The Fundamentals of r3 Investment

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The Fundamentals of r Investment real time. real data. real world.

By F. Parsons, Ph.D., Founder & CEO of Telemet America, Inc. & J. Min, Ph.D., Associate Professor of Economics, Northern Virginia Community College © Copyright Telemet America, Inc. 2019 © Copyright Telemet America, Inc. 2011

Index Chapter 1: What is an Investment? Chapter 2: Organized Stock Markets and Competition Chapter 3: Sources of Investment Information Chapter 4: Concept of Return and Risk Chapter 5: Modern Portfolio Theory Chapter 6: What Makes Common Stocks Interesting? Chapter 7: Analyzing Common Stocks Chapter 8: Stock Valuation Chapter 9: Technical Analysis Chapter 10: Fixed Income Securities Chapter 11: Mutual Funds Chapter 12: Portfolio – Putting Ideas Learned to Work Chapter 13: Options Chapter 14: Futures and Commodities Appendix: Useful Resources To Navigate Telemet Finance Lab

The Fundamentals of r3 Investment By F. Parsons, MBA, Ph.D. & J. Min, Ph.D. 2

Using Telemet Orion and ‘The Fundamentals of r3 Investment’

Chapter 1: What is an Investment?

The definition of an investment is any vehicle into which funds may be placed with the expectation that they will generate income and/or preserve or increase in value. Investments might include:     

Common stocks Mutual funds Bank savings accounts Antique furniture or artworks Real-estate

Investments that represent debt or ownership or the right to acquire or sell an ownership interest are called securities. Stocks, bonds, mutual funds, options are securities. Property consists of investments in real property or tangible personal property. Real property is defined as land and buildings. Tangible personal property includes artworks, gold jewelry, antiques, and other collectibles. Direct investments are ones where the investor directly acquires a claim on the security or property. Indirect investments are ones where the investor purchases a claim on a group of securities or properties without a direct ownership in any one. Debts represent funds lent in exchange for interest income and promised repayment of the loan. Bonds are a type of debt instrument. Equity represents an ongoing ownership interest in a business or property. Title to a property or common stocks are equities. Derivative securities are neither debt or equity but instead derive value from an underlying security. An option to purchase a stock in the future is a derivative security. Mortgage backed securities (an ownership in a group of mortgages) are derivative securities. Risk is the measure of variability of an investment, or, in other works, the probability that the actual return received from the investment is not what was expected. Higher variability is higher risk. Short term investments refer to being one year or less, while long term investments refer to being more than one year. These terms come from Internal Revenue Service (IRS) rulings. Domestic or Foreign refer to whether the investment is with a U.S. based vehicle or not. Foreign vehicles come with other risk factors such as political risk and currency risk.

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The Investment Process Suppliers of funds and demanders that need funds must be put in communication with one another. Financial markets are forums where suppliers and demanders are put in touch with one another. Financial institutions act as intermediaries sometimes and stand between suppliers and demanders of funds. Banks, br7okerage firms, Savings and Loan organizations, insurance companies and others are Financial Institutions. Who are the suppliers and demanders of funds? Government, businesses, and individuals. Individual investors should be differentiated from institutional investors. Institutional investors are paid a fee to manage other people's money.

Common Types of Security Investments Common stock represents an ownership interest in a business. Returns come from dividends (periodic payments to shareholders out of company profits) and capital gains (the result of selling common stock at a higher price than purchased). Fixed income securities offer a fixed periodic payment and a promise to repay the investment. Bonds are fixed income securities. Convertible securities provide a periodic payment and a promise to allow the investor to convert the security to common stock. Preferred securities represent an ownership position in a business and periodic payments (dividends) are given priority to holders of these securities. Derivative securities value and characteristics depend on that of an underlying security. Mutual funds are derivative securities that represent ownership of a group of securities. Options are derivative securities that give an investor the right to buy or sell a security at a specified price over a given period of time. Futures are contracts that say that the seller of the contract will make delivery and the buyer of the contract will accept delivery of an asset at some specific date at a specific price.

Plans for Investments Before investing, the investor must be sure to have funds for life necessities (food, shelter, transportation, clothing). Once deciding to invest, the investor must decide on their investment goals. Goals may include: accumulate funds for retirement, enhance current income, save for a new asset (car, boat, house). Once the investment goals have been decided, the investor must adapt a plan and evaluate investments based upon those goals. The investor will then select the investments, purchase the investments, and continue the evaluation and review process for the investments.

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For Fun: Who invented common stocks? 'Decades of incessant warfare had left European governments scrambling for cash. High taxes meant there was little currency in circulation, and most gold and silver coins were so debased (''shaving'' coins, though a capital offense, was commonplace) that merchants constantly haggled over the real value of payments, constraining trade. As early as 1705, a pioneering 18th century Scottish banker and financier named John Law believed he had the answer. He argued in a pamphlet for the establishment of banks that would issue paper money backed by land or other collateral. He realized that money was ''a functional medium--with no intrinsic value but backed by something of stable value, the gambler's chips that can be cashed in at the end of the evening.'' This was not an entirely original idea--the Bank of England had been established and begun issuing banknotes in 1694, and in Amsterdam, similar banks had been operating for nearly a century before that--but Law had the ears of some of Europe's most powerful men, and he pushed the concept of paper money to new extremes. He found his most receptive audience in France. After the death of Louis XIV, Law managed to persuade the Regent, the Duc d'Orleans, to establish the Banque Generale to issue paper money backed by deposits and to install him as its head. Despite fierce opposition inside and outside of government, the bank was a success: The banknotes it issued soon commanded a premium. The economy revived, and Law's became the nation's premier bank. Law was not content. He wanted to be an empire builder and saw his chance in France's vast North American territories. In 1717, he founded the Mississippi Company. ''It was given the right to all trade between France and its Louisiana colony for 25 years, and to maintain its own army and navy, to mine and to farm,'' Gleeson writes. ''Law held sway, ruling half of America in all but name.'' To underwrite the venture, Law began issuing public shares at 500 livres apiece. ''Over the summer of 1719, France savored her first taste of a bull market. By the time the second installment was due on the new issue, the share price had doubled to 1,000 livres.'' What's more, Law had become in effect France's central banker, and his printers were working round the clock to print new paper currency with which speculators could buy shares. It was as if the Federal Reserve and Drexel Burnham Lambert Inc. had merged. The soaring share prices floated upon a flood of paper money. By the end of the year, the price of Mississippi shares touched 10,000 livres. Hundreds of thousands of foreigners crowded Paris to play the market. So many shareholders found themselves richer than they had ever imagined that a new word--''millionaire''--was minted to describe them. Meanwhile, the cost of bread jumped fivefold in a matter of months. Law knew the frenzy was insupportable in the long run. But he had also discovered something Fed Chairman Alan Greenspan was to learn centuries later: Orchestrating a soft landing is extremely difficult. When share prices showed signs of softening, Law, who had recently been promoted to controller general of France, issued a stream of edicts designed to keep investors from stampeding out of Mississippi shares and dumping their paper currency! He outlawed the export of coinage and the ownership or purchase of gold, silver, or precious gems! Even silver crucifixes were banned! Finally, he announced that all gold and silver coins would be removed from circulation. Law hoped to restore public confidence in paper currency by diktat--a foolish idea.

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The final straw came on May 21, 1720, when Law announced that the value of Mississippi shares would be cut nearly in half, to 5,000 livres. Simultaneously, the face value of banknotes was also cut 50%. Paris mobs rioted for three days. Mississippi shares crashed, and Law was soon under house arrest. Although he was released briefly from custody to clean up the mess, his rehabilitation did not last long. By year's end, Law had fled France forever. He stayed just long enough to see the government declare its experiment with paper money dead; it would be 80 years before France would introduce banknotes again. Law died in 1729 in Venice.’ From BusinessWeek July 31, 2000

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Chapter 2: Organized Stock Markets and Competition Suppliers of funds and demanders that need funds must be put in communication with one another. Financial markets are forums where suppliers and demanders are put in touch with one another. There are two types of markets. The money market is the market for short term securities. The capital markets are used for long term securities. The primary market is the market in which new issues of stock are sold by businesses. Access to the primary market requires approval of the Securities and Exchange Commission (SEC), the main regulator of the securities markets. Shares or new issues may be sold as a public offering in the primary market. New shares may also be sold as a rights offering (shares sold to only existing shareholders). Finally, shares may be sold as a private placement, where the shares are sold to qualified persons without use of the primary markets. Going public refers to registering a security with the SEC using a prospectus (a document which sets forth the ownership rights and risks of the security). Investment bankers assist in public offerings. These are private firms that specialize in selling securities and advising businesses on how to go about it. Sometimes the offering of securities is quite large and an underwriting syndicate is used to sell the offering. An underwriting syndicate is a group of bankers. The Investment banker or underwriting syndicate puts together a selling group for the offering. The selling group may include members of the syndicate. In return for selling they receive a commission, or a payment based upon the dollar amount of the security sold. The secondary market or aftermarket is the market where the security is sold after the shares have been offered and sold. It provides liquidity. Liquidity is the ability to raise cash quickly by selling a security. There are two secondary market types - broker markets and dealer markets. Securities are exchanged in different ways on these two markets. Broker markets involve buyers and sellers trading at one specific point and exchanging the security with the help of a broker. Dealer Markets involve dealers directly. Buyers and sellers are not directly exchanging securities but are exchanging securities with dealers who ‘make a market’ in the security. In broker markets, the title of the security passes from the buyer to the seller. In dealer markets, the title passes through a dealer. The New York Stock Exchange (NYSE) and the American Stock Exchange (ASE) are both broker markets. The NYSE is the larger of the two and has 1,366 seats or members. Only members can act as brokers. Trading activity occurs on the floor of the exchange at 20 posts. Each post handles a specific group of securities.

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The brokers act as representatives of the buyers or sellers. A specialist at the post acts to bring the buyers and sellers together and somewhat acts as an auctioneer. For a business to 'trade' in the NYSE after market, it must list with the exchange. There are requirements on size and stability to list.

Regional Exchanges There are regional stock exchanges in Boston, Philadelphia, San Francisco and Chicago. The listing requirements for the regional exchanges are less arduous than that of the NYSE.

Dealer Markets As mentioned, dealer markets are made of market makers that buy and sell securities from one another and from investors. Each market maker has their own price to buy and sell a security (called the bid and ask price). Market makers specialize in owning just a few securities and they are said to 'make a market’ in those securities by providing prices at which they are willing to purchase (bid) or sell (ask) the securities. The largest dealer market is The NASDAQ Stock Market or the "National Association of Securities Dealers Automated Quotations Systems". To trade on the NASDAQ market, at least two dealers must be involved to make a market. NASDAQ has listing standards based upon size and financial stability just like NYSE and ASE. Their largest segment of their market is the Global Select and is the highest quality securities that trade.

Interactive: Let’s look at a Snap Quote for Apple Inc. (AAPL) in Telemet >> From the University Default Workspace ‘Snap Quote’ is on the Start Screen or from any page select New Display>Snap Quote>Enter Ticker: AAPL

Snap Quote provides information such as the exchange on which AAPL trades. Look at the Lstd.X which shows that Apple Inc. trades on the NASDAQ Global Select market or NqGS.

