MODULE OF INVESTMENT PORTFOLIO MANAGEMENTPortfolio management or investment helps investors in effective and efficient management of their investment to achieve this goal. The rapid growth of capital markets in India has opened up new investment avenues for investors. The stock markets have become attractive investment options for the common man. But the need is to be able to effectively and efficiently manage investments in order to keep maximum returns with minimum risk. Hence this study on PORTFOLIO MANAGEMENT & INVESTMENT DECISION” to examine the role process and merits of effective investment management and decision.A portfolio is a collection of securities since it is really desirable to invest the entire funds of an individual or an institution or a single security, it is essential that every security be viewed in a portfolio context. Thus it seems logical that the expected return of thePortfolio. Portfolio analysis considers the determine of future risk and return in holding various blends of individual securities contrast, can be something reduced portfolio risk is because risk depends greatly on the co-variance among returns of individual securities. Portfolios, which are combination of securities, may or may not take on the aggregate characteristic

Portfolio expected return is a weighted average of the expected return of the individual securities but portfolio variance, in short s of their individual parts.

Since portfolios expected return is a weighted average of the expected return of its securities, the contribution of each security the portfolio’s expected returns depends on its expected returns and its proportionate share of the initial portfolio’s market value. It follows that an investor who simply wants the greatest possible expected return should hold one security; the one which is considered to have a greatest expected return. In order to be successful, an investor must understand and be comfortable with taking risks. Creating wealth is the object of making investments, and risk is the energy that in the long run drives investment returns.

Modern portfolio theory has one, and really only one, central theme: “In constructing their portfolios investors need to look at the expected return of each investment in relation to the impact that it has on the risk of the overall portfolio”. The practical message of portfolio theory is that sizing an investment is best understood as an exercise in balancing its expected return against its contribution to portfolio risk- In an optimal portfolio this ratio between expected return and the marginal contribution to portfolio risk of the next pound invested should be the same for all assets in the portfolio

Unfortunately, many investors are not aware that such insights of modern portfolio theory have direct application to their decisions. Too often modern portfolio theory is seen as a topic for academia, rather than for use in real-world decisions. For example, consider a common situation: When clients of a firm decide to sell or take public a business that they have built and in which they have a substantial equity stake, they receive very substantial sums of money. Almost always they will deposit the newly liquid wealth in a money market account while they try to decide how to start investing. In some cases, such deposits stay invested in cash for a substantial period of time. Often investors do not understand and are not comfortable taking investment risks with which they are not familiar. Portfolio theory is very relevant in this situation and typically suggests that the investor should create a balanced portfolio with some exposure to public market securities (both domestic and global.).

Chapter concepts:

The investment setting

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Why Do Individuals Invest?By saving money (instead of spending it), individuals tradeoff present consumption for a larger future consumption.Defining an InvestmentA current commitment of $ for a period of time in order to derive future payments that will compensate for:

– the time the funds are committed– the expected rate of inflation– uncertainty of future flow of funds.

Risk Premium and Portfolio Theory• The relevant risk measure for an individual asset is its co-movement with the market portfolio • Systematic risk relates the variance of the investment to the variance of the market• Beta measures this systematic risk of an asset

Fundamental Risk versus Systematic Risk• Fundamental risk comprises business risk, financial risk, liquidity risk, exchange rate risk, and country

risk• Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of

the total market portfolio

SECURITY-MARKET INDICATOR SERIESUses of Security-Market Indexes

• As benchmarks to evaluate the performance of professional money managers• To create and monitor an index fund• To measure market rates of return in economic studies• For predicting future market movements by technicians • As a substitute for the market portfolio of risky assets when calculating the systematic risk of an asset

Dow Jones Industrial Average (DJIA)• Best-known, oldest, most popular series• Price-weighted average of thirty large well-known industrial stocks, leaders in their industry, and listed

on NYSE• Total the current price of the 30 stocks and divide by a divisor (adjusted for stock splits and changes in

the sample)Nikkei-Dow Jones Average

• Arithmetic average of prices for 225 stocks on the First Section of the Tokyo Stock Exchange (TSE)• Best-known series in Japan• Price-weighted series formulated by Dow Jones and Company• The 225 stocks represent 15 percent of all stocks on the First Section

Value-Weighted Series

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• Derive the initial total market value of all stocks used in the seriesMarket Value = Number of Shares Outstanding

X Current Market Price• Assign an beginning index value (100) and new market values are compared to the base index• Automatic adjustment for splits• Weighting depends on market value

