JANE SMITHS INVESTMENT DECISION (B) Steve Foerster Jeff Blair, an investment adviser for National Securities Inc.

was meeting with a new client, Jane Smith. Blair had recently helped Smith develop an investment policy statement and had provided advice regarding an initial asset allocation consistent with Smiths investment policy statement. Since Smith had not been an active investor in equities, she had many questions for Blair, particularly related to the notion of market efficiency. In addition, she wanted to understand the importance of different investment styles, such as growth versus value. Active versus Passive Investing and Market Efficiency While Smith was committed to placing a substantial amount of her portfolio in equities, she was still confused. Her previous independent investment counselor had started to explain to her about index funds and recommended such funds. While she still didnt fully understand the reason for the recommendation, she was now uncertain as to whether she should have Blair invest through passive index funds, which attempted to replicate market performance or whether she should have Blair invest in a more active strategy. Blair began by explaining the goal and strategy of active investing. He indicated that active managers essentially rely on two sets of skills: security selection and market timing. Some well known investors, such as Warren Buffet, John Templeton and Peter Lynch, focus exclusively on security selection while ensuring that their portfolios are virtually fully invested in equities at all times. Other managers attempt to time their investments and are not fully invested in equity markets during times of perceived weakness. Thus, the overall goal of active management is to outperform a passive strategy of buying and holding a well diversified portfolio, such as an index. After much discussion, it became clear that in order to understand the logic behind active investing, Smith needed to understand the concept of market efficiency. In order to assist Smith, Blair pulled out some notes from his MBA finance classes, which discussed the concept. As Blair explained, the notion of market efficiency simply stated that stock prices fully and immediately reflected all relevant information. However, attempting to validate or refute this statement presented researchers with a greater challenge. Efficient Market Hypothesis (EMH) tests came in three forms depending on the definition of relevant information. In the weak form of the EMH, relevant information consisted solely of past stock prices. In the semi-strong form of the EMH, relevant information consisted of all public information. In the strong form of the EMH, relevant information consisted of all public and private information. A common method for testing the EMH was to examine the markets reaction to new public information. Any good news not anticipated by the market should be immediately reflected in the stock price. Such studies were referred to as event studies. Blair decided to present Smith with a very crude EMH test. He recalled an announcement last week by a

large gold production company, Super Gold Inc. Super Golds stock had a beta of 1.0, which implied that the stock generally tracked market movements. Last weeks daily percentage returns for both Super Gold and the TSE 3000 Index are presented in Exhibit 1. The only relevant information last week regarding Super Gold was a good news announcement (made after the close of trading on Tuesday) that the company had made a new gold discovery (this news had not been anticipated by the markets). Blair wanted to show Smith how this example was an indication of support either for or against the EMH. Investment Styles: Growth versus Value If Smith were to agree to an active equity management strategy, she wanted to understand the differences in investment style approaches. She had heard that two popular styles were growth and value. But she was confused by the apparent controversy surrounding exactly what was a growth stock and what was a value stock. In fact, Blair indicated that different managers used different criteria to distinguish between the two style categories. Generally speaking, Blair indicated that value stock s were perceived as cheap, while growth stocks were perceived to have better prospects for increases in revenues and profits relative to other firms in the industry or in other industries. However, it was also recognized that growth and value could be viewed as end points on a spectrum, with some stocks in the middle showing characteristics of both growth and value. In order to demonstrate the different style approaches, Blair decided to gather some information about a stock, and then attempt to categorize the stock as growth, value or mix. The company he chose was Buldco Inc., a large producer of cement and concrete. Buildcos primary customers were companies that made readymade concrete as well as construction contractors and other cement companies. Blairs first task was to consider what key attribute should be examined in order to categorize a stock as either growth or value, and then explain to Smith the intuition behind these criteria. His second task was to apply the criteria to Buildco in order to categorize the stock either as value, growth or mix. Financial information is presented in Exhibit 2.

Exhibit 1 SUPER GOLD VERSUS TSE 300 STOCK PERFORMANCE

Day Monday Tuesday Wednesday Thursday Friday

Super Gold -0.5% -0.2% 0.5% 0.2% 0.3%

TSE 300 -0.5% -0.2% 1.2% -0.2% -0.4%

Exhibit 2 BUILDCO INC. FINANCIAL INFORMATION

Assets ($m) Long Term Debt ($m) Debt to Equity Dividend Yield Dividend Payout Ratio Beta Return on Equity Price to Earnings Price to Book

Buildco $1,200 150 0.25 1.20% 15% 1.21 13.50% 18.5 3.3 Buildco -30.50% 2.20% 425% 185%

% Versus Industry 140% 89% 35% 85% 82% 132% 67% 115% 126% Industry (actual) 5.8% 12.8% 172.0% 88.5%

%Versus TSE 300 70% 55% 52% 61% 43% 121% 107% 88% 140% TSE 300 (actual) 6.4% 21.1% 226.0% 180.0%

1 Year Earnings Growth 1 Year Stock Return 5 Year Earnings Growth 5 Year Stock Return