Investment Workshop Topics

1. Investment Workshop Topics • Constructing a Portfolio (Stocks, bonds, Funds, Real Estate, Tangibles) • Risk and Return – is there a trade-off? • Efficient Market Theory and Modern Portfolio Theory (MPT) • Components of MPT • Correlation • Portfolio Standard Deviation • The Efficient Frontier • Risk-adjusted Return Measures

2. Topics • Traditional Portfolio Management • Dividends • Technical Analysis • Information from financial statements • Fundamental Analysis

3. Portfolio Construction and Management • Record goals, tax situation, financial resources, liquidity requirements, risk tolerance and investment attitude. • Look at the world and national political, economic and investing climates. • Determine a strategy to develop the portfolio. • Screen potential investments to meet the needs and suit the risk tolerance. • Select investments based upon sound company fundamentals, the management team and the overall business climate.

4. Portfolio Construction and Management • Evaluate the portfolio. Reposition assets as necessary. • Determine $$ needed to meet each goal. How much must be invested and what must the return be? • Place $$ to fund the highest priority goals. • Monitor performance, situational changes (will you be having kids, retiring, paying for a wedding, going on vacation, etc.) changes in the economy. Revise the portfolio accordingly.

5. Risk and Return • Risk: The uncertainty of return vs expected. • Return: What you get for your invested money • Appreciation of asset value • Interest • Dividends • Rent received

6. Types of Risk Systematic Risk • Stems from events such as war, inflation, recession and high interest rates. These events have an impact on all business simultaneously. Therefore, you cannot reduce this risk through diversification. • Market Risk – A type of systematic risk where investor psychology changes. Corporate earnings may be declining, so even though all company earnings are not bad, they all go down.

7. Systematic Risk • Interest Rate Risk - Variation of interest rates. • Reinvestment Rate Risk – Interest rates decline. When bonds mature, the money has to be reinvested at the lower rates. • Purchasing Power Risk – Rising inflation reduces future purchasing power. • Exchange Rate Risk – If the dollar increases in value vs another currency, investments denominated in that currency will decrease in value.

8. Types of Risk • Unsystematic Risk -- This is diversifiable risk. It arises from factors unique to a particular business. • Business Risk – How a firm makes money, its competition, potential for strikes, etc. • Financial Risk – Debt vs equity financing. Debt increases the fixed costs of a firm. If sales decline, fixed costs stay, profits decline. • Default Risk – Issuer of bonds may not pay the obligation

9. Defining Risk • Variability of Returns • Measure total Risk by Standard Deviation • Represented by the Greek Letter Sigma () •  is really the dispersion of returns around the mean or expected mean. Outcomes tend to cluster around the mean; a bell curve can be used to represent outcomes. This "normal" curve is useful in determining probabilities of outcomes.

10. Beta () • Measure Systematic risk by Beta (). It assumes that unsystematic risk has been diversified away. How? • Indicates how the price of a security responds to market forces. Plot historical returns of the security vs. historical returns of the market. The slope of the line is . • Beta for the market is 1.0 (whichever market you use as a reference).

11. Beta () • The greater the , the more volatile the stock or fund. • With a higher , the expected return should be higher (Risk vs Return).

12. Coefficient of Determination • R2 is called the Coefficient of Determination. It tells you how good your Beta is, or whether you should use Beta at all. When viewed against the market, it tells how much of the portfolio risk is systematic.

13. Required Return • What you think the investment will earn in the future, in terms of income and capital gains. The more uncertain the investment is (more risk), the higher the required return should become. This added expectation is the risk premium. • You could go into an investment deciding what your minimum requirement is or you can do it by formula.

14. Capital Asset Pricing Model (CAPM) • Developed by Sharpe and Lintner. It is an equation relating the required investment return to the risk free rate, the market premium and . Ri = Rf + (RM -Rf)  Where RM is the market return, Rf is the risk free rate and Ri is the required return. The return we calculate is the discount factor we should apply to future earnings to determine value.

