Question:

• This individual assignment involves an analysis of general economic conditions or systematic risk, i.e., the risk that affects all industries and companies, in the U.S. macro economy. You will be asked to determine in percentage terms an optimal allocation of $1,000,000 among the following three asset classes: U.S. equities, U.S. Treasury bonds, and cash. The goal is to maximize your expected return over the next 12 months. You will be asked to write a 1- to 2-page business brief providing your analysis of the asset classes’ prospects and your justification of your allocation among them. Action Items Read the Equity Analyst Project document. Conduct any necessary research so that you can make a proper analysis. Review Business Brief Guidelines and Critical Thinking Process. Write a 1- to 2-page business brief that includes the following sections. Opening: Discussion of the general economic conditions in the U.S. macro economy. Analysis: Discussion on analysis of the economic conditions and risk. Recommendation: What is your recommendation and justification for, in percentage terms, of an optimal allocation of $1,000,000 among the three asset classes.

 

 

Equity Analyst Project                                                             (Version 5.2)

The Equity Analyst Project involves a total of three assignments:

1.      Individual Asset Allocation Exercise

2.      Team Analysis of Select Industry Groups

 

1. Team Analysis of Companies within an Industry Group

The intent of the project is to simulate a top-down, three-stage approach to security analysis that proceeds with, first, an analysis of general economic factors, then industry comparisons, and finally the analysis of individual companies within a particular industry.  Here is justification for this approach:

The results of several academic studies have supported this technique. First, studies indicated that most changes in an individual firm’s earnings could be attributed to changes in aggregate corporate earnings and changes in the firm’s industry, with the aggregate earnings changes being more important…

Second, studies…[have] found a relationship between aggregate stock prices and various economic series, such as employment, income, or production…

Third, an analysis of the relationship between rates of return for the aggregate stock market, alternative industries, and individual stocks showed that most of the changes in rates of return for individual stocks could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry.[1]

The following is provided as a guide to your analysis in these three assignments:

Individual Asset Allocation Exercise

This exercise involves an analysis of general economic conditions or systematic risk, i.e., the risk that affects all industries and companies, in the U.S. economy. You are asked to determine in percentage terms an optimal allocation of $1,000,000 among the following three asset classes: U.S. equities, U.S. Treasury bonds, and cash. The goal is to maximize your expected return over the next 12 months. You are asked to write a 1-2 page paper providing your analysis of the asset classes’ return prospects and your justification of your allocation of monies among them.

First, consider historical returns on various asset classes in the U.S. Look at Figure 10.4 on p. 292 of your textbook. Also, in Table 10.2 on p. 299 you can see that historically equities outperform bonds in terms of average return but they also carry more risk as defined by their standard deviations. These historical results show that on average the return on equities is highest but in some specific years this may not be true. For example, look at Table 10.1 on pp. 296-297 and you can see that in three out of the five years from 2000 to 2004 the annual return on large-company stocks (defined in the text as the S&P 500)[2] was negative.

In this exercise your investment horizon is one year. In considering your allocation among U.S. equities, long-term Treasury bonds, and cash to maximize your prospective return over the next twelve months, we might next more precisely define these asset classes. We can define U.S. equities as the Standard and Poor’s (S&P) composite index [“At present…includes 500 of the largest (in terms of market value) stocks in the United States.” (p. 291]. More detailed information is available directly from Standard & Poor’s:

http://us.spindices.com/indices/equity/sp-500

Excel spreadsheets of Index returns dating from 2009 back to the late 1980’s are available to download at

http://research.stlouisfed.org/fred2/series/SP500/downloaddata

 

 

Web-based finance sites also customarily carry data on the S&P 500. For example,

–at CNNMoney.com: http://money.cnn.com/data/markets/sandp/?

–at Bloomberg: http://topics.bloomberg.com/s%26p-500/

–at Yahoo! Finance: http://finance.yahoo.com/echarts?s=%5Egspc+interactive

We can define long-term Treasury bonds as 30-year U.S. government bonds. Historical data on yields on debt claims are available from the Federal Reserve at http://www.federalreserve.gov/releases/h15/data.htm. For historical daily rates on the 30-year T-bond, defined as “Market yield on U.S. Treasury securities at 30-year constant maturity, quoted on investment basis” go to

http://www.federalreserve.gov/datadownload/Build.aspx?rel=H15.

Long-bond Treasury rates are also available from the following sites:

— http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

— http://www.bloomberg.com/markets/rates/index.html

The third alternative is cash. Assume no return on that share of your monies held in cash.

