INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT

1. INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT SATURDAY MAY, 2010 by Fisayo Olowu (07034001681) AGM, ADHL

2. PART ONE: INVESTMENT ANALYSIS • DEFINITION OF AN INVESTMENT: An investment is the current commitment of money or other resources in expectation of reaping future benefits. The themes (to be discussed later), the risk-return trade-off and the efficient- pricing of financial assets are central to the investment process. • We have real assets: the land, buildings, machines, and knowledge that can be used to produce goods and services, and financial assets which are claims to the income generated by real assets. In other words, financial assets simply define the allocation of income or wealth among investors. Individuals can choose between consuming their wealth today or investing for the future. • INVESTMENT ALTERNATIVES: The various investment opportunities available to an investor are financial assets. These include • Non-marketable Financial Assets: Bank deposits – Has high liquidity, loans can be raised against them. • Company deposits – loans can also be raised against them • Provident Fund deposits: i.e. Provident Fund Scheme

3. OTHER FINANCIAL ASSETS Equity Shares: These represent ownership capital. Blue Shares. Income Shares. Speculative Shares. Bonds: Bonds or debentures represent long-term instruments. Government Securities – Tax advantage Debentures of private sector companies- could be convertible Preference shares –hybrid of debt and equity. Money market instruments: They are debt instruments with less than one year maturity. Treasury Bills- no credit and price risk Commercial Papers – short-term, unsecured note Certificates of deposits – risk-free, Mutual Funds – They are sold through underwriters to investors. Here one will invest in equity share & fixed income securities.

4. OTHER FINANCIAL ASSETS Life Insurance: This can be viewed as an investment. Insurance premiums represent the sacrifice and the assured sum, the benefit. The important types of insurance policies are: Endowment assurance policy; Whole life policy; Term assurance policy. Real Estate: Here, the assets usually considered include residential house; Agricultural land; Commercial properties and all forms of landed properties. Precious Objects: The important precious objects are Gold, Silver; Precious stones, Art object and Antiques. Financial Derivatives: The most important financial derivatives from the point of view of investors are Options Call (right to buy) & Put (right to sell at an exercised price)

5. CRITERIA FOR EVALUATION OF AN INVESTMENT The criteria are: Rate of return Rate of return = Annual Income + (Ending Price – Beginning Price) Beginning Price or = Annual Income + Ending - Beginning Price Beginning Price Beginning Price Current yield Capital gains/losses yield Annual Income= Dividend paid toward the end of the year Stock Returns: Ri = Pi – Po + Di Po Where Ri = return on a security (common stock) Pi = market price of the security at the end of period Po = market price of security at the beginning of the period (current price) Di = Dividend paid during period.

6. CRITERIA FOR EVALUATION contd • Ri = Di + Pi – Po Pi Po Return on a share is equal to the Dividend Yield (Di /Po) plus Capital gains Pi - Po Po EXAMPLE: Peter bought the common stock of Tatsie Plc when the market price was N2.60. He expects the stock will appreciate to N3.50 in one year’s time when he will later sell it. Calculate the expected return on the stock if • No dividend will be paid during the period • A dividend of 50k will be paid during the period. SOLUTION: • Expected return = N3.50 - N2.60 = 0.3461 34.61% N2.60 • Expected return = N3.50 - N2.60 +N0.5 N2.60 =0.5385 =53.85% Investment in shares or stocks is just one type of the numerous investments.

7. OTHERS ARE RISK: The risk of an investment refers to the variability of its rate of return. The simple measure of dispersion is the difference between the highest and the lowest values. Other measures used are VARIANCE: The is the mean of the squares of deviations of individual returns around their average values. STANDARD DEVIATION: This is the square root of variance. BETA: This reflects how volatile is the return from an investment relative to market swings.

8. OTHERS ARE MARKETABILITY: The factors responsible for an investment being marketable are 1) the transaction process is fast 2) transaction cost is low 3) price change between two successive transactions is negligible. How liquid a market is can be judged in terms of its depth; the existence of buy and sell orders around the current market price. Breadth: the presence of such orders in substantial volume. Resilience: New orders emerge in response to price changes. NOTE: Equity shares of multinationals (large and well-established firms ) enjoy high marketability while that of small companies in the formative years have low marketability Investors value liquidity because it allows them to change their minds. When an investment is non-marketable, one will explore the ease of withdrawals or loans taken against the deposit/investment.

