Thomas (1989) show that PEAD exists for all stocks and it increases monotonically from the lowest to the highest SUE
decile. The effect of PEAD is more significant for smaller firms.

Finally, most of the drift appears within the first sixty days, almost all of the effect happens within nine/six months for small/large firms
and the largest part occur during the first five days. Bernard and Thomas reject the hypothesis of CAPM misspecification but find evidence
consistent to delayed price response as an explanation for PEAD. They conclude that the 12 existence of PEAD is due to investors' failure
to realise the serial correlation of quarterly earnings. Ball and Bartov (1996) however suggest that investors understand this implication
but underestimate the degree of serial correlation between current and future earnings by 50%. However, the UK evidence Liu, Strong
and Xu (2003) are consistent with that of Bernard and Thomas (1989) their result shows evidence of PEAD in the UK. The PEAD
portfolio (highest decile minus lowest decile) yields significant profit of 2.9%, 5.2%, 8.2%, and 10.8% over 3-, 6-, 9-, and 12 months
investment horizon respectively. After controlling for risk and market microstructure effect, the price based earnings surprise measure
gives the strongest drift effect. Other evidences by Forner et al. (2009) in the Spanish stock market, Truong (2010) in New Zealand,
Booth et al (1996) in Finland. The overall results justify the presence of PEAD in their respective stock markets.

2.1.1 Price Momentum and Post-Earnings Announcement Drift

Price momentum is the predictability of future returns from past returns. High (low) stock prices continue to drift up (down) in the same
direction so that on average, past winners continue to outperform past losers over a three to twelve month period (Jegadeesh and Titman,
1993). Chan et al (1996) attributes the existence of price momentum to market's under reaction to earnings news. They analyse the returns
of different earnings momentum strategies which differ based on how earnings surprises are measured. They find that earnings momentum
strategy that buys stocks in the top decile over the previous six months and sell stocks in the bottom decile over the previous six months
generates the highest abnormal return of 8.8% when held for six months. Chan et al (1996) conclude that drifts in future returns for the
next six to twelve months are predictable from previous news about earnings and a stock's returns.

2.1.2. Conclusion
Since PEAD is observed in several countries, it is evident that investors do not respond efficiently to public information like earnings
announcements, thereby questioning the efficient market hypothesis. A delayed response to information is accepted as an explanation by
a few scholars, while models misspecification is less convincing due to insufficient evidence. A new area of research into a possible
explanation of PEAD is the ‘Inflation Illusion Hypothesis' where investors fail to consider the inflation effect while predicting future
earnings growth rate. This may partly explain the delay in stock price response ‘to information as visible and freely available as publicly
announced earnings' (Chordia and Shivakumar, 2005).

2.2.0 Investment Performance of common stocks in relation to their Price –

Earnings Ratio
In an efficient capital market, security prices rapidly respond to available information in an impartial way and thus provide an unbiased
estimate of the underlying values. Although there is significant empirical evidence supporting the efficient market hypothesis but many
still question its validity. As part of the anomalies of the efficient market hypothesis is that price earnings ratios (P/E) are indicators of
future investment performance of a security. The price earnings ratio (P/E) hypothesis proposes that low P/E securities will tend to
outperform high P/E stocks. Although, security prices reflect some degree of biasness and the P/E ratio is an indicator of this. Empirical
research by BASU(1977) to determine whether investment performance of common stocks is related to their P/E ratios and findings
reveals that returns on stocks with low P/E ratios tends to be larger than reasonable by the underlying risks, even after adjusting for
transaction costs, and differential taxes which is inconsistent with the efficient market hypothesis.

