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Investment Analysis ProcessInvestment Analysis Process
Type of Capital PerformanceAnalysis Economics => Markets => Style => Sector => Industry => Business Financial Valuation => Trading => Evaluation
Who Does It? Economist Strategist Strategist PM PM Analyst Analyst Analyst Trader Administrative
Value Added Highest ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> High(Importance)
Difficulty Very Difficult ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> Less Difficult
Company Analysis
OutlineOutline
Many roles in the investment management process
Areas overlap Left to right depicts a top-down approach to
investment management All add value and all are difficult (more
difficult and value added to the left)
Outline Cont…Outline Cont…
Today, we will focus our discussion on style analysis
Style analysis plays an important role in several areas of investment analysis– Style analysis– Sector/industry analysis– Company analysis– Trading– Performance evaluation
Investment Analysis ProcessInvestment Analysis Process
Type of Capital PerformanceAnalysis Economics => Markets => Style => Sector => Industry => Business Financial Valuation => Trading => Evaluation
Who Does It? Economist Strategist Strategist PM PM Analyst Analyst Analyst Trader Administrative
Value Added Highest ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> High(Importance)
Difficulty Very Difficult ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> Less Difficult
Company Analysis
EconomicsEconomics
The economic forecast is the most important forecast
Determined by the economist Major factors include: GDP, consumption,
investment, government spending, net exports, unemployment, inflation, and interest rates, etc.
We currently expect a mild recession and then a recovery in the second half of 2002, with continued low inflation
Investment Analysis ProcessInvestment Analysis Process
Type of Capital PerformanceAnalysis Economics => Markets => Style => Sector => Industry => Business Financial Valuation => Trading => Evaluation
Who Does It? Economist Strategist Strategist PM PM Analyst Analyst Analyst Trader Administrative
Value Added Highest ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> High(Importance)
Difficulty Very Difficult ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> Less Difficult
Company Analysis
Capital MarketsCapital Markets Economic forecast leads to the asset allocation
decision (the most important decision)– Asset classes do not move together– Asset classes are large in size
Difficult decision that can make or break performance
Determined by the Strategy team If the economy is strong and inflation is low, then
this is normally good for the stock market – Remember: P = (E1 * payout) / (r –g))
Currently over-weighted equities and real estate
-1.3%
0.1%
0.5%
1.1%
3.3%
Peak
LagLead
-2.9%-1.9%-0.7%-0.2%5 mo
-1.6%-0.6%0.8%1.3%1 moLag
-1.2%-0.2%1.2%1.7%Trough
-0.6%0.5%1.8%2.4%1 moLead
1.9%2.7%4.1%4.6%5 mo
5 mo1 mo1 mo5 mo
Capital Markets Cont…Capital Markets Cont…
Investment Analysis ProcessInvestment Analysis Process
Type of Capital PerformanceAnalysis Economics => Markets => Style => Sector => Industry => Business Financial Valuation => Trading => Evaluation
Who Does It? Economist Strategist Strategist PM PM Analyst Analyst Analyst Trader Administrative
Value Added Highest ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> High(Importance)
Difficulty Very Difficult ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> Less Difficult
Company Analysis
Style Style The style decision adds substantial value
– Movements in styles can differ greatly in magnitude– There are only a few styles– Style decisions impact all other parts of investment
analysis Difficult decision that can make or break
performance Determined by the Domestic Equities Strategy team Style is classified by size and valuation; although,
there are many characteristics that are applicable to investment managers/stocks
Morningstar Boxes
Value Blend GrowthLargeMid
Small
Valuation
Size
Style Cont…CharacteristicsStyle Cont…Characteristics