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Trading on Other Markets Transactions need not be done by the dealer or broker markets previously mentioned. Dealers may make transactions on NYSE and ASE listed securities. They handle transactions at lower commissions and bring together large buyers and sellers. They are called the third market. The fourth market consists of transactions made through computer networks between large buyers and sellers.These networks are called Electronic Communications Networks or ECNs.

Trading Terms

Bullish means that the expectation is that securities prices are to rise. Bearish means that the expectation is that securities prices are to fall.

Trading Hours Normal trading occurs on the U.S. Markets between 9:30 AM and 4:00 PM on business days. However all exchanges, and the ECNs offer extended trading hours. Most of this activity is called crossing markets and only involves matching buyers and sellers.

Interactive: Let’s look at Time&Sale for Apple Inc. (AAPL) in Telemet Finance Lab >>From any Telemet window select’ Display’>Time And Sale>Enter Ticker: AAPL

Premarket: Investors can see early trade times under the ‘Time’ column within Time&Sale

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Interactive: Let’s look at Time&Sale for Apple Inc. (AAPL) in Telemet Finance Lab >>From any Telemet window select ‘Display’>Time And Sale>Enter Ticker: AAPL

Extended Hours: Investors can see late trade times under the ‘Time’ column within Time&Sale

Trading Securities and Orders Market order is an order to buy or sell a security at the current market price. Limit order is an order to buy or sell a security at a specific price. Stop order is an order to buy or sell a security once the price reaches a specified price, known as the stop price. Stop-limit order is an order to buy or sell a stock that combines a stop order and a limit order. Day order is an order in which the request to purchase a security is good only for that current day or only until the transaction is completed that day. Good-Til-Cancelled order is an order to buy or sell a security at a specific or limit price that lasts until the order is completed or cancelled. Also known as a GTC order.

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Chapter 3: Sources of Investment Information

1. 2. 3. 4. 5. 6.

Newspapers (Wall Street Journal, Barrons, New York Times, Financial Times) Periodicals & Magazines (BusinessWeek, Fortune, Forbes) Television & Radio (CNBC, Bloomberg Radio) Subscription-based hard copy newsletters (Kiplinger Reports, Valueline) Government Publications (Economic Reports, Fed Reports, SEC Databases) Websites a. Free (Yahoo! Finance, CNN Money, MarketWatch) b. Paid (Edgar Online, The Motley Fool, Hoovers) or Brokerage (Schwab, Merrill Lynch) 7. Professional Organizations (CFA, IAA, NAAIM), Investment Advisors, Stock Brokers 8. Professional Investment Platforms (Telemet Orion, Bloomberg, ThomsonReuters)

Interactive: Let’s view Key Statistics for IBM Corp. (IBM) in Telemet Finance Lab >>From the Telemet Manager select>Student>Key Stats>Enter Ticker: IBM or if you are using the University Default Workspace, select the Key Stats window on the Start Screen.

Key Statistics provides investment professionals with fast access to company financial data including dividend history, earnings, financials, key ratios, revenues and company overview.

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Interactive: Let’s look at Financials for IBM Corp. (IBM) >>From ‘Key Statistics’ click on ‘Financials’>Income Statement

Above we can see detailed quarterly data from the income statements of IBM Corporation. Company Financials provides a 25-year history of quarterly and yearly fundamental data including income statements, balance sheets, cash flows and ratios to export to Microsoft Excel.

Interactive: Let’s look at Corporate Actions for IBM Corp. (IBM) >>In ‘Key Statistics’ select ‘Corp Actions’ in the ‘Company History’ or ‘Key Statistics’ menu

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Interactive: Let’s take another look at Corporate Actions for IBM Corp. (IBM) >>From any page, select New Display>Research>Corporate Actions>Enter ticker:IBM Below we see a history of Corporate Actions for IBM Corporation including acquisitions, dividends, stock buybacks, etc. Choose your symbol and dates to search Corporate Actions.

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Chapter 4: Concept of Return and Risk

The definition of compounding is simply building upon what is already there e.g. watching stuff grow. What grows as an add-on grows as well. Measuring return is the level of profit from an investment, and the components of return are dividends or interest. The return must be cash or convertible into cash in a rapid manner. (1) Bonds produce interest in the form of coupons that can be taken to a bank for cash. (2) Dividends come from stocks and mutual funds and are paid as cash or stock monthly, quarterly, semiannually or annually.

Capital Appreciation or Loss Capital appreciation or loss come from the change in market value. (1) If the market value rises due to market conditions, then we have a capital gain and (2) if the market value falls due to market conditions, then we have a capital loss. Note that the components of capital appreciation and loss are a change in market value. Suppose that there is no market. Now what is the value? This is what has happened in the securities mortgage business where the value of the investments (in this case bundles of mortgages) cannot be ascertained. There is no market or no liquid market! Total return is the sum of the capital appreciation (or loss) and the dividend or interest income.

Interactive: Let’s look at Dividends for General Electric Co. (GE) in Telemet >>Select ‘Key Stats’ in the Start Screen of the University Default Workspace or from the Telemet Manager select >Student>Key Stats>Enter then select ‘Dividends’in the ‘Company History’ menu

Telemet shows the dividend history for GE.

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Look at the GE dividend history over a holding period of year to date - the holding period is simply the time you own the stock. As of 12/11/18, there have been 3 dividend payments ($0.12, $0.12, $.12) if you have held the stock since 12/31/17. The record date is the date upon which you must own the stock to receive a dividend. So the record dates 09/17/18, 06/18/18 and 02/26/18 are the three dividends received so far in 2018. Note that the payment date is later than the record date, however if you were not the owner of record on 02/26/18, then you will not have received the payment on 04/25/18. Now let us look at the change in market value since the beginning of the year.

Interactive: Let’s look at a Snap Quote for General Electric Co. (GE) in Telemet >> From the University Default Workspace ‘Snap Quote’ is on the Start Screen and select, or from any page select New Display>Snap Quote>Enter Ticker: AAPL Note the bid and ask prices, the bid ask size, the volume, the dividend, the yield, and other vital information available in Snap Quote

GE closed at 17.45 at the end of 2017 GE closed at 6.76 on 12/12/18

The capital appreciation amount is equal to 6.76 minus 17.45 The total return is thus: TR = [(6.76-17.45)/17.45] + [(0.12+0.12+0.12)/17.45] TR = Capital Appreciation (Loss) + Dividend Return TR = -61.26% + 2.06% = -59.2% Total Return

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Note that we use percent return, not dollars returned so that we can compare investments with different prices directly. Has this GE been a good investment for a holding period of year to date 2018? Another way to see this is through the Chart Calculator within a Historical Chart in Telemet.

Interactive: Let’s look at a Historical Chart for General Electric Co. (GE) >>From the Telemet Manager select ‘New Display’>Charts>Historical>Snap>Enter: GE

Reminder: Use your mouse wheel to scroll back (and forward) in time on any chart.

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Interactive: Let’s look at a Chart Calculator for General Electric Co. (GE) >>From the Historical Chart click on the ‘Chart Custom Calc’ button along the top toolbar Hint: To show toolbar>Options>Select “Show toolbar”

Set the dates. Both the Capital Appreciation and the Dividend Return are shown. Now why is return important? Clearly you would rather have a 14% return than a 10% return. But of course it is not past returns that are important. It is the future returns. But the past can sometimes suggest the future. A simple, but not too pleasant example, suffices. If you have seen one cockroach at your apartment one day and two the next, what are the chances of another? Yes, the trend is bad and extrapolating that trend suggests you invest in an exterminator! So it is with stocks…both the price trends (increasing or decreasing), the dividend trends (increasing or decreasing) and earnings trends (whether the company's earnings increasing or decreasing). In fact, some investors see a bad earnings statement from a company one quarter, and will avoid that company. No kidding, they call it the ‘roach theory of earnings’ (if you have seen one bad quarter, you are going to see more!).

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Interactive: Let’s look at Key Statistics for General Electric Co. (GE) >>From the University Default Workspace select ‘Key Statistics’ or select from the Telemet Manager Window >Student>Key Stats>Enter Ticker:GE

Click on Earnings per Share Amounts – Latest Quarter and see the quarterly trend over 5 years. According to the Key Statistics chart, the earnings per share trend is erratic and down over the last 5 years.

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Interactive: Let’s look at a Historical Chart for General Electric Co. (GE) >>From any Telemet Manager Window select ‘Research’>Charts>Historical>Snap>Enter: GE >>Now select Options>Time Frame>Choose your time frame e.g. 5 Years

According to the Historical Chart, the price of GE is also down over the last 5 years. The level of return depends upon many factors, both internal and external. Some internal factors include: 1. Management (Has it changed or is it the same? Where did Jeff Immelt go?) 2. Financing (A lot of debt may be risky and not available) 3. Customers (Trending up or down) Some external factors include: 1. The sector and industry (if going into a recession, luxury goods may not be a good place to invest, but necessities are safer) 2. Political factors - green industries are an ‘in’ now 3. Inflation - good for some, not for others. Can you think of an industry where inflation is good? (hint: houses)

Time Value of Returns A simple concept: Would you rather have the return today or in a year? Which is more valuable? Satisfactory investments are investments where the present value of the return is more than the present value of the costs.

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Measuring Risk and Components of Risk Noah Webster's definition of risk: Chance of injury, damage or loss. Our definition - variability in returns (a mathematical measure is useful). One surrogate is the standard deviation called sigma.

Assumptions in the Definition of Risk Standard deviations come from normal distributions. Unfortunately stock prices are not normally distributed and it can be shown that they have no standard deviation. (Professor Benoit Mandelbrot discovered this in the 1960s). The view Mandelbrot is arguing against goes like this: [stock] price is determined by binary decisions, like coin tossing. Heads, the price goes up; tails, it goes down. Investors putting in buy and sell calls should then act a bit like particles in a glass of milk, which remain suspended because they are constantly bustling into one another in a process known as Brownian motion. In theory, lots of tiny, bustling investors should have a similar effect--keeping stocks pretty much suspended, with only slow changes. Yet the stock market is subject to violent swings. "I have seen cases where something went down from $90 to 90 cents," Mandelbrot says. Where the model sees a gentle breeze, there is instead a mighty storm. Price drops or runups that the coin-tossing model sees as impossible-changes with a probability of a millionth of a millionth of a millionth of a millionth--occur frequently. "It should never happen," says Mandelbrot. "Never, never, never. But it happens all the time." Forbes, April 2, 2002 It is these violent swings that brought down Long Term Capital Management and almost the entire financial system in the late 1990s - LTCM lost 4.6 billion dollars in 4 months! LTCM used Black Scholes models among others all of which rely on a normal distribution to model the markets. Here is an updated example of a violent price movement not expected by the normal distribution, as shown on this Telemet Historical Chart for Facebook. On July 26, 2018 after a weak growth forecast, the stock price dropped 19%. This decline erased about $120 billion in market value and is the largest one-day drop in the history of the American stock market. This was a surprise and drove down the stock far beyond what would be expected in a normal distribution. The ‘toss of the coin model’ as noted above, works only until some unexpected event occurs. For additional insight, read The Black Swan by Nicholas Taleb; Random House; 2010.

