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«Item type text; Electronic Thesis Authors Kolesikova, Katarina Publisher The University of Arizona. Rights Copyright © is held by the author. ...»

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Managing a Diversified Portfolio

Item type text; Electronic Thesis

Authors Kolesikova, Katarina

Publisher The University of Arizona.

Rights Copyright © is held by the author. Digital access to this

material is made possible by the University Libraries,

University of Arizona. Further transmission, reproduction

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Downloaded 8-Jan-2017 05:55:22 Link to item http://hdl.handle.net/10150/244412 Abstract Stock picking rests on distinguishing the undervalued “good deals” in the market from the overvalued securities. This can be challenging because when you come up with a valuation that is significantly different from the current market rate, you are making the assumption that thousands of investors, most with more experience and resources that you, are wrong and that you found something fundamental about the company that they missed. Every investor has his or her own system for picking stocks. In my opinion, the most effective one is to focus on in depth research of the company, because this allows you to come create an accurate discounted cash flow valuation model. The paper talks about this investment process in detail. It is a series of short papers about a variety of investment topic, ranging from a discussion of the merits of active vs. passive management, asset allocation, and behavioral finance, all the way to accounting issues that investors should be aware of.

The Investment Process According to Peter Brimm The investment process is a complicated one; every investor believes that they have the “special secret” or gift that enables them to continuously create abnormal returns for their investors. Most of the time this is not true. However, some investment managers have been extremely successful. Peter Brimm is one such investor. His personal approach is very research focused. He prefers to invest for longer time horizons and to only have about 13 stocks in his portfolio at once.

This limits diversification, which could lead to excessive volatility and risk;

therefore it is extremely important that the research that he does is through and valid.

Stock picking rests on distinguishing the undervalued “good deals” in the market from the overvalued securities. This can be challenging because when you come up with a valuation that is significantly different from the current market rate, you are making the assumption that thousands of investors, most with more experience and resources that you, are wrong and that you found something fundamental about the company that they missed. Therefore, the most important question to ask in your research is “why”.

It is impossible to do quality research on all (or even on a small fraction) of the stocks that are currently trading in the marketplace. This is why it is important to have a strategy to distinguish the undervalued securities from the overvalued ones. Quantitative screens on financial rations and price movements can be invaluable tools. Investors can narrow their search by looking at growth, value, momentum, and a number of other factors. It is easier for the analyst if the search criteria are very specific and narrow; however, it is more difficult to find investors for a hedge fund or investment firm with this strategy because there is more risk with a concentrated strategy. Another useful tool to narrow down potential stocks to do further research on is to look at the 13-F fillings to see what influential investors such as Warren Buffet are currently investing in. One must be careful because these fillings only contain the investors’ positions in the stocks and not any options or derivative instruments that they have on the stock. This could be misleading because it looks like the investor is betting on a stock price increase, while if they own a large position in puts, in reality they are actually betting on a stock price decline.

Once the analyst has narrowed down a list of stock, he or she must learn everything that they can about the industry.

This will give the analyst a frame of reference that will deepen the analyst’s understanding about the competitive position of the company that he is interested in. The analyst must have a clear understanding of the macro economic factors that affect the value chain in the industry. This entails knowing which part of the chain has the highest margins and profits as well as knowing hoe goods flow from the beginning of the process up until the finished product. In his presentation, Peter Brimm mentioned that he finds it helpful to draw a diagram of every player in the industry. Along with the quantitative analysis of margins, sale growth, and ROIC, and EBTDA, the analyst should conduct a Porters five forces analysis. Porter’s analysis is a framework for industry analysis and business strategy development. It is a way to establish whether the industry that the firm is in is an “attractive” one.

The next step of the stock-picking process is researching the company itself.

This means reading the 10Ks and 10Q filling going back at least a yea and a half. The analyst should pay special attention to the proxy or the DEF 14 filling because that outlines how top management gets paid because if they make money based on revenue growth, they will act differently than if they are paid based on increasing their margins. According to Peter Brimm, a sock picker should make an effort tog et his hands on and read every single piece of information that was published about the company in the last three years. This included transcripts from earnings calls, earnings releases, news articles, and press releases because this enable you to get a feel for how effective management is and how they react in certain situations.





In order to beat the market, a stock picker has to find a mispricing. This means that he finds something that analysts with bigger resources missed. This is why the company research part of the stock picking equation is so important. It is what gives the investor a competitive advantage.

According to Peter brim, in order to value a company accurately a investor has to project the full financial statement of the company for the nest 2-3 years by building a discounted cash flow model. It is not wise to project more than 3 years because these models inherently have a lot of assumptions. Cash flows that are further in the future are much more uncertain because a lot can happen both in the company and the economy during that time. There should be a reason behind every assumption that is used in the discounted cash flow valuation because small changes in something such as a growth rate can have a significant impact on the price of the security.

At this point in the research process the analyst or investor SHOULD have a very long list of questions about the company that cannot be answered by reading earnings call transcripts or SEC fillings. As Peter Brimm said, if the stock picker has not complied a long list of questions, he is not doing his job. To get answers, to these questions, an analyst should turn to sell side analysts who follow that specific firm.