STRS Domestic Equities
Benchmarks----------------------- Value All Growth:: Value Blend Growth
S&P 500 Large A & I A & I A
S&P 400 Mid A I A
S&P 600 Small E P E=
S&P 1500
Specialty Funds: Technology and Health Care
Valuation/Style
Size
A = Active, E = External, I = Index, P = Passive
Style Cont…CharacteristicsStyle Cont…CharacteristicsCharacteristic Value Stock/Manager Growth Stock/Manager
Growth Rate *Low to High/ Average to *HighCyclical/Mature Defensive/Growth
Valuation of Stocks Low (i.e. P/E) High (i.e. P/E)Dividends High LowTime horizon Long Short to LongPatience of PM with Investment High LowDebt Mid to High Low to MidProfitability Low ROE High ROETrading Activities of PMs Supply Liquidity Pay up for Liquidity Management of Companies Bad to Good GoodCoverage by Sell Side Under-followed Highly followedView Cruddy to Good Glamour or Trendy
Turnaround Stories Look at Sales GrowthLook for Catalysts Look for Trends
Previous company performance Low HighPrevious stock performance Low HighMistakes of PMs Buy/Sell Too Early Extrapolate Current Growth (Too
Buy Without a Catalyst High) Too Long—Result is Pay Too Much for Inflated Expectations
Beta Low < 1 High > 1Size of Companies *Small to Large Small to *LargeExpectations for Companies Low HighIn/Out Out of Favor/Style In Favor/StyleBelief of PM Reversion to the Mean The Trend is My FriendStrategy of PMs (in Brief) Buy Low Valuation Stocks Buy High Price and
with Catalysts Earnings Momentum Stocks, Valuation Less Important
Style Cont…FactorsStyle Cont…Factors
Major factors include: inflation, interest rates, earnings growth, the phase of the economic cycle, phase of life cycle, etc.
The simple DDM captures many of these factors
P0 = (E1 * payout) / (r – g)
Interest rate moves do not affect all styles equallyGrowth stocks rise more than value securities as
rates move downExample:
– 2 stocks differ only with regard to growth rates (7% and 10%)
– RP = 6%, B = 1, E1 = $1, Payout = 40%
Style Cont…RatesStyle Cont…Rates
Style Rotation and Interest Rates
5.7 6.2 6.7 7.3 8.08.9
10.0
11.413.3
16.0
20.0
26.7
40.0
10.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
45.0
8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0%
T-Bill Rate
Pric
e
10% Growth Stock
7% Value Stock
Changes in economic growth do not affect all styles equally
Value stocks outperform growth stocks (ex tech) as the economy picks up– Why pay up for growth stocks during a recovery
when earnings growth is abundant?
Style Cont…EarningsStyle Cont…Earnings
The out-performance of growth stocks over value stocks from 1993-1998 can be explained by movements in interest rates and earnings– Both of these factors favored growth stocks
Earnings growth was slowingInflation was slowing, and interest rates were falling
Style Cont…1993-1998Style Cont…1993-1998
Style Cont…1999-TodayStyle Cont…1999-Today
1999-1Q2000 rates and earnings growth rose, but growth outperformed value (the bubble)—Why?
2Q2000-today rates have been falling but so has earnings growth and both value and growth have had their runs
Style Cont…1999-1Q2000Style Cont…1999-1Q2000
At this time, the Fed was pumping money into the system to get ready for Y2K– M * V = P * Q
P and Q were not rising rapidly, so V was falling
V falling means more people were investing versus spending—they invested in growth stocks
Style Cont…RecoveryStyle Cont…Recovery
What happens when rates fall and earnings rise? (i.e. the current environment?)
Value/small stocks tend to perform well during economic expansions even as rates fall– The “E” matters more than the “r” in the DDM
We are currently over-weighted mid-cap/growth and favor small/value during the next few quarters
Style Cont…What to Do?Style Cont…What to Do? Managers alter their styles only after they notice
events have changed (just before they change again)
Difficult to predict rotations– Must forecast many difficult to predict factors
(interest rates, economy, politics, etc.)
Unexpected events can (and do) arise (regularly)
You either win big or lose big, and the chance of winning is low
Style Cont…What to Do?Style Cont…What to Do?