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A weak growth forecast caused this price drop as indicated above. The normal distribution statistics cannot predict such price variations. So why do we use the normal distribution and the standard deviation? It is the only math we have (other than that developed by Mandelbrot) and math majors have to be employed too! The standard deviation measure is called sigma. It is a measure of the average variability of the return for each period (such as a day) from the average return. It is defined as the square root of (the returns for each period minus the average return) squared divided by the total number of periods less one. If we compare this variability to the market, we talk about beta and R squared. Beta is a measure of the stocks performance compared to the market and R Squared is how well this predictor works. For example if the market goes up 10% and the stock 20% .. the beta is two (it goes up - and down - on average twice the rate of the market - high beta stocks are high risk stocks). If the 'fit' or predictability of this is low, then the R Square is low. If it very closely follows the beta rule, then the R Square is high (perfect track is R Square of 1). Below are the beta and R Square of the Dow Jones 30 industrial stocks.

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Chapter 5: Modern Portfolio Theory

The assumptions built into the model: 1. 2. 3. 4.

Investors maximize utility and exhibit marginal utility of wealth (explain). Investors risk estimates are proportional to the variability of returns. Investors will base their decisions solely on expected return and risk. For a given level of risk, investors prefer higher returns to lower ones. For a given level of return investors prefer lower risk to higher risk.

Return and Risk Risk has two components: 1. Risk that can be cancelled by adding securities together (diversifiable risk). 2. Risk that cannot be cancelled (systematic risk or non-diversifiable risk) because it is related to the market as a whole.

The Capital Asset Pricing Model Beta – What is it, Which Beta? Beta measures systematic risk or non-diversifiable risk. William Sharpe, Professor of Finance at Stanford University won a Nobel Prize in Economics for his work on securities and risk. One of the big problems (especially before the advent of modern computers) was a way to calculate the risk of a portfolio. Markowitz in the 1950s suggested that risk can be minimized by combining securities in a way so that variations among them cancel out. Remember risk is associated with variability of return so if you had a large number of securities in a portfolio and you wanted to measure its risk the standard direct approach would be to measure the variance of the portfolio. To measure the variance, you add up all the variances from each stock AND take into account the relation of risk between each stock to every other (called the co-varience). So if you had 200 stocks in a portfolio, you would need to measure the relation between the first stock, and 199 others, the second stock and 199 others, etc. This becomes a problem of measuring the "covarience" among 200 x 200 securities or almost 40,000 calculations (actually a little less than half this because the correlation of security A with B is the same as the correlation of B with A)! What Sharpe did is show that only the "systematic" risk be calculated when the portfolio is properly constructed (the systematic risk is the tracking or variability of the security to the overall market index like the Standard & Poor 500) and he called this "Beta". So by measuring the tracking or variability of a stock to the index you have a measure of the return of that stock and by using a weighted average the "betas" of the portfolio you get a measure of the return of that portfolio compared to the market.

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In mathematical terms the return of any stock looks like: Ri = ai + biI + ci

where

R is the return of the i-th security a is a constant (usually called the Alpha of the security) b is 'beta' for that security I is the return on the index c is another variable representing uncertainty. This is the equation of a straight line of slope "b" and intercept "a". Stock Return

a I (the index value) So if you think the market is going up 10% this year and the beta of a stock is 1.2 then the stock may go up 12%. Remember beta goes both ways, so if the market goes down, high beta stocks can hurt a lot! Note that the time-frame for estimating beta is not defined. So you could have a 3 year beta, 5 year beta etc. they would be different numbers because the returns between any stock and the index differ for different time horizons.

Alpha – What is it, Which Alpha? Other than showing what it is as the intercept above, what is Alpha? Perhaps you have heard the term ‘seeking alpha’. Well see above, it is the return on a stock if the index return is zero, that is to say that it is the return on a stock if the market index return goes sideways or no where. So if the averages are ‘flat’ for the year, alpha represents the return on the stock (assuming alpha is positive) and hence the portfolio (no wonder then that people 'seek alpha'). Here is one place where you may find beta for any stock within Telemet Finance Lab in a page called ‘Fundamental Summary’. You may also choose to show ‘alpha’, or at least the historical alpha based upon the past three years of return history.

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Interactive: Let’s look at a Fundamental Summary for Dow Jones 30 Industrials >>From any Telemet window select ‘Display’>Pages>Open>Fundamental Summary >>Now select Options>List>Select>Choose the Dow Jones 30 Industrials List >>Now select Options>Columns>Statistical>Select Alpha and move it under Beta using the up/down arrows>Hit OK

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The Capital Asset Pricing Model (CAPM) The CAPM uses Sharpe's ideas to create a required return on an investment called i: RRi = RF + bi(I-RF)

where

RR is the required return RF is the risk free return b is the beta of the investment I is the return on the index (such as the S&P 500 index) Note as beta increases the RR must increase. Investors require more return for more systematic risk. Note that the equation for the required return RR is an equation for a straight line also and it is called the "Security Market Line (SML). Calculating the SML requires measuring historic returns from stocks and the historic returns from the market and coming up with a ‘best fit’. These historic returns create an historic beta which is then used to 'estimate' future returns.

Modern Portfolio Theory (MPT) We mentioned Markowitz and his idea to combine stocks in a way to minimize risk - finding stocks that do not correlate with one another. So the key is to find stocks that do not move together.

Key Concepts of MPT The efficient frontier and portfolio betas. We have discussed portfolio betas above, these are the weighted average of the betas from each stock in proportion to the dollar values in the portfolio. But what is the efficient frontier? As stocks are added to a portfolio, the nonsystematic risk decreases. Studies show that all you need is 15-20 stocks picked at random to remove most of the nonsystematic risk. If you remove this risk there is a set of portfolios that can be expected to have the best return for a given level of risk - these portfolios are called efficient. All other sets of portfolios that have more risk for a given expected return are said to be inefficient. Note that we said picked at random. You could not pick 15 oil stocks and expect to have an efficient portfolio. Now consider another higher level of risk. There is another set of portfolios that are efficient for this level of risk. In fact, you can describe a set of efficient portfolios for each level of risk that you are willing to consider. This describes a line that is called the efficient frontier. Any other portfolio not on this line, will either have lower expected return for some level of risk, or a higher risk for a level of expected return.

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Of course the trick here it to pick stocks where you can get high ‘expected return’ and at the same time, get a good estimate of the ‘risk’. That is what professionals are paid for. Here is the way it looks:

Return

Efficient Frontier Risk

Further reading: "Portfolio Theory and Capital Markets" by William F. Sharpe; Mcgraw Hill; 1970

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Chapter 6: What Makes Common Stocks Interesting?    

A wide variety of stocks to fit any investment objective Appeal of common stocks - historical returns Tech bubble - pros & cons of ownership Dividends and dividend history

Dividends Interactive: Let’s look at a Dividend History for General Electric Co. >>From the University Default Workspace select Key Stats>Enter Ticker: GE: Select ‘Dividends” in the Key Stats navigation manager in left of screen.

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Splits - Select ‘Splits” in the ‘Key Stats’ navigation manager in left of screen.

Other Corporate Actions- Select ‘Corp Actions” in the ‘Key Stats’ navigation manager in left of screen.

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Reading the Price Quotations Interactive: Let’s look at a Basic Pricing Page for the Dow Jones 15 Utilities >>From any Telemet window select ‘Display’>Pages>Basic Pricing Page >>Now select Options>List>Select>Choose the Dow 15 Utility Stocks

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Common Stock Values Interactive: Let’s look at Key Statistics for General Electric Co. (GE) >>From the University Default Workspace ‘Key Statistics’ is on workspace or from the Telemet Manager Workspace select ‘Key Stats’> Enter Ticker: GE

Types of U.S. Common Stocks Blue Chip – the best of the best companies Income – gaining dividends Growth – hoping for capital appreciation Tech – sector investment in technology Speculative – smaller companies with little or no earnings Cyclical – invest on economic cycle Defensive – invest on a down economic cycle; consumer staples Mid-cap – mid sized companies Small-cap – small sized companies

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Foreign Stocks Direct – purchase directly on a foreign exchange ADRs (American Depositary Receipts) – purchase on U.S. exchange

Strategies: Buy and Hold – ‘coffee can stocks’; buy and put away Current Income – buy stocks with large dividend yields Long term Growth – appreciation in value over long period Short term Trading – based upon speculation

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Chapter 7: Analyzing Common Stocks ‘Security Analysis’ was not invented by the TSA. Valuation process for stocks – finding the intrinsic value of a stock compared to the traded value.

Analysis: Top-down and Bottom-up Top-down analysis picks sectors, then industries in the sectors then finally the stock(s). The hypothesis is that the market is not efficient (stocks are not always 'fairly priced'). They may be efficient most of the time, but not perfectly efficient. Bottom-up analysis focuses on one or more individual stocks, rather than sector or market.

Economic Analysis What is the economic future? How do you estimate this? The business cycle: GDP.

Interactive: Let’s look at the Historical GDP Economic Workspace >>From the Telemet Manager double-click on the ‘GDP’ workspace under ‘Economy’

Telemet Finance Lab plots the US Gross Domestic Product and change in US GDP by quarter.

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Another measure is industrial production. >>From the Telemet Manager double-click on ‘Industrial Production’ under ‘Economy’

Telemet Finance Lab plots the industrial and total production by month. Other factors are taxes, government spending, debt management, money supply, interest rates, inflation, consumer spending, business investment, and foreign trade and exchange rates. Let’s look at a table of some economic indicators. >>From the Telemet Manager double-click on ‘Economic Indicators’ under the ‘Economy’ group

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After looking at the economic forecasts, use them to judge which industries and sectors will expand and which might contract. If the outlook is negative, consider defensive stocks (companies that sell things that people must have, recession or not – beer is always considered a good example). In general consumer staples are good bets during downturns. Look at the consumer staple sector versus the overall S&P 500 average. Key factors affecting the outlook: GDP Inflation Corporate Profits

Industrial Production Federal Budget Deficit or Surplus Unemployment

Weak Dollar Interest Rates US Money Supply

Take a look at some of these indicators in Telemet and put a plus or minus next to each. Guess where the economy is heading i.e. US unemployment rate may be signaling a downturn.

Telemet plots the unemployment rate. The chart shows a positive indication for the economy.

Sector and Industry Analysis Once the general condition of the economy is understood, the investor can begin to consider economic sectors and industries. Lots of sources for outlooks on sectors, industries and stocks. Included are magazines such as BusinessWeek and Forbes, web sites, paid services such as ValueLine and S&P.

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Professional investors also get outlooks and research from 'sell side' institutions - institutions that offer stock to investment professionals and retail investors. Services for research are available both on line and via paper reports.

Interactive: Let’s look at the Consumer Staples Sector vs S&P 500 Index Chart >>From the Telemet Manager double-click on Display>Charts>Historical>Open>Ticker vs S+P 500>Enter ‘S30’ and select ‘Index’

Telemet Finance Lab charts the various S&P sectors versus the overall averages.

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Seeing Sector and Industry Performance History You can judge trends on this with the following Telemet workspace: Key S&P Sectors

Interactive: Let’s look at the Key S&P Sectors Workspace in Telemet Finance Lab >>From the Start Screen, see ‘Monitor Page’ in lower right>Select ‘Options’>Toolbar>Select ‘Key S&P Sectors’ in left drop down menu at arrow below toolbar

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Chart 1: S10@COMP -I - vs – SPX Historical New Display>Chart>Historical>Select from list Ticker vs S&P500>Enter S10 and select Index in the window Chart 2: S10@COMP- I – vs –SPX Intraday New Display>Chart>Intraday>Select from list Ticker vs S&P500>Enter S10 and select Index in the window Chart 1

Chart 2

You can see the individual sectors of the economy and the performance over time and the relative performance to the overall S&P averages.

