Investments: Principles of Portfolio and Equity Analysis / Edition 1

by Michael McMillan, Jerald E. Pinto, Wendy L. Pirie, Gerhard Van de Venter, Lawrence E. Kochard

Overview

A comprehensive guide to investment analysis and portfolio management by an expert team from the CFA Institute

In a world of specialization, no other profession likely requires such broad, yet in-depth knowledge than that of financial analyst. Financial analysts must not only possess a broad understanding of the financial markets-including structure, organization, efficiency, portfolio management, risk and return, and planning and construction-but they must also have a strong sense of how to evaluate industries and companies prior to engaging in an analysis of a specific stock. Investments: Principles of Portfolio and Equity Analysis provides the broad-based knowledge professionals and students of the markets need to manage money and maximize return. The book

• Details market structure and functions, market anomalies, secondary market basics, and regulation
• Describes investment assets and asset classes, types of positions and orders, as well as forecasting methodologies
• Discusses return and risk characteristics, portfolio diversification and management, the basics of both technical analysis and major technical indicators, and much more
• A companion Workbook, which includes learning outcomes, summary overviews, and problems and solutions sections is available and sold separately

Investments provides readers unparalleled access to the best in professional quality information on investment analysis and portfolio management.

Product Details

ISBN-13:	9780470915806
Publisher:	Wiley
Publication date:	02/08/2011
Series:	CFA Institute Investment Series , #37
Pages:	656
Product dimensions:	7.00(w) x 10.00(h) x 1.60(d)

About the Author

MICHAEL G. MCMILLAN, CFA is Director, Ethics and Professional Standards in the Education Division of CFA Institute. Dr. McMillan joined CFA Institute in 2008 after more than a decade as a professor of accounting and finance at Johns Hopkins University's Carey Business School and The George Washington University's School of Business. He has a doctorate in accounting and finance from The George Washington University, an MBA from Stanford University, and a BA from the University of Pennsylvania. Dr. McMillan is a member of the CFA Society of Washington, DC and the East African Society of Investment Professionals.

JERALD E. PINTO, CFA is Director, Curriculum Projects, in the Education Division of CFA Institute. Before coming to CFA Institute in 2002, he consulted to corporations, foundations, and partnerships in investment planning, portfolio analysis, and quantitative analysis. He has also worked in the investment and banking industries in New York City and taught finance at New York University's Stern School of Business. He holds an MBA from Baruch College, a PhD in finance from the Stern School, and earned his CFA charter in 1992.

WENDY L. PIRIE, CFA is Director, Curriculum Projects, in the Education Division of CFA Institute. Prior to joining CFA Institute in 2008, she taught finance, accounting, statistics, taxation, business law, and marketing for over twenty years at both large and small, public and private universities, religious colleges, and military academies. Her work has been published in Journal of Financial Research and Journal of Economics and Finance. She holds a PhD from Queen's University in Kingston, Ontario and MBAs fromthe Universities of Toronto and Calgary.

GERHARD VAN DE VENTER, CFA is Deputy Head of the School of Finance and Economics at University of Technology, Sydney. He was previously director, Curriculum Projects, in the Education Division of CFA Institute. He began his career in South Africa as a financial analyst and later as a dealer at the Bond Exchange, where he traded fixed income securities. He holds a PhD in finance from the University of Technology, Sydney. He is a member of CFA Institute and the New York Society of Security Analysts.