Be consistent with whatever style chosen – Value and growth both “work”, but at different
times
Easier to forecast at the sector/industry level (and within the industry), where the probability of success is higher
Investment Analysis ProcessInvestment Analysis Process
Type of Capital PerformanceAnalysis Economics => Markets => Style => Sector => Industry => Business Financial Valuation => Trading => Evaluation
Who Does It? Economist Strategist Strategist PM PM Analyst Analyst Analyst Trader Administrative
Value Added Highest ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> High(Importance)
Difficulty Very Difficult ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> Less Difficult
Company Analysis
Sector/Industry Sector/Industry
The sector/industry decision adds value– Sectors do not move together (but generally in the same
direction)– Only 10 sectors
Driven by the economic cycle, so it is difficult to forecast
Determined by the portfolio managers The Domestic Equities department is currently
over-weighted technology; however, we took a lot of money off the table during the tech run in 4Q2001
Sector/Industry Cont…Sector/Industry Cont… Sectors can be divided by into value and
growth
Growth?Defensive?Utilities
Growth?Defensive?Telecom
CyclicalMaterials
GrowthCyclical?Info Tech
CyclicalIndustrials
Defensive/GrowthHealth Care
Growth?CyclicalFinancials
Growth?CyclicalEnergy
DefensiveCons Staples
Growth?CyclicalCons Discretionary
GrowthValueSector
Investment Analysis ProcessInvestment Analysis Process
Type of Capital PerformanceAnalysis Economics => Markets => Style => Sector => Industry => Business Financial Valuation => Trading => Evaluation
Who Does It? Economist Strategist Strategist PM PM Analyst Analyst Analyst Trader Administrative
Value Added Highest ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> High(Importance)
Difficulty Very Difficult ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> Less Difficult
Company Analysis
Company AnalysisCompany Analysis
Company analysis adds less value than other types of analysis (on an individual basis) – Stocks in an industry generally move in the same
direction– Many stocks in a portfolio
Determined by the analysts Must compare business, financial and valuation
fundamentals of one company to another firm in the same industry
Co Analysis Cont…Co Analysis Cont… Business analysis:
– Compare/contrast strategy, products, management, phase of life cycle, etc.
Financial analysis: – Utilize history to project the future – Can the firm finance the business plan? – A lot of room for manipulation (cash flow is best)
Valuation: – The art and science of a recommendation– To determine whether the business and financial
fundamentals are appropriately priced into the stock
Co Analysis Cont…CharacterCo Analysis Cont…CharacterCharacteristic Value Stock/Manager Growth Stock/Manager
Growth Rate *Low to High/ Average to *HighCyclical/Mature Defensive/Growth
Valuation of Stocks Low (i.e. P/E) High (i.e. P/E)Dividends High LowTime horizon Long Short to LongPatience of PM with Investment High LowDebt Mid to High Low to MidProfitability Low ROE High ROETrading Activities of PMs Supply Liquidity Pay up for Liquidity Management of Companies Bad to Good GoodCoverage by Sell Side Under-followed Highly followedView Cruddy to Good Glamour or Trendy
Turnaround Stories Look at Sales GrowthLook for Catalysts Look for Trends
Previous company performance Low HighPrevious stock performance Low HighMistakes of PMs Buy/Sell Too Early Extrapolate Current Growth (Too
Buy Without a Catalyst High) Too Long—Result is Pay Too Much for Inflated Expectations
Beta Low < 1 High > 1Size of Companies *Small to Large Small to *LargeExpectations for Companies Low HighIn/Out Out of Favor/Style In Favor/StyleBelief of PM Reversion to the Mean The Trend is My FriendStrategy of PMs (in Brief) Buy Low Valuation Stocks Buy High Price and
with Catalysts Earnings Momentum Stocks, Valuation Less Important
Co Analysis Cont…BusinessCo Analysis Cont…BusinessMethod of Analysis
Sustained Competitive Advantage (SCA) Value Manager/Stock Growth Manager/Stock
General Information
Corporate Strategy Focus, Differentiation, Low Costs Worse Better
Life Cycle Focus, Differentiation, Low Costs Stable/Decline Pioneer/Growth
Quality of Company Focus, Differentiation, Low Costs Worse Better
Financial Summary Focus, Differentiation, Low Costs Worse Better
Products and Markets Focus Less Important More Important
Production and Distribution Low Cost More Important Less Important
Competition Differentiation More Less
Other Topics
Research and Development Focus, Low Cost, Differentiation Less Important More Important
Foreign Sales and Earnings Focus Important Important
Government Regulation Focus, Differentiation, Low Costs More Likely Less Likely
Personnel Low Cost Unions?/Incentives Incentives
Properties Low Cost More Important Less Important
Management Focus, Differentiation, Low Costs Worse Better
Focus = an example is a firm selecting a narrow customer base that is underserved by the industry.
