Building a balanced securities portfolio is a difficult task taking into account tendencies of contemporary stock exchange. This paper is devoted to this issue and represents two strategies of building stocks and bonds portfolios implementing fundamental and technical analyses. Also, main concepts of allocation of securities were described and analysis of created portfolios with the help of appropriate benchmarks was represented.
Investment Analysis and Strategy
Part 1. Fundamental and Technical Analyses of Securities
A) Fundamental Analysis of Stocks
Fundamental analysis aimed at buying stocks which prices are below the potential value. There are several methods used by analysts that help determine the right stocks to buy or sell. Among the most popular methods of fundamental analysis are: analysis of balance sheet, analysis of future earning, company news, analysis of financial ratios, analysis of macro- and microeconomic factors. For the purposes of this paper the following ratios were chosen for fundamental analysis: EPS (current and estimated), PEG (current and estimated), P/E ratio (current and estimated), P/B ratio, dividend yield, price to sales ratio, ROE.
With regard to fundamental analysis implemented the following securities were chosen for making stocks portfolio:
1. Da Vita Inc. (DVA, US, healthcare)
2. XOMA (XOMA, US, healthcare)
3. Airgas Inc. (ARG, US, chemicals)
4. Wells Fargo & Co (WFC, US, financial consultancy)
5. Liberty Media Corp (LMCA, US, communication)
6. On Track Innovations (OTIV, US, software)
7. Dangdang (DANG, China, Internet (E-Commerce))
8. Wal Mart (WMT, US, retail)
9. Brazil Foods (BRFS3, Brazil, food)
Stock portfolio was formed taking into account current market tendencies, financial and economic analysis of the companies. It was important to reveal growth tendencies since the period of trading was short. For the analysis data presented by Bloomberg.com (2012) was used.
In accordance with Bloomberg.com (2012) the following industries are currently the fastest growing industries in the world: healthcare, e-commerce, software, insurance, human resources, communication and consultancy. As US economy is frequently recovering from the crisis, a significant growth is promised. Thus, the majority of companies chosen located in the US. In addition, there are two companies chosen which operate in emerging markets which have strong tendency to grow next month (China, Brazil) (Weiss, 2008). A portfolio is supposed to be balanced with accepted risk level. There were eight equity sectors chosen, namely: healthcare, chemicals, financial consultancy, communication, software, e-commerce, retail, and food. To achieve necessary balance the stock portfolio emphasize on growing stocks (DVA, XOMA, DANG, OTIV, LMCA) having certain amount of stocks with low beta and high dividend yield (ARG, WFC, WMT, BFRS3) as well. The results of fundamental analysis are shown in the Appendix 1.
Technical Analysis of Stocks
On the contrary to fundamental analysis, technical analysis aimed at evaluation of quantity of the stocks in the market while fundamental analysis aimed at evaluation of its price. Technical analysis is based on historical data of market and individual stocks. There are several methods used for conducting this kind of analysis, namely: trend indicators, indicators based on volumes and oscillations, Japanese candlestick.
For the purposes of this paper trend analysis was chosen. Trend analysis represented in this paper includes analysis of the following measures: 20-days and 50-days moving average, weighted moving average, and 10-days momentum. The results of technical analysis of stocks are shown in the Appendix 2.
Moving average gives a signal to buy when it is from bottom and to sell when it is from the top. Also, it is important to analyze moving average trend. For this portfolio short moving average is significant because the funds will placed for four weeks. However, short-term signal given by moving average can be irrelevant. This is the reason why learning moving average trends is important. As it is considered to static, weighted moving average was developed. Moving average is calculated using the following formula:
MAtn = ∑ Pt – I / n
where MAtn - the n days moving average at the date t, Pt - the closing price at the date t, Pt-1 - the closing price at the date t-1.
Weighted moving average interpretation is the same as for simple moving average. The trend is also important when studying weighted average moving. The advantage of the weighted average moving over simple average moving is that it is supposed to give more dynamic signals. The formula for computing weighted moving average:
where WMAtn - the n days weighted moving average at the date t, Pt - the closing price at the date t, Pt-1 - the closing price at the date t-1.
