Harvard Investment Association Investment Bootcamp Finance Fundamentals

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Harvard Investment Association Investment
Bootcamp Finance Fundamentals
October 7, 2006 (Saturday) 2 p.m. 5 p.m. Lamont
Forum Room
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Calendar of Events

• Intro to Stocks
• Trip to Harvard Management Company
• Speaker Event
• Intro to Bonds
• etc
• Full calendar on www.

• 10/10 (Tues)
• 10/12 (Thurs)
• 10/17 (Tues)
• 10/24 (Tues)
• harvardinvestment.org

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IBC OUTLINE

• Equities
• Fixed Income
• Investment Management
• Conclusions

4
Equities

• Ownership in a company that entitles the
  stockholder to a portion of the cash flows
• To get the financial capital the company needs,
  the owner divides his/her ownership of the
  company into a specific number of shares and
  sells, offers, a portion of these shares to
  investors.
• The process by which the owner receives the
  capital he needs for expansion from this sale of
  stock is called an initial public offering (IPO).

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Sources of Returns

• The value of a share of stock depends on the
  value of the company as a whole.
• A shareholder can benefit from an investment in
  different ways
• growth of a stock
• dividend payments

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Growth

• The stock price of a growing business, ought to
  increase as its profits increase.
• Examples
• A growing company making 10 million in profits
  and expected to make 13 million next year, will
  rise in value and its shares should follow.
• A firm that which has falling profits, one
  earning profits of 10 million, but expected to
  earn only 5 million the following year is
  decreasing in value and its price should fall.

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Dividends

• When a company decides that it does not need to
  plowback all of its earnings, it pays out some of
  these earnings in the form of dividends.
• Generally associated with mature companies.

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The Financial Pages

• Year-To-Date Change
• 52-Week High
• 52-Week Low
• Stock Name
• Stock Symbol
• Dividend
• Yield
• Volume Traded
• Daily Close Price
• Net Change

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Price/Earnings Ratio

• The P/E ratio is one tool investors use to
  determine the value of stocks.
• P/E market value per share / earnings-per-share
  (EPS) for the last 12 months.
• EPS total profit of the corporation during the
  last 12 months / total number of shares.
• (These two statistics are found in the annual and
  quarterly reports of the company).
• It is one of the primary measurements used to
  determine whether a stock is overvalued or
  undervalued.
• It is very difficult to come to any useful
  conclusions by simply considering the P/E of one
  company without making any comparisons.

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Comparable Multiples

• The ratio is most useful as a tool for
  comparison. Two of the most common comparisons
  made by investors are
• Between the P/E of a specific stock and average
  P/E of all the stocks on the respective stock
  exchange.
• Between the P/E of a specific stock and the
  average P/E of similar companies competing in the
  same industry.
• An example is the comparison of the P/E ratio of
  Standard Corporation to the average P/E ratio of
  all the stocks on the NYSE. This figure
  indicates, in a very general sense, if the stock
  is overvalued or undervalued relative to other
  stocks on the exchange.
• The variety of industries on the exchange make
  this comparison not extremely useful in
  investment decisions. An industry comparison is
  much more focused.

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P/E Comparison within Industries

• Compare the P/E ratio of General Motors to the
  P/Es of Ford and Chrysler (domestic auto
  makers).
• The investor can judge whether the stock of one
  company is relatively inexpensive by comparing it
  to the P/E ratios of the other two.
• The oil industry is one in which there are a
  large number of similar companies.
• An example is to compare the P/Es of Texaco
  against those of ExxonMobil, Occidental
  Petroleum, Chevron, Atlantic-Richfield and
  others.
• If the earnings prospects for all the firms are
  the same, and Texacos P/E ratio is lower than
  most of the other firms, Texaco will likely rise
  over the long term as its P/E rises to match the
  ratio of similar companies.