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Fundamental Analysis Studying Financial Statements Interactive: Let’s look at the Financial Statements for General Electric Co. >>From the Telemet Manager>Student>Company Financials, enter ‘GE’, select all 4 financial statements, and ‘Run’ Balance Sheet – statement of assets and liabilities and who owns them at a single point in time Here is the assets portion of a GE balance sheet example taken from Telemet

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The assets are the things the company owns. The above balance sheet shows the last 4 quarters of assets of GE. The next area shows the liabilities, or GE’s financial obligations. Finally there is a section called stockholders’ equity which is the ownership section of the balance sheet. All the assets less the financial obligations (from the liability section) are owned by the stockholders, or shareholders.

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Liabilities are and stockholder’s equity are show above. Stockholders’ equity is the ownership section of the balance sheet. All the assets less the financial obligations (from the liability section) are owned by the stockholders, or shareholders. Income Statement – statement of financial summary of the operating results of the company The income statement shows revenues, as well as the costs and expenses for generating these revenues.

Statement of Cash Flows – this report shows how a company obtained its cash and where it went. Whereas the income statement can 'amortize' or 'accrue' certain expenses and income, the cash is the cash, and these results are not obscured by various accounting methods. The next page shows the Cash Flows – where the cash came from and where it went. Here are the last 4 quarters of Cash Flows Statements for GE.

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Financial Ratios - the real meat of the financial statements come from the financial ratios and the trends over time in these ratios. The trends in these ratios, although past history, may signify the future of the company. There are 5 types of ratios and we can see them all on one page. The 5 types are liquidity, operation performance, profitablity, financial risk and valuation. The next page shows the Ratios Report for GE as seen in Telemet Finance Lab.

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Liquidity Ratios Liquidity ratios measure how well the firm can meet day-to-day expenses. Here are a few example liquidity ratios and what they measure. Current Ratio is defined as current assets divided by current liabilities. An investor would like to see a rising or high ratio.

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Interactive: Let’s look at the Current Ratio within Key Statistics for GE >>From the Telemet Manager select ‘Student’>Key Stats>Enter: GE >>Click on ‘Current Ratio (mrq)’ to see the trend; ‘mrq’ stands for most recent quarter

Telemet shows the trend in the current ratio Working Capital is defined as current assets less current liabilities. While a good measure, a better one is the per share value, because a company can easily issue shares and increase their working capital.

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Interactive: Let’s look at the Working Capital per Share for GE >>From Telemet Manager double-click on ‘Research’> ‘Company Comparisons’ Compare: Multiple Symbols Over Time, Report: Ratios, Industry: Commercial and Industrial, Item: Working Capital per Share, enter ‘GE’, select ‘Compare’

Telemet Finance Lab shows the trend in working capital per share over time.

Operation Performance Ratios Account Receivable Turnover measures how fast revenue is being processed from a sales invoice. It can indicate a collections problem if it low or trending low. It is defined as sales divided by account receivable. Remember to click on a quarterly data cell to populate the comparison chart in this and other Company Comparisons.

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Telemet shows the trend in the accounts receivable turnover. When decreasing, this is negative. Inventory Turnover shows how long it takes inventory to be sold. High numbers and increasing numbers are better than low ones. It is defined as sales divided by inventory.

Telemet shows the trend in the inventory turnover decreasing, which is a negative indication.

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Total Assets Turnover measures how effectively assets are being used to support sales. It is defined as annual sales divided by total assets.

Telemet shows a different trend in total assets turnover; increasing is a positive indication.

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Profitability Ratios Net Profit Margin is the rate of profit earned on sales. It is defined as the net profit after tax divided by sales.

Telemet Finance Lab shows a negative trend of profit margin in past quarters. Return on Assets (ROA) is defined as the net profit after tax divided by total assets. It measures the management's effectiveness putting assets to work.

Telemet Finance Lab shows a negative trend towards a better return on assets.

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Return on Equity measures the return to the shareholders. It is defined as the net profit after tax divided by shareholder equity.

Telemet shows what appears to be a negative trend towards a better return on equity.

Financial Risk Ratios Debt to Equity tells the investor the ratio between amount of funds from debt holders and the amount from stockholders. It is the value of long term debt divided by shareholder equity.

Telemet shows a trend towards more debt being used by GE, making it riskier to shareholders.

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Interest Coverage tells the investor how well or easy it will be for the firm to cover its interest payments. It is defined as earnings before interest and tax divided by interest expense.

Telemet Finance Lab shows a trend towards lessened coverage of its interest payments for GE.

Valuation Ratios Price to Earnings or P/E measures the price of the stock in the market to the earnings of the company.

Telemet shows a downward trend for P/E, indicating slower growth or investor concern for IBM.

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PEG (price earnings to growth) Ratio is a measure that compares the price earnings ratio to the long term growth rate of the stock. It is the price earnings divided by the long-term growth rate of earnings. Dividends per Share is the total dividends paid by the company divided by shares outstanding.

Telemet Finance Lab shows the dividend per share in the Snap Quote window. Dividend Payout Ratio is a measure of how well the company covers its dividend payments. It is defined as the dividend per share divided by the earnings per share. High payout ratios mean that the dividend may not be sustainable.

Telemet Finance Lab shows a good coverage of dividend payments for GE.

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Book Value per Share is a measure of the shareholders claim on the company's worth. It is defined as the shareholder equity divided by the number of shares outstanding. Most often, stocks sell at greater than book value. If they don't, the assets may be overstated, liabilities understated, or a good value.

Telemet shows a recent decline in the book value per share trend for GE.

Telemet Company Snapshot Several firms such as S&P and Value Line publish valuation reports. Here is the Telemet Company Snapshot report, summarizing a lot of metrics on any one company.

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Interactive: Let’s look at the Company Snapshot report for GE >>From any window select ‘Display’>Research>Corporate Reports>Company Snapshot>GE

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Chapter 8: Stock Valuation Valuation Process The objective is to try and estimate the stock's intrinsic value by using one of several models. This will give the investor an objective idea as to whether the stock is under or over valued. The previous discussions have centered around how the company has done in the past by looking at various ratios and metrics. Trends were examined as a hint to the path in the future. Valuation Models may include Dividend, Dividend Growth, Earnings Growth and PEG, etc.

Common Size Income Statement This simply shows the various expenses and profits as a percent of sales. With this approach every company in an industry may be compared to another.

Interactive: Let’s look at the Common Size Income Statement for IBM >>From Student Manager in the ‘Student” group, double-click ‘Company Financials’ , enter ‘IBM’, select ‘Income Statement’, select ‘Common Size’ and ‘Run’

Forecasted Dividends and Prices Once we estimate future profits, we can estimate future dividend payouts (if any), the expected number of shares outstanding, and the future P/E ratio.

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The dividend payout and number of shares are usually pretty stable (unless the company must issue a large number of shares for a future project, or is in trouble financially and must raise additional cash). The future P/E ratio is related to the growth in earnings (large growth in earnings means a higher P/E is likely), the state of the markets (there is systematic risk in all stocks), the amount of debt (more debt is more risky), the estimated rate of inflation (high inflation lowers P/E) and the level of dividends (a higher dividend increases the stock price and hence the P/E). The investor can look at past P/E range to get an idea of the future P/E. The investor can also look at the P/E of the market (say the S&P 500 P/E) and the relative P/E of the stock compared to the S&P 500 (called the "relative P/E").

Interactive: Let’s look at the Price & P/E Historical Chart for GE >>From any Telemet window, select ‘Display’>Charts>Historical>Open>Price & P/E Historical >enter GE

Estimated EPS Several methods may be used to estimate future EPS. One can use brokerage firm estimates, one can use projections of ROE and book value per share. Future EPS = ROE times BV/Share For example from Home Depot (Ticker HD) financials: After tax ROE as of 1.7.19 is about 652.61 and BV/Share is 1.16

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Future EPS with this formula is 6.526 X 1.16 or $7.57/share (after tax). With a trailing P/E of HD at 19.39 the investor would expect a future price of $146.78 per share. If an analyst were calculating this he would call this the 'target price'. Of course this depends upon the P/E staying at or above 19.39 (and an investor would note that it has been increasing) and the company earning $7.57. The stock (as of Dec. 31, 2018) traded at 171.82, so it may be over priced.

The Valuation Process The process by which an investor uses risk and return to determine the value of a security. Just like any investment, the required rate of return (given the risk) must be identified. The Capital Asset Price Model (CAPM) says: Required return = risk free return + beta times (estimated return above risk free rate). Remember beta measures the risk that cannot be eliminated from diversification. For Home Depot HD the beta is .94, the risk free rate is approximately 5%, and the estimated return above the risk free rate is somewhere between -5% (zero return because the stock is fully valued) and (26.8-24)/24 = 11.7% (expected return if the higher estimate is correct). Required return = 5% + .94(11.7-5)= 5%+7% = 11.30% On the low side the return required is 5% +.94(-5-3) <0

Valuation Models -Value investors rely on historic events to predict the future -Growth investors rely on estimates of growth in earnings -Dividend valuation investors look for dividend yield -Low P/E investors look for low P/E stocks These are called factors and any of them (or in combination) you can use to select stocks.

Dividend Valuation Models The investor looks at the future dividends as a cash flow and estimates the value of the investment based upon this. So the constant dividend model will require a present value of a share of stock to be Annual dividends divided by the required rate of return. For Home Depot HD (which has had a growing dividend) $4.12/.12 = $34.33 per share To adjust for a constant growth dividend use the current dividend less past dividend to get the historical dividend growth rate - over 4 years the dividend (.31-.22)/.22 - four years of dividend growth is compounding at about 9% per year.

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HD Cost equity cap. = 4.12/170+.09=.1142 or 11.42 Beware the constant growth model. Changes in the housing market, consumer spending, interest rates and transportation will affect both income and expenses at HD. Also note that the denominator in the above is the difference of two small and quite uncertain numbers - small changes in them will make a big difference in the price per share.

Dividend and Earnings Valuation Models Suppose the stock does not pay dividends or the investor does not want to rely on the dividends for the valuation process. Here is one way to proceed using the dividend and earnings valuation model. The value of a share of stock equals: Present value of future dividends at year ‘y’ + present value of the stock at date ‘y’. To do this, use the actuarial factor for year ‘y’. Let ‘y’ be 3 years from now (2021). The HD dividend will stand at 4.12 per year. The estimated stock price will be (discounting at the required return of 12%) 1.03 x 0.893 + 1.03 x 0.797 + 1.03 x 0.712 + (estimated share price 2021) x 0.712 = 2.47 + (est share price 2021) x 0.712. Note the estimate is now dominated by the estimated share price in 2021 and the required return. The estimates (from professional sources say that the earnings will be about $11.07 per share. With a p/e of 18, this is 199.26 multiplied by 0.712 is 141.87. Now add 2.47 and the total estimate is $144.34 per share. But the stock sells today at 171, so the stock's intrinsic value is less than what it trades for.

