CSC Exam 2

Fundamental analysis

method of evaluating capital market conditions in an attempt to measure the intrinsic or fundamental value of society

• To compare intrinsic value against security’s price to determine if security is over or undervalued

Market theories

1. Efficient market hypothesis

2. Random walk theory

3. Rational expectations theory

Efficient market hypothesis

stock’s price reflects all available information and its true value

• Assumes that profit-seeking investors react quickly to the release of information

• Three variations:

  • Weak form: all past market information is fully reflected in price, tech analysis has little or no value

  • Semi-strong form: all publicly available information is fully reflected in price, both fundamental and tech analysis have little or no value

  • Strong form: all information is fully reflected in price, all investors have equal information

Random walk theory

past price changes contain no useful information as developments have already been reflected in the current stock price

• Assumes that new information regarding a stock is disseminated randomly over time

Rational expectations theory

past mistakes can be avoided by using available information to anticipate change

• Assumes that people are rational and have access to all available information

Capital market inefficiencies

• New information is not available to everyone at the same time

• Investors do not react in the same way

• Not everyone can make accurate forecasts

• Investors may act irrationally

Macroeconomic factors affecting investor expectations

1. Fiscal policy

2. Monetary policy

3. Inflation

Fiscal policy impact

Taxation: higher taxes = less disposable income and spending, reduction of dividends or expansion

Government spending: increase in spending = stimulates economy in short run

Government debt: higher levels of debt can restrict both fiscal and monetary policy options

Monetary policy impact

Bank attempts to preserve value of dollar by keeping inflation low, stable, and predictable

• Changes in monetary policy affect both interest rates and corporate profits

Tilting of the yield curve

when short term yields rise and long term yields fall from monetary policy

• Decline in long term rates reduces competition between equities and bonds 

Inflation impact

creates a widespread uncertainty and undermines confidence in the future

• Causes: higher interest rates, lower corporate profits, lower earnings, higher inventory and labour costs, lower share prices

Industry classification

1. Product or service

2. Life cycle

3. Competitive forces

4. Reaction to the economic cycle

Classifying industries: product or service

Global Industry Classification Standard (GICS): comprehensive industry and sector classification system by S&P and Morgan Stanley 

• 163 sub-industries 

Classifying industries: life cycle

1. Emerging growth

2. Growth

3. Maturity

4. Decline

Emerging growth

brand new industries in the early stages of growth, software development

• Unprofitable at first, not directly accessible to equity investors

Growth

sales and earnings are consistently expanding at a faster rate

• Common shares are called growth stocks, high price-to-earnings ratios and low dividend yields

• Above average rate of earnings, lower costs of production, high competition, rising demand and profits

Maturity

slower, more stable growth in sales and earnings that closely match overall rate of economic growth

• High price competition, falling profit margins, steady during difficult economic conditions

Decline

declining demand due to tech changes, inability to compete on price, changes in consumer taste

• Large cash flow, low profits

Classifying industries: competitive forces

1. Threat of new entry: ease of entry for new competitors

• Depends on amount of capital required, opportunities to achieve economies of scale (cost dec as production inc), regulations etc

2. Competitive rivalry: degree of competition

• Depends on number of competitors, strength, industry growth, uniqueness of product

3. Threat of substitutes

4. Bargaining power of buyers: pressure to lower prices, depends on buyers' sensitivity to price

5. Bargaining power of suppliers: pressure to pay for more resources

Classifying industries: reaction to the economic cycle

1. Cyclical

2. Defensive

3. Speculative

Cyclical industries

particularly sensitive to swings in economic conditions

• Most are large international exporters of commodities such as lumber, metals, or oil -> sensitive to changes

Defensive industries

stable earnings, continuous dividend payments, stable during recessions

• Blue chip: shares of top investment quality companies, dominant market position, strong financing and management

  • Canadian banks: though bank stock prices are relatively sensitive to changes in interest rates

  • Utility companies: generate consistent earnings over cycles

Speculative industries 

risk and uncertainty are unusually high due to a lack of definitive information

• Emerging companies

Technical analysis

method of determining future price direction of security based on past price movements

• Look at trend in stock’s price instead of fundamental attributes

Assumptions of technical analysis

1. All influences on market action are automatically accounted for or discounted in price activity

2. Prices move in trends which persist for long periods of time

3. The future repeats the past

Technical vs fundamental analysis

Tech: effects of supply and demand which are reflected in price and volume

Fundamental: causes of price movements 

Chart analysis

analysis of graphic representations of relevant market data

• Identify support and resistance levels

• Reflect market participation patterns 

Support level

bottom price of trading range where investors are willing to buy, demand exceeds supply and prices rise

Resistance level

top price of range where investors are willing to sell, supply exceeds demand and prices fall