In summary, the behaviour of security prices over the 14 –year period studied is, possibly, not fully described by the efficient market
hypothesis to the extent that low P/E portfolios actually earn higher returns on a risk-adjusted basis which validate the price-ratio
hypothesis on the relationship between investment performance and their P/E ratios. Other recent researchers includes Ahmed and Nanda
(2001) use the growth in earnings-per-share (EPS) to capture growth in the US markets from 1982 to 1997. They show that strategies
focusing on investing in stocks that have the dual characteristics of a high E/P ratio (ie value stocks) and a high growth in EPS outperform
a high E/P alone. Bird and Whitaker (2003, 2004) focus on seven European markets (United Kingdom, France, Germany, Italy,
Switzerland, the Netherlands, and Spain) from January 1990 to June 2002. They indicate that a combination of value and earnings
momentum results in a small improvement when compared to using the sole book-to-market criterion.
 History of Fundamental Analysis As A Trading Mechanism

2.3 Relationship between Return and Market Value of Common Stocks

The single-period capital asset pricing model (CAPM) postulates that there exist a linear relationship between market risk of a security
and expected returns. However, Banz study examines the empirical relationship between the return and the total market value of NYSE
common stocks. But direct test on this have not been concluded. Additional factor which is relevant for asset pricing is recently suggested.
In 1979 Litzenberger and Ramaswany establish a significant positive relationship between return of common stocks and dividend yield
for the period of 1936-1977. Although Basu in 1977 summarised his findings that P/E ratios and risk adjusted returns are related and
concluded to interpret his findings as evidence of market ineffiency. But in 1978 Ball points out, some of the anomalies that have been
responsible for the lack of market efficiency is a result of a misspecification of the pricing model. Between 1936-1975 Banz study also
contributes another piece of emerging puzzle by examining the relationship between the total market value of common stocks of a firm
and its returns.

2.3.3 Conclusion
Over a forty year period, The analysis revealed that CAPM is misspecified on average, small NYSE firms had had significantly larger
risk adjusted return than large NYSE firms. Although the size effect is not in any way linear in the market proportion but it is most
pronounced for the smallest firms in the sample.
In summary, the size effect exists but the reason still remains questionable until we find an answer to it. As a result of this extra caution
is required during interpretation
2.4 EQUITY VALUATION M

3.0 Data and Research Methodology

3. 1 Data
The experimental analysis of this dissertation employ data from the Beazley Group Plc and Hardy Underwriting Plc annual reports for
the financial year ended 31st December 2009, in other to make an informed decision by calculating relevant financial ratios. The annual
report was obtained from the official website of the company.

3.2 Overview of the Company (Hardy Underwriting)

Hardy Underwriting Bermuda (HUB) is a management and holding company. The company's major activity is acting as a managing agent
at Lloyds's for syndicate 382 by providing capacity and specialist underwriting expertise amongst wider range of insurance and re-
insurance classes on a global basis. It's line of business operation is divided into four segments: marine and aviation, specialty lines, non
marine property and property treaty. The company carries out its operation through its subsidiaries namely Hardy Re Limited, a Bermuda-
based reinsurance company and Hardy Bermuda Limited, a coverholder company, which assumes risk on behalf of syndicate 382 via a
binding authority. It operates in four segments: Marine and aviation, Specialty lines, Non-marine property, and Property treaty. Its
subsidiaries include Hardy Underwriting Group Plc, Hardy Re Limited, Hardy Bermuda Limited, Hardy Underwriting Limited and Hardy
Names Limited. During the year ended December 31, 2009, it acquired 50% interest in a Bahrain-based company, HAIM Limited.

3.3 Business Description.

Hardy is a fully integrated insurance company, engaged in underwriting a wide range of insurance and reinsurance products. The
company's principal activities include managing agents and underwriters at Lloyd's for syndicates 382. It underwrites through its wholly
owned limited liability subsidiary, Hardy Underwriting Limited.

Through its Syndicate 382, the company underwrites commercial business except motor and liability sectors. The company is involved
in reinsurance to other underwriters against the risks in non-marine catastrophes such as hurricanes and earthquake. The major coverage
of the syndicate includes non-marine insurance lines such as direct property, accident and medical cover and financial institutions,
property treaty, political risks and conveyancing. Syndicate 382 is specialized in airline and general aviation business, mainly focused on
helicopters insurance. In addition, the company also has a business insuring ships and their cargo. The company is involved in a wide
range of non-marine underwriting, which includes direct insurance and reinsurance.

