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FIL 242: Special handout

Overview of Equity Portfolio Management and Security Analysis


Passive Equity Portfolio Management Active Equity Portfolio Management

Top-down versus bottom up approaches Technical versus Fundamental analysis

Security Analysis

Passive Equity Portfolio Management

Investors who favor passive investmentstrategies basically believe that the stock market is efficient and that they cant outperform it. Passive strategies are usually indexing strategies: create a portfolio of stocks whose return will mimic the return of a stock index. The choice of the stock index depends on the choice of the asset class and the sector/industry

Passive Equity Portfolio Management

Creating a portfolio that mimics the return of a stock index is not as easy as it seems. They could be problems in the design of the portfolio of stocks and performance testing problems. For instance:

Transaction costs involved in forming the portfolio may lower (net) returns on portfolio Choice of historical sample of data Selection of an inappropriate index benchmark

Passive Equity Portfolio Management

Passive equity management strategies are successful if the tracking error is minimized. Tracking error = total return on portfolio total return on benchmark There is a trade-off between minimizing the tracking error and incurring high commission or transaction fees.

Active Equity Portfolio Management

Portfolio construction: Top down approach Step 1: assess the macroeconomic environment and forecast a short-term outlook.

Step 2: based on above assessment and forecast, decide how much to allocate among various sectors of the stock market (if only invest in stock market).

e.g. predict what could happen to interest rates in coming months.

Step 3: pick individual stocks

E.g. how do changes in interest rates impact certain industries more than others (i.e. financial service companies). Higher interest rates make it more expensive for firms to borrow: makes it a bleak outlook. Higher interest rates could signal future inflation, making company earnings less valuable. Higher interest rates could lead to higher yields on bonds or notes.

Active Equity Portfolio Management

Portfolio Construction: Bottom up approach (generally less used) The portfolio manager only focuses on the analysis of individual stocks and cares little about the significance of economic cycles.

Equity Portfolio Management Technical versus Fundamental Analysis

Fundamental Analysis:

Analysis of the companys operations to assess its future earnings growth prospects (financial ratios, prediction of earnings, cash flow, profitability). For instance look at:

Historical financial performance:

Use of balance sheets, income statements, cash flow statements and financial ratios Compare companys performance with competitors

Trends in revenues and profit Current financial position (cash, debt position) Competitive environment Regulatory environment Product liability issues Overall quality of management team.

Equity Portfolio Management Technical versus Fundamental Analysis

Technical Analysis

Basically ignores information about the companys operations and finances. Focuses on price/trading volume of individual stocks or group of stocks, based on shifts of demand vs. supply

Equity Portfolio Management Technical versus Fundamental Analysis

Technical Analysis: In general, technical analysis involves investigating patterns based on historical trading data (past prices and trading volume) to identify the future movements of stocks.

Strategies based on technical Analysis

Popular strategies are: Simple filter rules

Buy (sell) the stock when it has decreased (increased) by a pre-determined %

Strategies based on technical Analysis

Relative Strength

Relative strength measured by the ratio of stock price to some price index. If ratio rises (falls) over time, buy (sell) stock
it takes volume to make price move. A significant rise in both trading volume and price of a stock is a signal of persistent demand in the stock (and vice-versa)

Price and Trading relationship

Security Analysis
Steps to perform security analysis: Security valuation: compare stock current market price with fair price Check companys fundamentals: check history and assess future prospects

Compare companys fundamentals with those of competitors or with an industry average Make a buy/sell/hold decision

Financial statements and ratios Earnings per share Profitability analysis Analysis of companys debt situation Future growth prospects for companys sales, revenues and profits

Companys fundamentals Financial Statements and Ratios:

Financial Statement analysis: Check your Business finance class and Chapter 13 in your book Financial ratios: check Chapter 13 in book and

Companys fundamentals: Earnings per Share (EPS)

Recall that EPS = Net Earnings/Number of outstanding


Why focus on EPS? Because research has shown that the price of the stock of a company reacts to earnings surprises (i.e. when actual earnings end up to be different than what was anticipated)

How to predict Earnings

The do-it-yourself method with extrapolative statistical models Rely on financial analysts who process the information for investors in the stock market.

The do-it-Yourself method

There are numerous extrapolative statistical models that can be used to predict earnings An extrapolative model applies a formula to historical data and projects results for a future period.