P/E Valuation Model This is simply an estimate of the P/E and the future earnings. HD is at $171, the P/E today is 18, the earnings in 3 years is estimated to be 9.5. The value will be 95.00 in three years. The question is whether the P/E will still be 18 and will the earnings be 9.5? Here is the P/E range:

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Telemet Finance Lab shows a steady increase in P/E for HD. So the more historic figure for HD P/E is 150 - not the current 175. If the P/E were to rise to what? , the stock could rally back to 2017 earnings.

Price to Cash Flow Model This model uses EBITDA (earnings before interest, tax, depreciation and amortization) as the cash flow and estimates the Price to Cash flow. Telemet charts this currently around 16.

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The estimated stock price is then 16 times the estimated cash flow per share.

Price to Sales and Price to Book Value These valuation measures rely on estimating future sales and future book values and relating them to the P/S and P/BV.

Future Price

Est. Sales Est. Shares

X

Current Price per Share Current Sales per Share

For Home Depot HD: Future Price

55.77 X 1.88 = 104.8

Est. Sales Est. Shares Est. Sales/Share

108,260 194,087 55.77

X

Price per Share 171.82 Sales Per Share 91.19 Price to Sales Ratio 1.88

Est. Sales Per Share X Price to Sales = Future Price For example if the estimated sales for HD in 2019 is $108,260 million (a third party estimate) and with 194,087M shares outstanding the estimated sales per share in 2019 is $55.77. The current price to sales is 1.88. The estimated price of the stock at the end of 2019 using this approach is $105.

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Chapter 9: Technical Analysis What is Technical Analysis? Technical Analysis is the analysis of forces at work in the market itself (such as trading volume and price movements). Below are some terms and techniques the investor uses for technical analysis. The assumption behind Technical Analysis: A non-random walk

Dow Theory Dow Theory says that both the transportation and industrials will move in the same direction until both change direction; at that point, a confirmation the trend is cancelled and reversed. In the chart below the trend is certainly bullish. Dow Theory has no predictive attribute, it is merely a confirmation of what has occurred.

Interactive: Let’s look at the Dow Jones 30 Industrials vs Dow Jones Transportation Historical Chart >>From any Telemet Window select ‘Display’>Tools>Ticker Lookup>Enter DJ 30 Industrials and select Index/Funds>Lookup. There several tickers displayed: You may use ZRA or INDU >>From any Telemet window, select ‘Display’>Charts>Historical>Open>Ticker vs DJ Industrial>enter ticker ZRA or INDU>select Index>Enter Tip: To add the price data at the top of the chart: Select ‘Chart Appearance’>Columns, Headers, Color & Font>Prices / Period>Select the Net% changes shown below>OK Tip: To display the legend: Select ‘Options’>Chart Appearance>Show Legend>Display Legend

Telemet Finance Lab shows the Dow Industrial and the Dow Transportation averages.

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Confidence Index This index measures the spread between high grade and medium grade corporate bonds. The confidence index = Average Yield ‘AAA’ bonds divided by the Average Yield ‘BBB’ bonds Lower yield spreads are indicative of higher confidence since investors require less premiums to purchase 'riskier bonds'. From any Telemet Finance Lab window select Fixed Income>Composite Yields and enter the selections shown in the screen shot below.

Interactive: Let’s look at the Historic Yield Spreads in Telemet >>From any Telemet Window select ‘Display’>Fixed Income>Composite Yields>Select the Instrument and Quality and use the tabs in the upper and lower window to select the data set.

Telemet Finance Lab shows the historic spread between AAA and BBB bonds.

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Breadth and Market Volume The volume when the market is rising and volume when the market is falling is an indicator of future direction. Rising volume on a rising market is a good signal. Breadth refers to the number of advances and declines.

Interactive: Let’s look at the Advance & Declines for the NYSE in Telemet >> Start by using >Tools>Ticker Lookup to find each Index ticker: Separately enter the name of each index and select index>ok. These are the tickers for each:AVOL, DVOL and UVOL >>From any Telemet window select Charts>Advance Decline Line >>Use the toolbar ‘+’ graphic “Add Ticker” to add each ticker to the chart >>For each Snap Quote, simply enter each ticker noted above and ‘Enter’

Telemet shows the volume figures and advance declines history. We see that the advance-decline line has been increasing and decreasing in 2018 indicating ongoing fluctuation in the advance of the market and a signal to buy. Investors may also see the advancing and declining volume.

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Note below the advance-decline line is rising prior to the surge in the Dow Jones Industrials.

Telemet shows that the Adv - Dec line suggests a stronger market prior to actual rise DJIA. This index takes into account trading volume on stocks rising and trading volume for stocks falling. It is popularly known as TRIN, and is a very volatile indicator. .

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Relative Strength This index measures the price performance of a stock vs. the market. One measure looks at the performance of the stock and ranks it compared to others. The statistical relative strength. Another measure of relative strength is called the relative strength index (RSI), which measures the strength of a stock not relative to the markets. Bullish is when the RSI moves from under 30 upward. Bearish is when it moves from over 70 downward. RSI covers days, weeks or months.

Interactive: Let’s look at the Relative Strength Index for GE in a Telemet Chart >>From any Telemet Window, select ‘Display’>Charts>Historical>Snap>enter GE >>Select ‘Options’>Studies & Overlays>Lower Indicators>select Relative Strength Index>hit OK

Telemet shows that the RSI for GE on 11/28/2018 was -7.19. Click on the chart to reveal RSI.

On Balance Volume OBV confirms price trends. It estimates whether money is moving in or out of a stock. When the movement is downward, it is considered bearish. Upward movement is considered bullish.

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Bar Charts Bar charts show price movements as bars, with the upper part of the bar as the high price for the day, and the lower part of the bar the low price. Ticks on the left and right side of the bar show the open price (the first trade of the day) and the close price (the last trade of the day).

Telemet shows a bar chart of GE for a three month period. All Telemet historical charts are bar charts: Scroll your mouse wheel towards you to reveal the bar chart view.

Point and Figure Charts These charts keep track of emerging price patterns. These track significant price changes. The rules used are developed by the investor, but generally prices move 1 or 2 points to record a box (depending upon the price of the stock). Here is the GE with a 2 point box. ‘X’ indicates 2 point rises. ‘O’ indicates a decline of 1.1 in this example. We see a lot of ‘O’ showing the stock drifting downward and no trend reversal. A new column is added only when the trend (up or down) reverses.

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In the toolbar Name select ‘Point and Figure’

Telemet shows a point and figure chart over a ten year period for GE.

Candlesticks Candlesticks originated in Japan. Analysis relies on pattern recognition but the interpretation is qualitative.

Interactive: Let’s look at a Candlestick Chart for GE in a Telemet Chart >>From any Telemet Window, select ‘Display’>Charts>Historical>Snap>enter GE >>Select ‘Options’>Tickers>select Candlesticks (where ‘Bar’ shown)>hit Ok Scroll “forward in time” with your mousewheel to see the candlesticks.

Telemet shows candlesticks over a three month period for GE. Note the down (dark) days.

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Candlesticks use open, high, low, and close prices. Each day a candle box is drawn and is filled if the close is below the open. The box size is between the open and close, the lines, called tails are the highs and lows for the day. If the close is above the open, the box is clear. Remember ‘down days are dark’. View candlesticks over a period of time.

Bar Chart Formations These are used to foretell the future movement of a stock. There is a whole vocabulary of formations; triple tops, head and shoulders, triangles, flag and pennant, inverted saucers, etc.

Moving Averages These help smooth out the 'noise' that is associated with daily trading and are useful for spotting trends. A moving average records the average value of a series of prices over time. The time period for the average can be from 10 to 200 days. There are simple weights, exponential and other mathematical functions (to count various periods more heavily or less heavily than others) applied to these averages.

Interactive: Let’s look at Moving Averages for IBM in a Telemet Chart >>From any window, select ‘Display’>Charts>Historical>Snap>enter IBM >>Select ‘Options’>Studies & Overlways>Upper Indicators>select Mvg Avg 2 line>hit Ok

Above shows the 50 day and 200 day moving averages for IBM. Investors use these averages for buy and sell signals. For example, a sell signal may be when the price closes below the 50 day moving average.

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Random Walks and Efficient Markets Many professionals argue that the markets (especially the highly organized ones) are efficient, that is that each price fairly reflects the underlying value of the company represented. If so technical analysis is useless. Further they argue that prices trade as a random walk...that is as a tossed coin, up few times, then down, etc. but of course there are large changes in prices when new information becomes available and this makes the random walk 'discontinuous'. During these periods of discontinuity, perhaps there are market inefficiencies due to emotion. In fact, if you take a stock chart, and turn it upside down, you will see that it may not look like the pattern right side up. There is a skew-like behavior, due to people's habits (wishing not to take a loss and jumping on a bandwagon are two likely explanations for part of this behavior). Research suggests this happens, or as market investors like to say ‘the trend is your friend’. So a pure random walk is likely not true.

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Some other efficient market anomalies that cannot be explained include: 1. Calendar Effects – certain months seem to favor small company stocks (the January effect) 2. Small Firm Effects – small firms tend to earn greater returns than larger ones (even after adjustment of risk) 3. Earnings Surprise Effects – prices do not adjust immediately to earnings announcement surprises 4. P/E Effects – studies show low P/E stocks do outperform high P/E ones

Behavioral Finance Behavior finance undertakes to explain some of the unusual behavior in stock prices and the markets. It notes people have certain ‘wired traits’ that may account for stock performance. These include: 1. 2. 3. 4. 5. 6.

Overconfidence in their judgement (underestimate risk) Biased Self Attribution (take credit for success and blame others for failures) Loss aversion (failure to sell stocks when they should) Representativeness (failure to use statistically significant samples) Narrow Framing (may sub-optimize decision making) Perseverance of false beliefs (ignore facts that do not fit their hypothesis)

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These traits lead to certain predictions about stock price movement: 1. The trend is your friend (investors hold their beliefs too long). 2. Growth performs less well than value (investors are overly optimistic about future growth). 3. Herding effects are collective behavior that may not be helpful in picking stocks.

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Chapter 10: Fixed Income Securities What is a Bond? A bond is a long term debt instrument. Investors lend money to an organization in return for interest and eventual payment of the amount of money lent. Bonds are sometimes referred to as fixed income securities because debt payments are fixed. Bonds offer two types of return 1. Current income 2. Capital gains or losses Current income comes from the coupons or interest paid by the organization to the investor. Capital gains or losses come from the gain or loss in the value of the bond. Note that interest rates and bond prices move in opposite directions. As rates increase, you can lend money to an organization and get a higher return. For those who have already lent money at a lower rate of interest, the value of their bond must fall so that its interest rate equals that of the current rate (otherwise someone could sell their lower interest bond, and buy a higher interest rate bond without penalty and with an instant increase in the interest payment – the market would not allow such an inefficiency). Bonds sell at a premium or a discount. What does this mean? It all depends upon the period of time examined, but in general bonds are less risky than stocks, so they offer less return. Risks from bonds are classified as 1. Interest rate risk (rates and prices move in ops directions – so if rates rise, the bond's value will fall) 2. Purchase power risk (inflation rates may exceed the interest rate on the bond) 3. Financial risk (the organization that issues the bond may fail to pay) 4. Liquidity risk (the bond market is an over the counter market and it is not always easy to sell bonds to someone else) 5. Call risk (some bonds come with a 'call provision' which means that it may be paid back prior to when you expect it)

Parameters of a Bond Coupon or coupon rate is the percentage amount of interest paid each year to the bondholder by the bond issuer. Current Yield is the ratio of the annual interest payment divided by the bond price excluding any interest accrued or the most recent coupon payment. Principal is the original amount of a bond on which interest is being calculated. Maturity Date is the date of final payment of a bond at which time the principal due and any remaining interest is paid.

