Chapter 1 Solution to Homework Questions

Applied Equity Analysis and Portfolio Management Tools to Analyze and Manage Your Stock Portfolio 1e Robert Weigand

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1 Applied Equity Analysis InstructorSolutions Manual © Robert A. Weigand, Ph.D., 2013 Chapter 1 Solution to Homework Questions 1.) Explain the main differences between active and passive investing, including time horizons and costs structures.Passive investors buy and hold investments for the long term, choosing vehicles that minimize costs and imitate the performance of indexes like the S&P 500. Active investors seek to beat the indexes, and almost always incur higher costs than passive investors, including research costs, trading costs, administrative costs, performance fees, and taxes on gains.

2.) Explain the main differences between absolute return and relative return investing.Relative return vehicles seek to outperform a benchmark (like the S&P 500), where "outperform" means earning a combination of higher returns and/or lower risk. Most equity portfolios, including equity mutual funds and student investment funds, are relative return vehicles, where the fund performance is compared to a widely-followed benchmark.Absolute return vehicles seek to deliver returns that are less risky, but are also usually lower than the returns of most index benchmarks. Many equity hedge funds are absolute return vehicles.

3.) Define the terms alpha and beta in the context of an investment portfolio.Alpha refers to the excess returns earned by relative return investors, either above or below the market index to which their performance is benchmarked. When a portfolio outperforms its benchmark index, the percentage return by which the portfolio exceeds the index return will be termed positive alpha. If a portfolio underperforms its benchmark index, we'll say it earned a negative alpha.Beta is a measure of risk that can apply to an individual stock or to a portfolio of stocks.The average market beta = 1.0. In the case of an individual stock, beta measures how much risk, or volatility, that stock is expected to contribute to the overall volatility of a diversified portfolio. High-beta stocks usually exhibit a more volatile reaction to marketwide or macroeconomic news, on both the upside and downside. Examples of high- beta stocks include cyclical stocks like Caterpillar and Ford. The stock prices of these companies are more volatile because businesses and consumers buy more tractors, cars and trucks during strong economic times, and cut back on investments in capital assets and purchases of durable goods during weak economic times. On the other hand, low-beta stocks tend to be less volatile, and therefore contribute less volatility to a diversified portfolio. Examples include food stocks like Heinz and pharmaceutical stocks like Bristol- Myers. These companies produce items consumers tend to buy regardless of economic conditions.When applied to a well-diversified equity portfolio, beta is a measure of the market risk, or volatility, of the portfolio. If a portfolio emphasizes high-beta stocks, its returns will tend to be more volatile, and vice-versa if it emphasizes low-beta stocks.

4.) According to finance theory, what is the expected difference in stock returns and volatility for high- and low-beta stocks and stock portfolios? 2 / 4

2 Applied Equity Analysis InstructorSolutions Manual © Robert A. Weigand, Ph.D., 2013 Finance theory asserts that risk and expected returns are positively related, which implies that high-beta stock stocks should earn higher returns and low-beta stocks should earn lower returns over long holding periods. Thus, high-beta stock portfolios should outperform low-beta portfolios, as higher returns compensate investors for bearing greater risk.

5.) Explain the importance of each step of the 4-step fundamental analysis process featured in this book. What does it mean to say the process is "top-down"?

• Economic analysis determines the current stage of the business and financial

cycles.

• Sectors to over- and underweight are then determined, depending on the current

stage of the business and financial cycles.

• The active weights of individual stocks within each sector depend upon how well

they model up on a fundamental basis.

• Performance attribution analysis identifies why a portfolio under- or outperformed

its benchmark.A "top-down" process begins by analyzing the overall economy, with an emphasis on gauging the stage of the business cycle in which the economy is operating (the topic of the following chapter). This activity helps the analyst identify sectors of the stock market in which to deploy new capital, and sectors from which capital should be withdrawn and re- deployed.

