Series 66 -- Portfolio Basics

An investor buys 1,000 shares of ABCD stock at $50 per share. At the end of the 1st year, ABCD has increased to $60 per share. At the end of the 2nd year, ABCD has increased to $75 per share. At the end of the 3rd year, ABCD has decreased to $70 per share. Assuming that the customer is in the 15% tax bracket for dividends and long-term capital gains, if the customer liquidates the position at the end of year 3, the after-tax annualized rate of return is:

11.33% This investment has increased from $50 in value to $70 in value over 3 years. The $20 gain will be taxed at 15%; so 85% of the gain is kept after tax. .85 x $20 = $17 after-tax gain / 3 year holding period = $5.66 annualized after-tax gain $5.66/ $50 original investment = 11.33% annualized rate of return.

Claim Priority in Liquidation

1st: Secured Creditors: such as mortgage bondholders and equipment trust certificate holders receive the proceeds from the sales of the property pledged; 2nd: Unpaid wages, taxes, and trade creditors are paid (in the order just presented); 3rd: Debenture bondholders are paid; 4th: Subordinated debenture bondholders are paid; 5th: Preferred stockholders are paid; and finally 6th: Common stockholders are paid anything that remains.

Balance Sheet Formula

Assets - Liabilities = Net Worth

Current Liabilities consist of:

Current liabilities are all the bills coming due within a year: 1. Account payable 2. Wages payable 3. Taxes payable 4. Interest payable

The analyst will examine the Debt to Equity ration to evaluate the company's capital structure.

Debt/Equity Ratio = Long Term Debt/ Stockholders Equity

Modern portfolio theorists use CAPM to find the: A. highest return investments B. lowest risk investments C. most efficient investments D. most economic investments

Explanation The best answer is C. Modern Portfolio Theory states that the best investments are those that lie on or above the "efficiency frontier." These are the investments that give the highest return per unit of risk assumed. The Capital Asset Pricing Model finds this efficient set of investments.

Current Assets - Current Liabilities =

Net Working Capital

Total Assets - Total Liabilities =

Net Worth. Net Worth is also called stockholder's equity. The excess of a company's total assets over and above its total liabilities on the balance sheet The difference between the total value of a person's assets and possessions - e.g., home, land, savings accounts, investments, etc. - and that person's total indebtedness - e.g., home mortgage, credit card debt, school loans, etc.

Real Rate of Return

Nominal Rate - Inflation Rate

Return Comparisons to Benchmark Portfolios

Portfolio returns achieved by a manager need to be compared to against relevant benchmark. (e.g. Small cap to Russel 2000 Index)

Holding Period Return

Rate of return over a given investment period. The shorter the holding period, the greater of the variability of return. And vice versa. Common stock price volatility may hurt short term holding period performance, but over the long term, the equity risk premium that the common stocks give produces a superior return with much lower overall volatility.

The priority of claim to corporate assets in a liquidation is:

Secured creditors, unpaid wages and taxes, trade creditors, unsecured bondholders, preferred stockholders, common stockholders.

Risk Free Rate of Return

Treasuries are the safest securities. The rate of return on risk-free investments. The interest rates on short-term U.S. government securities are commonly used to measure this rate.

A fundamental analyst can get a corp's financial statement from their major filling to the SEC: 10K & 10Q

1. 10K - Corporate Annual audited financial Statement. Filed from 60-90 days after year end. 2. 10Q - Corporate Quarterly unaudited financial Statement. Filed from 40-45 days after quarter end.

Current Assets consist of:

1. Cash and marketable securities 2. Account receivable 3. Inventory

Rations to measure liquidity

1. Current Ratio: Current Assets/Current Liabilities 2. Quick Ratio (Acid Test): (Current Assets - Inventory)/Current Liabilities

Time Weighted Average Return, same as Total Return of a mutual fund

1. Is a measurement used by a mutual fund performance charts and shows the growth of 1-time investment over a fixed time period. 2. Buy and hold strategy. 3. A single investment is made

A customer buys a $1,000 par Treasury Inflation Protection security with a 4% coupon and a 10 year maturity. If the inflation rate during the first year of the security's life is 5%, the:

1. coupon rate remains at 4% 2. principal amount is adjusted to $1,050 Treasury "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. Thus, there is no purchasing power risk with these securities.

Which statements are TRUE regarding Total Return and Standard Deviation?

