1. Chapter 5 Portfolio Management of Stocks Viewing recommendations for Windows: Use the Arial TrueType font and set your screen area to at least 800 by 600 pixels with Colors set to Hi Color (16 bit). Viewing recommendations for Macintosh: Use the Arial TrueType font and set your monitor resolution to at least 800 by 600 pixels with Color Depth set to thousands of colors

2. Copyright © Houghton Mifflin Company. All rights reserved. 5–1 What Is Equity? Equity in the form of common stock = an ownership stake in the profits of a business –Initial public offering (IPO) constitutes the primary market –Subsequent sales of the stock constitute the secondary market How are equity owners paid? –Through capital appreciation of their shares –Through periodic dividend payments by the company

3. Copyright © Houghton Mifflin Company. All rights reserved. 5–2 What Is Equity? (cont.) Why hold stocks versus bonds? –Although higher risk, stocks have the potential for higher rewards –Stocks allow investors to benefit directly from the success of a company

4. Copyright © Houghton Mifflin Company. All rights reserved. 5–3 Measures of Stocks Level of market capitalization –Company market cap = shares outstanding x share price –May be categorized or compared to: book value = assets – liabilities Level of selected financial ratios –P/E –P/CF –P/B –Dividend yield

5. Copyright © Houghton Mifflin Company. All rights reserved. 5–4 Measures of Stocks (cont.) Category of anticipated movement of company earnings –Cyclical –Growth –Value

6. Copyright © Houghton Mifflin Company. All rights reserved. 5–5 Types of Equity Research Fundamental –Rate stocks based on research into “fundamental” operations of a company –Predict future earnings and produce valuation measures from interpreting public information, talking to companies, suppliers, distributors, etc. Technical –Rate stocks based on data such as past price movements and trading patterns –Often concentrate on predicting changes in price direction (i.e., identifying peaks and valleys)

7. Copyright © Houghton Mifflin Company. All rights reserved. 5–6 Types of Equity Research (cont.) Quantitative –Rate stocks based on mathematical models developed by the analyst –May use fundamental and/or technical inputs in their models –Attempt to identify stocks that are mis-priced

8. Copyright © Houghton Mifflin Company. All rights reserved. 5–7 Buy-Side versus Sell-Side Analysts Buy-side analysts –Work directly for the investment adviser that will “buy” securities for managed portfolios –Produce proprietary research –Fund shareholders have “paid” for the research through management fees

9. Copyright © Houghton Mifflin Company. All rights reserved. 5–8 Buy-Side versus Sell-Side Analysts (cont.) Sell-side analysts –Work for Wall Street-type firms –Produce research that is widely disseminated (“sold”) to numerous investment advisers –Rarely issue sell recommendations on stocks, possibly due to existing or potential I-banking relationships –Can provide valuable insights on industries for buy-side analysts and help produce new investment ideas –Buy-side firms may pay for such research through trading commissions

10. Copyright © Houghton Mifflin Company. All rights reserved. 5–9 Functions of a Fundamental Analyst Analyze an individual company and determine appropriate valuation Assess relative attractiveness of stock to other stocks in the industry or appropriate security pool (relative valuation), taking into account –Earnings growth –Interest rates –Investor sentiment

11. Copyright © Houghton Mifflin Company. All rights reserved. 5–10 Functions of a Fundamental Analyst (cont.) Recommend buying or selling particular stocks to portfolio managers Monitor specific stocks over time and adjust recommendations for new information

12. Copyright © Houghton Mifflin Company. All rights reserved. 5–11 Sample Questions Asked by Fundamental Equity Analysts “What is the –Company’s historical financial performance?” –Company’s projected performance by segment?” –Company’s current cash position and intended uses?” –Supply and demand for the company’s products/services?” –Impact of existing and likely regulation or legislation?” –Track record and qualities of management?”

13. Copyright © Houghton Mifflin Company. All rights reserved. 5–12 Passive versus Active Investment Strategies Passive management –Objective is to match the performance of a particular market index –Success may be measured by “tracking error” (the deviation of the funds return from the return of the index) must try to minimize trading costs and fees –May use full replication or sampling –Periodic index rebalancing or changes in composition must be carefully monitored

14. Copyright © Houghton Mifflin Company. All rights reserved. 5–13 Passive versus Active Investment Strategies (cont.) Active management –Objective is to beat the return of the market, defined as A market index and/or A competitive universe of funds with similar objectives –Portfolio manager is buying and selling securities and may use Top-down or bottom-up approach Team, individual, or composite approach

15. Copyright © Houghton Mifflin Company. All rights reserved. 5–14 Portfolio Construction and Strategy Managers must make decisions within the basic parameters of the fund –Investment objectives (e.g., growth, capital appreciation, income, etc.) –Constraints Name test: 80% of assets must meet description implied by fund’s name (if specific) Diversification and other regulatory requirements Internal constraints

16. Copyright © Houghton Mifflin Company. All rights reserved. 5–15 Portfolio Construction and Strategy (cont.) Managing against indexes –May use broad market indices (e.g., S&P 500) –May use more specific style indices (e.g., Russell 1000 Growth) Managing against peers –Groupings are established by measurement organizations (e.g., Lipper Analytical) –Relative performance rankings are calculated and published on a regular basis; performers often divided into quartiles

17. Copyright © Houghton Mifflin Company. All rights reserved. 5–16 R2V R3V R1V R2 S&P Midcap Wilshire 5000 R3 R1 SP500 R2G NASDAQ R3G R1G RMV RMG Russell Midcap Small Cos. Large Cos. Value Cos. Growth Cos. Styles of Popular Benchmarks

18. Copyright © Houghton Mifflin Company. All rights reserved. 5–17 Portfolio Strategy: Security Selection Index weights as of Dec. 2001

19. Copyright © Houghton Mifflin Company. All rights reserved. 5–18 Portfolio Strategy: Sector Weighting

20. Copyright © Houghton Mifflin Company. All rights reserved. 5–19 Performance Attribution

21. Copyright © Houghton Mifflin Company. All rights reserved. 5–20 Summary of Steps in the Investment Process Identify security pool that is appropriate for portfolio objective and benchmark Choose individual securities with expected returns above average Design the portfolio by sector and individual security weightings Conduct performance attribution analysis to determine what did and did not add value Monitor and adjust portfolio composition Start over

22. Copyright © Houghton Mifflin Company. All rights reserved. 5–21 Other Portfolio Considerations Portfolio liquidity –Individual securities –Markets (e.g., foreign) Cash flows –Purchases and redemptions by shareholders –Settlement of portfolio trades