Investment Analysis and Portfolio Management, Summaries of Business Accounting

Download Investment Analysis and Portfolio Management and more Summaries Business Accounting in PDF only on Docsity! LEONARDO DA VINCI Transfer of Innovation Kristina Levišauskait÷ Investment Analysis and Portfolio Management Leonardo da Vinci programme project „Development and Approbation of Applied Courses Based on the Transfer of Teaching Innovations in Finance and Management for Further Education of Entrepreneurs and Specialists in Latvia, Lithuania and Bulgaria” Vytautas Magnus University Kaunas, Lithuania 2010 Investment Analysis and Portfolio Management 2 Table of Contents Introduction …………………………………………………………………………...4 1. Investment environment and investment management process…………………...7 1.1 Investing versus financing……………………………………………………7 1.2. Direct versus indirect investment …………………………………………….9 1.3. Investment environment……………………………………………………..11 1.3.1. Investment vehicles …………………………………………………..11 1.3.2. Financial markets……………………………………………………...19 1.4. Investment management process…………………………………………….23 Summary…………………………………………………………………………..26 Key-terms…………………………………………………………………………28 Questions and problems…………………………………………………………...29 References and further readings…………………………………………………..30 Relevant websites…………………………………………………………………31 2. Quantitative methods of investment analysis……………………………………...32 2.1. Investment income and risk………………………………………………….32 2.1.1. Return on investment and expected rate of return…………………...32 2.1.2. Investment risk. Variance and standard deviation…………………...35 2.2. Relationship between risk and return………………………………………..36 2.2.1. Covariance……………………………………………………………36 2.2.2. Correlation and Coefficient of determination………………………...40 2.3. Relationship between the returns on stock and market portfolio……………42 2.3.1. Characteristic line and Beta factor…………………………………….43 2.3.2. Residual variance……………………………………………………...44 Summary…………………………………………………………………………...45 Key-terms………………………………………………………………………….48 Questions and problems…………………………………………………………...48 References and further readings…………………………………………………...50 3. Theory for investment portfolio formation………………………………………...51 3.1. Portfolio theory………………………………………………………………51 3.1.1. Markowitz portfolio theory…………………………………………...51 3.1.2. The expected rate of return and risk of portfolio……………………..54 3.2. Capital Asset Pricing Model…………………………………………………56 3.3. Arbitrage Price Theory………………………………………………………59 3.4. Market Efficiency Theory……………………………………………………62 Summary…………………………………………………………………………...64 Key-terms………………………………………………………………………….66 Questions and problems……………………………………………………………67 References and further readings…………………………………………………...70 4. Investment in stocks………………….....................................................................71 4.1. Stock as specific investment……………………………………………….....71 4.2. Stock analysis for investment decision making………………………………72 4.2.1. E-I-C analysis……………………………………………………….73 4.2.2. Fundamental analysis………………………………………………..75 4.3. Decision making of investment in stocks. Stock valuation…………………..77 4.4. Formation of stock portfolios………………………………………………...82 4.5. Strategies for investing in stocks……………………………………………..84 Summary…………………………………………………………………………..87 Key-terms…………………………………………………………………………90 Investment Analysis and Portfolio Management 5 The course assumes little prior applied knowledge in the area of finance. The course is intended for 32 academic hours (2 credit points). Course Objectives Investment analysis and portfolio management course objective is to help entrepreneurs and practitioners to understand the investments field as it is currently understood and practiced for sound investment decisions making. Following this objective, key concepts are presented to provide an appreciation of the theory and practice of investments, focusing on investment portfolio formation and management issues. This course is designed to emphasize both theoretical and analytical aspects of investment decisions and deals with modern investment theoretical concepts and instruments. Both descriptive and quantitative materials on investing are presented. Upon completion of this course the entrepreneurs shall be able: • to describe and to analyze the investment environment, different types of investment vehicles; • to understand and to explain the logic of investment process and the contents of its’ each stage; • to use the quantitative methods for investment decision making – to calculate risk and expected return of various investment tools and the investment portfolio; • to distinguish concepts of portfolio theory and apply its’ principals in the process of investment portfolio formation; • to analyze and to evaluate relevance of stocks, bonds, options for the investments; • to understand the psychological issues in investment decision making; • to know active and passive investment strategies and to apply them in practice. The structure of the course The Course is structured in 8 chapters, covering both theoretical and analytical aspects of investment decisions: 1. Investment environment and investment process; 2. Quantitative methods of investment analysis; 3. Theory of investment portfolio formation; 4. Investment in stocks; Investment Analysis and Portfolio Management 6 5. Investment in bonds; 6. Psychological aspects in investment decision making; 7. Using options as investments; 8. Portfolio management and evaluation. Evaluation Methods As has been mentioned before, every chapter of the course contains opportunities to test the knowledge of the audience, which are in the form of questions and more involved problems. The types of question include open ended questions as well as multiple choice questions. The problems usually involve calculations using quantitative tools of investment analysis, analysis of various types of securities, finding and discussing the alternatives for investment decision making. Summary for the Course The course provides the target audience with a broad knowledge on the key topics of investment analysis and management. Course emphasizes both theoretical and analytical aspects of investment decision making, analysis and evaluation of different corporate securities as investments, portfolio diversification and management. Special attention is given to the formulation of investment policy and strategy. The course can be combined with other further professional education courses developed in the project. Investment Analysis and Portfolio Management 7 1. Investment environment and investment management process Mini-contents 1.1. Investing versus financing 1.2. Direct versus indirect investment 1.3. Investment environment 1.3.1. Investment vehicles 1.3.2. Financial markets 1.4. Investment management process Summary Key terms Questions and problems References and further readings Relevant websites 1.1. Investing versus financing The term ‘investing” could be associated with the different activities, but the common target in these activities is to “employ” the money (funds) during the time period seeking to enhance the investor’s wealth. Funds to be invested come from assets already owned, borrowed money and savings. By foregoing consumption today and investing their savings, investors expect to enhance their future consumption possibilities by increasing their wealth. But it is useful to make a distinction between real and financial investments. Real investments generally involve some kind of tangible asset, such as land, machinery, factories, etc. Financial investments involve contracts in paper or electronic form such as stocks, bonds, etc. Following the objective as it presented in the introduction this course deals only with the financial investments because the key theoretical investment concepts and portfolio theory are based on these investments and allow to analyze investment process and investment management decision making in the substantially broader context Some information presented in some chapters of this material developed for the investments course could be familiar for those who have studied other courses in finance, particularly corporate finance. Corporate finance typically covers such issues as capital structure, short-term and long-term financing, project analysis, current asset management. Capital structure addresses the question of what type of long-term financing is the best for the company under current and forecasted market conditions; project analysis is concerned with the determining whether a project should be undertaken. Current assets and current liabilities management addresses how to Investment Analysis and Portfolio Management 10 companies, pension funds, insurance companies, commercial banks) the investors are entitled to their share of dividends, interest and capital gains generated and pay their share of the institution’s expenses and portfolio management fee. The risk for investor using indirect investing is related more with the credibility of chosen institution and the professionalism of portfolio managers. In general, indirect investing is more related with the financial institutions which are primarily in the business of investing in and managing a portfolio of securities (various types of investment funds or investment companies, private pension funds). By pooling the funds of thousands of investors, those companies can offer them a variety of services, in addition to diversification, including professional management of their financial assets and liquidity. Investors can “employ” their funds by performing direct transactions, bypassing both financial institutions and financial markets (for example, direct lending). But such transactions are very risky, if a large amount of money is transferred only to one’s hands, following the well known American proverb “don't put all your eggs in one basket” (Cambridge Idioms Dictionary, 2nd ed. Cambridge University Press 2006). That turns to the necessity to diversify your investments. From the other side, direct transactions in the businesses are strictly limited by laws avoiding possibility of money laundering. All types of investing discussed above and their relationship with the alternatives of financing are presented in Table 1.1. Table 1.1. Types of investing and alternatives for financing Types of investing in the economy Alternatives for financing in the economy Direct investing (through financial markets) Raising equity capital or borrowing in financial markets Indirect investing (through financial institutions) Borrowing from financial institutions Direct transactions Direct borrowing, partnership contracts Companies can obtain necessary funds directly from the general public (those who have excess money to invest) by the use of the financial market, issuing and selling their securities. Alternatively, they can obtain funds indirectly from the general public by using financial intermediaries. And the intermediaries acquire funds by allowing the general public to maintain such investments as savings accounts, Certificates of deposit accounts and other similar vehicles. Investment Analysis and Portfolio Management 11 1.3. Investment environment Investment environment can be defined as the existing investment vehicles in the market available for investor and the places for transactions with these investment vehicles. Thus further in this subchapter the main types of investment vehicles and the types of financial markets will be presented and described. 1.3.1. Investment vehicles As it was presented in 1.1, in this course we are focused to the financial investments that mean the object will be financial assets and the marketable securities in particular. But even if further in this course only the investments in financial assets are discussed, for deeper understanding the specifics of financial assets comparison of some important characteristics of investment in this type of assets with the investment in physical assets is presented. Investment in financial assets differs from investment in physical assets in those important aspects: • Financial assets are divisible, whereas most physical assets are not. An asset is divisible if investor can buy or sell small portion of it. In case of financial assets it means, that investor, for example, can buy or sell a small fraction of the whole company as investment object buying or selling a number of common stocks. • Marketability (or Liquidity) is a characteristic of financial assets that is not shared by physical assets, which usually have low liquidity. Marketability (or liquidity) reflects the feasibility of converting of the asset into cash quickly and without affecting its price significantly. Most of financial assets are easy to buy or to sell in the financial markets. • The planned holding period of financial assets can be much shorter than the holding period of most physical assets. The holding period for investments is defined as the time between signing a purchasing order for asset and selling the asset. Investors acquiring physical asset usually plan to hold it for a long period, but investing in financial assets, such as securities, even for some months or a year can be reasonable. Holding period for investing in financial assets vary in very wide interval and depends on the investor’s goals and investment strategy. Investment Analysis and Portfolio Management 12 • Information about financial assets is often more abundant and less costly to obtain, than information about physical assets. Information availability shows the real possibility of the investors to receive the necessary information which could influence their investment decisions and investment results. Since a big portion of information important for investors in such financial assets as stocks, bonds is publicly available, the impact of many disclosed factors having influence on value of these securities can be included in the analysis and the decisions made by investors. Even if we analyze only financial investment there is a big variety of financial investment vehicles. The on going processes of globalization and integration open wider possibilities for the investors to invest into new investment vehicles which were unavailable for them some time ago because of the weak domestic financial systems and limited technologies for investment in global investment environment. Financial innovations suggest for the investors the new choices of investment but at the same time make the investment process and investment decisions more complicated, because even if the investors have a wide range of alternatives to invest they can’t forgot the key rule in investments: invest only in what you really understand. Thus the investor must understand how investment vehicles differ from each other and only then to pick those which best match his/her expectations. The most important characteristics of investment vehicles on which bases the overall variety of investment vehicles can be assorted are the return on investment and the risk which is defined as the uncertainty about the actual return that will be earned on an investment (determination and measurement of returns on investments and risks will be examined in Chapter 2). Each type of investment vehicles could be characterized by certain level of profitability and risk because of the specifics of these financial instruments. Though all different types of investment vehicles can be compared using characteristics of risk and return and the most risky as well as less risky investment vehicles can be defined. However the risk and return on investment are close related and only using both important characteristics we can really understand the differences in investment vehicles. The main types of financial investment vehicles are: • Short term investment vehicles; • Fixed-income securities; Investment Analysis and Portfolio Management 15 agreement to sell them at a specified price