Security Analysis and Portfolio Management - Assignment Example

Security Analysis and Portfolio Management Assignment Section A Q1: “Beta is dead! Long live Alpha” – Absolute Returns are now more important than relative performance in investment management In investment management, Beta is the measure of relative performance while Beta measures absolute returns. Alpha is the measure of excess returns made by portfolio managers while Beta is the measure of exposure to a benchmark in the market. Nowadays, investment managers are splitting Alpha from Beta as they increase their allocation on more volatile funds such as hedging funds in order to achieve Alpha. Therefore, relative return is the value of an investment portfolio as compared to a theoretical benchmark or reference market portfolio (Black 1995). Positive relative portfolio is considered to have outperformed the benchmark portfolio while a negative portfolio is considered to have underperformed the benchmark portfolio. On the other hand, an absolute return is the value of an investment portfolio as a gain or loss measured in terms of percentage of invested capital. This is distinguished from relative return because it does not involve a benchmark, but instead focuses only on the return of the portfolio. Portfolio and investment managers nowadays prefer absolute returns because it provides an additional return above expected the beta adjusted market return. This excess return is known as alpha. Alpha or absolute returns are the skill-based returns of an investment portfolio while beta or relative returns refer to the market-based returns (Black 1995). Therefore, absolute returns depend on the management skills of managers while relative returns depend on the market conditions. This has led managers to choose alpha over beta and absolute returns over relative returns because they have control over absolute returns compared to relative returns which depend on a benchmark in the market. Investment in a portfolio that will yield excess returns in absolute terms requires risk-taking. This is because investments of these nature including hedge funds are highly risky (Ineichen 2003). On the other hand, market-adjusted relative returns do not require high risks because the investment managers choose a portfolio that yields more returns than a benchmark in the market. In this case, investment managers seek high returns by investing in risky portfolios because the higher the risk, the higher the returns. Portfolio managers seeking absolute returns try to reduce volatility in the market while getting positive absolute returns in various markets. Since absolute returns are not restricted, they can go to any extent to achieve excess rates of return. As a modern portfolio management strategy, absolute return targets excess returns with less uncertainties than relative returns in order to enhance diversification of portfolios for investors. In constrained portfolios such as relative returns, prices of securities may fall due to systemic reasons (Ineichen 2003). As a result, portfolio managers have little to do in order to avoid negative results. However, if alpha or absolute measure of returns is used, portfolio or investment managers may adjust their portfolio to avoid negative returns because there is no benchmark to restrict them. The objective of an absolute return is to remove the constraints faced by managers and allow them to implement strategies to address market volatility. By taking an absolute returns approach, managers avoid the risk involved in full market exposure as experienced through the relative returns approach. Because the absolute returns are measured against their objective return goals rather than traditional market indexes, managers are able to avoid constraints on investment. Instead of being pressured to achieve similarity with a given benchmark security, the manager has more incentives to avoid negative returns of the current security. The absolute return is also important for investment managers because it provides diversification advantages. An objective for absolute returns enables managers to focus on positive real returns and encourage purchasing power. This is important to investors because it overcomes the problem of long term persistence of inflation. Inflation erodes relative returns because traditional funds do not have any objective ability to outperform inflation (Ineichen 2003). On the other hand, absolute returns can outperform inflation on some securities. Absolute return strategies are also effective in managing risks. Asset allocation strategies are necessary in order to ensure successful risk management for a portfolio. This is possible in absolute return strategies because they entail asset allocation as a starting point. On the other hand, traditional relative return strategies employ benchmarks on returns rather than risk. Alpha opportunities which refer to the excess returns beyond market returns of assets is achieved through absolute returns strategies because they involve the use of modern investment tools that can capture alpha opportunities. This can improve performance when markets are negative or flat. Although relative returns strategies may use the