Investment Analysis Book Summary CH 1-4
Chapter 1: The investment environment
An investment is the current commitment of money or other resources in the expectation of reaping
future benefits.
1.1 Real assets versus Financial assets
The material wealth of a society is ultimately determined by the productive capacity of its economy,
that is, the goods and services its members can create. This capacity is a function of the Real Assets of
the economy: the land, buildings, machines, and knowledge that can be used to produce goods and
services.
Financial assets, like stocks and bonds, do not directly contribute to the productive capacity of the
economy. Instead, these assets are the means by which individuals hold their claims on (the income
generated by) real assets.
Real assets generate net income to the economy, financial assets define the allocation of income or
wealth among investors.
1.2 Financial Assets
It is common to distinguish among three broad types of financial assets: fixed income, equity, and
derivatives.
1. Fixed-income / debt securities promise either a fixed stream of income or a stream of income
determined by a specified formula. Example: Corporate Bonds
a. Money market: refers to debt securities that are short term, highly marketable, and
generally of very low risk. Examples: Treasury bills or bank certificates of deposit
(CD’s)
2. Equity / common stock in a firm represents an ownership share in the corporation. They
receive any dividends the firm may pay and have prorated ownership in the real assets of the
firm. The performance is tied directly to the success of the firm and its real assets.
3. Derivative securities provide payoffs that are determined by the prices of other assets such as
bond or stock prices. Example: options and futures contracts. Derivatives are used for:
a. Hedge risks or transfer them to other parties
b. To take speculative positions
1.3 Financial Markets and the economy
Financial assets and the markets in which they trade play several crucial roles in developed
economies.
1. Informational role of financial markets
Stock prices reflect investors’ collective assessment of a firm’s current performance and
future prospects. When the market is more optimistic about the firm, its share price will rise.
The higher that price makes it easier for the firm to raise capital and therefore encourages
investment.
The stock market encourages allocation of capital to those firms that appear at the time to
have the best prospects.
2. Consumption timing
Some individuals in an economy are earning more than they currently wish to spend, but
others (retirees) spend more than they currently earn. One way to shift the purchasing power
is to “store” your wealth in financial assets.
Financial markets allow individuals to separate decisions concerning current consumption
, from constraints that otherwise would be imposed by current earnings.
3. Allocation of Risk
Financial markets and the diverse financial instruments traded in those markets allow
investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant
individuals can, to a greater extent, stay on the side-lines.
Capital markets allow the risk that is inherent to all investments to be borne by the investors
most willing to bear that risk.
4. Separation of Ownership and management
Many businesses are owned and managed by the same individual. Today, however with
global markets and large-scale production, the size and capital requirements of firms have
skyrocketed. These type of firms cannot exist as owner-operated firms and GE, for example,
has more than half a million stockholders. These group of individuals cannot actively
participate in the day-to-day management. They elect a board of directors that in turn hires
and supervises the management of the firm.
a. Agency problems: potential conflicts of interest between managers and shareholders.
Can be solved with some financial assets, like options.
Proxy contest: during takeover threat the shareholders launch a proxy contest in which they seek to
obtain enough proxies to take control of the firm and vote in another board.
5. Corporate Governance and Corporate Ethics
Market signals will help to allocate capital efficiently only if investors are acting on accurate
information. The markets need to be transparent for investors to make informed decisions.
Despite the many mechanisms to align incentives of shareholders and managers, during
2000-2002 were filed with a seemingly unended series of scandals.
In 2002, in response to the spate of ethics scandals, congress passed the Sarbanes-Oxley Act
to tighten the rules of corporate governance.
1.4 The investment process
A portfolio is simply the collection of investment assets. Investment assets can be categorized into
broad asset classes, such as stocks, bonds, real estate, commodities, and so on. Investors make two
types of decisions in constructing their portfolios.
1. Asset allocation: the choice among these broad asset classes. This also includes the decision
of how much of one’s portfolio to place in safe assets versus risky assets.
2. Security selection: the choice of which particular securities to hold within each asset class.
‘Top-down’ portfolio construction starts with asset allocation. A top-down investor first makes some
crucial asset allocation decisions (how much in a saving account and how much in stocks etc.) before
turning to the decision of the particular securities to be held in each asset class.
Security analysis: the valuation of particular securities that might be included in the portfolio.
