INVESTMENT ANALSIS & PORTFOLIO MGMT

COURSE REVIEW

CHAPTERS COVERED

CHAPTER 1 - OVERVIEW A Broad Map of the territory CHAPTER 2 - INVESTMENT ALTERNATIVES CHAPTER 3 SECURITIES MARKET CHAPTER 4 - RISK & RETURN CHAPTER 5 - TIME VALUE OF MONEY (PRT) SETTING PORTFOLIO OBJECTIVE AS DISCUSSED IN CLASS (TH) CHAPTER 7 - PORTFOLIO THEORY (PRT & TH) CHAPTER 8 - CAPM (PRT) CHAPTER 9 - EFFICIENT MARKET HYPOTHESIS (TH) CHAPTER 10 - BEHAVIORAL FINANCE (TH) CHPATER 13 - EQUITY VALUATION (PRT) CHAPTER 14 & 15 - FUNDAMENTAL ANALYSIS (TH & PRT) CHAPTER 16 - TECHNICAL ANALYSIS (REF PPT) (TH) CHAPTER 21 - PORTFOLIO MGMT FRAMEWORK (PRT & TH)

RISK RETURN
For earning returns investors have to almost invariably bear some risk. While investors like returns they abhor risk. Investment decisions therefore involve a tradeoff between risk and return. The total return on an investment for a given period is : C + (PE PB) R = PB The return relative is defined as: C + PE Return relative = PB

The cumulative wealth index captures the cumulative effect of total returns. It is calculated as follows: CWIn = WI0 (1 + R1) (1+ R2) (1+ Rn)
The arithmetic mean of a series of returns is defined as: n S Ri i=1 R = n The geometric mean of a series of returns is defined as: GM = [1+ R1) (1+ R2).(1+ Rn) ]1/n 1

 The arithmetic mean is a more appropriate measure of average performance over a single period. The geometric mean is a better measure of growth in wealth over time

The real return is defined as: 1+ Nominal return

-1 1+ Inflation rate The most commonly used measures of risk in finance are variance or its square root the standard deviation. The standard deviation of a historical series of returns is calculated as follows: 1/2 n S (R i R ) 2 t=1 s= n-1 Risk premium may be defined as the additional return investors expect to get for assuming additional risk. There are three well known risk premiums: equity risk premium, bond horizon premium, and bond default premium. The expected rate of return on a stock is: n E(R) = S piRi i=1 The standard deviation of return is: s = ( S pi (Ri E(R)2 ) 1/2

TIME VALUE OF MONEY

Money has time value. A rupee today is more valuable than a rupee a year hence. The general formula for the future value of a single amount is : Future value = Present value (1+r)n The value of the compounding factor, (1+r)n, depends on the interest rate (r) and the life of the investment (n). According to the rule of 72, the doubling period is obtained by dividing 72 by the interest rate. The general formula for the future value of a single cash amount when compounding is done more frequently than annually is: Future value = Present value [1+r/m]m*n

 An annuity is a series of periodic cash flows (payments and receipts) of equal amounts. The future value of an annuity is: Future value of an annuity = Constant periodic flow [(1+r)n 1) ] /r The process of discounting, used for calculating the present value, is simply the inverse of compounding. The present value of a single amount is: Present value = Future value x 1/(1+r)n The present value of an annuity is: Present value of an annuity = Constant periodic flow [1 1/ (1+r)n] /r The present value of growing annuity is: = A1 [1 {(1+gn)/ (1+r)n}] /r-g A perpetuity is an annuity of infinite duration. In general terms: Present value of a perpetuity = Constant periodic flow [1/r]

SETTING PORTFOLIO OBJECTIVES

Reasons of difficulty in security objectives
Semantics Indecision Subjectivity Multiple beneficiary Investment Policy & Strategy Precondition for Setting Portfolio Understanding current needs Time Horizon Liquidity Needs Ethical Consideration

SETTING PORTFOLIO OBJECTIVES

PRIMARY OBJECTIVES SECONDAR Y OBJECTIVE Stability of Principle Income Growth of Income Capital Appreciation Stability of Principle X Income Growth of Income Unacceptable Capital Appreciation ? (low coupon bonds) ? (preference share) At least 75% equity X

Debt & Preferred Stock X Varies often > 40% ? (preference share)

Short term debt Unacceptable

At least 40% equity X

Unacceptable

At least 75% equity

Inconsistent objectives are Unacceptable Infrequent objectives are ?

