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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
Lesson # 45
An economist says when people earn a dollar; they do one of two things with it: they either
consume it or save it. A person consumes a dollar by spending it on something like a car,
clothing, or food. People also consume some of their money involuntarily because they
must pay tax; a person saves a dollar by somehow putting it aside for consumption at a later
time. (Referred to Handout # 1)
Investing is risky but saving is not.
Assets are things that people own. The two kinds of assets are financial assets and real
assets. The distinction between these terms is easiest to see from an accounting viewpoint.
A financial asset carries a corresponding liability somewhere. If an investor buys shares of
stock, they are an asset to the investor but show up on the right side of the corporation's
balance sheet. A financial asset, therefore, is on the left-hand side of the owner's balance
sheet and the right-hand side of the issuer's balance sheet.
A real asset does not have a corresponding liability associated with it, although one
might be created to finance the real asset.
Financial assets have a corresponding liability but real assets do not.
Categories of Stock:
Although all common shares represent an ownership interest in the company, the investment
characteristics of these shares differ widely. Some share are stable, some are volatile. Some
pay dividends, some don't. Some are speculations about events years in the future, other are
investments in current results; investors often place stock into a particular group according
to its investment characteristics. (Referred to Handout # 4)
Types of Orders:
When investors place orders to buy or sell securities, they expect their instructions to be
precisely understood by the people involved in processing the order. A number of standard
packets of instructions are used in the brokerage business to aid in this process. (Referred to
Handout # 4)
People who buy or sell stock through a brokerage firm have an individual account in which
they make their trades. While a single account number is associated with each investor,
these accounts have important subsidiary accounts. Two such accounts are cash account and
margin account. (Referred to Handout # 5)
Investment Analysis & Portfolio Management (FIN630)
Fundamental Analysis:
Fundamental analyst at the company level involves analyzing basic financial variables in
order to estimate the company's intrinsic value. These variables include sales, profit mar-
gins, depreciation, the tax rate, sources of financing, asset utilization, and other factors.
Additional analysis could involve the firm's competitive position in its industry, labor re-
lations, technological changes, management, foreign competition, and so on. The end result
of fundamental analysis at the company level is a good understanding of the company's
financial variables and an assessment of the estimated value and potential of the company.
Investors could use the dividend discount model to value common stocks; alternatively, for
a short-run estimate of intrinsic value, the earnings multiplier model could be used. Intrinsic
(estimated) value is the product of the estimated earnings per share (EPS) for next year and
the expected multiplier or P/E ratio,
Stocks estimated value = V0 -/Estimated EPS X expected P/E ratio
The Balance Sheet:
The balance sheet shows the portfolio of assets for a corporation, as well as its liabilities and
owner's equity, at one point in time. The amounts at which items are carried on the balance
sheet are dictated by accounting conventions. Cash is the actual dollar amount, whereas
marketable securities could be at cost or market value. Stockholders equity and the fixed
assets are on a book value basis.
It is important for investors to analyze a company's balance sheet, carefully. Investors wish
to know which companies are undergoing true growth, as opposed to companies that are
pumping up their performance by using a lot of debt they may be unable to service.
Income Statement:
This statement is used more frequently by investors, not only to assess current management
performance but also as a guide to the company's future profitability. The income statement
represents flows for a particular period, usually one year.
The key item for investors on the income statement is the after-tax net Income, which,
divided by the number of common shares outstanding, produces earnings per share.
Earnings from continuing operations typically are used to judge the company's success and
are almost always the earnings reported in the financial press. Nonrecurring earnings, such
as net extraordinary items that arise from unusual and infrequently occurring transactions,
ate separated from income from continuing operations.
The Cash-Flow Statement:
The third financial statement of a company is die cash flow statement, which incorporates
elements of the balance sheet and income statement as well as other items. It is designed, to
track the how of cash through the firm. It consists of three parts:
1. Cash from operating activities
2. Cash from investing activities
3. Cash from financing activities
Investment Analysis & Portfolio Management (FIN630)
The cash-flow statement can help investors examine the quality of the earnings. For ex-
ample, if inventories are rising more quickly than sales, as happened in late 2000 and early
2001 for several companies, this can be a real sign pf trouble--demand may be softening. If
a company is cutting back on its capital expenditures, this could signal problems down the
road. If accounts receivable are rising at a rate greater than sales are increasing, a company
may be having trouble collecting money owed to it. If accounts payable are rising too
quickly, a company may be conserving cash by delaying payments to suppliers, a potential
sign of trouble for the company.
