investment strategies chapter 39 tools & techniques of investment planning copyright 2007, the...

Investment Strategies Chapter 39Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• Passive Investment Strategies– Passive investment strategies implicitly assume markets are

efficient.– Reducing investment trading and research costs is more

important than pursuing “market out-performance.”– A passive approach typically involves purchasing a basket of

securities that represent a market index and holding them for the long term (perhaps with periodic rebalancing).

– This approach typically does not focus on individual security

selection.


Investment Planning


What is it?

• Active Management Strategies– Active management strategies either assume:

• The market is inefficient, or

• Inefficiencies within the market can be profitably exploited.

– Under an active approach, a great deal of time and effort is expended in security selection and the timing of purchases and sales.


Investment Planning


Security Selection

• Active security selection usually involves fundamental analysis, technical analysis, or both.

• Fundamental analysis examines company-specific factors such as profitability, risk, relative valuation and growth prospects.

• Technical analysis studies market information such as price and volume to identify important trends and opportunities.


Investment Planning


Fundamental Analysis

• Many managers use fundamental analysis techniques to identify securities they believe are mispriced.

• Fundamental analysis can be employed using either a top-down or a bottom-up philosophy.

• Top down philosophy– Top-down managers begin with an overview of the entire economy and

market. – The idea behind such research is that one must first understand where

the overall economy is headed in order to identify the asset classes, economic sectors, and ultimately, securities that are expected to outperform.

– In a top down approach, the final step is typically to examine the fundamentals of a particular company whose securities are of interest.


Investment Planning


Fundamental Analysis

• Bottom up philosophy– Bottom-up analysts attempt to identify the best securities and the

price at which to buy them, regardless of sector or industry considerations.

• They often call themselves stock-pickers. – Bottom-up analysts typically begin by examining company

fundamentals, often by screening large databases of securities for information the analyst finds attractive.

– Only once they have identified securities of interest, do they

consider the prospects for the industry, sector, and economy. • Some investors blend both top-down and bottom-up

approaches in an attempt to add value across the spectrum.


Investment Planning


Company Fundamentals

Cash $ 10 $ 15

Accounts Receivable 50 60

Inventory 100 120

Current Assets 160 195

Property, Plant and Equipment 640 730

Accumulated Depreciation (300) (330)

Total Assets $ 500 $ 595

Accounts Payable $ 40 $ 45

Accrued Expenses 30 38

Current Liabilities 70 83

Long Term Debt 200 240

Total Liabilities 270 323

Common Stock 100 115

Retained Earnings 130 157

Total Equity 230 272

Total Liabilities and Equity $ 500 $ 595

2004 20052004 2005

Howard Electronic Retailers, Inc.

Balance Sheet

As of December 31st

(in millions of dollars)


Investment Planning



• The Balance Sheet – The balance sheet reflects the company’s financial position as

of a particular date. – It presents the company’s resources (assets) and the claims

against those resources (liabilities and equity). – The resources must always equal the claims (hence the term

balance sheet).


Investment Planning



• The Balance Sheet – Assets

• Assets are classified either as current or long-term. – Current assets are expected to be used up in a single operating

cycle, typically one year – Non-current assets have a lifetime that spans multiple operating

cycles

• U.S. accounting conventions list assets in order of how quickly they can be converted into cash.

• Cash– The balance sheet cash account includes cash on hand, in banks,

and other short-term deposits (such as certificates of deposits).


Investment Planning




• Accounts Receivable– Accounts receivable represents money the company is owed by its

customers for goods or services that have been provided.

• Inventory– Inventory is the unsold merchandise and materials on hand at the

end of the year.


Investment Planning




• Property, Plant and Equipment– Property, plant and equipment are long-term fixed assets of the

company such as a buildings, equipment, vehicles and furniture.– These assets are not used up in a single year, but rather benefit the

company over time.– The cost a company recognizes for a fixed asset in a future period is

called depreciation. Essentially, depreciation is an estimation of the economic wear and tear on the fixed assets over time.

» Relates to the Matching Principle» Requires the creation of the Accumulated Depreciation account

• Total assets are the sum of current and noncurrent assets.