and time. Using repos helps to increase the liquidity in the money market. Our focus in this course further will be not investment in short-term vehicles but it is useful for investor to know that short term investment vehicles provide the possibility for temporary investing of money/ funds and investors use these instruments managing their investment portfolio. Fixed-income securities are those which return is fixed, up to some redemption date or indefinitely. The fixed amounts may be stated in money terms or indexed to some measure of the price level. This type of financial investments is presented by two different groups of securities: • Long-term debt securities • Preferred stocks. Long-term debt securities can be described as long-term debt instruments representing the issuer’s contractual obligation. Long term securities have maturity longer than 1 year. The buyer (investor) of these securities is landing money to the issuer, who undertake obligation periodically to pay interest on this loan and repay the principal at a stated maturity date. Long-term debt securities are traded in the capital markets. From the investor’s point of view these securities can be treated as a “safe” asset. But in reality the safety of investment in fixed –income securities is strongly related with the default risk of an issuer. The major representatives of long-term debt securities are bonds, but today there are a big variety of different kinds of bonds, which differ not only by the different issuers (governments, municipals, companies, agencies, etc.), but by different schemes of interest payments which is a result of bringing financial innovations to the long-term debt securities market. As demand for borrowing the funds from the capital markets is growing the long-term debt securities today are prevailing in the global markets. And it is really become the challenge for investor to pick long-term debt securities relevant to his/ her investment expectations, including the safety of investment. We examine the different kinds of long-term debt securities and their features important to understand for the investor in Chapter 5, together with the other aspects in decision making investing in bonds. Preferred stocks are equity security, which has infinitive life and pay dividends. But preferred stock is attributed to the type of fixed-income securities, because the dividend for preferred stock is fixed in amount and known in advance. Investment Analysis and Portfolio Management 16 Though, this security provides for the investor the flow of income very similar to that of the bond. The main difference between preferred stocks and bonds is that for preferred stock the flows are for ever, if the stock is not callable. The preferred stockholders are paid after the debt securities holders but before the common stock holders in terms of priorities in payments of income and in case of liquidation of the company. If the issuer fails to pay the dividend in any year, the unpaid dividends will have to be paid if the issue is cumulative. If preferred stock is issued as noncumulative, dividends for the years with losses do not have to be paid. Usually same rights to vote in general meetings for preferred stockholders are suspended. Because of having the features attributed for both equity and fixed-income securities preferred stocks is known as hybrid security. A most preferred stock is issued as noncumulative and callable. In recent years the preferred stocks with option of convertibility to common stock are proliferating. The common stock is the other type of investment vehicles which is one of most popular among investors with long-term horizon of their investments. Common stock represents the ownership interest of corporations or the equity of the stock holders. Holders of common stock are entitled to attend and vote at a general meeting of shareholders, to receive declared dividends and to receive their share of the residual assets, if any, if the corporation is bankrupt. The issuers of the common stock are the companies which seek to receive funds in the market and though are “going public”. The issuing common stocks and selling them in the market enables the company to raise additional equity capital more easily when using other alternative sources. Thus many companies are issuing their common stocks which are traded in financial markets and investors have wide possibilities for choosing this type of securities for the investment. The questions important for investors for investment in common stock decision making will be discussed in Chapter 4. Speculative investment vehicles following the term “speculation” (see p.8) could be defined as investments with a high risk and high investment return. Using these investment vehicles speculators try to buy low and to sell high, their primary concern is with anticipating and profiting from the expected market fluctuations. The only gain from such investments is the positive difference between selling and purchasing prices. Of course, using short-term investment strategies investors can use for speculations other investment vehicles, such as common stock, but here we try to Investment Analysis and Portfolio Management 17 accentuate the specific types of investments which are more risky than other investment vehicles because of their nature related with more uncertainty about the changes influencing the their price in the future. Speculative investment vehicles could be presented by these different vehicles: • Options; • Futures; • Commodities, traded on the exchange (coffee, grain metals, other commodities); Options are the derivative financial instruments. An options contract gives the owner of the contract the right, but not the obligation, to buy or to sell a financial asset at a specified price from or to another party. The buyer of the contract must pay a fee (option price) for the seller. There is a big uncertainty about if the buyer of the option will take the advantage of it and what option price would be relevant, as it depends not only on demand and supply in the options market, but on the changes in the other market where the financial asset included in the option contract are traded. Though, the option is a risky financial instrument for those investors who use it for speculations instead of hedging. The main aspects of using options for investment will be discussed in Chapter 7. Futures are the other type of derivatives. A future contract is an agreement between two parties than they agree tom transact with the respect to some financial asset at a predetermined price at a specified future date. One party agree to buy the financial asset, the other agrees to sell the financial asset. It is very important, that in futures contract case both parties are obligated to perform and neither party charges the fee. There are two types of people who deal with options (and futures) contracts: speculators and hedgers. Speculators buy and sell futures for the sole purpose of making a profit by closing out their positions at a price that is better than the initial price. Such people neither produce nor use the asset in the ordinary course of business. In contrary, hedgers buy and sell futures to offset an otherwise risky position in the market. Transactions using derivatives instruments are not limited to financial assets. There are derivatives, involving different commodities (coffee, grain, precious metals, Investment Analysis and Portfolio Management 20 • From the perspective of a given country. By sequence of transactions for selling and buying securities:
Primary market
Secondary market All securities are first traded in the primary market, and the secondary market provides liquidity for these securities. Primary market is where corporate and government entities can raise capital and where the first transactions with the new issued securities are performed. If a company’s share is traded in the primary market for the first time this is referred to as an initial public offering (IPO). Investment banks play an important role in the primary market: • Usually handle issues in the primary market; • Among other things, act as underwriter of a new issue, guaranteeing the proceeds to the issuer. Secondary market - where previously issued securities are traded among investors. Generally, individual investors do not have access to secondary markets. They use security brokers to act as intermediaries for them. The broker delivers an orders received form investors in securities to a market place, where these orders are executed. Finally, clearing and settlement processes ensure that both sides to these transactions honor their commitment. Types of brokers: • Discount broker, who executes only trades in the secondary market; • Full service broker, who provides a wide range of additional services to clients (ex., advice to buy or sell); • Online broker is a brokerage firm that allows investors to execute trades electronically using Internet. Types of secondary market places: • Organized security exchanges; • Over-the-counter markets; • Alternative trading system. An organized security exchange provides the facility for the members to trade securities, and only exchange members may trade there. The members include brokerage firms, which offer their services to individual investors, charging commissions for executing trades on their behalf. Other exchange members by or sell Investment Analysis and Portfolio Management 21 for their own account, functioning as dealers or market makers who set prices at which they are willing to buy and sell for their own account. Exchanges play very important role in the modern economies by performing the following tasks: • Supervision of trading to ensure fairness and efficiency; • The authorization and regulation of market participants such as brokers and market makers; • Creation of an environment in which securities’ prices are formed efficiently and without distortion. This requires not only regulation of an orders and transaction costs but also a liquid market in which there are many buyers and sellers, allowing investors to buy or to sell their securities quickly; • Organization of the clearing and settlement of transactions; • The regulation of he admission of companies to be listed on the exchange and the regulation of companies who are listed on the exchange; • The dissemination of information (trading data, prices and announcements of companies listed on the exchange). Investors are more willing to trade if prompt and complete information about trades and prices in the market is available. The over-the-counter (OTC) market is not a formal exchange. It is organized network of brokers and dealers who negotiate sales of securities. There are no membership requirements and many brokers register as dealers on the OTC. At the same time there are no listing requirements and thousands of securities are traded in the OTC market. OTC stocks are usually considered as very risky because they are the stocks that are not considered large or stable enough to trade on the major exchange. An alternative trading system (ATS) is an electronic trading mechanism developed independently from the established market places – security exchanges – and designed to match buyers and sellers of securities on an agency basis. The brokers who use ATS are acting on behalf of their clients and do not trade on their own account. The distinct advantages of ATS in comparison with traditional markets are cost savings of transactions, the short time of execution of transactions for liquid securities, extended hours for trading and anonymity, often important for investors, trading large amounts. By term of circulation of financial assets traded in the market: Investment Analysis and Portfolio Management 22
Money market;
Capital market Money market - in which only short-term financial instruments are traded. Capital market - in which only long-term financial instruments are traded. The capital markets allow firms, governments to finance spending in excess of their current incomes. Table 1.2. The comparison of money market and capital market Features Money market Capital market Term of circulation of securities traded Short-term, less than 1 year Long-term, more than 1 year Level of risk Low, because of trading short-term securities which have lower level of risk and high liquidity Long-term securities, traded in this market, is more risky Fund suppliers Commercial banks, non- financial business institutions with the excess funds Banks, insurance companies, pension funds, lending the large amounts of funds for a long-term period; investment funds with big pools of funds for investing Financial instruments Certificates of deposit; Treasury bills; Commercial paper; Bankers’ acceptances; Repurchase agreements, other short-term investment vehicles Common stocks; Preferred stocks; Treasury bonds; Municipal bonds; Corporate bonds; other long-term investment vehicles Aims for raising money For financing of working capital and current needs For financing of further business development and investment projects By economic nature of securities, traded in the market:
Equity market or stock market;
Common stock market;
Fixed-income market;
Debt market;
Derivatives market. From the perspective of a given country financial markets are:
Internal or national market; Investment Analysis and Portfolio Management 25 This analysis examines the trends of historical prices and is based on the assumption that these trends or patterns repeat themselves in the future. Fundamental analysis in its simplest form is focused on the evaluation of intrinsic value of the financial asset. This valuation is based on the assumption that intrinsic value is the present value of future flows from particular investment. By comparison of the intrinsic value and market value of the financial assets those which are under priced or overpriced can be identified. Fundamental analysis will be examined in Chapter 4. This step involves identifying those specific financial assets in which to invest and determining the proportions of these financial assets in the investment portfolio. Formation of diversified investment portfolio is the next step in investment management process. Investment portfolio is the set of investment vehicles, formed by the investor seeking to realize its’ defined investment objectives. In the stage of portfolio formation the issues of selectivity, timing and diversification need to be addressed by the investor. Selectivity refers to micro forecasting and focuses on forecasting price movements of individual assets. Timing involves macro forecasting of price movements of particular type of financial asset relative to fixed-income securities in general. Diversification involves forming the investor’s portfolio for decreasing or limiting risk of investment. 