Reversal pattern

formation that precedes a decline in stock prices

• Head and shoulders formation: can occur at a market top or market bottom

  • Top = bearish, bottom = bullish 

• Continuation pattern: current trend will continue

  • Symmetrical triangle: pause in market 

Quantitative analysis

relies on statistics and computer technology

Moving average: device for smoothing out fluctuating values in an individual stock or aggregate market, shows long term trends

• Calculated by adding closing prices over a period and dividing total by number of days in the period

• Buy and sell signals 

Buy signal

price breaks through moving average from below and line starts to rise = declining trend has reversed 

Sell signal

price breaks through moving average from above and line starts to fall = upward trend has reversed 

Sentiment indicators

measure investor expectations or the mood of the market

• Contrarian investors use to move oppositely to other investors

• Should only be used as evidence to support other technical indicators 

Cycle analysis

helps forecast when the market will start moving in a particular direction and when it will reach peak or trough

• Based on assumption that cyclical forces drive price movements

• Lengths:

  • Trading: 4 weeks

  • Primary: 9-26 weeks

  • Seasonal: 1 year

  • Long term: >2 years

Company analysis

process of examining company specific factors that can influence investment decisions

Statement of comprehensive income analysis

see if management is making good use of the company's resources

• Revenue: increasing revenue as important indicator of investment quality

• Operating costs: use gross profit margin ratio to determine changes in ability to pay operating costs

• Dividend record: shows how much it generally pays out in the form of dividends to shareholders

  • High dividend payout rate: stable earnings, declining earnings (indicate future cut), depleting resources

  • Low payout rate: growing earnings, earnings reinvested back into company's operations

Statement of financial position analysis

Capital structure: distribution of debt and equity that comprise the company’s finances

Effect of leverage: earnings are leveraged if the capital structure contains debt or preferred shares, accelerates any cyclical rise or fall in earnings

• Small increase in revenue can produce a magnified increase in earnings per common share (EPS)

Financial ratios

financial calculations based on statements, provides clues about company’s financial health

Trend ratios

identify trends by selecting a base period, treating it as 100, then dividing it into comparable ratios for subsequent periods

• May be misleading when base period is not truly representative, impossible to apply if base period is negative

Liquidity ratios

 used to judge company's ability to meet short-term commitments

• Working capital ratio

• Quick ratio/acid test

Working capital ratio

shows the relationship between current assets and current liabilities

• Current assets/current liabilities

Quick ratio

subtracts inventories from current assets, more stringent and conservative

• (Current assets - inventories)/current liabilities

Risk analysis ratios 

how well the company can deal with its debt obligations

• Asset coverage ratio

• Debt to equity ratio

• Cash flow to total debt outstanding ratio

• Interest coverage ratio

Asset coverage ratio

a company's ability to cover its debt obligations with its assets after all non-debt liabilities have been satisfied

• Tangible assets - (current liabilities - short term debt)/total debt outstanding

Debt to equity ratio

shows relationship between company's borrowings and capital invested by shareholders

• Total debt outstanding/equity

Cash flow to total debt outstanding ratio

gauges a company's ability to repay borrowed funds

• Cash flow from operating activities/total debt outstanding

• Cash flow: measure of a company's ability to generate funds internally

  • Cash flow = profits + non-cash deductions - all additions not received in cash + change in net working capital

Interest coverage ratio

ability of a company to pay interest charges on its debt based on profit available to pay interest, indicates margin of safety for interest coverage

• Considered the most important quantitative test of risk for a debt security

• Indicates only the likelihood that a company will be able to meet interest obligations

• Profit before interest charges and taxes/interest charges

Operating performance ratios

how well management is making use of company’s resources, include profitability and efficiency measures

• Gross profit margin ratio

• Net profit margin ratio

• Return on common equity ratio

• Inventory turnover ratio

Gross profit margin ratio

indication of the efficiency of management in turning over the company's goods at a profit

• (Revenue - cost of sales)/revenue 

• For calculating internal trend lines and for making comparisons with other companies

Net profit margin ratio

how efficient the company is managed after taking expenses and taxes into account

• (Profit - share of profit of associates)/revenue

Return on common equity ratio

dollar amount of earnings that were produced for each dollar invested by company's shareholders

• Profit/total equity

Inventory turnover ratio

measures the number of times that a company's inventory is turned over in a year

• Cost of sales/inventory

• High turnover ratio is good as the company requires a smaller investment in inventory

• Low ratio: inventory contains a large portion of unsaleable goods, company has overbought inventory, value is overstated

 

Value ratios

shows investor what company’s shares are worth or return

• Dividend payout ratio

• Earnings per common share (EPS) ratio

• Dividend yield

• Equity value/book value per common share

• Price to earnings ratio

• Dividend discount model (DDM)

Dividend payout ratio

percentage of company's profit that is paid out to shareholders in the form of dividends

