Applied Fundamentals of Investing Midterm

Fiscal vs. Monetary Policy

• Fiscal Policy: how much money it spends

- roads, bridges, defense spending, COVID stimulus, unemployment assistance

• Monetary Policy: money supply

- raise or lower interest rates; increase/decrease bank reserves (aka manipulate)

Interests rates have been…

• interest rates have been declining

• the FED has been CUTTING interest rates

How are interest rates determined?

• the FED

• the FED cuts rates

When interest rates are LOW economic growth tends to be…

• higher

When interest rates are HIGH economic growth tends to be…

• lower

Risk free rate

• the interest rate an investor can expect to earn on an investment that has 0 risk

Fed Dual Mandate

• Full employment

• Price Stability (moderate inflation)

• balance between economic growth and inflation

What is the wanted unemployment rate?

4%

What is the wanted inflation rate?

2%

Fed funds rate?

• the target interest rate set by the Federal Open Market Committee at which commercial banks borrow and lend their excess reserves to each other overnight

Current fed funds rate?

• 3.5-3.75

2 most widely watched economic factors when it comes to the actions of the fed?

• employment report (job growth/unemployment rate)

• CPI (measures prices overtime that consumers pay)

Duty of the fed?

• balance between economic growth and inflation

How does the Fed manage monetary policy?

• lower interest rates for stronger economic growth

• raise interest rates for slower economic growth

Expected rate actions 2026?

• reduce rates

Buy vs. Sell side

• Buy: Buy securities and assets for their own or their client’s accounts (mutual fund, pension fund, hedge fund)

• Sell: investment bankers who serve as intermediaries between issuers of securities and investing public, analysts who perform stock research and make ratings

Which side was salopek on?

• Buy side

What is important to note about legal and ethical?

• just because something is legal does not make it ethical

• ethical behavior is often distinguished from legal conduct by describing legal behavior as what is required and ethical behavior as conduct that is morally correct

Knowledge of the law?

• Members and candidates must understand and comply with all applicable laws, rules, and regulations of any government, regulatory organization, licensing agency, or professional association governing their professional activities. In the event of conflict, Members and Candidates must comply with the more strict law, rule, or regulation. Members and Candidates must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, or regulations.

• ignorance is not an excuse!!

Objectivity

• members and candidates are personally responsible for maintaining independence and objectivity when preparing research reports/making investment recommendations

• recommendations must convey the member’s true opinions free from bias

• you can not accept gifts and then vote in favor for something you disagree with

Insider trading

• buying or selling a stock based on BOTH material and non-public information

Something is material if…

• would significantly affect the stock price

Neutral Rate

• interest rate that balances full employment + price stability

Current fed estimate of neutral rate?

• around 3.0%

Accommodative vs. Restrictive

• Accommodative: current fed funds rate below neutral rate

• Restrictive: current fed funds rate above neutral rate

• we are currently restrictive

Bull market

• a period of several months or years in which asset prices are rising

• an increase of 20% from a market trough

Bear market

• decline of 20% from a PEAK in a market

Correction

• decline of 10% from a PEAK in a market

We are currently in what kind of market?

• Bull market

What is the belief about market efficiency?

• Behavioral theorists believe that cognitive errors by investors can cause market efficiencies

• MARKETS ARE NOT EFFICIENT

Traditional Finance Theory

• traditional finance theory ignores how real people make decisions

• info or processing errors lead to inconsistent decisions

• believe markets are efficient

Loss aversion

• refers to the tendency for people to strongly prefer avoiding losses rather than acquiring gains

• losses loom larger than corresponding gains

Risk seeking vs. risk averse

• Risk seeking: willing to gamble/take on high volatility for a higher reward

• Risk averse: prefer a guaranteed lower return over a higher, uncertain return

Scores for risk tolerance

• higher score indicates high risk tolerance/risk seeking

• lower score indicates low risk tolerance/risk aversion

Framing

• when our decisions are influenced by the way information is presented

• ex: how something is worded

Anchoring

• the common human tendency to rely too heavily on the first piece of information offered (the anchor) when making decisions

