Investment Analysis

An Introduction to Portfolio Theory and Management

Mike Dempsey

• Publisher: Routledge
• Year: 2019
• ISBN:
  9780429754869
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Finanzwesen

This textbook is designed as a core text for finance courses that cover market investments, portfolio formation, and the management of investment portfolios. As such, the text seeks to convey insight and actual wisdom as to the nature of these activities. When combined with a commitment to thinking independently, the text offers the student a rigorous preparation for entry to the funds management industry.

The text is presented in three parts. In Part A, the text introduces the fundamental techniques of investment analysis: a "bottom-up" and "top-down" analysis of the firm aimed at an evaluation of the underlying share as a "buy", "hold", or a "sell" recommendation. Part B offers the reader an intuitive grasp of the nature of investment growth, both across time and across assets. Part C introduces the reader to the technicalities of portfolio construction and portfolio management. The text concludes with an assessment of the funds management industry.

The text builds in step-by-step stages with Illustrative Examples that consolidate the student's progress and understanding through each chapter. Each of parts A, B, and C (above) has sufficient material to justify a separate course. If the student has exposure to a more foundational course in finance, Parts A and B can be covered as a single course. If from other courses, the student is familiar with the essence of Parts A and B and with statistical concepts, the text can be covered as a single course. The text can therefore be presented readily at either an undergraduate or postgraduate level at a pace appropriate to the student's prior exposure to the concepts.

1 Introduction

Welcome to investments, portfolio theory, and management!

The aim of the text is to offer the student actual “wisdom” as to the nature of investments, portfolio formation, and the management of investment portfolios. When combined with a commitment to thinking independently, the text offers the student a rigorous preparation for entry to the industry. With such commitment, the student will have attained both “insight” and “authority” on the subject matter – such as to be able to engage confidently and professionally in the industry with both their peers and with their clients.

Typically, with successive editions over very many decades, previous texts have grown with an accretion of material while resisting the attempt to rethink the intellectual foundations of their subject matter. The outcome is that the texts have become outmoded, and retain at their core, concepts that have ceased to be viable outside the classroom. Thus, the capital asset pricing model (CAPM) and the propositions of Modigliani and Miller are presented as providing an essential intellectual framework. The CAPM – as the name implies – is presented as a model that reveals fundamentally how prices are determined in the market, when, in fact, the evidence is entirely against the model as a description of how assets are actually priced. The Modigliani and Miller propositions assert that, on a most fundamental level, debt is irrelevant, whereas, actually, debt is often the most essential dynamic in sustaining economic cycles of growth and decline along with the profitability of firms. An excess of debt was the key factor of the 2007–2008 global financial crisis (GFC).

It is no defense for a text to say that its aim is to provide an essentially algebraic model framework of understanding that is strictly “hypothetical”. Even the most elementary model must capture something of the essential truth of its application – which is to say, it must at least point us in the right direction – it must not point us in completely wrong, and dangerously wrong, directions. And the text must, at minimum, provide a realistic framework for addressing practical issues. For example, we might consider a practical question for the investor or anyone seeking meaningfully to advise clients on their investments, as: How does the intended duration of my investment affect how I should invest? For historical reasons (notably the repeated arguments of the economist Paul Samuelson that the investment horizon must not affect the composition of the investor’s portfolio), the texts refuse to give credibility to the practitioner’s recommendation based on experience, namely that “stocks are for the long haul”. However, when the unrealistic concepts of the texts – “market efficiency” and “perfect capital markets” – are relaxed, the practitioners’ position is seen to be justified.¹

A positive feature of successive editions of a text is the acquisition of plentiful reference materials. Nevertheless, the student often feels overwhelmed by such abundance of gifts. The result is that the text is often regarded by both lecturers and students as a manual for “reference”, rather than as the development of progressive readings with the objective of achieving a coherent understanding. The present text is unashamedly devoid of reference material, “further readings”, or “activities”. Rather, the text has been designed as both “necessary and sufficient” for the student as a first reading on the issues presented. That is not to deny that the teacher will offer their own experiences and anecdotes aimed at bringing the text to life, or that in the student’s real time of learning, economic and financial events will be introduced as either an illumination or a challenge to the textbook.

