PCMs Investment Strategy and Economic Sense - Case Study Example

PEARSON CAPITAL MANAGEMENT PCM’s Investment Strategy and Economic Sense Investment strategies are designed by aligning the macroeconomic indicators so that the investment strategy can be altered appropriately with the changes in macroeconomic environment. Capital markets of any country are highly dependent upon the macroeconomic factors such that in case of change in any such factor, there comes a bigger correction in the markets as the investors’ sentiments are changed. Capital markets not only present the performance of the companies but they are also indicative of the future expectations of financial performance and positions of the company. If the PCM’s investment strategy is taken into consideration, it quite evident that Mr. Pearson has developed such a strategy which can incorporate the impacts of major macroeconomic factors. For instance, if economy suffers recession, then stock markets and real estate markets take higher impacts and they also tend to experience massive slumps in their performances. However, with the inclusion of government and corporate bonds in the portfolio, the returns earned over those bonds closely maintain the overall risk and return matrix. On the other hand, during bullish seasons, stock markets and real estate markets tend to perform on a higher note and provide extra returns than expected. However, since the bond markets provide the stable and consistent returns during the bullish period, they are not liked by the active investors in those times. From this analysis, it can be concluded that PCM’s investment strategy is well aligned with the overall macroeconomic environment by taking into account the various past patterns as well as future expectations of the capital markets. Future Expectations of Outperformance of Portfolios Any investment strategy will likely to result in better performance than the market’s overall returns, given the fact that the assets included in the portfolio are well diversified and have a tendency to beat the markets. Diversification is mainly achieved through choosing those assets which are not correlated with any other security in the portfolio (Fabbozi & Fong, 1994). A well-diversified and well-balanced portfolio can minimize the overall risk of the portfolio while creating more chances for achieving higher portfolio returns. The question arises whether the history would repeat itself again as it would once again be outperforming the market. The answer of this myth cannot be explored with any confirmation as when markets start to tumble, they not only shatters the money of the investors but also their confidence in capital markets. Past performance can never be regarded as the measure of proven mechanism of outperforming the markets. Even, well-constructed and well-diversified portfolios tend to take impacts of the market debacles such that the previous higher returns become lower returns and previous lower risks become increased risks. Past patterns of performance only show a limited management philosophy that it might take similar steps for the prosperity of the company and so does with the outperformance of the stock in comparison with markets. However, in bad times, the real financial performance and position suffers a lot and the management thinks that it would take too long in order to get back to the previous performance levels (Fabbozi & Markovitz, 2011). In this way, the future expectations regarding the financial performance and position of the company deteriorates which actually hurt the confidence of the investors and thus the stocks take increased amount of time to perform well and provide higher returns. Thus, on a concluding note, past performance can predict future performance up to some extend but it would be a blunder to make a belief that the past performances would repeat themselves exactly in the similar manner once again. Safety of Investment Most of the times the investors seek the safety of their investments as the amount of investment, is their whole sole leftovers especially after retirements. Investors who have basic accounting and finance skills and expertise tend to take interest in investment management. However, those investors who are unaware of the basics of investment and financial management face difficulty in making fruitful investments. Here comes the role of mutual funds, banks trust and other similar industry participants. Individual investors might have the appropriate skills of selecting and creating best assets for their portfolio but it is also a fact that they cannot have more expertise than the management who is taking care of their investment at those mutual funds etc. The management of these funds are highly qualified, their finance skills are far superior and their investment and related knowledge is exemplary. They pay their full duty time watching the movements of the assets of the portfolio, the right time to buy and sell the assets from the portfolio, increased level of research work on the portfolio constituents, etc. make their presence in fund management more valuable. In the case of PCM, Mr. Pearson is himself quite knowledgeable and qualified financial