Financial Concepts and Investment Strategies

Kelly's Office Hours

• Kelly will hold office hours tomorrow night from 4 to 6 PM on Zoom.

Exchange Traded Funds (ETFs)

• ETFs are passively managed.

• This means no portfolio manager is actively making decisions to buy or sell specific stocks (e.g., Apple) within the ETF (e.g., QQQ).

• Professional money managers must adhere to a prospectus, similar to a company's prospectus when going public, outlining the fund's objectives and investment guidelines.

• Mutual funds typically require a minimum investment (e.g., $1,000$).

• Due to professional management, mutual funds incur fees, such as expense ratios.

• Mutual funds often employ diverse strategies, possibly utilizing derivatives and leverage.

Leverage

• Leverage involves using borrowed capital to amplify investment exposure.

Hedge Funds

• Hedge funds aim for high returns.

• They are typically available only to accredited investors.

• An accredited investor meets specific income or net worth criteria:

  • Earning $250,000$ or more in the past two years.

  • Having a net worth exceeding $1,000,000$, excluding their primary residence.

Real Estate Investment Trusts (REITs)

• REITs are companies that own or finance income-producing real estate across a range of property sectors.

• A REIT is formed when a company puts all of its real estate holdings into the REIT.

• Storage facilities example: A real estate company with storage facilities could place these facilities into a REIT.

• Investors can purchase shares of a REIT, entitling them to a portion of the REIT's income.

• REITs are required to distribute a significant portion (e.g., $95$%) of their taxable income to investors.

Portfolio Risk

• Portfolio risk calculation can be performed in Finance classes (e.g., in 2010).

• To build an effective portfolio, it is essential to include uncorrelated assets.

• Uncorrelated assets are those whose performance is independent of each other (e.g., oil prices and a software company with remote workers).

• Asset-specific risk, or unsystematic risk, affects individual companies (e.g., labor strikes, parts shortages).

• Diversification helps to minimize unsystematic risk.

• In a well-diversified portfolio, the impact of unsystematic risk is minimal.

• Systematic risk affects the entire market.

Risk and Return

• The systemic risk principle states that bearing risk should be rewarded, but unnecessary risk should not be taken.

Beta Coefficient

• Each stock has a beta coefficient that indicates how volatile its price is relative to the market.

Role of Financial Institutions

• Financial institutions facilitate the allocation of capital between savers (investors) and users (companies).

Investment Banks

• Investment banks connect buyers and sellers of securities.

• Investment banks generate revenue through various activities:

Research

• Providing research on publicly traded stocks by analysts.

Bid-Ask Spread

• The bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask).

• Investment banks profit from this spread.

Proprietary Trading

• Proprietary trading involves investment banks trading with their own capital.

• Prop traders, or the prop desk, execute these trades, often specializing in specific stocks or industries.

• These traders typically employ short-term technical trading strategies.

Entrepreneurship and Funding

• Raising capital involves different stages or rounds (e.g., series A, B, C).

Friends and Family Round

• An attorney typically creates a document specifying the terms for investment (e.g., $1,000$ for 25 shares).

• This is common when seeking funding from acquaintances, as banks may be unwilling to provide loans due to lack of assets.

Angel Investors

• Angel investors are individuals who invest in early-stage companies, often based on personal connections or interest.

Private Equity vs. Venture Capital

Venture Capital (VC)

• VC firms typically invest in earlier stages of a company.

• They usually take a minority stake (less than 50%) in the company.

• VCs often want their investment to vest over four years.

• They seek a higher return due to the increased risk of early-stage companies (e.g., 50% return in five years).

• VCs invest smaller amounts of capital.

Private Equity (PE)

• PE firms typically invest in later stages (e.g., round C, round D).

• They often take a majority stake (over 50%) and want a board seat.

• PE firms may aim to buy out the company.

• PE firms invest larger amounts of capital.

• They expect a lower return than VC firms due to the reduced risk (e.g., 35% return).

• Both VC and PE firms have clients they are looking out for, that help them raise money.

Blurring Lines

• PE firms may establish VC divisions to invest in earlier-stage companies.

• VC firms may seek to invest in companies for a longer period, leading to raising more capital.

Raising Capital (Series C)

• When raising capital (e.g., $1,500,000$ in a Series C round):

Covering the Cost of Capital

• Companies must generate sufficient revenue to cover the cost of capital raised.

• Example: WeWork needed to expand rapidly to generate revenue to cover the cost of capital from investors (e.g., SoftBank).

• WeWork's revenues suffered because they could not buy real estate fast enough to entice renters.

Initial Public Offering (IPO) Process

• Before an IPO, a preliminary prospectus is prepared, outlining the company's details and the number of shares to be distributed within a specific price range.

• A lead underwriter (e.g., JPMorgan) is selected to manage the IPO.

• The lead underwriter forms a syndicate of other banks to share the risk and responsibilities.

Syndicate Banks

• Syndicate banks receive compensation (lower than the lead underwriter's fee) for their participation.

Flotation Cost/Spread

• The flotation cost, or spread, is the difference between the price the bank pays for the shares and the price at which the shares are sold to the public.

Firm Commitment

• In a firm commitment, the bank agrees to purchase a specific number of shares at a predetermined price.

• If the bank cannot sell all the shares, it owns the remaining shares.

Dutch Auction

• In a Dutch auction, the company presents a prospectus to asset managers, specifying the number of shares to be sold and the price range.

• Buyers then submit bids for the number of shares they want at a specific price.

• The company compiles a book of orders and determines the final price based on the demand.

Weighted Average Cost of Capital (WACC)

• There are WACC questions on the exam, including questions about 'Cat's Creative Flowers' and 'Mini House'.

• These questions include debt, preferred stock, common stock and market information.

• There are 6-7 WACC questions so the recommendation is to finish the whole thing instead of answering them individually as you go.