ANALYSIS AND MANAGEMENT

Transcription

1 ANALYSIS AND MANAGEMENT T H 1RD CANADIAN EDITION W. SEAN CLEARY Queen's University CHARLES P. JONES North Carolina State University JOHN WILEY & SONS CANADA, LTD.

2 CONTENTS PART ONE Background CHAPTER 1 Understanding Investments 1 The Purpose of this Textbook 2 The Nature of Investments 3 Some Definitions 3 Investing as Part of Personal Financial Planning 3 Why Do We Invest? 5 The Importance of Studying Investments 6 The Personal Aspects 6 Investments as a Profession 7 Understanding the Investment Decision Process 8 The Basis of Investment Decisions 9 The Expected Risk-Return Trade-Off 10 Structuring the Decision Process 11 Important Considerations in the Investment Decision Process 12 The Great Unknown 12 The Global Investments Arena 13 The New Economy versus the Old Economy 15 The Role of the Internet 16 Institutional Investors 16 The Issue of Market Efficiency 19 Corporate Governance 19 Summary 21 Appendix 1A: The Chartered Financial Analyst Program 23 Appendix IB: The Canadian Securities Institute (CSI) 24 ^. CHAPTER 2 Investment Alternatives 25 Organizing Financial Assets 26 An International Perspective 27 Non-Marketable Financial Assets 27 Money Market Securities 30 Capital Market Securities 33 Fixed-Income Securities 33 Asset-Backed Securities 40 Equity Securities 41 Derivative Securities 47 Options 47 Forward and Futures Contracts 48 Summary 49 Appendix 2A: Taxation of Investment Income in Canada 52 CHAPTER 3 Investment Funds 57 Investing Indirectly 58 Investing Indirectly through Investment Funds 61 What Is an Investment Fund? 62 Types of Investment Funds 65 Unit Investment Trusts 65 Closed-End Investment Funds 65 Open-End Investment Funds (Mutual Funds) 65 Major Types of Mutual Funds 67 Money Market Funds 67 Equity and Bond and Income Funds 68 Indirect Investment Transactions 71 Closed-End Funds 71 Mutual Funds 71 Exchange-Traded Funds (ETFs) 73

3 CONTENTS Xlll Distinguishing among ETFs, Closed-End Funds, and Mutual Funds 75 Segregated Funds 75 Labour Sponsored Venture Capital Corporations (LSVCCs) 75 Investment Funds Performance 78 Benchmarks 79 How Important Are Expenses? 79 Mutual Fund Ratings 80 [ Consistency of Performance 83 ~" Investing Internationally through Investment Funds 84 The Future of Indirect Investing 85 Hedge Funds 85 Summary 87 CHAPTER 4 Securities Markets 91 The Importance of Financial Markets 92 The Primary Markets 92 Investment Dealers 94 The Underwriting Process 96 The Prompt Offering Qualification (POP) System 96 The Listing Process 97 Global Security Issues 97 Private Placements 98 The Secondary Markets 98 Equity Securities Auction Markets 98 Equity Securities Negotiated Markets 105 The Third and Fourth Markets 107 After-Hours Trading 108 In-House Trading 108 Comparison of International Equity Markets 109 Stock Market Indicators 109 Bond Markets 112 Derivatives Markets 113 The Changing Securities Markets 116 The Globalization of Securities Markets 116 Summary 117 Appendix 4A: Stock Market Indexes 121 CHAPTER 5 How Securities Are Traded 123 Brokerage Transactions 124 Brokerage Firms 124 Stockbrokers or Financial Consultants? 124 Types of Brokerage Accounts 125 Commissions 126 Electronic Trading and the Internet 126 Investing without a Broker 131 How Orders Work 131 Orders on the Organized Exchanges 131 Orders in the Over-the-Counter Market 132 Types of Orders 132 Clearing Procedures 133 Investor Protection in the Securities Markets 134 The Canadian Regulatory Environment 136 Margin 139 Short Sales 143 Summary 146 Appendix 5A: Trading on the NYSE 150 Appendix 5B: Securities Regulation in the United Stales 152

