11/12Stock Valuation & Risk

NOTE: For time’s sake, we skip most of Ch. 11. But there are a couple of key concepts from the chapter that I will cover in class and are summarized on the following slides.

Ch. 11 Diversification-- The Wise Man said: “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.” Eccl. 11:2-- You need to scramble your nest egg, even when it isn’t taking a beating!-- If you put all your eggs in one basket, make sure you like egg drop soup.-- The only investors who shouldn’t diversify are those who are right 100% of the time. John Templeton-- Wide diversification is only required when investors do not understand what they are doing. Warren Buffett

Diversification

As you can see, once you have about two dozen stocks in your portfolio, you’ve essentially maxed out the effect of diversification, assuming these stocks are in different random industries. This is why a portfolio manager, with hundreds of stocks in the portfolio, worries more about how the portfolio corresponds to the overall market . We measure the correlation using a mathematical coefficient called beta. See next slide.

BetaBeta is the mathematical coefficient measuring the correlation of the stock’s price movement in relation to the overall stock market’s price movements. A beta of 1 indicates a perfect correlation. A beta of 2 indicates the stock moves in the direction of the market but twice as far. A beta of .5 indicates a movement in the direction of the market by only half as much, and so forth. You can look up a stock’s beta by using Yahoo!Finance.

??? Why do you suppose that food company’s beta would likely be lower than a high-tech company’s beta?

AlphaAlpha is the excess return of an investment beyond the typical benchmark return of the market. Simply stated, alpha is the return a portfolio manager adds to the benchmark. An alpha of 1 means the fund has outperformed its benchmark index by 1%; and a negative alpha of 1 indicates underperformance of 1%. For investors, the more positive an alpha is, the better it is.

In portfolio street language, beta relates to the portion of return due to the movement of the overall market and alpha relates to the portion of return due to the specific investment performance.

Sharpe IndexMeasures the reward-to-risk ratio. Reward is the return above the risk-

free rate and the risk is the standard deviation.

Sharpe Index = Avg Return – Avg Risk-free ReturnStandard Deviation of Returns

e. g. Stock K has a SD of 2 and an avg return of 20, while stock M has a SD of 1 and an avg return of 14%. T-Bills are yielding 4%.Sharpe Index for K=8% and M=10%. M has more reward per unit of risk (SD).

The Sharpe Index is very helpful because higher return on a stock may not justify the higher risk.

E.g. Go to www.morningstar.com and enter VFINX. See Ratings & Risk

Market EfficiencyEFFICIENT MARKET HYPOTHESIS (EMH)Market efficiency refers to how quickly market prices accurately adjust to

new information.

 

Efficient Market Hypothesis (EMH)

 

Degrees of Market Efficiency (How quickly do market prices adjust accurately to new information?)

 

Not efficient

 

Weakly Efficient

 

Fairly Efficient

 

Strongly Efficient

 

 

 

(Weak Form)

 

(Semi-strong Form)

 

(Strong Form)

 

Market doesn't reflect info at all

 

Market already reflects past public info

 

Market already reflects all past and current public info

 

Market already reflects all past & current info, whether public

or private

 

 

 

This form is obviously true, which means

chartists are mostly wasting their time

 

Markets in reality follow this form closely

 

Insider trading proves this form can't be true

Warren Buffet Quotes:“If past history was all there was to the game, the richest people would be librarians” --scoffing at Wall Street's over-reliance on charting and history-based technical models.“I’d be a bum on the street with a tin cup if the markets were efficient” – referring to his ability to identify non-efficiently priced stocks – that’s how he made his fortune

Market EfficiencyMarkets are efficient when there are lots players who bring liquidity and cause prices to adjust quickly and accurately to new information.

INSIDER TRADING Definition - Trading stocks based on information not available to

the general public that you have reason to believe is true.

Insider trading is illegal according to SEC because it is not fair to the other stockholders to be taking personal advantage of information you learn because of your position. Only a few dozen people have been prosecuted to date--the most famous include Michael Milken, Ivan Boesky, Dennis Levine, and Raj Rajaratnam.

All formal insiders (i.e. executives, managers, board members, major stockholders) must disclose their trades of company stock to the SEC. But there are also many non-formal insiders who might be tempted to trade on inside info, such as accountants, auditors, janitors, relatives, friends, printers, psychologists, counselors. . . and any others who may learn about the information before it’s released to the public.

INSIDER TRADING

Raj Rajaratnam, billionaire hedge fund manager and co-founder of Galleon Group, is surrounded by photographers as he leaves Manhattan federal court, May 11, 2011. He was convicted of insider trading and securities fraud, coaxing corporate tipsters to give him an illegal edge, in what prosecutors called the largest insider trading case ever involving hedge funds.