Ratio Analysis:
Financial ratio analysis is a fascinating topic to study because it can teach us so much about
accounts and businesses. When we use ratio analysis we can work out how profitable a
business is, we can tell if it has enough money to pay its bills and we can even tell whether
its shareholders should be happy.
Ratio analysis can also help us to check whether a business is doing better this year than it
was last year; and it can tell us if our business is doing better or worse than other businesses
doing and selling the same things.
In addition to ratio analysis being part of an accounting and business studies syllabus, it is a
very useful thing to know anyway.
The overall layout of this section is as follows: We will begin by asking the question, what
do we want ratio analysis to tell us? Then, what will we try to do with it? This is the most
important question. The answer to that question then means we need to make a list of all of
the ratios we might use: we will list them and give the formula for each of them.
Once we have discovered all of the ratios that we can use we need to know how to use
them, who might use them and what for and how will it help them to answer the question
we asked at the beginning?
At this stage we will have an overall picture of what ratio analysis is, who uses it and the
ratios they need to be able to use it. All that's left to do then is to use the ratios; and we will
do that step- by-step, one by one.
By the end of this section we will have used every ratio several times and we will be experts
at using and understanding what they tell us. (Referred to Handout # 12)
Types of Charts:
Three principal types of charts are used by the technical analyst: line charts. Bar charts and
point and figure charts. A forth type, the candlestick chart, has recently gained favor and
may eventually become common. (Referred to Handout # 7)
Investing Indirectly:
Indirect investing in this discussion usually refers to the buying and selling of the shares of
investment companies' that, in turn, hold portfolios of securities. Most of our attention is
focused on investment-companies, arid mutual funds in particular, because of their
importance to investors. However, we will conclude the chapter with a discussion of
Exchange-Traded Funds (ETFs), which represent a bridge between direct and indirect in
vesting. Investors buy ETFs like any other stock, but many ETFs can be compared to
index mutual funds. (Referred to Handout # 20)
Investment Analysis & Portfolio Management (FIN630)
Closed-End Investment Companies:
One of the two types of managed investment companies, the closed-end investment
company, usually sells no additional shares of its own stock after the initial public offering.
Therefore, their capitalizations are fixed, unless a new public offering is made.
The shares of a closed-end fund trade in the secondary markets (e.g., on the-exchanges)
exactly like any other stock.10 To buy and sell, investors use their brokers, paying
(receiving) the current price at which the shares are selling plus (less) broker age
Open-End Investment Companies (Mutual Funds):
Open-end investment companies, the most familiar type of managed company are popularly
referred to as mutual funds and continue to sell shares to investors after the initial sale of
shares that starts the fund. The capitalization of an .open-end investment company is
continually changing--that is, it is open-ended--as new investors buy additional shares and
some existing shareholders cash in .by selling their shares back to the company.
Mutual funds typically are purchased either:
1. Directly from a fund company, using mail or telephone, or at the company's office
2. Indirectly from a sales agent, including securities firms, banks, life insurance
companies, and financial planners.
Mutual funds may be affiliated with an underwriter, -which usually has an exclusive right
to distribute shares to investors: Most underwriters distribute shares through broker/dealer
Mutual funds are either corporations or business trusts typically formed by an investment
advisory firm that selects the/board of trustees (directors) for the company. The trustees, in
turn, hire a separate management company, normally the investment advisory firm, to
manage the fund. The management company is contracted by the investment company to
perform necessary research and to manage the portfolio, as well as to handle the
administrative chores, for which it receives a fee.
