Equities And Investment Analysis

INVESTMENT ANALYSIS 14

Equities and Investment Analysis

06 September 2014

Investors are usually classified into two major groups depending on their nature of investment motive. There are speculative investors and dividend minded investors. Speculative investors will commit their funds in the company for only a short time and sell off their shares when they think the stocks of the company are overvalued. The other category of investors will invest in the company for a long period in order to continue earning dividends out of the proceeds of the company. This section will evaluate other member’s investments strategy based on speculative investments.

Carter’s investment strategy

The investment performance by Carter is good. He has invested in five stocks namely; Origin Energy Limited (ORG), Commonwealth Bank of Australia (CBA), Telstra Corporation Limited (TLS), Woolworths Limited (WOW) and Australia and New Zealand Banking Group Limited (ANZ). However, a portfolio consisting of the five stocks is not adequately diversified. The portfolio has diversifiable risk because it has not invested in a number of industries. Furthermore, carter has overspecialised in banks investment which introduces the risk specific to the banking industry in his portfolio. A well diversified portfolio has a very small diversifiable risk (Boudt, Peterson and Croux, 2008). As noted in Brigham and Herhardt (2009) total risk is equal to the sum of unsystematic risk and systematic risk. Therefore, the total risk for a portfolio that is sufficiently diversified should be equal to the systematic risk which is associated with the market in general hence an investor can do nothing about it. This means that the portfolio made up of the just five stocks has more systematic risk than the market in general. This can be argued that the portfolio has risk factors that are specifically affecting the stocks in the portfolio. According to Kothari & Barone (2006), this is a diversifiable risk which is easily eliminated through investing in a portfolio with different stocks from different industries. Both Commonwealth Bank of Australia (CBA) and Australia and New Zealand Banking Group Limited (ANZ) are from the same industry: the banking and financial services industry. It can be deduced that holding too many stocks from the banking and financial services industry exposed the portfolio to risks that can be diversified away (Preve and Sarria-Allende, 2010). The risk that this portfolio has above the market risk can be eliminated in two ways. The first way is to invest in stocks from five completely different industries. The other way is to increase the number of stocks in the portfolio (that is more than five stocks). According to McCrary (2010), this will help to eliminate some of the risks because there are some risks which only affect a limited number of stocks. The effect of this means of diversifying is elimination of industry specific risk thus the resultant risk to the portfolio will be close to the market risk (Needles,
Powers and Crosson, 2010). Carter seems to have a wrong dimension in investment that the best returns are obtained from the big companies. This is not necessarily the case especially for a speculative investor. Share price from these types of companies are generally constant which makes speculative business difficult.

Chow’s investment strategy

The investment performance by Chow is very poor compared to the performance by Carter. He has invested in four stocks namely; WOW, WAC, WPL and ANZ. The strategy used by Chow is wrong. This is because he has bought very little shares of WOW a stock that is doing well in the market. When the WOW stock increases in price he sells them which is a good strategy. However, buying more of this stock is not a good strategy since its price is considered already high. This will expose Chow’s investment into more risk because stock price move up and down. In addition, carter has overspecialised in WOW stocks which introduces the risk specific to this company in his portfolio. A well diversified portfolio has a very small diversifiable risk but this is not the case in Chow’s investment. He has invested in very few stocks thus exposing his portfolio to diversifiable risks. However, the frequency of trading by Chow is regular which is commendable. Through regular trading an investor is able to monitor stocks that are doing bad and dispose them in order to buy stocks where returns are anticipated to be high. Chow has employed a very good investment strategy of buying stocks that he considers undervalued and selling the stock which are already overvalued.

Ray’s investment strategy

The investment performance by Ray is good since there was an overall return of 6.59% in a week’s time. He has invested in four stocks namely; WES, NCM, RIO, WCB. This is a well diversified portfolio because it has invested in different industries. However, Ray can still improve diversification by reducing investment in each of the stocks in his portfolio and using the money to add more stocks from other different industries in his portfolio. This will help to reduce the overall risk in his portfolio close to the market risk. On average his portfolio has gained a return of 6.59% with the lowest performing stock gaining a return of 6.40%. This means that the expected return from his portfolio will be higher than 8.43% which is equivalent to the return by the highest performing stock. This is because investing in a number of different stock will reduce the risk and enhance portfolio returns. Ray is well informed of what is happening in the stock market and is taking advantage of this information. Investing in WCB stock is likely to be profitable since the US economy is recovering. Therefore, buying this lowly priced stock and then selling the stock when its price increase is a good investment strategy. However, investment in this kind of company should be left for a long term investor. This is the type of investor who waits the dividend reward. The shares of WCB may not rise in price but the company shows high prospects of profitability. Therefore, an investor will reap dividends when it is declared by the board of directors of the company.