This analysis necessarily involves your assessment of systematic risk, i.e., the risk that affects all industries and companies, in the U.S. economy over the next twelve months. Let’s more fully define systematic risk. According to the textbook, systematic risk “…influences a large number of assets, each to a greater or lesser extent…[and is] sometimes called market risks (or correlated risk)…[U]ncertainties about general economic conditions, such as GDP, interest rates, or inflation, are examples of systematic risks. These conditions affect nearly all companies to some degree” (p. 335). Your task is to consider your investment alternatives in light of systematic risk expected over the coming year.

Your considerations about investing in U.S. equities will thus involve your determination of the near-term prospects for the U.S. economy and the implications of these prospects for U.S. equities.

A useful site for recent and upcoming U.S. macroeconomic data releases is http://www.bloomberg.com/markets/economic-calendar/. Click on the highlighted report or “Consensus” next to any particular report to get data (either recently reported or the near-term consensus, respectively), the schedule of future data releases, and a definition. More generally, many other sites provide information on macroeconomic data, such as:

— http://info.wsj.com/classroom/Indicators/guide.html

— http://www.bea.gov/

— http://www.gpoaccess.gov/indicators/index.html

— http://research.stlouisfed.org/fred2/

Finally, the decision to invest in 30-year U.S. T-bonds importantly involves expectations about future inflation and the term structure of interest rates,  i.e., “the relationship between short- and long-term interest rates” (p. 153). On p. 151 of the textbook the distinction is made between “real” interest rates and “nominal” interest rates.  “Nominal” interest rates are the rates that are quoted in the financial press; they are the rates at which we borrow and lend. Per the approximated Fisher equation (Eq. 5.4 on p. 152), the nominal rate includes the so-called inflation premium, h, so that the higher the expected inflation, h, the higher the nominal rate, all else equal. In considering longer-term T-bonds one must also be aware that, in addition to expected long-term inflation, there is greater interest rate risk: “…longer term bonds have much greater risk of loss resulting from changes in interest rates than do shorter-term bonds” (p. 154). Specifically, should interest rates increase, the market value of 30-year bonds will fall and the fall will be more dramatic for a 30-year T-bond than for a 10-year Treasury note. Conversely, price gains from any drop in rates will be more dramatic the longer the term to maturity on a bond. One should also keep in mind that while in general longer-term rates are typically higher than short-term rates for the same level of overall risk, there have been occasions when the reverse is true, and the term structure of interest rates is inverted. (Please see Figure 5.5 on p. 153 on the historical relationship between long-term and short-term U.S. interest rates.) Finally, in finance we assume that there is no credit or default risk on Treasury securities. It is assumed that there is no risk that the U.S. government will fail to meet its outstanding debt obligations. This is, of course, not the case for corporate issuers.

Finally, what are the implications of interest rate changes for the equity market? Here is one response to this question: http://www.investopedia.com/articles/06/interestaffectsmarket.asp

Questions for Individual Asset Allocation Exercise:

1.      Allocate your fictional $1,000,000 among the following three asset categories:

Asset	U.S. Equities	U.S. 30-Year Treasury Bonds	Cash
Allocation				100%

2.      Justify your allocation based on your outlook for systematic risk in the U.S. economy over the next year.

Team Analysis of Select Industry Groups

This analysis is a team assignment that requires your team to analyze a select group of alternative industries to determine which is most likely to perform best in terms of growth and earnings over the next 12 months. Your instructor will create your teams, ideally based on similar views about the near-term prospects for the U.S. economy expressed in the Individual Asset Allocation Exercise.

To guide this second stage analysis, you are asked to rely on the North American Industry Groups database available at Yahoo! Finance at Yahoo! Finance. The system is comprised of 9 business sectors:

• Basic Materials:
• Conglomerates
• Consumer Goods:
• Financial
• Healthcare
• Industrial Goods
• Services
• Technology
• Utilities

To simplify the exercise, the 215 industry groups within these 9 sectors have been reduced to a more analytically manageable list that includes only those industries at Yahoo! Finance with public firms totaling no less than 5 and no more than 15 companies. This list is attached as an appendix to this document.

 

To access more details on these groups go to  http://biz.yahoo.com/ic/ind_index.html and click on any of the industries to go to each industry’s “Industry Center” page. Additional useful information is available via the link to “Industry Browser” on the left. Also, on each industry’s summary page click on “Company Index” and then on “Public” on the subsequent page next to “View:” to get the list of public companies in this industry. Our focus is on publicly listed companies in which we might ultimately invest. The list of public companies is provided alphabetically. Following each name is the company’s ticker symbol in brackets.  See http://www.investopedia.com/terms/s/stocksymbol.asp or http://www.investorwords.com/4968/ticker_symbol.html  for brief definitions of stock/ticker symbols.

 

Please note that on occasion the ticker symbol may also be followed by other letters, such as PK or OB (see http://www.investopedia.com/ask/answers/04/022004.asp

or http://www.investopedia.com/ask/answers/120.asp for explanations). It is recommended that we ignore stocks so designated in these exercises.