10-days momentum was used to reveal the tendency in price changing. Momentum is often analyzed together with moving average. Momentum moving from negative to positive value gives a signal to purchase the stock while sale signal is given when momentum shows movement from positive to negative value. This indicator is computed with the help of the following formula:
MOt = Pt - Pt-n,
where Pt - today's price, Pt-n - the price at the date t-n.
Expected return on stock portfolio is needed to form an appropriate stock allocation in the portfolio.
Return of each stock was computed with the help of the following formula:
ROE = Net income/Shareholder’s Equity
Data was derived from companies’ balance sheets and income statements.
Expected return on stock portfolio is computed using the following formula:
where Pi – return on each stock, Ri – assets allocation percentage.
Expected return on stock portfolio is described in Excel spreadsheet. Proposed stock allocation is shown in the Appendix 3.
On the assumption of such allocation of stocks in the portfolio the return will make 20%.
B) Fundamental Analysis of Bonds
Bonds make a low-risk portion of the investment portfolio being a good foundation for it. To build a balanced bond portfolio one should take into account diversification of credit risks and maturities.
Bond portfolio consists from the following government and corporate bonds:
1. UK government;
2. Australia government;
3. China Government;
4. Hong Kong government;
5. FIMMDA India Corporate bond.
6. World Bank Treasury;
7. First Data Corporation;
8. Principal Financial GP;
9. Intelsat Luxembourg SA.
This portfolio was built up in accordance with balanced approach: it includes high yield corporate bonds (First Data Corp., Intelsat Luxembourg, Principal Financial), supranational agency bonds (World Bank), and government bonds of the governments having best credit rating, such as UK, Australia, China, Hong Kong, and India, in accordance with Valeri (2012). Primary data for bonds portfolio is shown in the Appendix 4.
Technical Analysis of Bonds
Since the period of investment is short, a mixed strategy was implemented to maximize the yield from the bonds portfolio. The main strategy is active bond strategy because the goal of this portfolio was to maximize return in a short period.
Technical analysis of bonds includes analysis of yields and yield curves. The most popular yields are as follows: current yield, yield to maturity, yield to call/put, yield to average life.
Current yield on bonds is the simplest measure of bond yield. As the term of observation is short, an application of current yield of bonds is appropriate.
Current yield on bonds is computed using the following formula:
CY = (Coupon rate/Price of bond)*100
The allocation of bonds shown in the Appendix 5 will bring required 12% of return on bonds portfolio.
Yield to maturity is the most common method of bond valuation. This yield reflects compounding interest on the condition that the bond will be held until it mature. The formula of yield to maturity is as follows:
Y - yield to maturity (%), R- coupon rate, P - price of the bond, M - the number of years to maturity. Computation of yield to maturity make sense when an investor implements passive strategy (Standfield, 2005).
Expected yield on bond portfolio is described in Excel spreadsheet. Proposed bond allocation is shown in the Appendix 3.
C) Concepts for Determining the Best Allocation of Securities
Among the most important investment concepts are market timing, security selection, and asset allocation. Market timing is utilized when an investment decision is made on the basement of market forecast, class of assets and fluctuation of securities prices. In this case market timing is four weeks and there was a need to develop a short-term strategy to make appropriate stocks and bonds portfolios and maximize returns.
Security selection plays an important role for a certain investment strategy. Stock portfolio was built up taking into account tendencies of the market and potential returns. There were several types of stocks selected to make necessary balance between growing stocks having current negative returns but simultaneously having the tendency to grow and high yield stocks which ensure stable return. The same concept was implemented to the bond portfolio with regard to credit rating and coupon rates (Standfield, 2005).
The last but not the least is asset allocation which is an art and science at the same time. Asset allocation aimed at portfolio optimization, increasing returns and lowering risk.
Benchmarks to Stock and Bond Portfolios
As stock portfolio that was built up contains many US companies stock, Total Stock Market Index is a good benchmark to check this portfolio performance. Thus, the stock portfolio is to be compared to Vanguard Total Stock Market ETF (VTSM ETF). VTSM ETF reflects the minimum level of return in this stock segment. Thus, VTSM ETF as of 27 March 2012 reported return of 9.5% which is significantly lower that that of the created portfolio. Besides, the goal of creating this stock portfolio was to achieve 20% of annualized return. hence, the established goal was achieved (Stanfeild, 2005).
