SECURITIES ANALYSIS FIN: 4003

UNIVERSITY OF TECHNOLOGY, JAMAICA SCHOOL OF BUSINESS ADMINISTRATION SEMESTER 2 2011/12

UNIT 1 - CHAPTER 1 THE INVESTMENT SETTINGS

At the end of the unit, student should be able to: 1. Define Investment An investment is the current commitment of funds for a period of time to derive a future flow of funds that will compensate you for the time the funds are committed, for the expected rate of inflation, and for the uncertainty of the future flow of funds. The Time Value of Money concepts: A dollar today is worth more than a dollar tomorrow. Money has time value because of: Real risk free rate, Inflation protection, and risk Reasons for investing: Income. Capital Preservation. Capital Appreciation. Key Issues in Investing: There is a tradeoff between risk and expected return. Expected Return = (1 + nominal risk-free rate) (1 + risk premium) 1

2. Identify the components of Required Rate of Return In order to part with their money and to defer consumption, investors require compensation from three sources the pure or real interest rate inflation protection risk The real interest rate : Compensation for time The real risk-free rate of interest is the exchange rate between future consumption and present consumption. This rate of interest can be thought of as the pure rental rate on money in the absence of inflation and risk. Explain why the real risk-free rate positive. Borrowers are willing to pay to be able to spend more than their current resources allow. Savers need compensation in order to give up the right to consume today. Compensation for expected inflation: If the future payment will be diminished in value because of inflation, then investors will demand an interest rate higher than the real risk-free interest rate so that their expected purchasing power will actually increase. Compensation for the time value of money: The nominal risk-free rate of interest adjusts the real risk-free rate to reflect expected inflation over the life of the investment. Taking into account these two factors (time and expected inflation) compensates investors for the time value of their money. Compensation for Risk-bearing: Investors tend to be risk-averse, meaning that they need sufficient expected additional compensation in order to bear additional risk.

 If the future payment from an investment is uncertain, investors will demand an interest rate that exceeds the nominal risk-free rate of interest to provide a risk premium. The Required Rate of Return= (nominal risk-free rate + risk premium) The sum of the nominal risk-free interest rate and the risk premium on an investment gives that investments required rate of return. Note that for riskier investments, the risk premium, and therefore the required rate of return, will be higher than for lower risk investments. 3. State the Issues that investors should always consider There is a trade-off between risk and expected return. Developed financial markets are nearly efficient. Focus on after-tax returns, net of expenses. Diversify across asset types, industries, and even countries. Risk-Return Trade-Off Because investors tend to be risk averse, it makes sense that they will only take on riskier investments if they expect to earn more than with lower risk investments.

4. Explain Market Efficiency An efficient market is one where Information is quickly and accurately reflected in asset prices, So What appears to be news is not useful in predicting future asset prices, With the result that Investors cannot systematically and consistently beat the market without the aid of either inside information or loads of luck.

5. Explain Market Efficiency Its what is unexpected that moves the market (the genuinely new information in news). We should be skeptical of investment strategies that claim to be able to beat the market on a consistent basis. 6. The Paradox of Market Efficiency If markets are perfectly efficient, it makes no sense to seek out superior investments. But if nobody seeks out superior investments, the market would not remain efficient!

Take Taxes and Expenses into Account Its what you get to keep that counts! Taxes affect investment decisions Some allow for lower or no tax burden (Municipal bonds) Some allow for deferral of tax liability (IRAs) Take Taxes and Expenses Into Account Since financial markets are nearly efficient, even large investors generally do not beat the market, but that does not mean that they do not generate lots of expenses in trying to! Avoid high expense investments when possible since they tend to reduce net return without increasing gross return. Diversify, Diversify, Diversify Dont put all of your eggs in one basket! Diversification reduces risk without necessarily sacrificing expected return. Its a no-brainer!