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Interactive: Let’s look at the Treasury Yields Workspace in Telemet >>From any Telemet Window select ‘Display’>Fixed Income>Yield Curves

Telemet shows and charts in this workspace Treasury Yields for 3 month through 30 year.

Bond Prices How is a bond priced? Its present value is a function of the future cash flows. These cash flows are the interest payments and the par value (amount paid) at maturity. Bond price = (interest income) x (present value interest factor for an annuity) plus (Par value of the bond) x (present value factor for a single cash flow)

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Bond Valuation In the markets, a bond is evaluated based upon its yield – that is its return. Three different yields to understand: 1. Current Yield (annual interest/current price) 2. Yield to Maturity (the internal rate of return (IRR) of the cash flows). Note the computation builds in that interest is made on the cash flows from the bond interest payments at the IRR. You may or may not receive the full yield to maturity because you may not reinvest the cash flows at the internal rate of return. 3. Yield to Call is computed like yield to maturity but only based upon payments until the issue is called (and the final cash flow at whatever price it may be called)

Duration Duration is the bond price sensitivity to small interest rate changes. For math majors, it is like the first derivative of the bond price to interest rates. Note that YTM (yield to maturity) has a built in assumption that an investor can reinvest the interest payments at the IRR. If rates move downward, the investor is unlikely to do this. What affects the duration? Size of the interest payments, their frequency and the time to maturity. Larger payments will increase the risk that an investor cannot reinvest the interest payments at the IRR and produce shorter durations. If there are more payments this increases the risk of not being able to reinvest at the IRR. The time to maturity affects the price swing of the bond (longer maturities mean wider price swings and longer durations) How is it computed? The so called Macaulay Duration (person that described this concept) is: The sum of the present value of the coupons and future payment of principal multiplied times the year in which the payments are made divided by the current price of the bond. Duration is considered the weighted average life of the bond. Portfolios duration of bonds is just weighted average of the duration of each bond. And note that the modified maturity is defined as the Macaulay duration divided by 1+YTM. This is in fact the derivative of the price of the bond to interest rate and can be used to see how a bond price will change for small changes in interest rates.

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Immunization Matching modified duration of the bond portfolio to the investment horizon. If an investor wants to receive a certain amount of cash at a specified future date without worrying about the changes in real rates, the investor creates a portfolio of bonds where the modified duration equals the time horizon. Note not passive because the duration changes with time and with changing interest rates. The investor must continually rebalance the portfolio.

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Chapter 11: Mutual Funds A mutual fund is a financial service organization that receives money from shareholders then invests those funds in a variety of securities. Buying a fund means that the shareholders become part owners of a diversified portfolio. Securities are selected by a professional manager. Believe it or not, there are more mutual funds than U.S. stocks.

Benefits Wide diversification (which lowers unsystematic risk) at a low entry cost. There is a professional manager watching and selecting investments. They are easy to acquire.

Drawbacks High transaction costs (management fees, sales fees, load charges, etc). In general the professional managers do not beat market averages.

More on Mutual Funds Market values move up and down based upon the underlying security prices. Capital Gains and losses and dividends are sent to shareholders on a pro rata basis (Investors receive a form with the amounts each year - called a 1099). A mutual fund is actually a variety of institutions: The management company runs day-to-day ops and is usually the investment advisor too. It gets a management fee from the shareholders to pay its expenses and make a profit. The investment advisor oversees the portfolio – there are three players as part of the advisor organization. (1) the traders (executes trades on behalf of the fund); (2) the analysts (who provide security valuations and make recommendations); (3) the money (or portfolio) manager (who runs the portfolio) who actually decides what to buy and sell. The distributor who is the sales organization and sells the funds to banks, securities firms or to the public and gets a fee from the management company for doing this. The custodian who physically safeguards the securities and is independent of the distributor, management company and advisor (this provides a level of protection to the investors of the fund - and it is usually a bank). The transfer agent who keeps track of the purchases and redemption requests from the shareholders and maintains shareholder records.

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Types of Funds Open-end Fund Investors buy and sell shares from and to the fund directly in an open-end fund. An investor is simply issued new shares, and there is no limit to the number of shares that the open-end fund may sell. This is the most popular type of fund, over 95% of Assets Under Management in funds are this type of fund.

Closed-end Fund Closed-end funds are the opposite because there is a fixed number of shares. These shares trade on the markets all day and investors buy and sell shares from each other.

Interactive: Let’s look at a Quote for a Closed-end Mutual Fund in Telemet >>From the Start Screen select the ‘Snap Quote’ in the upper right>Enter Ticker: GAB

Telemet shows a quote for a closed-end fund known as an equity trust called the Gabelli Equity Trust. Mario Gabelli is a popular and well known figure in the investment community. Because shares of a closed investment company trade freely there may be a difference between the underlying value of the assets of the trust and the traded value on the exchange. These are called either premiums or discounts to their underlying value. When an investor buys or sells a closed end fund, he will pay a broker commission.

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Investment management style differences exist between closed-end and open-end funds. Open-end funds are continually experiencing flows in and out as investors buy or sell the fund. Thus the managers must put money to work quickly and have ready reserves for redemptions. Closed-end fund managers are not under these constraints and can be more aggressive if they need be since they have a fixed, known amount of cash to work with.

Exchange Traded Funds ETFs are a hybrid between closed-end and open-end funds. As their name implies they are traded on the exchanges. They are generally an open-end mutual fund (there are two other types: unit investment trusts and grantor trusts) that trades on an exchange. Additional shares of the ETF can be created or redeemed but when they are, a ‘payment in kind creation unit’ is used – a portfolio of the underlying stocks is deposited with a trustee by an exchange participant (authorized participant). The trustee than returns the participant new ETF shares to sell. Redemption works in the opposite manner, the participant's shares are returned. All this works without the shareholder having to get involved with the details. The benefit is that ETFs trade all day so they are liquid. ETFs may be bought on margin, and sold short. They rarely distribute gains and losses so there is no tax (until the investor closes out their position).

Fees for Mutual Funds Briefly mentioned above are the open end fund fees. There are several types of fees and investors should be aware of them. Load fees are commissions investors pay when purchasing a fund. They are called front-end loads. Some funds have are no-load and do not have commissions. However there may be other fees called 12(b)-1 fees and are designed to make up for the lost commissions (they are sometimes referred to as hidden loads. So investors have to ask for the load fees, the 12(b)-1 fees and the management fees to get a feel for the entire fee picture. The SEC has mandated overall caps on the fees (8.5%) and caps on the maximum 12(b)-1 fee that can be charged (0.25%) and still be called a no-load fund. Organizations such as Morningstar, Quicken, Kiplinger and Yahoo! keep investors aware of these fees.

Real Estate Investment Trusts REITs are a special type of closed end fund that invests in properties or mortgages or both. Investors are attracted to the high yields of REITs but dividends from these investments are taxed at ordinary rates (and do not qualify for special breaks on taxes given to shareholders that own other publicly traded companies - which are taxed at a maximum of 15%).

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Hedge Funds Hedge funds are not really funds at all but are limited partnerships. A general partner runs the fund and takes an upside fee of 10-20% and a management fee of 1-2%. The general partner does not get the upside fee if the fund loses money. So the fund manager has a different incentive structure than the limited partners (investors). How might this affect the general partner's views of investments?

More on Types of Funds (type, sector, industry, style, etc.) Growth funds focus on capital appreciation and usually invest in large, well known companies. Aggressive Growth funds look for large gains and invest in smaller companies Value funds use fundamental analysis to find undervalued companies before the rest of the market does. Equity Income funds invest in high yield (dividend) stocks Balanced funds hold both stocks and bonds (30-40%), the stocks selected for long term growth and the bonds for income. Growth and Income funds hold mostly stocks (90%) and place emphasis on growth companies. Bond funds invest only in bonds, corporate, treasury, etc. They are further classified by the type of bonds held. They have the advantage that they are more liquid than owning bonds directly. MBS, government, muni, high yield, high grade, convertible, intermediate term funds are among the types of bond funds. Money Market funds buy short-term treasuries and other fixed income instruments. They are further classified into government (invest only in government securities), general purpose (invest in a wide variety of fixed instruments), and tax exempt (invest in tax exempt instruments). Index funds buy a basket of shares that matches the weights in a popular index, Vanguard was the first to pioneer the S&P500 index fund and now there are funds for many popular indices. Sector funds buy only investments in a particular market sector or segment. Socially Responsible funds consider the moral, ethical and environmental issues when buying shares and make judgements on whether to buy certain issues based on their judgement of these issues before considering returns to shareholders. Asset Allocation funds buy securities across sectors and first consider the percentage mix of U.S. Equities, Bonds, foreign securities, money markets, etc. International funds, as the name implies, buy exclusively foreign securities. Investors that want exposure to foreign stocks will purchase an international fund as a way to add this exposure. Some funds invest only in certain geographic areas and within this group of funds, there are sub-categories of growth, value, bond, etc.

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Investor Services Mutual fund companies offer several convenient services to attract shareholders including: Automatic Investment Plans allow investors to make automatic investments in funds from their savings or checking accounts. Automatic Reinvestment Plans allow investors to take dividends from the fund they own and automatically reinvest it in the fund. Systematic Withdrawal Plans allow investors to automatically receive checks from their fund so that they may have a steady source of cash each month. Conversion Privileges allow investors to move money from one fund to another within a family of funds avoiding load charges. Family of Funds are a group of funds offered by one management company. Offering conversion privileges simplifies, and lowers the costs of, the buying and selling for the investor and of course also is advantageous to the management company. It keeps the investor within the same management company and thus preserves management company fees. Retirement Programs allow self employed individuals and others to set up tax advantaged ways to purchase mutual funds in IRAs, 401Ks and self directed retirement plans (SEP). This helps management companies gather assets and helps investors save for retirement.

Investing and Selecting Funds Start with investment objectives (return, risk tolerance, no expertise in an area, etc.) Is the use of the fund to accumulate wealth, store value, speculate? Sources of detailed information include: Morningstar, The Wall Street Journal, Value Line Mutual Fund Survey, Money, Fortune, Forbes, etc.

Loads vs. No-Loads There is no credible evidence that funds that charge loads produce any better results than those that do not. Since loads (and 12(b)-1 fees) are extra charges which subtract from performance, avoid funds with load fees.

Closed-end vs. Open-end Funds Closed-end funds represent only 3% of the fund assets under management. Obviously openend funds have been very successful in gathering assets. Closed-end funds have been great at creating bond funds (they control 60% of these assets). It has been shown that it is better to buy a closed-end fund when the security is trading at a deep discount to the net asset value. Morningstar and Value line offer a wealth of information on closed-end funds.

