FININVE

Introduction to Portfolio
Diversification & Concentration
 A portfolio can either be diversified or concentrated/ focused
 A diversified portfolio is best exemplified by “don’t put all your eggs in one basket”
 diversification has become the standard finance advice when it comes building a stock portfolio

Rebalancing
 The process of realigning the weightings of a portfolio of assets
 Involves periodically buying or selling assets in a portfolio to maintain an original desired level
of asset allocation
 As it gives investors the opportunity to sell high and buy low, taking the gains from high-
performing investments and reinvesting them in areas that have not experienced such
notable growth

Real assets vs Financial assets

 Real assets are used to produce goods and services
 Used to determine the material wealth of an economy as these are the inputs that are used to
create goods & services (productivity)
 Financial assets are claims on real assets or the income generated by them.
 These assets are the means by which individuals in well-developed economies hold their
claims on real assets.
 While real assets generate net income to the economy, financial assets simply define the
allocation of income or wealth among investors.

Types of portfolio construction

1. Top-down
 Begins with asset allocation in mind
 Decide what proportion of the overall portfolio ought to be moved into stocks, bonds, and so on

2. Bottom-up
 Constructed from the securities that seem attractively priced without as much concern for the
resultant asset allocation
 Such a technique can result in unintended bets on one or another sector of the
economy (concentrated portfolio)
Macroeconomics
Macroeconomics
 Study of the economy as a whole, including growth in incomes, changes in prices, and the rate
of unemployment.
  Macroeconomists attempt both to explain economic events and to devise policies to improve
economic performance.

Microeconomics
 Study of how firms and individuals make decisions and how these decisionmakers interact. 
3 Main Macroeconomic Variables
1. Output (level & growth)
2. Unemployment Rate
3. Inflation Rate

Relating to Finance
1. Top-down investing
 Investment approach that consists of analyzing the “big picture” (world or domestic economy),
then moving down to the industry –level then down to company-specific level.

2. Valuation

 Cyclically Adjusted Price to Earnings Ratio (CAPE, Shiller P/E, and P/E10 ratio)
 Total Market Cap to GDP Ratio (Buffett indicator)

John Maynard Keynes

 Widely regarded as the father of Macroeconomics
 Was a successful stock market investor in the later part of his investing career and held
a concentrated portfolio instead of a diversified one
 The core of Macroeconomics evolved from the principles laid out in his 1936 book General
Theory of Employment, Interest, and Money

Friedrich Hayek
 Austrian economist whose anti-big-government book, Road to Serfdom (1944), inspired
Milton Friedman and many other libertarians his 1945 article, “The Use of Knowledge
in  Society,” helped inspire the efficient market hypothesis

Aggregate Output
Different Measures of Output:
1. Gross Domestic Product (GDP)
-the market value of the goods and services produced by labor and property located in a
particular economy (usually a state)
2. Gross National Product (GNP)
-the market value of the goods and services produced by labor and property supplied by the
residents of a particular economy (usually a state)
3. Gross National Income (GNI)
 - sum of value added by all resident producers plus any product taxes (less subsidies) not
included in the valuation of output plus net receipts of primary income (compensation of
employees and property income) from abroad (World Bank)
Types:
1. Nominal GDP
-sum of the quantities of final goods produced times their current price
-definition makes clear that nominal GDP increases over time for 2 reasons:
1. Production of most goods increases over time
2. Prices of most goods also increase over time
2. Real GDP
-sum of the quantities of final goods times constant (rather than current) prices
- shows what would have happened to expenditure on output if quantities had changed but
prices had not.
Recession
- a significant decline in economic activity spread across the economy, lasting more than a
few months, normally visible in real GDP, real income, employment,
industrial production, and wholesale-retail sales.

Inflation Rate
-sustained rise in the general level of prices—the price level.
-Inflation rate is the rate at which the price level increases
Effects of Inflation
1. Creditors/savers lose and debtors gain if the lender does not anticipate inflation
correctly. For those who borrow, this is similar to getting an interest-free loan. 
2. People living off a fixed-income, such as retirees, see a decline in their purchasing power
and, consequently, their standard of living. 
 Value Investing
Value Investing
 Developed by Ben Graham & later in collaboration with David Dodd in 1934 at Columbia
University
 Value Investing involves buying stocks trading at less than their fair value and selling
those stocks when that fair value is reached

Ratios used to determine if a stock is undervalued or overvalued:

1. Price to earnings (P/E) ratio: measures the number of years it will take to recoup investments
assuming earnings stay the same

2. Price to book (P/B) ratio: measures the relationship between the market value and the
accumulated investment in the firm’s equity.