2 techniques of diversification: • random diversification, when several available financial assets are put to the portfolio at random; • objective diversification when financial assets are selected to the portfolio following investment objectives and using appropriate techniques for analysis and evaluation of each financial asset. Investment management theory is focused on issues of objective portfolio diversification and professional investors follow settled investment objectives then constructing and managing their portfolios. Portfolio revision. This step of the investment management process concerns the periodic revision of the three previous stages. This is necessary, because over time investor with long-term investment horizon may change his / her investment objectives and this, in turn means that currently held investor’s portfolio may no longer be optimal and even contradict with the new settled investment objectives. Investor should form the new portfolio by selling some assets in his portfolio and buying the Investment Analysis and Portfolio Management 26 others that are not currently held. It could be the other reasons for revising a given portfolio: over time the prices of the assets change, meaning that some assets that were attractive at one time may be no longer be so. Thus investor should sell one asset ant buy the other more attractive in this time according to his/ her evaluation. The decisions to perform changes in revising portfolio depend, upon other things, in the transaction costs incurred in making these changes. For institutional investors portfolio revision is continuing and very important part of their activity. But individual investor managing portfolio must perform portfolio revision periodically as well. Periodic re- evaluation of the investment objectives and portfolios based on them is necessary, because financial markets change, tax laws and security regulations change, and other events alter stated investment goals. Measurement and evaluation of portfolio performance. This the last step in investment management process involves determining periodically how the portfolio performed, in terms of not only the return earned, but also the risk of the portfolio. For evaluation of portfolio performance appropriate measures of return and risk and benchmarks are needed. A benchmark is the performance of predetermined set of assets, obtained for comparison purposes. The benchmark may be a popular index of appropriate assets – stock index, bond index. The benchmarks are widely used by institutional investors evaluating the performance of their portfolios. It is important to point out that investment management process is continuing process influenced by changes in investment environment and changes in investor’s attitudes as well. Market globalization offers investors new possibilities, but at the same time investment management become more and more complicated with growing uncertainty. Summary 1. The common target of investment activities is to “employ” the money (funds) during the time period seeking to enhance the investor’s wealth. By foregoing consumption today and investing their savings, investors expect to enhance their future consumption possibilities by increasing their wealth. 2. Corporate finance area of studies and practice involves the interaction between firms and financial markets and Investments area of studies and practice involves the interaction between investors and financial markets. Both Corporate Finance and Investments are built upon a common set of financial principles, such as the Investment Analysis and Portfolio Management 27 present value, the future value, the cost of capital). And very often investment and financing analysis for decision making use the same tools, but the interpretation of the results from this analysis for the investor and for the financier would be different. 3. Direct investing is realized using financial markets and indirect investing involves financial intermediaries. The primary difference between these two types of investing is that applying direct investing investors buy and sell financial assets and manage individual investment portfolio themselves; contrary, using indirect type of investing investors are buying or selling financial instruments of financial intermediaries (financial institutions) which invest large pools of funds in the financial markets and hold portfolios. Indirect investing relieves investors from making decisions about their portfolio. 4. Investment environment can be defined as the existing investment vehicles in the market available for investor and the places for transactions with these investment vehicles. 5. The most important characteristics of investment vehicles on which bases the overall variety of investment vehicles can be assorted are the return on investment and the risk which is defined as the uncertainty about the actual return that will be earned on an investment. Each type of investment vehicles could be characterized by certain level of profitability and risk because of the specifics of these financial instruments. The main types of financial investment vehicles are: short- term investment vehicles; fixed-income securities; common stock; speculative investment vehicles; other investment tools. 6. Financial markets are designed to allow corporations and governments to raise new funds and to allow investors to execute their buying and selling orders. In financial markets funds are channeled from those with the surplus, who buy securities, to those, with shortage, who issue new securities or sell existing securities. 7. All securities are first traded in the primary market, and the secondary market provides liquidity for these securities. Primary market is where corporate and government entities can raise capital and where the first transactions with the new issued securities are performed. Secondary market - where previously issued securities are traded among investors. Generally, individual investors do not have Investment Analysis and Portfolio Management 30 8. Describe how investment funds, pension funds and life insurance companies each act as financial intermediaries. 9. Distinguish closed-end funds and open-end funds. 10. How do you understand why word “hedge’ currently is misapplied to hedge funds? 11. Explain the differences between a) Money market and capital market; b) Primary market and secondary market. 12. Why the role of the organized stock exchanges is important in the modern economies? 13. What factors might an individual investor take into account in determining his/ her investment policy? 14. Define the objective and the content of a five-step procedure. 15. What are the differences between technical and fundamental analysis? 16. Explain why the issues of selectivity, timing and diversification are important when forming the investment portfolio. 17. Think about your investment possibilities for 3 years holding period in real investment environment. a) What could be your investment objectives? b) What amount of funds you could invest for 3 years period? c) What investment vehicles could you use for investment? (What types of investment vehicles are available in your investment environment?) d) What type(-es) of investment vehicles would be relevant to you? Why? e) What factors would be critical for your investment decision making in this particular investment environment? References and further readings 1. Black, John, Nigar Hachimzade, Gareth Myles (2009). Oxford Dictionary of Economics. 3 rd ed. Oxford University Press Inc., New York. 2. Bode, Zvi, Alex Kane, Alan J. Marcus (2005). Investments. 6th ed. McGraw Hill. 3. Fabozzi, Frank J. (1999). Investment Management. 2nd. ed. Prentice Hall Inc. 4. Francis, Jack C., Roger Ibbotson (2002). Investments: A Global Perspective. Prentice Hall Inc. Investment Analysis and Portfolio Management 31 5. Haan, Jakob, Sander Oosterloo, Dirk Schoenmaker (2009).European Financial Markets and Institutions. Cambridge University Press. 6. Jones, Charles P. (2010). Investments Principles and Concepts. John Wiley & Sons, Inc. 7. LeBarron, Dean, Romesh Vaitlingam (1999). Ultimate Investor. Capstone. 8. Levy, Haim, Thierry Post (2005). Investments. FT / Prentice Hall. 9. Rosenberg, Jerry M. (1993).Dictionary of Investing. John Wiley &Sons Inc. 10. Sharpe, William F. Gordon J.Alexander, Jeffery V.Bailey. (1999). Investments. International edition. Prentice –Hall International. Relevant websites • www.cmcmarkets.co.uk CMC Markets • www.dcxworld.com Development Capital Exchange • www.euronext.com Euronext • www.nasdaqomx.com NASDAQ OMX • www.world-exchanges.org World Federation of Exchange • www.hedgefund.net Hedge Fund • www.liffeinvestor.com Information and learning tools from LIFFE to help the private investor • www.amfi.com Association of Mutual Funds Investors • www.standardpoors.com Standard &Poors Funds • www.bloomberg.com/markets Bloomberg Investment Analysis and Portfolio Management 32 2. Quantitative methods of investment analysis Mini-contents 2.1. Investment income and risk. 2.1.1. Return on investment and expected rate of return. 2.1.2. Investment risk. Variance and standard deviation. 2.2. Relationship between risk and return. 2.2.1. Covariance. 2.2.2. Correlation and Coefficient of determination. 2.3. Relationship between the returns on asset and market portfolio 2.3.1. The characteristic line and the Beta factor. 2.3.2. Residuale variance. Summary Key terms Questions and problems References and further readings 3 basic questions for the investor in decision making: 1. How to compare different assets in investment selection process? What are the quantitative characteristics of the assets and how to measure them? 2. How does one asset in the same portfolio influence the other one in the same portfolio? And what could be the influence of this relationship to the investor’s portfolio? 3. What is relationship between the returns on an asset and returns in the whole market (market portfolio)? The answers of these questions need quantitative methods of analysis, based on the statistical concepts and they will be examined in this chapter. 2.1. Investment income and risk A return is the ultimate objective for any investor. But a relationship between return and risk is a key concept in finance. As finance and investments areas are built upon a common set of financial principles, the main characteristics of any investment are investment return and risk. However to compare various alternatives of investments the precise quantitative measures for both of these characteristics are needed. 2.1.1. Return on investment and expected rate of return General definition of return is the benefit associated with an investment. In most cases the investor can estimate his/ her historical return precisely. Investment Analysis and Portfolio Management 35 2.1.2. Investment risk Risk can be defined as a chance that the actual outcome from an investment will differ from the expected outcome. Obvious, that most investors are concerned that the actual outcome will be less than the expected outcome. The more variable the possible outcomes that can occur, the greater the risk. Risk is associated with the dispersion in the likely outcome. And dispersion refers to variability. So, the total risk of investments can be measured with such common absolute measures used in statistics as • variance; • standard deviation. Variance can be calculated as a potential deviation of each possible investment rate of return from the expected rate of return: n δ²(r) = ∑ hi × [ ri - E(r) ]² (2.5) i=1 To compute the variance in formula 2.5 all the rates of returns which were observed in estimating expected rate of return (ri) have to be taken together with their probabilities of appearance (hi). The other an equivalent to variance measure of the total risk is standard deviation which is calculated as the square root of the variance: ______________ δ(r) = √ ∑ hi ×[ri - E(r)]² (2.6) In the cases than the arithmetic average return or sample mean of the returns (ř) is used instead of expected rate of return, sample variance (δ²r ) can be calculated: n ∑ (rt - ř) ² t=1 δ²r = -------------------- (2.7) n– 1 Sample standard deviation (δr) consequently can be calculated as the square root of the sample variance: ____ δr = √ δ²r (2.8) Investment Analysis and Portfolio Management 36 Variance and the standard deviation are similar measures of risk and can be used for the same purposes in investment analysis; however, standard deviation in practice is used more often. Variance and standard deviation are used when investor is focused on estimating total risk that could be expected in the defined period in the future. Sample variance and sample standard deviation are more often used when investor evaluates total risk of his /her investments during historical period – this is important in investment portfolio management. 2.2. Relationship between risk and return The expected rate of return and the variance or standard deviation provide investor with information about the nature of the probability distribution associated with a single asset. However all these numbers are only the characteristics of return and risk of the particular asset. But how does one asset having some specific trade-off between return and risk influence the other one with the different characteristics of return and risk in the same portfolio? And what could be the influence of this relationship to the investor’s portfolio? The answers to these questions are of great importance for the investor when forming his/ her diversified portfolio. The statistics that can provide the investor with the information to answer these questions are covariance and correlation coefficient. Covariance and correlation are related and they generally measure the same phenomenon – the relationship between two variables. Both concepts are best understood by looking at the math behind them. 2.2.1. Covariance Two methods of covariance estimation can be used: the sample covariance and the population covariance. The sample covariance is estimated than the investor hasn‘t enough information about the underlying probability distributions for the returns of two assets and then the sample of historical returns is used. Sample covariance between two assets - A and B is defined in the next formula (2.9): n Investment Analysis and Portfolio Management 37 ∑ [( rA,t - ŕA ) × ( rB,t - ŕB)] t=1 Cov (ŕA, ŕB) = -----------------------------------------, (2.9) n – 1 here rA,t , rB,t - consequently, rate of return for assets A and B in the time period t, when t varies from 1 to n; ŕA, ŕB - sample mean of rate of returns for assets A and B consequently. As can be understood from the formula, a number of sample covariance can range from “–” to “+” infinity. Though, the covariance number doesn’t tell the investor much about the relationship between the returns on the two assets if only this pair of assets in the portfolio is analysed. It is difficult to conclud if the relationship between returns of two assets (A and B) is strong or weak, taking into account the absolute number of the sample variance. However, what is very important using the covariance for measuring relationship between two assets – the identification of the direction of this relationship. Positive number of covariance shows that rates of return of two assets are moving to the same direction: when return on asset A is above its mean of return (positive), the other asset B is tend to be the same (positive) and vice versa: when the rate of return of asset A is negative or bellow its mean of return, the returns of other asset tend to be negative too. Negative number of covariance shows that rates of return of two assets are moving in the contrariwise directions: when return on asset A is above its mean of return (positive), the returns of the other asset - B is tend to be the negative and vice versa. Though, in analyzing relationship between the assets in the same portfolio using covariance for portfolio formation it is important to identify which of the three possible outcomes exists:
positive covariance (“+”),
negative covariance (“-”) or
