Portfolio 1
The following table presents a summary of the portfolio constructed using a mix of technical and fundamental analysis. The technical part considers the volume of the trading selecting stocks with substantial trading volume for purpose of ease of buying and selling as well as price movement. On the other hand, the fundamental analysis part considers the stocks’ performance in terms of market capitalization, EPS and P/E ratio. Further, it considers the factors likely to influence the UK stock market as well as individual organization’s performance. With that, the table summarizes the individual stocks and overall portfolio’s performance.
Source: (Virtual trader 2016a).
Although the invested portfolio’s return equals -2.13%, the cash reserve brings the return to -0.39%.
Barclays
Barclays PLC and its subsidiaries offer financial services and products across the world. It provides personal, mortgage, and corporate banking as well as wealth management services to businesses and individuals. The following is a summary of its trading volume as well as EPS and P/E as at 13 March 2016 (Barclays, 2014). Further, with the UK market shifting its focus from the stock market to the bonds market owing to the Bank of Scotland announcement of a cataclysmic year, the financial sectors service the bond market is expected to gain from the shift hence the choice for Barclays.
Source: (Yahoo finance, 2016)
Although the stock has high P/E and EPS its operations in the banking sector which is projected to grow results to its selection for long-term holding. Further, the business has suitable strategies that could improve its performance hence an expected stock price gain.
British Land
British Land PLC is involved in managing, developing and financing, commercial property across the UK. Its property comprises of retail warehouses, shopping centers, super stores as well as department stores and supermarkets (British Land, 2014)
Source: (Yahoo finance, 2016)
The stock is selected for its high EPS and low P/E that indicates that it is undervalued by the market hence potential for price gain. Further, the real estate industry is one of the markets expected to gain from the shift from the stock markets investments hence the firms in the industry are expected to perform better. That comes as investors react to the Bank of Scotland’s advice to investors that 2016 could be a bad year for stocks.
Croda International
Croda International is involved in production and selling of specialty chemicals across the North America, Western Europe, Latin America, Eastern Europe as well as Middle East and Africa. It operates through Life Sciences, Personal Care, Performance Technologies segments as well as Industrial Chemicals (Croda International, 2014). The business is also bound to gain from the falling oil prices that could translate to low production cost and high margins that could create value for investors.
Source: (Yahoo finance, 2016)
The stock is selected for its substantial EPS that means that there is possibility for price gain as investors seeks to own a share of the earnings.
Easy jet
Easy Jet plc operates airline carrier across Europe. As at September 30, the year 2015, its operations were in 735 having a fleet made of 241 aircrafts. It engages in leasing and trading of aircrafts as well as provision of services in graphic design (Easy Jet, 2014).
Source: (Yahoo finance, 2016)
Although the business operates in a highly competitive industry, it has a high EPS and a relatively low P/E meaning it is undervalued. That provides potential for capital gain hence its selection. With the 2016 fall in oil price, the company is expected to gain given the fact that fuel accounts for a significant cost of the industry players. With that, investors’ value would be expected to rise (Evans, 2016).
William Hill
William Hill provides services in sports betting as well as gaming across the UK, US, Australia, Spain and Italy. Its operations are through Retail, Telephone, Online, as well as other segments (William Hill, 2014). The following table summarizes its trading and financial performance.
Source: (Yahoo finance, 2016)
The company was selected for its suitable EPS that means that it has potentials for creating wealth for shareholder hence possibility of stock gain. Its selection is also informed by the fact that it operates in a technology led industry which is considered a growth industry.
Further, in view of the factors that could affect the volatility of the UK stock market, the portfolio has been chosen with an aim of diversifying risks across sectors. That owes to the effect of the low interest rate and the expected deflationary crisis with countries such as China already showing signs of correction (Evans, 2016). With that, the diversification mainly into less volatile sectors such as manufacturing, sports and gaming, airline as well as real estate as opposed to focusing on the financial sector or a single industry is a means of managing the portfolio’s risk.
Events affecting the UK stock market
During the trading the London market was subject to events that affected the level of trading and performance. By January7, 2016 the close of the Chinese market for the second week sent turmoil across the global market affecting operations even in the UK. The event resulted in the FTSE 100 share index shedding down 2% to close the day at 5954.08. 5,954.08. On January 21, the stock prices across the globe including the UK experienced a gain as oil price had the highest one day gain. With that, the FTSE index edged up 1.7% in line with other markets in France, US and Germany. In February 2016, the turmoil in the European market affected the global stock prices with the FTSE 100 shedding 2.7% on the 9 February resulting from the further drop in the European market.
Portfolio 2
The following table summarizes the individual stocks’ as well as the second portfolio’a performance. The portfolio is constructed of stocks that are selected using the CAPM model.
Source: (Virtual trader 2016).
Although the invested portfolio return equals 3.31%, the consideration of the cash and reserved margin brings the total investment return to 0.98%.
