Fundamentals of Investment

A Practitioner's Guide

Brian O'Loughlin, Frank O'Brien

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781351667562
• Edition: 3
• Topic: Negocios y empresa
• Subtopic: Inversiones y valores

Post the Financial Crash, the role of regulation and the impact of regulation on all aspects of the financial industry has broadened and intensified. This book offers a comprehensive review of the operations of the industry post-financial crisis from a variety of perspectives. This new edition builds upon the authors' predecessor book, Fundamentals of Investment: An Irish Perspective.

The core of the original text is retained particularly concerning fundamental concepts such as discounted cash flow valuation techniques. Changes in this new text are driven by two important factors. First, the long shadow of the Global Financial Crisis and the ensuing Great Recession continues to impact economies and financial markets. Second, the new text adopts a more international perspective with a focus on the UK and Ireland. The authors present the reader with a clear linkage between investment theory and concepts (the 'fundamentals') and the practical application of these concepts to the financial planning and advisory process. This practical perspective is driven by the decades-long fund management and stockbroking experience of the authors.

Investment knowledge is a core competence required by large numbers of organisations and individuals in the financial services industry. This new edition will be an invaluable resource for financial advisers, financial planners and those engaged in advisory and/or support functions across the investment industry. Those taking investment modules in third-level educational institutes will find this book to be a useful complement to the more academically focused textbooks.

1 Introduction

This book builds upon our predecessor book [Fundamentals of Investment: An Irish Perspective, Gill & Macmillan, 1st edition 2006, 2nd edition 2011]. The content and style of this book is driven by our experience of designing and delivering investment training programmes to investment intermediaries, investment advisors and wealth managers. We continue with the theme of explaining and illustrating fundamental investment concepts in a manner that integrates with the practical aspects of investing. Where feasible, the perspective that we adopt is that of the investment advisor, intermediary or financial planner. The objective of this textbook is not to equip the reader with the skills to become a professional investment manager, rather it is to enable the reader to appreciate how investment theory interacts with fund management. In so doing the reader can become better equipped to understand and evaluate the vast array of investment products available to investors. This will be of particular benefit to those working in an investment advisory capacity. Also, those in the various support functions in the investment industry, such as technical support staff and fund administrators, can enhance their capabilities through a better understanding of how investment management works.

We began writing the first edition shortly after the bursting of the stock market technology bubble in 2001. The second edition was written post the Great Financial Crisis (GFC) of 2008–09 and during the subsequent Eurozone crisis of 2011–12. The past 15 years have been a turbulent period in the financial markets and it is a period that has witnessed many changes in the workings of financial markets and in how they are regulated.

Even though many of the topics covered in this book are fundamental in nature, such as discounted cash flow valuation techniques, others, such as the structure of the market for retail investment products, approaches to portfolio construction, and the regulatory environment, are constantly evolving. The GFC and its enduring aftermath has cast a long shadow over financial markets, and therefore the environment in which a book such as this is written does influence many of the topics covered.

Current environment

The shock to the global financial system of the GFC has been profound and long-lasting. Indeed, as we write this book the reverberations continue and arguably the financial and political developments playing out during 2017–18 could be viewed as just the second or third act in what will become a multi-act and long-running crisis aftermath. It is generally accepted that the unconventional monetary policies of quantitative easing (QE) and negative interest rates were critical in preventing another Great Depression. Instead, the world endured only a relatively short ‘Great Recession’. By 2017–18 these policies had become increasingly controversial, not just for their impact on financial markets and real economies, but also for their influence on broader political developments. The rise of anti-globalisation sentiment and the growth of ‘populism’ are factors behind the seismic political shifts exemplified by the UK electorate’s vote in favour of Brexit, and the election of Donald Trump in the USA. Nevertheless, as we write this book the global economy is enjoying a period of moderate synchronised economic growth that arguably supports the contention that unconventional monetary policies have been successful in avoiding a catastrophe and in stimulating robust economic recovery.