7. Basic Investment Philosophies In forming an investment portfolio, several questions are paramount: In what types of securities should I invest? Asset Allocation Within each security type, how do I select which assets to purchase? Security Selection Finally, how active should I manage my portfolio? Should I be an active or passive investor? Summarizing the Basic Strategies

Active Passive

Asset Allocation Market timing Maintain predetermined allocation(s)

Security Selection Stock picking Try to track a wellknown market index

9. Explain Ethics in Investments Financial markets are vitally important to a well-functioning economy. Trust in information and faith in fairness is essential. Codes of ethics for financial professionals and strict regulations attempt to create such an environment where financial markets can efficiently fulfill their economic function.

RISK AND RETURN BASICS What are the sources of investment returns? How can returns be measured? What is risk and how can we measure risk? What are the components of an investments required return to investors and why might they change over time?

Sources of Investment Returns Investments provide two basic types of return: Income returns The owner of an investment has the right to any cash flows paid by the investment. Changes in price or value- Capital Gains The owner of an investment receives the benefit of increases in value and bears the risk for any decreases in value. Income Returns Cash payments, usually received regularly over the life of the investment. Examples: Coupon interest payments from bonds, Common and preferred stock dividend payments. Returns from Changes in Value Investors also experience capital gains or losses as the value of their investment changes over time. For example, a stock may pay a $1 dividend while its value falls from $30 to $25 over the same time period. Measuring Returns Dollar Returns How much money was made on an investment over some period of time? Total Dollar Return = Income + Price Change 3

Holding Period Return By dividing the Total Dollar Return by the Purchase Price (or Beginning Price), we can better gauge a return by incorporating the size of the investment made in order to get the dollar return. HPR= Total Dollar Return Purchase Price

Annualized Returns If we have return or income/price change information over a time period in excess of one year, we usually want to annualize the rate of return in order to facilitate comparisons with other investment returns. Another useful measure: Return Relative = Income + Ending Value Purchase Price

Annualized Returns Annualized HPR = (1 + HPR)1/n 1 Annualized HPR = (Return Relative)1/n 1 With returns computed on an annualized basis, they are now comparable with all other annualized returns.

Measuring Historic Returns Starting with annualized Holding Period Returns, we often want to calculate some measure of the average return over time on an investment. Two commonly used measures of average: Arithmetic Mean Geometric Mean Arithmetic Mean Return The arithmetic mean is the simple average of a series of returns. Calculated by summing all of the returns in the series and dividing by the number of values. RA = (SHPR)/n Oddly enough, earning the arithmetic mean return for n years is not generally equivalent to the actual amount of money earned by the investment over all n time periods.

Arithmetic Mean Example Year 1 2 3 4 5 Holding Period Return 10% 30% -20% 0% 20%

RA = (HPR)/n = 40/5 = 8% Geometric Mean Return The geometric mean is the one return that, if earned in each of the n years of an investments life, gives the same total dollar result as the actual investment. It is calculated as the nth root of the product of all of the n return relatives of the investment. RG = [ (Return Relatives)]1/n 1

Geometric Mean Example Year Holding Period Return 1 10% 2 30% 3 -20% 4 0% 5 20% Return Relative 1.10 1.30 0.80 1.00 1.20

RG = [(1.10)(1.30)(.80)(1.00)(1.20)]1/5 1 RG = .0654 or 6.54% Arithmetic vs. Geometric To ponder which is the superior measure, consider the same example with a $1000 initial investment. How much would be accumulated? Year Holding Period Return 1 10% 2 30% 3 -20% 4 0% 5 20% Investment Value $1,100 $1,430 $1,144 $1,144 $1,373