Unweighted Price Indicator Series• All stocks carry equal weight regardless of price or market value• May be used by individuals who randomly select stocks and invest the same dollar amount in each stock• Some use arithmetic average of the percent price changes for the stocks in the index

Morgan Stanley Capital International (MSCI) Indexes• All the indexes are market-value weighted• Reporting is in U.S. dollars and the country’s local currency• Also provides

– price to book value (P/BV) ratio– price to cash earnings (earnings plus depreciation) (P/CE) ratio– price to earnings (P/E) ratio– dividend yield (YLD)

AN INTRODUCTION TO ASSET PRICING MODELS

An Overview• Capital market theory extends portfolio theory and develops a model for pricing all risky assets• Capital asset pricing model (CAPM) will allow you to determine the required rate of return for any risky

assetRisk-Return Possibilities with LeverageTo attain a higher expected return than is available at point M (in exchange for accepting higher risk)

• Either invest along the efficient frontier beyond point M, such as point D• Or, add leverage to the portfolio by borrowing money at the risk-free rate and investing in the risky

portfolio at point MSystematic Risk

• Only systematic risk remains in the market portfolio• Systematic risk is the variability in all risky assets caused by macroeconomic variables• Systematic risk can be measured by the standard deviation of returns of the market portfolio and can

change over timeThe Capital Asset Pricing Model: Expected Return and Risk

• The existence of a risk-free asset resulted in deriving a capital market line (CML) that became the relevant frontier

• An asset’s covariance with the market portfolio is the relevant risk measureThis can be used to determine an appropriate expected rate of return on a risky asset - the capital asset pricing model (CAPM)

AN INTRODUCTION TO SECURITY VALUATIONThe Investment Decision Process

• Determine the required rate of return• Evaluate the investment to determine if its market price is consistent with your required rate of return

– Estimate the value of the security based on its expected cash flows and your required rate of

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return– Compare this intrinsic value to the market price to decide if you want to buy it

Valuation Process• Two approaches

– 1. Top-down, three-step approach– 2. Bottom-up, stock valuation, stock picking approach

• The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks

Top-Down, Three-Step Approach1. General economic influences

– Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash

2. Industry influences– Determine which industries will prosper and which industries will suffer on a global basis and

within countries3. Company analysis

– Determine which companies in the selected industries will prosper and which stocks are undervalued

Theory of Valuation• The value of an asset is the present value of its expected returns

You expect an asset to provide a stream of returns while you own it

Stream of Expected Returns• Form of returns

– Earnings– Cash flows– Dividends– Interest payments– Capital gains (increases in value)

• Time pattern and growth rate of returns

Investment Decision Process: A Comparison of Estimated Values and Market PricesIf Estimated Value > Market Price, BuyIf Estimated Value < Market Price, Don’t BuyApproaches to the Valuation of Common StockTwo approaches have developed1. Discounted cash-flow valuation

• Present value of some measure of cash flow, including dividends, operating cash flow, and free cash flow

2. Relative valuation technique• Value estimated based on its price relative to significant variables, such as earnings, cash

flow, book value, or salesWhy and When to Use the Discounted Cash Flow Valuation Approach

• The measure of cash flow used– Dividends

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• Cost of equity as the discount rate– Operating cash flow

• Weighted Average Cost of Capital (WACC)– Free cash flow to equity

• Cost of equity• Dependent on growth rates and discount rate

Macroeconomic and Market Analysis: The Global Asset Allocation Decision

Economies and Markets• A strong relationship exists between the economy and the stock market

• Security markets reflect what is going on in an economy because the value of an investment is determined by

– its expected cash flows– required rate of return

Economic Activity and Security MarketsStock Market As A Leading Indicator

– Stock prices reflect expectations of earnings, dividends, and interest rates– Stock market reacts to various leading indicator series– Stock prices consistently turn before the economy does

Cyclical Indicator Approach to Forecasting the EconomyThis approach contends that the aggregate economy expands and contracts in discernable periods Cyclical Indicator Approach to Forecasting the Economy

• National Bureau of Economic Research (NBER)• Cyclical indicator categories

– leading indicators– coincident indicators– lagging indicators

• Composite series and ratio of seriesCyclical Indicator Categories

• Leading indicators – economic series that usually reach peaks or troughs before corresponding peaks or troughs in aggregate economy activity

• Coincident indicators – economic series that have peaks and troughs that roughly coincide with the peaks and troughs in the business cycle

• Lagging indicators – economic series that experience their peaks and troughs after those of the aggregate economy

• Selected series – economic series that do not fall into one of the three main groups Cyclical Indicator Approach to Forecasting the Economy