Bond portfolio performance can be evaluated with the help of standard securities. Traditionally, 10-years US treasury bonds are used as benchmark for evaluating quality of investment portfolios. In accordance with Bloomberg.com (2012) yield of this benchmark bond was 2.18% as of 27 March 2012. This security measures the minimum yield of bonds to stay profitable. In the bond portfolio that was created annualized return made 12% which is much higher than this benchmark. It is a high yield for short-term bonds. The goal of 12% of return was achieved and maturity was diversified. Credit risk was diversified as well: high returns from risky bonds were balanced with moderate yields of high credit rating companies.
Part 2. Monitoring of Stocks and Bonds Portfolios on Weekly Basis
Monitoring of stocks and bonds prices, yield and beta fluctuations offers excessive information for analysis. Stocks were selected with regard to the market growth tendencies and historical moves. Fundamental analysis of stocks revealed potential for the growth of certain industries, such as healthcare, communication, e-commerce that were likely to outperform the market in April, 2012. Companies’ and government news is an important part of fundamental analysis. For example, such events as tax changes, participation in social initiatives or implementing new technology makes positive impact on the company performance. On the contrary, such news as lawsuits, financial fraud committed by the top management related certain company may cause harm to the image and, as a result, make a negative impact on the stock price (Bloomberg, 2012).
Other stocks in the portfolio were selected with regard to its stability (ARG, WFC, WMT). The majority of stocks are the stocks of US companies reflecting the tendency of US economy to quick recovering from the world crisis. Also, many investors pay attention to the growing share of emerging markets stocks, such as, Asian and Pacific region countries as well as Latin America and South America markets. The economies of these countries are developing intensively offering many investment opportunities.
Bonds returns deviations are quite insignificant. This is the reason why bonds are considered more stable investments than stocks. Government bonds are dependent on the overall economic situation in the country, GDP and external indebtedness. Such events as wars and economic crisis negatively influence government rating thus making impact on the government bonds.
Choosing municipal bonds could be a good idea, but the end of March and the beginning of April are bad for municipal bonds since it is tax time, for example, in the USA. Therefore, municipal bonds do not represent good investment like stocks in September and October.
Part 3. Evaluation of Stocks and Bonds Portfolios Using Sharpe Ratio
Sharpe ratio measures an excessive return per unit of deviation in an investment asset. It is calculated in accordance with the following formula:
S = E[R-Rf]/σ,
where R – asset return, Rf – return of benchmark asset, σ – standard deviation.
Standard deviation of stock portfolio is 0.15 and standard deviation of bond portfolio is 0.11 (the number was calculated with the help of standard deviation calculator).
Sa = (0.2-0.095)/0.15 = 0.7.
Sb = (0.12 – 0.218)/0.11 = 0.89.
Thus, Sharpe ratio of stock portfolio is 0.7 and Sharpe ratio of bond portfolio is 0.89. The Sharpe ratio shows how well risk of the portfolio is managed. The higher this ratio, the better is portfolio performance.
Part 4. Analysis of Divergences between Portfolios and Benchmarks
Divergences between built portfolios of stocks and bonds and benchmark indices can be explained by the attempt to generate high return portfolios and short investment period. Benchmarks reflect acceptable level of risk and returns unlikely to portfolios which are supposed to generate high returns. In order to generate higher returns an investor runs additional risk. Short investment period forces an investor to implement active strategy towards acquiring certain securities. In this case portfolios contain high yield but high risk securities to cover negative returns from stocks and bonds that supposed to outperform the market accordingly to forecast for the next month. The portfolios were balanced at the expense of stocks of stable well-known US companies and government bonds.
Bloomberg, 2012. Business and Financial News. [online] Availavle at: <http://www.bloomberg.com/> [Accessed 24 March 2012].
Standfield, K. ed. (2005). Intangible Finance Standards: Advances in Fundamental Analysis and Technical Analysis. London: Academic Press.
Valeri, A., 2012. Bond Market Perspectives. LPL Financial Research. [pdf] Available at: <http://www.franklin-wealth.com/new/franklin-wealth//munibreather2.28.12.pdf> [Accessed 24 March 2012].
Weiss, T., 2008. Fastest-Growing Industries. [online] Forbes. Available at: <http://www.forbes.com/2008/09/26/fastest-growing-industries-lead-careers-cx_tw_0926jobgrowth.html> [Accessed 24 March 2012].