analyst. Moreover, the junior staff working in PCM is also quite educated relating to their financial background. The historic success of Mr. Pearson being a fund manager also shows how skillful he is in respect of managing funds of other investors. In this way, Mr. Bhatia has every reason to rely on PCM’s management skills and right expertise to manage his investment in a far better manner than he would manage in his standalone capacity. Investing in Bonds Investment in bonds can be simple yet tricky at times. They are included in the portfolio to maintain the risk paradigm as they are regarded as less risky compared to that of other assets such as stocks or real estate. Unlike stocks, bonds have variety of types which require greater understanding of their nature, risk, timings, cash flows etc. Moreover, all the individual are not allowed to invest in specified bonds such that only institutional investors or High-Net-Worth-Individuals can participate in those bonds. Bonds may be categorized into various types such that they can be segregated with each other on the basis of issuing authority. For instance, government bonds, corporate bonds, sovereign bonds etc. They can also be categorized with respect to risk associated with each type of bonds. The example of risks can default risk, credit risk, interest rate risks etc. Based on risk attributes, the bonds are categorized by some rating agencies like S&P500, Moody’s, and Finch. Bonds can also be separated on the basis of cash flows associated with them. For instance, a bond might provide annual cash flows, some of them might give semi-annual cash flows in the form on coupons and there is a category of bonds which does not provide any coupon payments to investors rather they provide all the returns at the time of maturity of those bonds. Another method of distinctions between various kinds of bonds is the maturity period and associate coupon rates. It has been an established fact that the longer the maturity, the higher will be the coupon rates. Based upon the above level of understanding, it might not be an easy decision for Mr. Bhatia to take initiative upon investing in bonds himself and allowing a portion of money to the fund manager for investing in stocks or other risky asset class. The decision should be left to PCM as they have higher competence to design such a portfolio where bonds can balance the overall risk of portfolio while ensuring the same level of returns. Mr. Bhatia can also minimize this risk by only investing a specific amount of him investment to PCM and the rest of investment can be managed by some other funds managers. Management Fee As studied in the case study that the investment managers provide this facility of managing money of investors only for a return in the form of management fees. Management fees vary client to client on the basis of objectives and requirements of each investor. Most of the investors have different mindsets as they require different investment strategy especially based on their risk appetite. For risk-averse investors, a portfolio is created in which low risk assets have higher weights such as corporate bonds followed by a very meager weightage of risky assets such as real estate or stocks. There are investors who believe that they are risk-neutral and they demand a balanced portfolio containing equal weighted securities. Risk-seeker investors desire greater extent of risky assets in their portfolio as they believe on aggressive investment strategy. Not only risk appetite plays a crucial role in devising an investment strategy, asset class is also equally important. There are investors who demand local asset class as well as international securities to be included in their portfolio. Similarly, there are investors who can require other asset classes such as foreign currencies, commodities etc. in addition to the conventional asset classes. Arranging all these mixed securities require immense financial skills and hectic analysis of all the asset classes. In this way, management fees is quite justifiable in creating the portfolios which are directly based on investors’ demands incorporating the investors’ risk appetite. Final Words Managing investments with the help of investment managers might create some sort concerns especially when a larger amount of money is involved. In the case of Mr. Bhatia, PCM is found to be a long-lasting option for him as PCM has opted a rather secure investment strategy across the board. Investment management is a full-time duty which requires comprehensive knowledge, skills and abilities of the fund managers as the financial markets are highly volatile these days especially after the heavy slump of financial markets during the recession of 2008. Mr. Bhatia may be a successful businessman but his abilities towards managing a huge amount of investment in a successful manner may not be as easy. On the other hand, the previous record of PCM enables it to make investment approach to clients like Mr. Bhatia who has serious concerns over the nature of risk associated with his money. Due to moderate level of diversification involved in the investment strategy of PCM, it is advised to Mr. Bhatia to invest the bigger chunk