The Valuation of Security Analysis

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.