• Analytical measures of performance– diffusion indexes

• trends• rates of change• direction of change• comparison with previous cycles

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• Analytical measures of performance– diffusion indexes

• trends• rates of change• direction of change• comparison with previous cycles

• Limitations of cyclical indicator approach– high variability– currency of the data and revisions– no series reflects the service sector– no series represents the global economy– political and international developments are not factored into a statistical system

• Leading indicators and stock prices• Other leading indicator series

– CIBCR: • Long-leading index• leading employment index• Leading inflation index

– Analysis of alternative leading indicators of inflation– International leading indicator series– Survey of sentiment and expectations

Monetary Variables, the Economy, and Stock Prices• Money supply and the economy• Money supply and stock prices• Excess liquidity and stock prices

– year to year percentage change in M2 money supply adjusted for small time deposits less the year-to-year percentage change in nominal GDP

Money Supply and the Economy• Declines in the rate of growth of the money supply have preceded business contraction by an average of

20 months• Increases in the rate of growth of the money supply have preceded economic expansions by about 8

months Money Supply and Stock Prices

• Excess Liquidity and Stock Prices• Historical Excess Liquidity in the United States• Historical Excess Liquidity in Foreign Countries

Monetary Variables, the Economy, and Stock Prices• Other economic variables and stock prices

– growth in industrial production– changes in the risk premium– twists in the yield curve– measures of unanticipated inflation– changes in expected inflation during periods of volatile inflation

Inflation, Interest Rates, and Security Prices• Inflation and interest rates

– generally move together– investors are not good at predicting inflation

• Inflation rates and bond prices

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– negative relationship– more effect on longer term bonds

• Interest rates and stock prices– not direct and not consistent– effect varies over time

Analysis of World Security Markets• Goldman, Sachs & Co.

World Investing Strategy Highlights• Inflation and exchange rates• Correlations among returns• Individual country stock price changes• Individual country analysis• World asset allocation

Stock Market Analysis

Applying the DDM Valuation Model to the Market• The stream of expected returns• The time pattern of expected returns• The required rate of return on the investment

Determinants of the Earnings Multiplier:1. The expected dividend payout ratio2. The required rate of return on the stock3. The expected growth rate of dividends for the stock

Market Valuation Using the Reduced Form DDM

• Estimating k and g for the U.S. equity market• The nominal risk-free rate• The equity risk premium• The current estimate of Risk Premium and k• Estimating the growth rate of dividends (g)

g = f(b,ROE)ROE = Net Income / EquityEstimating Growth Rate

• Growth rate of dividends is equal to– Retention rate - the proportion of earnings retained and reinvested – Return on equity (ROE) – rate of return earned on investment

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– An increase in either or both of these variables causes an increase in the expected growth rate (g) and an increase in the earnings multiplier

Return on Equity (ROE)

Market Valuation Using the Free Cash Flow to Equity (FCFE) ModelFCFE is:+ Net Income+ Depreciation Expense- Capital Expenditures- D in Working Capital- Principal Debt Repayments+ New Debt issuesMarket Valuation Using the Free Cash Flow to Equity (FCFE) Model

• The Constant Growth FCFE Model• The Two Stage Growth FCFE Model

Market Valuation Using Relative Valuation Approach• The price-earnings ratio (P/E)• The price-book value ratio (P/BV)• The price-cash flow ratio (P/CF)• The price-sales ratio (P/S)• Two-part valuation procedure

Profit Total Asset Financial Margin Turnover Leverage=

xx

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• Importance of both components of value1. Estimating the future earnings per share for the stock-market series2. Estimating a future earnings multiplier for the stock-market series

Industry Analysis

Why Do Industry Analysis?• Help find profitable investment opportunities• Part of the three-step, top-down plan for valuing individual companies and selecting stocks for a

portfolioWhat Do We Learn From Industry Analysis?

• Is there a difference between the returns for alternative industries during specific time periods?• Will an industry that performs well in one period continue to perform well in the future? That is, can

we use past relationships between the market and an individual industry to predict future trends for the industry?

• Do firms within an industry show consistent performance over time?• Do firms within an industry show consistent performance over time?• Is there a difference in the risk for alternative industries?• Do firms within an industry show consistent performance over time?• Is there a difference in the risk for alternative industries?• Does the risk for individual industries vary or does it remain relatively constant over time?