Meaningful wisdom is unlikely to flourish when students are required to assimilate formulas without clear insight into their source. Indeed, the exercise becomes actually dangerous when students are led to believe that they have acquired an effective toolbox of solutions. In the current text, formulas are presented as an effective expression for what has been conceptualized and firmly understood – not as a substitute for conceptualizing and understanding. Ultimately, the formulas are a shorthand for expression, which, when clearly understood, allow for meaningfully deeper insights.

Our preference is that the student take time out to read an assigned chapter as a progressive and continuous whole. The Illustrative Examples are implemented in each chapter and aimed at assisting the student to achieve consolidation as they progress step by step through each chapter. And the student should at least “contemplate” the Illustrative Examples in the “Over to you …” tutorial at the end of each chapter before turning to the solutions at the end of the text. Provided the application of the question and the reasoning of the solution are assimilated, much can be achieved by simply reading carefully through the questions and solutions.

The text is in three parts as follows.

Part A: Foundations of investment analysis. Part A introduces the essentials of firm valuation. We introduce the share valuation models, the price-to-earnings (P/E) ratio, and the capital asset pricing model (CAPM). The implications of debt and financial leverage are considered for both the firm and the economy. And we examine in some detail the financial statements of the firm by which the financial analyst seeks to determine a “buy”, “hold”, or “sell” recommendation for the firm’s shares.

Part B: The nature of investment growth. Part B continues to a consideration of continuously compounding asset growth, with consideration of growth across many time periods and growth across many simultaneously performing assets.

Part C: Principles of portfolio construction and management. Part C progresses to the formation of models for portfolio construction, and their modification by the investment industry. The text concludes with an assessment of the funds management industry.

In more detail, we summarize the three-part structure of the text as follows.

Part A: Foundations of investment analysis

We commence our intellectual journey in Part A by considering the essential tools of investment analysis:

Chapter 2: We consider the essential concept of share valuation as the present value of the earnings stream that the firm is expected to deliver to its current shareholders. The problem for the analyst, however, is that the two essential inputs to the model – the earnings stream that the firm is expected to deliver (above the line) and the rate at which such expected earnings must be discounted (below the line) so as to arrive at the current share value – are exceedingly difficult to quantify. Nevertheless, we are able to demonstrate the application of the models in allowing the analyst to assess at least the reasonableness of a firm’s P/E ratio in relation to the P/E ratio of other firms, and, thereby, allowing the analyst to assess the reasonableness of one firm’s market valuation in relation to another firm’s market valuation. On such basis, the analyst will seek to recommend a “buy’, “hold”, or a “sell” for a firm’s shares.

Chapter 3: We consider the capital asset pricing model (CAPM) and its practicality as a means of determining the discount rate with which to discount the firm’s expected earnings stream. The fact that the CAPM actually fails to describe the formation of historical share prices prompts us to consider more openly the nature of investment activity and share price formation. We are led to consider (i) that institutional investors respond to investment risk with a “tournament” mentality (the risk of underperforming against their competitors in the industry, as opposed to the risk of losing absolute amounts of (other people’s) money), as well as (ii) the psychology of stock market pricing activity.

Chapter 4: We consider the relation between a firm’s earnings potential and its financial leverage. In addition, we consider how financial leverage contributes a fundamental dynamic in the context of the broader economy. Here, we consider the “stability is de-stabilizing” contribution of the economist Hyman Minsky, who argues that economic growth is fueled by increasing debt, up to the point that an excess of debt turns to bring about a downturn in the economy. In such a manner, excessive debt brought about the downfall of investment banks during the global financial crisis.

