Morris Capital: The Complex Interrelationships Of Different Market Segments - Essay Example

Morris Capital: The Complex Interrelationships Of Different Market Segments Introduction Financial markets have evolved over the years and in the current economic scenario they offer diverse prospects of investment. Returns against investments depend primarily on the risk that is inherently involved with the particular financial instrument that is chosen, and also on the stipulated maturity period. Funds with a long term maturity benefit from higher returns that are offered by high risk oriented and yet lucrative equity markets. Apart from equity, there are additional long term avenues of investment. They comprise insurance, commercial property, bonds, etc. Current Investment Scenario Equity generally has a high degree of inherent risk and hence the returns are also proportionately higher as compared to other financial instruments. Consequently, probability of loss is also quite high for this lucrative instrument (Goetzmann & Ibbotson, 2006, P. 141). The equity market had taken a serious blow in November 2008 and thus investors had lost their faith to a great extent on this investment avenue. However, owing to their long term maturity, equity markets still have the potential to offer superior returns on investments (Credit Suisse, 2009). Considering this intrinsic potentiality, investors should have sufficient tenacity while venturing into the risky waters of equity market. As has already been mentioned, equity is characterised by high degrees of riskiness. Financial markets are quite unpredictable and hence neither nature nor the course of the activities involved in such markets can be anticipated accurately. The harshest justification was recently given by the global recession which had forced markets to go belly up thereby making investors extremely cautious. However, financial analysts are of the idea that owing to a fall in share prices it will be a good decision to purchase equities. Current market figures reveal that returns generated from equity compound at a faster rate and hence investors are expected to be benefitted in the due course (Credit Suisse, 2009). It can be observed that financial markets have started showing signs of recovery which are reflected through an increase in market demand as well as organisational revenues. As the earnings of an organisation depends heavily on market perception, the value of its share falls and rises along with its projected performance. Thus, incremental growth in terms of organisational earnings invigorates the financial markets and makes them lucrative. Bond markets were forced to shut down in the backdrop of the worldwide financial crisis. After becoming temporarily dormant in last quarter of 2008, they revived in 2009 and since then they have been concentrating specifically on the top notch organisations (Indepen, 2009). In order to improve the local as well as the collective global economy by stimulating fresh investments, central banks across the globe have been maintaining low interest rates. It is pretty worthwhile to note in this context that high inflation rates coupled with low rates of interest have brought down the actual interest rate which is again reflected through returns paid by bond. Low rates of interest have affected the appeal of bonds as instruments of long term investment and the scenario is not expected to improve soon. According to chief of the central bank of UK, the increase in inflation is an impermanent phenomenon (King, 2008). Given the tensions that were created by the recession, it may be interpreted from this optimistic statement that interest rates are not likely to be hiked in UK in the near future (Yahoo Finance, 2010). Though there are chances of recovery, the fact is that UK is still grappled by recession. In the property sector prices have risen negligibly and in low volumes, and thus recovery has not been manifested yet (This is Money, 2010). The housing sector has slumped by 20% as compared to the 2007 figures and recovery is expected to be time consuming (Walayat, 2009). Scenario at Morris Capital Morris Capital is an English charitable fund which offers an investment medium with the aim to finance educational pursuits. Investing members may withdraw their funds only after a span of five years. Asset allocation of Morris is spread over various instruments such as equity, bonds and commercial property. The allocation structure is appended below. Figure 1: Asset Allocation of Morris Capital, UK Asset allocation is formulated on the basis of portfolio management and is influenced by the fund’s financial objectives as well as risk tolerance. Since the objective of Morris is to provide financial support for educational ventures, its risk tolerance is supposedly low and the same can be inferred from its restricted exposure to equity. As its overall risk is low, Morris may invest its funds in comparatively safer government bonds as well as in high yielding corporate bonds. The scenario at Morris is such that the