 

The goal of this second stage in our equity analyst project is to select one industry out of this list of 24 whose performance prospects you determine are best over the next year. Here are some factors to consider when comparing industry groups:[3]

• Degree of Competition in the Industry
• Supply/Demand Dynamics for the Industry’s Products
• Industry Cost Structure
• Degree of Government Regulation-Favorable or Not
• Exposure to the Business Cycle
• Relative Financial Norms and Standards

 

Your team is asked to write a 5-10 page paper providing your analysis of the issues involved in your selection of the industry group that you conclude is most likely to prosper in the coming months and your justification of your choice of that industry.

 

Team Analysis of Companies within an Industry Group

 

The Equity Analyst Project concludes with a final team assignment. The company analysis is based on your team’s industry selection in the Team Analysis of Select Industry Groups assignment. Your team is next asked to determine which public firm classified within the industry you have selected as the most promising is itself the most promising investment within that industry.

 

Again, to access more details on any industry group’s public companies go to  http://biz.yahoo.com/ic/ind_index.html and click on the name of your group to go to its “Industry Center” page. On each industry’s summary page click on “Company Index” and then on “Public” on the subsequent page next to “View:” to identify the public companies in your industry. You are asked to choose one of these companies in which to invest.

 

At the list of public companies you can access each company’s “Industry Center…Company Profile” by clicking on its name. More useful is the company’s stock summary page accessible by clicking on its ticker symbol. Additional comparable financial information is available via the link to “Industry Browser” on the left of the “Industry Center” page for the industry.

 

Beyond the information available at Yahoo! Finance more detailed information on any public company is available in the company’s annual (10-K) and quarterly (10-Q) SEC filings. The SEC’s database of reports is accessible at http://www.sec.gov/edgar/searchedgar/companysearch.html. Please note that searches of the SEC database can be conducted using the company’s stock ticker symbol or its CIK (Central Index Key) number, which is used by the SEC’s systems to identify filers. Mergent Online, available via the University’s online library, provides a company’s CIK.  Alternatively, information is available in the company’s annual report (often available on the company’s homepage or via http://www.annualreports.com/).

 

Your team is asked to write a 5-10 page paper providing your analysis of the companies in the selected industry group and your justification of your choice of the best company to invest in within that group.

In conducting your analysis you are strongly encouraged to draw on the material in the textbook’s Chapter 3, specifically 3.1 Financial Statement Analysis, as well as Chapter 6, Stock Valuation. There is also ample support online. Here are a few possibilities:

 

— http://www.investopedia.com/university/stockpicking/

— http://www.fool.com/school/basics/basics06.htm

— http://www.fool.com/School/HowtoValueStocks.htm

— http://www.moneychimp.com/articles/valuation/stockvalue.htm

 

 

 

 

 

 

Please remember that you are seeking to choose the stock of the company that represents the best investment, which may likely not be the best company in terms of revenue and earnings. The best company’s stock may already be so highly valued that it provides limited upside as an investment.  A poorer performing company, in contrast, may have a stock price that trades below its intrinsic value and provides better prospects of appreciation.

 

To assist in your deliberations and best ensure the common use of terminology,  here are some                terms and definitions that capture concepts in stock selection from the CFA Institute Level 1 2007 curriculum:[4]

 

• Growth company: “… a firm with the management ability and the opportunities to make

investments that yield rates of return greater than the firm’s required rate of return”

(p. 262).

• Growth stock: “…a stock with a higher rate of return than other stocks in the market with similar risk characteristics…because at some point in time the market undervalued it…”

(pp. 262-263).

• Defensive company: a company “…whose future earnings are likely to withstand an economic downturn” (p. 263).
• Cyclical company: a company whose “…sales and earnings will be heavily influenced by aggregate business activity” (p. 263).
• Cyclical stock: a stock that “…will experience changes in its rates of return greater than changes in overall market rates of return” (p. 264).
• Speculative company: “…one whose assets involve great risk but that also has a possibility of great gain” (p. 264).
• Speculative stock: a stock that “…possesses a high probability of low or negative rates of return and a low probability of normal or high rates of return. Specifically…one that is overpriced, leading to a high probability that…it will experience either low or                negative rates of return (p. 264).

 

• Value stock: a stock “…that appears[s] to be undervalued for reasons other than earnings growth potential… usually identified by analysts as having low price-earning or price-book value ratios” (p. 264). Please note that often a “growth stock” is defined not as we did above but in contrast to a “value stock” so that a “growth stock” sometimes is defined  “…as a stock of a company that is experiencing rapid growth of sales and earnings…As a result of this company performance, the stock typically has a high P/E and price-book value ratio” (p. 264).