Investment Planning



• The Balance Sheet – Liabilities

• Liabilities are classified as current or noncurrent.

• They are listed in the order they are expected to be paid.

• Accounts payable – Represent the amounts owed to suppliers.

• Accrued expenses – Represent additional expenses payable to others, such as

employees, the government, or landlords.

• Long-term debt – Represents amounts due to creditors, such as banks.


Investment Planning



• The Balance Sheet – Equity

• Equity represents the amount owners have invested in a business, either initially or by reinvesting the company’s earnings.

• Common stock – Represents the amounts paid into the company when the stock was

first sold to shareholders

• Retained Earnings– Retained earnings are the earnings accumulated in the company

(not paid out to shareholders as dividends) since inception.


Investment Planning



2003 2004 2005

Revenues $ 750 $ 800 $ 900

Cost of Goods Sold 560 600 713

Gross Profit 190 200 187

Operating Expenses 100 120 130

Operating Income 90 80 57

Interest Expense 18 18 18

Pre-Tax Income 72 62 39

Income Tax Expense 21 19 12

Net Income $ 51 $ 43 $ 27

Shares Outstanding (millions) 100 100 102

Earnings Per Share $ 0.51 $ 0.43 $ 0.26

Howard Electronic Retailers, Inc.

Income Statement

For the Year Ended December 31st


• Income Statement

– Shows how profitable a company was during a particular period

– Typically three years are presented

– Consists of

• Revenues

• Expenses


Investment Planning



• The Income Statement – Revenues

• Represent the total amount received (or due) from customers for goods and services provided during the period.

– Costs of Goods Sold• Represent the costs of the aforementioned goods and services that have

generated revenue• Example: Materials and labor used directly in delivering the goods (or

services)

– Gross Profit• The difference between revenues and cost of goods sold.• It is a basic measure of how the company is doing.


Investment Planning



• The Income Statement – Operating Expenses

• Other expenses incurred in the operation of a business• Example: Overhead costs

– Operating Income• The subtotal reflecting gross profit minus operating expenses

– Interest Expense• The interest paid to creditors for the use of their money during the period.

– Pre-Tax Income • The subtotal that includes operating and non-operating (financing) results.


Investment Planning



• The Income Statement– Income tax

• The amount owed on the reported income– Net income

• The overall net profit during the period• Commonly termed “the bottom line” • When net income is divided by the number of shares of stock

outstanding, the result is known as earnings per share (EPS).– EPS allows each investor to determine his share of net income.

– Matching principal• Revenues must be reported when earned and expenses when

incurred. • This does not necessarily coincide with when cash is received or

paid.


Investment Planning



Net Income $ 51 $ 43 $ 27

Plus Depreciation 25 25 30

Change in Working Capital (20) 10 (17)

Operating Cash Flow 56 78 40

Investing

Capital Expenditures (60) (70) (90)

Investing Cash Flow (60) (70) (90)

Financing

Borrowing 0 0 40

Issuance of Stock 0 0 15

Financing Cash Flow 0 0 55

Total Cash Flow (4) 8 5

Beginning Cash 6 2 10

Ending Cash $ 2 $ 10 $ 15

Howard Electronic Retailers, Inc.Statement of Cash FlowsFor the Year Ended December 31st


Operating 2003 2004 2005


Investment Planning



• The Cash Flow Statement – Operating Cash Flows

• Relate to operating the business

– Investing Cash Flows• Relate to investments in long-term assets

– Financing Cash Flows• Relate to financing the company

• Examples: Issuing/repaying debt, issuing/repurchasing shares, and paying dividends.


Investment Planning



• The Cash Flow Statement – Generally, it is preferable to have strong, positive operating

cash flows that can be used to invest in long-term assets and repay capital providers (debt and equity).

– Recent accounting scandals have highlighted the importance of paying attention to the cash flow statement.

• Some companies abuse and pervert accounting guidelines to overstate net income.

• If a company has rising net income but declining operating cash flow, this is a warning sign and the company should be scrutinized carefully.


Investment Planning


Company Ratios

• In order to evaluate how a company is doing over time and relative to other companies in the industry, we must compare their financial performance and position.

• Comparisons between companies of different sizes or growth rates can be difficult.