6.) Define the terms "sector over- and underweights" and "active portfolio weights." When an actively-managed portfolio allocates funds by sector in a way that differs from their current market weights, the portfolio manager is employing active portfolio weights.When a portfolio's sector weight deviates from the weighting of that sector in the index benchmark, the portfolio has sector overweights and underweights.

7.) Describe the stock price behavior of Bristol-Myers and Johnson & Johnson during the spring 2012 US stock market correction.Bristol-Myers (BMY) follows the market through early April, but as investors become increasingly nervous about an impending correction, buyers gradually bid BMY's stock price up until it decouples from the market trend. This occurs because investors sell many of their risky, high-beta stock positions during market corrections and invest the proceeds in stocks with superior fundamentals. Johnson & Johnson initially follows the market's downward move, but investors only allow it to fall so far before it offers compelling value in a declining market. Towards the end of the 3-month market correction, JNJ has outperformed the market by almost 6%.

8.) Describe the stock price behavior of Wal-Mart and Citigroup before, during and after the spring 2012 US stock market correction.Citigroup's stock earned a total return of 40% from late December 2011 through March

• The S&P 500 gained 16% during this "risk-on" period, while Wal-Mart's stock

gained only 4%. Over the subsequent 3 months (April through June) the S&P 500 corrected downward by −10%, Citigroup declined by −25%, and Wal-Mart gained another 3 / 4

3 Applied Equity Analysis InstructorSolutions Manual © Robert A. Weigand, Ph.D., 2013 +12% as investors rotated into safer stocks. Three months later, by the end of September, Citigroup's total return still trailed Wal-Mart's by a significant amount.

9.) Over the long-term, do active money managers tend to outperform or underperform their benchmark indexes?The vast majority of active money managers underperform their benchmarks.

10.) What are the two major findings of the Barras, Scalliet and Wermers (2010) paper reviewed by Mark Hulbert?Even fewer managers beat the market than previously thought. After accounting for fees, the vast majority of active mutual funds had negative returns. But these authors also conclude that the proportion of zero-alpha mutual funds is higher than previously thought.They find that 75% of funds earn zero alphas, implying that the pros earn just enough to cover their fees and other costs. Less than 1% of funds were found to deliver positive alpha in a way that is consistent with manager skill.

11.) Describe the paradox of active fundamental analysis.If an analyst believes the market is mispricing a stock today, why shouldn't it be the case that this mispricing will continue to persist? For an analyst to rationally make the case that shares of ABC are worth $100, but are temporarily undervalued at $80, he should also be able to identify the upcoming information or change of perception that will convince other investors and traders to begin paying more for the stock. There must be an event that changes the market's mind about the value of ABC, or the analyst will simply own many shares of a stock whose price is stuck at $80. Therefore, identifying a mispriced security (an irrational valuation by the overall market) is an important but insufficient step in the fundamental analysis process. The final necessary step is to anticipate the catalysts that will help the rest of the market recognize the true value of the under- and overvalued securities identified by a fundamental process.

12.) Describe the importance of a "catalyst" in the context of fundamental analysis.Analysts refer to potentially market-moving information that may not be fully reflected in a stock's price as a "catalyst." The term is borrowed from chemistry, where catalyst connotes a substance or event that spurs change.

13.) What is the main idea behind the concept of market efficiency?Market efficiency is concerned with the extent to which the prices of financial securities promptly and accurately reflects all relevant information.

14.) What is the most practical reason for understanding market efficiency?When information is not accurately reflected in a stock's price, there may be an opportunity to buy or sell this mispricing and earn abnormal returns.

15.) Describe the behavior of securities prices in an efficient market. According to believers in the efficient markets hypothesis, what keeps securities prices efficient?The prices of stocks and other securities in an efficient market will react rapidly and accurately to news, where news is defined as information that is 1.) relevant to the value of the security and 2.) unanticipated by the market (in other words, "new"). Thus, securities

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