PORTFOLIO THEORY Portfolio theory, originally proposed by Markowitz, is the first formal attempt to quantify the risk of a portfolio and develop a methodology for determining the optimal portfolio.
The expected return on a portfolio of n securities is : E(Rp) = wi E(Ri)
The variance and standard deviation of the return on an n-security portfolio are: sp2 = wi wj ij si sj sp = wi wj ij si sj A portfolio is efficient if (and only if) there is an alternative with (i) the same E(Rp) and a lower sp or (ii) the same sp and a higher E(Rp), or (iii) a higher E(Rp) and a lower sp

 Given the efficient frontier and the risk-return indifference curves, the optimal portfolio is found at the tangency between the efficient frontier and a utility indifference curve. If we introduce the opportunity for lending and borrowing at the risk-free rate, the efficient frontier changes dramatically. It is simply the straight line from the risk-free rate which is tangential to the broken-egg shaped feasible region representing all possible combinations of risky assets.

The Markowitz model is highly information-intensive.

The single index model, proposed by sharpe, is a very helpful simplification of the Markowitz model.

CAPM
The relationship between risk and expected return for efficient portfolios, as given by the capital market line, is: E (Ri) = Rf + sI = E(RM) Rf

sM
The relationship between risk and expected return for an inefficient portfolio or a single security as given by the security market line is : E (Ri) = Rf + E (RM) Rf iM x 2 The beta of a security is the slope of the following regression relationship: Rit = i + i RMt + eit The commonly followed procedure for testing CAPM involves two steps. In the first step, the security betas are estimated. In the second step, the relationship between security beta and return is examined.

s sM

CAPM
Empirical evidence is favour of CAPM is mixed. Notwithstanding this, the CAPM is the most widely used risk-return model because it is simple and intuitively appealing and its basic message that diversifiable risk does not matter is generally accepted. The APT is much more general in that asset prices can be influenced by factors beyond means and variances. The APT assumes that the return on any security is linearly related to a set of systematic factors. SHARPE OPTIMAL PORTFOLIO CUTOFF

EQUITY VALUATION

While the basic principles of valuation are the same for fixed income securities as well as equity shares, the factors of growth and risk create greater complexity in the case of equity shares.

Three valuation measures derived from the balance sheet are: book value, liquidation value, and replacement cost.
According to the dividend discount model, the value of an equity share is equal to the present value of dividends expected from its ownership. If the dividend per share grows at a constant rate, the value of the share is : P0 = D1/ (r g)

A widely practised approach to valuation is the P/E ratio or earnings multiplier approach. The value of a stock, under this approach, is estimated as follows: P0 = E1 x P0/E1

 In general, we can think of the stock price as the capitalised value of the earnings under the assumption of no growth plus the present value of growth opportunities (PVGo) E1 P0 = r Apart from the price-earnings ratio, price to book value (PBV) ratio and price to sales (PSR) ratio are two other widely used comparative valuation ratios + PVGO

Two broad approaches are followed in managing an equity portfolio : passive strategy and active strategy.
Stock market returns are determined by an interaction of two factors : investement returns and speculative returns.

MACROECONOMIC ANALYSIS
A commonly advocated procedure for fundamental analysis involves a 3 step analysis: macroeconomic analysis, industry analysis, and company analysis. In a globalised business environment, the top-down analysis of the prospects of a firm must begin with the global economy.
There are two broad classes of macroeconomic policies, viz. demand side policies and supply side policies. Fiscal and monetary policies are the two major tools of demand side economics. Fiscal policy is concerned with the spending and tax initiatives of the government.

 Monetary policy is concerned with money supply and interest rates. The macroeconomy is the overall economic environment in which all firms operate. Almost every industry goes through a life cycle consisting of four stages viz., pioneering stage, rapid growth stage, maturity and stabilisation stage, and decline stage. Michael Porter has argued that the profit potential of an industry depends on the combined strength of five basic competitive forces.

COMPANY ANALYSIS

In practice, the earnings multiplier method is the most popular method. The key questions to be addressed in this method are: what is the expected EPS for the forthcoming year? What is a reasonable PE ratio given the growth prospects, risk exposure, and other characteristics? Historical financial analysis serves as a foundation for answering these questions.