zero covariance (“0”). If the positive covariance between two assets is identified the common recommendation for the investor would be not to put both of these assets to the same portfolio, because their returns move in the same direction and the risk in portfolio will be not diversified. If the negative covariance between the pair of assets is identified the common recommendation for the investor would be to include both of these assets to the Investment Analysis and Portfolio Management 40 The population covariance is estimated when the investor has enough information about the underlying probability distributions for the returns of two assets and can identify the actual probabilities of various pairs of the returns for two assets at the same time. The population covariance between stocks A and B: m Cov (rA, rB) = ∑ hi × [rA,i - E(rA) ] × [rB,i - E(rB)] (2.10) i=1 Similar to using the sample covariance, in the population covariance case the graphical method can be used for the identification of the direction of the relationship between two assets. But the graphical presentation of data in this case is more complicated because three dimensions must be used (including the probability). Despite of it, if investor observes that more pairs of returns are in the sections I and III than in II and IV, the population covariance will be positive, if the pairs of return in II and IV prevails over I and III, the population covariance is negative. 2.2.2. Correlation and Coefficient of determination. Correlation is the degree of relationship between two variables. The correlation coefficient between two assets is closely related to their covariance. The correlation coefficient between two assets A and B (kAB) can be calculated using the next formula: Cov(rA,rB) kA,B = ------------------- , (2.11) δ (rA) × δ(rB) here δ (rA) and δ(rB) are standard deviation for asset A and B consequently. Very important, that instead of covariance when the calculated number is unbounded, the correlation coefficient can range only from -1,0 to +1,0. The more close the absolute meaning of the correlation coefficient to 1,0, the stronger the relationship between the returns of two assets. Two variables are perfectly positively correlated if correlation coefficient is +1,0, that means that the returns of two assets have a perfect positive linear relationship to each other (see Fig. 2.4), and perfectly negatively correlated if correlation coefficient is -1,0, that means the asset returns have a perfect inverse linear relationship to each other (see Fig. 2.5). But most often correlation between assets returns is imperfect (see Fig. 2.6). When correlation coefficient equals 0, there is no linear relationship between the returns on the two Investment Analysis and Portfolio Management 41 assets (see Fig. 2.7). Combining two assets with zero correlation with each other reduces the risk of the portfolio. While a zero correlation between two assets returns is better than positive correlation, it does not provide the risk reduction results of a negative correlation coefficient. Fig. 2.4. Perfect positive correlation Fig. 2.5. Perfect negative correlation between returns of two assets. between returns of two assets. . Fig. 2.6. Imperfect positive correlation Fig. 2.7. Zero correlation between between returns on two assets. returns on two assets. r B r A r B r A r B r A r B r A Investment Analysis and Portfolio Management 42 It can be useful to note, that when investor knows correlation coefficient, the covariance between stocks A and B can be estimated, because standard deviations of the assets’ rates of return will already are available: Cov(rA, rB ) = kA,B × δ(rA) × δ (rB) (2.12) Therefore, as it was pointed out earlier, the covariance primarily provides information to the investor about whether the relationship between asset returns is positive, negative or zero, because simply observing the number itself without any context with which to compare the number, is not very useful. When the covariance is positive, the correlation coefficient will be also positive, when the covariance is negative, the correlation coefficient will be also negative. But using correlation coefficients instead of covariance investor can immediately asses the degree of relationship between assets returns. The coefficient of determination (Det.AB) is calculated as the square of correlation coefficient: Det.A, B = k²A,B (2.13) The coefficient of determination shows how much variability in the returns of one asset can be associated with variability in the returns of the other. For example, if correlation coefficient between returns of two assets is estimated + 0,80, the coefficient of determination will be 0,64. The interpretation of this number for the investor is that approximately 64 percent of the variability in the returns of one asset can be explained by the returns of the other asset. If the returns on two assets are perfect correlated, the coefficient of determination will be equal to 100 %, and this means that in such a case if investor knows what will be the changes in returns of one asset he / she could predict exactly the return of the other asset. 2.3. Relationship between the returns on stock and market portfolio When picking the relevant assets to the investment portfolio on the basis of their risk and return characteristics and the assessment of the relationship of their returns investor must consider to the fact that these assets are traded in the market. How could the changes in the market influence the returns of the assets in the investor’s portfolio? What is the relationship between the returns on an asset and returns in the whole market (market portfolio)? These questions need to be answered Investment Analysis and Portfolio Management 45 reality the stock produce returns that deviate from the characteristic line (see Fig. 2.8). In statistics this propensity is called the residual variance. Residual variance is the variance in the stock’s residuals and for the stock J can be calculated using formula: n Σ ε²J,t t =1 δ²ε,t = -------------- , (2.15) n - 2 here εJ,t - residual of the stock J in period t; n - number of periods observed. To calculate residual variance the residual in every period of observations must be identified. Residual is the vertical distance between the point which reflect the pair of returns (stock J and market) and the characteristic line of stock J. The residual of the stock J can be calculated: εJ,t = rJ,t - ( AJ + βJ × r M,t ) (2.16) c.1 c.2 It is useful for the interpretation of residual to investor to accentuate two components in formula of residual (see 2.16): • Component 1 reflects the return actually generated by the stock J during period t; • Component 2 (in the bracket) represents investor’s expectations for the stock’s return, given its characteristic line and market’s returns. Note the difference between the variance and the residual variance:
The variance describes the deviation of the asset returns from its expected value ;
The residual variance describes the deviation of the asset returns from its characteristic line. Summary 1. The main characteristics of any investment are investment return and risk. However to compare various alternatives of investments the precise quantitative measures for both of these characteristics are needed. 2. General definition of return is the benefit associated with an investment. Many investments have two components of their measurable return: (1) a capital gain or Investment Analysis and Portfolio Management 46 loss; (2) some form of income. The holding period return is the percentage increase in returns associated with the holding period. 3. Investor can‘t compare the alternative investments using holding period returns, if their holding periods (investment periods) are different. In these cases arithmetic average return or sample mean of the returns can be used. 4. Both holding period returns and sample mean of returns are calculated using historical data. However all the investors’ decisions are focused to the future, or to expected results from the investments. The expected rate of return of investment is the statistical measure of return, which is the sum of all possible rates of returns for the same investment weighted by probabilities. 5. Risk can be defined as a chance that the actual outcome from an investment will differ from the expected outcome. The total risk of investments can be measured with such common absolute measures used in statistics as variance and standard deviation. Variance can be calculated as a potential deviation of each possible investment rate of return from the expected rate of return. Standard deviation is calculated as the square root of the variance. The more variable the possible outcomes that can occur, the greater the risk. 6. In the cases than the arithmetic average return or sample mean of the returns is used instead of expected rate of return, sample variance and sample standard deviation is calculated. 7. Covariance and correlation coefficient are used to answer the question, what is the relationship between the returns on different assets. Covariance and correlation coefficient are related and they generally measure the same phenomenon – the relationship between two variables. 8. The sample covariance is estimated than the investor hasn‘t enough information about the underlying probability distributions for the returns of two assets and then the sample of historical returns is used. The population covariance is estimated when the investor has enough information about the underlying probability distributions for the returns of two assets and can identify the actual probabilities of various pairs of the returns for two assets at the same time. 9. Analyzing relationship between the assets in the same portfolio using covariance for portfolio formation it is important to identify which of the three possible outcomes exists: positive covariance, negative covariance or zero covariance. If the Investment Analysis and Portfolio Management 47 positive covariance between two assets is identified the common recommendation for the investor would be not to put both of these assets to the same portfolio, because their returns move in the same direction and the risk in portfolio will be not diversified; if the negative - the common recommendation for the investor would be to include both of these assets to the portfolio, because their returns move in the contrariwise directions and the risk in portfolio could be diversified; if the zero covariance - it means that there is no relationship between the rates of return of two assets. 10. The correlation coefficient between two assets is closely related to their covariance. But instead of covariance when the calculated number is unbounded, the correlation coefficient can range only from -1,0 to +1,0. The more close the absolute meaning of the correlation coefficient to 1,0, the stronger the relationship between the returns of two assets. Using correlation coefficients instead of covariance investor can immediately asses the degree of relationship between assets returns. 11. The coefficient of determination is calculated as the square of correlation coefficient and shows how much variability in the returns of one asset can be associated with variability in the returns of the other. 12. Theoretical interpretation of the market portfolio is that it involves every single risky asset in the global economic system, and contains each asset in proportion to the total market value of that asset relative to the total value of all other assets (value weighted portfolio). Investors can think of the market portfolio as the ultimate market index. 13. Stock’s characteristic line describes the relationship between the stock and the market, shows the return investor expect the stock to produce, given that a particular rate of return appears for the market and helps to assess the risk characteristics of one stock relative to the market. 14. The slope of the characteristic line is called the Beta factor. The Beta factor of the stock is an indicator of the degree to which the stock reacts to the changes in the returns of the market portfolio. 15. The intercept is the point where characteristic line passes through the vertical axis. The interpretation of the intercept from the investor’s point of view is that it shows Investment Analysis and Portfolio Management 50 a) Calculate the main statistic measures to explain the relationship between stock A and the market portfolio: • The sample covariance between rate of return for the stock A and the market; • The sample Beta factor of stock A; • The sample correlation coefficient between the rates of return of the stock A and the market; • The sample coefficient of determination associated with the stock A and the market. b) Draw in the characteristic line of the stock A and give the interpretation - what does it show for the investor? c) Calculate the sample residual variance associated with stock‘s A characteristic line and explain how the investor would interpret the number of this statistic. d) Do you recommend this stock for the investor with the lower tolerance of risk? References and further readings 1. Fabozzi, Frank J. (1999). Investment Management. 2nd. ed. Prentice Hall Inc. 2. Francis, Jack, C. Roger Ibbotson (2002). Investments: A Global Perspective. Prentice Hall Inc. 3. Haugen, (Robert A. 2001). Modern Investment Theory. 5 th ed. Prentice Hall. 4. Levy, Haim, Thierry Post (2005). Investments. FT / Prentice Hall. 5. Rosenberg, Jerry M. (1993).Dictionary of Investing. John Wiley &Sons Inc. 6. Sharpe, William F., Gordon J.Alexander, Jeffery V.Bailey. (1999). Investments. International edition. Prentice –Hall International. 7. Strong, Robert A. (1993). Portfolio Construction, Management and Protection. Investment Analysis and Portfolio Management 51 3. Theory for investment portfolio formation Mini-contents 3.1. Portfolio theory. 3.1.1. Markowitz portfolio theory. 3.1.2. The Risk and Expected Return of a Portfolio. 3.2. Capital Asset Pricing Model (CAPM). 3.3. Arbitrage Pricing Theory (APT). 3.4. Market efficiency theory. Summary Key terms Questions and problems References and further readings 3.1. Portfolio theory 3.1.1. Markowitz portfolio theory The author of the modern portfolio theory is Harry Markowitz who introduced the analysis of the portfolios of investments in his article “Portfolio Selection” published in the Journal of Finance in 1952. The new approach presented in this article included portfolio formation by considering the expected rate of return and risk of individual stocks and, crucially, their interrelationship as measured by correlation. Prior to this investors would examine investments individually, build up portfolios of attractive stocks, and not consider how they related to each other. Markowitz showed how it might be possible to better of these simplistic portfolios by taking into account the correlation between the returns on these stocks. The diversification plays a very important role in the modern portfolio theory. Markowitz approach is viewed as a single period approach: at the beginning of the period the investor must make a decision in what particular securities to invest and hold these securities until the end of the period. Because a portfolio is a collection of securities, this decision is equivalent to selecting an optimal portfolio from a set of possible portfolios. Essentiality of the Markowitz portfolio theory is the problem of optimal portfolio selection. The method that should be used in selecting the most desirable portfolio involves the use of indifference curves. Indifference curves represent an investor’s preferences for risk and return. These curves should be drawn, putting the investment return on the vertical axis and the risk on the horizontal axis. Following Markowitz approach, the Investment Analysis and Portfolio Management 52 measure for investment return is expected rate of return and a measure of risk is standard deviation (these statistic measures we discussed in previous chapter, section 2.1). The exemplified map of indifference curves for the individual risk-averse investor is presented in Fig.3.1. Each indifference curve here (I1, I2, I3 ) represents the most desirable investment or investment portfolio for an individual investor. That means, that any of investments (or portfolios) ploted on the indiference curves (A,B,C or D) are equally desirable to the investor. Features of indifference curves:
All portfolios that lie on a given indifference curve are equally desirable to the investor. An implication of this feature: indifference curves cannot intersect.