• Common share dividends/profit x100

• Generally unstable as they are tied directly to earnings of company which change year to year

Earnings per common share (EPS) ratio

earnings available to each common share

• Profit/weighted average number of common shares outstanding

• When estimating dividend possibilities consider:

  • Amount and stability of profit, company's working capital, policies etc

Dividend yield

annual dividend rate expressed as a percentage of the current market price of the stock

• Indicated annual dividend per share/current market price x100

Equity value/book value per common share

net asset coverage for each common share if all assets were sold and all liabilities were paid

• Equity/number of common shares outstanding

Price to earnings ratio

links market price of common share to EPS, help determine a reasonable value for a common stock

• Current market price of common shares/earnings per share

• Most widely used because it combines all other ratios into one figure, allows comparison of different company shares

• P/E ratios increase in a rising stock market or with rising earnings, when investor confidence is high

  • Want to be low (undervalued)

  • Inversely related to inflation

Dividend discount model (DDM)

how companies with stable growth are priced, related stock's current price to present value of all expected future dividends

• Assumes an indefinite stream of dividend payments

• current dividend(1+g)/r-g = expected dividend/r-g

Investment quality assessment

1. Preferred dividend coverage ratio: margin of safety for preferred dividends, amount of money a firm has to pay dividends to preferred shareholders

• Higher ratio = company has little difficulty in paying preferred dividends, calculated the last 5 years

2. Equity/book value per preferred share: minimum value is at least two times the dollar value of assets that each preferred share would be entitled to at liquidation

3. Dividend payments: continuous?

4. Credit assessment: rating?

Portfolio approach

creating a diversified portfolio that allows investors to reduce risk without decreasing expected returns

Diversification

strategy that combines a variety of investments in a portfolio with aims to reduce investor’s risk of any single security 

• More diversified = closer to mirroring the market 

Capital gain

selling a security for more than its purchase price 

Cash flow

any income derived from a security in the form of interest payments or dividends

Expected return

expected cash flow + expected capital gain divided by beginning value 

Rate of return/yield

returns expressed as a percentage

• Return % = (cash flow + (ending value - beginning value)/beginning value x100

• Portfolio rate of return = (equity portion x return) + (fixed income portion x return)

• Percentage of return is also called annual rate of return

Holding period return

transactional rate of return that takes into account all cash flows and changes in value over time, can be greater or less than a year

Ex ante

expected returns, use to determine where funds should be invested

• Can expect t-bill rate plus a certain performance percentage related to risk

Ex post

actual historical returns

Risk

likelihood that the actual return will be different from actual return

• Risk/return scale: t-bills, bonds, debentures, preferred shares, common shares

• T-bills have zero risk

Types of risk

Inflation

Business

Political

Liquidity

Interest rate

Foreign investment

Default

Systematic

Non-systematic/specific

Inflation rate risk

risk that inflation will reduce future purchasing power and real return

Business risk

risk that a company's earnings will be reduced as a result of business operations (labour strike, new products, competition)

Political risk

risk of unfavourable changes in government policies, general instability associated with investing in a particular country

Liquidity risk

risk that an investor will not be able to trade a security quick enough because opportunities are limited

Interest rate risk 

risk that changing interest rates will adversely affect an investment, rising rates = falling value

Foreign investment risk

risk of loss resulting from an unfavourable change in exchange rates/drop off of liquidity/large bid-ask spreads

Default risk

risk that a company will be unable to make timely interest payments or repay principal amount upon maturity

Systematic risk

risk associated with investing in each capital market, cannot be diversified away

Non-systematic/specific risk

risk that the price of a specific security or group of securities will change in price to a certain degree or different direction from market

• Can be reduced through diversification -> eliminated by buying a portfolio of shares that consist of all stocks in index

Standard deviation

percentage gives investor an indication of the risk associated with a security or portfolio

• Commonly applied to portfolios and individual securities

• Past performance is used to determine a range of possible future outcomes (more volatile price = larger range)

• Greater deviation = greater risk

Beta

links the risk of securities to the market as a whole

• Measures the degree to which securities tend to move up or down with the market

• Greater beta = greater risk

Calculating rate of return in a portfolio

calculate return generated by each security and calculate the weighted average return on all securities

*equation

Combining securities in a portfolio

Correlation

Portfolio beta

Portfolio alpha

Correlation

statistical measure of how the returns on two securities move together over time, how a change to the value of one can predict the change in value of another

• Perfect negative correlation: when one falls and other rises, allows for a positive return with little risk (only systematic), maximum gain from diversification

Portfolio beta

measures fluctuation in returns driven by changes in the stock market

• Equity that moves up or down to the same degree as the stock market has a beta of 1, moves up more >1, moves down more <1

• Most portfolio betas indicate a positive correlation between equities and the stock market

