Investment analysis Daniek Scholte Lubberink FENSI
Chapter 1 Investments: background and issues
Investment = Current commitment of money or other resources in the expectation of reaping future
benefits.
1.1 Real assets versus financial assets
Real assets = Assets used to produce goods and services
Land, buildings equipment, knowledge
Financial assets = Claims on real assets or the income generated by them
Stocks, bonds
While real assets generate net income to the economy, financial assets simply define the allocation
of income or wealth among investors.
Household wealth includes financial assets such as bank accounts, corporate stock or bonds
Debt securities, financial assets, are liabilities of the issuers of those securities
Your asset in Toyota is Toyota’s liability
National wealth consists of structures, equipment, inventories of goods, and land
1.2 Financial assets
Distinguish three broad types of financial assets: debt, equity and derivatives.
Debt securities/fixed income = promise either a fixed stream of income or a stream of income that is
determined according to a specified formula.
Money market refers to fixed-income securities that are short term, highly marketable, and gernarlly
very low risk
Capital market refers to long-term securities such as treasury bonds as well as bonds issued by
federal agencies, state and local municipalities, and corporations. These bonds range from very safe
in terms of default risk to relative risky. Designed with extreme diverse provisions regarding
payments provided to the investor and protection against the bankruptcy of the issuer.
Equity = An ownership share in the corporation
The performance of equity investments is tied directly to the success of the firm and its real assets
and thus equity investments tend to be riskier than investing in debt securities
Derivative securities = Securities providing payoffs that depend on the values of other assets
(options, futures contracts)
The use of derivates is to hedge risks or transfer them to other parties.
Can also be used to take highly speculative positions
Commodity and derivative markets allow firms to adjust their exposure to various business risks.
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,Investment analysis Daniek Scholte Lubberink FENSI
1.3 Financial markets and the economy
Real assets determine the wealth of an economy while financial assets merely represent claims on
real assets.
The informational role of financial markets
Stock prices reflect investors’ collective assessment of a firm’s current performance and future
prospects.
No one knows with certainty which ventures will succeed and which will fail. It is therefore
unreasonable to expect that markets will never make mistakes.
Financial markets show firms that seem to have the best prospects at that time, the stock market
encourages allocation of capital to these firms.
Consumption timing
Some individuals in an economy are earning more than they currently wish to spend. Others spend
more than they currently earn. How can you shift your purchasing power from high-earnings periods
to pow-earnings periods of life?
1. Store your wealth in financial assets
High-earnings periods: invest savings in financial assets such as stocks/bonds
Low-earning periods: sell these assets to provide funds for your consumption needs
Financial markets allow individuals to separate decisions concerning current consumption from
constraints that otherwise would be imposed by current earnings
Allocation of risk
Financial markets and the diverse financial instruments trade in those markets allow investors with
the greatest taste for risk to bear that risk while other less risk-intolerant individuals can, to a greater
extent, stay on the sidelines.
Capital markets allow the risk that is inherent to all investments to be borne by the investors most
willing to bear that risk.
This allocation of risk also benefits the firms that need to raise capital to finance their investments.
When investors are able to select security types with the risk-return characteristics that best suit
their preferences, each security can be sold for the best price possible. This facilitates the process of
building the economy’s stock of real assets.
Separation of ownership and management
A large group of owners, stockholders, cannot actively participate in the day-to-day management of
the firm. Instead, they elect a board of directors that in turn hires and supervises the management of
the firm. Here, owners and managers are different parties. This gives the firm a stability that the
owner-managed firm cannot achieve.
Financial assets and the ability to buy and sell those assets in the financial markets allow for easy
separation of ownership and management.
Agency problems = Conflicts of interest between managers and stockholders
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,Investment analysis Daniek Scholte Lubberink FENSI
Several mechanisms have evolved to mitigate potential agency problems:
1. Compensation plans tie the income of managers to the success of the firm
2. Boards of directors can and have forced out management teams that are underperforming
3. Outsiders such as security analysts and large institutional investors monitor the firm closely and
make the life of poor performers at the least uncomfortable.
