Portfolio Analysis: Growth on the Frontier - Essay Example

?Portfolio Analysis: Growth on the Frontier [ID The Wall Street Journal famously held a contest for years that pitted the best financial analysts in the world against stocks chosen by a dartboard and readers' picks. The results were fairly embarrassing. “The pros won 61 of the 100 contests versus the darts...On the other hand, the pros losing 39% of the time to a bunch of darts certainly could be viewed as somewhat of an embarrassment for the pros. Additionally, the performance of the pros versus the Dow Jones Industrial Average was less impressive. The pros barely edged the DJIA by a margin of 51 to 49 contests” (Investor Home, 2011). An investor simply parking their money in the Dow would have beaten the specific picks of the professionals about half the time, even without transaction costs or taxes. Even worse, later research found that the pros got a break due to the announcement effect of the stock (Liang, 1996). When the pros made an announcement, others invested naively, but these stocks later reversed quite quickly: When taking this into account, the pros did not beat the dartboard! And in the last year of the contest, the readers won slightly (Jasen, 2002). All of this seems to sink the idea of portfolio analysis: If the best pros in the world using the best techniques can't beat random chance, how can anyone? But modern portfolio tools have given investors, particularly newer ones, skills for constructing an asset portfolio that will beat out mutual funds and naive investment. The Failure of Mutual Funds It's not just professionals that struggle to create value. Mutual funds are also very bad at generating growth, and they have the advantage not only of many investors and many analysts but also time and a diverse portfolio! “By and large, what you're going to find is that very, very few active funds consistently match the performance of the various indexes over the long-term, much less beat them... Finding a fund that consistently beat its index is like looking for a needle in a haystack” (Distad, 2009). Distad's data shows that very few funds beat out the market over time. Further, he notes that many of these actively managed funds are highly unreliable in terms of their fidelity. 80% had performance history only going back a year, out of a random sample of almost 3500 funds! Investors need to construct their own portfolio, not just rely on mutual funds that have had a mixed record of success and have certainly suffered after events like Enron, WorldCom and the 2008 collapse. Assets Chosen I chose two assets: Whole Foods (WFMI) and Nintendo (NTDOY.PK). I wanted to pick two assets, one of which was more of a growth asset and another which was an asset that produced products I was familiar with and that I knew something about the likely market response to. The goal for both was risk control first and growth second: That is, I wanted there to be a steadiness to the line, whether it was going horizontally or sloping upwards. I selected based off of a visual analysis of both companies over five years, then used iQfront's analysis to see what the statistics were, and was pleasantly surprised. Modern portfolio theory emphasizes that risk has to be measured based on the variance of the stock (Goetzmann, 2011). Indeed, the core idea is that a tangency line can be created that has a riskless asset used as a baseline for comparison where both risk-averse and risk-accepting investors could invest comfortably, a perfect middle ground (Goetzmann, 2011). But finding that perfect portfolio is difficult, because “a major difficulty in estimating an efficient frontier accurately is that errors grow as the number of assets increase. You cannot just dump all the means, std's and correlations for the world's assets into an optimizer and turn the crank” (Goetzmann, 2011). We will return to why analyzing risk this way is compelling since other forms of risk are so appallingly inaccurately determined (Danielsson, 2009). In any respect, while growth is easy to measure (just look at how it's doing over time with regression analyses), risk is not. But looking at the variance of a stock lets one know that, if it's growing, it will tend to stay that way. WFMI's stocks consistently go up, and the amount of spikes and valleys are low: Only one major spike and valley. Meanwhile, NIKYO.PA grew immensely from 2006 onto 2007. The recession brought the value down to about 38.60 and it has leveled off, but that is all it has done: Leveled off. Microsoft and Sony, their two major competitors in the field of consoles, have seen much worse losses recently, and these are established and trusted companies. Nintendo's business strategy, a disruptive strategy, is one that has served them well and should continue to lead to their success (Malstrom, 2008). The risk profile