Undergraduate
Student Managed Fund Portfolio
UNIVERSITY OF CONNECTICUT
Mission Statement
“The Objective of the fund is to provide University of
Connecticut students of business, commerce, and economics
with an opportunity to gain valuable hands-on experience in
fiduciary management of investment assets. Additionally, it will
provide to the School of Business a long-term method of
attracting high quality candidates, and will provide to the
UConn Foundation management services.”
PRESENTATION
University of Connecticut Foundation
March 11, 2004
Timothy Blais
Kristen Candella
Edmund Chung
George Kruglov
Patrick Mastan
Daniel McCarthy
Philip Odackal
Emeka Okafor
Todd Shrier
Timothy Sweeney
Julia Yelevich
2
Table of Contents
I. Investment Philosophy/Process
-Objective
-Stock Selection Procedure
-Valuation Models
II. Portfolio Performance
-Values
-Returns
-Risk Assessment
-Risk Adjusted Performance
III. Attribution Analysis
-Sector Allocation Effect
-Security Selection Effect
-Current Holdings
IV. Forward Expectations
V. Retrospection and Self-Analysis
3
I. Investment Philosophy/Process
Objective
The Student Managed Fund employs a strategic and thorough approach to portfolio management
with a primary objective to outperform the S&P 500. As a newly formed fund manager group,
we began our tenure with a total portfolio value of $200,577 invested in the S&P 500 Index
Fund. With access to critical information and faculty guidance we are able to use valuation
models to justify stock selection.
Based on our objective, our portfolio is currently allocated in
98% equity and 2% money market holding. Our selection of equities is based on a combination
of “top down” and “bottom up” analysis and we strive to invest consistently with market
forecast. This methodology along with improved economic conditions has led us to focus on the
consumer discretionary, consumer staples, information technology, and healthcare sectors.
results have been solid and to date we have outperformed the S&P 500.
The
4
Stock Selection Procedure
Industry Selection
Quantitative Research Using Value Line
(Financial Forecasting based on Historical Data)
-Sales Growth -Earnings Growth
-ROE
-ROI
-Earnings Yield -Free Cash Flow
Qualitative Research
-Management
-Strategy
-Competition
-Pipeline
Valuation Models
-Earnings Yield
-Value Line
-Discounted Cash Flow
Discussion
Group Vote
-Number of Shares to Purchase
-Stop-Loss Orders
5
Valuation Models
Earnings Yield Model
The earnings yield model is analyzed through two financial metrics: earnings per share and stock
price per share. The earnings yield is calculated by dividing the current year earnings per share
by the current stock price per share. The result yields valuable insight when analyzed in terms of
opportunity cost. To clarify, if a proposed investment possesses an opportunity cost that is
relatively greater than it would be in an alternative use of the funds, the investment decision
should be abandoned.
A typical metric used as a representation of an alternative use of funds is the return on the tenyear government treasury. As of February 9, 2004, the 10-year government treasury yielded
4.09%. In order to make this figure meaningful, it is crucial to compare this yield to the earnings
yield discussed above. If a stock holds an earnings yield of 4.00% for instance, it would be
unwise to pursue the investment, as a starting point, because an alternative investment in the
long-bond would yield a .09% higher return. The exception to this rule can potentially lie in the
perceived growth of the company. For example, if a company is expected to grow 15% a year
and outpaces the long-bond yield, then it is acceptable to pursue the investment because the
return will higher than the cost of capital.
Overall, the key to this model is to create a significant gap between the earnings yield of the
company and the yield on the long-bond. To illustrate, the graph below charts the yield on the
long-bond (assuming a return to 6%, its historical average, in ten years) versus Harley-Davidson
(at the time of purchase, assuming annual company growth of 13%). The gap will provide a
form of insurance to protect against unexpected fluctuations in interest rates.
6
Yield Comparison
16.00%
14.00%
12.00%
Yield
10.00%
Harley
Treasury
8.00%
Harley-Davidson
Treasury
6.00%
4.00%
2.00%
0.00%
1
2
3
4
5
6
7
8
9
10
Years
Value Line Model
The Value Line model provides an alternative method of valuation for an investment. The model
is driven by a growth assumption applied to the amount of capital available within a company.
Trends in additional measures, including the P/E ratio, return on total capital, and shares
outstanding are then used to calculate the book value, EPS, and an approximated 10 year value of
the investment assuming no splits in the stock. Once a ten year value is calculated it is
discounted back 15% less dividend yield to determine an appropriate buy price for inclusion in
the portfolio. Investments within or below the buy range are strong candidates for inclusion in
the portfolio.