Vince’s investment strategy

The investment performance by Ray is good since there was an overall return of 8% which is a better return compared to Ray and Carter. Vince has invested in four stocks namely; NAB, TLS, CSL, CTX, CBA and ORG. however, it is wrong to assume that since there s good news with respect to ANZ then there will be an overall improvement in the banking industry. This is because the good performance from the ANZ may be contributed to factors outside the industry, for instance good management and prudent investment. Therefore, it would have been wise for Vince to invest in the specific company that has good news. Hence instead of investing in NAB stock, Vince should have invested in ANZ. Vince should increase his portfolio by investing in more stocks from different industries in order to diversify his portfolio and reduce asset specific risk. This is the sure way that his investment is not exposed to diversifiable risk.

The best performing shares are ANZ, Woolworths Limited (WOW), Commonwealth Bank of Australia (CBA) whereas the worst performing shares are Origin Energy Limited (ORG), Telstra Corporation Limited (TLS). The good performance in the banking companies is attributed to the low cash rate. This has helped the banks to have adequate funds to extend credit facilities and other loan products to several businesses and individuals. This has resulted to a corresponding increase in business volume and by extension increased profits. In addition, there is insignificant increase in wage rate which means that the related expenditure has been maintained to the minimum resulting in profitability of the companies. Globally, the US manufacturing output was quite optimistic; this figure rises 0.3% in June and gained 4.9% during the last one year. Increase in the US manufacturing output and strengthening of the US Dollar has a great impact in many companies. WOW stock is in the retail sector. The slight increase in consumers’ income compared to the corresponding increase in inflation means that the purchasing power of households has improved which is good news for the retailing industry. This must have caused the good performance in Woolworths Limited (WOW). Foreign economic has also influenced the performance of these shares. Most countries are recovering from global recession. In the US, consumer confidence is regained due to lower unemployment and higher growth. European countries are also recovering. Greece has gained positive economic growth, supported by tourism services. The Greece government expenditure is being controlled. This is highly important for the European countries since consumer and investor confidence is positively correlated to the credit of Greek government.

Nevertheless, some stocks may not be performing well because at a global level there is bad news including highly sensitive Ukraine affair, Italy’s possible recession and high fluctuation in gold price. Among them, it appears that Ukraine affair has great impact because the stock markets all over the world experienced a decline after Russia intensified its force on the border. Italy’s recession figures also indicate concerns about European recovery.

The table below shows the shares invested by the different members of the group and their average daily returns and standard deviation of the daily returns.

Stock symbol

average daily

Standard deviation

of daily returns

Woolworths Limited

Australia and New Zealand Banking Group Limited

Commonwealth Bank of Australia

Origin Energy Limited

Telstra Corporation Limited

Woodside Petroleum Ltd

Wild Acre Metals Limited

Wesfarmers Limited

Newcrest Mining Limited

Rio Tinto Ltd

iProperty Group Limited

Warrnambool Cheese And Butter Factory Company Holdings Limited

Myer Holdings Limited

NAT. BANK FPO

Caltex Australia Ltd

In analysing the daily share prices, this paper has used the closing prices of the different shares for the last two years starting on 7th September 2012 to 6th September 2014. This data is available at Yahoo finance website. All the stocks in the group are listed in the Australian stock index. The closing prices used are adjusted for dividends and share splits hence making the shares comparable. This period is long enough to extract important information and performance trend of the companies under the group. The closing prices are shown in Australian dollars. The group’s best and worst performing shares can be identified from this information.

According to the data analysed (in the excel workbook attached) the best performing shares are IPP, WCB, CTX and CSL. These are the shares whose average daily return is above 0.10%.

While the worst performing shares are WAC and NCM. These are shares with negative average daily returns. In addition, these shares have very high standard deviation of daily returns. A high standard deviation shows that investment in these companies is very risky hence investors should avoid these investments.

