ECON S-1920

PROJECT: PORTFOLIO CONSTRUCTION

(15% of overall grade)
Submission: Initial report: July 10; Final report: July 31, 2014

I. OBJECTIVE

The objective of this project is to construct a portfolio for Mr. Donothing. He hires you to manage his money.

II. INVESTOR PROFILE

Mr. Donothing is a real person. He is 50 years old and single. He does not work. He survives based on an
inheritance of $10 million. He is an amphibious person: he spends his time in cruise lines. He needs $600 per day throughout
the year for cabin charges and food. He needs another about $25,000 for secretarial services and incidental expenses. He
wants to settle in Pompano Beach, Florida at 55, get married, and father a child. The type of house he wants to buy sells
today for $500,000. His cash needs would remain unchanged after he settles on land.

In investing money for a client you will consider factors like necessities of life, precautionary needs, need for lump-
sum expenditure in the future, retirement needs, and insurance needs. After investing appropriate sums to meet some or all of
these needs, if there is money left over, you can consider active investing: invest to beat the market – do better than the
overall market does. Two approaches to beating the market are: asset allocation (market timing) and identifying mispriced
securities (security selection).

III. POLICY STATEMENT

After identifying needs and preferences of the investor, the next step is to construct a policy statement. This will
specify the type of risk the investor is willing to take, and investment goal(s) and constraints. This statement is periodically
updated as investor needs change. The statement helps the investor decide on realistic but challenging investment goals after
learning about the prospects of the markets and the risks. It also creates the standard by which the performance of the
portfolio is judged. A policy statement should incorporate the investor’s objectives (risk and return) and constraints (liquidity,
time horizon, tax factors, legal and regulatory constraints, and unique needs and preferences. Chapter 28 goes over the inputs
for the policy statement.

IV. CONCEPTUAL NOTES: ASSET ALLOCATION ISSUES

One approach used in outperforming the market is asset allocation: identifying how much to invest in stocks, bonds,
cash, real estate, precious metals, international assets, etc. After you have assessed the proportion you should invest in stocks,
bonds, cash, etc., you might delve into the issue of security selection: selecting individual securities in each asset category
(stocks, bonds, cash, etc.).

A. Economic Analysis
The starting point for asset allocation is economic analysis. Based on short-run and long-run forecasts made by
economists, try to assess short-run and long-run direction of the economy.

Economists look at a host of macro-economic variables to help us in assessing the direction of the economy. The
more important ones are:

 Money supply and interest rates (which determine easy of credit availability);
 Retail sales, unemployment rate, personal income, personal consumption, new-car sales, consumer credit (these and
other variables help to assess consumer spending);
 Budget deficit (which reflects government spending);
 Merchandise trade deficit (which reflects relative strength of exports compared to imports);
 2

 Industrial production, capacity utilization, order for durable goods, business inventories, non-residential
construction, capital outlays (these and other variables including some mentioned earlier, help to assess the level of
business activity).

If these and other variables suggest a continued growth of the economy then investing major part of your money in
stocks might appear an attractive prospect. The possibility of recession might suggest that a larger portion be devoted to
bonds. An uncertainty in the state of the economy in the near future might suggest that if you have new money to invest,
you should invest in money market instruments as a temporary “parking-place” – which can subsequently be easily
divested and invested in stocks and/or bonds when the direction of the economy is known with more certainty.

You do not have to collect raw data and analyze each of the macroeconomic variables listed. Financial services
companies analyze various macroeconomic variables and provide outlook about the economy through such publications as:

 Standard and Poor's Industry Surveys;

 Standard and Poor's The Outlook;
 Valueline Investment Survey;
 Moody's Bond Survey -- for bonds;
 Wiesenberger Investment Companies Services -- for mutual funds;
 Business periodicals like Wall Street Journal, Business Week, Fortune, Forbes, etc., provide economic outlook in
every issue;

All of these sources – and many more – are available in the Library. For further help contact the Reference Section in
the
Library. Also you will find a whole gamut of information in the internet. Examples are:

 www.bea.gov.
 bx.businessweek.com/economic-analysis/
 www.cbo.gov/

Even if strong indications suggest that the economy will continue to grow at a healthy rate, portfolio theory still suggests
that our money be diversified among different asset classes: stocks, bonds, cash, etc. -- maybe more in stocks and less in
bonds and cash. Through this, even if a stock investment goes sour, the position in bonds and/or cash would offset some of
the losses incurred.