The company conducts its business operations through four reportable segments: Marine and Aviation, Specialty Lines, Non-Marine
Property and Property Treaty. The Marine and Aviation is a company's core business segment. It principally focuses on risk coverage for
general aviation, marine, and cargo and specie. In aviation insurance, the company is a market leader in risk coverage to rotor wing
aircraft. The company underwrites range of marine risks, including fishing vessels, harbour craft and loss of hire. The company's cargo
and specie insurance products include coverage for jewelers block, fine art, small motor, classic cars and other niche areas. The company
is organised into four business operating divisions: Management service, Adjusting service, Insurance support service and Insurance
Company's run-off.

The Specialty Lines segment provides insurance for financial institutions, political risks, terrorism and conveyancing and other
miscellaneous niche lines and schemes. To financial institutions, the company offers bankers bond and professional indemnity coverages.
Political insurance includes contract frustration, confiscation, trade credit, war on land and overseas terrorism. The conveyancing
insurance portfolio include defective title, restrictive covenant, chancel repair, search and title risk coverage; offered to lenders,
 History of Fundamental Analysis As A Trading Mechanism

purchasers, sellers, owners and conveyancers of residential and commercial property. The Non-Marine segment provides risk coverages
for direct & facultative insurance and direct property insurance. In Property Treaty, the company mainly offers Cat XL.

The company generated net insurance premium revenue of GBP 61.8 million from Marine and Aviation segment in 2009 as compare to
GBP 43.862 million in 2008, followed by Specialty Lines generated GBP 33.968 millions in 2009 as compare to GBP 29.493 millions in
2008, Non-Marine Property segment generated GBP 37.468 millions in 2009 as compare to GBP 16.777 million in 2008, Property Treaty
generated GBP 51.050 millions in 2009 as compare to GBP 33.469 millions in 2008.
The company carries out its operations through seven wholly owned subsidiaries: Hardy Underwriting Group Plc, Hardy Re Limited,
Hardy Bermuda Limited, Hardy Underwriting Limited, Hardy Names Limited, Hardy (Underwriting Agencies) Limited and Hardy
Insurance Services Limited (HIS).

Beazley Company Overview

Beazley Group plc is the holding company for the Beazley group, which engaged in the underwriting of specialist risk insurance and
reinsurance business, through its managed syndicates 2623, 6107, 3623, 3622 and 623 at Lloyd's in the United Kingdom and Beazley
Insurance Company, Inc. Their underwriting business range for clients worldwide can be summarised into five segments: marine, which
underwrites a range of marine classes, including hull, energy and cargo; political risks and contingency, which underwrites terrorism,
political violence and credit risks; property, which underwrites commercial, homeowners and engineering property insurance;
reinsurance, which specializes in writing property per risk, aggregate excess of loss and pro-rata business, and specialty lines, which
underwrites professional lines, employment practices liability, specialty treaty, directors and officers liability and healthcare. In June
2009, Beazley plc acquired Beazley Group plc. Beazley Group plc was renamed Beazley Group Limited. On June 2, 2009, it acquired
Beazley Re Limited. The group primarily operates in the US, the UK, Singapore, Hong Kong and other European countries.

Business Description
Beazley is one the ultimate holding company for the Beazley Group, a global specialist risk insurance and reinsurance business. The
company operates through Lloyd's syndicate 2623 and 623 in the UK and BICI, a US-admitted carrier in the US. In the US, the
underwriters of the company concentrate on writing the specialist insurance products in the admitted market, backed by Beazley Insurance
Company, Inc., an admitted property/casualty carrier in all 50 states and the surplus lines risks are backed by the Beazley syndicates at
Lloyd's. The participation in the Lloyd's market gives the company an opportunity to access to the brokered business all around the world
and also enables the company to underwrite the admitted business in the US.
The company operations are divided into four reportable segments namely Marine, Property, Reinsurance and Specialty Lines.