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Basic Reasons for High and Low P/Es

• It is not uncommon for two different Wall Street
  analysts to interpret the P/E ratio of the same
  company and come up with entirely different
  conclusions about the value of the stock.
• The most common cases of unusually high P/E
  ratios is when companies have very high growth
  rates.
• Because the P/E ratio uses one figure from the
  future (P) ad one figure from the past (E), and
  the two periods are drastically different, the
  P/E ratio can be exceptionally high.
• Why High Growth Companies Have High P/E Rations
• Price of Stock Based on high future
  performance Large P
• -------------------------------------------------
  ---------------------------- High P/E
• Earnings-per- Lower past earnings
  Small E
• Share

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The Financial Pages

• Certain types of companies often have predictable
  ratios.
• One type of industry that has had very consistent
  average P/Es in the past is the electrical
  utility industry because these companies were
  regulated by local governments which controlled
  their profits, keeping their profits consistent.
• Small high-technology companies in the computer
  and biotechnology industries often have P/E
  ratios relatively high compared to the rest of
  the market. These companies have potential for
  drastic changes in future earnings.
• The largest and most well known companies, the
  blue chip stocks, rarely will have P/E ratios
  that are extraordinarily high because their
  businesses are established and the probability of
  them developing a product that would double their
  profits is so much more remote than for smaller
  high-tech companies.

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Annual Reports

• The annual and quarterly repots of companies are
  usually their only communication with their
  shareholders.
• Reports inform their investors about the
  companys performance,
• Share management strategies for the future,
• Explain major new products and projects, and
• Offer an estimate of the impact the management
  expects those new developments to have on
  revenues and profits.
• Annual reports will include a balance sheet and
  other financial statements, from which the
  investor can calculate many indicators including
  book value, debt-to-equity ratios, current
  ratios, and others.
• Annual reports give the investor the opportunity
  to evaluate both the performance of the companys
  management and the companys current financial
  situation.

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Stock Splits

• A stock split occurs only when approved by the
  board of directors of the corporation.
• A split means that each share of stock is
  converted into more shares. The split can occur
  in any ratio of new shares to old shares with the
  most common split ratio being two-for-one.
• The primary reason the directors choose to split
  their companys stock is to keep the price within
  a certain range.
• When the market price goes too far above the
  range, the directors split the stock, in turn
  lowering the price.
• Example of a Split (2-for-1)
• Pre-Split Post-Split
• Investor owns Investor owns
• 10 shares _at_ 50 500 20 shares _at_ 25 500
• It is important to remember that a one point
  swing in the price of the stock will now have
  twice the effect on the investors portfolio than
  a one point change would have had before the
  split.

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Short Selling

• The traditional advice is to buy low, sell high.
  This holds true even in selling short, except
  that contrary to buying the stock before selling
  it (going long), the investor sells the stock
  before he/she buys it.
• Short selling is made possible by brokerage firms
  that arrange to borrow stock from one investor
  and loan it to the investor shorting the stock.
• After selling the borrowed stock, the short
  investor hopes the price falls so he/she can buy
  it back at the lower price.
• After buying the shares back, the investor
  returns the shares to the investor from whom they
  were borrowed.
• The effect of selling short is the same as if the
  investor had first bought stock at a low price
  and later sold it at a high price, the process is
  simply reversed.

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Short Selling (example)

• Steve followed TWA airlines closely and felt its
  CEO was running it into the ground.
• He did not own any TWA stock, but he put in an
  order to sell short 1,000 shares of TWA at 40.
• His brokerage firm arranged to borrow 1,000
  shares of TWA for the short sale from another
  investor named Jennifer who held 1,000 shares of
  TWA.
• A month later, after TWA fell to 35 a share,
  Steve bought 1,000 shares for a cost of 35,000.
• The stock he just bought went to the brokerage
  firm which returned it to Jennifer.
• The brokerage firm was paid for its efforts to
  arrange the loan by receiving commissions from
  Steves transactions.
• Steve made a profit of 5,000 minus commissions.

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Margin

• Buying stocks can be a fairly risky investment,
  and buying stocks on margin adds even more risk
  to the investor.
• Margin accounts are one of the many ways
  investors can attain leverage (meaning that the
  investor controls more money than he actually
  invests).
• A margin transaction involves taking out a loan
  from a brokerage firm to cover up to half the
  cost of a transaction.