• Analysts often create ratios to remove the impact of size differences.

• Ratios can be categorized as follows:– Liquidity and Solvency– Efficiency– Profitability– Price multiples.


Investment Planning


Company RatiosCategory Ratio Formula

Liquidity & Solvency Current Ratio (Current Assets)/(Current Liabilities)

Debt Ratio (Total Liabilities)/(Total Assets)

Times Interest Earned (Earning Before Interest and Taxes)/(Interest Expense)

Efficiency Accounts Receivable Turnover (Sales)/(Average Accounts Receivable)

Inventory Turnover (Cost of Goods Sold)/(Average Inventory)

Total Asset Turnover (Sales)/(Average Total Assets)

Profitability Net profit margin (Net Income)/(Sales)

Return on assets (Net Income)/(Average Total Assets)

Return on equity (Net Income)/(Average Total Equity)

Price Multiples Price/Earnings (Price Per Share)/(Earnings Per Share)

Price/Book Value (Price Per Share)/(Book Value Per Share)

Price/Operating Cash Flow (Price Per Share)/(Operating Cash Flow Per Share)


Investment Planning


Company Ratios• Liquidity and Solvency

– Show the ability of a company to pay short- and long-term obligations, respectively.

– Current ratio: Current assets to current liabilities• When the current ratio is greater than one, current assets are sufficient to satisfy

current liabilities.

• A company with a higher current ratio is less likely to default on its payments, but an extremely high current ratio may indicate the company is not using its resources efficiently.

– Debt Ratio: Total liabilities to total assets• In terms of solvency, a lower number would indicate lower financial risk.

• However, debt can be beneficial if the company can use the debt-financed assets to earn more than it pays in interest.

– Times interest Earned: EBIT over interest expense• Measures whether the company earns enough operating income to make its interest

payments.


Investment Planning


Company Ratios

• Efficiency Ratios– Provide insight into how well the company is managing various activities.

– Accounts Receivable Turnover: Sales to Average Accounts Receivable

• Indicates how quickly the company collects money owed by its customers

• A high number means the company collects its receivables quickly.

– Inventory Turnover: Cost of Goods Sold to Average Inventory

• Measures how often the company turns over its inventory

– Total Asset Turnover: Sales to Average Total Assets

• Indicates the companies overall efficiency

• Measures the amount of sales generated for every dollar of assets


Investment Planning


Company Ratios

• Profitability Ratios

– Indicate the company’s relative profitability. – Net Profit Margin: Net Income to Sales

• Measures earnings per $100 of revenues

– Return on Assets: Net Income to Average Total Assets• Measures earnings per $100 of assets

– Return on Equity: Net Income to Average Total Equity• Measures earnings per $100 of equity


Investment Planning


Company Ratios

• Price Multiples– Indicate the relative valuation of the company by the market.

• A low ratio indicates a low valuation relative to some fundamental measure, and could indicate that the company is a bargain or that investors expect it to do poorly.

• A high ratio could indicate overvaluation or high expected future growth.

– Price to earnings ratio• Price per share of relative earnings per share

– Price to book ratio• Price share divided by book value (stockholders’ equity) per share

– Price to operating cash flow• Price per share relative to operating cash flow per share

– These measures can be compared to peer companies and the overall market to assess the company’s relative valuation.


Investment Planning


Example: Case Study

• Landstar System, Inc. provides transportation services, mainly truckload transportation over medium distances.

• The company does not own its own vehicles, but instead uses technology to match loads sourced by commissioned agents with drivers who provide their own vehicle. – As a result, Landstar’s fixed asset base is relatively small.


Investment Planning


Example: Case Study

• An investor looking at Landstar in early 2006 might find the following information in the company’s annual report:

• At first glance, the investor is pleased with the company’s rapid revenue growth rate (24.7% in 2005 and 26.5% in 2004).– Net profit margins have risen from 3.2% in 2003 to 3.6% in 2004 and

4.8% in 2005.• Each year the cash flow has fallen even though the company

reported higher income.

