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Chapter 3

The Investment Process

Ayşe Yüce – Ryerson University

42.pdf

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

The Investment Process

Ayşe Yüce – Ryerson University

“Don’t Gamble! Take all your savings and buy some good stock and hold it till it goes up. If it don’t go up, don’t buy it.”

– Will Rogers

Don’t sell yourself short. Instead, learn about these key investment subjects:

1. The importance of an investment policy statement.

2. The various types of securities brokers and brokerage accounts.

3. How to calculate initial and maintenance margin.

4. The workings of short sales.

Ayşe Yüce – Ryerson University

Learning Objectives

Investing Overview

Ayşe Yüce – Ryerson University

Fundamental Question: Why invest at all?
We invest today to have more tomorrow.
Investment is simply deferred consumption.
We choose to wait because we want more to spend later.

Investors have their own investment objectives and strategies

The Investment Policy Statement (IPS)
Designed to reflect your objectives and strategies
Two parts
Objectives
Constraints

Ayşe Yüce – Ryerson University

Objectives: Risk and Return

In formulating investment objectives, the individual must balance return objectives with risk tolerance.
Investors must think about risk and return.
Investors must think about how much risk they can handle.

Your risk tolerance is affected by
Your ability to take risk
Your willingness to take risk

Ayşe Yüce – Ryerson University

Investor Constraints

Resources. What is the minimum sum needed? What are the associated costs? Trading commissions? Subsequent transactions?
Horizon. When do you need the money? Buying a home? Retirement?
Liquidity. How high is the possibility that you need to sell the asset quickly? Are funds for emergency purposes or long term goals?
Taxes. Which tax bracket are you in? After tax returns are essential
Special circumstances. Does your company provide any incentive? What are your regulatory and legal restrictions?

Ayşe Yüce – Ryerson University

Investment Strategies and Policies

Investment management. Should you manage your investments yourself? Investment Advisor or Broker? Financial Planner?
Market timing. Should you try to buy and sell in anticipation of the future direction of the market?
Asset allocation. How should you distribute your investment funds across the different classes of assets? Dependent on your risk tolerance
Security selection. Within each class, which specific securities should you buy? Which stock and bonds to invest funds in & what percentage of funds to invest in each security?

Asset Allocation or Security Selection?

Ayşe Yüce – Ryerson University

Is asset allocation or security selection more important to the success of a portfolio?
Most people are inclined to think security selection is the more important element for successful investing.
Research shows, however, that asset allocation is the more important determinant of portfolio returns. Many experts suggest:
About 90 percent of portfolio performance stems from asset allocation.
So, 10 percent of portfolio performance comes from security selection.
How is this result possible? Well, consider the Crash of 2008.
Bonds outperformed stocks in 2008
Even those elusive “skilled stock pickers” might underperform bonds
Stocks tend to move together
Even a “skilled stock picker” would have trouble beating bonds if most stock prices are performing poorly relative to bond prices

Ayşe Yüce – Ryerson University

Choosing a Broker/Advisor

What do you do after carefully crafting your Investment Policy Statement (IPS)?

If so, you need to choose the type of brokerage account and your broker/advisor from:
full-service brokers
discount brokers
deep-discount brokers
These three groups can be distinguished by the level of service provided, as well as the level of commissions charged.

Ayşe Yüce – Ryerson University

Choosing a Broker/Advisor

As the brokerage industry becomes more competitive, the differences among broker types continues to blur.
Another important change is the rapid growth of online brokers, also known as e-brokers or cyberbrokers.
Online investing has really changed the brokerage industry.
slashing brokerage commissions
providing investment information
Customers place buy and sell orders over the Internet

Many full-service brokers offer an advisory-based relationship for clients.
Rather than charging commissions on every transaction, the investment advisor charges an annual fee, say 1-2%, based on the account balance.
This fee covers all services associated with advice and trading.
An advisory-based relationship can align the interests of the client and the advisor.

Ayşe Yüce – Ryerson University

Advisor-Customer Relations

There are several important things to remember when you deal with any broker/advisor:
Any advice you receive is not guaranteed.
Your broker works as your agent and has a legal duty to act in your best interest.
Brokerage firms, however, do make profits from brokerage commissions and/or annual fees.
Your account agreement will probably specify that any disputes will be settled by arbitration and that the arbitration is final and binding.

Ayşe Yüce – Ryerson University

Canadian Investor Protection Fund

Canadian Investor Protection Fund (CIPF): Insurance fund covering investors’ brokerage accounts when member firms go bankrupt or experience financial difficulties.
Most brokerage firms belong to the CIPF, which insures each account for up to $1,000,000 in cash and securities
Important: The CIPF does not guarantee the value of any security

Rather, CIPF protects whatever amount of cash and securities that were in your account, in the event of fraud or other failure.