CAPM overview and application
The CAPM is built based on Markowitz and efficiency model through which the investors who are risk averse and having a single period horizon view only about the expected returns as well as variance of the returns. The investors select only the efficient portfolios that have the minimum variance provides a certain expected return, as well as maximum return, provided a given variance. The variance and the expected returns plots a parabola with the points above the global minimum identifying the efficient frontier regarding the risky assets.
The Sharpe’s CAPM converts mean variance to market-clearing and asset-pricing system. All the investors are in agreement on the return’s distributions and can lend or borrow without limit with a rate that is risk-free. The rate clears markets for the borrowing as well as lending. Combining risk-free and the risky assets leads to an efficient frontier, which is linear mean–variance and tangent to that efficient frontier. All those who have the risky investments hold that tangent portfolio, risky assets weighted portfolio. The CAPM model has the implication that market portfolio has to be efficient (Chen & Ang, 2007)
The Sharpe’s version has the assumption of a rate that is risk-free, but the Black’s CAPM version allows for short selling that is unlimited. Both have the implication that beta; the asset returns’ covariance with the variance of that market, is adequate for explaining the differences in portfolio’s or assets’ returns and the relation between the beta and the expected returns has to be positive. The risk that is risk-free is represented by the intercept on Sharpe version. However, Black’s version needs only the market return to be higher than expected return for the assets uncorrelated with market return (Lintner, 1965).
CAPM model reflects qualitative development from the normative patterns and pattern of the balance between the supply and the demand of the risky assets generating unique financial assets prices. CAPM also adjusts to size of company eliminating absence of influence of companies’ dimensions regarding estimated return of the issued securities. In their study, Banz, (1981), who also the authored the model showed that size of residual profit can explain expected variations better than the beta. More authors including (Chen & Ang, 2007) analyzed CAPM model, and insisted on possibilities of its adaption to requirements of modern economy as well as minimize risks for investments. In further studies, the researchers and another specialist (Chen et al, 2006) published research examining relationship between evolution of the market’s risk and benefits expected from a portfolio by the investors.
CAPM Model issues
The model that was modeled by Sharpe resulted from fluctuations in securities that were influenced by both changes in stock market general index and specific changes of issuing companies (Chou, Ho and Ko, 2012). In that respect, the model is considered the sum variance of financial basis results from simultaneous action by two risks categories namely:
Systematic risk also referred to as undiversifiable market risk occurring from variations in main macroeconomic factors such as inflation rate, GDP, interest rate and exchange rate. It also results from variations in social economic aspects as well as specific policies of a country.
Specific risk that is solely determined by characteristics of every financial instrument, which is broken down as follows:
Specific and intrinsic risk that is determined by real economic conditions of the securities issuer.
Sectoral risk that is specific to an activity or sector to which issuers of the instrument belongs.
In drafting the model, Sharpe introduced the risky assets portfolio and an asset that is risk-free in the different combinations relating to risk for the portfolio. That led to new efficiency frontier with particular form involving a line referred to as Capital Market’s Line (Sharpe, 1964).
The CAPM model measuring the portfolios average profitability regarding risky assets can be summarized as follows
Ep = Rf + ((Em- Rf)/ σM)* σp
Rate that is risk-free Rf representing the constant exogenous financial market return on the money market.
Risk of the title relating to σM square; the price for risk within the market. That represents the CML slope and market risk.
Expected market profitability; the EM
The portfolio’s risk shown by σp.
In the study of the markets, Sharpe also introduced idea of market portfolio that contain one of every title, weighting made in line with ratio between each title’s market value and total market. Thus, efficiency of the CAPM model, together with identification the right through the CML entails determining a linear relation between the expected systematic risk and profitability assumed by the investors who buy a stock (Sharpe, 1964). The relationship is referred as the SML:
Ei= Rf + βi (EM – Rf),
Where:
Ei is the expected return of the stock.
Rf is the rate that is risk-free
EM is the market return
βi is the volatility coefficient of the stock relative to market’s return (Fama & French, 2006).
This relationship indicates that expected return entails of the rate that is risk-free plus risk premium. First risk equals product of difference between average yields for market as well as expected rate without a risk and the volatility coefficient. Then, the Beta is a parameter calculated for every stock individually and depends on risk of the stock relative to the market risk (Van, 2011). The indicator’s interpretation is as follows:
If beta equals 0, it means the stock has no risk.
If beta equals 1, the stock has same risk as the market hence being neutral. In that case, when average returns from stock market shows a variation of 1% point, and the expected return from the stock is of same size.
If beta is greater than 1, the stock is riskier compared to the market meaning it is much volatile or aggressive. Hence, variation in average return on the market by 1% increase results in change of the stock’s expected return by greater than the 1%.