 

The authors conclude their discussion of definitions with the following useful advice for this exercise:

The major point…is that you must initially examine a company to determine its characteristics and use this information to derive an estimate of the intrinsic value of its stock. When you compare this intrinsic value of the stock to its current market price you decide whether you should acquire it—that is, will it be a growth stock that provides a rate of return equal to or greater than what is consistent with its risk? (p. 264).

 

[1] Reilly, Frank K., and Keith C. Brown. (2007). An Introduction to Security Valuation. Equity and Fixed Income CFA® Program Curriculum·•Volume 5 (pp. 115-153).  (p. 264). Boston: CFA Institute.

[2] For a brief history of the S&P 500 see http://www.cftech.com/BrainBank/FINANCE/SandP500Hist.html.

[3] Source: http://www.markrosa.com/UNO%20Finance%202302/economic_analysis.htm. Please note that this site also contains helpful discussions about all three stages of the top-down approach to security valuation.

 

[4] All quotes that follow are from Reilly, Frank K., and Keith C. Brown. (2007). Company Analysis and Stock Valuation. Equity and Fixed Income CFA® Program Curriculum·•Volume 5 (pp. 261-323). Boston: CFA Institute.

 

Answer:

Optimal allocation of $1,000,000 in the three asset classes: equitiesTreasury bonds, and cash in U.S. macroeconomy

Diversification is considered to be a crucial aspect in decisions related to investment as it assists investors in reducing the risk of loss and enhance chances for maximisation of profits. For a safe or moderate investment, investors are required to keep their money in the stock market as well as in treasury bonds to balance risk and security aspects in investment options (Bloom, 2014). Further, cash in hand is kept to avail market opportunities to earn extraordinary profits.

For diversification, it is essential to allocate an optimum percentage to equities, Treasury bonds and cash in U.S. macro economy. This percentage is required to be determined on the basis of macroeconomic factors. In accordance with the study of Reilly & Keith (2007), in the U.S. economy return from equities outperforms treasury bonds in terms of return but a similar concept is applied to risk. However; in various situations, stock equities provide negative returns which make investment highly risky.

US economy is the world’s largest economy which provides stable economic market to invest. With the increasing inflation and GDP there is increase in interest rate which makes safe investment option more beneficial. Growth in economic data can be noticed through following table:

Figure 1: US economic data

(Source: U.S. Economic Outlook, 2017)

Data shows that higher proportion in equity will be beneficial as market is growing and valuable opportunities are available for investment.

Analysis of U.S. macro economy shows that average annual portfolio return is 7% by considering the trend of past years. Henceforth, target return of portfolio should be equivalent to 7% or higher than that (Handley & Limao, 2015). Further, annualised return of treasury bills is 1.02%.  These rate of return shows that higher proportion should be in equity option to get positive value. Although, to froze secure amount part of amount will be invested in treasury bills.

The aggregate portfolio of the investor will have a higher proportion of stock equity and treasuries. In stock equity, investment will be made by considering companies listed on stock exchange and five stock options will be considered on the basis of their performance. With this option, the systematic risk as well unsystematic risk will be managed. Equity will cover a maximum percentage of stock equity as it is highly profitable, but it will be risk-oriented.  60% of the investment will be allocated to this option (Bodie, 2013). Further, 30% of the amount will be invested in holdings of U.S. Treasury and related securities.  In this investment option, supreme usage of zero-coupon securities and discount treasuries will be made for the minimisation of the risk in order to assure the availability of invested amount. 10% of the amount will be kept as cash reserve as sudden ups and downs occur in the stock market. By considering this fact, this portion of the investment will be free to be utilised in quick decisions.

On the basis of the present study; allocation of the amount to be invested is as follows:

Investment options	Proportions
U.S. equities	60%
U.S. Treasury bonds	30%
Cash	10%

 

By this allocation, the investor will be able to maximise return with minimum risk. In addition to this, the investor will be in a position to avail market opportunities to earn extraordinary profits. This study concludes that each investment option has its own significance which is required to be considered by investor while making such decisions.

 

References

Bloom, N. (2014). Fluctuations in uncertainty. The Journal of Economic Perspectives, 28(2), 153-175.

Bodie, Z. (2013). Investments. McGraw-Hill.

Handley, K., & Limao, N. (2015). Trade and investment under policy uncertainty: theory and firm evidence. American Economic Journal: Economic Policy, 7(4), 189-222.

Reilly, F. K., & Keith C. B., (2007). Introduction to Security Valuation. Equity and Fixed Income CFA® Program Curriculum. 5 (p. 264). Boston: CFA Institute.

U.S. Economic Outlook, (2017). Available through < http://www.focus-economics.com/countries/united-states>. [Accessed on 10^th April 2017].