3. Price to cash ratio & Price to Net Cash ratio: One of the most conservative valuation ratios

2 types of cheap stocks

1. Cigar-butt 
 Also known as “deep value”
 Involves “killing” the company by closely scrutinizing the company’s balance sheet and writing
off some of their not-so tangible assets in order to come up with a conservative estimate of its
fair value (super cheap stocks)
2. Compounders
 These are called “Buffett-type stocks”
 Involves buying superior companies at cheap prices (cheap high-quality companies)
 Benefits of Margin of Safety:
1. Protection against downside risks
2. Higher return

Valuation
 the process of estimating the intrinsic or fair value of a stock
Investing in compounders
Debt levels
1. Debt to Equity (D/E) ratio: Total liabilities ÷ Total equity
2. Debt ratio: Total liabilities ÷ Total assets
3. Financial leverage: Total assets  ÷ Total equity

Other Formulas:
 Return on Equity (ROE): Net income ÷ Stockholders’ equity
 Return on Assets (ROA): Net income ÷ Total assets

 Earnings Quality: Net income < Net cash from Operations

 Earnings Yield: Diluted EPS  ÷ Current price per share
 PEG ratio: P/E ratio ÷ Compound Annual Growth Rate of Return (CAGR) of the Diluted EPS.
 (CAGR) = (End value/ Beg. Value)(1/# of years) – 1
 Price to Cash Flow ratio = Current Price per Share / Operating Cash Flow per Share
 Price to Free Cash Flow ratio = Current Price per Share / Free Cash Flow per Share
 Price to Sales = Price/ Sales per share
Michael On’s (洪瑞泰) valuation method
1. Get the average ROE the past 5 years
2. Figure out the most probable ROE based on historical data
3. Get the EPS by multiplying the ROE in #2 by the most recent book value per share
4. Get the entry price by multiplying the figure in #3 by your margin of safety (Mr. On’s margin of
safety is 12x earnings while intrinsic value is 15x earnings)

One last indicator

- The stock is a good buy if the current price has fallen off by at least 50% from its 52 week high or The
stock is a good buy if the current price is close to its 52 week low

FININVE
TEST YOURSELF
TRUE OR FALSE
1) John Maynard Keynes is the father of Macroeconomics
2) Real GDP is the sum of the quantities of final goods produced times their current rice
3) Gross Domestic Product is the market value of the goods and services produced by labor and
property supplied by the residents of a particular economy (usually a state)
4) Value Investing involves selling stocks trading at less than their fair value and buying those stocks
when that fair value is reached.
5) Valuation is the process of estimating the intrinsic or fair value of a stock.
6) The stock is a good buy if the current price is close to its 55 week low
IDENTIFICATION
7) _____________ is the rate at which the price level increases.
8) ____________ is the study of how firms and individuals make decisions and how these
decisionmakers interact.
9) ______________ a significant decline in economic activity spread across the economy.
10) Price to book ratio measures the relationship between the _______________ and the
______________________ in the firm’s equity.
11) _______________are called “Buffett-type stocks”.
12) _______________ involves periodically buying or selling assets in a portfolio to maintain an original
desired level of asset allocation.
13) _____________ ratio & ____________ ratio is one of the most conservative valuation ratios.
14) Value Investing is developed by _________________.
MULTIPLE CHOICE
15) Which of the following are benefits of margin of safety?
a) Protection against downside risks
b) Higher output level
c) Higher return
d) a & c
e) a & b
16) The fair value of cigar-butt is:
a) Constantly increasing
b) Slightly decreasing
c) fixed
d) None of the above
17) Which of the following is false?
a) Nominal GDP is the sum of the quantities of final goods produced times their current price.
b) People living off a minimum income see a decline in their purchasing power.
c) Friedrich Hayek helped inspire the efficient market hypothesis.
d) Top-down investing is an approach that consists of analyzing the “big picture”.
18) Nominal GDP increases over time because:
a) Prices of most goods decreases over time
b) Production of most goods increases over time
c) a & b
d) None of the above
19) Which of the following are macroeconomic variables?
a) Output (level & growth)
b) Unemployment Rate
c) Inflation rate
d) All of the above
20) Earnings Quality:
a) Net income ÷ Net Cash From Operations
b) Net income > Net Cash From Operations
c) Net income - Net Cash From Operations
d) None of the above

ANSWER KEY

1. TRUE
2. FALSE
3. FALSE
4. FALSE
5. TRUE
6. FALSE
7. Inflation Rate
8. Microeconomics
9. Recession
10. Market Value; Accumulated Investment
11. Compounders
12. Rebalancing
13. Price to cash; price to net cash
14. Ben Graham
15. d
16. c
17. c
18. b
19. d
20. d