• ex: sale price in big font, price highlighted next to others

Recency Bias

• a cognitive bias that may lead us to make investment decisions that are based on recent conditions that we extrapolate into the future

• ex: focusing only on recent performance

Confirmation Bias

• the tendency to accept evidence that confirms our beliefs and reject evidence that contradicts them

• we tend to seek out information that supports our beliefs

Overconfidence

• observed when people’s subjective confidence in their own ability is greater than their objective (actual) performance

Snake bite effect

• refers to the unwillingness of investors to take a risk following a loss

Herding

• the tendency for an individual to mimic the actions of a larger group

Investment Philosophy

• a set of beliefs that guides an investors approach to selecting investments

• guiding principles that shape how you make decisions

Warren Buffet Philosophy

• wonderful business at a fair price

• invest in what you know

• invest as an owner of the business

• economic MOAT

• margin of safety

Wide economic moat?

• want company with high level of profitability

Margin of safety?

• only purchasing securities when their market price is significantly below their intrinsic value

Who was Peter Lynch and what was his investment philosophy?

• Legendary manager of Fidelity Magellan Fund

• invest in what you know

• do your own research (good product DOES NOT MEAN good stock)

• tenbaggers can be powerful

Hawkish vs. Dovish?

• Hawkish: member who is more concerned with inflation than growth

• Dovish: member who is usually more concerned with growth than inflation

What does the VIX measure?

• widely used measure of market risk

• measures expected market volatility in the S&P 500 over the next 30 days

VIX calculation and interpretation?

• take current VIX and divide by 12 for %

• % change in the S&P 500 over the next 30 days

• higher VIX means FEAR

• lower VIX means complacency

• average vix is 20

Market Risk premium?

• the additional return the you require OVER the risk free rate to take the risk of investing in the equity market

What does the VIX tell you about the market risk premium?

• around 4% - 7% probs closer to 4

• higher VIX means higher market risk premium due to volatility

Investment style

• closely linked to your investment philosophy

• in a function of your tolerance for risk

• 2 types growth and value

Value investing

• companies that are undervalued by the market and trading at a discount to their intrinsic value

• lower P/E ration

• lower P/B ratio

• slower earnings growth

• higher dividend yields

Growth investing

• companies they believe will generate superior long term earnings growth, higher than the consensus growth rates implicit in their share price

• higher P/E ratio

• higher P/B ratio

• Faster earnings growth

• low dividend yield

FCF yield investing

• look at FCF/market price per share

• generating excess cash

• removes distortion of GAAP accounting

• sweet spot 4-7%

Why FCF?

• company is self funding

• generates excess cash (higher reinvestment and return to shareholders)

• removes distortion of GAAP accounting

Salopeks simple investment philosophy?

• BUY GOOD COMPANIES, IN GOOD

  BUSINESSES AT THE RIGHT PRICE!

FCF vs. EBITDA vs. GAAP?

• FCF: cash based shows true liquidity

• EBITDA: shows earnings before interest, taxes, depreciation, and amortization; ignores cash of buying assets

• GAAP: provides strict view under accounting rules; less accurate than FCF for determining cash health

Bobby Murphy who is he?

• worked for Vela Investment Management

Bobby Murphy Investment style?

1) Value Centric- buy a $1 for 80 cents

2) experienced investors

3) long-term temperament- everything they do is a 5 term lens

4) alignment of interests

• is a VALUE INVESTOR

Hedge Funds

• a private investment fund that pools capital from a limited number of sophisticated individuals or institutional investors

How are hedge funds different from mutual funds?