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Table of Contents

Foreword xiii

Acknowledgments xv

Introduction xvii

Chapter 1 Market Organization and Structure 1

Learning Outcomes 1

1. Introduction 1

2. The Functions of the Financial System 2

2.1. Helping People Achieve Their Purposes in Using the Financial System 3

2.2. Determining Rates of Return 8

2.3. Capital Allocation Efficiency 9

3. Assets and Contracts 10

3.1. Classifications of Assets and Markets 11

3.2. Securities 13

3.3. Currencies 16

3.4. Contracts 16

3.5. Commodities 22

3.6. Real Assets 22

4. Financial Intermediaries 24

4.1. Brokers, Exchanges, and Alternative Trading Systems 25

4.2. Dealers 26

4.3. Securitizers 27

4.4. Depository Institutions and Other Financial Corporations 29

4.5. Insurance Companies 30

4.6. Arbitrageurs 31

4.7. Settlement and Custodial Services 33

4.8. Summary 35

5. Positions 35

5.1. Short Positions 36

5.2. Levered Positions 38

6. Orders 41

6.1. Execution Instructions 42

6.2. Validity Instructions 45

6.3. Clearing Instructions 47

7. Primary Security Markets 47

7.1. Public Offerings 48

7.2. Private Placements and Other Primary Market Transactions 50

7.3. Importance of Secondary Markets to Primary Markets 51

8. Secondary Security Market and Contract Market Structures 51

8.1. Trading Sessions 51

8.2. Execution Mechanisms 52

8.3. Market Information Systems 56

9. Well-Functioning Financial Systems 56

10. Market Regulation 58

11. Summary 61

Problems 63

Chapter 2 Security Market Indices 73

Learning Outcomes 73

1. Introduction 73

2. Index Definition and Calculations of Value and Returns 75

2.1. Calculation of Single-Period Returns 75

2.2. Calculation of Index Values over Multiple Time Periods 77

3. Index Construction and Management 78

3.1. Target Market and Security Selection 79

3.2. Index Weighting 79

3.3. Index Management: Rebalancing and Reconstitution 88

4. Uses of Market Indices 90

4.1. Gauges of Market Sentiment 90

4.2. Proxies for Measuring and Modeling Returns, Systematic Risk, and Risk-Adjusted Performance 90

4.3. Proxies for Asset Classes in Asset Allocation Models 90

4.4. Benchmarks for Actively Managed Portfolios 91

4.5. Model Portfolios for Investment Products 91

5. Equity Indices 91

5.1. Broad Market Indices 91

5.2. Multimarket Indices 92

5.3. Sector Indices 92

5.4. Style Indices 93

6. Fixed-Income Indices 94

6.1. Construction 94

6.2. Types of Fixed-Income Indices 95

7. Indices for Alternative Investments 96

7.1. Commodity Indices 98

7.2. Real Estate Investment Trust Indices 98

7.3. Hedge Fund Indices 98

8. Summary 101

Problems 102

Chapter 3 Market Efficiency 109

Learning Outcomes 109

1. Introduction 109

2. The Concept of Market Efficiency 111

2.1. The Description of Efficient Markets 111

2.2. Market Value versus Intrinsic Value 113

2.3. Factors Contributing to and Impeding a Market’s Efficiency 114

2.4. Transaction Costs and Information-Acquisition Costs 117

3. Forms of Market Efficiency 118

3.1. Weak Form 119

3.2. Semistrong Form 119

3.3. Strong Form 122

3.4. Implications of the Efficient Market Hypothesis 122

4. Market Pricing Anomalies 124

4.1. Time-Series Anomalies 125

4.2. Cross-Sectional Anomalies 127

4.3. Other Anomalies 128

4.4. Implications for Investment Strategies 130

5. Behavioral Finance 131

5.1. Loss Aversion 131

5.2. Overconfidence 132

5.3. Other Behavioral Biases 132

5.4. Information Cascades 133

5.5. Behavioral Finance and Efficient Markets 133

6. Summary 134

Problems 134

Chapter 4 Portfolio Management: An Overview 139

Learning Outcomes 139

1. Introduction 139

2. A Portfolio Perspective on Investing 140

2.1. Portfolio Diversification: Avoiding Disaster 140

2.2. Portfolios: Reduce Risk 142

2.3. Portfolios: Composition Matters for the Risk–Return Tradeoff 145

2.4. Portfolios: Not Necessarily Downside Protection 145

2.5. Portfolios: The Emergence of Modern Portfolio Theory 148

3. Investment Clients 149

3.1. Individual Investors 149

3.2. Institutional Investors 150

4. Steps in the Portfolio Management Process 156

4.1. Step One: The Planning Step 156

4.2. Step Two: The Execution Step 156

4.3. Step Three: The Feedback Step 159

5. Pooled Investments 160

5.1. Mutual Funds 160

5.2. Types of Mutual Funds 164

5.3. Other Investment Products 167

6. Summary 172

Problems 172

Chapter 5 Portfolio Risk and Return: Part I 175

Learning Outcomes 175

1. Introduction 175

2. Investment Characteristics of Assets 176

2.1. Return 176

2.2. Other Major Return Measures and Their Applications 185

2.3. Variance and Covariance of Returns 189

2.4. Historical Return and Risk 192

2.5. Other Investment Characteristics 197

3. Risk Aversion and Portfolio Selection 200

3.1. The Concept of Risk Aversion 201

3.2. Utility Theory and Indifference Curves 202

3.3. Application of Utility Theory to Portfolio Selection 206

4. Portfolio Risk 209

4.1. Portfolio of Two Risky Assets 210