4. Bad performers are subject to the threat of takeover.
Corporate governance and corporate ethics
Market signals will help to allocate capital efficiently only if investors are acting on accurate
information. We say that markets need to be transparent for investors to make informed decisions. If
firms can mislead the public about prospects, much can go wrong.
Scandals include systematically misleading and overly optimistic research reports and allocation of
initial public offerings to corporate executives as a quid pro quo for personal favor of the promise to
direct future business back to the manager of the IPO.
1.4 The investment process
Investment assets can be categorized into broad asset classes, such as stocks, bonds, real estate,
commodities etc. Investors make two types of decisions in constructing their portfolios.
Asset allocation = allocation of an investment portfolio across broad asset classes
Security selection = choice of specific securities within each asset class
Security analysis = Analysis of the value of securities
“Top-down” portfolio construction: starts with asset allocation. A top-down investor first makes
decisions on what proportion of the overall portfolio ought to be moved into stocks, bonds and so
on. In this way the broad features of the portfolio are established. He also first makes decisions on
other crucial asset allocation decisions before turning to the decision of the particular securities to be
held in each asset class.
“Bottom-up” portfolio construction: the portfolio is constructed from the securities that seem
attractively priced without as much concern for the resultant asset allocation. This strategy does
focus the portfolio on the assets that seem to offer the most attractive investment opportunities
1.5 Markets are competitive
“Free-lunches” → securities that are so underpriced that they represent obvious bargains. There are
several implications of this no-free lunch proposition:
The risk-return trade-off
= Assets with higher expected returns entail greater risk
If all else could be held equal, investors would prefer investments with the highest expected return.
However, the no-free-lunch rule tells us that all else cannot be held equal. If you want higher
expected returns, you will have to pay a price in terms of accepting higher investment risk.
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, Investment analysis Daniek Scholte Lubberink FENSI
If higher expected return can be achieved without bearing extra risk, there will be a rush to buy the
high-return assets with the result that their prices will be driven up. Individuals considering the
investing in the asset at the now-higher price will find the investment less attractive.
The asset will be considered attractive and its price will continue to rise until its expected return is no
more than commensurate with risk.
Similarly, there would be a rush to sell high-risk assets if returns were independent of risk. Their
prices would fall (improving the expected future rates of return) until they eventually were attractive
enough to be included again in investor portfolios.
Efficient markets
Passive management = Buying and holding a diversified portfolio without attempting to identify
mispriced securities
Active management = Attempting to identify mispriced securities to forecast broad market trends
If markets are efficient and priced reflect all relevant information, perhaps it is better to follow
passive strategies instead of spending resources in a futile attempt to outguess your competitors
Without ongoing security, however, prices eventually would depart from “correct” values, creating
new incentives for experts to move in.
1.6 The players
1. Firms are net demanders of capital
2. Households typically are suppliers of capital
3. Government can be borrowers or lenders, depending on the relationship between tax revenue and
government expenditures.
Corporations and governments do not sell all or even most of their securities directly to individuals.
Half of their stock is often held by large financial institutions that stand between the security issuer
(the firm) and the ultimate owner of the security (the individual). This is why they are called financial
intermediaries
What makes it hard for households to make direct investments?
- An individual seeking to lend money to businesses that need to finance investments doesn’t
advertise in the local newspaper to find a willing and desirable borrower
- An individual lender would not be able to diversify across borrowers to reduce risk
- An individual is not equipped to assess and monitor the credit risk of borrowers
Financial intermediaries
Financial intermediaries = Institutions that “connect” borrowers and lenders by accepting funds
from lenders and loaning funds to borrowers
Financial intermediaries are distinguished from other businesses in that both their assets and their
liabilities are overwhelmingly financial. Intermediaries simply move funds from one sector to another
→ investment companies, insurance companies, credit unions, banks.
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