The company through its Marine segment offers long term insurance solutions to the maritime related industries. It underwrites all marine
classes. The clients include ship-owners, chatterers, port authorities, cargo owners and energy companies. It provides specialist coverage
for specie & cargo, hull, war and energy risks as well as other risks exposed to catastrophes. In addition, it includes coverage to voyage
and towage risks, total loss only, building risks, port risks,yachts/pleasure craft, mortgages interest and offshore and onshore exposures
of production and exploration companies.
The company helps to insure 10% of the world's oceangoing tonnage and cover 35% of the top 200 oil and gas companies.

The Property segment of the company comprised of insures engineering property, commercial property and high-value homeowners. The
clients include companies in mining, steel, utilities, retail, commercial real estate, homeowners, jewelers, art dealers, private collectors
and construction. The company operates its underwriting business in the US, Singapore and London. The company underwrites the
commercial property risks in the US for large risks, small risks, US both admitted

and non-admitted and Binding Authorities; engineering and construction risks for Contractors All Risks (CAR), Erection All Risks
(EAR), Machinery Breakdown (MB), Machinery Loss of Profits (MLOP), Electronic Equipment (EEI) and Plant and Equipment All
Risks (P.A.R) in Singapore; and homeowners for high value homeowners risks in the UK & overseas, the US high value and Binding
authorities. The company's clients range from Fortune 1000 companies to homeowners.

The company through its Reinsurance segment provides reinsurance products and services to general insurers. It concentrates in the areas
of casualty catastrophe, aggregate excess of loss, property catastrophe, pro-rata business and property per risk. The company is specialized
in writing the property catastrophe excess of loss on a worldwide basis. The diverse client base includes regional cedants, large nationwide
carriers and multi regional companies. Under the casualty
clash risk the company's portfolio mainly comprises of programmes protecting client's auto and workers compensation accounts. The
segment covers the areas of Australasia, the US, UK, Canada, Continental Europe, West Indies and Japan.
Under its Specialty Lines segment, the company underwrites specialty insurance and reinsurance, including professional liability,
directors' and officers' liability, employment practices' liability, healthcare, terrorism, contingency and political risks. The segment even
underwrites management liability business on both a primary and excess basis, from Europe, North America and around the world. The
US clients of the company are served by underwriters at Lloyd's and by private enterprise team who focus on smaller scale clients. The
clients of the professional liability include Lawyers, Healthcare, Architects & Engineers, Programmes, Technology, Media & Business
 History of Fundamental Analysis As A Trading Mechanism

Services, Specialty treaty and Programmes. The clients of the management liability include: Public company D&O, Employment practices
liability, Non-profit organizations, Private company management liability, Crime and Fiduciary.

he subsidiaries of the company are Tasman Corporate Limited, Beazley Furlonge Holdings Limited, Beazley Furlonge Limited and
Beazley Pte. Limited, BFHH Limited, Beazley Investments Limited, Beazley Corporate Member No. 2, Beazley Corporate Member
Limited, Global Two Limited, Beazley Underwriting Limited, Beazley Management Limited, Beazley Staff Underwriting Limited,
Beazley Solutions Limited, Beazley Corporate Member No. 3, Beazley USA Services, Inc., Beazley Holdings, Inc., Beazley Insurance
Company, Inc., Beazley Limited Hong Kong, Beazley Group (USA) General Partnership and Beazley Dedicated No.2 Limited.

During the fiscal year 2007, the company generated 49.12% of total revenue from Specialty lines segment, 24.75% from Property, 7.96%
from Reinsurance and 18.15% from Marine segment.