Chapter 5: As well as seeking to assess the firm in the context of the broader economy, the analyst will wish to assess the firm in relation to its individual attributes and positioning in its own industrial sector. We show how the firm’s financial statements provide a rich data set that the trained analyst is able to exploit when seeking to determine a “buy”, “hold”, or “sell” recommendation for the firm’s shares.

Part B: The nature of investment growth

Chapter 6: We commence Part B by inviting the student to contemplate growth as something that occurs “continuously” (“money never sleeps”). The transition from “discrete” growth to “continuously compounding” growth – alternatively expressed as “exponential” growth – is a subtle one. Nevertheless, a satisfactory appreciation of investment growth requires that we are able to understand growth as continuously compounding growth. The chapter is therefore given to establishing a firm understanding of growth as continuously compounding.

Chapter 7: We introduce the concept of a “normal distribution” and consider that continuously compounding or exponential growth rates can be modeled by such a distribution. The useful feature of a normal distribution is that predictions for investment outcomes can be linked to a normal distribution with a mean (μ) = 0 and a standard deviation (σ) = 1; for which the probability for an outcome performance in any range can be determined from available tables.

Chapter 8: We progress to link the mean (μ) and standard deviation (σ) of the returns of a portfolio to the mean return and standard deviation of returns for the individual assets in the portfolio. Thereby, we are able to apply the predictive apparatus of Chapter 7 (as applied to a single asset) to a portfolio of assets. The analysis will lead us from “means” and “standard deviations” to the concepts of “co-variance”, “correlation”, and “beta”, along with their inter-relationships.

Chapter 9: The final two chapters of Part B are the “payoff” for recognizing growth as continuously compounding and subject to a normal distribution. In this chapter, we extend the model of continuously compounding growth to predict wealth outcomes as a function of the investment time horizon. The model predictions are compared with empirical observations for the US markets. The model reveals how the symmetry of returns about a mean growth rate generates a higher expected return outcome. The chapter concludes by showing how growth rates that are subject to a normal distribution of outcomes can be modeled by the repeated application of a “binomial” distribution, which allows for a single upside and a single downside possibility at each point in time.

Chapter 10: Having examined the features of growth over many time periods, we turn to examine the features of growth over many assets simultaneously. We find that diversification across many performing assets allows an investor to maintain the individual upside potentials of inherently risky assets, while simultaneously reducing the downside probability of making a loss.

Part C: Principles of portfolio construction and management

Chapter 11: In this chapter the model of Chapters 9 and 10 is developed to allow for investment in a risky market in conjunction with investment in a riskless asset. The model reveals that while inclusion of a riskless asset necessarily reduces the portfolio’s “expected” return outcome, the addition of the riskless asset works to increase the median or “mid-value” return outcome. Thereby, we observe the dilemma facing the investor choosing their investment proportions between risky and non-risky investments. We complete the model with a “propensity to invest” as captured by “log-wealth” utility.

Chapter 12: The model of Chapter 11 is extended to allow for many risky assets, in addition to allowing for more general levels of investor “risk aversion”. The outcome is that we are obliged to accept either that (1) investors are more risk-averse than is captured by a “log-wealth” utility, or, alternatively, that (2) the riskiness of stocks is insufficiently captured by their ongoing volatility. We are accordingly led to consider, as a market “risk factor”, the possibility of a market “break” or “crash”, followed by a prolonged period of self-sustaining declining prices; and that this ultimate risk exposure is not captured by the day-to-day variations of stock prices as “volatility”. We proceed to apply the model equations to a determination of an optimal portfolio of risky investments.

Chapter 13: We develop our model by allowing “fluctuations of opinion” or “mispricing” of stock prices. In the context of such stock mispricing, we determine that with a longer investment horizon, an investor will rationally expose proportionately more of their investment wealth to the risky market than would be the case when facing a shorter investment horizon. We also consider how mispricing can...