Question

Soon after your graduation, you would be all set for your career path. As you have studied and learnt several investment and portfolio related theories and concepts, you would be interested to start investing and creating portfolio right from the beginning phase of your career. Before you start doing so, it would be ideal to recap those important concepts and theories. You may want to write down those in brief especially covering the following: (a) How do you think about your required rate of return? What affects the required rate of return? What would be your perspective on risk? (b) Suppose you learn about two good investment options and you would like to evaluate both of them. You will have AED 10,000 available for making the investment. The GLuck investment is expected to generate a return of 15.5% with a standard deviation of 8.2% while the SLuck investment is expected to generate a return of 9.8% with a standard deviation of 5.3%. Given a small saving of AED 10,000, you would be interested to invest in only one option. Which one would you choose and why?

CASE – 2: (Based on Ch-13: Equity Portfolio Management Strategies) – 10 Marks In the financial markets the case for active portfolio management is often a difficult one to make. While many individuals opt to put their money in index funds, others trust their money with active managers who are on a search for positive alphas and undervalued securities. The question is whether or not there is any value in putting your money into an actively managed equity fund. Although active managers claim they can create better returns, it is often the costs of investing that make their funds not as attractive or profitable. Management fees and high turnover ratios often cause these active managers to miss their benchmarks. Passive funds on the other hand are much less expensive because they try to imitate an index and trade with much less frequency. In order for active managers to outlast passive funds they must be able to produce large enough returns that will offset the fees incurred from trading and managing the fund. The job of an active portfolio manager is to select securities, find positive alphas, and create returns. It sounds simple enough, but creating value in a very efficient market is difficult. Passive funds nowadays are very attractive due to their reduction in cost, increased tax efficiency, and ability to avoid spending an increasing amount of time researching companies. Empirical research studies show some evidence in favor of active portfolio management strategies yielding higher returns than the market index. There are some global level portfolio institutions (e.g., Vanguard, Blackrock, Fidelity, Franklin Templeton etc) that claim to generate better returns for the investors. In view of the above and based on your learning, you are required to critically evaluate the active and passive portfolio management strategies. You may want to emphasize on the mechanisms used under these strategies, the role of anomalies and attributes, technical and fundamental analysis, and the style analysis.

CASE – 3: (Based on Ch-12: Company Analysis and Stock Valuation) – 15 Marks You are planning to create a portfolio based on your learning of the ‘portfolio management and theory’ course. You are well aware of the risk and return aspects of various types of investible products such as stocks, bonds, commodities etc. Your objective is to maximize returns and wealth for the longer-term, therefore, you are interested in investing in stocks. Considering UAE as a growth-oriented economy, you decided to invest in UAE stock markets. As you have gained some good understanding about the fundamental analysis of stocks and companies, you would like to do this fundamental analysis yourself. Spotting HypoReal as a real-estate company in the UAE, you gathered some relevant information in order to supplement your fundamental analysis. Being a real estate company, HypoReal’s revenues and profits have shown a considerable growth in the past. The company’s free cash flows to equity (FCFE) at the end of the year 2019 was AED118 million, and it projected to grow in future at the rates given below. The number of shares outstanding remains 560 million. Year Growth Rate 2020 6% 2021 10% 2022 16% 2023 20% 2024 16% 2025 12% 2026 9% 2027 7% The company’s FCFE is expected to grow at a constant growth rate of 5% per annum from 2028 onwards. The company’s stock beta is 1.3. Supposing the end of 2019 market price of the stock AED4.00 per share, the equity risk premium of 6% while the risk-free rate is 3%. Calculate (i) required rate of return on equity; (ii) the present value as of 2019 of FCFE during the period of increasing growth (that is for years 2020 to 2023); (iii) the present value as of 2019 of FCFE during the period of declining growth (that is for years 2024 to 2027); (iv) the present value as of 2019 of FCFE during the period of constant growth (that is for years 2028 onwards); and (v) the intrinsic value of the stock as of 2019. Suppose you were to make decision at the end of 2019 year, what would you have decided keeping in mind the so-calculated intrinsic price and the market price of end-2019? Critically evaluate your confidence in this type of fundamental valuation.

Answer 1

Case 1 Since Coefficient of variation is less in Gluck Investment ,Gluck Investment should be selected.

Case 3.

1 10.8%

2 469.3472

3 527.53

4 2312.89

5 AED 5.91 per share

Since market price is less than IV,stock is undervalued. Buy the stock.