of his money to PCM followed by a slight shorter slice with some other fund manager. He may also put in his own skills of investing a sum of money which he can make himself. In this way, the ultimate of objective of creating a portfolio i.e. diversification would be achieved at various levels. Firstly, the investment amount will be diversified among different fund managers and secondly each fund manager will deploy the amount as per the stated requirements of Mr. Bhatia given the risk appetite and time horizon of his investment. LAFARGE MANUFACTURING, INC. The case of Lafarge Manufacturing Inc. (LMI) is considering a project of adding up new product line i.e. high-strength steel products. The Product Development Manager, Jake Webster is the in-charge of this new project. He prepared some workings based on financial projections. However, the workings resulted in negative NPV which means that the project should not be commenced and be avoided as it would result in loss. There are various issues that need the attention of the New Product Review Committee in addition to their existing advices. The existing suggestions included the following treatments in brief: 1) The project should be regarded as to have two distinct phases such that each phase should have its own Net Present Value. Once the NPVs of both projects come up, they should be added together and compared with the standalone NPV of the project. This suggestion did not provide any proper solution to the issue as the sum of individual phases of the project is also found to be negative. 2) The second suggestion provided in this regard was to treat some cash flows as less risky as compared to some other cash flows. It was advised to change the discount factor such that those cash flows that are highly risky should be discounted with higher discount rate and the ones which are less volatile should be discount with single-digit discount factor. This suggestion also could not add the value as expected by the committee as the results were pessimistic again. 3) Lastly, the final suggestion was provided to consider using Real Options in order to check whether the project will become worthwhile in future or not. The following discussion is based upon working and analysis of treating 2nd phase of the project as the whole sole option that LMI currently have at the moment. Real Options Real options are actually the choice that the company might have to accept the further stage of any project. The overall NPV might turn out to be negative but by virtue of deploying Option Pricing technique, the 2nd phase of the project may become worthwhile as the ultimate and core phase of the project is its 2nd phase. The technique of Real Options work on the basis of Black-Scholes Option Pricing Model. Under this model, the 2nd phase of the project is analyzed such that the value of call option of 2nd phase is computed which actually provides the management an option to see whether it will be beneficial for the company to go for the 2nd phase of the project or. The value of call option through this model is summed up with the standalone NPV of the whole project in order to check the aggregate outcome of the project. The following are the inputs and the results of call option of 2nd phase of the project: Black-Scholes Real Option Value Input Data   Value of underlying asset (P) 250.3 Exercise Price of Option (X) 382 Number of periods to Exercise in years (t) 3 Compounded Risk-Free Interest Rate (rf) 6.00% Standard Deviation (annualized  38.00% Output Data   Present Value of Exercise Price (PV(EX)) 319.0732 *t^.5 0.6582 d1 -0.0397 d2 -0.6979 Delta N(d1) Normal Cumulative Density Function 0.4841 Delta N(d2)*PV(EX) 77.4109 Value of Call 43.7712 Value of Put 112.5444 The inputs of the above model are taken from the case. However, the value of underlying asset is the present value of all the cash flow arising in the 2nd phase of the project and they totaled to 250.3. Moreover, the exercise price is actually the amount of investment that the company intends to make. This is actually right to invest (call option) such that if the outcomes are favorable, then company can exercise this right of investing in the 2nd project, otherwise the company has the right to lapse with the 2nd phase of the project. The overall outcome of this project is as follows: Total Project’s NPV = Value of Call Option + NPV of 1st phase of the project = 43.77 – 6.5 = $37.27 million This result shows that the company may gain this much advantage even though the traditional NPV technique is unable to provide. Nevertheless, the volatilities are there to come up in future and the expected results may deviate from the actual results, but still the company has the better option to seek the project and may accept it. However, after the completion of 3 years and before the time of initial investment of 2nd phase of the project, the company may reevaluate the whole scenario once again to achieve more realistic objectives. References Fabozzi, F., & Fong, H. (1994). Advanced fixed income portfolio management. Chicago: Probus. Fabozzi, F., & Markowitz, H. (2011). The theory and practice of investment management. Hoboken, N.J.: John Wiley & Sons. Read More