4 XIV CONTENTS CHAPTER 6 The Returns and Risks from Investing 153 Return 154 The Components of Return 154 Risk 155 Sources of Risk 155 Types of Risk 158 Measuring Returns 1.59 Total Return 159 ~~ Return Relative 161 Cumulative Wealth Index 162 International Returns 163 Summary Statistics for Returns 164 Inflation-Adjusted Returns 167 Measuring Risk 168 Standard Deviation 168 Risk Premiums 170 Realized Returns and Risks from Investing 171 Total Returns and Standard Deviations 171 Cumulative Wealth Indexes 172 Summary 175 PART TWO Important Investment Concepts CHAPTER 7 Expected Return and Risk 185 Future Return and Risk 186 Estimating Security-Return and Risk 188 Dealing with Uncertainty 188 Calculating Expected Return 192 Calculating Risk 192 Portfolio Return and Risk 193 Portfolio Expected Return 193 Portfolio Risk 194 Analyzing Portfolio Risk 195 Risk Reduction in Stock Portfolios 195 Diversification 195 Markowitz Diversification 201 Measuring Co-Movements in Security Returns 201 The Correlation Coefficient 201 Covariance 204 Calculating Portfolio Risk 205 The Two-Security Case 206 The n-security Case 208 Simplifying the Markowitz Calculations 210 The Single-Index Model 210 Summary 213 CHAPTER 8 Portfolio Selection 223 Introducing Riskless Assets 224 Building a Portfolio 224 Step 1: Use the Markowitz Portfolio Selection Model 225 Efficient Portfolios 225 Selecting an Optimal Portfolio of Risky Assets 226 Alternative Methods of Obtaining the Efficient Frontier 227 Selecting Optimal Asset Classes 228 Step 2: Consider Borrowing and Lending Possibilities 231 Risk-Free Borrowing and Lending 231 The New Efficient Set 235

5 CONTENTS XV Step 3: Choose the Final Portfolio Based on Preferences 236 The Separation Theorem 236 The Implications of Portfolio Selection 237 Systematic and Non-Systematic Risk 237 Summary 240 i Appendix 8A: A Modern Portfolio Theory and the Portfolio Management Process 247 CHAPTER 9 Capital Market Theory 250 Introduction to Capital Market Theory 250 The Assumptions of the CAPM 250 Equilibrium in the Capital Markets 251 The Market Portfolio 252 The Importance of the Market Portfolio 253 Composition of the Market Portfolio 253 The Equilibrium Risk Return Trade-Off 256 The Capital Market Line 256 The Security Market Line 258 Estimating the SML 264 Estimating Beta 264 Tests of the CAPM 266 The Fama and French Studies 267 Difficulties in Testing the CAPM 268 Arbitrage Pricing Theory 269 Understanding the APT Model 270 Using APT in Investment Decisions 272 Some Conclusions about Asset Pricing 273 Summary 273 ' CHAPTER 10 Market Efficiency 283 The Concept of an Efficient Market 284 What Is an Efficient Market? 285 Why the Market Can Be Expected to Be Efficient 286 Forms of Market Efficiency 287 Evidence on Market Efficiency 289 Weak-Form Evidence 289 Semi-Strong-Form Evidence 292 Strong-Form Evidence 295 Implications of the Efficient Market Hypothesis 297 For Technical Analysis 297 For Fundamental Analysis 297 For Money Management 298 Behavioural Finance 300 Market Anomalies 301 Momentum in Stock Returns 301 Earnings Announcements 302 Value Stocks 304 The Size Effect 306 Seasonality in Stock Returns 306 The Value line Ranking System 307 Other Anomalies 309 Some Conclusions about Market Efficiency 309 Summary 315 PART THREE Fixed-Income Securities: Analysis, Valuation, and Management CHAPTER 11 Bond Yields and Prices 319 Bond Prices 320