Year ended December 31, in thousands of dollars 2005 2004 2003

Total revenue 2,520,523 2,021,282 1,597,791

Net income 119,956 71,872 50,700

Cash flow from operating activities 6,529 49,744 53,396


Investment Planning


Example: Case Study

• The investor looks at the cash flow statement and determines that rising receivables have been the culprit.

• A look at the footnotes to the financial statements provides this explanation:– Included in revenue at the global logistics segment for the 2005

and 2004 fiscal years was $275,929,000 and $63,790,000, respectively, of revenue related to disaster relief efforts for the storms that impacted the United States. These emergency transportation services were provided primarily under a contract between Landstar Express America, Inc. and the United States Department of Transportation/Federal Aviation Administration (the “FAA”)….


Investment Planning


Example: Case Study

• A look at the footnotes to the financial statements provides this explanation (cont’d):– Included in accounts receivable at December 31, 2005 was trade

accounts receivable due from various departments of the United States Government of $226,057,000, which includes $215,250,000 in trade receivables from disaster relief services provided under the contract with the FAA. The decrease in cash provided by operating activities was primarily due to an increase in trade receivables resulting in large part from revenue related to the emergency transportation services provided under the FAA contract. The financing of a portion of this $215,250,000 receivable from the FAA with borrowings under the Company’s revolving credit agreement is the primary reason for the increase in long term debt….

– The FAA contract expires December 31, 2006.


Investment Planning


Example: Case Study

• The investor was able to use ratios and fundamental analysis to spot a potential problem, which could then be tracked to its source using other information.

• The investor can feel more confident about the company’s ability to collect the receivables (the US Government is a reliable customer) and can easily explain the falling cash flow in spite of rising income.– The March quarter 10Q shows $97 million in cash flow against

$24 million net income, as a good portion of the disaster relief receivables were collected.


Investment Planning


Example: Case Study

• The information also reveals that a large portion of the growth depended on severe weather that may not happen again. – With the contract expiring in 2006, it is unclear that the

company would benefit even in the event that severe weather did strike again.


Investment Planning


Fundamental Screening

• Advisors are often unable to examine the financial statements and ratios in detail for every company when considering potential investments.– There are more than 10,000 potential public company

investments to consider.


Investment Planning


Fundamental Screening

• The process often begins by screening a large database of securities to find a small number that have desirable attributes. – Example: A value manager may look for companies with

relatively low price multiples but strong profitability and growing cash flows.

• The database could be screened to select companies that meet these criteria.

• The smaller sample of companies that is produced can then be

analyzed in more detail.


Investment Planning


Technical Analysis

• Technical analysis assumes that fundamental information is reflected in market data such as price and trading volume

• Therefore, an analyst can focus on charts of such data to make investment decisions.– This does not necessarily mean that markets are perfectly

efficient. – Example: If markets react slowly to new information, this can

be found by looking at the trend in a price chart and making an investment decision based on this trend.


Investment Planning


Technical Analysis

• Technical analysis includes a study of charts depicting trends in price and volume and indicators as to when a trend is expected to continue or reverse.

• While many view technical analysis as the antithesis of fundamental analysis, some analysts view them as complementary tools.– Technical analysts can benefit by understanding how

fundamentals may be driving trends and fundamental analysts can benefit from using trend information to time buy and sell decisions.

• In its simplest form, technical analysis involves preparing a chart of past price and volume data.


Investment Planning


Technical Analysis

• Chart of past price and volume data– The top portion of

the chart depicts price information.

– Each bar on the graph summarized a day’s trading activity: showing the open, high, low and closing prices.


Investment Planning


Technical Analysis

• Day’s trading bar– This bar depicts the

opening price with a horizontal line to the left, the closing price with a horizontal line to the right.

– The vertical bar depicts the range of prices for the day from the low (bottom) to the high (top).

Low

High

Open

Close

Low

High

Open

Close


Investment Planning


Technical Analysis• In technical analysis, a trend is

generally considered to continue until a reversal signal or pattern emerges in the chart

• One such signal compares the price to a moving average of price over some period

– The solid line in the price area is a moving average of the last 50 days of prices.

– A reversal of the short-term trend is signaled when the price crosses the moving average line

– When the price falls below the moving average it is considered a sell signal

– When prices rises above the moving average it generates a buy signal.