members are expected to start withdrawing funds in June 2010 and at the same time it is also expected that withdrawals will surpass inflows at an annual rate of 3% over the next five years. This implies that Morris will substantially lose its time horizon in terms of maturity of funds. In order to make funds accessible by members, Morris should also maintain adequate levels of liquidity. Unlike funds with longer time horizons, Morris cannot afford to venture into highly risky avenues and hence it should invest judiciously in equity. As has been observed, equity markets offer healthy returns over longer time span and hence, they constitute the preferred investment choice on a long term basis. Owing to the fact that Morris doesn’t have much time before its members start withdrawing funds, it really cannot think of placing its funds in equity market. In order to generate liquidity, Morris should evaluate the status of about 55% of its funds that it has already invested in equity. The mature funds should be reinvested in fixed income generating instruments such as government bonds and commercial papers. Asset allocation becomes an important activity during periods of financial trouble. Under stringent circumstances, it is safest to invest in bonds because these are financial instruments that involve the least amounts of risk. However, if the prevailing rates of interest are low, bonds having shorter maturity periods should be given preference primarily because a rise in the interest rates will allow liquid funds to be instantaneously reinvested in high yielding bonds (Texas Bank and Trust, 2006). Hence, Morris should carefully choose the bonds. As the actual interest rate is low owing to the recent interventions of the government, Morris should concentrate more on bonds having shorter maturity periods in order benefit optimally from the markets as soon as they revive. Commercial properties represent a long term alternative for investment. Though prices of property appreciate quite fast, this asset class lacks in liquidity. Owing to an acute shortage of time, Morris should not allocate too much fund in the property market. Judicious steps are required to be taken because the English property market is yet to recover substantially. Going by the current market trends it can be forecasted that this market will need quite some time to stabilise and as a matter of fact Morris has hardly a few months before its outflows begin. As has been estimated at Morris, its cash outflows will surpass its cash inflows from June 2010. If this estimation materialises, Morris will face serious troubles in meeting the demands of its members in case its funds are locked up in long term investments. However, after a thorough analysis of the property market, Morris may invest some portion of its funds in it as it won’t need to liquidate its all its funds immediately. Recommendations It can be observed that the markets have already started showing symptoms of recovery though at variable rates across different sectors. Market indices in the growing economies of Asia provide significant evidence of the ongoing recovery. As the market demands have increased, organisational earnings have also gradually improved, thereby providing the financial markets with an optimistic signal. Most importantly, the recovery of the markets has restored attention to equity markets. Consequently share prices of organisations have received a proportional fillip. Under such circumstances of market recovery, Morris may decide on stock selection method. After identifying undervalued as well as overvalued stocks, it can take a subsequent investment position which may either be long or short. On assuming the long position it may purchase overvalued stocks and similarly it may assume the short position in order to purchase undervalued stocks. The overvalued stocks can be sold when they start getting devaluated and the undervalued stocks can be traded off when prices increase. Morris can actually adopt a dynamic plan in accordance with the market scenario. As far as bond markets are concerned, Morris should take careful steps and take the maturity period in serious consideration. In the current market scenario interest rates are low and hence Morris should not invest in long term instruments owing to the fact that such bonds will yield lower prices on maturity even if interest rates increase in the future (Washington State University, n.d.). In the recent market environment, investing in short term instruments is strongly recommended because they mature faster and thus provide quick liquidity. Hence, as the interest rates increase, returns from such bonds can be subsequently invested in instruments that guarantee higher yields. Quite obviously, Morris should vigilantly keep a track of changes in interest rates in order to utilise the rate that will most favourably support its investment decisions. Market data suggests that the property segment needs some time to revive and this in turn points to the fact that Morris cannot use it as an active