Industry Performance• Wide dispersion in rates of return in different industries• Performance varies from year to year• Company performance varies within industries• Risks vary widely by industry but are fairly stable over time

The Business Cycle and Industry Sectors• Economic trends can and do affect industry performance• By identifying and monitoring key assumptions and variables, we can monitor the economy and gauge

the implications of new information on our economic outlook and industry analysis The Business Cycle and Industry Sectors

• Cyclical or Structural Changes– Cyclical changes in the economy arise from the ups and downs of the business cycle– Structure changes occur when the economy undergoes a major change in organization or how it

functions

• Rotation strategy is when one switches from one industry group to another over the course of a business cycle

The Business Cycle and Industry Sectors• Economic Variables and Different Industries

– Inflation

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– Interest Rates– International Economics– Consumer Sentiment

The Stock Market and the Business Cycle

Structural Economic Changes and Alternative Industries• Social Influences

– Demographics– Lifestyles

• Technology• Politics and regulations

– Economic reasoning– Fairness– Regulatory changes affect numerous industries– Regulations affect international commerce

Evaluating the Industry Life CycleFive Stage Model

• Pioneering development• Rapidly accelerating industry growth• Mature industry growth

Exhibit 14.2

Financial Stocks Excel

trough

peakConsumer Durables

Excel

Capital Goods Excel

Basic Industries

Excel

Consumer Staples Excel

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• Stabilization and market maturity• Deceleration of growth and decline

Analysis of Industry CompetitionCompetition and Expected Industry Returns

– Porter’s concept of competitive strategy is described as the search by a firm for a favorable competitive position in an industry

– To create a profitable competitive strategy, a firm must first examine the basic competitive structure of its industry

–––– The potential profitability of a firm is heavily influenced by the profitability of its industry

Competitive Structure of an Industry• Porter’s Competitive Forces

– Rivalry among existing competitors– Threat of new entrants– Threat of substitute products– Bargaining power of buyers– Bargaining power of suppliers

Estimating Industry Rates of Return• Present value using required rate of return for the equity in the industry• Two-step P/E ratio approach uses expected value at the end of investment horizon and compute the

expected dividend return during the period• Valuation using the reduced form DDM

Pi = the price of industry i at time tD1 = the expected dividend for industry i in period 1 equal to D0(1+g)k = the required rate of return on the equity for industry ig = the expected long-run growth rate of earnings and dividend for industry i

Estimating the Required Rate of Return• Influenced by the risk-free rate• Expected inflation rate• Risk premium for the industry versus the market

– business risk (BR)– financial risk (FR)– liquidity risk (LR)– exchange rate risk (ERR)– country political risk (CR)

• Or compare systematic risk (beta) for the industry to the market beta of 1.0

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Estimating the Expected Growth Rate• Earnings and dividend growth are determined by the retention rate and the return on equity

– Earnings retention rate of industry compared to the overall market– Return on equity is a function of

• the net profit margin• total asset turnover• a measure of financial leverage

Industry Valuation Using the Free Cash Flow to Equity (FCFE) ModelFCFE is defined as follows:Net income+ Depreciation- Capital expenditures- D in working capital- Principal debt repayments+ New debt issuesIndustry Valuation Using the Free Cash Flow to Equity (FCFE) Model

• The Constant Growth FCFE Model

Company Analysis and Stock Valuation

Company Analysis and Stock Valuation• After analyzing the economy and stock markets for several countries, you have decided to invest some

portion of your portfolio in common stocks• After analyzing various industries, you have identified those industries that appear to offer above-

average risk-adjusted performance over your investment horizon• Which are the best companies?• Are they overpriced?

Company Analysis and Stock Valuation• Good companies are not necessarily good investments• Compare the intrinsic value of a stock to its market value• Stock of a great company may be overpriced• Stock of a growth company may not be growth stock

Growth Companies • Growth companies have historically been defined as companies that consistently experience above-

average increases in sales and earnings• Financial theorists define a growth company as one with management and opportunities that yield rates

of return greater than the firm’s required rate of returnGrowth Stocks

• Growth stocks are not necessarily shares in growth companies• A growth stock has a higher rate of return than other stocks with similar risk• Superior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks

Defensive Companies and Stocks• Defensive companies’ future earnings are more likely to withstand an economic downturn• Low business risk

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• Not excessive financial risk• Stocks with low or negative systematic risk

Cyclical Companies and Stocks• Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business

activity • Cyclical stocks are those that will experience changes in their rates of return greater than changes in

overall market rates of return Speculative Companies and Stocks

• Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain

• Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return

Value versus Growth Investing• Growth stocks will have positive earnings surprises and above-average risk adjusted rates of return

because the stocks are undervalued• Value stocks appear to be undervalued for reasons besides earnings growth potential• Value stocks usually have low P/E ratio or low ratios of price to book value

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