9. TAXES TAX SHELTER: There are three kinds of Tax benefits. Initial Tax Benefits: This refers to the tax relief enjoyed at the time of making an investment (tax rebate). Continuing Tax Benefit: One is referring to the tax shield associated with the periodic returns from the investment for example dividend income. Terminal Tax Benefit: Convenience: This is the ease with which the investment can be made and look after.

10. SUMMARY EVALUATION OF VARIOUS INVESTMENT AVENUES

11. THE MUST Dos OF INVESTMENT • Determine the returns one can expect from different investment along with the risks associated with these investments. • Investors must clearly spell out their risk disposition and investment policy. • Decisions must be based on thoughtful, quantified assessment of business. • Market, business and interest rate risks must not be ignored. • Avoid trading excessively thereby reducing transaction cost. • Avoid over-diversification and under-diversification which could lead to risk exposure. • Admit one’s mistakes and cut losses short.

12. QUALITIES FOR SUCCESSFUL INVESTING The qualities are: Contrary thinking: The investor goes with the market during beginning and intermediate phases of bullishness and bearishness but go against the market when it moves towards the extremes. • Avoid stocks with high price earnings ratio: Market price per share Earnings per share This reflects that the stock is popular with investors. • Sell to the optimists and buy from the pessimists. Specify the target prices at which you will sell and buy. • Investors performance depends mainly on patience and diligence because the random movements tend to even out. • Rely more on actual figures and less on judgement (which is more prone to be influenced by emotions of greed and fear). • Ride the winners and sell the losers. • Never throw good money after the bad.

13. QUALITIES FOR SUCCESSFUL INVESTING (cont’d) To achieve superior performance, you have to be different from the majority. One of the most highly talented investors of our time is Benjamin Graham, widely acclaimed as the father of modern security analysis who relied on hard financial facts and religiously practised the “margin of safety” principle.

14. PORTFOLIO MANAGEMENT Portfolio management is a complex activity that can be broken down into the following steps; Specification of Investment Objectives and Constraints: Most investors seek current income; capital appreciation and safety of principal Choice of the Asset Mix: The most important decision in portfolio management is the asset mix decision. This step is concerned with the proportions of equities and fixed income securities in the portfolio. The appropriate mix depends mainly on the risk tolerance and investment horizon of the investor. Formulation of Portfolio Strategy: Once a certain asset mix is chosen, one can either opt for an active portfolio strategy or a passive portfolio strategy.

15. Selection of Securities: To select equities, investors go by technical analysis, and for fixed income securities yield to maturity, credit rating, term to maturity, tax shelter and liquidity is utilized. Portfolio Execution: This phase is concerned with the buying and or selling of specified securities in given amounts. It is an important practical step that has a bearing on investment results. Portfolio Revision: This involves the periodic rebalancing of the portfolio in terms of its value and composition. Performance Evaluation: The performance of a portfolio should be based on if the return is commensurate with its risk exposure

16. PORTFOLIO MANAGEMENT contd The most important portfolio decision an investor makes is the proportion of the total investment fund allocated to risky as opposed to safe assets such as money market securities. This choice is the most fundamental means of controlling investment risk. The first decision an investor must make is the asset allocation decision. Asset allocation refers to the allocation of the portfolio across major asset categories such as: • Money market assets (Cash equivalents) • Fixed-income securities (Bonds & Treasury Bills) • Stocks/Company shares • Real Estate • Precious metals and other commodities

17. Cont’d • A) High risk tolerance: Select asset allocations concentrated in higher risk investment classes i.e. equity to obtain higher expected rate of return • B) Conservative: Choose asset allocations with a greater weight in Bonds and cash equivalents. This offers a higher degree of stability plus the comfort of regular income. • A balanced approach has characteristics of both A) & B) plus the benefit of diversification across asset classes. This balanced portfolio will be able to withstand the financial markets’ ups and downs.