B. Industry/Sector Analysis
Once you get an idea (via economic analysis) as to how much to invest in stocks/bonds/cash/etc., you then have to
select securities from these asset classes through industry/sector analysis. The objective is to identify promising sectors
within the economy in which you might invest. Even in a bull market all sectors of the economy do not grow/benefit to the
same degree. During your economic analysis, note the industries/sectors which are considered by experts to be highly
prospective.

C. Company/fund Analysis
Analyze the companies to identify the most promising/mispriced stocks and/or funds within the most promising
industries/sectors that you identify from industry/sector analysis.

V. REPORT

You will submit an initial report and a final team report on your exercise. The format of the reports will be as
follows:

Submit initial report on: July 10, 2014 (Submit as many of the Report Sections [see below] as you have been able to
complete, but at least include (1) investor profile, (2) policy statement, (3) economic analysis, (4) asset
allocation decision, (5) criteria for industry selection (Appendix 2A), (6) analysis of one industry using the
criteria listed in Appendix 2A (put this as Appendix 2B), (7) criteria for company selection (Appendix 3A),
 3

(8) analysis of one company using the criteria listed in Appendix 3A (put this as Appendix 3B). You will
include analysis of additional industries and companies as well as analysis of other assets in the final report).

Submit final report on: July 31, 2014 (You can do modifications to your initial portfolio. Also, resubmit Initial Report
with Final Report.)

Cover Page: Provide title of report, course, names of team members, section, name of instructor and
date of submission.

Table of Contents: List each section of report as well as appendixes showing page numbers on which they appear.

Management Summary: 13 to 15 pages (1.5 spaced) containing sections 1 through 6 listed below. Include section headings.

Appendixes: As required. No page limit.

REPORT SECTIONS
A. MANAGEMENT SUMMARY

1. Introduction: ¼ of a page
State briefly the objective of the report

2. Investor Profile and policy statement: 2 to 3 pages

Provide a brief but clear sketch of the investor in terms of the short-run and specific long-run goal(s) he likes to achieve, level
of return sought, level of risk tolerance, tax status, investment horizon, etc. (Please note that the investment
vehicles/instruments you select has to match with these factors. For example, if you assume a low level of risk tolerance
for the investor, you may choose not to invest in high beta stocks or in junk bonds).

3. Economic analysis/outlook: 2 to 3 pages

Follow guidelines given under "Economic Analysis", and any guideline to be given in class. The analysis should contain
adequate data and statistics to support your assessment about the near term (one to four quarters) direction of the
economy. Provide detailed analyses as appendix(es) and include synopsis of it in the management summary. Refer to the
sources of statements, data and statistics as footnotes. Refer to such appendixes in the relevant part(s) of your
management summary. The last paragraph of this section should outline your asset allocation decision (that is, given the
economic scenario and the goals and preferences of the investor, how much would you put in stocks, bonds, cash, etc.?
You can invest in any other type of asset category).

4. Industry/sector analysis: 3 to 4-page summary (detailed analysis as appendixes: 1 to 2 pages per industry)
Based on criteria you consider to be appropriate, select sectors/industries in which you would invest. Criteria might include
potential competition, stability, industry helpers, historical and prospective growth rate, return on investment, return on
equity, stability, etc. Selection criteria should match the needs and preferences of the investor. For example, if the level
of investors risk tolerance is low, one of the criteria for selecting industries would be their ‘stability’. (But how do you
measure stability? Mention that in the section on criteria). Include as appendix detailed analysis and relevant data on
industries/sectors you opt to invest in. Justify why you decide to invest in some industries over others. The management
summary would contain synopsis of the detailed industry/sector analyses included as appendix(es).