The do-it-yourself method

Model 1: The simple linear model asserts that earnings have a base level and grow at a constant amount each period Model 2: The simple exponential model asserts that earnings have a base level and grow at a constant rate each period Model 3: (called the random walk model). States that all past info about a company is already contained in past earnings and that any change in a companys earnings comes from an unexpected announcement about the firm (change of management, announcement of a law suit)

Analyst forecasts

Earnings forecasts can be done by:

buy-side analysts: work for firms seeking to invest in securities issued by corporations or sell-side analysts: work for investment banks (i.e. underwriting firms).

There are also some organizations that specializes in providing consensus forecasts based on an average of analyst forecasts:

Institutional Brokers Estimate System (

Consensus forecasts can be found on many websites (CNN, Yahoo)

How experts are the experts?

There has been research done by people in academics to study how good are the forecasters. Overall:

Forecasters tend to overestimate EPS Sell-side analysts are reluctant to say negative things about the firm that issues the securities. Forecasters issue more buy than sell recommendations

Companys fundamentals: Profitability Analysis

EPS = Earnings/number of shares outstanding This ratio can be further decomposed as follows: EPS = (Earnings/stockholders' equity) x (stockholders' equity/number of shares outstanding) EPS = Return on Equity (ROE) x book value per share Where ROE can be further decomposed using the DuPont analysis (remember your 240 class?)

Profitability Analysis

Profitability ratios are used to understand the reasons of a change in EPS for a corporation.

Why can the book value/share of a company change? What can impact the Return on Equity (ROE) of a company?

Book value per share

Book value per share = (stockholders equity
/number of shares)
Can increase if: Stockholders equity increases: from chapter 12, it can be shown that if a company finances all of its assets with equity, equity increases by retention rate x ROE where the retention rate is the % of net income re-invested in the firm.

Book value per share

RECALL EXAMPLE FROM CHAPTER 12 Assume that a company has $100 million in equity finances all of its assets with 100% equity has a net income of $15 million. As result, the companys ROE is 15% If the company pays 40% of its earnings in dividends, it means that it re-invests 60% of its net income or 60% x $15 million = $9 million. The firms equity then grows by $9 million or 9% ($9 million/$100 million). If equity increases by 9% and assuming number of shares stays the same, then the book value/share of company increase by 9%

What impacts ROE?

ROE = NI or earnings/equity Which can be decomposed as: ROE = (NI/sales) x (sales/total assets) x (total assets/equity) Or: ROE = profit margin x total asset turnover x equity multiplier

What impacts ROE?

Compare companys profit margin and TA turnover with rest of the industry in which the company operates. Such analysis can reveal strength or weakness of the company A high profit margin is always a good thing Generally, the TA turnover is a measure of companys efficiency in turning its assets into sales. Note that TA turnover can fall sharply if a company makes a big investment in a long-term asset will might take time to generate additional sales. In that sense a fall in TA turnover is not that bad.

What impacts ROE?

The equity multiplier is a measure of how much debt has been used in financing assets Equity multiplier = (total assets/equity)
equity)/equity = (total debt +

= (total debt/equity) + 1 The higher the use of debt compared to equity, the higher the equity multiplier

Debt and a companys earnings per share

Paradox: When a firm is leveraged, (i.e. if it uses debt as a source of funds), if it uses more debt to finance assets, it boosts the ROE and everything else equal, it boosts earnings/share.

Analysis of the companys debt

You want to answer the following question: what is the ability of the firms to meet its financial obligations?. To answer such question, you must perform ratio analysis and calculate:

Short-term solvency ratios, which assess the firms ability to meet debts occurring over the coming year
Financial leverage ratios, which assess the extent to which the firm relies on debt financing

Current ratio =current assets/current liabilities) Quick ratio = (current assets inventory) /current liabilities)

Equity multiplier as seen above Total debt ratio = (current liabilities + long-term debt)/equity

Analysis of the companys sales

The aim of sales analysis is to project revenues for the next few years. To do so, the analyst should: 1) Calculate growth rates of companys sales for a period of at least 10 years 2) Look at past sales variability (take standard deviation of average sales) 3) Observe how companys sales change when economic conditions are bad. 4) Assess the major factors that could impact the firms sales pattern 5) Compare companys sales pattern with other companies in same business

Analysis of the companys sales


Perform an industry analysis look at competitive threats

Assess companys strategy for maintaining its leadership position in its market, and its financial and operating abilities to carry out these strategies Look at the major product lines offered by the company and assess where they are in their life-cycle

New entrants New products offered by competitors