An investor has an infinitive number of indifference curves. Every investor can represent several indifference curves (for different investment tools). Every investor has a map of the indifference curves representing his or her preferences for expected returns and risk (standard deviations) for each potential portfolio. Fig. 3.1. Map of Indiference Curves for a Risk-Averse Investor Two important fundamental assumptions than examining indifference curves and applying them to Markowitz portfolio theory: 1. The investors are assumed to prefer higher levels of return to lower levels of return, because the higher levels of return allow the investor to spend more on consumption at the end of the investment period. Thus, given two portfolios with the same standard deviation, the investor will choose the Risk ( D B C r B r C r A r D I1 I2 I3 σ B σ D σ C σ A σ A Expected rate of return ( ) r ) Investment Analysis and Portfolio Management 55 The expected rate of return of the portfolio can be calculated in some alternative ways. The Markowitz focus was on the end-of-period wealth (terminal value) and using these expected end-of-period values for each security in the portfolio the expected end-of-period return for the whole portfolio can be calculated. But the portfolio really is the set of the securities thus the expected rate of return of a portfolio should depend on the expected rates of return of each security included in the portfolio (as was presented in Chapter 2, formula 2.4). This alternative method for calculating the expected rate of return on the portfolio (E(r)p) is the weighted average of the expected returns on its component securities: n E(r)p = Σ wi * Ei (r) = E1(r) + w2 * E2(r) +…+ wn * En(r), (3.1) i=1 here wi - the proportion of the portfolio’s initial value invested in security i; Ei(r) - the expected rate of return of security I; n - the number of securities in the portfolio. Because a portfolio‘s expected return is a weighted average of the expected returns of its securities, the contribution of each security to the portfolio‘s expected rate of return depends on its expected return and its proportional share from the initial portfolio‘s market value (weight). Nothing else is relevant. The conclusion here could be that the investor who simply wants the highest posible expected rate of return must keep only one security in his portfolio which has a highest expected rate of return. But why the majority of investors don‘t do so and keep several different securities in their portfolios? Because they try to diversify their portfolios aiming to reduce the investment portfolio risk. Risk of the portfolio. As we know from chapter 2, the most often used measure for the risk of investment is standard deviation, which shows the volatility of the securities actual return from their expected return. If a portfolio‘s expected rate of return is a weighted average of the expected rates of return of its securities, the calculation of standard deviation for the portfolio can‘t simply use the same approach. The reason is that the relationship between the securities in the same portfolio must be taken into account. As it was discussed in section 2.2, the relationship between the assets can be estimated using the covariance and coefficient of correlation. As covariance can range from “–” to “+” infinity, it is more useful for identification of the direction of relationship (positive or negative), coefficients of correlation always Investment Analysis and Portfolio Management 56 lies between -1 and +1 and is the convenient measure of intensity and direction of the relationship between the assets. Risk of the portfolio, which consists of 2 securities (A ir B): δp = (w²A × δ²A + w²B ×δ²B + 2 wA × wB × kAB × δA×δB)1/2, (3.2) here: wA ir wB - the proportion of the portfolio’s initial value invested in security A and B ( wA + wB = 1); δA ir δB - standard deviation of security A and B; kAB - coefficient of coreliation between the returns of security A and B. Standard deviation of the portfolio consisting n securities: n n δ = ( ∑ ∑ wi wj kij δi δj )1/2 , (3.3) i=1 j=1 here: wi ir wj - the proportion of the portfolio’s initial value invested in security i and j ( wi + wj = 1); δi ir δj - standard deviation of security i and j; kij - coefficient of coreliation between the returns of security i and j. 3.2. Capital Asset Pricing Model (CAPM) CAPM was developed by W. F. Sharpe. CAPM simplified Markowitz‘s Modern Portfolio theory, made it more practical. Markowitz showed that for a given level of expected return and for a given feasible set of securities, finding the optimal portfolio with the lowest total risk, measured as variance or standard deviation of portfolio returns, requires knowledge of the covariance or correlation between all possible security combinations (see formula 3.3). When forming the diversified portfolios consisting large number of securities investors found the calculation of the portfolio risk using standard deviation technically complicated. Measuring Risk in CAPM is based on the identification of two key components of total risk (as measured by variance or standard deviation of return):
Systematic risk
Unsystematic risk Systematic risk is that associated with the market (purchasing power risk, interest rate risk, liquidity risk, etc.) Investment Analysis and Portfolio Management 57 Unsystematic risk is unique to an individual asset (business risk, financial risk, other risks, related to investment into particular asset). Unsystematic risk can be diversified away by holding many different assets in the portfolio, however systematic risk can’t be diversified (see Fig 3.4). In CAPM investors are compensated for taking only systematic risk. Though, CAPM only links investments via the market as a whole. Portfolio Risk 0 1 2 3 4 5 6 7 8 9 10 Number of securities in portfolio Fig.3.4. Portfolio risk and the level of diversification The essence of the CAPM: the more systematic risk the investor carry, the greater is his / her expected return. The CAPM being theoretical model is based on some important assumptions: • All investors look only one-period expectations about the future; • Investors are price takers and they cant influence the market individually; • There is risk free rate at which an investors may either lend (invest) or borrow money. • Investors are risk-averse, • Taxes and transaction costs are irrelevant. • Information is freely and instantly available to all investors. Following these assumptions, the CAPM predicts what an expected rate of return for the investor should be, given other statistics about the expected rate of return in the market and market risk (systematic risk): Systematic risk Unsystematic risk Total risk Investment Analysis and Portfolio Management 60 1976. Still there is a potential for it and it may sometimes displace the CAPM. In the CAPM returns on individual assets are related to returns on the market as a whole. The key point behind APT is the rational statement that the market return is determined by a number of different factors. These factors can be fundamental factors or statistical. If these factors are essential, there to be no arbitrage opportunities there must be restrictions on the investment process. Here arbitrage we understand as the earning of riskless profit by taking advantage of differential pricing for the same assets or security. Arbitrage is is widely applied investment tactic. APT states, that the expected rate of return of security J is the linear function from the complex economic factors common to all securities and can be estimated using formula: E(rJ) = E(ŕJ) + β1J I1J + β2J I2J + ... + βnJ InJ + εJ , (3.6) here: E(rJ) - expected return on stock J; E(ŕJ) - expected rate of return for security J, if the influence of all factors is 0; IiJ - the change in the rate of return for security J, influenced by economic factor i (i = 1, ..., n); βiJ - coefficient Beta, showing sensitivity of security’s J rate of return upon the factor i (this influence could be both positive or negative); εJ - error of rounding for the security J (expected value – 0). It is important to note that the arbitrage in the APT is only approximate, relating diversified portfolios, on assumption that the asset unsystematic (specific) risks are negligable compared with the factor risks. There could presumably be an infinitive number of factors, although the empirical research done by S.Ross together with R. Roll (1984) identified four factors – economic variables, to which assets having even the same CAPM Beta, are differently sensitive: • inflation; • industrial production; • risk premiums; • slope of the term structure in interst rates. Investment Analysis and Portfolio Management 61 In practice an investor can choose the macroeconomic factors which seems important and related with the expected returns of the particular asset. The examples of possible macroeconomic factors which could be included in using APT model : • GDP growth; • an interest rate; • an exchange rate; • a defaul spread on corporate bonds, etc. Including more factors in APT model seems logical. The institutional investors and analysts closely watch macroeconomic statistics such as the money supply, inflation, interest rates, unemployment, changes in GDP, political events and many others. Reason for this might be their belief that new information about the changes in these macroeconomic indicators will influence future asset price movements. But it is important to point out that not all investors or analysts are concerned with the same set of economic information and they differently assess the importance of various macroeconomic factors to the assets they have invested already or are going to invest. At the same time the large number of the factors in the APT model would be impractical, because the models seldom are 100 percent accurate and the asset prices are function of both macroeconomic factors and noise. The noise is coming from minor factors, with a little influence to the result – expected rate of return. The APT does not require identification of the market portfolio, but it does reguire the specification of the relevant macroeconomic factors. Much of the current empirical APT research are focused on identification of these factors and the determination of the factors’ Betas. And this problem is still unsolved. Although more than two decades have passed since S. Ross introduced APT model, it has yet to reach the practical application stage. The CAPM and APT are not really essentially different, because they are developed for determing an expected rate of return based on one factor (market portfolio – CAPM) or a number of macroeconomic factors (APT). But both models predict how the return on asset will result from factor sensitivities and this is of great importance to the investor. Investment Analysis and Portfolio Management 62 3.4. Market efficiency theory The concept of market efficiency was proposed by Eugene Fama in 1965, when his article “Random Walks in Stock Prices” was published in Financial Analyst Journal. Market efficiency means that the price which investor is paying for financial asset (stock, bond, other security) fully reflects fair or true information about the intrinsic value of this specific asset or fairly describe the value of the company – the issuer of this security. The key term in the concept of the market efficiency is the information available for investors trading in the market. It is stated that the market price of stock reflects: 1. All known information, including:
Past information, e.g., last year’s or last quarter’s, month’s earnings;