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Margin (example)

• A investor with a cash account invests 2,000 to
  buy 200 shares of a 10 stock.
• For every 1 in stock this investor will gain or
  lose 10 of his/her original investment ( or -
  200 of total investment)
• BUT an investor with a margin account makes the
  same 2,000 investment to buy 200 shares of the
  same 10 stock.
• The investor borrows an additional 2,000 to buy
  another 200 shares on margin for a total of 400
  shares.
• The investor gains leverage by using 2,000 to
  control 4,000 worth of stock.
• For every 1 change in price, the investor will
  gain or lose 20 of his/her original investment
  ( or - 400 of total investment)

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Options

• Stock options another type of security offer
  another opportunity to increase leverage and
  greatly boost both the risk and the potential
  return of the investment.
• Option refers to a contract which gives the
  holder the right, or option, to buy or sell a
  specified number of shares of a specified stock
  for a specified price up until a specified date.
• Two kinds of options the call and the put.
• A call refers to the option to buy the stock at a
  certain price within a specific period of time,
  and
• A put refers to the option to sell stock at a
  certain price within a specific period of time .

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Options (Example)

• IBM February 01 call
• Type of option Call
• Number of shares 100
• Name of stock IBM
• Price at which the
• Investor can buy 95
• Expiration date Third Friday of February, 2001
• Option to buy stock is completely dependant upon
  the market price of IBM stock.
• If IBM is trading at 75-a-share on the day of
  expiration, this contract is worth nothing.
• If IBM is trading at 105 on or before the day of
  expiration, the contract does have value. It is
  valuable because the holder of the contract can
  exercise it by buying the 100 shares at 95 from
  the person with whom the contract was made.
• The person can go sell those new shares for 105,
  and make a 10 profit on each of the 100 shares.

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Option Listing

• Stock Name the name of the stock which the
  option corresponds to is on the first line.
• Closing stock price the closing price of that
  stock is repeated on each of the following lines
• Strike Price this is the price on which the
  option is based. e.g. an investor holding an ATT
  call has the right to buy 100 shares of ATT for
  30 each before the third Friday in the specified
  month. He/She can buy these shares at 30 despite
  the market price.
• Option Price the price of an ATT call or put
  for the month indicated. Remember all options
  prices must be multiplied by 100!

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Options CBOE

• The Chicago Board of Exchange (CBOE) is a market
  for many commodities like sugar and wheat etc.
• It is also the largest exchange for stock
  options.
• The regional exchanges such as the Pacific and
  Philadelphia exchanges play very significant
  roles in the option market.
• The NYSE does a relatively small amount of the
  option trading even though it lists most of the
  stocks to which the options correspond.

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IBC OUTLINE

• Equities
• Fixed Income
• Investment Management
• Conclusions

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Whats Fixed Income?

• A fixed-income security is a bond
• Bond is a series of fixed future cash flows
  (hence your income is fixed)
• Though the payments are known in advance, there
  is the risk that the borrower (i.e., the seller
  of the bond), will default on the debt obligation
  and not make these fixed payments
• Think of a bond as an IOU/borrowing arrangement
• The borrower sells you a bond and promises to
  repay you plus interest

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Terminology

• Price
• Face value (par value)
• Coupon rate
• Maturity
• Yield

• What you pay today to purchase the bond to
  receive future payments
• Payment at maturity that returns principal to
  investor
• Payment of interest on the principal
• When bond cash flows should stop
• Discounting factor
• This is why interest rates drive bond markets
• High interest rates discount future cash flows
  more and thus drive prices down
• YIELD MOVES INVERSELY TO PRICE

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Bond Pricing

• Mathematically,
• Where, CFt cash flow at time t, and R
  interest rate/yield
• In words, the price of a bond is the present
  value of all the discounted future cash flows of
  the bond
• Long story short-bond trading is all about
  interest rates

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Three Different Risks

• Interest Rate Risk
• Credit Risk
• Currency Risk (lets just ignore this)

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Interest Rate Risk

• When interest rates rise, R in the preceding
  formula increases
• This means your future cash flows are discounted
  by a larger number
• This implies the sum of these cash flows, namely
  the price, is smaller
• This is why PRICES MOVE INVERSELY TO YLDS

