GENERAL INVESTMENT
ANALYSIS
INVESTORS NEED TO
•gather (info services)
• process (computer)
• and interpret (models) information
•then make logical investment decisions
•fits many skilled job requirements - not just invest.
STEPS TO SELECTING AMONG SICs and
COMPANIES (STOCKS) IN YOUR SIC
1.
Choose an SIC for which detailed knowledge of
such financial group offers you some benefit - better
performance in present job - potential for future
employment - better personal financial success.
2.
Among SIC’s that fit criterion (1) consider an SIC
you expect to benefit from economic trends.
3.
Gather information on general industry trends and
important factors that determine what types of
companies in your SIC will be most successful.
4.
Gather information on all companies in the SIC select the stocks of the most promising companies.
INFORMATION TYPES
1. Direct information from financial statements,
•
newspapers, internet etc.
•
financial position - ratios, etc.
•
differential strengths - patents, size, economies of
scale, scientists, brand name
•
read brokerage reports - especially those that
compare competing firms
•
consider past and potential future growth of total
market and firm’s market share
2. Indirect information
•
stock ownership of management
•
level and incentives in management pay
•
ownership of institutional investors
•
management credentials and experience
•
suppliers and partners - call and question
•
customers - call and question
•
customer service and product distribution
•
test products yourself - ask others their opinion
of products - store sales people
•
watch for price cutting
•
check competitor’s products and potential
competitors outside the industry
•
technical analysis - let the market lead you
Financial Systems
1. Financial Systems not just Intermediaries
• Financial intermediaries compete with financial
markets in an innovation spiral.
• Both facilitate financial trade with services/products.
• Financial intermediaries often buy illiquid and risky
financial claims (corporate loans) and transform
(engineer, produce) them into less risky, more
liquid claims (demand deposits) - best for custom,
illiquid, low-volume, complex assets.
• Financial markets provide a centralized place to trade
financial claims - best for standardized, liquid,
high-volume, simple products.
Financial System
Global Flow of Funds
Full System
MARKETS
SURPLUS
UNITS
DEFICIT
UNITS
Intermediaries
The lines trace the flow of funds. Not shown is the flow of securities,
information, guarantees, etc., flowing in the opposite direction.
Flow of Funds
Simple System
MARKTS
SURPLUS
UNITS
DEFICIT
UNITS
Examples : Early history - lending to tribe, family, friends.
Recently - Boston Market funds franchisees.
- Firms sell stocks and bonds on web
directly to investors, DRIPS.
Question: What problems may occur in these examples?
Question: How can intermediaries help solve the problems?
Flow of Funds
Intermediaries but no Markets
Example: Insurance (exception, Llyods of London).
SURPLUS
UNITS
Intermediaries
DEFICIT
UNITS
Flow of Funds
Markets but no Intermediaries
Example: Stock exchanges, ECNs like Instinet.
SURPLUS
UNITS
Markets
DEFICIT
UNITS
Question: Salomon Brothers sold “Bowie” bonds which pay
investors coupons from the future royalties from
David Bowie’s record sales. Who are the surplus
and deficit units and the market or intermediary?
Functional Perspective on
Financial Intermediaries
Six Primary Financial Functions
•Intermediaries come and go but their functions remain.
• Banks originated in Italy as money changers “Banca” refers to money changers’ benches.
• In the U.S. banks largely pool deposits and lend
whereas in Europe they perform many functions.
•Institutional form can be explained and changes predicted
from competition within function.
• The proper question to answer is how best to satisfy
customer demand for a function rather than which
particular institution usually handles the function.
Example of Institutional
Form Following Function
Suppose you want a levered position in the S&P 500.
• Buy the 500 individual stocks on margin (broker lending).
• Borrow and buy an S&P 500 index fund/unit trust.
• Buy an S&P 500 futures contract.
• Buy an S&P 500 forward contract.
• Enter into an S&P 500 for LIBOR swap contract.
• Buy S&P 500 call options and sell S&P 500 put options.
• Buy a bond that pays a coupons based on the S&P 500.
• Buy a CD that pays a return based on the S&P 500.
• Buy a variable annuity linked to the S&P 500.
Function 1
1. Clearing and settling transactions to facilitate trade in
goods, services and financial products.
• Barter makes trade time consuming and costly.
• Using gold is cheaper and more convenient.
• Currency is even better (flooz,beenz).
