GENERAL INVESTMENT ANALYSIS

1
GENERAL INVESTMENT ANALYSIS

• INVESTORS NEED TO
• gather (info services)
• process (computer)
• and interpret (models) information
• then make logical investment decisions
• fits many skilled job requirements - not just
  invest.

2
STEPS TO SELECTING AMONG SICs and COMPANIES
(STOCKS) IN YOUR SIC
1. Choose an SIC for which detailed knowledge of
such financial group offers you some benefit -
better performance in present job - potential
for future employment - better personal
financial success. 2. Among SICs that fit
criterion (1) consider an SIC you expect to
benefit from economic trends. 3. Gather
information on general industry trends and
important factors that determine what types of
companies in your SIC will be most
successful. 4. Gather information on all
companies in the SIC - select the stocks of the
most promising companies.
3
INFORMATION TYPES

• 1. Direct information from financial statements,
• newspapers, internet etc.
• financial position - ratios, etc.
• differential strengths - patents, size,
  economies of
• scale, scientists, brand name
• read brokerage reports - especially those that
  compare competing firms
• consider past and potential future growth of
  total market and firms market share

4

• 2. Indirect information
• stock ownership of management
• level and incentives in management pay
• ownership of institutional investors
• management credentials and experience
• suppliers and partners - call and question
• customers - call and question

5

• customer service and product distribution
• test products yourself - ask others their
  opinion
• of products - store sales people
• watch for price cutting
• check competitors products and potential
• competitors outside the industry
• technical analysis - let the market lead you

6
Financial Systems

• 1. Financial Systems not just Intermediaries
• Financial intermediaries compete with financial
  markets in an innovation spiral.
• Both facilitate financial trade with
  services/products.
• Financial intermediaries often buy illiquid and
  risky financial claims (corporate loans) and
  transform (engineer, produce) them into less
  risky, more liquid claims (demand deposits) -
  best for custom, illiquid, low-volume, complex
  assets.
• Financial markets provide a centralized place to
  trade financial claims - best for standardized,
  liquid, high-volume, simple products.

7
Financial System Global Flow of Funds
Full System
MARKETS
SURPLUSUNITS
DEFICIT UNITS
Intermediaries
The lines trace the flow of funds. Not shown is
the flow of securities, information, guarantees,
etc., flowing in the opposite direction.
8
Flow of Funds
Simple System
MARKTS
DEFICIT UNITS
SURPLUSUNITS
Examples Early history - lending to tribe,
family, friends. Recently - Boston Market
funds franchisees. - Firms sell
stocks and bonds on web directly to investors,
DRIPS. Question What problems may occur in these
examples? Question How can intermediaries help
solve the problems?
9
Flow of Funds
Intermediaries but no Markets Example Insurance
(exception, Llyods of London).
SURPLUSUNITS
DEFICIT UNITS
Intermediaries
10
Flow of Funds
Markets but no Intermediaries Example Stock
exchanges, ECNs like Instinet.
SURPLUSUNITS
DEFICIT UNITS
Markets
Question Salomon Brothers sold Bowie bonds
which pay investors coupons from the future
royalties from David Bowies record sales. Who
are the surplus and deficit units and the
market or intermediary?
11
Functional Perspective on Financial Intermediaries

• Six Primary Financial Functions
• Intermediaries come and go but their functions
  remain.
• Banks originated in Italy as money changers -
  Banca refers to money changers benches.
• In the U.S. banks largely pool deposits and lend
  whereas in Europe they perform many functions.
• Institutional form can be explained and changes
  predicted from competition within function.
• The proper question to answer is how best to
  satisfy customer demand for a function rather
  than which particular institution usually
  handles the function.

12
Example of Institutional Form Following Function

• Suppose you want a levered position in the SP
  500.
• Buy the 500 individual stocks on margin (broker
  lending).
• Borrow and buy an SP 500 index fund/unit trust.
• Buy an SP 500 futures contract.
• Buy an SP 500 forward contract.
• Enter into an SP 500 for LIBOR swap contract.
• Buy SP 500 call options and sell SP 500 put
  options.
• Buy a bond that pays a coupons based on the SP
  500.
• Buy a CD that pays a return based on the SP
  500.
• Buy a variable annuity linked to the SP 500.

13
Function 1

• 1. Clearing and settling transactions to
  facilitate trade in goods, services and
  financial products.
• Barter makes trade time consuming and costly.
• Using gold is cheaper and more convenient.
• Currency is even better (flooz,beenz).
• Checks, credit cards, travelers checks.

