INVESTMENT ANALYSIS AND
PORTFOLIO MANAGEMENT
SATURDAY MAY, 2010
by
Fisayo Olowu (07034001681)
AGM, ADHL
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PART ONE: INVESTMENT ANALYSIS
•
DEFINITION OF AN INVESTMENT: An investment is the current commitment of
money or other resources in expectation of reaping future benefits. The themes
(to be discussed later), the risk-return trade-off and the efficient- pricing of
financial assets are central to the investment process.
•
We have real assets: the land, buildings, machines, and knowledge that can be
used to produce goods and services, and financial assets which are claims to the
income generated by real assets. In other words, financial assets simply define
the allocation of income or wealth among investors. Individuals can choose
between consuming their wealth today or investing for the future.
•
INVESTMENT ALTERNATIVES: The various investment opportunities available
to an investor are financial assets. These include
– Non-marketable Financial Assets: Bank deposits – Has high liquidity,
loans can be raised against them.
– Company deposits – loans can also be raised against them
– Provident Fund deposits: i.e. Provident Fund Scheme
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OTHER FINANCIAL ASSETS
Equity Shares: These represent ownership capital.
Blue Shares.
Income Shares.
Speculative Shares.
Bonds: Bonds or debentures represent long-term instruments.
Government Securities – Tax advantage
Debentures of private sector companies- could be convertible
Preference shares –hybrid of debt and equity.
Money market instruments: They are debt instruments with less than one
year maturity.
Treasury Bills- no credit and price risk
Commercial Papers – short-term, unsecured note
Certificates of deposits – risk-free,
Mutual Funds – They are sold through underwriters to investors. Here one will
invest in equity share & fixed income securities.
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OTHER FINANCIAL ASSETS
Life Insurance: This can be viewed as an investment. Insurance premiums
represent the sacrifice and the assured sum, the benefit. The important
types of insurance policies are: Endowment assurance policy; Whole life
policy; Term assurance policy.
Real Estate: Here, the assets usually considered include residential house;
Agricultural land; Commercial properties and all forms of landed properties.
Precious Objects: The important precious objects are Gold, Silver; Precious
stones, Art object and Antiques.
Financial Derivatives: The most important financial derivatives from the point
of view of investors are Options Call (right to buy) & Put (right to sell at an
exercised price)
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CRITERIA FOR EVALUATION OF AN INVESTMENT
The criteria are:
Rate of return
Rate of return = Annual Income + (Ending Price – Beginning Price)
Beginning Price
or
= Annual Income
+ Ending - Beginning Price
Beginning Price
Beginning Price
Current yield
Capital gains/losses yield
Annual Income= Dividend paid toward the end of the year
Stock Returns: Ri = Pi – Po + Di
Po
Where Ri = return on a security (common stock)
Pi = market price of the security at the end of period
Po = market price of security at the beginning of the period (current price)
Di = Dividend paid during period.
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CRITERIA FOR EVALUATION contd
•
Ri = Di + Pi – Po
Pi
Po
Return on a share is equal to the Dividend Yield (Di /Po) plus Capital gains Pi - Po
Po
EXAMPLE:
Peter bought the common stock of Tatsie Plc when the market price was N2.60. He
expects the stock will appreciate to N3.50 in one year’s time when he will
later sell it. Calculate the expected return on the stock if
i)
No dividend will be paid during the period
ii)
A dividend of 50k will be paid during the period.
SOLUTION:
I)
Expected return = N3.50 - N2.60 = 0.3461 34.61%
N2.60
ii)
Expected return = N3.50 - N2.60 +N0.5
N2.60
=0.5385 =53.85%
Investment in shares or stocks is just one type of the numerous investments.
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OTHERS ARE
RISK: The risk of an investment refers to the variability of
its rate of return. The simple measure of dispersion is
the difference between the highest and the lowest
values. Other measures used are
VARIANCE: The is the mean of the squares of deviations
of individual returns around their average values.
STANDARD DEVIATION: This is the square root of
variance.
BETA: This reflects how volatile is the return from an
investment relative to market swings.
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OTHERS ARE
MARKETABILITY: The factors responsible for an investment being
marketable are
1) the transaction process is fast
2) transaction cost is low
3) price change between two successive transactions is negligible.
How liquid a market is can be judged in terms of its depth; the existence of
buy and sell orders around the current market price.
Breadth: the presence of such orders in substantial volume.
Resilience: New orders emerge in response to price changes.
NOTE: Equity shares of multinationals (large and well-established firms )
enjoy high marketability while that of small companies in the formative years
have low marketability
Investors value liquidity because it allows them to change their minds.
When an investment is non-marketable, one will explore the ease of
withdrawals or loans taken against the deposit/investment.
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TAXES
TAX SHELTER: There are three kinds of Tax benefits.
Initial Tax Benefits: This refers to the tax relief enjoyed at the time of
making an investment (tax rebate).
Continuing Tax Benefit: One is referring to the tax shield associated
with the periodic returns from the investment for example dividend
income.