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Past Performance Past performance for a fund includes both dividend and interest income (from the underlying securities). It is paid to investors after all the fees permitted to be charged have been charged to the shareholders of the fund. The fund passes through to shareholders the net of dividends, interest less fees. The fund itself is not taxed on these dividends and interest, but the shareholder is if the fund is not owned in a tax sheltered vehicle (like a 401K or SEP). When the fund distributes the dividends and interest, it identifies that portion which is subject to the special common stock dividend rate (currently 15%). Capital gains from the fund work the same way as dividends. Gains in the fund are reported when realized and are distributed to shareholders as either long term (if the fund has held them long term) or short term. Funds do not have to mark-to-market or report gains that are only 'on paper'. The paper gains and or losses of a fund make up the NAV of the fund. The shareholder has a gain if he or she sells the fund at a profit. For closed end funds, an additional source of return is the trading price of the fund as the premium or discount changes. If it moves from deep discount of net asset value to par, or a premium to net asset value, this additional return is the shareholders obviously and reflected in the market price of the fund.

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Chapter 12: Portfolio – Putting Ideas Learned to Work Investors Should Be Clear About Their Objectives Retirees will want a more conservative approach which may emphasize dividend yield and income. A younger person with a larger, steady income may be able to accept more risk in the hopes of improving net worth over the long term. If the investor is a retiree, low beta stocks with high yields may be a good choice. Here is a checklist the investor should assess and answer: 1. 2. 3. 4. 5.

Current income needs Capital preservation needs Capital growth needs Tax considerations Risk aversion

If 1 and 2 above are important, a conservative approach like that of the retiree is used. If 3 is important, then there will be more risk and more chance of a longer term higher return If 4 above is important, the investor is in a high tax bracket, then long term capital gains and municipals are appropriate Number 5, risk is important for all investors, and should be considered no matter what the rest of the objectives are.

First Step: Asset Allocation Asset allocation divides investments into broad classes (equities, bonds, foreign securities, gold, real estate, etc.) Allocation uses either fixed weights, flexible weights, or tactical measures. Fixed allocation is what it says. The investor chooses a percentage of his or her wealth to be in particular asset classes. The investor then, perhaps once per year, adjusts the amounts in each class (based upon moves in each class) to maintain the fixed weights. A retiree may have an allocation like: U.S. Stocks U.S. Bonds Foreign Stocks Cash equivalents

20% 60% 10% 10%

A younger person with a steady income might have an allocation like: U.S. Stocks U.S. Bonds Foreign Stocks Cash equivalents

75% 10% 20% 5%

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Flexible weights scheme called strategic asset allocation. Weights are adjusted based upon market conditions, such as higher inflation or changes in economic growth prospects. Tactical allocation is a market timing approach that uses derivatives to switch allocations. Derivatives such as stock index futures and bond index futures are used to quickly change allocations. It is used by larger institutions. For any asset allocation, each class should be examined for its returns, risks, tax effects, and income. The allocation decisions should be ones the investor can be comfortable with over a 10 year or more time horizon.

Performance Data There are many sources of data and Telemet Finance Lab contains much of what you need. You will need information about how the economy is performing and its future prospects. You will also need information about how individual sectors, industries and securities are performing and their prospects.

Current Market Information Interactive: Let’s look at an Intraday Portfolio Holdings Page in Telemet >>From Telemet Manager, select ‘Display’>Portfolio Analytics>Holdings

Telemet shows the holdings as well as the prices and valuations based upon the current prices.

The Economic Landscape The Wall Street Journal, the Economist, Forbes and Fortune are among the many print journals that keep continuous tabs on the economy. In addition, Telemet shows the trends in many economic indicators that foretell of future conditions. Within the ‘Economy’ area of the Telemet Manager, you will find many useful economic data:

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Producer Price Index Industrial Production Personal Consumption Employment Data Key Rates and Currencies List of 100+ Economic Indicators Retail Sales

Consumer Price Index Capacity Utilization Housing Data Gross Domestic Product Corporate Profits US Money Supply Personal Income

Interactive: Let’s look at the Employment Workspace in Telemet >>From Telemet Manager, double-click on ‘Employment’ within the ‘Economy’ group

Telemet shows the unemployment rate decreasing over the past 8 years, a positive sign.

Indices as Measures of Performance Thousands of indices can be used to measure market performance. Different indices measure different views of the market. The Dow Jones industrial average is not representative of the entire market because it consists only of 30 stocks, equally weighted. The S&P 500 consists of mostly large capitalization stocks. For an overall view of the market, the Russell 3000 may be a better judge of the market's performance. Investment managers pick indices to measure their performance against a benchmark based upon their style of investing. If they are large cap managers, then the S&P 500 is a good measure, but if they are small cap managers, then other indices may be more appropriate. Obviously bond managers would use a bond index.

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Interactive: Let’s look at the Major Indices Workspace in Telemet Finance Lab >>From any Telemet Window, select ‘Display’>Pages>Open scroll and select ‘Indices’

Telemet shows thousands of real-time equity, fixed income, international and commodity indices

Sector Allocation After asset allocation, the investor should consider sector and industry allocations. Economic and market factors dictate whether to overweight or underweight a sector or industry. Here are the 10 sectors as defined by Standard & Poors (Russell uses a different 12 sector set). 1. 2. 3. 4. 5.

Consumer Discretionary Consumer Staples Energy Financials Health Care

6. Industrials 7. Information Technology 8. Materials 9. Telecommunications 10. Utilities

In weak economic climates, consumer staples stocks are considered the best and should be overweighted. Purchases of Consumer Discretionary items are by definition postponed during hard times.

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Interactive: Let’s look at a Portfolio Balance Report in Telemet Finance Lab >>From any Telemet Window, select “Display”> Portfolio Analytics>Balance, select “Account”> Telemet Lists>Lipton’s Sample Acct; at ‘Select Benchmark’ > ‘Telemet 500 Equal Weights’ >>You may select today’s date and then click ‘Finish’

Portfolio Balance shows the sector weights on the portfolio and on the Telemet 500 benchmark.

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>>Now, within the same Portfolio Balance display, click on the toolbar button ‘Sector Allocation vs Benchmark in Table and Pie Chart’ (hint: it is the 7th toolbar button from the right)

Here is another view of the Portfolio Balance Report showing table and pie chart sector weights.

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>>Again, within the same Portfolio Balance display, click the toolbar button ‘Absolute Weights’ (Hint: it is the 10th toolbar button from the right shall we delete the hint/need to count? Faster option?)

Telemet shows the industries and stocks that are in this portfolio in the health care sector

Telemet shows over and under weights of a portfolio compared to the Telemet 500 benchmark

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>>One more time, within the same Portfolio Balance display, click the toolbar button ‘Differential Weights’

Financials and Health Care are underweighted, while Communications and Industrials are overweighted.

Once the sector over and under weights are chosen, industry weights may be selected for each sector. The first Portfolio Balance Report shows an example of the Consumer Discretionary, Consumer Staples and Energy sectors.

Stock Selection and Performance Measurement Principals discussed previously should be used to select stocks in the sectors and industries that the investor decides should be over weighted. Returns may be measured as before with both capital appreciation and dividend income included. The Holding Period Return (HPR) is simply the returns obtained from the time of purchase to the time of sale of a security. Total Return = Capital Appreciation + Dividends Each dividend period should be calculated separately and the results combined based on assumptions regarding dividend reinvestment and the timing of that reinvestment.

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These calculations are automatically computed by Telemet. Below is an example for a sample portfolio account. Unrealized gains are gains that are paper profits; that is the stock has not yet been sold from the portfolio.

Interactive: Let’s look at a Portfolio Performance Report in Telemet Finance Lab >>From any Telemet Window, select ‘Display’>Portfolio Analytics, then select ‘Performance by Security’ >>At ‘Date’, choose today’s date for for year-to-date report >>At ‘Calculation Method’ choose ‘TWRR-Daily Valuation Method’ >>At ‘Source of Income Data’ choose ‘Telemet Data’ >>At ‘Cost of Shares Sold’ choose ‘Average Basis’ and then click ‘Finish’

Portfolio Performance Report shows realized gains, unrealized gains and the dividend income for a year-to-date period, along with the total return for this period.

Comparing Returns to the Market Indices Telemet Finance Lab has a valuation screen to compare the investment returns to the market. In fact, it compares each sector's return to the return of the S&P500 sector for the same period. That way, the investor can see whether returns are beating sector averages or not.

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Interactive: Let’s look at a Portfolio Valuation Workspace in Telemet Finance Lab >>From any Telemet Window, select ‘Display’>Pages>Open>Select ‘Valuation with Sector Summary’>ok

Telemet shows the performance for each sector of a portfolio and compares it to the S&P500. An investor can also see the total return for any stock in the portfolio and compare this to the average sector return in order to see if that stock is contributing positively to the portfolio's return.

Telemet shows the total return for each stock and compares it to the performance of the S&P sector to which that stock belongs. Hint: double-click on ‘Total Return’ within ‘Portfolio Analytics’

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Attribution and Contribution Attribution and contribution analysis of a portfolio tells the investor in broad terms where the portfolio returns have come from. Recall the investor, after making asset class decisions, starts with sector allocation, then proceeds to select industries within the favored sectors, then picks what he or she thinks are the best stocks within each industry. After a suitable period the investor may see what is he or she is doing best and where the problems are within a portfolio. Naturally if the investor has only one portfolio, this job is relatively simple, compared to a professional investment manager who may look over 100 to 500 different portfolios.

Interactive: Let’s look at Multi-Style Attribution in Telemet Finance Lab >>From any Telemet Window, select ‘Display’>Portfolio Analytics, then select ‘Multi-Style Attribution’ >>Select ‘Lipton’s Sample Acct’ then click ‘Period’ tab >>At ‘Type’ select ‘YTD’ for year-to-date performance, then click ‘Benchmark’ tab >>Select ‘Telemet 500 Equal Weights’ then click ‘Analytics’ tab >>Select ‘GICS Sectors’ then click ‘Run’ >>Once task completed, in the top right corner dropdown menu, select ‘Attribution Analysis’

Telemet shows the return and weights for the portfolio, as well as the return and weights for the Telemet 500 Equal Weights benchmark. Telemet also shows how the portfolio performed in each sector compared to the Telemet 500. The Telemet 500 is an equally weighted S&P 500.

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>>In the same display and from the same dropdown menu, now select ‘Allocation Scatterplot’

A scatter plot shows the investor which sectors contributed best to the portfolio. The example above shows the portfolio overweight and outperforming in the Industrials and Energy sectors.

The ‘Contribution Summary’ is another report that details each company’s weight, return and contribution to the portfolio. Above, the Info Technology sector is the greatest contributor. *For more information on how these calculations are made, visit the ‘Multi-Style Attribution Information’ spreadsheet which can be found under the ‘Help’ menu in any Telemet window*

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Chapter 13: Options Note: This data set is included is not included in the premium package so may not be accessible to all users.

What are Options? Options are the right but not the obligation to purchase or sell a certain amount of a security at (or before) a date certain in the future. European style options grant rights only as of a certain date, whereas American style options grant rights any time before a specific date certain in the future. Options are in fact simply contracts between two parties. One investor who purchases the option has the right to exercise it, the counter party stands ready to meet that obligation. The most popular traded options are puts and calls. However there are other options: warrants (long term options), rights (very short term options) and other derivatives such as futures, which we will learn more about in the next chapter. With options the investor has purchased a leveraged investment and limited his or her losses to the purchase amount of the option.