Peter Brimm shared that the best way to approach this is to rank the analysts that follow the stock from best to worst and contact the least informed ones first. This way, you can get the “easier” questions out of the way and so that you are more and more informed as you move up the list. One question that should be asked of all of the analysts if, “ What are other people calling you to ask about this particular stock.” Although these conversations with sell side analysts often do not lead to a lot of new information if you have done your research correctly and thoroughly, they are important in the sense that they provide the analyst with a “feel” for how the market for the stock behaves. In addition this analysis will provide a tightened up financial valuation of the company as well as a list of potential catalysts that might move market sentiment on the stock.

Major suppliers and customers can also be a resource. Again, this will most likely not provide any new information because there are laws such as Regulation FD that address the selective disclosure of market information to people that can potentially trade on that information. When an issuer discloses such information, even accidentally, they must make sure to issue a press release as soon as possible so that the same information is available to all market participants. However, these conversations are a way to fact-check the information that the company claims on its 10K fillings and during its conference calls. In addition, you can get more information about the industry as a whole and how the company and its competitors are perceived in the marketplace.

Finally, an analyst should talk to the management of the firm. It is difficult to gain access to top-level management unless you are an investor with a significant amount of money to invest. Therefore, former management might be the best resource because they have more freedom to be forthright. This is the last step of the research process.

Stock picking can be a complicated procedure. You have to do enough research so that you can confidently claim that you know something about the company that the market has missed. This takes either a huge ego or diligent research. It is so important to read everything that you can about the company going back at least a few years. Many people view this process as extremely time consuming. And it is. This is why every investor has a different stock picking process; if you have a very diversified portfolio, doing such in depth research might not be the best way to approach stock picking. Peter Brimms method works best when you have a smaller portfolio and a longer-term time horizon. Of course, that means that you are making a bet that you know the companies well enough and they are undervalued enough that you will not be hurt by your lack of diversification.

This method has more risk; however the potential payoff is also significant.

The Active v. Passive Management Debate The desire to beat and to outperform the markets stems from peoples’ innate desire to win. We admire people who exhibit superior or special skills; we revere pro athletes and respect financial managers such as Warren Buffet who have become legends because of their market timing skill. But there cannot be winners without there being just as many, if not more, losers. So the question remains: which investment strategy is the best: passive or active? The Genspring speakers, Will Froelich, Evan Judge & Damon Miller, come down clearly on the passive side of the debate, while our class leans toward the active side. I believe that there are both pros and cons to both investment styles; the debate essentially boils down to an investors’ belief about market conditions and overall market efficiency.

Active management can be defined as an attempt to find “good deals” and mispricing in financial markets. They try to pick undervalued stocks, bonds, and mutual funds by analyzing both individual companies and markets as a whole. In essence active managers are seeking to maximize the value of alpha in the capital asset pricing model equation.

An important argument that people have against active management is that the transaction fees are much higher than with passive management, which makes it harder to achieve the returns that clients expect. Passive management is an opposing financial strategy where the manager invests in a portfolio with previously determine asset weights. A main reason for this is to avoid the investment fees that active managers must deal with. Active managers tend to incur more expenses (high-priced analysts, trading costs, marketing budgets, etc.) than their passive counterparts, which means that the post-expense return on a actively managed dollar is often lower than the return on a passively managed dollar. Of course, there are managers who regularly outperform the market, but it is unlikely that they will consistently do so for an extended period of time.

Research has shown that the highest performing mutual fund often have returns in the lowest third the following year. According to our speakers, investors get attracted to the next “hot” investment, which drives up demand and in turn prices, which eventually makes the stock overvalued. Proponents of passive financial management theories often point to the fact that researchers have not been able to show a clear link between past and future performance as a clear sign that active investing is not worth it. On the other hand, I read an article that argued that there are mangers who do regularly outperform in subsets of their portfolio. The problem is that oftentimes, the firm has restrictions on portfolio weights that prevent the portfolio from being concentrated in these “best ideas”, so the performance of the portfolio overall does not reflect the performance of these subsets. Also, it is easy to say that you outperform if you look at only specific stocks/parts of the portfolio, because then it could give you more leeway to look only at positive returns which would distort the real performance of the investment.

Passive managers have no opinion about the relative attractiveness of one specific security within an asset class as compared to another. Always being fully invested, they just make choices about asset allocation weights. They invest in broad asset classes. One poplar way to achieve this is to mirror the performance of an stock index or fund. Therefore, their returns are driven primarily by the market.

There are a few obvious advantages to this approach. First, it is cheaper than active investing because there are fewer transaction costs. There is no risk of missallocation and it is also more tax efficient.

The negatives to passive investing, as mentioned by Will Froelich, Evan Judge & Damon Miller, is that you’re returns are destined to be average. By giving up the benefit of over-performing, the financial manager also gives up the risk of underperforming. One of the things that draw people to investing is that by taking large risks, they have the potential to receive large rewards. But passive investors try to avoid this type of mindset because they believe that being invested in the market as a whole will bring about the most profitable returns.



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