May, 2013: An FBI photo shows former KPMG audit partner Scott London, left, allegedly accepting cash from jeweler Bryan Shaw. Shaw made $1.3M on insider tips from London, who received about $60k in kickbacks.

12Market Microstructure and Strategies

Stock Market TransactionsBrokerage firms:

Serve as financial intermediaries matching buyers with sellers Receive orders from customers and pass the orders on to the

exchange through a telecommunications networkFull-service brokers offer advice to customers

Charge about 4 % of the transaction amountDiscount brokers only execute the transactions

Charge about 1% of the transaction amount or fixed feeThe larger the transaction amount the lower the percentage charged by many brokers

Why do they call the guy who handles your money a broker?

Types of Orders Market orders (cheapest)

Execute transaction quickly at best price Limit orders (more expensive)

Stop-loss orders (or sell-stop orders): where the investor specifies a selling price that is below the current market

price of the stock (e.g. sell if price drops to $28) are typically placed by investors to either protect gains or limit losses.

Allows loss limits to be determined in advance, preventing emotional decision making. Used by those investors who are unable to watch their stocks for a period of time (vacation, etc.)

Stop-buy orders (or buy-stop orders) where the investor specifies a purchase price that is above the current

market price – used by those hoping to gain from a stock’s upward momentum (e.g. buy is stock goes up to $31). Also used by short sellers to limit their loss (e.g. buy if stock drops to $38).

Many other kinds

Internet orders Most brokers accept orders online, provide real-time

quotes and access to information About one in three stock transactions is initiated online,

and increasing every year Average execution speed is about 8 seconds Commission is typically $5-$15 Popular online brokers include Fidelity, TD Ameritrade,

Charles Schwab, Scottrade, E*Trade, and National Discount Brokers, etc.

Margin Trading Buying stock on margin= borrowing to buy stock Customer establishes credit with broker (margin account) Federal Reserve sets margin requirements (%) or

proportion of funds buyer must put down Used to dampen speculation and market crashes, backed-up by

Japanese study Currently margin requirements are a min. of 50% down in cash; the

rest can be borrowed Broker may set higher margin requirements

Initial margin—broker’s minimum margin requirement for stock purchase (50%). Set by Fed Reserve

Maintenance margin—minimum proportion of equity/total value of stock (25%). Set by exchanges, e.g. NYSE

Margin Trading, cont. Margin trading magnifies returns to investor

Investor must pay interest on borrowed funds Investor returns higher/lower with lower equity than a 100% purchase

Margin Call Stock price falls below maintenance margin requirements Margin call is a request for cash to maintain maintenance margin Broker/lender may sell stock to protect loan During crashes, many margin calls occur without investors having cash.

As stock is sold, this puts additional downward pressure on stock prices.

http://www.youtube.com/watch?v=sdFM0rIsBKo

Returns on Margin Accounts

Billy purchases one share of stock for $50 on margin, borrowing 50% of the funds necessary to complete the purchase. The stock pays an annual dividend of $.50 per share. The brokerage firm charges an annualized interest rate of 8% ($2 in this case). Assume that after one year, the stock is sold at a price of: (A) $55, (B) $47. What is the return on the margin transaction?

%1425$

50$.27$)25$55($

INVDLOANINVSPR

%1825$

50$.27$)25$47($

INVDLOANINVSPR

A

B

The Principal of Leverage

Compute the return that would have been realized in the previous two examples if Billy had paid the entire price of the stock, without borrowing on margin.

Stock Rises to $55:

Stock Falls to $47:

%1150$

50$.50$55$

R

%550$

50$.50$47$

R

Short Selling In a short sale, short-seller borrows stock from broker or another

investor Short-seller then sells stock for, say $100 Short-seller waits while stock declines to, say $60, and buys stock Short-seller covers dividend, say $1, and also may pay a fee, say $1

to lender Short-seller makes $38 on this transaction Somewhat risky since there’s a limited gain but unlimited loss (no limit

on how high a stock an increase) Concerns about Short Selling During Credit Crisis of 2008: hedge

funds and other investors took large short positions on many stocks. Critics argued that the large short sales placed additional downward pressure on prices and created paranoia in the stock market. Lehman Bros. said it was short sellers that caused it’s demise.

■ Restrictions on Short Selling

■ In October 2008, the SEC required that short-sellers borrow and deliver the shares to the buyers within three days. This rule is important because there were many cases in which brokerage firms were allowing speculators to engage in naked shorting, in which they sell a stock short without first borrowing the stock.

■ In 2009, the SEC and Congress proposed to reinstate the uptick rule (previously eliminated in 2007), which prohibits speculators from taking a short position except after the stock price increases. This rule is intended to prevent short selling in response to a stock’s continuous downward price momentum. However, the proposal was never passed.