Ayşe Yüce – Ryerson University

Opening Your Brokerage Account

of Disney

at $33 per share

(e) $6,650 Cash

in Account

$3,300 Stock

In Account

(d) Pay Commission,

Say $50

(b) Deposit $10,000

into account

(a) Open a brokerage

or trading account

Ayşe Yüce – Ryerson University

Two Types of Brokerage Accounts

A Cash account is a brokerage account in which securities are paid for in full.

A Margin account is a brokerage account in which, subject to limits, securities can be bought and sold short on credit.

(more on selling short later)

Ayşe Yüce – Ryerson University

Margin Accounts

In a margin purchase, the portion of the value of an investment that is not borrowed is called the margin.
Of course, the portion that is borrowed incurs an interest charge.
This interest is based on the broker’s call money rate.
The call money rate is the rate brokers pay to borrow money to lend to customers in their margin accounts.

Ayşe Yüce – Ryerson University

Example: Margin Accounts, The Balance Sheet

You buy 1,000 Pfizer (PFE) shares at $24 per share.
You put up $18,000 and borrow the rest.
Amount borrowed = $24,000 – $18,000 = $6,000
Margin = $18,000 / $24,000 = 75%

Assets	Liabilities and Account Equity
1,000 Shares, PFE	$ 24,000	Margin Loan	$ 6,000
Account Equity	$ 18,000
Total	$ 24,000	Total	$ 24,000

Ayşe Yüce – Ryerson University

Margin Accounts

In a margin purchase, the minimum margin that must be supplied is called the initial margin.
The maintenance margin is the margin amount that must be present at all times in a margin account.
When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call.

Ayşe Yüce – Ryerson University

Example: The Workings of a Margin Account

Your margin account requires:
an initial margin of 50%, and
a maintenance margin of 30%
A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50.
You have $20,000, and you want to buy as much WHOA as you can.
You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA.

Assets	Liabilities and Account Equity
800 Shares of WHOA @ $50/share	$ 40,000	Margin Loan	$ 20,000
Account Equity	$ 20,000
Total	$ 40,000	Total	$ 40,000

Ayşe Yüce – Ryerson University

Example: The Workings of a Margin Account

After your purchase, shares of WHOA fall to $35. (Woe!)
New margin = $8,000 / $28,000 = 28.6% < 30%
Therefore, you are subject to a margin call.

Assets	Liabilities and Account Equity
800 Shares of WHOA @ $35/share	$ 28,000	Margin Loan	$ 20,000
Account Equity	$ 8,000
Total	$ 28,000	Total	$ 28,000

Ayşe Yüce – Ryerson University

Example: The Effects of Margin

You have $30,000 in a margin account, 60% initial margin required.
You can buy $50,000 of stock with this account (why?).
Your borrowing rate from your broker is 6.00%.
Suppose you buy 1,000 shares of Coca-Cola (KO), for $50/share.
Assume no dividends, and that your borrowing rate is still 6.00%, what is your return if:

In one year, KO is selling for $60 per share?
In one year, KO stock is selling for $60 per share, but you did not borrow money from your broker?

Ayşe Yüce – Ryerson University

Example: The Effects of Margin

KO is selling for $60 per share.

Your investment is worth $60,000.
You owe 6% on the $20,000 you borrowed: $1,200.
If you pay off the loan with interest, your account balance is: $60,000 – $21,200 = $38,800.
You started with $30,000.

Therefore, your return is $8,800 / $30,000 = 29.33%.

Suppose Coca-Cola stock was selling for $40 per share instead of $60 per share? What is your return?

Ayşe Yüce – Ryerson University

Example: The Effects of Margin

Coca-Cola stock is selling for $60 per share, but you did not borrow from your broker.

You started with $30,000, which means you were able to buy $30,000 / $50 = 600 shares.

Your investment is now worth $36,000.

Therefore, your return is $6,000 / $30,000 = 20.00%.

Suppose Coca-Cola is selling for $40 per share instead of $60 per share. What is your return in this case?

Ayşe Yüce – Ryerson University

Example: How Low Can it Go?

Suppose you want to buy 300 shares of Pepsico, Inc. (PEP) at $55 per share.
Total cost: $16,500
You have only $9,900—so you must borrow $6,600.
Your initial margin is $9,900/$16,500 = 60%.
Suppose your maintenance margin is 40%. At what price will you receive a margin call?