• hedge funds are private investment pools they are much less regulated than mutual funds

Perfomance Mutual vs. Hedge Funds

• Mutual funds: relative performance (measured versus an index)

• Hedge Fund: absolute return (make money or don’t)

Fees Mutual vs. Hedge Funds

• Mutual Funds: percentage of assets 2%

• Hedge Funds: 2% management fee + 20% performance management fee on profits

Management for Hedge funds vs. Mutual Funds

• Hedge: actively managed, loosely regulated, accredited investors, CAN SHORT + USE DERIVATIVES

• Mutual: highly regulated, publicly available

Investors for Mutual vs. Hedge Funds

• Hedge Funds: cater to accredited high net worth investors seeking returns through aggressive strategies

• Mutual Funds: open to general public

Ohio State endowment

• Vish was the presenter and manages it

• donations and money helps fund new innovations at OSU

• those who donate can decide where the money goes

• includes public, private equity, and hedge funds

Short selling

• benefit from a decline in the stock price

You short 100 shares and $25. You are correct and the stock goes to $17. You cover the short. The short sale is…?

• 25-17=$8

• 100×8= $800

Risks of short sales?

• potential gain is 100% while potential loss is INFINITE (asymmetric outcome)

Short sales cost?

• broker will charge you a FEE for borrowing shares

• you are required to put cash collateral in your account usually 50%

Short squeeze and how to identify it?

• unexpected rise in the price of a heavily shorted stock prompts large numbers of short sellers to exit positions by buying the stock, thus driving the price up further

• short interest= shares short/shares outstanding

Tactical vs. Structural?

you think the price of a stock is going to go down…

• tactical: short term 1 week to 1 quarter

• structural: 1 to 2 years (longer term implosion)

Why is Macro opinion important?

• every company is impacted by secular and cyclical dynamics

• it is the job of an analyst to identify both and understand these forces

• depending where we are in the business cycle will have an impact

Secular vs Cyclical?

• Secular: trend that persists over a long period of time

• Cyclical: moves with business or economic cycle

Business cycle approach?

• business cycles: recurring cycles of recession and recovery

• peak: transition from end of expansion to start of contraction

• trough: transition point between recession and recovery

How to position portfolio in cyclical vs. defensive cycle?

• Position your portfolio by tilting toward cyclical stocks (energy, materials, industrials) during economic expansion to maximize growth

• shift to defensive sectors (staples, healthcare, utilities) during contractions to protect against volatility.

• Cyclicals thrive on growth, while defensives provide stability in downturns

Cyclical vs. Defensive industries?

• Cyclical: above average sensitivity to state of economy

• Defensive: below average sensitivity to state of the economy

GDP what it measures?

• A measure of how fast the economy is growing/declining (market value of goods/services)

Components of GDP?

• personal consumption expenditures (goods/services)

• business investment

• government spending

• net exports of goods and services

Dual Mandate of Fed?

• Full employment

• Price Stability

• unemployment rate=4% and inflation rate=2%

CPI measures…?

• measures monthly change in price for a figurative basket of goods and services

What does employment report measure?

• full employment

• measures percentage of labor force that is unemployed and seeking work

What does a steep, flat, and inverted yield curve mean in terms of bond market expectations?

• Steep: improving economic growth and or higher inflation (fed will raise rates)

• Flat: expect slowing economic

• Inverted: recession (fed will cut rates)

What does steep, flat, and inverted look like?

• Flat: straight line across

• Steep: rising quickly upward

• Inverted: trending to right and downwards

How to measure steepness of yield curve?

• 2 year 10 year spread

• (subtract 10 year - 2 year)

• + 1.2% steep

• 1.2 is normal

• 0-.99 is flat

• negative number means inverted

What do Junk Bond Spreads measure?

• used as a measure to evaluate the overall credit market

• can reflect the market opinions of future economic conditions

What does a higher (widening) junk bond spread mean? What does a smaller/narrowing junk bond spread mean?

• Widening: higher default risk; lower economic growth (interest rates on junk bonds go up)

• Narrowing: default rates will decrease; lower risk and greater economic growth (interest rates on junk bonds go down)

Current junk bond spread and interpretation?

• current junk bond spread: 3.17

• slides said 3.96

• optimistic or confident about future economic state

What is NIM?

• NET INTEREST MARGIN

• 10 year treasury rate- deposit rate

Secular change?

• trend that persists over a long period of time

• is not influenced by economic cycle

Dividend

• distribution of a portion of a company’s earnings to shareholders of its stock

Dividend yield formula?

Dividend Yield= dividend/price per share