6 XVI CONTENTS The Valuation Principle 320 Bond Valuation 321 Bond Yields 327 The Basic Components of Interest Rates 327 Measuring Bond Yields 329 Bond Price Changes 334 Bond Price Changes Over Time 334 Bond Price Changes as"a Result of Interest Rate Changes 335 Measuring Bond Price Volatility: Duration 338 Summary 347 Appendix 11 A: Treasury Bill Yields and Prices 353 Appendix 11B: Effective Duration and Effective Convexity 354 Appendix 11C: Convertible Bonds 356 CHAPTER 12 Bonds: Analysis and Strategy 361 Why Buy Bonds? 362 Buying Foreign Bonds 364 Important Considerations in Managing a Bond Portfolio 366 Understanding the Bond Market 366 The Term Structure of Interest Rates 367 The Risk Structure of Interest Rates Yield Spreads 371 Bond Strategies 375 Passive Management Strategies 376 Active Management Strategies 377 Immunization A Hybrid Strategy 381 Building a Fixed-Income Portfolio 385 Conservative Investors 385 Aggressive Investors 386 The International Perspective 386 Summary 387 PART FOUR Common Stocks: Analysis, Valuation, and Management CHAPTER 13 Common Stock Valuation 395 The Present Value Approach 396 The Required Rate of Return 396 The Expected Cash Flows 397 The Dividend Discount Model 399 The Multiple-Growth Case 407 Dividends, Dividends What about Capital Gains? 410 Intrinsic Value 411 The Dividend Discount Model in Practice 411 Relative Valuation Approaches 414 / The P/E Ratio Approach 414 Market-to-Book Ratio (M/B) 419 Price/Sales Ratio (P/S) 420 Other Relative Valuation Approaches 421 Other Valuation Issues 422 Economic Value Added 422 Market Value Added 423 Which Valuation Method to Use? 424 Bursting the Bubble of New Economy Stocks A Lesson in Valuation 425 Some Final Thoughts on Valuation 426 Summary 426 Appendix 13A: The Analysis and Valuation of Preferred Stock 438 Appendix 13B: The Free Cash Flow Valuation Approach 440

7 CONTENTS XV11 CHAPTER 14 Common Stocks: Analysis and Strategy 445 Taking a Global Perspective 446 Some Important Issues Involving Common Stocks 446 The Impact of the Overall Market on Individual Stocks 446 The Required Rate of Return 448 Risk and the Required Rate of Return T49 Building Stock Portfolios 450 The Passive Strategy 450 Buy-and-Hold Strategy 452 Index Funds and Exchange-Traded Funds 453 The Active Strategy 454 Security Selection 454 Sector Rotation 460 Market Timing 461 Efficient Markets and Active Strategies 464 Ways of Analyzing and Selecting Stocks 465 Technical Analysis 465 Fundamental Analysis 466 Efficient Markets and Behavioural Finance 466 A Framework for Fundamental Analysis 467 Bottom-Up Fundamental Analysis 467 Top-Down Fundamental Analysis 471 The Framework for Fundamental Analysis in Perspective 472 Summary 474 ^ PART FIVE Security Analysis CHAPTER 15 Analysis of the Economy and the Stock Market 477 The Economy and the Stock Market 478 Taking a Global Perspective 478 Measures of Economic Activity 478 The Business Cycle 479 Other Factors Affecting the Aggregate Economy 484 The Relationship between the Bond Market and the Stock Market 494 Macroeconomic Forecasts of the Economy 494 Understanding the Stock Market 495 What Do We Mean by the Market? 495 The Determinants of Stock Prices 496 Valuing the Market 500 The Earnings Stream 501 The Multiplier 503 Putting the Two Together 503 Forecasting Changes in the Market 504 Using the Business Cycle to Make Market Forecasts 505 Using Key Variables to Make Market Forecasts 505 Using Valuation Models to Make Market Forecasts 507 Summary 508 CHAPTER 16 Industry Analysis 513 The Importance of Industry Analysis 514 Performance of Industries over Time 515 What Is an Industry? 517 Classifying Industries 518 Analyzing Industries 519 The Industry Life Cycle 519 Qualitative Aspects of Industry Analysis 521

8 XV111 CONTENTS Industry Rotation 523 Evaluating Future Industry Prospects 523 Assessing Longer-Term Prospects 523 Picking Industries for Next Year 524 Business Cycle Analysis 526 Summary 531 CHAPTER 17 Company Analysis 535 Fundamental Analysis 536 The Accounting Aspects of Earnings 538 The Financial Statements 538 The Problem with Reported Earnings 542 The Global Arena International Accounting 546 Analyzing a Company's Profitability 547 Analyzing Return on Equity (ROE) 548 Estimating the Internal (Sustainable) Growth Rate 550 Earnings Estimates 552 A Forecast of EPS 552 The Accuracy of Earnings Forecasts 553 Earnings Surprises 554 ' The Earnings Game 555 Useful Information for Investors about Earnings Estimates 556 Sales Growth An Alternative to Earnings 556 The P/E Ratio 557 Determinants of the P/E Ratio 557 Why P/E Ratios Vary among Companies 559 The PEG Ratio 559 Fundamental Security Analysis in Practice 561 Putting All the Pieces Together 565 Summary 569 Appendix 17A: Financial Ratio Analysis: An Overview 582 CHAPTER 18 Technical Analysis 593 Introduction 594 What Is Technical Analysis? 596 A Framework for Technical Analysis 597 Stock Price and Volume Techniques 599 The Dow Theory 599 Charts of Price Patterns 600 Moving Averages 605 Relative Strength 607 Obtaining Charts to Use in Technical Analysis 607 Technical Indicators 609 Breadth Indicators 609 Sentiment Indicators 610 Testing Technical Analysis Strategies 611 Some Conclusions about Technical Analysis 612 Summary 613 PART SIX Derivative Securities CHAPTER 19 Options 619 Introduction to Options 621 Options Basics 622 Why Options Markets? 622 Understanding Options 623