of this investment is low-to-medium. The five year stock reports show immense success for both companies, particularly WFMI. Nintendo controls the two most popular consoles in the world by far: The DS and the Wii (Malstrom, 2008). And, as the majority of women below 18 are gaming, the population of the country that is gaming will increase from its traditionally young male-dominated sector (McGonigal, 2011). Video games are a growth industry: The success of the Wii in turning Nintendo from the third-place contender in two market cycles in a row, the N64 and the Gamecube cycles, into the first place contender, alone shows that there is immense interest in video games as long as accessibility is combined with quality. Their competitors are only now realizing this with the Move and the Kinect, but the issue is that Microsoft and Sony still don't understands that it's not motion control per se or casual games per se but a disruptive strategy. In a disruptive strategy, one stops competing for a larger section of the same pie and expands the pie, going downmarket. If one is successful, like Nintendo was with the Wii, then those downmarket consumers get involved and come upmarket. Games like Wii Sports, very simple, introduced people to gaming and developed their skills so they could move up to the more “hardcore” games like Mario Kart and Metroid. The rest of the industry responded by assuming the move was about casual gamers, when in fact there is no such thing as a casual gamer. There are gamers, and there are potential gamers who are either former gamers or non-gamers (Malstrom, 2008). Nintendo's long-term success is guaranteed and risk managed because disruptive strategies have long-term market effects. The brand is associated with the customers who were once downmarket, so Nintendo owns almost all of a new pie. As the recession turns around and people begin to consume electronic and consumer goods again, Nintendo should be assured. Nintendo did have a weak 2009, and that has to be taken into account. But, again, it makes sense that there would be a decline during a recession year. Microsoft and Sony also suffered during the recession, and indeed they have not been able to stop their stocks from falling recently even after major successful announcements like the Move and Kinect! “During the fiscal year ended March 31, 2009, the worldwide economy deteriorated significantly primarily …However, the video game industry, which was less impacted by the economic downturn than most industries, remained relatively stable in spite of the large consumer spending decline. Under such circumstances, Nintendo has continued to execute its strategy of expanding the gaming audience by broadening the definition of video games and so on” (Nintendo, 2009). Record results were in net sales and profit were still to be had even in a weak year! Meanwhile, WFMI's growth rates speak for themselves: Almost double growth in this year alone, and while the recession hit them hard, their overall growth from 1992 has been sixty-fold. The risks involved in WFMI are real: The organic food market might crash or fail to grow as expected. But all signs point against this possibility. The organic food market in general has been experiencing explosive growth (OTA, 2011). “U.S. sales of organic food and beverages have grown from $1 billion in 1990 to $24.8 billion in 2009. Sales in 2009 represented 5.1 percent growth over 2008 sales. Experiencing the highest growth in sales during 2009 were organic fruits and vegetables, up 11.4 percent over 2008 sales” (OTA, 2011). This is especially noteworthy because 2009 was one of the worst years of the recession, yet a market associated with higher costs grew. Major competitors like Wal-Mart, Safeway and others are getting into the organic market. Whole Foods has immense market clout and penetration (Novak, 2011). Stores are to be found all over the country. If the organic market ticks upwards, they will reap the benefits. Indeed, the transformation of the market to big business is immense. “Now companies from Wal-Mart (WMT ) to General Mills (GIS ) to Kellogg (K ) are wading into the organic game, attracted by fat margins that old-fashioned food purveyors can only dream of. What was once a cottage industry of family farms has become Big Business, with all that that implies, including pressure from Wall Street to scale up and boost profits” (Bloomberg, 2006). Companies like Stonyfield are seeing annual sales growth from 20-40% (Bloomberg, 2006). Consumers will continue to embrace organic food for a variety of reasons. First: Health concerns like diabetes and obesity are becoming dire issues for consumers (BBC, 2001). Second: People perceive organic food to taste better. Third: Governments are getting involved, like the pilot program of the US Women, Infant and Children's program to embrace farmer's