Management service
The management service includes the following: mutual management, investment management, underwriting services, captive
management, and risk management
The mutual management is engaged in the development and management of mutual insurance associations. It provides the full range of
management skills including underwriting, risk assessment, accounting, documentation, claims negotiation and paying, investment and
regulatory and compliance functions.

The captive management is engaged in the identification, evaluation and implementation of a captive insurance solution. Its activities are
carried out principally in Bermuda through CTC Allegro Insurance and Risk Management Services. Captives are also managed by the
CTC group in the Isle of Man, and in other domiciles through independently-owned partner management companies.
The investment management provides investment management serves to both clients mutual's and group owned insurance companies.

The risk management provides solutions for risk management and insurance problems through its division Taylor Risk Consulting. It
specializes in helping corporate risk management teams on a day-to-day or project basis in a variety of industries including energy,
manufacturing, construction and transportation.

The underwriting facilities operates through the company's subsidiary, Charles Taylor Underwriting Agencies. This division acts as a
cover holder in the business areas including property and liability covers for ports and terminals operators, property and liability covers
for the public sector, scheme and affinity business, and professional liability risks.

Adjusting Services
The loss adjusting division provides loss adjusting capabilities to the world's insurance markets and Average Adjusting to ship owners.

Insurance Support Services

This division concentrate on core competencies of financial reporting, consulting and claims management services to managing agents,
brokers and underwriting support service to clients.

Insurance companies' run-off

In run-off division, the company, through its subsidiary LCL, provides a wide range of specialist run-off and other services to the
insurance industry, including claims management, balance sheet finality and release of shareholder value.
The company's subsidiaries include PT Radita Hutama Internusa, Bateman Chapman (Australia), Wyndham Insurance Company
(Bermuda), Charles Taylor Consulting (Canada), CTC (Shanghai),Charles Taylor (Hamilton), Lansdowne Insurance Company, Charles
Taylor Consulting Services France, LCL, Axioms holdings limited Acquisitions and Metrowise.

3.2 Research Methodology

3.2.1 Main Financial Ratio
There are probably as many different views on essential financial ratios as there are financial statement analysts! However, I have
summarised the main financial ratio into five groups, this includes: Investment Ratio or Valuation Ratio, Gearing Ratio, Profitability
Ratio, Liquidity Ratio, efficiency Ratio and Combined Ratio.

3.2.2 Investment Ratios or Valuation Ratios

• These help investors to determine the financial performance of equities/shares in the firm.

• The firm must bear these ratios in mind to ensure that they appear a good investment prospect, to enable them to raise lower cost funds
when they are required.
• Investors tend to focus on the risk and return of purchasing a share in the firm.
 History of Fundamental Analysis As A Trading Mechanism

Under the Investment Ratio or Valuation Ratio we have the following:

(a) Dividend per share (DPS)

DPS =

This ratio measures the dividend announced during the year per each share in issue. It gives a measure of the absolute returns to the
investor in terms of the relevant
currency. It is useful in monitoring the returns of a particular firm through time though
is less useful for comparing firms as the size of DPS obviously depends on the value
of each share. Also, it measures only part of the returns to investors as it does not
take into account the capital gain they may receive for holding the share.

(b) Dividend yield (DY)

DY =

This ratio helps to overcome the problems with the DPS measure by showing the cash dividend returns to equity investors as a proportion
of the share's current market value i.e. it shows equity dividend returns as a yield. This return can then be more easily compared with the
returns available on other shares or other forms of investment (e.g. bonds). The numerator DPS must be ‘grossed up' for tax to allow
comparison with other forms of investment which are also quoted in terms of gross yields.

(c) Dividend payout ratio (DPR)

DPR =

This ratio measures the proportion of its earnings which are actually distributed (paid out) to shareholders. The higher is this ratio, the
more the firm is focused on keeping shareholders happy by distributing the created wealth, though if this ratio is high then the firm may
suffer by not retaining funds for updating or expanding its productive capacity.