4.2. Portfolio of Many Risky Assets 215

4.3. The Power of Diversification 216

5. Efficient Frontier and Investor’s Optimal Portfolio 222

5.1. Investment Opportunity Set 222

5.2. Minimum-Variance Portfolios 223

5.3. A Risk-Free Asset and Many Risky Assets 225

5.4. Optimal Investor Portfolio 228

6. Summary 234

Problems 234

Chapter 6 Portfolio Risk and Return: Part II 243

Learning Outcomes 243

1. Introduction 243

2. Capital Market Theory 244

2.1. Portfolio of Risk-Free and Risky Assets 244

2.2. The Capital Market Line 248

3. Pricing of Risk and Computation of Expected Return 256

3.1. Systematic Risk and Nonsystematic Risk 257

3.2. Calculation and Interpretation of Beta 259

4. The Capital Asset Pricing Model 267

4.1. Assumptions of the CAPM 267

4.2. The Security Market Line 269

4.3. Applications of the CAPM 272

5. Beyond the Capital Asset Pricing Model 284

5.1. The CAPM 284

5.2. Limitations of the CAPM 284

5.3. Extensions to the CAPM 286

5.4. The CAPM and Beyond 287

6. Summary 287

Problems 288

Chapter 7 Basics of Portfolio Planning and Construction 295

Learning Outcomes 295

1. Introduction 295

2. Portfolio Planning 296

2.1. The Investment Policy Statement 296

2.2. Major Components of an IPS 297

2.3. Gathering Client Information 309

3. Portfolio Construction 312

3.1. Capital Market Expectations 312

3.2. The Strategic Asset Allocation 313

3.3. Steps toward an Actual Portfolio 321

3.4. Additional Portfolio Organizing Principles 325

4. Summary 326

Problems 327

Chapter 8 Overview of Equity Securities 331

Learning Outcomes 331

1. Introduction 331

2. Equity Securities in Global Financial Markets 332

3. Types and Characteristics of Equity Securities 338

3.1. Common Shares 339

3.2. Preference Shares 343

4. Private versus Public Equity Securities 345

5. Investing in Nondomestic Equity Securities 347

5.1. Direct Investing 348

5.2. Depository Receipts 349

6. Risk and Return Characteristics of Equity Securities 353

6.1. Return Characteristics of Equity Securities 353

6.2. Risk of Equity Securities 354

7. Equity Securities and Company Value 356

7.1. Accounting Return on Equity 356

7.2. The Cost of Equity and Investors’ Required Rates of Return 361

8. Summary 362

Problems 363

Chapter 9 Introduction to Industry and Company Analysis 369

Learning Outcomes 369

1. Introduction 370

2. Uses of Industry Analysis 370

3. Approaches to Identifying Similar Companies 371

3.1. Products and/or Services Supplied 371

3.2. Business-Cycle Sensitivities 372

3.3. Statistical Similarities 374

4. Industry Classification Systems 374

4.1. Commercial Industry Classification Systems 374

4.2. Governmental Industry Classification Systems 378

4.3. Strengths and Weaknesses of Current Systems 380

4.4. Constructing a Peer Group 380

5. Describing and Analyzing an Industry 385

5.1. Principles of Strategic Analysis 386

5.2. External Influences on Industry Growth, Profitability, and Risk 405

6. Company Analysis 412

6.1. Elements That Should Be Covered in a Company Analysis 413

6.2. Spreadsheet Modeling 416

7. Summary 417

Problems 420

Chapter 10 Equity Valuation: Concepts and Basic Tools 425

Learning Outcomes 425

1. Introduction 426

2. Estimated Value and Market Price 426

3. Major Categories of Equity Valuation Models 428

4. Present Value Models: The Dividend Discount Model 430

4.1. Preferred Stock Valuation 434

4.2. The Gordon Growth Model 436

4.3. Multistage Dividend Discount Models 441

5. Multiplier Models 445

5.1. Relationships among Price Multiples, Present Value Models, and Fundamentals 445

5.2. The Method of Comparables 449

5.3. Illustration of a Valuation Based on Price Multiples 452

5.4. Enterprise Value 454

6. Asset-Based Valuation 457

7. Summary 461

Problems 462

Chapter 11 Equity Market Valuation 469

Learning Outcomes 469

1. Introduction 469

2. Estimating a Justified P/E Ratio 470

2.1. Neoclassical Approach to Growth Accounting 470

2.2. The China Economic Experience 472

2.3. Quantifying China’s Future Economic Growth 474

2.4. Equity Market Valuation 476

3. Top-Down and Bottom-Up Forecasting 484

3.1. Portfolio Suitability of Each Forecasting Type 485

3.2. Using Both Forecasting Types 487

3.3. Top-Down and Bottom-Up Forecasting of Market Earnings per Share 488

4. Relative Value Models 491

4.1. Earnings-Based Models 491

4.2. Asset-Based Models 502

5. Summary 506

Problems 508

Chapter 12 Technical Analysis 515

Learning Outcomes 515

1. Introduction 515

2. Technical Analysis: Definition and Scope 516

2.1. Principles and Assumptions 516

2.2. Technical and Fundamental Analysis 518

3. Technical Analysis Tools 520

3.1. Charts 520

3.2. Trend 530

3.3. Chart Patterns 532

3.4. Technical Indicators 544

3.5. Cycles 562

4. Elliott Wave Theory 563

5. Intermarket Analysis 566

6. Summary 568

Problems 570

Glossary 575

References 589

About the Authors 595

About the CFA Program 601

Index 603