Investment Planning


Technical Analysis• Trend reversal

– Head and Shoulders Top– The jagged line represents a

summary of the price action– The line with an arrow is

added to show the point at which a sell signal would be generated

• This is termed the neckline– When a price chart forms a

head and shoulders pattern, the analyst watches as the right shoulder is formed to see if the price falls below the neckline, which would be a sell signal.

Left Shoulder Right Shoulder

Neckline

Left Shoulder Right Shoulder

Neckline


Investment Planning


Technical Analysis

• The bottom portion of the chart provides vertical bars depicting daily volume information.– In technical analysis,

trading volume is used to confirm signals generated by price data.


Investment Planning


Technical Analysis• Support Line

– Each time the price falls to this line, it rebounds indicating that buyers are coming into the security at that price.

• Resistance Line– Resistance levels indicate a point at

which sellers step in to sell at a particular price, driving the price down.

• Support (resistance) levels may indicate target purchase (sale) prices.– Breaking a support or resistance line

can indicate that a new trend is forming.

SupportSupport

ResistanceResistanceResistance


Investment Planning


Overall Market Analysis

• In addition to charting individual securities, technical analysis involves the evaluation of overall security markets.

• Technical indicators can be used to determine the trend in the overall market and evaluate when it is desirable to make an investment in a particular asset class or alter asset allocation.

• Technical analysis of security markets can include the use of:– Sentiment indicators– Flow of funds indicators– Market structure indicators.


Investment Planning



• Sentiment indicators– Sentiment indicators are used to evaluate the overall

bullishness or bearishness of the market.– Commonly used sentiment indicators include:

• The volatility index

• Put/call ratio

• Short-interest ratio

• Insider trading activity.


Investment Planning


Overall Market Analysis• Volatility Index

– The CBOE Volatility Index® (VIX®) is a measure of market expectations of near-term volatility derived from S&P 500 stock index option prices (www.cboe.com).

– According to the Chicago Board Options Exchange:“VIX is based on real-time option prices, which reflect investors' consensus view of future expected stock market volatility. During periods of financial stress, which are often accompanied by steep market declines, option prices - and VIX - tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline. It is important to note, however, that past performance does not necessarily indicate future results.” (www.cboe.com, Frequently Asked Questions, as of July 23, 2006).”


Investment Planning


Overall Market Analysis• Put/Call Ratio

– The CBOE also presents daily data on the ratio of put options to call options for equities, indices and total (equity plus indices).

– The ratio is the daily volume of put options divided by the daily volume of call options.

– The lower the ratio the more bullish market participants are and the higher the ratio the more bearish market participants are.

– Sentiment indicators such as this though are contrary indicators, bullishness of market participants gives a bearish signal and bearishness of market participants gives a bullish signal.

• This results from overconfidence of market participants at market tops and pessimism at market bottoms.


Investment Planning



• Short Interest Ratio– The short interest ratios measures the volume of short sales for

an index or security relative to average volume.– This is a contrary sentiment ratio since a high ratio indicates a

high level of short activity and is considered bullish, whereas a low ratio is considered bearish.

• Insider Trading– While the overall market is often wrong at market tops and

bottoms, insiders have been found to be right at tops and bottoms.

• High insider buying relative to insider selling is therefore a bullish sentiment indicator.

• Low insider buying relative to selling is bearish.


Investment Planning



• Flow of funds indicators– Flow of funds indicators are used to assess the prospects for

inflows or outflows of cash into the market or sectors. – Flow of funds analysis involves examining trends sources of

cash such as the cash positions of large investors such as mutual funds and pension funds.

• Example: Mutual fund data can be obtained from the Investment Company Institute.

– This analysis also involves examining potential demands for cash such as new public offerings and overall liquidity in the economy.


Investment Planning



• Market structure indicators– These indicators examine charts of market indices for

patterns and trends in both prices and volume.– Market indices that are subject to analysis include:

• The Dow Jones Industrial Average

• S&P 500 Composite

• Dow Jones Transportation Average

• Dow Jones Utility Average

• The NASDAQ Index

• The Russell Index


Investment Planning



• Market structure indicators– These indicators can also include those that examine market

breadth.– Market breadth measures the extent to which issues

underlying the indices are participating in the market trend. • A market trend is stronger when more issues are participating.