(d) Price-earnings ratio (PE)

PE =
This ratio measures the multiple which investors are prepared to pay in the equity market for each unit (pound) of earnings. It gives a
useful indication of the price that investors are willing to pay for future earnings and thus gives us a useful measure of earnings
expectations. PE ratios can vary significantly across industries and across economic cycles, though prices are generally between 10 and
20 times earnings.

(e) Earnings per share (EPS)

EPS =
This ratio measures total earnings (whether ultimately distributed or not) available to
shareholders per share. The shareholder then has some measure of the earnings

generating power of the firm, regardless of its current dividend policy. However, as it gives an absolute currency figure it is not a useful
measure for comparing across firms, rather it is useful for comparing an individual firm's performance through time.

3.2.3 Gearing Ratios

• These help to describe the relationship between the owners' (shareholders) investment in the firm and the investment of outsiders such
as banks or bondholders.

• They help in assessing the financial risk of the firm, that is the possibility that the firm will encounter financial distress in the coming
financial periods.

(a). Debt-equity ratio (DE)

DE =

This ratio measures the ratio of external financing to internal (equity) financing and shows the reliance of the firm on outside funds. A
higher gearing ratio can signify a firm which finds it difficult to raise new equity finance. A rule of thumb for gearing is that a ratio greater
than 1 represents a fairly financially risky firm i.e. a firm which has more debt than risk capital to support its operations. However, the
rule of thumb will vary across industries and some industries having very highly geared but successful firms.
 History of Fundamental Analysis As A Trading Mechanism

(b) The borrowing ratio or Debt to Capital Ratio

Borrowing ratio =
This ratio measures not only the ratio of long-term debt to equity capital and reserves but also includes short-term debt in both the
numerator and denominator. The reason it is useful is because firms will often continually renew short-term debt, thereby treating it as if
it is a form of longer-term capital, particularly when shorter-term interest rate are more favourable than longer-term rates. It is a more
inclusive measure of debt gearing.

(c) Gearing ratio

Gearing ratio = or
Gearing ratio =
This ratio measures the proportion of the capital structure contributed by external

claimholders i.e. debt investors and others with a long-term claim on the firm. It is more encompassing than the debt-equity ratio as it
includes other long-term claims. The higher the gearing ratio, the higher the probability that equity holders will be left with very little
residual income (i.e. income left after debt holders have been paid) and therefore this is a good measure of financial risk.

(d) Interest cover

Interest cover =

This ratio measures the ‘financial safety' of the firm i.e. to what extent can it cover the interest payments to its debt holders? It is sometimes
referred to as ‘income gearing'. A rule of thumb for income gearing is that firms should be concerned if this ratio falls below about 5.
Certainly a firm which has a ratio approaching 1 should be very concerned as it is approaching a situation of financial distress.

3.2.4 Profitability Ratios

• As with investment ratios, they help us to ascertain the financial performance of the firm, though they focus on the wealth generated by
the business in total rather than the wealth generated and distributed to shareholders.

• They tend to tell us how successful those managing the firm are at generating wealth from the sales made and capital employed by the
firm.

1. Gross profit margin (GPM)

Gross profit margin =

This ratio measures the profitability of purchasing or manufacturing goods and selling them. Gross profit here is simply sales less the
cost of sales.

2. Net profit margin (NPM)

Net profit margin =

This ratio measures the profitability of the firm, regardless of its form of financing or tax position. It is a very useful measure for comparing
profitability across firms. If a healthy gross profit margin produces only a small net profit margin then the firm has incurred significant
indirect or overhead costs in its trading operations.

3. Return on capital employed (ROCE)

ROCE =
This ratio measures the profit produced by the firm from its capital base (its debt and
equity). It is one of the most commonly quoted profitability measures.