Puts and Calls One put contract is a contract to allow an investor to put 100 shares of a stock to another party at a specific price within a certain time period in the future. One call contract allows an investor to call 100 shares of stock from another party at a specific price within a certain time period in the future. If they do this, it is called exercising the call. Consider the example shown on the following page for Apple Inc. Shown are the February 2011 calls. This means that these are contracts that expire at the end of the third week of February. The current stock price is $353.84. The calls can be purchased with strike prices between 155 and 400. The strike price – this is the price that the stock may called (purchased at) between now and the 3rd week in February. Calls with strike prices below the AAPL market price ($353.84) are called in the money. Calls with strike prices above the market price are out of the money. Remember that if the strike price is below the current stock price then the option is in the money. If the strike price is above the current stock price then the option is out of the money.

In the Money Calls Note the price of the 230 call which is in the money and $127.60. Naturally it is expensive because when purchased it permits the investor to call or purchase 100 shares at $230. However the market price is $353.84, so the price of the call is bid up and the actual cost to get the stock is $127.60 + $230 = $357.60. This is more than the cost of the stock alone. Why do this call if the investor can buy the stock for $353.84 right now? Because of the call’s time value. There is a distinct possibility that the stock will rise between now and expiration. The owner of the call gets an additional benefit if the stock goes way up and gets another benefit if the stock goes way down. Given that the stock trades up and down (volatility) there is the possibility that it will rise. If you bought the stock at $230 today, you are betting that there is enough volatility so that the stock could sometime between now and the third week if February, be much higher in price.

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The Greeks (Delta, Vega, Theta, Rho and Gamma) come from the Black-Scholes model and measure the risk or sensitivity of the value of the option to a change in the underlying parameters of the option. measures the rate of change of option value with respect to changes in the underlying asset's price. Delta is the first derivative of the option value with respect to the underlying stock price. One could gather that with the Delta value for AAPL being 1.0 for the 230 call, the price of the stock could potentially increase by 10% (1.0 x 10). Let’s suppose that tomorrow it rises 10% or $35.38. Now the stock is trading at $389.22. What will the call price be? Likely around $392.98 (strike + call option price) minus $230 (strike price) or $162.98. So the stock went up 10% but the call increased by 27%! This is known as leverage and that is why the price premium is built in. You cannot lose more than $127.60 because if for some reason AAPL dropped to below $176.92, you would loose one half of your money or $176.92. But the option total cost was $127.60, and you are not forced to exercise it, so your maximim loss is $127.60.

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Interactive: Let’s look at Real-Time Ccall Options in Telemet Finance Lab >>From any Telemet Window, select ‘Display’>Options>Montage>Enter ticker AAPL

Telemet shows real-time call options with February 2011 expiration for Apple Inc (AAPL).

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Telemet shows real-time call options with December 2018 expiration for Apple Inc (AAPL). To view only ‘Calls’ select ‘Options’ in the header, and select ‘Show Calls’: You may select only “Puts” by selecting ‘Show Puts”

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Out of the Money Calls Out of the money calls can sometimes have more leverage than in the money calls, but if they are way out of the money they do not have much leverage at all. Here is why. If they are way out of the money, they may not move much at all if the stock goes up (because the probability of the stock moving very high is remote). But if they are close to being in the money they can have a lot of leverage. Shown below is an example of November 2008 calls for IBM Corp.

Telemet shows real-time call options with December 2018 expiration for IBM Corp (IBM). Look at the November 120 calls. They sell for $2.25. Let us say the stock goes up $10. Now the stock is $113.44. The calls will go up to about $0.80 so they move to $3.05. So the gain is $0.80 divided by $2.25 or 35%. If we go further out of the money, say to the November 130 calls and the stock goes up $10, the gain will be about $0.10 and they cost $0.60 so the gain is only 16%. There are special calculations to estimate the value of a call or put contract. The Black Scholes model values puts and calls based upon a bell curve. Another model is the binomial model. Remember these calculations are just models and depend upon normal statistics. It is known that normal statistics do not apply to stock prices – they are just the best model available. The column labeled ‘T-Val’ on the previous table shows the Theoretical Value based upon the Black Scholes model. The following page explains more on the Black-Scholes model.

Black-Scholes Model Black-Scholes is a model used to evaluate the sensitivity of an option to its underlying variables. The model can produce a Theoretical Value for an option, the Implied Volatility based upon the option’s current price, and:

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the option’s sensitivity to expiration time (the decrease in the option’s value as a function of time alone – known as theta), the option’s sensitivity to changes in interest rate (the increase or decrease in the option’s value as a function of the short term interest rate – known as rho), the option’s sensitivity to volatility of the underlying stock (the increase or decrease in the option’s value as a function of volatility alone – known as vega), the option’s sensitivity to changes in the underlying stock price (the increase or decrease in the option’s value as a function of the stock price alone – known as delta), the option’s delta sensitivity changes in the underlying stock price (the increase or decrease in the option’s delta as a function of the underlying stock price – known as gamma) The Black-Scholes formula calculates the price of a call option to be: C = S N(d1) - X e-rT N(d2) where C = price of the call option S = price of the underlying stock X = option exercise price r = risk-free interest rate T = current time until expiration N() = area under the normal curve d1 = [ ln(S/X) + (r + σ2/2) T ] / σ T1/2 d2 = d1 - σ T1/2 Put-call parity requires that: P = C - S + Xe-rT Then the price of a put option is: P = Xe-rT N(-d2) - S N(-d1)

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Chapter 14: Futures and Commodities Note: This data set is included is not included in the premium package so may not be accessible to all users.

What are Futures? A future is a commitment to deliver a certain amount of a specified item at a specific date in the future at an agreed price. In the organized futures market, each commitment has its own specific contract specifications, amounts, delivery procedures and delivery dates.

Trading hours Each contract is developed and traded on a specific exchange. Each exchange has its own trading hours which differ from those of the ordinary hours of the stock and options exchanges.

Interactive: Let’s look at Futures in Telemet Finance Lab >>From any Telemet Window, select Display>Pages>Open>Futures

Telemet shows the ‘near term’ contracts (the next term contracts set to expire) for some agriculture, energy and index futures. Shown are the contract expiration dates, the exchange that trades the contract, the name, the last price, the last trade date and the last trade time.

Cost for Contract The second line of the above table shows Coffee "C" trading at 259.9. This price is in cents.

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Here are the terms and specifications for the contract as shown on the ICE website: “The Coffee C contract is the world benchmark for Arabica coffee. The contract prices physical delivery of exchange-gradegreen beans, from one of 19 countries of origin in a licensed warehouse to one of several ports in the U. S. and Europe, withstated premiums/discounts for ports and growths.” The contract size for Coffee C is 37,500 pounds. Since the price is 259.9 and contract size is 37,500 pounds, the cost of a contract is $97,462.50. The investor does not pay the full $97,462.50 but rather a fraction of it – considered a security deposit. The amount of the deposit depends on the contract and exchange but is typically between 2–10% of the value. This is called buying on margin.

The Larger Exchanges The Chicago Board of Trade (CBT) opened in 1848 and was the oldest exchange. It was purchased by the most active exchange quite recently (in 2008) by the Chicago Mercantile Exchange. The CME recently also started an electronic exchange called CME Globex and trades 23 hours each business day. Since it is open in all time zones, it has become a defacto standard for the Eurodollar contract (this contract delivers Euros in exchange for dollars).

Trading the Markets There are two types of traders called hedgers and speculators, and both are necessary. The hedgers are producers, consumers, and processors that use these contracts to protect their interests in an underlying commodity. The hedge by Southwest Airlines allowed Southwest to purchase oil for its aircraft at lower than market prices. Southwest bought contracts for future delivery so that it would know with a high degree of certainty what its fuel costs would be. Thus when fuel prices rose, it was able to maintain its cost structure and profitability long after other airlines were losing money because of the high costs of jet fuel. The speculators give the market liquidity. They trade to earn a profit and take risks betting that prices will rise or fall. They have no interest in actually taking delivery and in fact, do nothing more than shift demand to a different moment. They do not affect long term demand at all, because for every contract purchased, they sell one at a later date. Buying a contract or contracts is considered taking a long position. Selling a contract or contracts is considered taking a short position.

Margin The margin deposit is the term used for the amount put up to go long or short on the position.

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This deposit is not related to the size of the contract, nor is it a partial payment for the contract. There are two types of margin deposits. The initial deposit is the amount of money that the investor must put up to initiate the transaction. The maintenance deposit is additional money that may be required if the contract price decreases (if the investor is long on the contract) and is termed a margin call. The margin calls may come at the end of any trading session because each contract position for each investor is marked to the market. If there is not enough money in the account, the broker will call the investor and it is the margin call.

The coffee futures shown are the contract names with expiration, the last price, the net change, the net percentage change, the trade date and trade time.

Return on Capital Futures have only one source of return and that is capital gains. There are no dividends associated with any futures. The return is the profit (or loss) divided by the invested capital (this is the initial margin and any maintenance deposits). Looking at coffee for example. If we had bought at the settle or close price yesterday, the investor would have paid $2.5805/lb for 37,500 pounds of Coffee “C”. If the investor sold it today at the current price of $2.5909 the investor would have a gain of $0.0104 per pound or $390. The initial margin for coffee C is $6,300 (per ICE website). So the return on capital is: Return on capital is $390/$6,300 or 6% for less than one day. Clearly the margin creates huge opportunities for gain and loss for small amounts of capital. The exchanges put price limits on to protect investors and themselves. Daily price limits are limits that the price may move in any day. If it moves more the markets are shut for that commodity. There are also maximum ranges per day imposed.

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A commodity investor can get trapped with large losses if the market moves limit down early in a day and is unable to sell the contract. Cases are know where the market may move limit down several days in a row, and the investor is trapped with large losses, unable to close out the futures contract even if they want to do so. Remember there is no limit to the loss the investor may get with a futures contract.

Three Trading Strategies Speculating, hedging and spreading. Speculating and hedging have been described above, but spreading has not. Spreading involves selling one contract month for a commodity and buying another month in the same commodity. The hope is that the spread either narrows or widens creating a profit opportunity. This limits the leverage obtained with the margin, since if the two months are not far apart, they tend to move together.

Financial Futures The futures market was traditionally a agricultural market, but with the advent of global trade, financial turmoil in the 1970s and other factors, the exchanges launched financial and currency futures contracts as new products. Financial futures can hedge against changes in interest rates, changes in currency rates and other items. Note that an investor can hedge interest rates, on short, intermediate and long term bonds as well as currencies such as the British Pound, and the Euro. These hedges are valuable if the investor is being paid for services or goods in a foreign currency and would like to be assured that they are protected against fluctuations in that currency.

Telemet shows the contract name with expiration, the last price, the net change, the net percentage change, the trade date, the trade time and the previous day close. The contracts above are for interest rate and currency futures and these are the near term contracts.

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Appendix: Useful Resources To Learn Telemet Finance Lab To most successfully complete this curriculum we recommend that you view our training tips videos available on Telemet Finance Lab Help at: http://www.taquote.com/training/demos/index.html Our Client Services team is available to assist via Live Chat or by phone at 800.368.2078 on Monday-Friday from 8:30am to 7:30pm. Recommended Video:        

Time Saving Tips & Tricks, June 2018 Searching For and Ranking Potential Investments Search Screens, February 2017 Company Financial Reports, October 2018 Powerful Charting, February 2018 Multi-style Attribution Professional Charting Made Easy Utilizing Economic Data, August 2016

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