markets, where they found that participants didn't get less food but instead consumed more fruit and vegetables (Parker-Pope, 2008). Fourth: Consumers are increasingly concerned about pesticides, poisons, outbreaks of E.coli, etc. (BBC, 2001; Schlosser, 2003). I chose a 300 Whole Foods weight and a 250 Nintendo weight. I wanted the growth stock to dominate by a 6-to-5 ratio but the safe stock with potential for expansion to be able to weigh down the growth stock. Both companies have two scenarios: Slow continued growth as the markets settle down, or continued growth as the markets expand. The latter scenarios are far more likely based on the low risk variance and high growth over time of the companies, but the former scenario is still a good bet for investors. The portfolio as a whole is weighted towards the slightly riskier stock at a 6-to-5 ratio, but recall that the iQfront portfolio analysis found very low variance even for the WFMI stock. FA Stocks also returned good results, close to my analysis, with 51% in Nintendo and 49% in WFMI, with betas below 1.1, amazingly reliable return! WFMI in particular, despite being the growth stock, has an RS rating of 1.33, an extremely good risk rating; a 1.12 RV, a good relative value; a VST of 1.17. It does, unfortunately, have an estimated real value of $37.89 and a stop price below of $50.77 which is lower than its current value, pointing to present over-value. However, since organic food is slated to grow, holding onto the asset is worth it. Over a five year analysis, the portfolio went from $22,689 to $26,183.5, leading to a 15.4% profit even through a recession. The index beta is .44, an incredibly low variance. The volatility is 2.29% with a Sharpe ratio of 0.02. The total risk of the portfolio is thus very low, with risk-free growth of 2% a year. Portfolio Strategy and Theory Portfolio strategy is defined by Harry Markowitz thusly: “The process of selecting a portfolio may be divided into two stages. The first stage starts with observation... and ends with belief about the future performance of available securities. The second stage starts with the relevant beliefs about future performances and ends with the portfolio” (1952). This is the path chosen here: Knowing about the growth in the organic and video game industry, the portfolio was chosen to maximize on that growth by picking on the most dynamic, specialized growth players. Risk itself is virtually impossible to analyze in any real way (Danielsson, 2009). This is because economic principles are themselves not well-known, economic systems and markets are chaotic (e.g. highly responsive to changes in initial state) and because of endogenous risk caused by observing the system leading to changes in that system. Because of this, the best that most risk analyses can do is an error margin of 30%! Portfolio analysis avoids this problem by sticking to stock variance. If a stock varies a lot, at any given point it may lose the investor money. If a stock varies less, than it should lead to less risk. The companies chosen have long-term growth and so their variances are overwhelmingly upwards. Risk and reward go hand-in-hand: Better growth leads to more risks. This portfolio is a bit risky because it only has two assets: If both go belly-up or even fail to grow, then it is a losing portfolio. That having been said, it is a well-controlled risk due to the proven nature of both companies, their long-term growth and their markets. Portfolio theory suggests that portfolios can be diverse or focused, but that the portfolio should be chosen with a strategy in general (Hearth and Zalma, 2003). The idea is that the portfolio as a whole should get as close to the tangential return as possible, with a perfectly even return between risk and reward, keyed to long-term indicators like bond markets, interest rates or inflation (Goetzmann, 2011). “Suppose you were a CAPM-style investor holding the world wealth portfolio, and someone offered you another stock to invest in. What rate of return would you demand to hold this stock? The answer before the CAPM might have depended upon the standard deviation of a stock's returns. After the CAPM, it is clear that you care about the effect of this stock on the TANGENCY portfolio” (Goetzmann, 2011). The tools used indicate that this portfolio mix, by combining an established stock and a growth stock, is a very good bet. Portfolio theory still cannot conquer the dartboard problem, nor the difficulty of it being impossible to meaningfully measure endogenous risk. The bases of microeconomic and macroeconomic theory are so poorly understood and have such strange theoretical elements, like perfect prediction of the future and no desire to hedge against risk, that they provide almost no information (Albert, 2009; Benicourt and Guerrien, 2008). Portfolio analysis can only get so close to an ideal combination, and since changes outside of the control of the analyst could cause the whole market to collapse such as a major war or terrorist activity, a famine, a new technology discovered in a university that makes other technologies obsolete, a disease outbreak, etc., no portfolio is safe. But the portfolio chosen, all else held equal, should grow successfully as it chooses two leaders in industries poised for explosive growth. References Aguilar, O. “Bayesian Time Series Analysis of Stock Selection Strategies”. ING. Available at: http://www.chicagobooth.edu/research/workshops/econometrics/docs/aguilar.pdf Albert, M. “Neoclassical Micro And Macro Economics--Science Or Silliness?” Z Magazine. 