Short Selling (cont.)

Short Ratios The short position or interest is the ratio of the number of

shares sold short divided by the total number of shares outstanding Higher figures indicate investors’ expectation of price decline

The short interest ratio (days to cover) is the shares sold short divided by the average daily trading volume The higher the short interest ratio, the higher the level of short sales Is measured for each individual stock, can be as high as 100 or more The short interest ratio is also measured for the market to determine the

level of short sales for the market overall (NYSE short interest)

Individual Stock Short Interest: http://www.nasdaqtrader.com/Trader.aspx?id=ShortInterest

Investing in Stock Index Mutual Funds Advantages

Auto-diversification Auto reinvest dividends (DRIPs) Lower fees than managed-funds (low mgmt fee, low turnover &

transaction fees) Defer taxes longer Benchmark comparability Returns not dependent on a single individual No style drift Outperform managed funds at least 2/3rds of the time.

Example: Vanguard VFINX https://personal.vanguard.com/us/FundsSnapshot?FundId=0040&FundIntExt=INT

Exchange-Traded Funds (ETFs) vs. Indexed Mutual Funds

Both ETFs and indexed mutual funds Share price adjusts in response to change in index Pay dividends earned in added shares Lower management fees than actively managed mutual funds

ETFs are different from index funds in that they May be traded on an exchange any time during the day May be purchased on margin, sold short, hedged & bundled Slightly more tax efficient (pay only capital gains tax and only when

sold; no capital gains distributions) Have low minimum investment compared to index funds Better price efficiency (price adjusts all day long while mutual funds

price only once at the end of the day) But investor must pay brokerage costs when buying/selling

Examples of ETFsQubes (QQQQ – Nasdaq100 Trust Series I)

Tracks Nasdaq100 index (1/40th of the 100 largest non-financial stocks on Nasdaq, mostly tech companies)

Traded on Amex, can purchase on margin or sell shortSpiders (SPY- S&P Depository Receipt)

Tracks S&P 500 index Trade at one-tenth S&P 500 Index level Traded on Amex, can purchase on margin or sell short

Diamonds (DIA – Diamonds Trust) Trade at 1/100th of the Dow Jones Industrial Average Traded on Amex, can purchase on margin or sell short

How Trades Are Executed - NYSEFloor Broker Floor brokers fulfill trade orders on exchange trading floor May work for the brokerage house or serve as their agent Completes the physical trade with other floor participants Most trading is now done electronically

Here’s is an excellent illustration of how a typical stock trade actually occurs: http://www.businessweek.com/articles/2012-12-20/how-your-buy-order-gets-filled

Market Maker- Specialists - NYSE

Hundreds of specialist or market-maker firms take orders for 5-8 different assigned stocks thru both NYSE computer system and floor brokers

Floor brokers gather around the 20 specialist trading posts looking to trade shares for their customers

Specialists must allow floor brokers to independently trade with each other

But if a floor broker cannot find someone to trade with, specialists are required to step in as market-makers, trading from their own accounts

Market Makers/Specialists – NYSE (cont.)

Critics say specialist add little value and should be eliminated. Rather, traders should trade exclusively thru computer networks

Specialists counter that they play the important role of providing liquidity, smoothing volatility and making sure buyers/sellers get the best prices

SEC has charged some specialist firms with artificially inflating the price of shares they hold in order to make additional profit (called front-running)

SEC is seeking tens of millions of dollars in fines against these specialist firms.

NYSE FloorNow and in 1929

In Dec/12, IntercontinentalExchange (based in Atlanta) purchased the NYSE Euronext for $8B, ending 200+ years of independence. No change on the trading floor occurred because of this acquisition.

NYSE Controversy

Late 2003 – the $140 million pay package of Richard Grasso, Chairman of NYSE, became public info (i.e. he was making $50,000 per day!)

NYSE got a firestorm of protest from the public & gov’t

Finally, NYSE Board voted 13-7 to ask Grasso to resign

This stroked an already smoldering SEC investigation into NYSE corporate governance issues

Together with SEC charges against specialists, the NYSE faced its biggest shakeup in its 213-year history.

How Trades Are Executed - NasdaqOTC Market Makers – for smaller companiesMarket-makers have dealer positions in specific stocks and complete transactions on NASDAQ market No specific location as with

specialists on exchanges—telecommunications link only

Market-makers provide continuous market liquidity

Pinksheets is where tiny companies not registered with the SEC trade

Headquarters in NYC

Electronic Communications Networks (ECNs)

Automated systems for disclosing and executing stock trades

Focus on institutional market trading with large-size trades and lower spreads

Started on NASDAQ; spreading to exchange-traded stocks

ECNs specialize by types orders: market, limit, etc.

http://www.trackecn.com/index.html http://batstrading.com/

Example of an ECN Book

http://batstrading.com/

Program Trading Trading completed by computer “program” Typically involves simultaneously buying and selling at least

15 different stocks in the S&P500 Index. Purpose is to reduce susceptibility of a stock portfolio to

market movements. Can be combined with futures/options to create portfolio insurance.