Differentiation = does the firm offer something that is unique?
Low Costs = is the firm's cost of producing its goods/services lower than the competition?
Co Analysis Cont…FinancialCo Analysis Cont…Financial
Characteristic Value Manager/Stock Growth Manager/Stock
Margins * Lower Higher
Asset Utilization * Lower Higher
Interest Burden * Higher Lower
Financial Leverage * Higher Lower
Tax Effect = ? ?
ROE * Lower Higher
Retention = Lower Higher
Growth Lower Higher
Co Analysis Cont…ValuationCo Analysis Cont…Valuation
Expectation (i.e. growth) and valuation (i.e. value) factors work
These factors work at different times and in different sectors of the market
Time
+391na+459+389na+314+504+3961963-8/99
+484+377+127-262+41+149-326-2411994-8/99
+428+357+415+254+257+154+291+2101978-8/99
Price MoEPS Rev
FCF/PCF/PEst E/PT4Q E/PP/SP/BYear
Co Analysis Co Analysis ContCont… Valuation… Valuation Sectors—value/growth factors for value/
growth sectors
+740+274+1137+1662+526+8+1614+812Commodities
+213+711-1139-809+463+503-1493-1914Health
Care
-1948-348+237+541-292-314+1361+2067Energy
+97+948+1837+1264+213+1034+331+1175Technology
+12-132+1094+994+113+874+832+535Capit Equip
Price Mo
EPS Rev
FCF/PCF/PEst E/PT4Q E/PP/SP/BSector
1994-8/99
Investment Analysis ProcessInvestment Analysis Process
Type of Capital PerformanceAnalysis Economics => Markets => Style => Sector => Industry => Business Financial Valuation => Trading => Evaluation
Who Does It? Economist Strategist Strategist PM PM Analyst Analyst Analyst Trader Administrative
Value Added Highest ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> High(Importance)
Difficulty Very Difficult ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> Less Difficult
Company Analysis
TradingTrading Trading is an important component of the
investment process– Average round-trip cost is over 2%– Many of the costs are invisible
Trading is performed by the traders Keys
– Communication/networking– Technical analysis (e.g. price momentum and volume
—growth factors)
Investment Analysis ProcessInvestment Analysis Process
Type of Capital PerformanceAnalysis Economics => Markets => Style => Sector => Industry => Business Financial Valuation => Trading => Evaluation
Who Does It? Economist Strategist Strategist PM PM Analyst Analyst Analyst Trader Administrative
Value Added Highest ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> High(Importance)
Difficulty Very Difficult ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> Less Difficult
Company Analysis
Performance Evaluation Performance Evaluation
Performance evaluation has value (knowing how you are doing can prompt you to make decisions)
Performance evaluation is performed by the back office (with the great help of the ITS staff)
Performance evaluation can take place at the asset level, style level, portfolio level, sector/industry level, company (i.e. analyst) level, and execution level
Investment Analysis ProcessInvestment Analysis Process
Type of Capital PerformanceAnalysis Economics => Markets => Style => Sector => Industry => Business Financial Valuation => Trading => Evaluation
Who Does It? Economist Strategist Strategist PM PM Analyst Analyst Analyst Trader Administrative
Value Added Highest ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> High(Importance)
Difficulty Very Difficult ----------------------------------------------------------------------------------------------------------------------------------------------------------------------> Less Difficult
Company Analysis