The Passive Strategy:
A natural outcome of a belief in efficient markets is to employ some type of passive strategy
in owning and managing common stocks. If the market is highly efficient, impounding
information into prices quickly and on balance accurately, no active strategy should be able
to outperform the market on a risk-adjusted basis. The efficient market hypothesis (EMH)
has implications for fundamental analysis and technical analysis, both of which are active
strategies for selecting common stocks. (Referred to Handout # 22)
Buy-And-Hold Strategy:
A buy-and-hold strategy means exactly that an investor buys stocks and basically holds
them until some future time in order to meet some objective. The emphasis is on avoiding
transaction costs, additional search costs, and so forth. The investor believes that such a
strategy will, over some period; of time, produce results as good as alternatives that require
active management whereby some securities are deemed not satisfactory; sold, and replaced
Investment Analysis & Portfolio Management (FIN630)
with other securities. These alternatives incur transaction costs and involve inevitable
mistakes. (Referred to Handout # 22)
The Active Strategy:
Most of the techniques discussed in this text involve an active approach to investing. In the
area of common stocks, the use of valuation models to value and select stocks indicates that
investors are analyzing and valuing stocks in an attempt to improve their performance
relative to some benchmark such as a market index. They assume or expect the benefits to
be greater than the costs. (Referred to Handout # 22)
Degrees of Informational Efficiency:
1. Weak form Efficiency:
The least restrictive form of the EMH is weak form efficiency, which states that future stock
prices cannot be predicted by analyzing price from the past. In other words, charts are of no
use in predicting future prices. (Referred to Handout # 23)
2. Semi-strong Form:
The weak form of the EMH states that security prices fully reflect any information
contained in the past series of stock prices. Semi-strong form efficiency takes the
information set s step further and includes all publicly available information. The semi-
strong form of the EMH states that security prices fully reflect all relevant publicly
available information. (Referred to Handout # 23)
3. Strong Form Efficiency:
The most extreme version of the EMH is strong form efficiency. This version states that
security prices fully reflect all public and private information. In other words, even
corporate insiders cannot make abnormal profits by exploiting their private; inside
information about their company. Inside information is formally called material, nonpublic
information. (Referred to Handout # 23)
Bond Ratings:
Bond Ratings are letters of the alphabet assigned to bonds by rating agencies to express the
relative probability of default.
Corporate bonds, unlike Treasury securities, carry the risk of default by the issuer. Three
rating agencies, Standard & Poor's (S&P) Corporation, Moody's Investors Service Inc., and
Fitch Inc. provide investors with bond ratings; that is, current opinions on the relative
quality of most large corporate-and municipal bonds, as well as commercial paper. As
independent organizations with no vested interest in the issuers, they can render objective
judgments on the relative merits of their securities. By carefully analyzing the issues in
great detail, the rating firms, in effect, perform the credit analysis for the investor. '
Standard & Poor's bond ratings consist of letters ranging from AAA, AA, A, BBB, and so
on, to D. Plus or minus signs can be used to provide more detailed standings within a given
Investment Analysis & Portfolio Management (FIN630)
The first four categories, AAA through BBB, represent investment-grade securities. AAA
securities are judged to have very strong, capacity to meet all obligations, whereas BBB
securities are considered to have adequate capacity. Typically, institutional investors must
confine themselves to bonds in these four categories. Other things being equal, bond ratings
and bond coupon rates are inversely related.
Bonds rated BB, B, CCC, and CC is regarded as speculative, securities in terms of the
issuer's ability to meet its contractual obligations. These securities early significant
uncertainties, although they are not without positive factors. Bonds rated C are, currently
not paying interest, and bonds rated D are in default.
Thus far, our discussion has concerned the total risk of an asset, which is one important
consideration in investment analysis. However, modern investment analysis categorizes the
traditional sources of risk identified previously as .causing variability in returns into two
general types: those that are pervasive in nature, such as market risk or interest rate risk, and
those that are specific to a particular security issue, such as business or financial risk.
Therefore, we must consider these two categories of total risk.