15. Efficient Market theory • Markets are so efficient that stock prices are properly valued and thus investors cannot consistently outperform the market. Reasons: • There are a large number of profit maximizing participants concerned with analysis and valuation of securities operating independently of each other. • New information is widely available and random.

16. Efficient Market theory • Stock prices adjust rapidly in response to the new information • Therefore stock prices represent past and current news, as well as future projections. Weak Form • Past prices are of no use in predicting future price changes (i.e., technical analysis is no good). Prices follow a “random walk.”

17. Efficient Market theory Semi-strong Form • Asserts that large, abnormally high profits cannot be earned consistently using publicly available information, because stock prices adjust so quickly to new information (therefore, technical and fundamental analysis is no good).

18. Efficient Market theory Strong Form • There is no information, public or private that allows investors to consistently earn abnormally high profits. Thus, even insider info is of no long-term benefit.

19. Modern Portfolio Theory (MPT) • Portfolioconstruction is based on statistical measures, such as expected returns, standard deviation and correlation. • Diversification is reached by combining assets that have returns of negative or low correlation between them. • Practically we look at Beta and R2, theoretically we can also look at the efficient frontier.

20. Modern Portfolio Theory (MPT) • If assets are perfectly correlated, their combination cannot produce a standard deviation below that of the least risky asset. The maximum standard deviation will be that of the riskiest asset. • Diversification is the key to constructing a portfolio

21. Diversification How do we Diversify according to MPT? • Select assets which are not affected the same way by similar events.That is, those investments whose returns do not correlate with each other. • Correlation: Statistically determined and measured by the correlation coefficient (r). It is the extent to which variables move in concert; (r) has a range from -1.0 (perfect negative correlation) to +1.0 (perfect positive correlation). A value of zero means no correlation exists between the variables.

22. Correlation Look at a Two-asset Portfolio Standard Deviation. Each asset has a mean return (μ) and a standard deviation() and you mix the assets in some proportion (from 0% to 100% or 0 to 1.0). The mean return is linear: Return = [a x μ1] + [(1-a) x μ2] but the standard deviation is not linear. It is: 12 = [a2 12 + (1-a)2 22 + (2 a) (1-a) (1 )(2 )(r12)]1/2

23. Correlation • As the correlation decreases from 1 to something less than 1, the total standard deviation decreases, in effect reducing the overall portfolio risk. • Note what happens if the correlation coefficient is zero or negative. • What are the implications?

24. Two Assets

25. Two Assets • Correlation of +0.4

26. Two Assets • Correlation of 0

27. Two Assets • Correlation of -0.8

28. The Efficient Frontier Developed by Markowitz, an efficient portfolio gives the highest return for a given risk level, or a minimum risk for a given return. Values below the frontier are a feasible set, but not as good as those lying on the frontier. Anything above the frontier is not feasible.

29. Modern Portfolio Theory (MPT) • MPT assumes investors are risk averse or low risk investors. • Portfolio risk can be reduced more by investing internationally in the same industry than by diversifying across industries within one country. • There is greater risk reduction if you diversify across industries, across countries and across asset classes.

30. Risk Adjusted Performance • What we look for with MPT are the highest risk adjusted returns. We find these using Sharpe & Treynor Measures, as well as with Jensen’s Alpha.

31. Sharpe Measure Return of Portfolio – Risk Free Rate Sm = ------------------------------------ Standard Deviation

32. Treynor Measure Return of Portfolio – Risk Free Rate Tm = ------------------------------------ Beta What is the difference between the two?

33. Jensen’s Alpha •  = (portfolio return -Rf) -[(beta) *(Market return -Rf)] or, written another way:  = Portfolio Return – Expected return (per CAPM) • An  greater than 0 means the portfolio earned an excess return above the required rate, given its systematic risk (as determined by Beta).