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Credit Risk

• Risk that the seller of the bond doesnt make
  good on their payments
• SP, Moodys, Fitch issue credit ratings in
  letters
• Under a certain line, bonds are deem
  non-investment grade, or junk
• Because of this artificial line drawn between
  investment grade and junk, junk bonds used to
  yield much more than they should have and Drexel
  Burnham Lambert ravaged the junk bond market

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The 4 Parts of the Fixed Income Universe

• Government bonds
• Corporate bonds
• Mortgage-backed securities (MBS)
• Asset-backed securities (ABS)

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I. Government Debt

• Called govies by traders
• Issued by government to borrow money
• Treasury bills and bonds (T-bills)
• Range in maturity from 30 days to 30 years
• Bonds with longer maturities yield more (are
  cheaper) because as time increases the discount
  factor is raised to a progressively higher
  number, making the sum of the future payments
  less
• Agency Debt (Agencies)
• Issued by quasi-governmental agencies like
  Fannie, Freddie, Ginnie, Sallie
• Municipal Bonds (Munis)
• Issued by states/counties
• Tax-exempt so they yield less than equivalent
  Treasuries
• Treasury Inflation Protected Securities (TIPS)
• Larry Summers bond
• Coupon rate matches inflation as measured by CPI

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Yield Curve

• Graph of maturities versus yields is known as
  yield curve/term structure of interest rates
• The curve has flattened in recent years
• Curve can invert
• Inverted yield curve has preceded every recession
  in US since 1960s

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Yield Curve (as of Sept 06)
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Trading on the Curve

• At any time, the curve is either flattening or
  steepening
• There are 4 types of behavior
• Bear flattener (current situation)
• Bull flattener
• Bear steepener
• Bull steepener

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II. Corporate Bonds

• Issued by corporations rather than government
• Because companies are perceived to be less
  creditworthy than the government, corporates
  yield more (are cheaper) than Treasuries
• 10-yr bond issued by Microsoft paying 5 coupon
  will be cheaper than 10-yr Treasury paying 5
  coupon
• This might not make sense with Microsoft, but
  think about GM today
• There is a decent risk (futures markets say 37)
  that GM will default on its bond payments
• Potential buyers of GM bonds demand a risk
  premium because of this
• This risk premium translates into a lower price
  for the bond
• That is, bond price falls until there are buyers
  who are comfortable taking the risk of holding a
  GM bond
• As we know, lower price means higher yield, so
  corporates yield more than Treasuries

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III. Mortgage-Backed Securities

• When you want to buy a house, you go to a local
  bank and take out a loan for a mortgage
• You repay the principal plus interest at some
  rate X with fixed payments (usually monthly)
• If interest rates fall below X, it is in your
  advantage to refinance your mortgage at the lower
  interest rate and you might even prepay the
  mortgage
• Problemthrifts are exposed to significant
  volatility in this world because they get back
  their money in a low-rate environment, which
  means prices are high and opportunities for
  return are low

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III. Mortgage-Backed Securities (cont.)

• Small banks dont like exposure to this risk
• About 35 years ago, the government created
  Freddie, Fannie, Ginnie (GSEs) to buy the loans
  from thrifts (payments on mortgage would go to
  Fannie not the regional bank)
• To create liquidity in the secondary mortgage
  market
• Fannie and Freddie buy mortgages and pool them
  together, and then issue bonds that represented
  claims to the payments the homeowners made
• securitization
• Bond investors buy these pass-through securities
  from Fannie and the homeowner payments
  pass-through Fannie and go to bondholders

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III. Mortgage-Backed Securities (cont.)

• If homeowners default on payments, housing
  agencies intervene (they are backed by full
  faith and credit of the government)
• So there is essentially zero credit risk
• Salomon Bros slaughtered people in the mortgage
  market in the late 70s/early 80s
• Then why do mortgages yield more than Treasuries?

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III. Mortgage-Backed Securities (cont.)

