1. Investment and portfolio management MGT 531

2.  MGT 531   Lecture # 16

3.  The course assumes little prior applied knowledge in the area of finance.  Kristina Levišauskait (2010) ‘Investment Analysis and Portfolio Management’

4.  Why no market can be fully efficient  optimal portfolio selection  Diversification  Summary points

5.  Key-terms  Questions and problems  Chapter 4: Investment in Stocks  1. Stock as specific investment.  2. Stock analysis for investment decision making.  3.E-I-C analysis.  4.Fundamental analysis S

6.  Arbitrage, Arbitrage Pricing Theory (APT), Coefficient Beta (β)  Capital Market Line (CML) Capital Asset Pricing Model (CAPM)  Efficient frontier Efficient set of portfolios Expected rate of return of the portfolio Feasible set Indifference curves Map of Indifference Curves Market efficiency Markowitz Portfolio Theory  Market Portfolio Non-satiation Portfolio Beta Risk aversion  Risk free rate of return Risk of the portfolio Security Market Line (SML) Systematic risk Standard deviation of the portfolio  Semi- strong form of market efficiency Strong form of market  efficiency Total risk Unsystematic (specific) risk Weak form of market efficiency

7.  1. Explain why most investors prefer to hold a diversified portfolio of securities as opposed to placing all of their wealth in a single asset.  2. In terms of the Markowitz portfolio model, explain, how an investor identify his / her optimal portfolio. What specific information does an investor need to identify optimal portfolio?  3. How many portfolios are on an efficient frontier? How is an investor’s risk aversion indicated in an indifference curve?  4. Describe the key assumptions underlying CAPM.

8.  5. Many of underlying assumptions of the CAPM are violated in some degree in “real world”. Does that fact invalidate model’s calculations? Explain.  6. Under the CAPM, at what common point do the security market lines of individual stocks intersect?  7. How does the CAPM differs from the APT model?  8. What is meant by an efficient market? What are the benefits to the economy from an efficient market?  9. If the efficient market hypothesis is true, what are the implications for the investors?

9.  Mini-contents  1. Stock as specific investment.  2. Stock analysis for investment decision making.  3.E-I-C analysis.  4.Fundamental analysis.  4.1. Decision making of investment in stocks. Stock valuation  4.2. Formation of stock portfolios.  4.3. Strategies for investing in stocks.  Summary

10.  Stock as specific investment  Stock represents part ownership in a firm.  2 main types of stock (see Chapter 1)  Common stock  Preferred stock  In this chapter we focus only on the investment in common stocks.  Common stock = Common share = Equity  The main features of the common stock:  Typically each common stock owned entitles an investor to one vote in corporate shareholders’ meeting.

11.  Investor receives benefits in the form of dividends, capital gains or both.  But: dividends are paid to shareholders only after other liabilities such as interest payments have been settled;  typically the firm does not pay all its earnings in cash dividends;  special form of dividend is stock dividend, in which the corporation  pays in stocks rather than cash.  Common stock has no stated maturity.  Common stock does not have a date on which the corporation must buy it back.

12.  But: some corporations pay cash to their shareholders by purchasing their own shares.  These are known as share buy backs.  Common stocks on the whole historically have provided:  a higher return,  but they also have higher risk.  An investor earns capital gains (the difference between the purchase price and selling price)  when he / she sell at a higher price than the purchase price.

13.  the investment income is usually higher;  the investor can receive operating income in cash dividends;  common stock has a very high liquidity and can easily be moved from one investor to the other;  the costs of transaction with common stocks involved are relatively low;  the nominal price of common stock is lower in comparison with the other securities.

14.  common stock is more risky in comparison with many other types of securities;  the selection of these securities is complicated: high supply and difficult to evaluate;  the operating income is relatively low (the main income is received from the capital gain – change in stock price).

15.  Here the focus is on the fundamental analysis of common stocks.  Although technical analysis is used by many investors, fundamental analysis is far more prevalent.  By performing fundamental analysis, investor forecasts among other Things:,  the future changes in GDP,  changes serials,  other performance indicators for a number of industries and,  in particular, future sales, earnings for a number of the firms.  The main objective of this analysis for investor is to identify the attractive potential investments in stocks.

16.  Analysts and investors use two alternative approaches for fundamental analysis:  “Top-down” forecasting approach;  “Bottom-up” forecasting approach.  Using “top-down” forecasting approach the investors are first involved in making the analysis and ;  The industry forecasts are based on the forecasts for the economy and;  a company’s forecasts are based on the forecasts for both its industry and the economy.

17.  Using “bottom-up” forecasting approach, the investors start:  with the analysis and forecast for companies,  then made analysis and forecasts for industries and for the economy.  In practice “top down” approach prevail in analysis and forecasting because:  logically for forecasting of the companies performance ;  the changes in macroeconomic environment must be analyzed first.  otherwise the inconsistent assumptions could be drawn.

18.  The combination of two approaches is used by analysts too.  For example, analysis and forecasts are made for the economy using “top-down” approach and then using “bottom-up” approach continuing with the forecasts for individual companies.  But despite of the different approaches to the sequence of the analysis the content of it is based on the E-I-C analysis.

19.  E-I-C analysis includes:  E - Economic (macroeconomic) analysis (describes the macroeconomic situation in the particular country and its potential influence on the profitability of stocks).  I - Industry analysis (evaluates the situation in the particular industry/economic sector and its potential influence on the profitability of stocks).

20.  C - Company analysis (the financial analysis of the individual  companies from the shareholder approach)  The contents of Macroeconomic analysis:  The behavior of economics in the context of economic cycle (at what point of this cycle is the economy now: growth stage? peak? Decline stage? recession stage?);  Fiscal policy of the government (financial stability, budget deficit, public debt, etc.)