Perhaps of even greater import are the profound changes wrought across national financial systems and, by extension, the global financial system. The impact of many of these changes, particularly those that involved legal and regulatory actions, is likely to last well beyond the current business cycle. Furthermore, central banks are finding it extremely difficult to unwind what were supposed to be temporary unconventional monetary measures. The prolonged period of QE, involving price-insensitive purchases of bonds by central banks, has driven bond yields to historically low levels. Normal relationships across the asset spectrum have been disrupted and risk premia have been altered.

Banking has had to be radically restructured and is subject to much more intrusive regulation. Although the insurance and investment management industries weathered the storm reasonably well, they too have been the focus of much deeper and pervasive regulatory oversight.

Impact of the financial crisis on investment theory and practice

Not surprisingly the GFC and its aftermath led to many awkward questions regarding aspects of investment theory and practice. If markets are supposed to be broadly efficient, why did the financial system implode in the way that it did? The financial crisis highlighted that many financial markets are not efficient; the prices of many financial securities were priced at levels that bore little relationship to their true ‘value’ and risk level. Although some of the assumptions and conclusions of investment theory are being critically re-examined, the crisis has re-instilled interest in many of the tried and tested techniques of valuing securities based on their capacity to generate cash flows into the future. It is beyond the scope of this textbook to address the debates that are occurring at the cutting edge of investment theory and practice. Our view, however, is that the core fundamentals of investment theory described here are enduring. Indeed, if there is one lesson that the crisis has emphasised, it is that the fundamental value of an asset eventually manifests itself. Therefore, many of the concepts and techniques underlying the valuation of securities that appeared as far back as the first half of the last century are being re-embraced by most serious investors. The core principles underlying the theory and practice of investment management have not changed. Sensible diversification across asset categories and a clear understanding of the implications of financial leverage remain at the core of managing investment risk and return. Our view is that much of what went wrong over the past decade in financial markets was because too many participants across the financial system lost sight of many of these core principles of investment. Excessive use of leverage and the belief that financial engineering could somehow spirit away investment risk have been shown up for what they are – fool’s gold.

This book seeks to describe and explain those enduring theoretical concepts that are fundamental to an understanding of the investment process and the investment markets. The book also seeks to set out the key features of market structures and how the fund management industry is organised. The legal and regulatory environment is examined only in the context of understanding the impact that it has on providing investment advice and managing assets. It is beyond the scope of this text to provide a comprehensive exposition of regulation and market structures. In writing this book we have kept to the forefront the task of ensuring that the concepts, theories, issues and debates that we outline are brought to the reader in a format that brings them to the heart of the daily challenges faced by industry professionals, especially those in client-facing roles.

Organisation of the book

The book introduces the basic building blocks of investment and reviews the operations of the industry from a variety of perspectives. These include the retail investor, the pension fund investor, the professional fund manager, and also the perspective of the professional investment advisor/financial planner. The approach adopted is to introduce investment concepts and issues in a discursive manner. The book is organised in three parts:

Part I: Assets and investment returns

In Chapter 2 the mainstream investment assets – fixed interest, equities, real estate and cash – are described and their key characteristics are detailed. The more important valuation concepts such as dividend yield, price earnings ratio, and gross redemption yield are introduced. How securities markets are organised and the methods by which securities are issued and sold to investors are set out.

The distinction between primary markets and secondary markets is explained and the mechanism by which an initial public offering is brought to the market is described. This chapter also provides an introduction to alternative assets such as private equity and hedge funds.

Chapter 3 builds on the introduction to bonds in Chapter 2 and provides a fuller analysis of bonds including the valuation of bonds and the calculation of the flat yield and the gross redemption yield (GRY) or yield to maturity (YTM). This chapter will help the reader to develop an understanding of how to value a bond applying the time value of money concept. The nature of the inverse relationship between changes in interest rates and bond prices is examined and the important concept of duration is explained. The term structure of interest rates and its various applications are discussed. The issues involved in managing bond portfolios are examined. Corporate bonds and emerging market bonds are defined and examined. Index-linked bonds are described and compared with conventional fixed-interest bonds.