‘Bottom-up’ strategy: the portfolio is constructed from the securities that seem attractively priced
without as much concern for the resultant asset allocation.
, 1.5 Markets are competitive
Financial markets are highly competitive. This competitions means that we should expect to find few,
if any, “free lunches”, securities that are so underpriced that they represent obvious bargains. This
propositions has several implications:
The risk-return trade-off
‘If you want higher expected returns, you will have to pay a price in terms o accepting higher
investment risk’.
Risk-return trade-off: higher-risk assets are priced o offer higher expected returns than lower-risk
assets.
Diversification: many assets are held in the portfolio so that the exposure to any particular asset is
limited.
Efficient markets
Another implication of this proposition is that we should rarely expect to find bargains in the security
market since financial markets process all relevant information about securities quickly and efficient.
This means that the security price usually reflects all the information available to investors concerning
its value.
Passive management: calls for holding highly diversified portfolios without spending effort or
other resources attempting to improve investment performance through security analysis.
Active management: the attempt to improve performance either by identifying mispriced
securities or by timing the performance of broad asset classes.
If markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive
strategies instead of spending resources in a futile attempt to outguess your competitors.
1.6 The players
1. Firms: net borowers.
They raise capital now to pay for investments in plant and equipment. The income generated
by those real assets provides the returns to investors who purchase the securities issued by
the firm.
2. Households: net savers.
They purchase the securities issued by firms that need to raise funds.
3. Governments can be borrowers or lenders
This depends on the relation between tax and government expenditures.
4. Financial intermediaries
Corporations and governments do not sell all or even most of their securities directly to
individuals. These institutions that stand between the security issuers and the ultimate owner
of the securities are financial intermediaries.
a. Goal: bring lenders and borrowers together.
b. Social function: channel household savings to the business sector.
c. Advantages
i. By pooling the resources of many small investors, they are able to lend
considerable sums to large borrowers.
ii. By lending to many borrowers, intermediaries achieve significant
diversification, so they can accept loans that individually might to be risky.
iii. Intermediaries build expertise through the volume of business they do and
can use economies of scale/scope to assess and monitor risk.
Chapter 1: The investment environment
An investment is the current commitment of money or other resources in the expectation of reaping
future benefits.
1.1 Real assets versus Financial assets
The material wealth of a society is ultimately determined by the productive capacity of its economy,
that is, the goods and services its members can create. This capacity is a function of the Real Assets of
the economy: the land, buildings, machines, and knowledge that can be used to produce goods and
services.
Financial assets, like stocks and bonds, do not directly contribute to the productive capacity of the
economy. Instead, these assets are the means by which individuals hold their claims on (the income
generated by) real assets.
Real assets generate net income to the economy, financial assets define the allocation of income or
wealth among investors.
1.2 Financial Assets
It is common to distinguish among three broad types of financial assets: fixed income, equity, and
derivatives.
1. Fixed-income / debt securities promise either a fixed stream of income or a stream of income
determined by a specified formula. Example: Corporate Bonds
a. Money market: refers to debt securities that are short term, highly marketable, and
generally of very low risk. Examples: Treasury bills or bank certificates of deposit
(CD’s)
2. Equity / common stock in a firm represents an ownership share in the corporation. They
receive any dividends the firm may pay and have prorated ownership in the real assets of the
firm. The performance is tied directly to the success of the firm and its real assets.
3. Derivative securities provide payoffs that are determined by the prices of other assets such as
bond or stock prices. Example: options and futures contracts. Derivatives are used for:
a. Hedge risks or transfer them to other parties
b. To take speculative positions
1.3 Financial Markets and the economy
Financial assets and the markets in which they trade play several crucial roles in developed
economies.
1. Informational role of financial markets
Stock prices reflect investors’ collective assessment of a firm’s current performance and
future prospects. When the market is more optimistic about the firm, its share price will rise.
The higher that price makes it easier for the firm to raise capital and therefore encourages
investment.
The stock market encourages allocation of capital to those firms that appear at the time to
have the best prospects.
2. Consumption timing
Some individuals in an economy are earning more than they currently wish to spend, but
others (retirees) spend more than they currently earn. One way to shift the purchasing power
is to “store” your wealth in financial assets.