1.. The greater the risk level of the security; the greater the Total Return demanded by the market. 2. The greater the risk level of the security; the greater the Standard Deviation of Total Return Markets demand a "risk premium" above the risk free rate of return provided by risk-free investments such as 1 year Treasuries for any investment that shows variability in its returns (as measured by standard deviation). Thus, the greater the risk level of a security, the greater the Total Return demanded by the market. Since the measure of risk is standard deviation, this, by definition, increases as "risk" of a security increases.

Arithmetric Mean Return

Average annual return that the investment generates.

CAPM Capital Asset Pricing Model To find the best investment in the market

Formula: Expected Return of a specific Investment = Risk-Free rate of return + Risk Premium Risk Premium = Beta x (Excess of Expected Market Return over Risk-Free Rate of Return) The return calculated using CAPM is the minimum RRR - Required Rate of Return Required Rate of Return is also named Hurdle Rate. The minimum rate hurdle that must be cleared in order to make this investment.

Efficient Market Theory

Holds that securities prices instantaneously and fully reflect all available information. Because of this random selection of a portfolio should provide a return that is as good as selection by any other analytical method. In essence, the theory says that there is no way to improve on the return that the market is giving.

Portfolio Returns -- RRR Required Rate of Return, minimum rate of return required

If an ROI is less than RRR, the investment would not be made.

Approaches when constructing a portfolio - Bottom-Up Approach

Looks at a specific company first, say based on a new product coming to market. Regardless of overall economic conditions or trend.

Dividend Payout Ratio

Measures of the portion of a company's earnings that are paid to common shareholders as dividend. Dividend Payout Ration = Common Dividend Paid/ Earning for common Mature companies and utilities tend to have high dividend payout ratios.

Monte Carlo Simulation

Monte Carlo simulation is a computer-driven "decision-tree" analysis of possible portfolio returns that can be achieved based on varying factors, such as differing future interest rate levels; equity return levels; inflation rate levels, etc. It assesses the probability of getting the desired portfolio return over a long time horizon, during which these variables can change thousands of times.

Dollar Weighted Average Return, same as Internal Rate of Return for a specific fund investor

Return is often lower then Time Weighted Average return. Because buy too late, sell too soon.

Efficient Market Theory Semi-Strong Form:

Securities prices fully reflect all publicly available information. Thus, the use of publicly reported information to select stocks cannot result in a better return, since their prices already reflect this information. · Widely accepted · Insider can select stocks to generate a better return. · The average investor cannot do better than the market by selecting specific stocks. · The growing popularity of index fund purchases attests the fact that more and more people understand this theory and the reality behind it.

Efficient Market Theory Weak Form:

Securities prices only reflect old information, thus attempting to predict future market movements based on historical data is impossible, because what has happened in the past is not necessarily a predictor of the future.

Portfolio Returns -- ROI Return on Investment

Simply the average annual cash flow, divided by initial investment outlay, without giving any consideration to the time value of money and also ignoring the negative cash flow of the initial investment and the positive offsetting cash flow representing the return of principal.

Risk Premium definition

Small capitalization stocks are the most risky securities. Investors demand a higher total return from these investments. Securities yield above the risk free treasury rate.

Geometric Mean Average Rate of Return

Takes compounding into effect

Price/Book Value Ratio

The Price/Book Value Ratio of a corporation is the company's Market Price (per share) / Common Stockholders' Equity (per share). While the "price" is the market value per share, book value is simply the accounting value of common stockholders' equity. Common stockholders' equity is based on accounting as of the date each transaction happened, which could be years in the past. Thus, if the market values of those assets or liabilities booked years in the past have moved dramatically, then "book value" really has little meaning.

A customer buys 100 shares of ABCD stock at $23.00 per share. At the end of the year, the stock is valued at $29.53. During the year, the stock paid $.30 in annual dividends. The stock's dividend yield is: A .13% B 1.02% C 1.11% D 1.30%

The best answer is B. Dividend yield is based on the current market share price, not on cost of the stock. The formula is: Latest Annual Dividends/Current Market Price = $.30 $29.53 = .01016 = 1.02% (rounded)

If stockholders' equity is subtracted from total assets, you are left with: A.current liabilities B.long term debt C.current liabilities and long term debt D.retained earnings

The best answer is C. current liabilities and long term debt The balance sheet formula is: Total Assets = Total Liabilities + Stockholders' Equity If Stockholders' Equity is subtracted from Total Assets, you are left with Total Liabilities - which consists of both Current Liabilities and Long-Term Liabilities.