14
Function 2

• 2. Provide information directly or implicitly in
  prices.
• Interest rates encourage (discourage)
  savings/investment.
• Stock prices signal business to expand - brand
  value.
• Index options provide information on market risk
  (VIX).
• Intermediaries sell investment information and
  advice.
• You can hire a real estate appraiser or set the
  price of your house by using the price of recent
  sales.

15
Function 3

• 3. Alleviating incentive problems.
• Problems occur when one party to a trade has
  more information than another - reduces or stops
  trade.
• Type 1 Moral Hazard - after insuring,
  risk-taking behavior changes - Boston Market.
• Type 2 Adverse Selection - after setting a
  fixed premium, only poor risks find it
  attractive - lemons.
• Type 3 Principal/Agent - delegating stock
  selection - Merrill Lynch ad Whats your
  motivation.

16

• Occurs often because public ownership implies a
  separation between owners and managers of
  firms.
• Information gathering, convertible debt,
  collateral or compensation systems can
  alleviate the problems.
• Solving the problems increases trade and leaves
  both parties better off.

17
Function 4

• 4. Pooling funds and subdividing ownership
• Pooling facilitates risk diversification and
  financing of large projects.
• Subdividing facilitates risk transfer and
  ownership transfer - race horse syndicate on
  web.
• Spreads information gathering and trading costs
  over many investors.
• Berkshire Hathaway - 55,000 stock - facilitates
  pooling but not subdividing.

18
Function 5

• 5. Transfer resources across time, place and
  industry.
• The more developed and complex a country, the
  more important this is to an efficient financial
  system.
• Asset allocation funds.
• Old economy stocks versus new economy stocks.
• In Europe - people are selling bonds and buying
  stocks.
• Question Does the U.S. Social Security System
  satisfy this function?

19
Function 6

• 6. Risk management and transfer - the most
  important and fastest growing function.
• Management includes hedging, diversifying and
  insuring.
• Insurance transfers risk from policyholder to
  insurer.
• Insurance companies spread risk among policies.
• Bank transfers risk to loan co-signers -
  parents.
• Jewelry maker fixes metal costs in the futures
  market.
• Question What happens in agriculture price
  supports?
• Question Why do few people by hurricane
  insurance?

20

• Technology and communications advances reduce
  information and transactions costs, leading to
  more efficient responses to small changes in
  consumer tastes and economic events.
• Better information reduces incentive problems
  leaving risk management as most important - more
  class time.
• Firms shed risks they know little about and
  manage internally, risks in which they are
  expert.
• Intermediaries help match risk sellers with
  buyers.
• Securitization is exploding - markets match risk
  traders.
• Manger self-interest, progressive taxes and
  bankruptcy costs increase the demand for risk
  management.

21
The Changing Functions of Banks

• In the past, banks primarily settled customer
  transactions, pooled customer deposits and
  loaned funds locally.
• Now banks pool deposits and transfer funds
  nationally through securities such as
  mortgage-backed bonds.
• Loan origination, servicing and funding are now
  often done by specialist institutions with local
  banks focussing on origination and perhaps
  funding.
• Each institution focuses on its core competency
  - for a local bank- its competitive advantage is
  knowledge of local businesses and its proximity
  for monitoring. Their knowledge and monitoring
  generates valuable information and mitigates
  incentive problems.

22

• The clearing and settling functions of banks is
  less significant as money market funds have
  grown. Money market funds operating costs are
  ten time lower than those of banks.
• Given that money market funds invest in very
  highly rated securities, banks risk absorption
  function is less important.
• Banks risk management function is becoming more
  sophisticated as they resell loans or
  securitize them instead of holding mortgages
  and commercial loans on their books.

23
Future of Financial System

• Information scale economies leads to larger
  institutions.
• Large institutions reduce costs by netting
  transactions internally, cross-selling
  products, customize products.
• Financial research important to support complex
  products.
• With less risk kept internally, more firms
  remain privately held - less need for co-owner
  diversification.
• Individuals shift from direct financial holdings
  to specialized intermediary products.
• In 1966 (1995), individuals held 85 (52) of
  stocks.
• In 1966 (1995), individuals held 5 (25) of
  their stocks as mutual funds.

24

• Traditional strategies and technologies of
  intermediation are losing out to structured
  finance and market-making.
• Structuring securities and making markets for
  them relies on proprietary knowledge and models.
• Skill sets for doing this include, technological
  knowledge, analytic ability, customer and
  supplier networking as well as regulatory and
  political networking.

25
Finance Careers

• Basic Job Groupings
• Corporate Finance
• Investments
• CD-ROM - Careers in Finance
• www.careers-in-finance.com