1. 1 Investments: Introduction Business Administration 365 Professor Scott Hoover

2. 2 Syllabus  Contact information no calls after 9PM except for emergencies  Course website  Readings Books available online (Amazon, Barnes and Noble, etc.)  Prerequisites You must have already completed BUS 221—no exceptions!  Learning objectives Security Analysis

3. 3  Course Design heavy on class discussion and group work you may not use (in any way) any materials from prior terms except as authorized by me  Assignments two exams two major homeworks one course project  Grading there will almost certainly be a curve

4. 4 Investments  definition: Investing involves the commitment of cash today for the chance of more cash at some future date.  Three primary elements Cash flow Time Risk

5. 5 The Investment Process  1. Establish Investment Policy  2. Analyze Securities  3. Build a Portfolio  4. Continual Monitoring and Updating of Portfolio  5. Performance Evaluation

6. 6  Can we beat the market? How can we earn abnormal profits when information is revealed? Two possibilities  …be among the first to obtain the information  …be among the best to interpret the information  Is this enough? No…..  Not only must we correctly identify mispriced stocks, but the market must correct the mispricing at some future date.  example: short sales of Amazon stock  example: Tulip Bulb Craze (Netherlands, 1620-1637)

7. 7  Cautions Things are not always as they seem  Example: Mike Jackson duplexes  Example: Are declining asset prices good or bad for investors?  A good idea and good management do not necessarily make a good buy. We want underpriced companies (which are not necessarily well-run companies).  Example: Best Buy

8. 8 We tend to overestimate our abilities.  Establish 90% confidence intervals for the following items.  1. What is the average weight of the adult blue whale, in pounds?  2. In what year was the Mona Lisa painted by Leonardo da Vinci?  3. How many independent countries were there at the end of 2006?  4. What is the air distance in miles between Paris, France, and Sydney, Australia?  5. How many bones are in the human body?  6. How many total combatants were killed in WWI?  7. How many books were in the Library of Congress at the end of 2006?  8. How long, in miles, is the Amazon River?  9. How fast does the earth spin (in mph) at the equator?  10. How many transistors are in the Pentium III computer processor?  Adapted from The Psychology of Investing, by John Nofsinger

9. 9  Answers  1. …weight of blue whale: 250,000  2. … date of Mona Lisa: 1513  3. … independent countries: 192  4. … air distance, Paris to Sydney: 10,543  5. … bones in human body: 206  6. …combatants killed in WWI: 8.3 million  7. …books in Library of Congress: 20,532,692  8. …length of Amazon: 3,969 miles  9. … speed at equator: 1,044 mph  10. …transistors in Pentium III: 9.5 million  If you accurately estimate your abilities, you will get nine of the ten items correct on average. What can we infer because nearly everyone gets fewer than 9 correct?

10. 10 Key Concepts  Market Efficiency def’n: An abnormal return is the return above that which would compensate investors for the relevant risk associated with the investment. def’n: A market is said to be efficient if we cannot expect to earn abnormal returns consistently. Open question: Are markets efficient?

11. 11  Replicating portfolios replicating portfolio  a portfolio that has future payoff/value distributions that are identical to the asset/portfolio being replicated. Example: A 4-year U.S. Treasury Bond pays 4.6% annual coupons. U.S. Treasury Strips are available with maturities on the same dates that the bond payments will be paid. How could we replicate the payoffs on the bond?

12. 12  Indifference Suppose we are indifferent between two things. What can we say about their values?  Indifference  Identical Values  Example: Revisiting our previous example, for what price should the Treasury bond sell?

13. 13  Arbitrage Suppose that two items are identical, but are priced differently. What would we do? Example: Suppose iPhones are selling in Lexington for $399 and in Roanoke for $299.  Your business: Buy phones in Roanoke, drive them to Lexington and sell them.  What would happen over time?  Prices in Roanoke would increase (higher demand)  Prices in Lexington would decrease (higher supply)  The opportunity would disappear when the prices converged.

14. 14  Revisiting our Treasury bond example, what would happen if the cost of the replicating portfolio differed from the cost of the bond? def’n: an arbitrage portfolio is one that satisfies three conditions  1. zero net investment  2. zero risk (i.e., zero probability of losing money)  3. positive expected payoff No Arbitrage Condition: Arbitrage opportunities cannot exist in equilibrium.  As we will see later, this is a valuable tool in asset pricing.

15. 15  Implied Returns implied return  the interest rate that makes the present value of the expected cash flows equal to the current price. Example: A security is expected to pay cash flows of $100 in one year, $200 in two years, and $300 in three years. If the current price of the security is $500, what is the implied return?  $500 = $100/(1+R) + $200/(1+R) 2 + $300/(1+R) 3  This gives us R = 8.21% In some settings, the implied return is called the internal rate of return.

16. 16  Implied Growth Rates implied growth  the growth rate that makes the present value of the expected cash flows equal to the current price. Example: A security is expected to pay a cash flow of $100 in one year, followed by constant growth forever. If the current price of the security is $1200 and the appropriate discount rate is 10%, what is the implied growth rate?  Recall the perpetual growth formula V = C/(R-g)  $1200 = $100/1.1 + $100×(1+g)/1.1 2 + $300×(1+g) 2 /(1+R) 3 + … = $100/(0.1-g)  Solving gives us g = 1.67%.

17. 17 Who values stocks?  Investors individuals asset managers  Corporate managers  Financial analysts investment bankers research analysts  Economic policymakers

18. 18 Perceptions and Reality  Good companies vs. good stocks We want cheap companies, not necessarily good ones.  Growth vs. value The two are one and the same!  Earnings vs. cash flow earnings ≡ accounting profits cash flow ≡ actual profits The average investor focuses on earnings; the great investor knows that cash flow is more important

19. 19  Large companies vs. small companies Large companies tend to be widely followed.   less likely to be mispriced. Small companies are not so widely followed.   more likely to be mispriced.  Few stocks vs. many stocks Few stocks are easier to monitor, but many stocks provide a diversification benefit. In theory…a portfolio of few stocks will outperform one with many stocks, all else equal.  Why? Empirical evidence  Funds holding fewer stocks tend to outperform funds holding more stocks.

20. 20  Concentrated portfolios vs. broad-based portfolios Concentration requires an analysis of the pricing of the industry, not just of the stocks in an industry. A broad-based strategy allows investors to take advantage of relative valuation.  This is a much easier task.   Generally speaking, we should prefer to hold stocks from many different industries.