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COURSE REVIEW

INVESTMENT ANALSIS &

PORTFOLIO MGMT

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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 INCLASS (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)

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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+ (PEPB)

R =PB

The return relative is defined as:C+P

E

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:nSRi

i=1R = n

The geometric mean of a series of returns is defined as:

GM = [1+ R1) (1+ R2).(1+ Rn) ]1/n

1

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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:n 1/2S (RiR)

2

t=1s =

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 piRii=1

The standard deviation of return is:

s

= ( Spi (RiE(R)2

)1/2

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TIME VALUE OF MONEY

Money has time value. A rupee today is more valuable than arupee 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 theinterest 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 thanannually is:

Future value = Present value [1+r/m]m*n

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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)n1) ] /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 [11/ (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]

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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

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SETTING PORTFOLIO OBJECTIVESPRIMARY OBJECTIVES

SECONDAR

Y

OBJECTIVE

Stability of

Principle

Income Growth of

Income

Capital

Appreciation

Stability of

Principle

X Debt & Preferred

Stock

Unacceptable ? (low coupon

bonds)

Income Short term debt X At least 40%

equity

? (preference

share)

Growth ofIncome

Unacceptable Varies often >40%

X At least 75%equity

Capital

Appreciation

Unacceptable ? (preference

share)

At least 75%

equity

X

Inconsistent objectives are Unacceptable

Infrequent objectives are ?

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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 ofn securities is :

E(Rp) = wi E(Ri)

The variance and standard deviation of the return on an

n-security portfolio are:

sp2 = wi wjij sisj

sp = wi wjijsisj

A portfolio is efficient if (and only if) there is an alternative

with (i) the sameE(Rp) and a lowersp or (ii) the same sp and

a higherE(Rp), or (iii) a higherE(Rp) and a lowersp

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Given the efficient frontier and the risk-return indifference

curves, the optimal portfolio is found at the tangencybetween 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 istangential 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 helpfulsimplification of the Markowitz model.

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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 x

The beta of a security is the slope of the following regression relationship:

Rit= i + iRMt+ 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 securitybeta and return is examined.

siMsM

2

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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 itsbasic 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 beyondmeans and variances. The APT assumes that the return on any security is linearly relatedto a set of systematic factors.

SHARPE OPTIMAL PORTFOLIOCUTOFF

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EQUITY VALUATION

While the basic principles of valuation are the same for fixed

income securities as well as equity shares, the factors of growthand 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 equityshare 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/ (rg) A widely practised approach to valuation is the P/E ratio or

earnings multiplier approach. The value of a stock, under thisapproach, is estimated as follows:

P0 =E1 xP0/E1

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In general, we can think of the stock price as the capitalised value

of the earnings under the assumption of no growth plus thepresent value of growth opportunities (PVGo)

E1P0 = + PVGO

r

Apart from the price-earnings ratio, price to book value (PBV)

ratio and price to sales (PSR) ratio are two other widely usedcomparative valuation ratios

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.

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MACROECONOMIC ANALYSIS

A commonly advocated procedure for fundamental analysis

involves a 3step 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 ofdemand side economics.

Fiscal policy is concerned with the spending and tax

initiatives of the government.

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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 basiccompetitive forces.

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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 areasonable 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.

h dl h ki d f h h b i i d

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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 dividendmodel, 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.

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TECHNICAL ANALYSIS

Past Prices & Volumes

AssumptionsMarket 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

C A O S S

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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 strongform efficiency.

The weak form efficient market hypothesis says that thecurrent price of a stock reflects all information found in therecord 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.

E i i l id id f

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Empirical evidence seems to provide strong support for

weak-form efficiency, mixed support for semi-strong formefficiency, and weak support for strong-form efficiency.

The efficient market hypothesis is an imperfect and limiteddescription 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 routinefundamental analysis is not of much help.

BEHAVIORAL FINANCE

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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 gainabout 2 times as strongly, according to

Kahneman and Tversky. This phenomenon is referred to as lossaversion

People separate their money into various mental accounts and treat a

rupee in one account differently from a rupee in another.

I i f i h f h i l h

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Investors engage in narrow-framingthey 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 beexpressed along an emotional time line.

Thanks to informationcascade, 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.

Th f t l id d i l ti b d i ld

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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

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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 investmenthorizon 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 itrelatively unchanged over time.

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ALL THE BEST FOR YOUR EXAMS..

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