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Investment Analysis Lecture Notes

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Lecture notes of Investment Analysis 2017/2018 Complete!

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  • October 11, 2017
  • October 13, 2017
  • 65
  • 2017/2018
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Investment Analysis
Lecturers: P. de Goeij, R. Frehen
Exam: 4 questions (2 about part 1 and 2 about part 2) -> 19 October

Lecture 1: Introduction
The essential nature of investment is:
 Reduced current consumption
 Planned later consumption

Types of assets:
 Real Assets: assets used to produce goods and services
 Financial Assets: claims on real assets.

The informational role of financial markets
 Playing a central role in the allocation of capital resources
o Consumption timing
o Allocation of risks
o Separation of Ownership and Management
 This comes with agency issues

Corporate governance and corporate ethics is also important in financial markets
 Huge accounting scandals
o Enron, Royal Ahold, AIG, Bernard L. Madoff
 Analyst scandals
o Favorable analysis traded for the promise of future investment banking business

Therefore some regulation has originated:
1. Sarbanes-Oxley Act
2. Code Tabaksblat (Netherlands)
These regulations are both aimed to tighten the rules of corporate governance.

Example Consumption Timing




To choose among the possible outcomes, whe need to look at utility/indifference curves.

, An utility/indifference curve represents the investors preference for income
in two periods. These curves are constructed so that everywhere along the
same curve the investor is assumed to be equally happy.

The ‘steepness’ of the curve depends on personal preferences such as risk-
aversion.
The solution in this case gives point D.


Markets are competitive
 Active Management
o Finding mispriced securities
o Timing the market
o Is it really profitable? You need to take into account the trading costs/management
fees.

 Passive management
o No attempt to find undervalued securities
o No attempt to time the market
o Holding a highly diversified portfolio
o Tradingcost/management fees are much lower
 Including ETFs = index trackers.

The Players
 Firms – net borrowers
 Households – net savers
 Governments – can be both borrowers and savers

 Financial intermediaries
o Investment companies
 The investment banking business performs specialized services for business
such as an IPO / SEO (Morgan Stanley Guest Lecture)
 Handles the marketing of securities in the primary market
o Pension funds
o Banks
o Insurance companies

,Lecture 2
The Investment Process
The Investment Process describes how a (individual or institutional) investor should go about making
decisions with regard to:
 What marketable securities to invest in
 How extensive the investments should be
 When the investments should be made

The process consists of:
 Asset allocation: choice among broad asset classes
 Security Selection: choice of securities to hold within asset class
 Security analysis

The steps in the investment process
1. Set investment policy (amongst other things: asset allocation and security selection
 Define investor’s unique objective
 Determine amount of investable wealth
 State objectives in terms of risk and return
 Identify potential investment categories

Investment policy should address:
 Mission statement: a statement including the long-run financial goals
 Risk tolerance: amount of risk that an investor is willing to bear
 Policy asset mix: the long-run allocation to broad asset classes (most important decision)
 Active or Passive management
o The choice mainly depends on the transaction costs.

Factors that affect risk
 The maturity of an instrument; general rule: the longer the maturity is, the more risky it is
 The risk characteristics and creditworthiness of the issuer or guarantor of the investment
o Example: If the counterparty is the Greek/Italian government instead of the
Dutch/German government, your investment will be riskier.
 The nature and the priority of the claims the investment has on income and assets
o Stocks / Bonds
o Junior / Senior
 The liquidity of the instrument and the type of the market in which it is traded.

Why doesn’t it make sense to establish an investment objective of ‘making a lot of money’?
Making a lot of money is also associated with more risk. Maximizing returns might entail inordinate
levels of risk

2. Perform security analysis
 Using potential investment categories, find mispriced securities
You need to estimate the securities by a model/benchmark, otherwise you can’t
compare.
 Using fundamental analysis; intrinsic value should equal discounted present value
 Compare current market price to true market value
 Identify undervalued securities
 Timing

, 3. Construct a portfolio
 Identify specific assets and proportion of wealth in which to invest
 Address issues of
o Selectivity
o Timing
o Diversification
4. Revise the portfolio
 Periodically repeat step 3
 Revise if necessary -> incur your loss on time
o Increase/decrease existing securities
o Delete some securities
o Add new securities

5. Evaluate Performance
 Involves periodic determination of portfolio performance with respect to risk and
return
 Requires appropriate measures of risk and return

Trading of Securities
Securities only can be traded when they are listed on a
stock market / exchange.
Initial public offering is the process to become listed. This
process contains road shows and bookbuilding.
Research suggests that the IPO starts with underpricing,
leading to post sale returns and costs to the issuing firm.
The underpricing comes from:
 The syndicate / underwriter wants (to maintain) a long
term relation with the big (institutional investors).
 The underwriter guaranteed to sell a proportion of the
shares.

The IPO is associated with a positive initial return but in the
long term the performance is worse than the competitors
(which were already listed).

Characteristics of trading
 Type of markets
o Direct search; this is the least organized form
o Brokered; Trading in a good is active
o Dealer; Trading in a particular type of asset increases
o Auction; most integrated form

,  Types of orders
o Market; this will be executed immediately Price-Contingent Order
 Bid / Ask Price -> see the limit order
book
o Price-contigent
 Investors specify prices
 Stop orders


1. Limit buy order: buy if and when stock may be obtained at or
below a stipulated price.
2. Limit sell order: Sell if and when to stock price rises above a
specified limit
3. Stop-loss order: the stock is to be sold if its price falls below a specified limit
4. Stop-buy order: a stock should be bought when its price rises above a limit




High Frequency Trading
Due to technology, liquidity has increased and the spreads
have decreased.
This caused a rise in High Frequency Trading (HFT). These
firms are gaming the market in doing anything they can to
be first in the market.

Takeaway from the picture
Instead of transferring your buy/sell order to the exchange,
via your briker the order could end up in a ‘darkpool’where
it could be matched with another buyer/seller without ever
ending up at exchange.

Takeaway from the book-snippets
As soon as you made clear that you wanted to buy/sell at a certain price; supply/demand would
disappear and you could not trade anymore for the listed price.
Chipotle Example It appears as that there is another player
1 4
(HFT say) ‘jumping’ in the middle of trades.
It seems as if this player knows that shares
are offered at a low price and there is
demand at a high price and takes
2
advantage of this.

5
3 Snippets: Instead of trying to match limit
orders with the highest volume, HFT firms
‘chip away’ from the high demand volume
using small supply orders and in this way
6 drive up the price

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