9 CONTENTS XIX Options Terminology 623 How Options Work 626 The Mechanics of Trading 627 Some Basic Options Characteristics 629 In the Money, At the Money, and Out of the Money 629 Intrinsic Values 630 [ Payoffs and Profits from Basic Option Positions 630 Calls 631 Puts 633 Some Observations on Buying and Selling Options 635 Some Basic Options Strategies 638 Covered Calls 638 Protective Puts 640 Portfolio Insurance 641 Option Valuation 642 A General Framework 642 Time Values 642 Boundaries on Option Prices 643 The Black-Scholes Model 645 Put Option Valuation 647. Summarizing the Factors Affecting Options Prices 648 Hedge Ratios 648 Using the Black-Scholes Model 649 An Investor's Perspective on Puts and Calls 650 What Puts and Calls Meatfto Investors 650 The Evolutionary Use of Options 650 Other Types of Options 650 The Basics of Stock-Index«Options 651 Strategies with Stock-Index Options 651 The Popularity of Stock-Index Options 653 Summary 654 Appendix 19A: Spreads and Combinations 660 Appendix 19B: Rights and Warrants 662 Appendix 19C: Put-Call Parity: The No-Arbitrage Argument 665 CHAPTER 20 Futures 667 Introduction 668 Understanding Futures Markets 668 Why Futures Markets? 668 Current Futures Markets 669 International Futures Markets 673 Futures Contracts 673 The Structure of Futures Markets 673 Futures Exchanges 673 The Clearing Corporation 674 The Mechanics of Trading 674 Basic Procedures 674 Margin 675 Using Futures Contracts 677 Hedgers 677 How to Hedge with Futures 678 Speculators 678 Financial Futures 681 Interest Rate Futures 682 Stock-Index Futures 684 Speculating with Stock-Index Futures 689

10 XX CONTENTS Conclusion 690 Summary 690 Appendix 20A: Futures Options 696 Appendix 20B: Other Derivative Securities 697 PART SEVEN Investment Management CHAPTER 21 Portfolio Management 699 Portfolio Management as a Process 700 Individual versus Institutional Investors 702 Formulate an Appropriate Investment Policy 703 Objectives 706 Constraints and Preferences 707 Determine and Quantify Capital Market Expectations 711 Forming Expectations 711 Rate of Return Assumptions 711 Constructing the Portfolio 712 Asset Allocation 712 Portfolio Optimization 716 Monitor Market Conditions and Investor Circumstances 716 Monitoring Market Conditions 716 Changes in Investor's Circumstances 716 Make Portfolio Adjustments as Necessary 717 Performance Measurement 717 Illustrative Examples 717 Summary 720 CHAPTER 22 Evaluation of Investment Performance 725 The Bottom Line 726 Framework for Evaluating Portfolio Performance 726 Differential Risk Levels 727 Differential Time Periods 727 Appropriate Benchmarks 727 Constraints on Portfolio Managers 728 "vother Considerations 728 CFA Institute's Global Investment Performance Standards (GIPS ) 728 Return and Risk Considerations 731 Measures of Return 731 Risk Measures 733 Risk-Adjusted Measures of Performance 734 The Sharpe Performance Measure 735 The Treynor Performance Measure 738 Jensen's Differential Return Measure 739 Problems with Portfolio Measurement 742 Other Issues in Performance Evaluation 743 Monitoring Performance 743 Performance Attribution 743 Can Performance Be Predicted? 744 Summary 744 Answers to Check Your Understanding 751 Glossary 763 Permission Credits 769 Index 770