Ohio State Presentation

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InvestmentsThe Process

• G. Kevin Spellman
• 2/14/02

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Investment Analysis Process
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Outline

• Many roles in the investment management process
• Areas overlap
• Left to right depicts a top-down approach to
  investment management
• All add value and all are difficult (more
  difficult and value added to the left)

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Outline Cont

• Today, we will focus our discussion on style
  analysis
• Style analysis plays an important role in several
  areas of investment analysis
• Style analysis
• Sector/industry analysis
• Company analysis
• Trading
• Performance evaluation

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Investment Analysis Process
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Economics

• The economic forecast is the most important
  forecast
• Determined by the economist
• Major factors include GDP, consumption,
  investment, government spending, net exports,
  unemployment, inflation, and interest rates, etc.
• We currently expect a mild recession and then a
  recovery in the second half of 2002, with
  continued low inflation

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Investment Analysis Process
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Capital Markets

• Economic forecast leads to the asset allocation
  decision (the most important decision)
• Asset classes do not move together
• Asset classes are large in size
• Difficult decision that can make or break
  performance
• Determined by the Strategy team
• If the economy is strong and inflation is low,
  then this is normally good for the stock market
• Remember P (E1 payout) / (r g))
• Currently over-weighted equities and real estate

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Capital Markets Cont
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Investment Analysis Process
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Style

• The style decision adds substantial value
• Movements in styles can differ greatly in
  magnitude
• There are only a few styles
• Style decisions impact all other parts of
  investment analysis
• Difficult decision that can make or break
  performance
• Determined by the Domestic Equities Strategy team
• Style is classified by size and valuation
  although, there are many characteristics that are
  applicable to investment managers/stocks

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Style ContCharacteristics
Morningstar Boxes
Valuation
Value
Blend
Growth
Large
Mid
Size
Small
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A Active, E External, I Index, P Passive
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Style ContCharacteristics
Characteristic Value Stock/Manager Growth
Stock/Manager Growth Rate Low to High/
Average to High Cyclical/Mature Defensive/Gr
owth Valuation of Stocks Low (i.e. P/E) High
(i.e. P/E) Dividends High Low Time
horizon Long Short to Long Patience of PM with
Investment High Low Debt Mid to High Low
to Mid Profitability Low ROE High ROE Trading
Activities of PMs Supply Liquidity Pay up for
Liquidity Management of Companies Bad to
Good Good Coverage by Sell Side Under-followed
Highly followed View Cruddy to Good Glamour
or Trendy Turnaround Stories Look at Sales
Growth Look for Catalysts Look for
Trends Previous company performance Low High Pre
vious stock performance Low High Mistakes of
PMs Buy/Sell Too Early Extrapolate Current
Growth (Too Buy Without a Catalyst High) Too
LongResult is Pay Too Much for Inflated
Expectations Beta Low lt 1 High gt 1 Size of
Companies Small to Large Small to
Large Expectations for Companies Low High In/Ou
t Out of Favor/Style In Favor/Style Belief of
PM Reversion to the Mean The Trend is My
Friend Strategy of PMs (in Brief) Buy Low
Valuation Stocks Buy High Price and with
Catalysts Earnings Momentum Stocks,
Valuation Less Important
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Style ContFactors

• Major factors include inflation, interest rates,
  earnings growth, the phase of the economic cycle,
  phase of life cycle, etc.
• The simple DDM captures many of these factors
• P0 (E1 payout) / (r g)

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Style ContRates

• Interest rate moves do not affect all styles
  equally
• Growth stocks rise more than value securities as
  rates move down
• Example
• 2 stocks differ only with regard to growth rates
  (7 and 10)
• RP 6, B 1, E1 1, Payout 40

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Style ContEarnings

• Changes in economic growth do not affect all
  styles equally
• Value stocks outperform growth stocks (ex tech)
  as the economy picks up
• Why pay up for growth stocks during a recovery
  when earnings growth is abundant?

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Style Cont1993-1998

• The out-performance of growth stocks over value
  stocks from 1993-1998 can be explained by
  movements in interest rates and earnings
• Both of these factors favored growth stocks
• Earnings growth was slowing
• Inflation was slowing, and interest rates were
  falling

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Style Cont1999-Today

• 1999-1Q2000 rates and earnings growth rose, but
  growth outperformed value (the bubble)Why?
• 2Q2000-today rates have been falling but so has
  earnings growth and both value and growth have
  had their runs

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Style Cont1999-1Q2000

• At this time, the Fed was pumping money into the
  system to get ready for Y2K
• M V P Q
• P and Q were not rising rapidly, so V was falling
• V falling means more people were investing versus
  spendingthey invested in growth stocks

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Style ContRecovery

• What happens when rates fall and earnings rise?
  (i.e. the current environment?)
• Value/small stocks tend to perform well during
  economic expansions even as rates fall
• The E matters more than the r in the DDM
• We are currently over-weighted mid-cap/growth and
  favor small/value during the next few quarters

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Style ContWhat to Do?