Terminal Tax Benefit: Convenience: This is the ease with which the
investment can be made and look after.
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SUMMARY EVALUATION OF VARIOUS
INVESTMENT AVENUES
RETURN
CURRENT YIELD
RETURN
CAPITAL
APPRECIATION
RISK
MARKETABILITY/
LIQUIDITY
TAX SHELTER
CONVENIENCE
EQUITY
SHARES
LOW
HIGH
HIGH
FAIRLY HIGH
HIGH
HIGH
Non-convertible
Debentures
HIGH
NEGLIGIBLE
LOW
AVERAGE
NIL
HIGH
Equity Schemes
LOW
HIGH
HIGH
HIGH
HIGH
VERY HIGH
Debt Schemes
MODERATE
LOW
LOW
HIGH
NO TAX ON
DIVIDENDS
VERY HIGH
Bank Deposits
MODERATE
NIL
NEGLIGIBLE
HIGH
LOW
VERY HIGH
EMPLOYEE
Provident Fund
NIL
MODERATE
NIL
AVERAGE
SOME BENEFIT
VERY HIGH
Life Insurance
Policies
NIL
MODERATE
NIL
AVERAGE
SOME BENEFIT
VERY HIGH
Residential
House
MODERATE
MODERATE
NEGLIGIBLE
LOW
HIGH
FAIR
Gold and Silver
NIL
MODERATE
AVERAGE
HIGH
NIL
AVERAGE
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THE MUST Dos OF INVESTMENT
 Determine the returns one can expect from different investment
along with the risks associated with these investments.
 Investors must clearly spell out their risk disposition and investment
policy.
 Decisions must be based on thoughtful, quantified assessment of
business.
 Market, business and interest rate risks must not be ignored.
 Avoid trading excessively thereby reducing transaction cost.
 Avoid over-diversification and under-diversification which could lead
to risk exposure.
 Admit one’s mistakes and cut losses short.
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QUALITIES FOR SUCCESSFUL
INVESTING
The qualities are:
Contrary thinking: The investor goes with the market during beginning
and intermediate phases of bullishness and bearishness but go against
the market when it moves towards the extremes.
 Avoid stocks with high price earnings ratio:
Market price per share
Earnings per share
This reflects that the stock is popular with investors.
 Sell to the optimists and buy from the pessimists. Specify the target
prices at which you will sell and buy.
 Investors performance depends mainly on patience and diligence
because the random movements tend to even out.
 Rely more on actual figures and less on judgement (which is more
prone to be influenced by emotions of greed and fear).
 Ride the winners and sell the losers.
 Never throw good money after the bad.
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QUALITIES FOR SUCCESSFUL
INVESTING (cont’d)
To achieve superior performance, you have to be different from the
majority.
One of the most highly talented investors of our time is
Benjamin Graham, widely acclaimed as the father of modern
security analysis who relied on hard financial facts and religiously
practised the “margin of safety” principle.
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PORTFOLIO MANAGEMENT
Portfolio management is a complex activity that can be broken
down into the following steps;
Specification of Investment Objectives and Constraints: Most
investors seek current income; capital appreciation and safety of
principal
Choice of the Asset Mix: The most important decision in portfolio
management is the asset mix decision. This step is concerned with
the proportions of equities and fixed income securities in the
portfolio. The appropriate mix depends mainly on the risk tolerance
and investment horizon of the investor.
Formulation of Portfolio Strategy: Once a certain asset mix is
chosen, one can either opt for an active portfolio strategy or a
passive portfolio strategy.
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Selection of Securities: To select equities, investors go by technical
analysis, and for fixed income securities yield to maturity, credit
rating, term to maturity, tax shelter and liquidity is utilized.
Portfolio Execution: This phase is concerned with the buying and or
selling of specified securities in given amounts. It is an important
practical step that has a bearing on investment results.
Portfolio Revision: This involves the periodic rebalancing of the
portfolio in terms of its value and composition.
Performance Evaluation: The performance of a portfolio should be
based on if the return is commensurate with its risk exposure
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PORTFOLIO MANAGEMENT contd
The most important portfolio decision an investor makes is the
proportion of the total investment fund allocated to risky as opposed
to safe assets such as money market securities. This choice is the
most fundamental means of controlling investment risk.
The first decision an investor must make is the asset allocation
decision. Asset allocation refers to the allocation of the portfolio
across major asset categories such as:





Money market assets (Cash equivalents)
Fixed-income securities (Bonds & Treasury Bills)
Stocks/Company shares
Real Estate
Precious metals and other commodities
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Cont’d
• A) High risk tolerance: Select asset allocations concentrated in
higher risk investment classes i.e. equity to obtain higher expected
rate of return
• B) Conservative: Choose asset allocations with a greater weight in
Bonds and cash equivalents. This offers a higher degree of stability
plus the comfort of regular income.
