As an investment manager, you frequently make decisions about investing in stock
ID: 2781915 • Letter: A
Question
As an investment manager, you frequently make decisions about investing in stocks versus other types of investments, and about types of stocks to purchase.
a. You have noticed that investors tend to invest more heavily in stocks after interest rates have declined. You are considering this strategy as well. Is it rational to invest more heavily in stocks once interest rates have declined?
b. Assume that you are about to select a specific stock that will perform well in response to an expected run-up in the stock market. You are very confident that the stock market will perform well in the near future. Recently, a friend recommended that you consider purchasing stock of a specific firm because it had decent earnings over the last few years, it has a low beta (reflecting a low degree of systematic risk), and its beta is expected to remain low. You normally rely on beta as a measurement of a firm’s systematic risk. Should you seriously consider buying that stock? Explain.
c. You are considering an investment in an initial public offering by Marx Co., which has performed very well recently, according to its financial statements. The firm will use some of the proceeds from selling stock to pay off some of its bank loans. How can you apply stock valuation models to estimate this firm’s value, when its stock is not yet publicly traded? Once you estimate the value of the firm, how can you use this information to determine whether to invest in it? What are some limitations involved in estimating the value of this firm?
d. Assume that you were also asked to manage a portfolio of European stocks. How would your method for measuring your performance in managing this portfolio differ from the U.S. stock portfolio in the previous question?
Explanation / Answer
You have noticed that investors tend to invest more heavily in stocks after interest rates have declined. You are considering this strategy as well. Is it rational to invest more heavily in stocks once interest rates have declined?
When the interest rates decline, then people do not want to invest their money in banks as they will earn less return. However, due to fall in interest rates, people have more money in hand. The money is then invested in stocks. It is generally observed that there is an inverse relationship between the interest rates and bond prices. As the interest rates fall, the bond prices will rise. Since the bond prices are high, the investors will not find it as an attractive investment opportunity. Hence, the investment is done in stock market. It is a rational decision to invest in stock markets, as the interest rates fall.
Assume that you are about to select a specific stock that will perform well in response to an expected run-up in the stock market. You are very confident that the stock market will perform well in the near future. Recently, a friend recommended that you consider purchasing stock of a specific firm because it had decent earnings over the last few years, it has a low beta (reflecting a low degree of systematic risk), and its beta is expected to remain low. You normally rely on beta as a measurement of a firm’s systematic risk. Should you seriously consider buying that stock? Explain.
The stock that the friend recommends has decent earnings and low beta. There is no specific detail about the stock that was selected earlier. It is only expected that the stock will perform well. However, the basis for such expectation is not clear. On the other hand, the stock suggested by the friend has low beta as well as good earnings. Both the characteristics are good indicators for investment. Thus, the proposal to buy the stock should be considered.
You are considering an investment in an initial public offering by Marx Co., which has performed very well recently, according to its financial statements. The firm will use some of the proceeds from selling stock to pay off some of its bank loans. How can you apply stock valuation models to estimate this firm’s value, when its stock is not yet publicly traded? Once you estimate the value of the firm, how can you use this information to determine whether to invest in it? What are some limitations involved in estimating the value of this firm?
In the given situation, the company Marx Co. is going for an IPO. The stock valuation model that can be used is technical analysis. This includes analyzing the number of shares being traded, the advance or decline ratio etc. The limitation here is that too many ratios are calculated that may give contradictory results. So deciding about investing in a stock may become difficult. There might not be complete accuracy in the result given by technical analysis.
Another aspect to be considered here is that the firm will be paying off some of its bank loans through selling stock. A proper understanding of the capital structure of the firm will also be useful. According to Modigliani & Miller approach, the value of the firm depends on the operating profits of the firm. The capital structure of the firm includes the way a company finances its activities. This will be done by maintaining a balance of debt and equity.
Assume that you were also asked to manage a portfolio of European stocks. How would your method for measuring your performance in managing this portfolio differ from the U.S. stock portfolio in the previous question?
European stocks do not generally perform as good as U.S. stocks. So, in case of managing a portfolio of European stocks, one has to be more careful in selecting the stocks. Only such stocks that have good performance records in the past should be invested in. The capital structure of these European stocks should be studied properly before putting in money.
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