– A popular measure of market breadth is the Advance/Decline line which measures the number of issues advancing in excess of those declining.

• An increasing advance/decline line is positive for the overall market.


Investment Planning


Timing of Investment Purchases and Sales

• In addition to selecting the right individual securities for purchase, the advisor must decide on the right price and the timing of the purchase and subsequent sale.– This involves exploring various purchase and sale

strategies available.


Investment Planning


Market Timing

• Market timing attempts to anticipate the market’s broad direction and individual security prices. – The focus is usually on the broader market.– Example: Investors who believe stocks are too expensive will

favor other asset classes. Those who believe stocks are cheap will sell other asset classes to buy more stocks.

• The timing can be based on economic trends, stock prices or valuation levels. – Example: When stocks are above their normal P/E multiple

range, this may be an indicator to reduce stock holdings. – Technical charts of market indices and individual securities can

generate buy and sell signals in a market timing strategy.


Investment Planning


Buy and Hold

• A buy and hold strategy does not attempt to anticipate moves in the market or even individual securities. – Contrasts market timing

• This strategy relies on the notion that a well-planned investment policy will result in a portfolio that best meets an investor’s risk and return profile.

• Buy and hold strategies tend to be long-term oriented.– Unlike market timing strategies, which are short-term in nature.


Investment Planning


Buy and Hold

• Advantages– Reduction of transaction costs

– Simplicity • Disadvantage

– Distortion of an investor’s asset allocations• Example: Consider an investor who decided in January 1996 that her

appropriate asset allocation was 50% stocks and 50% bonds. She makes a single decision to buy the assets in those proportions and promptly forgets about it. By year-end 1999, stocks have vastly outperformed bonds. Because of this relative difference in performance, stocks now comprise two thirds of her portfolio. She has unintentionally changed her asset allocations to favor stocks – just before the stock market crashes and bonds enjoy several years of superior performance.


Investment Planning


Buy and Hold

• A buy and hold strategy implies that only one investment decision is made (to buy).

• Occasionally, passive market timing strategies such as rebalancing will be described as “buy and hold.” – It could be argued that one decision is made to “buy” the

chosen allocation, and the later adjustments simply conform to the original strategy.

– It is important to understand which definition of “buy and hold” a particular pundit may espouse.


Investment Planning


Passive Investing or Indexing

• Passive investment strategies seek to mimic the returns on a benchmark index.– Example: The Standard & Poor’s 500

• The goal of a passive investment manager is not to beat the benchmark index, but rather to match it as closely as possible.

• Key advantage: Reduction of Costs– Trading costs are lower than with most actively managed

strategies.• Benchmark index constituents change only occasionally.

– Active strategies require skilled analysts and managers.• There is no need for active security selection in a

passive indexing strategy.


Investment Planning



• Available Method of Passive Investing: Replication– Construct the passive portfolio by simply buying and holding

the securities in the index, at their appropriate weightings.– Key advantage: low tracking error with the index– Complications/Disadvantages:

• In small portfolios, replication is likely to require owning partial shares.

• Investment flows such as new investments, withdrawals, or dividends would require the proceeds to be distributed to buy or sell tiny amounts of each stock in the index.

– An alternative is the use of index mutual funds or exchange-traded index funds.


Investment Planning



• Available Method of Passive Investing: Sampling– Construct the passive portfolio by choosing several securities

in such a way as to be representative of the overall index. – Key Advantage: Reduction of trading costs and the need to

buy small quantities of many stocks. – Complications/Disadvantages:

• It increases specific security risk

• It is unlikely to track the benchmark well.


Investment Planning


Where Can I Find Out More About It?

1. More information on financial analysis and ratios can be found on Tom Robinson’s Financial Education blog at www.financial-education.com

2. John J. Murphy, Technical Analysis of the Financial Markets (New York, NY: New York Institute of Finance, 1999).

3. Martin J. Pring, Technical Analysis Explained,4th Edition (New York, NY: McGraw-Hill, 2002).

investment strategies chapter 39 tools & techniques of investment planning copyright 2007, the...

Documents