What does "X" refer to in the following formula: X = P ( 1 + i)nth A. Net Present Value B. Internal Rate of Return C. Yield to Maturity D. Compound Value of an Amount

The best answer is D. This formula is for the compound value of an investment. For example, $100 (the principal amount, or "P"), compounded at 10% ("i" - the interest rate) for 2 years would be equal to: $100 (1 + .10)2 = $100 (1.21) = $121

Sharp Ration shows Incremental reward of assuming risk

The larger the ratio, the greater incremental reward of assuming the risk. If the ratio is 0, one should better hold the treasuries.

Capitalization

The sources of long-term capital for a company are: 1. Long term liabilities 2. Stockholder's Equity (Both common & Preferred)

real rate of return

the nominal rate of return minus the inflation rate

After Tax Yield

the percentage yield on a taxable investment after subtracting the effect of federal income taxes that will need to be paid on the investment. Taxable Yield x (100% - Tax Bracket %)

Efficient Market Theory Strong Form:

Strong Form: States that securities prices fully reflect all information, whether publicly available or not.

Fundamental Analysis are quantitive analysis to examine the company's financial results:

The analyst will examine: 1. Balance Sheet 2. Income Statement 3. Statement of changes to retained earnings

Portfolio Construction - types of equities included in the portfolio inculdes:

1. Blue chips - The highest quality companies with proven earnings and dividend records. Mainly NYSE listed. Mature companies. 2. Growth. Price/Earning Ratio High P/E Ratio because of their exceptional growth potential. 3. Emerging Growth - High risk, high potential reward. (Internet stocks.) 4. Income. Mature companies with high dividend payout, such as utilities. 5. Cyclical. Durable goods. (Washing machine and cars) 6. Counter cyclical. Basic food, grain company. 7. Defensive. Drug companies. Public utilities. 8. Speculative - Fly high during business cycle upturns. Airplane manufactures. 9. Special Situation - going through a takeover, restructuring, bankruptcy, or management change. Will hence its earning potentials.

Footnotes

1. Companies significant accounting policies 2. Scheduled debt maturities 3. Pension Obligations 4. Unsolved litigations....

Two methods valuing common stock: DDM & DCF

1. Dividend Discount Model Only works for companies that are in a steady state. 2. Discounted Cash Flow Model For companies doesn't pay a dividend. Simply discount future cash flows to value the business. The discount rate used in DCF is the company's average cost of capital.

Items included in the Capitalization of a company

1. Long term debt 2. Preferred stock 3. Common stock Common stockholders' equity include: Common at par, Capital in excess of par (CEP), Retained earnings

4 Basic Statistics Means on returns

1. Mean - Is the average return 2. Median - Returns in acceding order 3. Mode - The return that occurs most often 4. Range - From low to high

Other considerations evaluating portfolio investment return

1. The probability that the return may vary 2. The fact that the holding period can greatly affect the investment return. 3. The bite that taxes take out of investment return

Compound value of A sum/ Compound Interest -- Future Value

FV = P (1 + i) n

Total Return

Income + Growth (Income = dividend for equities; interest for debt)

Efficient market theory basically states that active asset managers cannot outperform the market, so there is no reason to pay them expensive management fees.

Index funds, which are passively managed, have much lower expenses than actively managed equity funds, will be purchased by those who believes in efficient market theory.

inflation-adjusted rate of return

Inflation-Adjusted return deducts the rate of inflation from the investment return, to approximate the "real rate of return." If an investment yields 8% when the inflation rate of 6%, the inflation adjusted rate of return is 2%.

Expected Return

Is the calculation of weighted average of its possible return, with the weighting being the probability of achieving each scenario.

Time Weighted Average Return

Is the measure used for mutual fund performance charts (Total Return, which shows dividends and capital gains as continually reinvested). It reflects the growth that would be achieved from a 1-time investment into the fund and then holding that investment over time - this is a buy and hold strategy. This method is consistent when comparing one fund's performance to another fund's performance.

Fundamental Analysis

Makes his investment decisions based on the "fundamentals" of the corporation. The analyst will exam: 1. The outlook of the industry 2. The management of the company 3. The product lines of the company 4. Anticipated introduction of new products 5. Market share of the company

Risk Adjusted Rate of Return/Sharp Ratio, another way of looking at Risk Premium

Sharp Ratio seeks to measure: Rewards, as defined by the risk adjusted rate of return; versus Volatility as defined by the Standard Deviation Sharp Ration = (Total Return - Risk-Free Rate of Return)/ Portfolio Standard Deviation

Dividend Yield

Shows a common stock's return on money invested, looking at dividend only. Dividend or Current Yield = Annual Income/ Market Price

Approaches when constructing a portfolio - Top-Down Approach

Starts from the big picture, then go to greater details to determine the appropriate investments.

Risk Premium

The additional return expected for assuming risk (From a growth company than a mature company.)