same tools, they may not have appropriate return goals that can be pursued to achieve the market opportunities. Only beta opportunities are achieved through relative return strategies because they involve a market benchmark. Absolute return goals give investment managers the flexibility to invest across sectors in an international context using modern tools. This gives professional and skilled managers the opportunity to consistently produce positive results. Absolute returns target gives managers a chance to gain experience in various markets and determine which markets are likely to appreciate and which ones are not. This leads allows the absolute returns managers to avoid weak investment markets and pursue those that can generate positive returns. Those managers can move cash into stocks and/or bonds or stocks and/or bonds into cash because there is no benchmark to constrain them. Absolute returns strategies can also be used to hedge risk with modern investment tools such as forwards, option contracts, and futures. Professional investment managers use these tools to gain knowledge about certain markets and fine-tune their portfolio strategies to manage market risks (Ineichen 2003). This is opposed to relative returns strategies which hedging is blunt and is restricted from using modern tools to hedge risks due to the market constraints imposed by beta or benchmarks in the market. Despite the importance of absolute returns over relative returns, there are a few advantages of relative returns. First, it uses stocks and bonds to build long term asset wealth through a market benchmark because these assets have a historical record of positive relative performance. Relative return investors have had an experience of being rewarded for taking risks through higher rates of return (Black 1995). The relative return strategies also help investors because they constrain managers from taking risky and unintended investments. This is because a benchmark in the market is used to restraint their choice of asset classes or markets. In conclusion, absolute returns are now more important than relative performance in investment management because they do not restrain professional managers from undertaking investment decisions that could earn excess returns. Absolute returns are flexible and can allow managers to use modern investment tools to achieve high returns and minimize market risks. They are also advantageous in terms of diversification and risk management. Q3: Company Specific Risk versus Market Risk Warren Buffet and Benjamin Graham suggest that market risk is less important than company-specific risk. A company specific risk is an unsystematic risk that affects a specific company in terms of operations and/or reputation, e.g. default by debtors. On the other hand, market risk refers to the risk arising from changes in overall market conditions e.g. risks occurring due to price fluctuations. Market risks are easier to estimate and quantify than company specific risks. Since company-specific risks are difficult to quantify, it is necessary to use qualitative mechanisms of analysing their nature and likelihood. Diversification can be used to reduce both market and company-specific risks. Graham and Buffet claim that market risks are not important compared to company-specific risks. Each of them provides specific evidence to show that market risk is not as important as company specific risks. Warren Buffet is one of the world’s leading investors but he does not diversify internationally because of his view on investment. He does not consider the modern theory of conventional portfolio structure; leading to a shift in his risk and return paradigm (Heller 2000). Most diversified portfolios invest in more than 20 stocks. However, Buffet invests in 10-12 stocks only despite his leading position in investment. This is not because he thinks that this is enough to manage stock market risks. Instead, he believes that the 10-12 stocks are the optimum number of stocks for his investment style. From this perspective held by Warren Buffet, it is clear that Buffet’s risk management is based on stock selection discipline which in turn depends on stock valuation as well as business structure and rationale. Business structure and rationale determines the level of specific risks faced by organisations. It is influenced by the operations and business environment of the organization. In this case, company-specific risk is more important than market risk in Warren Buffet’s risk management approach. It can be noted in this observation that Buffet relies on return management as a means of diversification rather than risk management. A risk management approach entails diversification of a portfolio in order to minimize the risk of exposure to only one company (Graham and Zweig 2003). Warren Buffet exposes himself to company-specific risks contrary to the risk management approach. The stock selection approach of Buffet limits him from holding a large number of stocks at the same time; hence limiting his global diversification. The modern portfolio theory holds that one can minimize his/her exposure to risk by holding as many stocks as possible until the only risk that remains is the