Value Line Model: Harley Davidson
Long Term Debt + Shareholder Equity:
Growth Estimate:
$
4,290.00
10%
7
10 Year Capital in Business
11,127.16
Common Shares Outstanding (2014)
303
Book Value / Share (2014)
$
Return on Total Capital
36.72
17%
EPS (2014)
$
Average Annual P/E Ratio:
6.24
25.00
2014 Price
$
Dividend Yield
156.07
0.6%
Appropriate Buy Price
$39.00 - $42.00
Price at Purchase:
Result:
$47.50
Review
Discounted Cash Flow Model
The value of any asset is equal to the expected cash flows of the asset, discounted for timing and
risk. When valuing and investment using the discounted cash flow model certain assumptions
have to be made, including revenue growth rate, fixed investment rate, and the working capital
requirement. The weighted average cost of capital (WACC) is calculated and applied to
expected cash flows to get the cash flows from operations as well as the investment’s residual
value. The corporate value is then calculated by adding the value of short term assets to the
residual value. The value of the company’s liabilities, including debt, preferred stock, and short
term liabilities, are subtracted to get the value to common equity. This is divided by the amount
of stock outstanding to get the intrinsic value per share value of the investment. Investments
currently priced below their intrinsic value are strongly considered for inclusion in the portfolio.
Valuepro.net (internet DCF model):
Harley Davidson Inc.
Growth
Fixed Investment Rate (% of Rev)
Working Capital Requirement (%
of Rev)_
Risk Free Rate
WACC
Beta
13%
8%
2%
6%
8.91%
1
8
Intrinsic Value: $58.31
HDI Price @ Purchase: $47.50
Result: Buy
Our use of valuation models brings about an interesting question: When the models produce
different results what will our decision be regarding purchase? The above example demonstrates
the Earnings Yield model and DCF model produced buy results for Harley Davidson while the
Value Line model did not. In this situation the group decided to conduct further analysis on the
Value Line model. Through this analysis we recalculated the discount rate, of the ten-year
expected price, using a 13% return instead of the previously used 15%. After recalculating we
established a buy range of $46-49. This result along with our qualitative analysis of Harley
Davidson led us to purchase at $47.50. In summary, when results differ amongst the models we
conduct further analysis on the company to determine whether or not we want to take the
position.
9
II. Portfolio Performance
Values
September 4,
2003
$200,577.00
$200,577.00
$1,027.97
Total Portfolio
Equity
Money Market
S&P 500
December 8,
2003
$211,393.36
$209,646.53
$1,746.83
$1,069.30
February 24,
2004
$231,532.00
$227,621.00
$3,911.00
$1,142.17
Returns
Period
Return on SMF
Return on S&P
(09/04/03-02/24/04)
15.43%
11.11%
(12/08/04-02/24/04)
9.53%
6.81%
Risk Assessment (As of 12/8/03)
Beta of
Symbol (12/8/04)
ANF
BUD
CSG
EAT
HDI
MO
MSFT
PAYX
PFE
TJX
S&P 500
Equity
1.61
-0.1
0.04
0.34
1.1
0.3
1.64
0.76
0.38
0.89
1.00
Value (As
of 12/8/03)
$19,736
$10,504
$15,619.40
$7,987.50
$15,067
$17,043
$20,729.60
$15,496
$22,379.50
$15,522.25
$49,562.28
Percentage Weighted
of
Average
Portfolio
Beta
9.41%
5.01%
7.45%
3.81%
7.19%
8.13%
9.89%
7.39%
10.67%
7.40%
23.64%
0.152
-0.005
0.003
0.013
0.079
0.024
0.162
0.056
0.041
0.066
0.236
$209,646.53
Portfolio Beta
*Beta as of 12/8/03 obtained from www.multexinvestor.com
.827
10
Assuming the S&P 500 effectively possesses a beta of one, the fund’s portfolio exhibits a beta
that is .173 less than that of the S&P 500. Taken in its entirety the SMF is theoretically “less
risky” than its benchmark. Such a finding is impressive considering the overall rate of return on
our portfolio exceeds the S&P 500 given its upward trend. The goal of any and all managers is
to achieve a high rate of return while absorbing the least amount of risk and up to this point we
have been able to accomplish this.
Risk Adjusted Performance (12/8/03-02/24/04)
(12/8/03-02/24/04)
Excess Return (Rp-Rfr)
Risk (Weighted Average
Beta)
Treynor Index
T=[(Rp-Rfr)/B]
Return on
Portfolio (Rp)
9.53%
6.25%
.827
Return on S&P
(Rsp)
6.81%
3.53%
1.000
7.56%
3.53%
Risk Free Rate
(Rfr)
3.28%
5-yr T-Bond
(12/8/03)
11
III. Attribution Analysis
Attribution analysis attempts to distinguish the source of the portfolio’s overall performance
either through selecting superior securities or demonstrating superior market timing skills by
allocating funds to different asset classes or market segments.