34. Traditional Portfolio Management • Balance the portfolio by mixing a wide variety of stocks and bonds. • Diversify across many industries and use ratio analysis, dividend growth models, dividends and earnings analysis, etc. when choosing securities for the portfolio. • Tend to invest in more blue-chip companies because: • They are stable and will most likely stay around. • They pay dividends. • Their shares are more marketable and are available in larger quantities. • They have proven management • They have earnings

35. Words to Live By? 1. Figure out what a company is worth. 2. Determine how much the stock market is asking for the business. 3. Invest based upon the difference between 1 and 2. 4. Wait for the market to realize and correct its mistake.

36. Stock Values • Par Value - the stated or face value of the stock. There is no real meaning except in some complicated circumstances. • Book Value - Represents the amount of shareholder equity in the firm. It is assets minus liabilities and preferred stock. • Market Value - Price of a stock in the market. What the market thinks a share is worth. • Market Capitalization - Market price x shares outstanding.

37. Dividends and Capital Gains Types of Dividends • Cash Dividends - Dividends paid in cash to holders of record. This is treated as ordinary income to the person receiving the dividend. • Stock Dividends - Dividends paid in the form of additional shares of stock (e.g., a 20% stock dividend means your 100 shares will now be 120). The downside is that the market value of the shares will typically be the same; the stock price will adjust for the dividend. The upside is that there is no tax until the stock is sold.

38. Dividends and Capital Gains • Stock dividends change the equity section of the balance sheet. They cause a transfer from retained earnings to common stock and paid in capital. • Stock dividends indicate to investors that earnings are being retained for future growth.

39. Stock Splits • Increases or decreases the number of shares outstanding by giving the holder a certain number of shares for each share the holder owns. • Stock splits can be used to enhance a stock's trading appeal by lowering the market price (or raising the price if a reverse split). • Stock splits do not change the equity section of the balance sheet, other than the par value of the stock.

40. Dates to Remember • Declaration Date - Public announcement that a dividend will be paid. The company will also announce at this time the holder of record date. • Holder of Record Date - Date on which an investor must be a registered shareholder to be entitled to receive a dividend. • Ex-dividend Date - The first day the stock no longer carries the right to the dividend. This is three business days prior to the holder of record date. • Payment Date - Actual date when the company mails dividend checks to holders of record.

41. Interest Rates • The return on debt capital • Rate = Real rate + inflation premium + default risk premium + liquidity risk premium + maturity risk premium (term premium) • Risk Free Rate (Rf) = Real Rate + Inflation Premium

42. Technical Analysis • Looks to predict short-term price movements based on past price movements. These movements can be based on several factors: • Supply and demand. • Irrational and rational behavior or investors (Greed and panic). • Trends in stock prices over time. • Shifts in supply and demand which changes a trend.

43. Common Stock Valuation Common Stock Equity capital. Each share entitles the holder to an equal ownership position, the right to earnings and dividends, an equal vote and an equal voice in management.

44. Fundamental Analysis Applies formulas and/or ratios to determine the value of a stock, either on an absolute or relative basis. An investor can then compare the value to the market price to determine if the stock is selling at a premium or a discount. The value can also be compared to the required rate of return of the investor to determine if it should be included.

45. Information Gathering Where do we find the information we need to make the right decisions? • Balance Sheets • Income Statements • Cash Flow Statements

46. Balance Sheet The statement of a company's assets, liabilities and shareholders equity. Assets = Liabilities + Equity

47. Income Statement Operating results of the firm. It is a summary of the amount of revenues, cost and expenses incurred and the company's profits incurred over a period of time.

48. Cash Flow Statements Provides a summary of the firms cash flow and changes in cash position • Cash from operations • Cash from investing activities • Cash from financing activities Cash flow from operations is the amount of money a company actually takes in as a result of doing business.

49. Using Financial Ratios • Price to Book Value= Price / (assets – liabilities – preferred stock), or Price / shareholder equity. This is the value determination if the company went bankrupt today and the assets were liquidated to shareholders.

50. Liquidity Ratios Current Ratio = Current Assets / Current liabilities Can the firm cover its current liabilities with current assets? Quick Ratio (or acid test ratio) = (Current Assets-Inventory) / Current Liabilities Excluding inventory can the firm cover its current liabilities with current assets. Why is this important?