5. Company/fund/money market instrument analysis: 3 to 4-page summary (detailed analyses as appendixes: 1 to 2

pages per company)
In case of investment in mutual funds, you will include analysis of the promising funds (stock funds, bond funds, money
market mutual funds) to rationalize why you would select a particular vehicle. Rationalize as to why you select certain
companies/funds over so many others. Selection must be based on some well thought out criteria as you do for industry
analysis. Include as appendix(es) relevant historical data on each instrument selected. The outcome of industry/sector
analysis and company/fund/money market instrument analysis is the resolution of the security selection decision. (The
outcome of economic analysis, as indicated earlier, is the resolution of asset allocation decision). Once again, include
 4

detailed company/fund/money market instrument analysis as appendix(es) and summarize your analyses in the
management summary.

6. Conclusion: ½ a page
How does your final portfolio look like in terms of its composition? What overall expected return does it promise? Is the
expected return for the long-term portfolio enough to meet the long-term goal(s)? Does the portfolio seem to meet the
needs and preferences (including risk tolerance) of the investor?

B. APPENDIXES

1. Appendix 1. The first appendix would be a table of the following suggested format:

Composition of Portfolio

# of shares Annualized
Price (as of purchased Amount expected
Instrument (give date)) (if applicable) invested return (%)

Annualized expected return must be realistic. Take transaction costs – commissions, interest paid on margin loan – into
account. Disregard taxes in calculation of expected returns. Provide at the end of the table overall (weighted-average)
expected return.

2. Appendix 2A. List and explain criteria you used for selecting industries/sectors for investing. State acceptable ranges you
set for each criterion. (“We selected industries which grew based on average roe by at least 25% over the last 5 years.”)

3. Appendix 2B, 2C, 2D, etc. Provide analysis for different industries/sectors selected (1 to 2 pages per industry/sector).

4. Appendix 3A. List and explain criteria you used for company/fund/investment analysis. State acceptable ranges you set
for each criterion. (“We selected companies which grew based on roe by at least 35% over the last 5 years.” You can set
a higher acceptable level here compared to the level for industry selection.)

5. Appendix 3B, 3C, 3D, etc. Provide analysis of companies/funds/instruments selected (1 to 2 page per item).

6. Appendix 4, 5, 6 etc. Put after this any other appendix(es) you may want to include.

7. Numbering appendixes. Number all the appendixes (Appendix l, Appendix 2, etc.). Provide title (caption) below that and
sequentially number each page. For example:

Appendix 3
Criteria used for company analysis

8. Finally, note well:

(i) Throughout the exercise, carefully review and apply principles, concepts and techniques covered in this
course.

(ii) If you choose not to invest internationally, put your reasons in Appendix 4.

(iii) Extra work in terms of meeting the requirements of this project will receive extra credit.

(iv) Number all appendixes and refer to them in the main report as (Appendix 1, p.15) or, (App. 1, p. 15).

(v) Indicate the extent of research you did by providing references to various sources you researched.
 5

(vi) Very important: Nonconformity to guidelines will cause loss of points. If you are doing it in a team,
may be worthwhile to appoint a team member who will ensure conformity to guidelines. PLEASE SEEK
CLARIFICATIONS FROM ME WHEN YOU NEED.

(vii) Broad criteria for grading are:

(a) Rationale of the portfolio (how well the portfolio fits with the needs and preferences of the investor,
and with economic prospect);

(b) Extent of research done and reflected in report;

(c) Extent to which concepts and techniques have been applied in the project;

(d) Extent to which the guidelines given for this project in this assignment and in the class have been
followed.

TEAMPROJ