4. Return on Equity (ROE)

ROE =
This ratio measures the profits available to shareholders in relation to the total claim
of such investors (i.e. the equity capital base)

3.2.5 Liquidity Ratios

• Cash and ‘near-cash' (current assets which can be converted to cash relatively easily) are the ‘lifeblood' of the firm and therefore should
be monitored very closely
 History of Fundamental Analysis As A Trading Mechanism

• They tell how us well the firm can cover its short-term commitments (current liabilities) from its short-term cash and ‘near-cash' (current
liabilities)

1. Operating cash flow to maturing obligations (OCFMO)

OCFMO =
This ratio measures the ability of the business to meet its maturing obligations i.e. to what extent can the firm pay commitments falling
due within the next financial period from its operating cash flows. Ultimately this is a good measure as it considers cash flows in the
numerator rather than some balance sheet measure of liquid resources. The higher this ratio, the healthier the liquidity position of the
firm.

2. Current ratio
Current ratio =
This ratio also measures the ability of the business to meet its maturing obligations, but concentrates on balance sheet measures i.e. how
many times can the firm ‘cover' its maturing obligations (current liabilities) from its current asset base (cash and ‘near cash' assets).
Obviously the firm would like this ratio to be higher, rather than lower and an ideal ratio of 2 is often suggested. However, if the ratio is
too high then it suggests that the firm has invested too high a proportion of its available resources in current assets which do not, of
themselves, earn profits for the firm. It would be preferable in this case to reduce the investment in current assets and invest the funds
instead in fixed assets which are productive.

3. Quick ratio
Quick ratio =

This ratio is another measure of liquidity, similar to the current ratio, though it excludes stock from the numerator. The reason for this is
that in the real world stock (inventory) can be difficult to convert into cash quickly in times of need and therefore should not be considered
part of our definition of ‘cash and near-cash'. Again, a rule of thumb is that this ratio should not fall below 1 for firms, otherwise they
may experience liquidity problems.

3.2.6 Efficiency ratios of Activity Ratios

• These ratios measure the efficiency with which the firm uses the resources available to it
• They also measure how fast the firm ‘turns over' its stock, debtors and creditors, for example

1. Sales to capital employed ratio (SCE)

SCE =

This ratio measures how effectively managers employ the long-term capital of the firm to produce sales. The higher it is, the more
effectively such capital is being employed, though a very high ratio signifies that the firm does not have enough capital to support its
current level of sales i.e. it is ‘over-stretching' itself.

2. Debtors days
Debtors days =

This ratio measures how many days, on average, it takes for debtors (those customers who have been sold goods on credit) take to pay.
The firm would ideally like to keep this period short, though if it chases its customers for payment too vigorously then it might lose
custom
to its competitors.

3. Creditors days
Creditors days =
This ratio measures how many days, on average, it takes for creditors (those suppliers from whom inputs have been bought on credit) to be
paid. The firm would ideally like to extend this period (as it is a form of free finance), though delaying payment for too long can damage the
firm's relationship with its suppliers.

Basu (1977) Investment Performance of Common relationship b/w price-earning (P/E) that rejected (EMH)
Stocks in Relation to their Price- ratios and excess returns.