• Answerprepayment risk
• If homeowners prepay their mortgage, bondholders
  receive their cash flows at the worst possible
  time-a low-rate environment
• Salomon devastated this market because it
  developed prepay models before anyone else
• Long MBS short volatility

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IV. Asset-Backed Securities

• If you can securitize mortgages, why not
  securitize other types of loans?
• ABS bonds are claims to payments on auto loans,
  credit cards, home equity loans

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Other Fixed Income Instruments

• Convertible Bonds
• Collateralized Debt Obligations
• Interest Rate Swaps
• Interest Rate Swaptions
• Total Rate of Return Swaps
• STRIP IOs and POs
• Credit Default Swaps
• Called protection
• Long CDS short bond
• These derivatives allow for disaggregating risk
• You isolate interest rate risk with swaps
• You isolate credit risk with CDS

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IBC OUTLINE

• Equities
• Fixed Income
• Investment Management
• Conclusions

44
Classifications of mutual funds

• A mutual fund is a pooled investment vehicle.
• Classifications
• By size
• By style
• Other
• Specialized funds
• Index Funds

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Fees

• Load funds have a sales charge (usually a
  percentage of total value)
• 3 types of load funds
• Class A shares Front End Load fee charged when
  you buy
• Class B Shares Contingent Deferred Sales Load
  (CDSL) or back-end load is charges when a fund is
  sold (i.e. exit fee)
• Level Load is charged every year

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More Fees

• A Management Fee is a percentage of your total
  value paid towards paying for administrative
  purposes
• Sometimes there are hidden fees by way of
  taxes
• If assets in your fund pay dividends, you will
  pay taxes on them
• If a manager sells assets for a profit, there
  might be a capital gains distribution tax.
• Avoid this fee by choosing a tax-free fund or by
  making sure that your fund has a low turnover
  ratio (measures the amount of selling in the
  fund -gt e.g. A 100 turnover ratio means that
  the fund manager changed the entire portfolio by
  100 once during that year.)

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Alternative Investment Vehicles

• Private Equity
• Angel Investing
• Middle- and Late-Stage Investing
• Distressed Investing
• Leveraged Buyouts
• Hedge Funds

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Venture Capital

• Venture capital is money provided by
  professionals who invest alongside management in
  young, rapidly growing companies that have the
  potential to develop into significant economic
  contributors. Venture capital is an important
  source of equity for start-up companies.
• Venture capitalists generally
• Finance new and rapidly growing companies
• Purchase equity securities
• Assist in the development of new products or
  services
• Add value to the company through active
  participation
• Take higher risks with the expectation of higher
  rewards
• Have a long-term orientation

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Leveraged Buyouts

• Taking a public company private by issuing debt
  against the cash flows of the target company.
• Those cash flows are then used to service the
  debt while operations and management is improved.
  
• The LBO investors then either sell the company to
  another private investor or issue a second IPO as
  an exit.

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Hedge Funds

• Equity Long/Short strategies attempt to add value
  through stock selection with hedged market
  exposure that generally has a long bias. The
  objective is to profit from continued equity
  market growth, while reducing portfolio
  volatility.
• Global Macro strategies make leveraged
  directional investments on anticipated price
  movements of global stock markets, interest
  rates, foreign exchange and physical commodities.
  Global macro advisors use a top-down approach and
  may invest in any markets using any instruments
  to participate in expected global market
  movements.

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More Hedge Funds

• Equity Market Neutral strategies attempt to
  generate profits through the selection of equity
  securities, while reducing or eliminating the
  effects of market-wide or industry sector-wide
  price movements by simultaneously taking long and
  short positions in equities in approximately
  equal volumes.
• Statistical Arbitrage is a relative value,
  systematic trading strategy that exploits short-
  and long-term relationships among stock prices
  and volatility. Can be based on proprietary
  models that focus on short-term corporate events
  and structural relationships between stocks, or
  longer term models that focus on the predicted
  shape of a given stocks price distribution

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More Hedge Funds (cont.)

• Fixed Income Arbitrage seeks to exploit pricing
  inefficiencies between related fixed income
  securities, while neutralizing exposure to
  interest rate risk.
• Convertible Arbitrage strategies involve
  investing in the convertible securities of
  companies and then selling short such companies
  common stock as a hedge.
• Distressed strategies invest in obligations of
  troubled companies, which are most often already
  in bankruptcy. Advisors attempt to identify
  specific securities or other obligations that are
  trading at discounts to their long-term
  realizable or intrinsic value.
• Merger Arbitrage, also called risk arbitrage,
  involves investing in event-driven situations,
  such as leveraged buyouts, mergers and hostile
  takeovers. It usually involves taking long and
  short positions in companies involved in a
  proposed transaction.