18. BALANCED APPROACH

19. BALANCED APPROACH cont’d • 20s; 30s- 40s: Stocks with potentially higher long-term returns • 50s: Reduce risk, increase income by trimming stocks and raising bond & money market investments • 60s: Shift focus to receiving income. The majority of one’s portfolio should be allocated to bonds and money market funds. • As an inflation hedge, maintain a significant stock position (40% is a good starting point) particularly early in one’s retirement years. • However, to have a balanced investment strategy, one should move assets from high-performing funds to those that may be lagging.

20. ACTIVE PORTFOLIO MANAGEMENT • ACTIVE PORTFOLIO MANAGEMENT: • Here, one assumes an ability to outguess the other investors in the market, and to identify either securities or asset classes that will shine in the near future. • Active selection thus requires: • 1) Security analysis • 2) Portfolio Choice • In both 1) & 2), the analysts must assess industries/company reports and use forecasts of market conditions, and use the security analysts recommendations to choose the particular securities to include within each asset class.

21. Contd. • Inflation and Real Rate of Return: If the interest rate on a one year deposit is 9%p.a. and one expects inflation to be 5% over the coming year, the real rate of interest will be • r = 8% - 5% = 3% • or • r= 0.08 – 0.05 = 0.0286 or 2.86% • 1+0.05 SUGGESTIONS: • The traditional balanced portfolio is typically 60% stocks, 40% Bonds. This remains a firm favourite with many investment experts. • Another is to skip Bonds and instead add cash investments such as Treasury Bills, money market funds, gold and real estate. Gold and real estate gives one an hedge against hyperinflation. But, real estate is better than gold because one gets better long-run returns.

22. OTHER MEASURES OF RISK/RETURN • Coefficient of Variation: This is a relative measure of risk and is measured thus: • Coefficient of Variation = Standard Deviation Expected return The higher the coefficient of variation, the higher the risk of the investment. The expected return on a portfolio is the weighted average of the expected return of each investment Below is an example for illustration:

23. ILLUSTRATION • SECURITY A SECURITY B • RETURN PROBABILITY RETURN PROBABILITY • 24% 0.3 12% 0.6 • 15% 0.1 13% 0.3 • 12% 0.6 14% 0.1 • QUESTION: Calculate the expected return on portfolio consisting of 60% of Security a and 40 of Security b. • Solution: • Ra = (0.24) x(0.3) + (0.15)x(0.1) + (0.12) x(0.6) • Rb = (0.12) x (0.6) + (0.13)x(0.3) + (0.14)x(0.1) • = 0.6(0.159) + 0.4(0.125) • = 0.1454 or 14.54% =Expected return on the Portfolio

24. DIVERSIFICATION • The risk of a portfolio depends not only on the risk nature of the securities making up the portfolio but also on the relationship among the securities. This must be considered in calculating the standard deviation of a portfolio return. • Therefore, an investor can reduce relative risk by selecting securities that have little relationship with each other. Diversification is the process of combining securities in a way that reduces total risk without losing portfolio return. • Benefits from Diversification: • 1) Perfect Positively Correlation: Here, there is a linear relationship between risk and return. It is not possible to reduce risk without reducing return. There is no benefit from diversification when returns of securities are perfect positively correlated.

25. Diversification contd • 2) Perfect Negative Correlation: Here one is referring to a Portfolio that has higher expected return and lower risk. But, at the same level of expected return, the Portfolio has no risk. Therefore, there are more benefits to be derived from diversification when securities are negatively correlated. • 3) Uncorrelated Returns: At the same level of expected returns, different Portfolios have different levels of risk. As more assets with uncorrelated returns are included in the portfolio, the benefits from diversification increases. • In conclusion, the Portfolio Manager must anticipate threat, spread their clients investment and thereby minimize risks. There is the need to reshuffle portfolio from financial stocks/equities that were worst hit by the economic crisis into more resilient ones like FGN Bonds, in their strategic positioning to hedge against losses and grow their liquid asset needs. In my opinion, developed and emerging markets offer good investment opportunities thanks to their faster rate of growth.

26. REFERENCE MATERIALS • Asset & Fund Management by Patrick Vandenbroucke • Security Analysis and Portfolio Management by Donald E. Fischer • Investment Analysis and Portfolio Management by Prasanna Chandra. • Essentials of Investments by Alex Kane, Zvi Bodie & Alan J. Marcus. • Articles in the Business Day Newspaper