The function of the primary market is to transact new financial instruments. This means it is the market where securities that are in their initial public offer (IPO) are traded. McCrary (2010) observes that the function of the secondary market is slightly different from the function of the primary market in that it specifically facilitates the transfer of financial instruments which have already been issued under the primary market. As an example, if Lynas Corporation (LYC) was issuing its shares for the first time to the public will do so in the primary market, but later when a LYC shareholder wish to sell his shares the trade will take place in the secondary market. The secondary market is where continuous trading takes place hence the movement of shares either upwards or downwards in response to the forces of demand and supply in the share market. There are many risk factors which influence the movement in share prices. Ang, Hodrick, Xing & Zhang (2009) observe that risk indicates some element of uncertainty about results in a particular situation. Risk is seen as the unpredictability, the likelihood that actual LYC share price may differ from the expected price and returns. There is no specific theory addressing the levels of risk to find in the market; however, there are theories explaining the relationship between expected return and risk that would prevail in a rational share market. Nevertheless, analysis of historical experience can be used to estimate the risk levels that investors are likely to encounter. The situation is to be expected because share prices fluctuate in response to information about corporation’s events and developments in macroeconomic environment that affects the rates of interest. Since the importance and frequency of such events are unknown, it becomes difficult to determine a natural risk level. This difficulty is compounded by the fact that neither risk nor expected returns are directly observable (Clarke, De Silva and Thorley, 2006). The rates of return are observed after they have been realized. Therefore, in order for an analyst to forecast the future anticipated risk and return he must be knowledgeable in forecasting the risk and expected returns that investors anticipated from historical data. An investor cannot be sure of their holding period returns since uncertainty holds about share price plus dividend income. Risk in investment in stocks is measured by the standard deviation of the share returns. Standard deviation is determined by finding the square root of the variance. The variance is the expected value of the squared deviations from the anticipated returns. The higher the volatility in share price, the higher will be the average value of the squared deviations. Therefore, standard deviation and variance provides the measure of uncertainty of returns.

Under the EMH (Efficient Market Hypothesis), the 3 forms of market efficiency are:

  • Weak form market efficiency: this is the form of EMH where security prices reflect only past information about the market and not the current information.

Semi-strong form market efficiency: this is the form of EMH where security prices reflect all publicly available information about the market both past and current but there is no knowledge of privately available information. This hypothesis means that all publicly available information is useful in calculating the current share price of a stock thus implying that neither technical nor fundamental analysis is useful in achieving abnormal returns. This hypothesis is very significant for the investors and market participants because the investors will quickly take advantage of the company’s information that is not in the public domain to benefit from superior gains on investments. On the other hand, the other market participants will endeavour to be well informed about the company and its events in order to monitor the movement of share prices hence establishing the correct pricing of the stocks in the market.

  • Strong form market efficiency: this is the form of EMH where security prices reflect both publicly and privately (both past and current) available information about the market. In this case there is full disclosure of information. This includes the insider information about the company of interest.

There is no evidence that the market was adequately informed before the share price spike in July. This is because when the public is well informed the share prices are not likely to spike because the market will respond to establish a new equilibrium of the share price.

Conclusion

A time series has been used in this paper to refer to any set of data which is recorded over time. It may, for example, be annual, quarterly, monthly or weekly data. Models use the historical pattern of the time series to forecast how the variable will behave in the future. The short term forecast will be more accurate than the longer term forecast. The further the forecast is to the future, the less likely it is that the historical pattern of share price will remain the same, and the errors will be huge.

The mean variance portfolio theory assumes that investors are risk averse. This implies that investors will select diversification opportunities which have the lowest risk if they were provided with a range of investment opportunities with similar anticipated returns, which means they can only accept a riskier investment if it commensurate with higher anticipated return. Investors only consider risk and returns when making their investment decisions. Risks are measured by standard deviation or the volatility of anticipated returns. On the other hand expected returns are subjected to probability distribution under different situations over the holding period of the financial asset. By combining different levels of risk and different levels of anticipated returns indifference curves for investors are obtained (Barberis & Huang, 2001). Investors will only invest in portfolios which are perceived to be efficient because of their risk aversion nature. A portfolio is deemed efficient if there is no other portfolio which can offer a higher anticipated return at a lower or similar level of risk.

References

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