Current information as well as events, that have been announced but are still forthcoming, e.g. shareholders’ meeting. 2. Information that can reasonably be inferred, for example, if many investors believe that ECB will increase interest rate in the nearest future or the government deficit increases, prices will reflect this belief before the actual event occurs. Capital market is efficient, if the prices of securities which are traded in the market, react to the changes of situation immediately, fully and credibly reflect all the important information about the security’s future income and risk related with generating this income. What is the important information for the investor? From economic point of view the important information is defined as such information which has direct influence to the investor’s decisions seeking for his defined financial goals. Example, the essential events in the joint stock company, published in the newspaper, etc. Market efficiency requires thet the adjustment to new information occurs very quikly as the information becomes known. Obvious, that Internet has made the markets more efficient in the sense of how widely and quickly information is disseminated. There are 3 forms of market efficiency under efficient market hypothesis: • Weak form of efficiency; • Semi- strong form of efficiency; • Strong form of the efficiency. Investment Analysis and Portfolio Management 65 4. Efficient set theorem states that an investor will choose his/ her optimal portfolio from the set of the portfolios that (1) offer maximum expected return for varying level of risk, and (2) offer minimum risk for varying levels of expected return. 5. Efficient set of portfolios involves the portfolios that the investor will find optimal ones. These portfolios are lying on the “northwest boundary” of the feasible set and is called an efficient frontier. The efficient frontier can be described by the curve in the risk-return space with the highest expected rates of return for each level of risk. Feasible set is opportunity set, from which the efficient set of portfolio can be identified. The feasibility set represents all portfolios that could be formed from the number of securities and lie either or or within the boundary of the feasible set. 6. Capital Market Line (CML) shows the trade off-between expected rate of return and risk for the efficient portfolios under determined risk free return. 7. The expected rate of return on the portfolio is the weighted average of the expected returns on its component securities. 8. The calculation of standard deviation for the portfolio can‘t simply use the weighted average approach. The reason is that the relationship between the securities in the same portfolio measured by coefficient of correlation must be taken into account. When forming the diversified portfolios consisting large number of securities investors found the calculation of the portfolio risk using standard deviation technically complicated. 9. Measuring Risk in Capital asset Pricing Model (CAPM) is based on the identification of two key components of total risk: systematic risk and unsystematic risk. Systematic risk is that associated with the market. Unsystematic risk is unique to an individual asset and can be diversified away by holding many different assets in the portfolio. In CAPM investors are compensated for taking only systematic risk. 10. The essence of the CAPM: CAPM predicts what an expected rate of return for the investor should be, given other statistics about the expected rate of return in the market, risk free rate of return and market risk (systematic risk). 11. Each security has it’s individual systematic - undiversified risk, measured using coefficient Beta. Coefficient Beta (β) indicates how the price of security/ return on security depends upon the market forces. The Beta of the portfolio is simply a Investment Analysis and Portfolio Management 66 weighted average of the Betas of its component securities, where the proportions invested in the securities are the respective weights. 12. Security Market Line (SML) demonstrates the relationship between the expected return and Beta. Each security can be described by its specific security market line, they differ because their Betas are different and reflect different levels of market risk for these securities. 13. Arbitrage Pricing Theory (APT) states, that the expected rate of return of security is the linear function from the complex economic factors common to all securities. There could presumably be an infinitive number of factors. The examples of possible macroeconomic factors which could be included in using APT model are GDP growth; an interest rate; an exchange rate; a defaul spread on corporate bonds, etc. 14. Market efficiency means that the price which investor is paying for financial asset (stock, bond, other security) fully reflects fair or true information about the intrinsic value of this specific asset or fairly describe the value of the company – the issuer of this security. The key term in the concept of the market efficiency is the information available for investors trading in the market. 15. There are 3 forms of market efficiency under efficient market hypothesis: weak form of efficiency; semi- strong form of efficiency; strong form of the efficiency.Under the weak form of efficiency stock prices are assumed to reflect any information that may be contained in the past history of the stock prices.Under the semi-strong form of efficiency all publicly available information is presumed to be reflected in stocks’ prices.The strong form of efficiency which asserts that stock prices fully reflect all information, including private or inside information, as well as that which is publicly available. Key-terms • Arbitrage • Arbitrage Pricing Theory • (APT) • Coefficient Beta (β) • Capital Market Line (CML) • Capital Asset Pricing Model • (CAPM) • Efficient frontier • Efficient set of portfolios • Expected rate of return of the portfolio • Feasible set • Indifference curves • Map of Indiference Curves Investment Analysis and Portfolio Management 67 • Market efficiency • Markowitz Portfolio Theory • Market Portfolio • Nonsatiation • Portfolio Beta • Risk aversion • Risk free rate of return • Risk of the portfolio • Security Market Line (SML) • Systematic risk • Standard deviation of the • portfolio • Semi- strong form of market • efficiency • Strong form of market • efficiency • Total risk • Unsystematic (specific) risk • Weak form of market efficiency Questions and problems 1. Explain why most investors prefer to hold a diversified portfolio of securities as opposed to placing all of their wealth in a single asset. 2. In terms of the Markowitz portfolio model, explain, how an investor identify his / her optimal portfolio. What specific information does an investor need to identify optimal portfolio? 3. How many portfolios are on an efficient frontier? How is an investor’s risk aversion indicated in an indiference curve? 4. Describe the key assumptions underlying CAPM. 5. Many of underlyong assumptions of the CAPM are violated in some degree in “real world”. Does that fact invalidate model’s calculations? Explain. 6. If the risk-free rate of return is 6% and the return on the market portfolio is 10%, what is the expected return on an asset having a Beta of 1,4, according to the CAPM? 7. Under the CAPM, at what common point do the security market lines of individual stocks intersect? 8. Given the following information: • Expected return for stock A = 18% • Expected return for stock B = 25% • Standartd deviation of stock A = 12% • Standard deviation of stock B = 20% • Correlation coefficient = 1,0. Choose the investment below that represents the minimum risk portfolio: Investment Analysis and Portfolio Management 70 References and further readings 1. Fama, Eugene (1965). Random Walks in Stock Prices. // Financial Analysts Journal, September. 2. Fama, Eugene (1970).Efficient Capital Markets: A Review of Theory and Empirical Work// Journal of Business. 3. Haugen, Robert A. (2010). The New Finance. 4 th ed. Prentice Hall. 4. Haugen, Robert A. (2001). Modern Investment Theory. 5 th ed. Prentice Hall. 5. Jones, Charles P.(2010).Investments Principles and Concepts. JohnWiley & Sons, Inc. 6. Markowitz, Harry. (1952). Portfolio Selection. // Journal of Finance,7(1), p. 77-91. 7. Sharpe, William F. (1964). Capital Assets Prices: A Theory of Market Equilibrium under Conditions of Risk // Journal of Finance, 19 (3), p. 425-442. 8. Sharpe, William F., Gordon J.Alexander, Jeffery V.Bailey. (1999). Investments. International edition. Prentice –Hall International. 9. Strong, Robert A. (1993). Portfolio Construction, Management and Protection. Investment Analysis and Portfolio Management 71 4. Investment in Stocks Mini-contents 4.1. Stock as specific investment. 4.2. Stock analysis for investment decision making. 4.2.3.E-I-C analysis. 4.2.4.Fundamental analysis. 4.3. Decision making of investment in stocks. Stock. valuation 4.4. Formation of stock portfolios. 4.5. Strategies for investing in stocks. Summary Key terms Questions and problems References and further readings Relevant websites 4.1. Stock as specific investment Stock represents part ownership in a firm. 2 main types of stock (see Chapter 1) • Common stock • Preferred stock In this chapter we focus only on the investment in common stocks. Common stock = Common share = Equity The main features of the common stock: • Typically each common stock owned entitles an investor to one vote in corporate shareholders’ meeting. • Investor receives benefits in the form of dividends, capital gains or both. But:  dividends are paid to shareholders only after other liabilities such as interest payments have been settled;  typically the firm does not pay all its earnings in cash dividends;  special form of dividend is stock dividend, in which the corporation pays in stocks rather than cash. • Common stock has no stated maturity. Common stock does not have a date on which the corporation must buy it back. But: some corporations pay cash to their shareholders by purchasing their own shares. These are known as share buybacks. Investment Analysis and Portfolio Management 72 • Common stocks on the whole historically have provided a higher return, but they also have higher risk. An investor earns capital gains (the difference between the purchase price and selling price) when he / she sell at a higher price than the purchase price. Main advantages of common stock as investment: • the investment income is usually higher; • the investor can receive operating income in cash dividends; • common stock has a very high liquidity and can easily be moved from one investor to the other; • the costs of transaction with common stocks involved are relatively low; • the nominal price of common stock is lower in comparison with the other securities. Main disadvantages of common stock as investment: • common stock is more risky in comparison with many other types of securities; • the selection of these securities is complicated: high supply and difficult to evaluate; • the operating income is relatively low (the main income is received from the capital gain – change in stock price). 4.2.Stock analysis for investment decision making In this section the focus is on the fundamental analysis of common stocks. Although technical analysis is used by many investors, fundamental analysis is far more prevalent. By performing fundamental analysis investor forecasts among other things, the future changes in GDP, changes sales, other performance indicators for a number of industries and, in particular, future sales, earnings for a number of the firms. The main objective of this analysis for investor is to identify the attractive potential investments in stocks. Analysts and investors use two alternative approaches for fundamental analysis: • “Top-down” forecasting approach; • “Bottom-up” forecasting approach. Using “top-down” forecasting approach the investors are first involved in making the analysis and forecast of the economy, then for industries, and finally for Investment Analysis and Portfolio Management 75 • Are the goods in this industry expensive? luxury goods? cheap? For day-to-day consumption? II. Pricing: • How consolidated (concentrated) is this industry? • What are the barriers for entrance to this industry? Are they high? • How powerful and demanding are the consumers in this industry? • Is where in the market of industry’s goods the surplus, how strong is the fight for market share? • Is where in this industry a high competition in the international environment? III. Costs: • How is the industry supplied with the implements of production? • Are the tendencies of the prices for raw materials used in this industry substantially influencing the profit? • Are the labor costs the main component? • Is the question of qualification for the human resources in this industry? IV. The influence of the whole economics and financial market to the industry: • Is this industry defensive or growing? How it could function in period of economic recession? • How is this industry influenced by interest rates? • Are severe stocks dominated in this industry? • Is this sector global? • How the fluctuations in currency exchange rate are influencing the sector? Are these fluctuations of currency exchange rate influencing the amount of profit received from abroad or the competitiveness of the sector? • Is it possibility that political and/ or regulation risk could influence the sector? 4.2.2. Fundamental analysis The base for the company analysis is fundamental analyses are the publicly disclosed and audited financial statements of the company: Investment Analysis and Portfolio Management 76 • Balance Sheet • Profit/ loss Statement • Cash Flow Statement • Statement of Profit Distribution Analysis could use the period not less than 3 years. Ratio analysis is useful when converting raw financial statement information into a form that makes easy to compare firms of different sizes. The analysis includes the examination of the main financial ratios: 1. Profitability ratios, which measure the earning power of the firm. 2. Liquidity ratios, which measure the ability of the firm to pay its immediate liabilities. 