Specifically, this method
compares the total return to the manager’s actual investment holdings to the return for a
predetermined benchmark portfolio and decomposes the difference into an allocation effect and a
selection effect.
* Our security allocation effect and security selection effect are based on the period: 12/08/0302/06/04. Mattel and Fossil, which were purchased on February 9th, are not included in the
attribution analysis because of the limited holding period of these positions. An explanation of
performance will be deferred until similar returns persist over a longer observation period.
However, we do include these positions in our current holdings listed later in the report.
Sector Allocation Effect (12/08/03-02/06/04)*
Sector
SMF
S&P
500
Difference
in weights
Sector
Return
12/8/032/6/04
Sector
Allocation
Contribution
(basis points)
0.0575
Excess
Returns
(S&P
Sector**Overall
S&P)
(0.0112)
Information
Technology
Consumer
Discretionary
Consumer Staples
Health Care
Utilities
Financials
Energy
Materials
Industrials
Telecommunications
Services
0.2192
0.1775
0.0417
0.4709
0.1102
0.3607
0.0543
(0.0144)
(0.0052)
0.1684
0.1415
-
0.1102
0.1364
0.0280
0.2091
0.0567
0.0286
0.1078
0.0355
0.0582
0.0051
(0.0280)
(0.2091)
(0.0567)
(0.0286)
(0.1078)
(0.0355)
0.0500
0.0890
0.0565
0.0786
0.0898
0.0110
0.0667
0.1311
(0.0187)
0.0203
(0.0122)
0.0099
0.0211
(0.0577)
(0.0020)
0.0624
(0.0011)
0.0001
0.0003
(0.0021)
(0.0012)
0.0016
0.0002
(0.0022)
Total
(0.0099)
(0.0005)
12
**S&P performance from 12/08/2004-02/06/2004 was 6.87%
***SMF performance from 12/08/2004-02/06/2004 was 7.57%
Security Selection Effect (12/08/03-02/06/04)*
Overall Return Difference = ***SMF Performance - **S&P 500 = .0070 or 70 Basis Points
Security Selection Effect = (.0070) – (-.0099) = .01693 or 169.3 Basis Points
Analysis
The results of our attribution analysis show that as a group we are better at selecting securities
than forecasting broader economic trends.
Our decision to overweight certain sectors
(information technology, consumer discretionary, consumer staples, and healthcare) was due to
the consistency in growth and strong earnings of these sectors. During the sector allocation we
looked at quantitative and qualitative factors. The group focused on industries that produced a
high ROIC while considering broad issues such as increased consumer confidence, maturity risk,
and business risk.
The sectors that we are not allocated in did not meet our criteria of consistency in growth and
strong earnings. Many of the unallocated sectors involve complication in the industry beyond
the scope of our experience, thus preventing comfortable investment beyond short term
speculation. In addition to this, a considerable amount of debt and low return on total capital has
led us to continue to observe these sectors with caution. For example: although many companies
in the energy sector have recovered in the last year with considerable returns, we believe based
on our valuation models that these companies are overvalued and will not provide the estimated
10-15% return we are seeking.
13
Current Holdings
Symbol
ANF
BUD
Company
Name
Abercrombie &
Fitch
Shares
800
Anheuser-Busch
Cadbury
Schweppes
200
250
HDI
Brinker
Harley
Davidson
MO
Altria
325
MSFT
Microsoft
790
PAYX
Paychex
400
PFE
Pfizer
650
TJX
Tj Maxx
725
MAT
Mattel
1056
FOSL
Fossil
690
CSG
EAT
580
325
Price
12/8/03
$24.75
10/27/03
$49.80
11/13/03
$26.01
10/27/03
$30.72
10/27/03
$47.50
10/29/03
$47.1
11/19/03
$25.298
11/5/03
$39.17
10/27/03
$31.18
10/27/03
$20.85
2/9/04
$18.90
2/9/04
$28.78
Original
Investment
Current
Price
(As of
02/24/04)
Current Value
(As of
02/24//04)
Holding Period
Return (As of
02/24/04)
$19,800.00
$29.48
$23,584.00
19.11%
$9,960.00
$53.78
$10,756.00
7.99%
$15,085.80
$34.30
$19,894.00
31.87%
$7,680.00
$36.73
$9,182.50
19.56%
$15,437.50
$53.96
$17,537.00
13.60%
$15,307.50
$56.92
$18,499.00
20.85%
$19,985.42
$26.87
$21,227.30
6.21%
$15,668.00
$34.15
$13,660.00
-12.82%
$20,267.00
$37.36
$24,284.00
19.82%
$15,116.25
$24.30
$17,617.50
16.55%
$19,958.40
$18.99
$20,053.44
0.48%
$19,858.20
$29.61
$20,430.90
2.88%
As evidenced above, the SMF’s performance is due, in large part, to the performance of three
stocks in particular: CSG, EAT and PFE.