• Industries with volatile earnings (cyclical) tend to have higher betas and defensive industries tend to have lower betas

Portfolio alpha

excess return due to skill of the advisor of manager in picking securities that outperform

Active investment strategy

goal is to outperform a benchmark portfolio on a risk-adjusted basis, compare performance of a portfolio to an appropriate benchmark

• Bottom up analysis: focus on individual stocks

• Top down analysis: study of broad macroeconomic factors, then industry-specific factors, then company specific factors to assess value of stock

Passive investment strategy

tend to replicate the performance of a specific market index

• Indexing: buying and holding a portfolio that matches the composition

• Buy and hold: securities markets are efficient, manager believes it is not possible to identify stocks as under or overpriced

Equity manager styles

Growth

Value

Sector rotation

Growth manager style

focus on current and future earnings (specifically EPS) of individual companies, will pay more if growth potential warrants higher price

• Lower dividend yield, securities are turned over more often

• Risks:

  • If EPS falters, can cause large percentage price declines

  • High portfolio volatility

  • Highly vulnerable

• Characteristics:

  • High price to earnings

  • High price to book value

  • High price to cash flow

• Based on expectations -> focus on long term investments, avoid paying too much, greater potential for capital appreciation

Value manager style

focus on stocks that are perceived to be trading for less than their value, bottom-up stock pickers with a research-intensive approach

• More successful in inefficient markets, price may be low for a good reason in efficient markets

• Risks:

  • Lower annualized standard deviation

  • Lower historical beta

  • Low stock price

• Characteristics:

  • Low price to earnings

  • Low price to book value ratio

  • Low price to cash flow ratio

  • High dividend yield

• Produces total returns similar to growth but with a higher current dividend yield and less portfolio volatility, performs best in down markets

• Requires patience: long term investment horizons, ignore short term fluctuations

Sector rotation manager style

focus on analysing prospects for the overall economy, invest in sectors expected to outperform

• Identify the current phase of the economic cycle, direction, and various sectors affected

• Buy large cap stocks to maximize liquidity

• Risks:

  • High volatility caused by industry concentration

  • Investors may significantly underperform the market benchmark, high turnover

  • Individual company stocks get overlooked -> picked stocks may not be representative of entire sector

• Concerned with trying to outperform the market averages (S&P index)

• Most basic industry rotation strategy involves shifting between cyclical and defensive industries

  • When stock prices fall: cyclical stocks fall faster, defensive fall slow and help the investor to preserve capital

 

Fixed income manager styles

Term to maturity:

• Short term: t-bills and <5 year bonds, less volatile to interest rates

• Medium term: 5-10 years, mortgage funds

• Long term: >10 years

Credit quality: lower quality = higher yield

• High yield bonds: non-investment grade/junk bonds, face greater credit risk, mature in less than 3 years

• Lower rated bonds have less liquidity than government issues

Interest rate anticipators:

• Anticipate a decrease in rates = extend average term on bond investments

• Form of duration switching: anticipate falling interest rates = sell lower duration bonds and replace with higher duration for higher capital gains

• Works best when yield curve is normal (wide gap between short and long term rates)

Portfolio management

analyzing client’s personal and financial information to determine an asset mix that best suits them (cash, fixed income securities, equities)

• Selection of securities based on their interaction with each other and contribution to the portfolio 

Portfolio management process 

1. Objectives and constraints

2. Investment policy statement

3. Asset mix

4. Select the securities

5. Monitor client, market, and economy

6. Evaluate portfolio performance

7. Rebalance

Investment objectives

1. Safety of principal: assurance that client's initial capital will remain intact

• Short term bonds and t-bills have a very high degree of security

2. Income: regular series of cash flows received from debt and equity securities

• Maximize rate of income return = give up safety when purchasing corporate bonds or preferred shares

3. Growth of capital: profit generated when securities are sold for more than cost to buy

4. (Secondary):

• Liquidity: nearly always buyers, important for investors who need money on short notice (sell within one business day)

• Tax minimization: tax treatment of returns influences the choice of investments

Securities and their investment objectives

Short term bonds: best safety, very steady income, very limited growth

Long term bonds: next best safety, very steady income, variable growth

Preferred shares: good safety, steady income, variable growth

Common shares: least safety, variable income, most growth

Types of equities

1. Conservative: low risk, high capitalization, predictable earnings, high yield, high dividends, lower price to earnings ratio, low volatility

2. Growth: medium risk, average capitalization, potential for above average growth in earnings, aggressive management, lower dividends, higher price to earnings ratio, higher volatility 

3. Venture: high risk, low capitalization, limited earnings, no dividends, low significance of price to earnings ratio, short operating history, high volatility

4. Speculative: max risk, short term, max volatility, no earnings, no dividends, no significance of price to earnings ratio