The ROE, perhaps the most important metric of financial performance, is decomposed in two ways for analytical purposes. ROE = Net profit margin x Asset turnover x Leverage ROE = PBIT efficiency x Asset turnover x Interest burden x Tax burden x Leverage To measure the historical growth, the CAGR in variables like sales, net profit, EPS and DPS is calculated.

To get a handle over the kind of growth that can be maintained, the sustainable growth rate is calculated.

Beta and volatility of ROE may be used as risk measures. An estimate of EPS is an educated guess about the future profitability of the company. The PE ratio may be derived from the constant growth dividend model, or cross-section analysis, or historical analysis. The value anchor is : Projected EPS x Appropriate PE ratio

PBV-ROE matrix, growth-duration matrix, and expectation risk index are some of the tools to judge undervaluation or overvaluation.

TECHNICAL ANALYSIS

Past Prices & Volumes

Assumptions Market discounts everything, Moves in trend, History repeats Fundamentals V/s Technical (chart,time,trading) Uptrend , downtrend , sideways

Channels, Support Resistance

Scaling & types of charts

Dow Theory (Primary (longterm), intermediate & short term)

Pattern (Reversal(HS,DT,TT & Continuation(CH,TRI,FLAG) Moving Average(SMA,EMA), RSI, MACD

EFFICIENT MARKET HYPOTHESIS

Stock prices appear to follow a random walk. The randomness of stock prices is the result of an efficient market
It is useful to distinguish three levels of market efficiency : weak form efficiency, semi-strong form efficiency, and strong form efficiency. The weak form efficient market hypothesis says that the current price of a stock reflects all information found in the record of past prices and volumes. The semi-strong form efficient market hypothesis holds that stock prices adjust rapidly to all available public information. The strong form efficient market hypothesis holds that all available information, public and private is reflected in stock prices.

 Empirical evidence seems to provide strong support for weak-form efficiency, mixed support for semi-strong form efficiency, and weak support for strong-form efficiency. The efficient market hypothesis is an imperfect and limited description of the stock market. however, at least for the present, there does not seem to be a better alternative. The key implications of the efficient market hypothesis are that technical analysis is of dubious value and routine fundamental analysis is not of much help.

BEHAVIORAL FINANCE
The central assumption of the traditional finance model is that people are rational. However, psychologists argue that people suffer from cognitive and emotional biases.
The important heuristic-driven biases and cognitive errors that impair judgment are: representativeness, overconfidence, anchoring, aversion to ambiguity, and innumeracy. The form used to describe a problem has a bearing on decision making. Frame dependence stems from a mix of cognitive and emotional factors. People feel more strongly about the pain from a loss than the pleasure from an equal gain about 2 times as strongly, according to Kahneman and Tversky. This phenomenon is referred to as loss aversion People separate their money into various mental accounts and treat a rupee in one account differently from a rupee in another.

 Investors engage in narrow-framing they focus on changes in wealth that are narrowly defined, both in a cross-sectional as well as a temporal sense. The psychological tendencies of investors prod them to build their portfolios as a pyramid of assets

People seem to consider a past outcome as factor in evaluating a current risky decision.
The emotions experienced by a person with respect to investment may be expressed along an emotional time line. Thanks to information cascade, large trends or fads begin when individuals ignore their private information but take cues from the action of others.

Due to various behavioural influences, often there is a discrepancy between market price and intrinsic value.
To overcome psychological biases, a disciplined approach is required.

 The factors commonly considered in selecting bonds are : yield to maturity, risk of default, tax shield, liquidity, and duration. Three broad approaches are employed for stock selection : technical analysis, fundamental analysis, and random selection. Motives of trading are cognitive and emotional. Portfolio revision involves portfolio rebalancing and portfolio upgrading The key dimensions of performance evaluation are rate of return and risk. Treynor measure, Sharpe measure, and Jensen measure are three popularly employed performance measures.

PORTFOLIO MANAGEMENT FRAMEWORK

Portfolio management is a complex process or activity that may be divided into seven broad phases.
Investment objectives are expressed in terms of return and risk.

The strategic asset-mix decision (or policy asset-mix decision) is the most important decision made by the investor.
Investors with greater tolerance for risk and longer investment horizon should tilt the asset mix in favour of stocks The four principal vectors of an active portfolio strategy are : market timing, sector rotation, security selection, and the use of a specialised concept. A passive portfolio strategy calls for creating a well-diversified portfolio at a pre-determined level of risk and holding it relatively unchanged over time.

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