Financial markets allow individuals to separate decisions concerning current consumption
, from constraints that otherwise would be imposed by current earnings.
3. Allocation of Risk
Financial markets and the diverse financial instruments traded in those markets allow
investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant
individuals can, to a greater extent, stay on the side-lines.
Capital markets allow the risk that is inherent to all investments to be borne by the investors
most willing to bear that risk.
4. Separation of Ownership and management
Many businesses are owned and managed by the same individual. Today, however with
global markets and large-scale production, the size and capital requirements of firms have
skyrocketed. These type of firms cannot exist as owner-operated firms and GE, for example,
has more than half a million stockholders. These group of individuals cannot actively
participate in the day-to-day management. They elect a board of directors that in turn hires
and supervises the management of the firm.
a. Agency problems: potential conflicts of interest between managers and shareholders.
Can be solved with some financial assets, like options.
Proxy contest: during takeover threat the shareholders launch a proxy contest in which they seek to
obtain enough proxies to take control of the firm and vote in another board.
5. Corporate Governance and Corporate Ethics
Market signals will help to allocate capital efficiently only if investors are acting on accurate
information. The markets need to be transparent for investors to make informed decisions.
Despite the many mechanisms to align incentives of shareholders and managers, during
2000-2002 were filed with a seemingly unended series of scandals.
In 2002, in response to the spate of ethics scandals, congress passed the Sarbanes-Oxley Act
to tighten the rules of corporate governance.
1.4 The investment process
A portfolio is simply the collection of investment assets. Investment assets can be categorized into
broad asset classes, such as stocks, bonds, real estate, commodities, and so on. Investors make two
types of decisions in constructing their portfolios.
1. Asset allocation: the choice among these broad asset classes. This also includes the decision
of how much of one’s portfolio to place in safe assets versus risky assets.
2. Security selection: the choice of which particular securities to hold within each asset class.
‘Top-down’ portfolio construction starts with asset allocation. A top-down investor first makes some
crucial asset allocation decisions (how much in a saving account and how much in stocks etc.) before
turning to the decision of the particular securities to be held in each asset class.
Security analysis: the valuation of particular securities that might be included in the portfolio.
‘Bottom-up’ strategy: the portfolio is constructed from the securities that seem attractively priced
without as much concern for the resultant asset allocation.
, 1.5 Markets are competitive
Financial markets are highly competitive. This competitions means that we should expect to find few,
if any, “free lunches”, securities that are so underpriced that they represent obvious bargains. This
propositions has several implications:
The risk-return trade-off
‘If you want higher expected returns, you will have to pay a price in terms o accepting higher
investment risk’.
Risk-return trade-off: higher-risk assets are priced o offer higher expected returns than lower-risk
assets.
Diversification: many assets are held in the portfolio so that the exposure to any particular asset is
limited.
Efficient markets
Another implication of this proposition is that we should rarely expect to find bargains in the security
market since financial markets process all relevant information about securities quickly and efficient.
This means that the security price usually reflects all the information available to investors concerning
its value.
Passive management: calls for holding highly diversified portfolios without spending effort or
other resources attempting to improve investment performance through security analysis.
Active management: the attempt to improve performance either by identifying mispriced
securities or by timing the performance of broad asset classes.
If markets are efficient and prices reflect all relevant information, perhaps it is better to follow passive
strategies instead of spending resources in a futile attempt to outguess your competitors.
1.6 The players
1. Firms: net borowers.
They raise capital now to pay for investments in plant and equipment. The income generated
by those real assets provides the returns to investors who purchase the securities issued by
the firm.
2. Households: net savers.
They purchase the securities issued by firms that need to raise funds.
3. Governments can be borrowers or lenders
This depends on the relation between tax and government expenditures.
4. Financial intermediaries
Corporations and governments do not sell all or even most of their securities directly to
individuals. These institutions that stand between the security issuers and the ultimate owner
of the securities are financial intermediaries.
a. Goal: bring lenders and borrowers together.
b. Social function: channel household savings to the business sector.
c. Advantages
i. By pooling the resources of many small investors, they are able to lend
considerable sums to large borrowers.
ii. By lending to many borrowers, intermediaries achieve significant
diversification, so they can accept loans that individually might to be risky.
iii. Intermediaries build expertise through the volume of business they do and
can use economies of scale/scope to assess and monitor risk.