Dividing total risk into its two components, a general (market) component and a
specific (issuer) component, we have systematic risk and nonsystematic risk, which are
additive: (Referred to Handout # 32)
Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Nonsystematic risk
What makes a financial asset risky? Traditionally, investors have talked about several
sources of total risk, such as interest rate risk and market risk, which are explained
below, because these terms are used so widely, Following this discussion, we will define the
modern portfolio sources of risk, which will be used later when we discuss portfolio and
capital market theory. (Referred to Handout # 32)
Random Diversification:
Random or naive diversification refers to the act of randomly diversifying without regard to
relevant investment characteristics such as expected return and industry classification. An
investor simply selects a relatively large number of securities randomly--the proverbial
"throwing a dart at the Wall Street Journal page showing stock quotes. For simplicity, we
assume equal dollar amounts are invested in each stock. (Referred to Handout # 34)
Markowitz Portfolio Theory:
Before Markowitz, investors dealt loosely with the concepts of return and risk. Investors
have known intuitively for many years that it is smart to diversify; that is, not to "put all of
your eggs in one basket? Markowitz however, was the first .to develop the concept of
portfolio diversification in a formal way-- he quantified the concept of diversification. He
showed quantitatively why and how portfolio diversification works to reduce the risk of a
portfolio to an investor. (Referred to Handout # 34)
Investment Analysis & Portfolio Management (FIN630)
Efficient Portfolios:
Markowitz's Approach to portfolio selection is that an investor should evaluate portfolios on
the basis of their expected returns and risk as measured by the standard deviation. He was
the first to derive the concept of an efficient portfolio, defined as one that, has the smallest
portfolio risk for a given level of expected return or the largest expected return for a given
level of risk. Rational investors will seek ethcient portfolios, because these portfolios are
optimized on the two dimensions of most importance to investors, expected return and risk.
(Referred to Handout # 35)
Capital Market Theory:
Capital market theory is a positive theory in that it hypothesis how investors do behave
rather than, how investors should behave, as, in the case of Modem Portfolio Theory
(MPT). It is reasonable "to view capital market" theory; as an extension of portfolio theory,
but it is important to understand that MPT is not based on the validity, or lack thereof, of
capital market theory. (Referred to Handout # 36)
The Market Portfolio:
Portfolio M is called the market portfolio of risky securities. It is the highest point of
tangency between RF and the efficient frontier and is the optimal risky portfolio. All
investors would want to be on the optimal line RF-M-L, and, unless they invested 100
percent of their wealth in the risk-free asset, they would own portfolio M with some portion
of their investable wealth or they would invest their own wealth plus borrowed funds in
portfolio M. This portfolio is the optimal portfolio of risky assets. (Referred to Handout #
Arbitrage Pricing Theory:
An equilibrium theory of expected returns for securities involving few assumptions
about investor preferences
(Referred to Handout # 37)
Performance Measurement:
The portfolio management process is designed to facilitate making investment decisions in
an organized, systematic manner. Clearly, it is important to evaluate the effectiveness, of the
overall decision-making process. The measurement of portfolio performance allows
investors to determine the success of the portfolio management process and of the portfolio
manager. It is a key part of monitoring the investment strategy that was based on investor
objectives, constraints and preferences. (Referred to Handout # 38)
Derivative assets get their name from the fact that their value derives from some other asset.
A coupon for a free Big Mac is not inherently valuable; the paper on which it is printed is
virtually worthless. We all agree that the coupon is valuable for what it represents: the
chance to get a $ 2.50 sandwich for nothing. The coupon is a simple derivative asset.
(Referred to Handout # 40)
Investment Analysis & Portfolio Management (FIN630)
The Futures Market:
A futures contract is a promise; the person who initially sells the contract promises to
deliver a quantity of a standardize commodity to a designated delivery point during a certain
month called a delivery month. The other party to the trade promises to pay a predetermined
price for the goods upon delivery. The person who promises to buy is said to be long; the
person who promises to deliver is short.
Understanding Futures Markets:
(Referred to Handout # 41)
Market Participants:
Two types of participants are required in order for a futures market to be successful: hedgers
and speculators. Without hedgers the market would not exist, and no economic function
would be performed by speculators. (Referred to Handout # 41)
Uses of Derivatives:
(Referred to Handout # 44)
Which represent claims on an underlying common stock, are created by investors and sold
to other investors? The corporation whose common stock underlies these claims has no
direct interest in the transaction, being in no way responsible for the creating, terminating,
or executing put and call contracts.
Contracts giving the owner the Tight to buy or sell the underlying asset
(Referred to Handout # 44)