Ayşe Yüce – Ryerson University

Example: How Low Can it Go? (Answer)

This will happen when the price of Pepsico, Inc. drops to $36.67. How so? Well,

Ayşe Yüce – Ryerson University

Example: Annualizing Returns on a Margin Purchase

You buy 1,000 shares of Costco (COST) at $60 per share.
Your initial margin is 50%.
You borrow at the 9 percent call money rate plus 2 percent.
You sell Costco (COST) 4 months later for $63.
There were no dividends paid (and suppose the prices above are net of commissions).
What is your holding period percentage return and your EAR?

Ayşe Yüce – Ryerson University

Annualizing Returns on a Margin Purchase

Answer: First, you have to repay the 3-month loan, so t = (3/12 = .25)

Amount Repaid = Amount Borrowed × (1 + interest rate per year)t

Amount Repaid = $30,000 × (1 + .11).25

= $30,000 × 1.02643

= $30,792.90

Your Sale Proceeds = Cash from Sale – Amount Repaid
= $63,000 – 30,792.90

= $32,207.10

Your Profit = Your Sale Proceeds – Your Investment

= $32,207.10 - $30,000

= $2,207.10

Ayşe Yüce – Ryerson University

Annualizing Returns on a Margin Purchase

Note that there are 12/3 = 4 three-month holding periods in a year. Therefore, m = 4.

Hypothecation and Street Name Recognition

Ayşe Yüce – Ryerson University

Hypothecation is the act of pledging securities as a collateral against a loan.

This pledge is needed so that the securities can be sold by the broker if the customer is unwilling or unable to meet a margin call.

Street name registration is an arrangement under which a broker is the registered owner of a security. (You, as the account holder are the “beneficial owner.”)

Other Account Issues

Ayşe Yüce – Ryerson University

Trading accounts can also be differentiated by the ways they are managed.
Advisory account - You pay someone else to make buy and sell decisions on your behalf.
Wrap account - All the expenses associated with your account are “wrapped” into a single fee.
Discretionary account - You authorize your broker to trade for you.
Asset management account - Provide for complete money management, including check-writing privileges, credit cards, and margin loans.

Other Account Issues

Ayşe Yüce – Ryerson University

To invest in financial securities, you do not need an account with a broker.
One alternative is to buy securities directly from the issuer.

Another alternative is to invest in mutual funds.

Short Sales

Ayşe Yüce – Ryerson University

Short Sale is a sale in which the seller does not actually own the security that is sold.

Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position.”

Borrow

from

someone

Sell the

in the

market

Buy

From the

market

Return

the

Today

In the Future

Short Sales

Ayşe Yüce – Ryerson University

An investor with a long position benefits from price increases.
Easy to understand
You buy today at $34, and sell later at $57, you profit!
Buy low, sell high

An investor with a short position benefits from price decreases.
Also easy to understand
You sell today at $83, and buy later at $27, you profit.
Sell high, buy low

Example: Short Sales

Ayşe Yüce – Ryerson University

You short 100 shares of Verizon Communications (VZ) at $30 per share.
Your broker has a 50% initial margin and a 40% maintenance margin on short sales.
The value of stock borrowed that will be sold short is:
$30 × $100 = $3,000

Assets	Liabilities and Account Equity
Sale Proceeds	$ 3,000	Short Position	$ 3,000
Initial Margin Deposit	$ 1,500	Account Equity	$ 1,500
Total	$ 4,500	Total	$ 4,500

Example: Short Sales

Ayşe Yüce – Ryerson University

Verizon Communications stock price falls to $20 per share.
Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000.
Also, new margin: $2,500 / $2,000 = 125%

Assets	Liabilities and Account Equity
Sale Proceeds	$ 3,000	Short Position	$ 2,000
Initial Margin Deposit	$ 1,500	Account Equity	$ 2,500
Total	$ 4,500	Total	$ 4,500

Example: Short Sales

Ayşe Yüce – Ryerson University

Verizon Communications stock price rises to $40 per share.
You sold short at $30, stock price is now $40, you are "behind" by $10 per share, or $1,000. (“He who sells what isn’t his’n, must buy it back—or go to prison.”)
Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call.

Assets	Liabilities and Account Equity
Sale Proceeds	$ 3,000	Short Position	$ 4,000
Initial Margin Deposit	$ 1,500	Account Equity	$ 500
Total	$ 4,500	Total	$ 4,500

81.pdf

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

Brokerage Accounts
Cash Accounts
Margin Accounts and how to calculate initial and maintenance margin
A Note on Annualizing Returns

Short Sales
Basics of a Short Sale
Some Details
Forming a Real Investment Portfolio

Ayşe Yüce – Ryerson University

Chapter Review

82.pdf

VALUATION AND MANAGEMENT

Investments

JORDAN MILLER DOLVIN YÜCE

third canadian edition

fundamentals of

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