• Managers alter their styles only after they
  notice events have changed (just before they
  change again)
• Difficult to predict rotations
• Must forecast many difficult to predict factors
  (interest rates, economy, politics, etc.)
• Unexpected events can (and do) arise (regularly)
• You either win big or lose big, and the chance of
  winning is low

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Style ContWhat to Do?

• Be consistent with whatever style chosen
• Value and growth both work, but at different
  times
• Easier to forecast at the sector/industry level
  (and within the industry), where the probability
  of success is higher

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Investment Analysis Process
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Sector/Industry

• The sector/industry decision adds value
• Sectors do not move together (but generally in
  the same direction)
• Only 10 sectors
• Driven by the economic cycle, so it is difficult
  to forecast
• Determined by the portfolio managers
• The Domestic Equities department is currently
  over-weighted technology however, we took a lot
  of money off the table during the tech run in
  4Q2001

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Sector/Industry Cont

• Sectors can be divided by into value and growth

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Investment Analysis Process
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Company Analysis

• Company analysis adds less value than other types
  of analysis (on an individual basis)
• Stocks in an industry generally move in the same
  direction
• Many stocks in a portfolio
• Determined by the analysts
• Must compare business, financial and valuation
  fundamentals of one company to another firm in
  the same industry

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Co Analysis Cont

• Business analysis
• Compare/contrast strategy, products, management,
  phase of life cycle, etc.
• Financial analysis
• Utilize history to project the future
• Can the firm finance the business plan?
• A lot of room for manipulation (cash flow is
  best)
• Valuation
• The art and science of a recommendation
• To determine whether the business and financial
  fundamentals are appropriately priced into the
  stock

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Co Analysis ContCharacter
Characteristic Value Stock/Manager Growth
Stock/Manager Growth Rate Low to High/
Average to High Cyclical/Mature Defensive/Gr
owth Valuation of Stocks Low (i.e. P/E) High
(i.e. P/E) Dividends High Low Time
horizon Long Short to Long Patience of PM with
Investment High Low Debt Mid to High Low
to Mid Profitability Low ROE High ROE Trading
Activities of PMs Supply Liquidity Pay up for
Liquidity Management of Companies Bad to
Good Good Coverage by Sell Side Under-followed
Highly followed View Cruddy to Good Glamour
or Trendy Turnaround Stories Look at Sales
Growth Look for Catalysts Look for
Trends Previous company performance Low High Pre
vious stock performance Low High Mistakes of
PMs Buy/Sell Too Early Extrapolate Current
Growth (Too Buy Without a Catalyst High) Too
LongResult is Pay Too Much for Inflated
Expectations Beta Low lt 1 High gt 1 Size of
Companies Small to Large Small to
Large Expectations for Companies Low High In/Ou
t Out of Favor/Style In Favor/Style Belief of
PM Reversion to the Mean The Trend is My
Friend Strategy of PMs (in Brief) Buy Low
Valuation Stocks Buy High Price and with
Catalysts Earnings Momentum Stocks,
Valuation Less Important
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Co Analysis ContBusiness
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Co Analysis ContFinancial
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Co Analysis ContValuation

• Expectation (i.e. growth) and valuation (i.e.
  value) factors work
• These factors work at different times and in
  different sectors of the market
• Time

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Co Analysis Cont Valuation

• Sectorsvalue/growth factors for value/ growth
  sectors

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Investment Analysis Process
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Trading

• Trading is an important component of the
  investment process
• Average round-trip cost is over 2
• Many of the costs are invisible
• Trading is performed by the traders
• Keys
• Communication/networking
• Technical analysis (e.g. price momentum and
  volumegrowth factors)

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Investment Analysis Process
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Performance Evaluation

• Performance evaluation has value (knowing how you
  are doing can prompt you to make decisions)
• Performance evaluation is performed by the back
  office (with the great help of the ITS staff)
• Performance evaluation can take place at the
  asset level, style level, portfolio level,
  sector/industry level, company (i.e. analyst)
  level, and execution level

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Investment Analysis Process