Used by large institutional investors with large orders, high volume trades

NYSE listed stocks dominate program trading• See video • http://www.cbsnews.com/video/watch/?id=7368460n&tag=cbsnewsMainColumnArea.12

http://www.cbsnews.com/news/michael-lewis-stock-market-rigged-flash-boys-60-minutes/

• See Eric Hunsader video on the abuse of high-speed trading• http://fora.tv/2013/05/07/Nanex_CEO_Eric_Hunsader_Flash_Trading_Detective_Work

Program Trading, cont. Program trading associated with increased volatility of

stock market (e.g. especially during stock market crashes)BUT

Some research has refuted this claim NYSE implemented “collars” or curbs to program trading

in volatile periodsDark Pools

Platforms that use software to connect buyers and sellers of stocks Trades are not immediately disclosed to the public allowing investors to

accumulate large amounts of shares without public knowledge. Also attract high-frequency traders. Increasing in popularity and might account for 40% of all trading of stocks.

Program Trading, cont. On May 6, 2010, stock prices declined abruptly in what is now referred

to as the “flash crash.” Stocks declined by more than 9 percent (600 points) on average before reversing and recovering most of those losses on that same day, when more than 19 billion shares were traded. It appears that the flash crash was triggered by computerized high-frequency trading. In April of 2015, Navinder Singh Sarao, a small-time London computer trader, was arrested for instigating the flash crash.

Securities and Exchange Commission Most stock market regulation comes from the SEC

(Securities Act of 1933 and 1934)

Congress provided SEC with broad powers to regulate stock markets by Prescribing accounting standards Establishing regulations for stock trading and disclosure from

“insiders”

Structure of the SEC Five Commissioners

Appointed by president, confirmed by Senate Five-year staggered terms SEC Divisions

• The Division of Corporate Finance reviews the registration statement filed when a firm goes public, corporate filings for annual and quarterly reports, and proxy statements.

• The Division of Market Regulation requires the orderly disclosure of securities trades

• The Division of Enforcement assesses possible violations of the SEC’s regulations and can take action against individuals or firms.

Regulation of Stock Trading Purpose of stock trading

regulation To make market more efficient

Promote and preserve competition

Prevent unfair or unethical trading practices

Provide adequate disclosure of information

To prevent market failure, circuit breakers and trading halts (time outs) exist

SEC uses surveillance system to watch trading Insider trading Attempts to corner market

Regulation of Stock Trading Regulation Fair Disclosure (FD), passed in Oct. of 2000

Corporations must disclose relevant financial info broadly to all investors at the same time, either thru its website, SEC filing, news release, or conference call.

http://biz.yahoo.com/research/earncal/today.html No longer will analysts and financial journalists get the inside scoop

before other people do. Before Reg FD, firms would often hint to analysts whether they beat

projections or not. Prevents unfair or unethical favoritism in release of info

Moving stock quotes from fractions to decimals

SEC Oversight of Analysts’ Recommendations

Sell-side analysts rewarded for success of underwriting (sale of securities)

Do analysts “tout” stocks after they are aware of “negative” information?

Should analysts make high income when investors lost money on recommended stocks?

Big scandal for analysts, covered later in Ch. 25, where analysts told investors the stock was a great investment but private emails showed they thought the stock was a “POS” (which stands for piece of “something”)

See analyst ratings for a particular stock at Yahoo!

Three Traditional Barriers to International Stock Trading

Classic Barriers

To Capital Flow

Transaction Costs

Information Costs

Exchange Risk Costs

Three Traditional Barriers to International Stock Trading• 1. Reduce Transactions Costs

• Increased consolidation and increased efficiency of international stock exchanges

• Computerized order flow/matching provide more objective, fairer trading, lowering bid/ask differentials

• Transaction costs lowered by competition, technology, and less regulation

• 2.Reduce Information Costs • Information on foreign stocks now more accessible • More uniform accounting standards between countries • Increased disclosure reduces information gathering costs

Three Traditional Barriers to International Stock Trading

3. Reduce Exchange Rate Risk Investing in foreign stocks denominated in foreign

currency exposes investor to forex risk Changes in foreign exchange rates changes actual return

from expected Exchange rate risk reduced as single currency adopted—

euro example