When we considered the purchase of Cadbury (CSG) we immediately compared Cadbury to its
primary competitors in the beverage market, Pepsi and Coke. Through our quantitative and
qualitative analysis we found Cadbury to be the “better buy.” One reason was our finding of
Cadbury’s renewed focus on high growth potential products such as functional gum, candy and
sweets. Our findings proved to be correct as demonstrated in the chart below:
14
As shown, in the last three months Cadbury has significantly outperformed Pepsi and Coke by
more than 15%.
Meanwhile, the performance of Brinker (EAT) is mainly due to the rise in same-store sales of 1.3
percent in January. Reports have indicated that price increases and menu changes are primarily
responsible for the recent success. The third stock that has significantly contributed to the
success of the fund is Pfizer (PFE). Despite struggling throughout the course of 2003 like many
other pharmaceuticals, Pfizer has experienced significant price appreciation recently as a result
of the expected launch of several new products through 2004 and 2005 such as Inspra, Caduet
and Pregabalin.
After looking at the largest gainers, it is vital to focus on the largest underperformer of the
portfolio as well: Paychex (PAYX). The stock price of Paychex has suffered principally from
their underlying weakness in investment income. Because Paychex earns a significant portion of
income from funds held for clients in addition to its own investment portfolio, the bottom line
has suffered from the presence of low interest rates.
15
IV. Forward Expectations
Market Outlook
Our outlook of the market is positive due to improved economic activity. We feel the prospects
are good for sustained expansion in the U.S. economy. Companies are taking advantage of
favorable economic conditions and are bolstering their balance sheets. Businesses are likely to
retain their focus on controlling costs and boosting efficiency by making organizational
improvements and exploiting investments in new equipment with low financing rates.
A
decrease in credit risk spreads and a considerable rally in equity prices have reduced financing
costs and have increased household wealth.
Expansion in Demand
Increased household wealth will provide substantial support for spending by businesses and
households, which in turn will lead to an increase in aggregate demand in 2004. Expansion in
demand is also believed to result from the lower foreign exchange value of the dollar and a
sustained economic expansion among U.S. trading partners. Despite this expansion, the Federal
Reserve expects that inflation will remain quite low this year due to the previously mentioned
increases in efficiency along with a significant level of underutilized resources. For these
reasons we will continue to monitor the consumer staples and consumer discretionary sectors
with a focus on companies with high free cash flow and stable growth.
Risks
Despite these favorable conditions and prospects, the economic outlook is not void of all
certainty. In particular, questions remain as to how willing businesses will be to hire. Modest
decreases in unemployment must be mentioned when considering economic expansion.
Specifically, the loss off manufacturing jobs will continue to be a great concern. Over the last
three years nearly 3 million manufacturing jobs have been lost. Unemployment will be a key
issue in the upcoming election, and Democrats are expected to especially focus in the upcoming
16
election on the issue of American jobs being shipped overseas. However, employment will not
be the only question businesses will be faced with.
Questions also remain as to how much businesses will spend under the shadow of possible
increases in interest rates. Credit risk is perhaps the greatest risk in the long run, given the
Federal Reserve’s recent sentiment that interest rates will eventually need to rise toward a more
neutral level. The Reserve has stated that they will employ patience but acknowledges that
current policy will not be compatible indefinitely with price stability and sustainable growth. As
a result, we will remain reluctant to take the positions in companies with large amounts of debt.
Given the outlook and risks we will continue as a group to apply a strategic methodology to our
portfolio with the primary objective to outperform the S&P 500.
17
IV. Retrospection and Self-Analysis
In retrospect, our methodology of stock selection has proven to be successful in outperforming
the S&P. However as a group, not only do we understand the unique educational opportunity the
SMF provides us but also we realize there is still much to learn. One such area we will look to
improve, for the remainder of our tenure as managers, is our market timing and sector allocation
skills.
We would like to thank the UConn Foundation for granting us an additional $150,000 which we
plan to have invested by the end of March. With these additional funds we will focus on the
opportunities that exist among the sectors we are not allocated in. Although we will not abandon
our philosophy of selection based on stable undervalued companies with high ROIC we
recognize the possibility of even greater returns with a well-diversified portfolio.
Thank You,
Undergraduate SMF Managers