3. Debt ratios, which measure the firm’s ability to pay the debt obligations over the time. 4. Asset – utilization ratios, which measure the firm’s ability to use its assets efficiently. 5. Market value ratios are an additional group of ratios which reflect the market value of the stock and the firm. Table 4.1 Financial ratios by category Ratio Equation Profitability ratios Gross profit margin Gross profit/ Sales Operating profit margin Operating profit / Sales Net profit margin Net income/ Sales Return on assets (ROA) Net income / Total assets Return on equity (ROE) Net income / Stockholders’ equity Liquidity ratios Current ratio Current assets / Current liabilities Quick ratio (Current assets – Inventory) / Current liabilities Net working capital Current assets - Current liabilities Debt ratios Debt to assets Total liabilities / Total assets Debt to equity Total Debt / Equity Times interest earned Income before interest and taxes / Interest Investment Analysis and Portfolio Management 77 Asset utilization ratios Inventory turnover Cost of goods sold / Inventory Receivables turnover Sales (credit) / Receivables Fixed asset turnover Sales/ Fixed assets Total assets turnover Sales/ Total assets Market Value Ratios Capitalization Number of common stock * Market price of the common stock Earnings per share (EPS) (Net Income – Cash Dividends of Preferred stock) / Number of Common Stocks Price/Earnings ratio (PER) Market price of the stock/ Earnings per share Book value of the stock (Equity–Preferred stock- Preferred stock dividends) / Number of Common Stock Market price to Book value Market price of the stock / Book value of the stock Dividends per share (Dividends - Preferred stock dividends)/ Number of Common Stock Payout Ratio Dividends per share / Earnings per share Market value ratios provide an investor with a shortest way to understand how attractive the stock in the market is. But looking for long-term investment decisions investor must analyze not only the current market results but to assess the potential of the firm to generate earnings in the future. Thus, only using the other groups of financial ratios investor can receive “a full picture” of the financial condition of the firm and when continue with stock valuation. After calculating the ratios, the investor must compare the ratios of the firm with the ratios of a relevant benchmark. The selection of the appropriate benchmark is a difficult decision. For this reason firms are frequently benchmarked against other firms with similar size and in the same home country and industry. However, such comparisons do not always reveal whether the company is buy-worthy, because the whole size category, country or industry may under perform. When using these ratios for analysis of the firm investors compare them also with industry average. 4.3. Decision making of investment in stocks. Stock valuation Valuation theory is grounded on the assumption that investors are rational, wealth maximizing individuals and that stock market prices reflect the fundamental value. The distinction between fundamental and speculative value of stock is very important one. Fundamental value here we understand the value of an equity Investment Analysis and Portfolio Management 80 Dt) are forecasted individually. Investor individually defines then the period T will start. Future dividend cash flows for the stock, using this model: T before period T: VT1 = Σ Dt / (1 + k ) t ; t=1 after period T : VT2 = DT + 1 / ( k – g ) ( 1 + k ) T Stock value using multistage growth method: T V = VT1 + VT2 = Σ Dt / (1 + k )t + D T+1 /( k – g ) ( 1 + k )T (4.7) t=1 Valuation, when the stock keeping period is fixed Example for 1 year: V = (D1 + P1) / (1 + k) = + P1 / (1 + k) , (4.8) here P1 - selling price for the stock after 1 year: P1 = D2 / ( 1 + k ) + D3 / ( 1 + k )² + … + Dt / ( 1 + k ) t-1 And value of the stock will be: V = D1 / (1 + k) + [D2 / ( 1 + k ) + D3 / ( 1 + k )² + … + Dt / ( 1 + k ) t-1 ] / (1 + k) = N = ∑ Dt / (1 + k) t (DDM basic formula, see 4.2) t=1 Decisions for the investor in stocks:
If Pm < V - decision to buy the stock, because it is under valuated;
If Pm > V - decision to sell the stock, because it is over valuated;
If Pm = V - stock is valuated at the same range as in the market and its current market price shows the intrinsic value. Valuation using multiples Practitioners value stock price using multiples. The most common used multiply is the Price Earning Ratio (PER): PER = P / EPS, (4.9) here: P – market price of the stock; Investment Analysis and Portfolio Management 81 EPS - earnings per share Given PER and EPS, price P = PER x EPS (4.10) Observed PER. Prices of stock and earnings measures, from which observed PERs are derived, are publicly available. Earnings per share are observed or estimates of analysts. The observed PERs for a firm, a group of firms, an industry, of the index derives directly from such data. What should be the PER, according to analysts, might differ from observed PER. It is important to make a distinction between observed PER with normative PER*, or what the PER should be. PER* = V / EPS0 , (4.11) here: PER* - normative PER V - intrinsic value of the stock; EPS0 - earnings per share for the last period. Investor might consider that the PER* that should apply to the firm, of which stock value has to be estimated, should be in line with peer firms selected or the industry average. Decision making for investment in stocks, using PER:
If PER* > PER - decision to buy or to keep the stock, because it is under valuated;
If PER* < PER - decision to sell the stock, because it is over valuated;
If PER* = PER - stock is valuated at the same range as in the market. In this case the decision depends on the additional observations of investor. There are remarkable variations of PERs across firms, industries, etc. This is because PERs are a synthetic measure combining all effects of different equity value drivers: growth, profitability, risk. PER is increasing, then the profitability of the firm and its growth rates are increasing. PER is decreasing then the risk of the firm is increasing. Interest rates are correlated with inverse of PER, because PER increases when risk free rate decreases. The other alternative multiples used for stock valuation by investors include: • Sales / Market capitalization of the firm • Sales / Equity value • Market capitalization /Book Value of the Equity Ratio. Investment Analysis and Portfolio Management 82 These alternative multiples are used when earnings are not representative. Example could be the high growth (Internet) firms with negative net income, negative EPS and actual stock price irrelevant usage. When using these multiplies investors usually consider that the PER* that should apply to the firm, of which stock value has to be estimated, should be in line with peer firms selected or the industry average. 4.4. Formation of stock portfolios In this section we review the important principles behind the stock selection process that are relevant in the formation and management of the stock portfolios. We focus on the explanation of the principal categories of common stock, especially the investment characteristics that make a category of stock suitable for one portfolio but not for another. The most widely used categories of stocks are: • blue chip stocks; • income stocks; • cyclical stocks; • defensive stocks; • growth stocks; • speculative stocks; • Penny stocks. Blue chip stock is the best known of all the categories of stocks presented above. These stocks represent the best-known firms among the investment community. But it is difficult to define exactly this category of stock, because in most cases blue chip stocks are presented using the examples of the firms. One common definition of Blue Chip Company is that this company has long continuous history of divided payments. For example, Coca Cola has a history of dividend payments more than for 100 years. But it doesn’t mean that the younger successful companies running business for some decades and paying dividends can’t be categorized as “blue chips” in the specific investment environment. From the other side, many high quality stocks do not meet the criterion of uninterrupted dividend history. It is a practice that brokerage firms recommend for their clients – individual investors the list of blue chip stock as high quality ones in their understanding, based on the analysis of information about the firm. Investment Analysis and Portfolio Management 85
Defensive stocks
Interest-sensitive stocks
Consumer durables
Capital goods Defensive stocks were defined in the previous section (4.4). These stocks are usually related with food industry, retail, tobacco, beverages industries, pharmaceuticals and other suppliers of the necessity goods and services. The prices of these stocks reach their highest levels in the later phases of business cycle. Interest-sensitive stocks are related with the sectors of communications, utilities, housing industry, also with the insurance and other financial institutions. The behavior of these stocks is most unfavorable for the investor in the phase of economic crises/ recession. These stocks are considered as a good investment in the early phases of business cycle, i.e. in the optimistic phase. Consumer durables are related with automobile, domestic electric appliances, furniture industries, and luxury goods and also with the wholesale. These stocks are a good investment in the middle of business cycle. Capital goods are related with industries producing machinery, plant, office equipment, computers and other electronic instruments. Because of the remarkable time gap between the orders of this production and the terms of their realization, these stocks demonstrate their high and stabile prices in the latest phases of business cycle. Thus by knowing and identifying the different patterns of prices relating to the industries in the real investment environment the investor can diversify his / her stock portfolio which will reflect to the changes in the economic (business) cycle. Market timing strategy. The essentiality of this strategy: the investors endeavor to be „in-the-market“ when market is in a „bullish“ phase, i.e., when prices are growing, and to withdraw from the market in the „bearish“ phase, i.e., when prices are slumping. Investors use several different techniques for forecasting the major ups and downs in the market. The most often applied techniques using market timi9ng strategies: • Technical analysis; • Stock valuation analysis • Analysis of economic forecasting Investment Analysis and Portfolio Management 86 Technical analysis is based on the diagrams of price fluctuations in the market, the investors continuously watch the stocks which prices are growing and which falling as they signalize about the presumable changes in the stock market. The purpose of the stock valuation analysis is to examine whether the stock market is a supply market, or is it a demand market. If the under valuated stocks prevail in the market it reflects to supply market and vice versa – if the over valuated stocks prevail, it reflects to demand market. The concept and key methods of stock valuation was discussed in section 4.2. The valuation tools frequently used when applying for market timing strategy are: • Price/Earnings ratio (PER); • The average market price/ book value ratio; • The average dividend income. Analysis of economic forecasting. Investors by forecasting changes in the macro economy and in interest rates endeavor to decrease the investment in stocks in the phases of economic downturn and to return to these investments during upturn phases of the economy. Valuation screening strategy. The essentiality of this strategy: by choosing and applying one or combining several stock valuation methods and using available information about the stocks from the data accumulated in the computer database, the valuation screens are set by investor. All stocks on these screens are allocated on the basis of their ratings in such an order: on the top of the screen – under valuated stocks, at the bottom – over valuated stocks. Using these screens investors can form their diversified stock portfolio and exercise the changes in the existent portfolio. Various financial indicators and ratios can be used for the rating of stocks when applying valuation screening strategy. The most often used are following indicators: • Price/Earnings ratio (PER); • Dividend income • Return on Equity (ROE) • Return on Investments (ROI). Valuation screening is very popular strategy; it is frequently used together with the other investment strategies, because the investors in the market have possibility to choose from the variety of stocks even in the same market segment. Investment Analysis and Portfolio Management 87 What could be the best choose? – rating of the stocks as alternatives using the screen can be the answer. Usually investors setting the screens combine more than one indicator for rating of stocks searching for the better results in picking the stocks to their portfolios. The examples of the other financial indicators used applying valuation screening strategy: • Return on assets (ROA) • Net profit margin • Debt to assets • Debt to equity • Earnings per share (EPS) • Market price to Book value Summary 1. Higher investment income, possibility to receive an operating income in cash dividends, high liquidity and low costs of transactions are the main advantages of investment in common stock. 