Arithmetic vs. Geometric How much would be accumulated if you earned the arithmetic mean over the same time period? Value = $1,000 (1.08)5 = $1,469 How much would be accumulated if you earned the geometric mean over the same time period? Value = $1,000 (1.0654)5 = $1,373 Notice that only the geometric mean gives the same return as the underlying series of returns. Investment Strategy Generally, the income returns from an investment are in your pocket cash flows. Over time, your portfolio will grow much faster if you reinvest these cash flows and put the full power of compound interest in your favor. Dividend reinvestment plans (DRIPs) provide a tool for this to happen automatically; similarly, Mutual Funds allow for automatic reinvestment of income. See Exhibit 2.5 (in the text) for an illustration of the benefit of reinvesting income. What is risk? Risk is the uncertainty associated with the return on an investment. Risk can impact all components of return through: Fluctuations in income returns; Fluctuations in price changes of the investment; Fluctuations in reinvestment rates of return. Sources of Risk Systematic Risk Factors Affect many investment returns simultaneously; their impact is widespread. Examples: changes in interest rates and the state of the macro-economy. Asset-specific Risk Factors Affect only one or a small number of investment returns; come from the characteristics of the specific investment. Examples: poor management, competitive pressures. How can we measure risk?

Since risk is related to variability and uncertainty, we can use measures of variability to assess risk. The variance and its positive square root, the standard deviation, are such measures. Measure total risk of an investment, the combined effects of systematic and asset-specific risk factors. Variance of Historic Returns 2 = [(Rt-RA)2]/n-1 or [Sum(Return-Mean)2]/n-1

Standard Deviation of Historic Returns Year Holding Period Return 1 10% Mean= RA = 8% 2 30% 2 = 370 3 -20% = 19.2% 4 0% 5 20% 2 = [(10-8)2+(30-8)2+(-20-8)2+(0-8)2+(20-8)2]/4 = [4+484+784+64+144]/4 = [1480]/4 Using the Standard Deviation If returns are normally distributed, the standard deviation can be used to determine the probability of observing a rate of return over some range of values. Coefficient of Variation The coefficient of variation is the ratio of the standard deviation divided by the return on the investment; it is a measure of risk per unit of return. CV = /RA The higher the coefficient of variation, the riskier the investment. From the previous example, the coefficient of variation would be: CV =19.2%/8% = 2.40 Components of Return The required rate of return on an investment is the sum of the nominal risk-free rate (Nominal RFR) and a risk premium (RP) to compensate the investor for risk. Required Return = Nominal RFR + RP Or to be more technically correct: RR = (1 + Nom RFR) x (1 + RP) - 1 The Risk-Return Relationship The Capital Market Line (CML) is a visual representation of how risk is rewarded in the market for investments. The greater the risk, the greater the required return, so the CML slopes upward. Components of Return Over Time What changes the required return on an investment over time? Anything that changes the risk-free rate or the investments risk premium. Changes in the real risk-free rate of return and the expected rate of inflation (both impacting the nominal risk-free rate, factors that shift the CML). Changes in the investments specific risk (a movement along the CML) and the premium required in the marketplace for bearing risk (changing the slope of the CML).

INVESTMENT POLICY STATEMENTS AND ASSET ALLOCATION ISSUES What is asset allocation? The process of deciding how to distribute wealth among asset classes, sectors, and countries for investment purposes. Not an isolated choice, but rather a component of the portfolio management process. Managing Risk Since risk drives expected return, investing involves managing risk rather than managing return. Risk Management Strategies Risk Avoidance Can avoid any real chances of loss Generally a poor strategy except for a part of an overall portfolio Risk Anticipation Position part of your portfolio to protect against anticipated risk factors For example, maintain a cash reserve Risk Transfer Insurance and other investment vehicles can allow for the transfer of risk, often at a price, to another investor who is willing to bear the risk Risk Reduction Effective diversification and asset allocation strategies can reduce risk, sometimes without sacrificing expected return. Individual Investor Life Cycle