market risk. Warren’s approach is highly exposed to company-specific risk as opposed to the modern portfolio theory which is highly exposed to market risk. In this case, Warren believes that the higher the specific risk, the higher the return. Therefore, Warren is rewarded for taking specific risk of the company instead of taking market risk. The success of Warren as an investor taking on company-specific risks shows that company-specific risks are more important that market risks. However, this needs a structural paradigm as applied by Warren. It is difficult to diversify away a market risk, but it is easy to diversify away specific risk. Some investors argue that embracing specific risks leads to minimization of broad market risks (Graham and Zweig 2003). Therefore, a portfolio needs to be efficiently exposed to a specific risk in order to minimize exposure to market risk and a portfolio needs to be efficiently exposed to a market risk in order to manage specific risk. Investment philosophy of Benjamin Graham also supported the fact that specific risk is more important than market risk (Graham and Zweig 2003). This philosophy suggests that the success of an investment depends on the expertise and knowledge of the investor. In this case, believing that the risk of the company determines the value of an investment, Graham argued that investors should calculate the true value of the company they wish to invest in by themselves. Graham suggested that the company that one should invest in is the company with a higher value than the current market value. This should be derived from facts and reliable analysis. The market value should not be the market value but the value that is derived from proper analysis (Graham et al, 2003). In security analysis, some of the aspects that need to be analyzed in a company include assets, warrants, debts and equity. The analysis should be carried out from the perspective of an outside investor using publicly available financial information of the company. The financial statements of the company are important sources of information for effective analysis by the investor. An example of a security analysis method is the Capital Asset Pricing Model (CAPM) which measures expected return on equity using the formula: re = rf + βe (rm - rf) where re = risk-free rate; rm = market return; and βe = equity beta. This method takes into consideration risks by incorporating beta and risk-free rate of return. It gives the value of the company when risk is taken into consideration. One of the methods used by Graham to measure the value of the company was the earning power of the company. This was done by considering the average of the company’s income for the last 10 years. This is important because it eliminates the tricks of the company to hire insider managers to increase income temporarily in order to improve the image of the company before its investors. Other business factors that need to be analysed before investing in a company include profitability, stability, growth, dividend yield, price history and financial position of the company. This perspective shows that Graham was concerned about the company-specific risk by ensuring that all factors that impact on the operations of the company have been taken into consideration. Graham’s perspective is also supported by the CAPM method of analysis in determining equity value of a company as discussed earlier. It is also consistent with the Treynor-Black model of selecting securities. In this case, the value of equity is determined by measuring the risk-free rate of return and expected rate of return (Treynor and Fischer 1973). It also takes risks into consideration such as alpha and beta risks. In conclusion, it is clear company specific risks are more important than market risks when deciding on investments. Graham taught specific ways of analyzing a company in order to determine its value before investing in it. His mentored Buffet took on specific risks of companies in his investments. This made him of the most successful investor in the world. However, his perspective took a specific structure that allowed him to invest in a number of fruitful stocks. When specific risks are taken and an appropriate analysis is conducted, marketing risks are reduced and one is able to invest successfully. Works Cited Black, Angela J. Absolute and Relative Measures of Time-Varying Risk Premia Ad the Predicatability of Stock Returns. St. Andrews: St. Salvators College, 1995. Print. Buffett, Warren, and Lawrence A. Cunningham. The Essays of Warren Buffett: Lessons for Corporate America. New York: L. Cunningham, 2001. Print. Graham, Benjamin, and Jason Zweig. The Intelligent Investor. New York: HarperBusiness Essentials, 2003. Print. Graham, Benjamin, David L. Dodd, and John Lescault. Security Analysis. Burlington, NC: McGraw-Hill Audio, 2003. Print. Heller, Robert. Warren Buffett. New York: Dorling Kindersley, 2000. Print. Ineichen, Alexander M. Absolute Returns: The Risk and Opportunities of Hedge Fund Investing. New York: John Wiley & Sons, 2003. Print. Treynor, Jack and Black, Fischer. How to Use Security Analysis to Improve Portfolio Selection, Journal of Business, January, 1973: 66–88. Read More