Discussion of Theory

Describe about investment game corporate finance?

The main aim of this report is to review an investment game whereby we had to invest £1,000,000 on behalf of Archie keeping in mind his needs, preferences and risk appetite. This report highlights the underlying theory, strategy employed and underlying research which was done in order to frame a customised portfolio for Archie.

According to Markowitz, it is possible to design an efficient portfolio keeping the risk appetite, preferences and needs of a particular investor in mind. In this regard, particular attention needs to be paid on the liquidity requirements, investment horizon and asset preference of the investor. Besides, it is known that investment in stocks in the form of equity can be a risky proposition hence effective diversification holds the key so that unsystematic risk associated with investing in stock can be minimised. Also it is imperative that with the change in investor needs the portfolio should also reflect the same and therefore an active involvement may be required in management of the asset portfolio (Brealey, Myers & Allen, 2008).

With regards to investing in stocks, investors and academicians suggest two basic parameters for choosing stocks namely the price of entry and the fundamental strength of the company and sector. These two core principles form the tenet of the major theories in stock investment namely technical analysis and fundamental analysis. It is normally assumed that traders go for the former while investors go for the latter primarily due to difference in their investment horizons. However some advocate that given the vagaries and unexpected movements in stock prices, it is prudent to combine both the approaches as and when possible (Damodaran, 2008).

The technical analysis is primarily based on the belief that past price movements can help in prediction of future prices and essentially relies on finding support and resistance levels through constant observation of the stock price movements. It recommends entering a stock near the support price level and booking profits near the resistance levels. During this not much importance is given to the business model and performance of the underlying company. However the fundamental analysis refutes this and relies on the fundamentals of not only the organization but the sector and economy as a whole. Investors relying on fundamental analysis typically invest in only those companies whose business they understand and believe would well in the future. Although a number of stock market participants tend to rely on at least one of these approaches, however the utility of these is refuted by the Efficient Market Hypothesis (EMH) which is propagated by Eugene Fama and advocates that no investor can earn above average returns in the stock market on a sustainable basis and thus stock analysis through various tools is essentially a futile exercise (Parrino & Kidwell, 2011).

Our group strategy is to primarily fulfil the requirements of the clients and frame a portfolio which can give reasonable returns.

• Archie seeks to retire in 5 years and till that time aims to increase his capital to the maximum, hence the investment decisions have been taken considering that the longest horizon possible is 5 years. Hence small cap specialist pharmaceutical companies dedicated to R & D which may have the potential to yield phenomenal returns in a longer horizon of around 10 years have not been considered. Additionally emphasis has been given to fundamentally sound companies since enough time horizon is available. Also for deploying technical analysis, observation of a particular stock for a sizable time may be required which has not been really possible in the limited exposure we have had with the stock market. However while making trades price has also been given due consideration and not only the fundamentals of the underlying stock.
• Since Archie during the next 5 years also expects to receive some income in the form of dividends, hence majority stocks chosen were those which had a lucrative and regular dividend income flow. This would enable Archie to meet his holiday funding and expenses related to car.
• Since Archie would like to contribute to the purchase of property in10 years time, hence the investments are such which maximise the return but simultaneously do not enhance the risk too much. Therefore even though some of the small cap companies offered immense potential but due to inconsistent execution record such companies were not invested into.
• Since Archie is generally risk averse, hence investments has been limited to large cap companies which are part of FTSE 100 index so that in the long run at least capital preservation is assured.
• Further due to lack of any experience in stock market investing and lack of knowledge about smaller companies, even though Archie permits 10% of the fund to be invested in risky investments, this has not been exhibited since there was no consensus in the group with regards to a particular company and also there was a general lack of conviction.
• Due emphasis has been given to diversification of the portfolio so that the unsystematic risk is minimised. However since the portfolio could contain a maximum of 5 stocks hence the portfolio is rather not very diversified. Further 10% of the fund has been kept aside in banks for contingency usage.

To begin with, we have tried to shortlist certain stocks/sectors that we would like to invest so as to make handsome gains in the short to medium term. These opportunities are discussed below.

• We were aware that during the time period when we were supposed to trade that crude oil had crashed below $ 50 per barrel which clearly seemed highly oversold and thus the situation or trend would have to take a turn in the near to medium future. Due to crashing crude prices, the crude oil producers and refiners are hit as a result of which there stock would tumble. In this regard, the first company we could think was British Petroleum since it satisfies the tenets of our overall investment strategy. We studied the stock price movements of BP using Yahoo Finance Interactive chart and compared the movements with that of crude oil and thus were able to identify a visible correlation. However care was taken to enter the stock at the right price and hence when it took a major dip in the second week of March (i.e. Week 8), we bought BP shares (Yahoo Finance, 2015).

• We were aware about the recovery in the US economy which was apparent with the halt in QE program and hence this recovery meant an increase in demand by the US consumers which would fuel the growth of manufacturing sector of the East particularly China. This would lead to a greater demand of various commodities and would result in the increase of global commodity prices. As a result we wanted to buy into a assorted miner which has global presence. We had two choices namely Rio Tinto and BHP Billiton but we eventually settled for BHP Billiton due to analyst opinion and some reports available on e-databases and online search (Yahoo Finance, 2015).

• Since BP and BHP Billiton are both commodity based businesses, we wanted to invest in another sector which is robust and is expected to do well in wake of global economy recovery. This sector we felt is the organized retail sector and thus we bought Tesco which is the largest retailer based in UK and has a robust business model. Although there was debate regarding an investment in pharmaceutical company such as GSK but the majority were not in favour as they felt that the global economy after a tough phase is looking for better times.

The summary of trades is presented in the table shown below (Yahoo Finance, 2015).

The final portfolio as on 20^th March end of day is as follows (Yahoo Finance, 2015).

Conclusion

From the above discussion, it can be concluded that within the limited knowledge and exposure that we had, we did a decent job at choosing a portfolio for Archie which fulfils most of the criteria which were given by Archie. However looking back, we felt that we could have devoted 10% of the fund value to a more aggressive small cap company which could have enhanced the returns. But lack of confidence and the fact that we were doing this for the first time made us adopt a cautious and calibrated approach. With this experience, it is apparent that going forward we can be more creative and try to make trading picks based on constant news flow which we were not able to do this time round. Additionally we would have ideally liked to have one or two more stocks in the portfolio particularly belonging to the cyclic industries such as automobiles which would result in some more diversification and may be factor in defensive sector such as pharmaceutical in case of any global crisis in the near future.

References

Brealey, R, Myers, S & Allen, F 2008, Principles of Corporate Finance, 9th edition, McGraw Hill Publications, New York

Damodaran, A 2008, Corporate Finance, Wiley Publications Pvt. Ltd, London

Parrino, R & Kidwell, D 2011, Fundamentals of Corporate Finance, Wiley Publications Pvt. Ltd, London

Yahoo Finance  2015.  Historical Stock Prices, Yahoo Finance, Available [Online] from: https://uk.finance.yahoo.com (Accessed February 20, 2015)