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Equity Portfolio Management
Equity Portfolio Management
Outline
Security Analysis
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
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 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.
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. 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.
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:
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.
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
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.
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)
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
Financial Statement analysis: Check your Business finance class and Chapter 13 in your book Financial ratios: check Chapter 13 in book and www.investopedia.com
shares
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)
The do-it-yourself method with extrapolative statistical models Rely on financial analysts who process the information for investors in the stock market.
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.
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
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:
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
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?
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.
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
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
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