2009. Available at: http://www.punksinscience.org/kleanthes/courses/UK04S/WV/ Neoclassical_Economics.html Baourakis, G. 2004, Marketing trends for organic food in the 21st century, World Scientific. BBC H2G2. 2001, “Organic food in the UK”, Available at: http://www.bbc.co.uk/dna/h2g2/A575679 Benicourt, Emmanuelle and Guerrien, Bernard. 2008, “Is Anything Worth Keeping in Microeconomics?” Review of Radical Political Economics. Volume 40, Number 3. Summer. Bloomberg Businessweek. 2006, “The Organic Myth”, October 16. Canavari, M. and Olson, DM. 2007, Organic food: consumers' choice and farmers' opportunities. Danielsson, J. “The myth of the riskometer”. VOX. January 5, 2009. Distad, L. “Are Your Actively Managed Funds Beating the Index?” Automatic Finances. July 24, 2009. FA Stocks. Available at http://www.fastocks.com/ Flyvbjerg, B. 2008, “Curbing Optimism Bias and StrategicMisrepresentation in Planning: Reference Class Forecasting in Practice”. European Planning Studies. Volume 16, Number 1. January . Goetzmann, WN. 2011, An Introduction to Investment Theory, Available at http://viking.som.yale.edu/will/finman540/classnotes/class4.html Hearth, D. and Zalma, JK. 2003, Contemporary Investments: Security and Portfolio Analysis, 4th edition, South-Western College Pub. InvestorHome. “The Wall Street Journal Dartboard Contest”. 2011. Available at http://www.investorhome.com/darts.htm IQFront. Available at: http://www.iqfront.com/index.php? option=com_content&view=article&id=5&Itemid=4 Liang, B. 1996, “The "Dartboard" Column: The Pros, the Darts, and the Market”. SSRN. November. Malstrom, S. 2009, “Birdmen and the Casual Fallacy”. Markowitz, H. 1952, “Portfolio Selection”, Journal of Finance, vol.7 no. 1, 77-91, March. McGonigal, J. 2011, Reality is Broken. Nintendo. 2009, “Financial Statement”, Available at: http://press.nintendo.com/docs/corporate/FinancialHighlights090507.pdf Novak, J. “SWOT Analysis Whole Foods”, Marketing Teacher, Available at: http://marketingteacher.com/swot/whole-foods-swot.html Parker-Pope, T. 2008, “The Farmers' Market Effect”, New York Times, January 15. Organic Trade Association. 2010, “Industry Statistics and Projected Growth”, June. Unger, Jason. “Can Monkeys Pick Stocks Better than Experts?” August 17, 2009. Automatic Finances. Van der Hart, J, de Zwart, G and van Dijk, D. 2005, “The success of stock selection strategies in emerging markets: Is it risk or behavioral bias?” 2005. Emerging Markets Review. Wilson, G. 1999, “The Role of Speculation in Currency Crises”. University of London, School of Oriental and African Studies. Yahoo Finance. 2011, “WFMI”. 2011, “NTDOY.PK” Portfolio report from 02-Mar-2006 to 02-Mar-2011 Overall portfolio characteristics          - Initial value: 22689 $        - Final value: 26183.5 $        - Profit/loss: 15.4 %        - Expected return: 0.03 %/day (or 6.39 % annualized)        - Expected volatility: 2.29 %/day (or 36.34 % annualized)        - Expected Value at Risk (5%): 3.77 %/day (or 59.78 % annualized)        - Expected Value at Risk (1%): 5.33 %/day (or 84.67 % annualized)        - Expected Sharpe ratio: 0.02        - Expected index beta: 0.44   Portfolio component performance Ticker # $ % pf 1 d % 4 w % 1 y % all % &sigma WFMI 300 16986 64.87 -3.43 7.01 56.84 -7.15 50.21 NTDOY 250 9197.5 35.13 0.38 5.14 -0.78 109.27 40.21 &Sigma 26183.5 100 -2.05 6.35 30.27 15.4 36.33 ^GSPC 1306.33 -1.57 -0.1 16.76 1.48 25         TABLE LEGEND         # - number of shares         $ - final value of position         % pf - percent of total portfolio value at the end of reporting period         1 d % - most recent one day %-change         4 w % - most recent four weeks (one month) %-change         1 y % - most recent one year (252 trading days) %-change         all % - realized %-change during entire period         &sigma - realized annual volatility         &Sigma - whole portfolio         ^GSPC - reference index   Report assumptions          - Risk-free rate of return: 2 % / year        - Recency emphasis: None        - Optimization algorithm: None.        - Only long positions in optimal portfolios: N/A        - Annualization: 252 trading days Read More