In Chapter 4 we examine ways in which we can analyse and assess the investment merits of a company’s shares. The questions that investors are interested in seeking answers to include:

• What is the fair price for a share and how can we calculate it?

• What are the key financial ratios relevant to an analysis of the investment prospects of a company?

• What yardsticks should be employed to compare one share with another?

• Are there ways to establish the investment value of an equity market?

• How can equity markets in different countries be compared with one another?

This chapter shows how discounted cash-flow techniques can be used to estimate the fair price of a share. The chapter then goes on to describe the most commonly used relative valuation techniques, such as the price-earnings ratio and the dividend yield.

Alternative assets are defined and their characteristics listed in Chapter 5. Investor interest in alternatives has grown exponentially over the past decade as investors have striven to find ways to deal with the volatility and risks associated with investing in stock markets. The persistence of historically low interest rates and bond yields post the GFC has generated even greater interest in alternative assets as investors search for better and more stable returns. Alternative assets cover a broad spectrum, including private equity, hedge funds, commodities and infrastructural projects.

Chapter 6 presents the data covering over 100 years of historical investment returns. The evidence from the US and UK markets is examined in detail and this is placed in the context of a global perspective, where data from a selection of other countries is also presented. The evolution of returns from the various assets over different business cycles are compared and contrasted. The historical data on risk is examined and the concept of the equity risk premium is defined and discussed. Analysis of the more recent history of returns (the past 20 years) provides insights into how the various assets performed through the 2008–09 bear market.

Chapter 7 is entitled ‘The real economy and the markets’, and here the central importance of growth and inflation are identified in determining asset prices and in driving both the real economy and the financial markets. The relevance of the economic cycle in influencing the asset allocation decision is discussed. Periods of speculative excess are examined to isolate their common denominators and to identify the insight that there is a difference between price and value.

Chapter 8 analyses derivative contracts, which form an intrinsic part of the global financial fabric. Derivatives first emerged in a significant way in agricultural commodities markets in Chicago in the mid-nineteenth century. Although financial derivatives made their appearance quite early in the history of stock markets, they have really only come to prominence since the early 1980s. Today financial derivatives play a central role in all developed financial markets. This chapter focuses on describing basic futures and options contracts and analysing how they can be used either to manage risk, or to speculate on the price movements of underlying securities. The conceptual framework that underpins many structured investment products is outlined, and the risk reward characteristics of structured products are compared with other products.

Part II: Investment risk and capital market theory

Chapter 9 introduces the key concept of risk and starts by distinguishing between the investor, the gambler and the speculator. It examines the relationship between risk and return and sets out the different sources of investment return. What risk means to different investors is explored and the subjective nature of risk is examined. The quantitative concept of risk as defined and measured by Markowitz is examined. The insights of the Markowitz approach are extended to the implications for portfolio construction.

Chapter 10 develops further the important concept of Markowitz diversification. This chapter shows how a concept such as the correlation coefficient can be used to construct portfolios. The concept of the efficient frontier is discussed and the impact on the efficient frontier of introducing a risk-free asset is explored. The separation theorem is also discussed. Markowitz portfolio theory is normative in the sense that it describes how investors should go about the task of selecting portfolios of risky securities. Capital market theory tries to explain how security prices would behave under idealised conditions. The most widely known model is the capital asset pricing model (CAPM). The CAPM is attractive as an equilibrium model because it can be applied to the job of portfolio construction relatively easily. It does have a number of weaknesses and alternative theories have been developed, the most important of which is arbitrage pricing theory (APT). This relates return and risk to underlying factors such as economic growth, inflation and company size. More recently it has spawned the development of ‘smart beta’ strategies which have enabled asset managers to build products that attempt to profit from factors that have exhibited outperformance. The most well-known factor model is built upon Fama and French’s extensive analysis of the ‘small company effect’.

Chapter 11 – Modelling prospective returns – marries the historical analysis presented in Chapter...