A customer buys a TIPS at par with a 3½% coupon. Inflation stays at 4% over the life of the security. What is the inflation-adjusted yield? A. 3½% B. 4% C. 7½% D. This cannot be determined from the information presented

The best answer is A. This one borders on being a trick question. Treasury Inflation Protection Securities (TIPS) give a fixed coupon rate (3½% in this example), but they also adjust the principal value of the bond up each year for inflation (4% per year in this example). At maturity, the investor gets the inflated principal amount. The Total Return on this TIPS would be 3½% annual income + 4% annual gain = 7½%. However, this question asks for inflation-adjusted rate of return (real rate of return), which subtracts out the inflation rate. So the real rate of return is simply 3½%. Also note that the coupon on a TIPS will always be the real rate of return.

Dollar Weighted Average Return is the same as: A. Annualized Rate of Return B. Internal Rate of Return C. Time Weighted Average Return D. Expected Rate of Return

The best answer is B. Dollar weighted average return is most often used when evaluating a specific investor's mutual fund return. It is the return achieved, accounting for the timing of all cash flows (deposits) into the fund and all cash redemptions from the fund made by that investor. It is the same as the Internal Rate of Return, and will vary with the timing of each investor's deposits and withdrawals. Because investors often "chase" past performance, they will buy a fund "too late" (after the fund has posted its best performance and now enters a period of lesser performance) and will sell "too soon." Thus, for the individual investor, dollar weighted average return is often lower than time weighted average return.

A customer, age 30, believes that equity investments for growth are the best choice for his long-term investment goals. He does not believe that asset managers can outperform the market over long time periods and doesn't wish to pay for them. The best recommendation for this customer is the purchase of: A. High Tech Mutual Fund Shares B. Government Bond Fund Shares C. Equity Index Fund Shares D. Corporate Bond Fund Shares

The best answer is C. This customer believes in efficient market theory - that asset managers cannot outperform the market. The best recommendation is an index fund, since these have much lower expenses than actively managed equity funds, such as a high tech fund. Since he believes that you can't do better than the "market," this is the best investment because its expenses are low, so returns are not eroded. Bond funds are not appropriate, since he is young and wants an equity investment for growth

Which statements are TRUE when comparing arithmetic mean return to geometric mean return? I Arithmetic mean return considers compoundingII Arithmetic mean return does not consider compoundingIII Geometric mean return considers compoundingIV Geometric mean return does not consider compounding A. I and III B. I and IV C. II and III D. II and IV

The best answer is C. Arithmetic mean return is simply the average annual return of an investment over its time horizon. For example, if an investment has a 3-year life, one would take each year's return, add them together and divide the total by 3 to get the arithmetic annual return. In contrast, the geometric rate of return is the compound annual rate of return produced by that investment. For example, a 3 year investment that returns +20% in the first year; -10% in the second year; and +20% in the third year has an arithmetic mean return of 10% (+20-10+20 = 30/3 = 10%) However, in this example, $1 invested will equal $1.20 after year 1 (+20%); $1.08 after year 2 (-10%); and $1.296 after year 3 (+20%). This is the same as a compound annual return of 9% and this is the geometric rate of return.

Efficient Market Theory uses "CAPM" - the Capital Asset Pricing Model - to find the best investments in the market.

The efficient set of investments are those that give the highest expected return relative to their risk-class. Risk in the model is based on the standard deviation of returns. The best investments are those that give the highest expected return relative to the level of risk assumed (lower is better).

Modern Portfolio Theory uses "CAPM" - the Capital Asset Pricing Model - to find the best investments in the market.

The efficient set of investments are those that give the highest expected return relative to their risk-class. Risk in the model is based on the standard deviation of returns. The best investments are those that give the highest expected return relative to the level of risk assumed (lower is better). When these "best" investments are plotted out on a graph where the vertical axis is expected return and the horizontal axis is risk, the result is an upward sloping line called the "efficiency frontier." Any investments made that lie on the line or above give the best "bang for the buck" - the greatest return per unit of risk assumed. Those that are below the line are inferior investments.

Standard Deviation

The measure of risk of variability of returns is the standard deviation of the return. It measures the spread of the distribution of return compare to the average of return.

Time Value of Money (TVM)

The potential to earn interest on money affecting its relative value. The productivity of money is known as its time value. For example $1 received today is the same as $1.10 received 1 year from now, if market rates of interest are 10%.

Efficient market theory states that:

holds that prices of securities in the market fully reflect all publicly available information, so that undervalued or overvalued securities should not exist. Thus, securities selection based on any type of analytical method is irrelevant.