If beta is less than 1, the stock has less risk compared to the market meaning it is a little less volatile. In that context, variance of 1% point in average return on the market attracts associates with a lesser variation in the stock’s return (Eugene, Fama & French, 2004).
Construction of the portfolio
Portfolio construction begins with identification of financial instruments to be involved in which case this trade entails trading stocks listed in the LSE stock exchange. It also entails identifying when to enter the market and preparation of suitable moment for buying the stocks, which means timing the market for optimal trading. That stage involves carrying out analysis with aim of getting necessary information for decision-making regarding the investment. Thus, investment activity should have a basis on thorough analysis of both individual stock performance and to overall analysis of the involved market. In that view and the research, the second portfolio consist of shares traded in the UK and whose suitability for inclusion is evaluated using the CAPM model.
In view of the CAPM model application, the portfolio construction begins with selection of stocks with suitable earnings and risk. In that respect, the CAPM model has been used to calculate the expected earnings of each stock that are then compared with the market benchmark for purpose of deciding whether they can be included in the portfolio.
Source: (Yahoo finance 2016a; 2016b; 2016c; 2016d; 2016e)
In view of the above analysis and results, it is clear that all the selected stocks for the portfolio had an expected return higher than that of the FTSE which acts as the market benchmark. With that, all the considered stocks are included in the second portfolio.
Portfolios comparative analysis
In view of the analysis, portfolio 1 that has been constructed using a combination of fundamental and technical analysis provides a negative return of – 2.13%. On the other hand, the second model that is constructed with application of the CAPM model to determine the stocks to be included has had a return of 3.31%. In that respect, the CAPM constructed portfolio has better return than the first portfolio that only considers the companies’ fundamentals and the trading’s technicals. Thus, a portfolio constructed of the CAPM model could be expected to perform better given the consideration of the stocks key factors such as risk and expected return.
Recommendations
In view of the analysis, it is clear that the most effective is the application of the CAPM model that sought to consider stocks for investments based on their returns comparison with the market return. In that respect, for an investor, the second portfolio would be the most suitable but would require improvement in terms of weight allocation depending on each stocks expected return. That is because the return considers both the return and the risk of an individual stock which are accounted for by the CAPM model calculation of the expected return.
Reference list
Banz, R., 1981. The relationship between return and market value of common stocks. Journal of Financial Economics, pp. 3–l8.
Barclays, 2014. 2014 Annual Report. [Online] Available at <ttps://www.home.barclays/content/dam/barclayspublic/docs/InvestorRelations/AnnualReports/AR2014/Barclays_PLC_Annual_Report_%202014.pdf>[Accessed 13 March 2016]
British land, 2014. 2014 Annual Report. [Online] Available at <http://www.britishland.com/~/media/Files/B/British-Land/documents/ar-2014/pdf/Annual-Report-2014.pdf>[Accessed 13 March 2016]
Chen J. and Ang A., 2007. CAPM. Over the long-run: 1926-2001. Journal of Empirical Finance,14(1), pp. 1-40.
Chen J., Ang A., and Yuhan X, 2006. Downside risk. Review of Financial Studies, 19, pp.1191-1239.
Chou P.H., Ho P.H. and Ko K.C., 2012. Do industries matter in explaining stock returns and assets-pricing anomalies? Journal of Banking & Finance, 36(2), pp. 355-370
Croda International, 2014. 2014 Annual Report. [Online] Available at <http://www.croda.com/download.aspx?s=1&m=doc&id=6564bc4c-dd71-4810-8fb7-f9726a28e4b3>[Accessed 13 March 2016]
Easyjet. 2014. 2014 Annual Report. [Online] Available at <http://corporate.easyjet.com/~/media/Files/E/Easyjet-Plc-V2/pdf/investors/result-center-investor/annual-report-2014.pdf>[Accessed 13 March 2016]
Eugene, F. and Kenneth, French, R., 2004. The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives. 18(3), pp. 25–46.
Evans, P. 2016. RBS cries 'sell everything' as deflationary crisis nears. Telegraph 11 January 2016, [Online] Available at <http://www.telegraph.co.uk/business/2016/02/11/rbs-cries-sell-everything-as-deflationary-crisis-nears/>[Accessed 13 March 2016]
Fama F.,and French K. R., 2006. The Value Premium and the CAPM. The Journal of Finance, 61(5), pp. 2163-2185.
Lintner, J., 1965. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. Review of Economics and Statistics, 47(1), pp. 13-37.
Sharpe W., 1964. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, Journal of Finance, pp. 425-442.
Van Dijk M.A., 2011. Is size dead? A review of the size effect in equity returns, Journal of Banking & Finance, 35(12), pp. 3263-3274.
William Hill, 2014. 2014 Annual Report. [Online] Available at <http://files.williamhillplc.com/media/1832/2014-final-results-accounts.pdf>[Accessed 13 March 2016]
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