investment avenue as it needs immediate liquidity. It is justifiable to recommend that Morris should not invest much in this market as such a move will lead to an unnecessary blockage of funds and pose a further impediment to liquidity. As far as investing in property in concerned Morris has already invested 5% of its funds in this avenue and hence it is further recommended that instead of channelizing more funds to this asset class, it should wait until the current investment matures. Finally, Morris can be recommended to devise a strategy whereby it will be able to invest more in the growing Asian economies on which the global financial crisis could not take a heavy toll. Moreover, it should also carefully monitor market fluctuations across relevant sectors and also scan the movements of interest rates. These will help Morris in taking investment decisions more practically. It should also take into consideration tax benefits which can be availed on the basis of investment choice as they enhance the returns on investment. Conclusion When it comes to financial markets and the instrument involved therein, predicting the future is very difficult and often, nearly impossible owing to the complex interrelationships of different market segments, numerous local markets and a large number of financial intermediaries as well as investors all over the world. Financial markets are driven to a large extent by the perception of the investors and hence, it is very difficult to predict market dynamics completely. Owing to the element of uncertainty and risk that are inherent in financial instruments, investors are necessitated to allocate strategic significance to them. Strategic allocation of weights depends primarily on the objective of the investment decision and the maturity period. Any fund that has a longer investment horizon can allocate more funds in the equity markets. When a fund is aimed at investing in instruments that involve less low risk, it may not consider equity as the prime avenue and instead invest more in government bonds, commercial papers, etc. During the course of materialising this report, it was observed that Morris is running short of time in terms of its investment spectrum. Owing to the fact that withdrawals by members soon commence, it cannot go for fresh investments which are long term in nature. However, Morris should utilise returns from previous investments in short term instruments in order to enhance its liquidity. It should avoid risky avenues such as the equity market and at the same time should not further invest in the property market. References 1. Credit Suisse. 2009. Credit Suisse Global Investment Returns Yearbook 2009. [Pdf]. Available at: http://emagazine.credit-suisse.com/app/_customtags/download_tracker.cfm?dom=emagazine.credit-suisse.com&doc=/data/_product_documents/_shop/254094/research_institute_yearbook.pdf&ts=20100217064308 [Accessed on February 23, 2010]. 2. Goetzmann, N. W. & Ibbotson, G. R. 2006. The Equity Risk Premium: Essays and Explorations. USA: Oxford University Press. 3. King, M. March 31, 2008. Extract From A Speech To The Bank Of Israel, Jerusalem. [Pdf]. http://www.bankofengland.co.uk/publications/speeches/2008/speech340.pdf [Accessed on: February 23, 2010]. 4. Texas Bank and Trust. 2006. Investment Strategies in the Current Market Environment. [Pdf]. Available at: http://www.texasbankandtrust.com/trust_pdf/1grow/Investment%20strategies.pdf [Accessed on February 23, 2010]. 5. This is Money. 2010. Are House Prices Rising in Your Postcode? Mortgages & Homes. [Online]. Available at: http://www.thisismoney.co.uk/house-prices-postcodes [Accessed on February 23, 2010]. 6. Walayat, N. 2009. Current UK Housing Market Analysis and Forecast Trends. UK Housing Market Crash and Depression Forecast 2007 to 2012. [Online]. Available at: http://www.marketoracle.co.uk/Article8080.html [Accessed on February 23, 2010]. 7. Washington State University. No Date. Bond Value: Three Important Relationships. Session 3: Bond Valuation. [Online]. Available at: http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page24.htm [Accessed on February 23, 2010]. 8. Water UK. 2009. 2009. Investor Survey: A Report by Indepen for Water UK. [Pdf]. Available at: http://www.water.org.uk/home/policy/reports/finance/2009-investor-survey/investor-survey-2009.pdf [Accessed on February 23, 2010]. 9. Yahoo Finance. 2010. Bonds Round-up: Stable UK Rates Expected. [Online]. Available at: http://uk.finance.yahoo.com/news/bonds-round-up-stable-uk-rates-expected-digilook-f417b276538a.html [Accessed on February 23, 2010]. Table of Contents Introduction 1 Current Investment Scenario 1 Scenario at Morris Capital 3 Recommendations 5 Conclusion 7 References 9 Bibliography 11 Bibliography 1. BBC. 2008. The downturn in facts and figures. UK Downturn. [Online]. Available at: http://news.bbc.co.uk/2/hi/business/7734971.stm 2. Dimson, E. Marsh, P. Staunton, M. 2002. Global evidence on equity risk premium. [Pdf]. Available at: http://faculty.london.edu/edimson/assets/documents/Jacf1.pdf Read More