The valuation of security analysis - Stock selection is potentially extremely valuable

Active portfolio management is commonly partitioned into two types of activ ities: market timing, which requires forecasts of broad-based market moveme nts, and security analysis, which requires the selection of individual stoc ks thar are perceived to be underpriced by the market. Robert Merton and ot hers have provided an insightful and easily implemented means to place a va lue on market timing and fundamental analysis skills. While a normative the ory of stock selection was outlined in 1973 by Jack Treynor and Fischer Bla ck, 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 ma rket timing ability in this framework, and are therefore able to compare th e relative values of each type of investment analysis. They find that stock selection is potentially extremely valuable, but that its value depends cr itically 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 the value of selection for the important case in which a nalysts' forecasts of stocks' alphas art: subject to error.