2. The relatively higher risk in comparison with many other types securities, the complicated selection of the stocks because of their high supply in the financial market, the relatively low the operating income are the main disadvantages of investment in common stock. 3. E-I-C analysis includes: Economic (macroeconomic) analysis, Industry analysis and Company analysis. Two alternative approaches used for analysis: (1) “Top- down” forecasting approach; (2) “Bottom-up” forecasting approach. Using “top- down” forecasting approach the investors are first involved in making the analysis and forecast of the economy, then for industries, and finally for companies. Using “bottom-up” forecasting approach, the investors start with the analysis and forecast for companies, then made analysis and forecasts for industries and for the economy. The combination of two approaches is used by analysts too. 4. The Macroeconomic analysis includes the examining of economic cycle, fiscal policy of the government, monetary policy, the other economic factors: inflation, the level of unemployment; the level of consumption; investments into businesses; the possibilities to use different types of energy, their prices; foreign trade and the exchange rate, etc. Investment Analysis and Portfolio Management 90 Using these screens investors can form their diversified stock portfolio and exercise the changes in the existent portfolio. Key-terms • Asset – utilization ratios • Blue chip stocks • “Bottom-up” forecasting approach • Capital goods • Cyclical stocks • Company analysis • Constant growth DDM • Consumer durables • Debt ratios • Defensive stocks • Discounted dividend models (DDM) • Economic analysis • E-I-C analysis • Fundamental analysis • Growth stocks • Income stocks • Income capitalization • Industry analysis • Interest-sensitive stocks • Intrinsic (investment) value • Liquidity ratios • Market timing strategy • Market value ratios • Multiples method • Multistage growth DDM • Penny stocks • Profitability ratios • Sector rotation and business cycle strategy • Speculative stocks • Stock valuation process • Technical analysis • “Top-down” forecasting approach • Value screening strategy • “Zero” growth DDM Questions and problems 1. The investor wants to identify if the stock of firm A is cyclical. How he/ she would proceed? 2. Common stock hasn‘t term to maturity. How then can a stock that does not pay dividends have any value? Give an examples of such firms listed in the domestic market of your country. 3. What is the difference between blue chip and income stocks? 4. Give examples of defensive stocks in the domestic market of your country. 5. Present the examples of blue chip stocks in the domestic market Explain, why did you categorize them as blue chips. Investment Analysis and Portfolio Management 91 6. What is meant by the intrinsic (investment) value of a stock? 7. How can investors obtain EPS forecasts? Which sources could be used? 8. What are the variables that affect the price/ earnings ratio? Is the effect direct or inverse for each component? 9. What is meant by normalized price/earnings ratio? 10. If the intrinsic value for the stock is 8 Euro and the market price for this stock is 9 Euro, than: a) Stock is over valuated and could be good investment; b) Stock is over valuated and isn‘t good investment; c) Stock is under valuated and could be good investment; d) Stock is under valuated and isn‘t good investment. 11. Firm currently pays a dividend of 4 EURO per share. That dividend is expected to grow at a 5 % rate indefinitely. Stocks with similar risk provide a 10 % expected return. Estimate the intrinsic value of the firm’s stock based on the assumption that the stock will be sold after 2 years from now at its expected intrinsic value. 12. Using the given historical data of the company for 5 previous years analyze and comment on the company‘s performance. Upon the analysis based on this historical data do you find this company attractive for investment in stocks? Explain. FINANCIAL RATIOS 2010-01-01 2009-01-01 2008-01-01 2007-01-01 2006-01-01 LIQUIDITY RATIOS Current ratio 0.81 0.99 1.24 2.60 4.43 Quick ratio 0.39 0.45 1.02 0.89 1.61 PROFITABILITY RATIOS Gross profit margin 38.8% 57.9% 57.6% 52.0% 47.4% Profit from operations margin 10.0% 26.9% 27.3% 26.9% 22.3% Net profit margin 7.9% 23.8% 33.1% 18.0% 14.5% ROA 10.6% 18.5% 24.8% 12.4% 6.8% ROE 15.0% 25.5% 38.2% 19.6% 9.4% DEBT RATIOS Debt to assets 29.2% 27.5% 34.9% 36.9% 27.6% Debt to equity 41.2% 38.0% 53.7% 58.4% 38.0% ASSET- UTILIZATION RATIOS Investment Analysis and Portfolio Management 92 Inventory turnover 88 91 133 166 240 Receivables turnover 31 49 50 34 51 Long term assets turnover 0.37 0.95 1.05 0.96 0.63 Asset turnover 0.31 0.78 0.75 0.69 0.47 MARKET VALUE RATIOS Capitalization, mln. EURO 118,221,72 116,442,06 240,002,85 71,950,00 42,373,38 P/E ratio 7.72 4.60 8.08 6.90 10.03 Earnings per share, EURO 0.60 0.99 1.17 1.23 0.50 Market price to book value 1.16 1.18 3.08 1.35 0.94 Book value of share, EURO 4.01 3.90 3.06 6.28 5.33 Cash dividend per share, EURO 0.06 0.16 0.16 0.25 0.12 Payout ratio 10.2% 16.1% 13.7% 20.3% 24.2% 13. The new little known firm is analyzed from the prospect of investments in its shares by two friends. The firm paid dividends last year 3 EURO per share. Tomas and Arnas examined the prices of similar stocks in the market and found that they provide 12 % expected return. The forecast of Tomas is as follows: 4 % of growth in dividends indefinitely. The forecast of Arnas is as follows: 10% of growth in dividends for the next two years, after which the growth rate is expected to decline to 3 % for the indefinite period. a) What is the intrinsic value of the stock of the firm according to Tomas forecast? b) What is the intrinsic value of the stock of the firm according to Arnas forecast? c) If the stocks of this firm currently are selling in the market for 40 EURO per share, what would be the decisions of Tomas and Arnas, based on their forecasting: is this stock attractive investment? Explain. 14. Look through the listed companies on the domestic stock exchange. What industries they represent? Would you be able to construct the stock portfolio applying sector rotation strategy in the domestic stock exchange? Investment Analysis and Portfolio Management 95 Bonds classification by their key features:
By form of payment: • Noninteresting bearing bonds - bonds issued at a discount. Throughout the bond’s life its interest is not earned, however the bond is redeemed at maturity for face value. • Regular serial bonds - serial bonds in which all periodic installments of principal repayment are equal in amount. • Deferred –interest bonds –bonds paying interest at a later date; • Income bonds – bonds on which interest is paid when and only when earned by the issuing firm; • Indexed bonds - bonds where the values of principal and the payout rise with inflation or the value of the underlying commodity; • Optional payment bonds – bonds that give the holder the choice to receive payment on interest or principal or both in the currency of one or more foreign countries, as well as in domestic currency.
Coupon payment: • Coupon bonds – bonds with interest coupons attached; • Zero-coupon bonds – bonds sold at a deep discount from its face value and redeemed at maturity for full face value. The difference between the cost of the bond and its value when redeemed is the investor’s return. These securities provide no interest payments to holders; • Full coupon bonds – bonds with a coupon rate near or above current market interest rate; • Floating-rate bonds – debt instruments issued by large corporations and financial organizations on which the interest rate is pegged to another rate, often the Treasury-bill rate, and adjusted periodically at a specified amount over that rate.
Collateral: • Secured bonds – bonds secured by the pledge of assets (plant or equipment), the title to which is transferred to bondholders in case of foreclosure; Investment Analysis and Portfolio Management 96 • Unsecured bonds – bonds backed up by the faith and credit of the issuer instead of the pledge of assets. • Debenture bonds – bonds for which there is no any specific security set aside or allocated for repayment of principal; • Mortgage bonds (or mortgage-backed securities) – bonds that have as an underlying security a mortgage on all properties of the issuing corporation; • Sinking fund bonds – bonds secured by the deposit of specified amounts. The issuing corporation makes these deposits to secure the principal of the bonds, and it is sometimes required that the funds be invested in other securities; • Asset-Backed Securities (ABS) – similar to mortgage bonds, but they are backed by a pool of bank loans, leases and other assets. The ABS are related with the new market terminology – securitization which understood as the process of transforming lending vehicles such as mortgages into marketable securities. The main features of ABS for investor: relatively high yield, shorter maturities (3-5 years) and monthly, rather than semiannual principal/ interest payments. From their introducing to the market they were ranked as high credit quality instruments. But the recent financial crises showed that these debt instruments could be extremely risky investment when banks loans portfolios as a guarantee of ABS become worthless causing banks’ insolvency problems. • General obligation bonds – bonds, secured by the pledge of the issuer’s full faith and credit, usually including unlimited tax-power; • Guaranteed bonds – bonds which principal or income or both are guaranteed by another corporation or parent company in case of default by the issuing corporation; • Participating bonds – bonds which, following the receipt of a fixed rate of periodic interest, also receive some of the profit generated by issuing business; • Revenue bonds – bonds whose principal and interest are to be paid solely from earnings.
Type of circulation: Investment Analysis and Portfolio Management 97 • Convertible bonds – bonds that give to its owner the privilege of exchanging them for other securities of the issuing corporation on a preferred basis at some future date or under certain conditions; • Interchangeable bonds – bonds in coupon form that can be converted to the other form or its original form at the request of the holder paying the service charge for this conversion.
Type of issuers: • Treasury (government) bonds – an obligation of the government. These bonds are of the highest quality in each domestic market because of their issuer – Government. This guarantee together with their liquidity makes them popular with both individual and institutional investors. The government bonds are dominant in the fixed-income market. • Municipal bonds - bonds issued by political subdivisions in the country (county, city, etc.); • Corporate bonds – a long-term obligation of the corporation; • Industrial bonds – bonds issued by corporations other than utilities, banks and railroads. This debt is used for expansion, working capital and retiring other debts; • Public utility bonds – high quality debt instruments issued by public utility firms.
Recall possibility: • Callable (redeemable) bonds – bonds issue, all or part of which may be redeemed by the issuing corporation under definite conditions, before the issue reaches maturity; • Noncallable (irredeemable) bonds – bonds issued which contains no provision for being “called” or redeemed prior to maturity date.
Place of circulation: • Internal bonds - bonds issued by a country payable in its own currency; • External bonds - bonds issued by government or firm for purchase outside the nation, usually denominated in the currency of the purchaser. The term Eurobond is often applied to these bonds that are offered outside the country of the borrower and outside the country in whose currency the securities are denominated. As the Eurobond market is neither regulated