• Checks, credit cards, travelers checks.
Function 2
2. Provide information directly or implicitly in prices.
• Interest rates encourage (discourage) savings/investment.
• Stock prices signal business to expand - brand value.
• Index options provide information on market risk (VIX).
• Intermediaries sell investment information and advice.
• You can hire a real estate appraiser or set the price of
your house by using the price of recent sales.
Function 3
3. Alleviating incentive problems.
• Problems occur when one party to a trade has more
information than another - reduces or stops trade.
•Type 1: Moral Hazard - after insuring, risk-taking
behavior changes - Boston Market.
• Type 2: Adverse Selection - after setting a fixed premium,
only poor risks find it attractive - “lemons”.
• Type 3: Principal/Agent - delegating stock selection Merrill Lynch ad “What’s your motivation.”
•Occurs often because public ownership implies a
separation between owners and managers of firms.
• Information gathering, convertible debt, collateral or
compensation systems can alleviate the problems.
• Solving the problems increases trade and leaves both
parties better off.
Function 4
4. Pooling funds and subdividing ownership
• Pooling facilitates risk diversification and financing of
large projects.
• Subdividing facilitates risk transfer and ownership
transfer - race horse syndicate on web.
• Spreads information gathering and trading costs over
many investors.
• Berkshire Hathaway - $55,000 stock - facilitates pooling
but not subdividing.
Function 5
5. Transfer resources across time, place and industry.
• The more developed and complex a country, the more
important this is to an efficient financial system.
• Asset allocation funds.
• Old economy stocks versus new economy stocks.
• In Europe - people are selling bonds and buying stocks.
• Question: Does the U.S. Social Security System satisfy
this function?
Function 6
6. Risk management and transfer - the most important and
fastest growing function.
• Management includes hedging, diversifying and insuring.
• Insurance transfers risk from policyholder to insurer.
• Insurance companies spread risk among policies.
• Bank transfers risk to loan co-signers - parents.
• Jewelry maker fixes metal costs in the futures market.
• Question: What happens in agriculture price supports?
• Question: Why do few people by hurricane insurance?
•Technology and communications advances reduce
information and transactions costs, leading to more
efficient responses to small changes in consumer
tastes and economic events.
• Better information reduces incentive problems leaving risk
management as most important - more class time.
• Firms shed risks they know little about and manage
internally, risks in which they are expert.
• Intermediaries help match risk sellers with buyers.
• Securitization is exploding - markets match risk traders.
• Manger self-interest, progressive taxes and bankruptcy
costs increase the demand for risk management.
The Changing Functions of
Banks
• In the past, banks primarily settled customer transactions,
pooled customer deposits and loaned funds locally.
• Now banks pool deposits and transfer funds nationally
through securities such as mortgage-backed bonds.
• Loan origination, servicing and funding are now often done
by specialist institutions with local banks focussing
on origination and perhaps funding.
• Each institution focuses on its core competency - for a local
bank- its competitive advantage is knowledge of local
businesses and its proximity for monitoring. Their
knowledge and monitoring generates valuable
information and mitigates incentive problems.
• The clearing and settling functions of banks is less
significant as money market funds have grown.
Money market funds’ operating costs are ten time
lower than those of banks.
• Given that money market funds invest in very highly rated
securities, banks’ risk absorption function is less
important.
• Banks risk management function is becoming more
sophisticated as they resell loans or securitize them
instead of holding mortgages and commercial loans
on their books.
Future of Financial System
• Information scale economies leads to larger institutions.
• Large institutions reduce costs by netting transactions
internally, cross-selling products, customize products.
• Financial research important to support complex products.
• With less risk kept internally, more firms remain privately
held - less need for co-owner diversification.
• Individuals shift from direct financial holdings to
specialized intermediary products.
• In 1966 (1995), individuals held 85% (52%) of stocks.
• In 1966 (1995), individuals held 5% (25%) of their stocks
as mutual funds.
• Traditional strategies and technologies of intermediation
are losing out to structured finance and market-making.
• Structuring securities and making markets for them relies
on proprietary knowledge and models.
• Skill sets for doing this include, technological knowledge,
analytic ability, customer and supplier networking as well as
regulatory and political networking.
Finance Careers
Basic Job Groupings
• Corporate Finance
• Investments
• CD-ROM - Careers in Finance
• www.careers-in-finance.com