The individual investors life cycle can often be described using four separate phases or stages: Accumulation Phase Consolidation Phase Spending Phase Gifting Phase Accumulation Phase Early to middle years of careers Attempting to satisfy intermediate and long-term goals Net worth is usually small, debt may be heavy Long-term investment horizon means usually willing to take moderately high risks in order to make above-average returns Consolidation Phase Past career midpoint Have paid off much of their accumulated debt Earnings now exceed living expenses, so the balance can be invested Time horizon is still long-term, so moderately high risk investments are still attractive Spending Phase Usually begins at retirement Saving before, prudent spending now Living expenses covered by Social Security and retirement plans Changing emphasis toward preservation of capital, but still want investment values to keep pace with inflation Gifting Phase Can be concurrent with spending phase If resources allow, individuals can now use excess assets to provide gifts to other individuals or organizations Estate planning becomes important, especially tax considerations

The Portfolio Management Process A four step process: 1. Construct a policy statement 2. Study current financial conditions and forecast future trends 3. Construct a portfolio 4. Monitor needs and conditions 1. Policy statement Specifies investment goals and acceptable risk levels The road map that guides all investment decisions 2. Study current financial and economic conditions and forecast future trends Determine strategies that should meet goals within the expected environment Requires monitoring and updates since financial markets are everchanging 3. Construct the portfolio Given the policy statement and the expected conditions, go about investing Allocate available funds to meet goals while managing risk 4. Monitor and update Revise policy statement as needed Monitor changing financial and economic conditions Evaluate portfolio performance Modify portfolio investments accordingly The Policy Statement Understand and articulate realistic goals Know yourself Know the risks and potential rewards from investments Learn about standards for evaluating portfolio performance Know how to judge average performance Adjust for risk Dont try to navigate without a map! Important Inputs: Investment Objectives Investment Constraints Investment Objectives Need to specify return and risk objectives Need to consider the risk tolerance of the investor Return goals need to be consistent with risk tolerance These will change over time Possible broad goals: Capital preservation Maintain purchasing power Minimize the risk of loss Capital appreciation Achieve portfolio growth through capital gains Accept greater risk Current income Look to generate income rather than capital gains May be preferred in spending phase Relatively low risk Total return Combining income returns and reinvestment with capital gains Moderate risk

Investment Constraints

These factors may limit or at least impact the investment choices: Liquidity needs How soon will the money be needed? Time horizon How able is the investor to ride out several bad years? Legal and Regulatory Factors Legal restrictions often constrain decisions Retirement regulations Tax Concerns Realized capital gains vs. Ordinary income? Taxable vs. Tax-exempt bonds? Regular IRA vs. Roth IRA? 401(k) and 403(b) plans Unique needs and preferences Perhaps the investor wishes to avoid types of investments for ethical reasons Investment Education The type of information necessary to construct a good policy statement is neither common sense or common knowledge. Many investors fail to diversify. Many fail to plan completely. Data indicates that many Americans have greatly under-invested for the future. The bottom line: If you do not plan for the future, you will likely not be prepared for it.

Asset Allocation Decisions

Four decisions in an investment strategy: What asset classes should be considered? What should be the normal weight for each asset class? What are the allowable ranges for the weights? What specific securities should be purchased?

The Importance of Asset Allocation

The asset allocation decision (which classes and at what weights) is very important. Using fund data: About 90% of return variability over time can be explained by asset allocation. About 40% of the differences between returns can be explained by differences in asset allocation. Asset allocation is thus the major factor that drives portfolio risk and return.

Risk/Return History and Asset Allocation

Looking at return data on various asset classes indicate some important factors for investors: Over long time horizons, stocks have always outperformed low-risk investments. So the additional risk of stock investing (higher return standard deviations) over shorter time horizons seems to all but disappear over time. Need to consider real investment returns over taxes and costs

Asset Allocation and Cultural Differences

Differences in social, political, and tax environments influence asset allocation. For instance, 58% of pension fund assets are invested in equities in the U.S. 78% in equities in United Kingdom, where high average inflation impacts this choice 8% in equities in Germany, where generous government pensions and greater risk aversion seem to play a strong role