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IBC OUTLINE

• Equities
• Fixed Income
• Investment Management
• Conclusions

54
Where to go from here

• Stay Informed
• Wall Street Journal
• Barrons
• Coursework
• Ec1723, Ec1733, Ec1745, Ec1760, QR43, 15.501
  (Financial Accounting) at MIT
• HIA
• Weekly Meetings
• Speaker Series
• Special Visits (HMC, Wall Street)

55
Classes
Economics and business are related, but business
is professional training ultimately aimed at
making profits, while economics is a science that
pursues an improved understanding of our social
world. -Harvard Economics Department
56
Classes
Economics and business are related, but business
is professional training ultimately aimed at
making profits, while economics is a science that
pursues an improved understanding of our social
world. -Harvard Economics Department
aka--Harvard makes it as tough as possible to get
background for the financial world..
57
Classes
Classes to Take
58
Classes
QR43 Intro to Investments

• Next offered fall 2006
• Taught by John Campbell
• Probably the easiest class on investments at
  Harvard, but still extremely useful and
  worthwhile to take.
• Counts as a QR core or an economics related
  field.
• Open to economics concentrators although
  Professor Campbell recommends they dont take it.
• Lots of problem sets.

59
Classes
Economics 1723 Capital Markets

• Next offered fall 2006
• Also Taught by John Campbell this year
• High Difficulty
• Requires Math 20

60
Classes
Economics 1733 Topics in Investment Management

• Next offered fall 2006
• Taught by Tuomo Vuolteenaho when last offered
• Prerequisite Ec 1723 Capital Markets Ec 1745
  Corporate Finance or both Ec 10 permission of
  the instructor

61
Classes
Ec1745 Corporate Finance

• Next offered spring 2006
• Taught by Efraim Benmelech
• While very worthwhile, it has been noted that the
  class is difficult.
• If you are entering into the world of finance,
  this class is a definite plus for you to learn
  about corporate finance for employers to see that
  you have background.

62
Classes
Ec1760 Topics in Financial Economics

• Next offered spring 2006
• Taught by Jeremy Stein
• The general consensus is that this is one of the
  best classes offered at Harvard (CUE overall
  rating 4.7)
• Prerequisite Ec1723 Capital Markets

63
Classes
Psych 1501 Social Psychology of Organizations

• Next offered fall 2006
• Taught by J. Richard Hackman
• Also high CUE rating 4.7
• But large amounts of reading, 830 a.m. lecture
  time
• Enrollment limited to 45
• Prereq Psych 1 Intro to Psychology

64
Classes
MIT Accounting

• Learn all about financial accounting--this
  includes reading and understanding financial
  statements
• Offered through cross-registration at MIT as
  15.501 Financial Accounting
• Offered in both the fall and spring to Harvard
  students
• No additional cost
• Recommended for all going into finance

65
Classes
Good luck!
66
Some relevant books

• Stocks for the Long Run
• A Random Walk Down Wall Street
• Irrational Exuberance
• When Genius Failed
• The Intelligent Investor
• Liars Poker
• The Winners Curse

Jeremy Siegel Burton Malkiel Robert Shiller Roger
Lowenstein Ben Graham Michael Lewis Richard
Thaler
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Contact Us

• Website
• www.harvardinvestment.org
• Subscribe to the Weekly Newsletter
• E-mail secretary_at_harvardinvestment.org
• Or subscribe on our website
• Meetings
• Tuesdays 7 PM, Lamont Library Forum Rm

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Contact Us

• co-president_at_harvardinvestment.org
• speakers_at_harvardinvestment.org
• recruiting_at_harvardinvestment.org
• research_at_harvardinvestment.org
• treasurer_at_harvardinvestment.org
• secretary_at_harvardinvestment.org

• Presidents
• Ravi Mehta
• Winnie Nip
• Vice President of Speaker Series
• Andrew Krumholz
• Vice President of Recruitment
• Christopher Yen
• Vice President of Investment Research
• Kevin Klein
• Treasurer
• Alex Radu
• Secretary
• Alex Sloane