• A balanced approach has characteristics of both A) & B) plus the
benefit of diversification across asset classes. This balanced
portfolio will be able to withstand the financial markets’ ups and
downs.
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BALANCED APPROACH
75%
65%
60%
40%
STOCKS
15%
20%
25%
40%
BONDS
10%
15%
15%
20%
MONEY
MARKETS
30s
40s
50s
60s
AGE
BRACKET
RISK APPETITE
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BALANCED APPROACH cont’d
• 20s; 30s- 40s: Stocks with potentially higher long-term returns
• 50s: Reduce risk, increase income by trimming stocks and raising
bond & money market investments
• 60s: Shift focus to receiving income. The majority of one’s portfolio
should be allocated to bonds and money market funds.
• As an inflation hedge, maintain a significant stock position (40% is a
good starting point) particularly early in one’s retirement years.
• However, to have a balanced investment strategy, one should move
assets from high-performing funds to those that may be lagging.
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ACTIVE PORTFOLIO MANAGEMENT
• ACTIVE PORTFOLIO MANAGEMENT:
• Here, one assumes an ability to outguess the other investors in the
market, and to identify either securities or asset classes that will
shine in the near future.
•
•
•
•
Active selection thus requires:
1) Security analysis
2) Portfolio Choice
In both 1) & 2), the analysts must assess industries/company reports
and use forecasts of market conditions, and use the security
analysts recommendations to choose the particular securities to
include within each asset class.
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Contd.
•
Inflation and Real Rate of Return: If the interest rate on a one year
deposit is 9%p.a. and one expects inflation to be 5% over the coming
year, the real rate of interest will be
–
r = 8% - 5% = 3%
–
or
–
r= 0.08 – 0.05
= 0.0286 or 2.86%
–
1+0.05
SUGGESTIONS:
1) The traditional balanced portfolio is typically 60% stocks, 40%
Bonds. This remains a firm favourite with many investment experts.
2) Another is to skip Bonds and instead add cash investments such as
Treasury Bills, money market funds, gold and real estate. Gold and
real estate gives one an hedge against hyperinflation. But, real
estate is better than gold because one gets better long-run returns.
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OTHER MEASURES OF RISK/RETURN
• Coefficient of Variation: This is a relative measure of risk and is
measured thus:
• Coefficient of Variation = Standard Deviation
Expected return
The higher the coefficient of variation, the higher the risk of the
investment.
The expected return on a portfolio is the weighted average of the
expected return of each investment
Below is an example for illustration:
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ILLUSTRATION
• SECURITY A
SECURITY B
•
•
•
•
•
RETURN
PROBABILITY RETURN
PROBABILITY
24%
0.3
12%
0.6
15%
0.1
13%
0.3
12%
0.6
14%
0.1
QUESTION: Calculate the expected return on portfolio
consisting of 60% of Security a and 40 of Security b.
• Solution:
• Ra = (0.24) x(0.3) + (0.15)x(0.1) + (0.12) x(0.6)
• Rb = (0.12) x (0.6) + (0.13)x(0.3) + (0.14)x(0.1)
– = 0.6(0.159) + 0.4(0.125)
– = 0.1454 or 14.54% =Expected return on the Portfolio
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DIVERSIFICATION
• The risk of a portfolio depends not only on the risk nature of the
securities making up the portfolio but also on the relationship among
the securities. This must be considered in calculating the standard
deviation of a portfolio return.
• Therefore, an investor can reduce relative risk by selecting securities
that have little relationship with each other. Diversification is the
process of combining securities in a way that reduces total risk
without losing portfolio return.
• Benefits from Diversification:
• 1) Perfect Positively Correlation: Here, there is a linear
relationship between risk and return. It is not possible to reduce risk
without reducing return. There is no benefit from diversification when
returns of securities are perfect positively correlated.
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Diversification contd
•
2) Perfect Negative Correlation: Here one is referring to a Portfolio that
has higher expected return and lower risk. But, at the same level of
expected return, the Portfolio has no risk. Therefore, there are more
benefits to be derived from diversification when securities are negatively
correlated.
•
3) Uncorrelated Returns: At the same level of expected returns, different
Portfolios have different levels of risk. As more assets with uncorrelated
returns are included in the portfolio, the benefits from diversification
increases.
•
In conclusion, the Portfolio Manager must anticipate threat, spread their
clients investment and thereby minimize risks. There is the need to
reshuffle portfolio from financial stocks/equities that were worst hit by the
economic crisis into more resilient ones like FGN Bonds, in their strategic
positioning to hedge against losses and grow their liquid asset needs. In
my opinion, developed and emerging markets offer good investment
opportunities thanks to their faster rate of growth.
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REFERENCE MATERIALS
 Asset & Fund Management by Patrick Vandenbroucke
 Security Analysis and Portfolio Management by Donald
E. Fischer
 Investment Analysis and Portfolio Management by
Prasanna Chandra.
 Essentials of Investments by Alex Kane, Zvi Bodie &
Alan J. Marcus.
 Articles in the Business Day Newspaper
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