Earnings Ratios: A Test of the
Efficient Market Hypothesis
Banz (1981),. The Relationship between Return and
Market Value of Common Stocks
Reinganum (1981),
Marc R. Reinganum A New Empirical Perspective on the
CAPM
Rosenberg et al. (1984),
Fama and French (1992), A Cross Section of Stock Returns
Lakonishok et al (1994) Contrarial Investment, Extrapolation,
and Risk
Fama and French (1995) Size and Book-to-Market Factors in
Earnings and Returns
Fama and French (1998) Value Versus Growth: The
International Evidence
Frankel and Lee (1998) Accounting valuation, market
expectation, and cross-sectional stock
returns
Piotroski (2000) Value Investing: The Use of
Historical Financial Statement
Information to Separate Winners from
Losers
Aby et al. (2001) fundamentals to screen stocks for
value
Aby et al (2001) Selection of undervalued stock
investments for pension plans
and deferred compensation
programs
Aby et al (2001) Value stocks: a look at benchmark
fundamentals and company
priorities
History of Fundamental Analysis As A Trading Mechanism
Returns to low P/E tends to be larger
than reasonably by the underlying
risks, even after adjusting for
transaction costs, and differential
taxes which is inconsistent with the
efficient market hypothesis
P/E ratios and risk adjusted returns
are related and concluded to
interpret his findings as evidence of
market ineffiency
observed market capitalization and
return, smallest firms outperformed
largest ones. examines the empirical
relationship between the return and
the total market value of NYSE
common stocks
Total market value of common
stocks of a firm and its returns
firm size and excess returns
high book-to-market value yield
higher long-term returns.
if asset pricing is rational, then size
and ratio of book-to-market value
must be proxies for risk.
rejected Fama and French,
respond to Lakonishok (1994), size
and book-to-market equity are proxies
for sensitivity to risk factors in return
value stocks tend to have higher
returns than growth stocks,
firm fundamental values highly
correlated with stock prices, and
that V/P is a good predictor of long-
term return.
High book-to-market returns more.
returns are concentrated in small
and medium size companies, low
share turnover, and firms with low
analyst following.
Four criteria are used to screen
stocks, quality investments seem to
result
four fundamental conditions, single
value P/E’s; Market

Fama (1970)
Richard (2004)
Ball and Brown (1968)
Foster, Olson and Shelvin (1984)
Ball et al 1988 in
Bernard and Thomas, (1989)
Ball and Bartov (1996)
Liu, Strong and Xu (2003)
Forner et al. (2009)
Truong (2010)
Booth et al. (1996)
Price Momentum and Post-Earnings Announcement Drift
Jegadeesh and Titman (1993)
Chan et al (1996)
Chordia and Shivakumar, (2005).
Ahmed and Nanda (2001)
Bird and Whitaker (2003, 2004)
Litzenberger and Ramaswany (1979)
Ball (1978)
History of Fundamental Analysis As A Trading Mechanism
Security prices respond quickly to
new information; earnings
announcement
Apparent delay in share price
response to earnings information
Even after earnings are announced,
cumulative abnormal returns for
stock with unexpected positive
(negative) earnings surprise
continue to drift upward
(downward)
(PEAD) Post Earnings ‘+’ Sample Methodology with Foster
Announcement Drift. et al. (1984)
PEAD exists for all stocks and it ‘-‘ reject CAPM’s hypothesis
increases monotonically from the
lowest to the highest SUE decile. Find evidence to delayed price
The effect of PEAD is more response as an explanation for PEAD
significant for smaller firms.
Investors understand this
implication but underestimate the
degree of serial correlation between
current and future earnings by 50%
‘+’ results consistent with Bernard
and Thomas (1989)
Spanish Stock Market PEADS present
New Zealand PEADS present
Finland PEADS present
Attritubes the existance of price
momentum to market’s under
reaction to earnings news. Drifts in future returns for the next six
to twelve months are predictable from
previous news about earnings
Style Investing: Incorporating Used growth in EPS,
Growth Characteristics in Value
Stocks Investing in stock with dual
characteristics of a high E/P ratio
(Value Stocks) and a high growth in
EPS outperform a high E/P alone
Combination of value and earnings
momentum results in a small
improvement when compared to
using the sole book-to-market
criterion
establish a significant positive
relationship between return of
common stocks and dividend yield
for the period of 1936-1977
some of the anomalies that have
been responsible for the lack of
market efficiency is a result of a
misspecification of the pricing
model
 History of Fundamental Analysis As A Trading Mechanism

docear Literature xray

JSTOR, Emorld,

Hist (journal topics Mediating variables/ Mediating moderating and

moderating mediating
Most important paper Moderating variables

Intr

Obj

Statmnt

Systematic risk, total risk and size as determinants of stock market returns

Author links open overlay panel JosefLakonishokab∗Alan C.Shapiro∗