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# SAPM LECTURE I

## Time Value of Money, Risk & Return Investment Framework

INVESTMENT
Investment is a commitment of funds for a period of time to derive a rate of return that would compensate the investor for the time Determine your required rate of return (and also the risk, if the two doesnt match, one need to set the expectations realistic) Investment alternatives available T-bills, bonds, FD (cash flows are fixed, easy to match with your rate of return), Equity, Alternative investments Key aspects Time (bonds)
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Risk (Stocks)

## TIME PREFERENCE FOR MONEY

Time preference for money is an individuals preference for possession of a given amount of money now, rather than the same amount at some future time Three reasons may be attributed to the individuals time preference for money:
risk preference for consumption investment opportunities

## REQUIRED RATE OF RETURN

The time preference for money is generally expressed by an interest rate. This rate will be positive even in the absence of any risk. It may be therefore called the risk-free rate. An investor requires compensation for assuming risk, which is called risk premium. The investors required rate of return is: Risk-free rate + Risk premium.

## REQUIRED RATE OF RETURN (CONT)

Would an investor want Rs. 100 today or after one year? Cash flows occurring in different time periods are not comparable. It is necessary to adjust cash flows for their differences in timing and risk. Example : If preference rate =10 percent
An investor can invest Rs. 100 if he is offered Rs 110 after one year. Rs 110 is the future value of Rs 100 today at 10% interest rate. Also, Rs 100 today is the present value of Rs 110 after a year at 10% interest rate. If the investor gets less than Rs. 110 then he will not invest. Anything above Rs. 110 is favorable.

Two most common methods of adjusting cash flows for time value of money: Compoundingthe process of calculating future values of cash flows and Discountingthe process of calculating present values of cash flows. The interest rate used for discounting cash flows is also called the discount rate.

## TIME VALUE - FORMULAE

= = (1 + ) (1 + ) (1 + ) 1 1 1 (1 + )

= =

1+ 1+ =

= (1 +

) 1

## TIME VALUE MS EXCEL FUNCTIONS

=PV(rate, nper, pmt, fv, type) =RATE(nper, pmt, pv, fv, type, guess) =PMT(rate, nper, pv, fv, type) =NPER(rate, pmt, pv, fv, type) =FV(rate, nper, pmt, pv, type)
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## TIME VALUE - APPLICATIONS

Sinking fund Capital Recovery and Loan amortization Retirement plan PV of uneven cash flows PV of growing annuity & perpetuity Annuity Due Multi-period compounding Net Present Value (NPV)
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## RISK & RETURN

What is Risk
Probability of loss Volatility of return Deviation of actual return from the planned return Uncertainty associated with change in asset price

Relationship between risk and return directly proportional This principle gets reflected in pricing of an instrument safer the instrument, higher the demand and higher the price and so lower the return and vice versa Recent Examples Yield on US 10-yr Bond 1.53% Yield on German 2-yr bond turned negative UK 30-yr below 3%,
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SOVEREIGN YIELDS
Country Australia Austria Belgium Canada Denmark Finland France Germany Greece Italy Japan New Zealand Portugal Spain Sweden Switzerland UK US Latest Spread vs Spread vs Tyield bund bonds 3.00% 2.20% 3.08% 1.75% 1.21% 1.63% 2.51% 1.30% 28.91% 5.77% 0.86% 3.44% 11.34% 6.16% 1.38% 0.59% 1.60% 1.57% 1.7 0.9 1.78 0.45 -0.09 0.33 1.21 -27.61 4.47 -0.44 2.14 10.04 4.86 0.08 -0.71 0.3 0.27 1.43 0.62 1.51 0.17 -0.37 0.05 0.93 -0.27 27.33 4.2 -0.71 1.86 9.76 4.59 -0.19 -0.99 0.03 --

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RISK AVERSION
10,000

Risk Averse < 5000 Risk Neutral = 5000 Risk Lover > 5000
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SOURCES OF RISK
Business Risk Competition, technology, substitutes, raw material, consumer preference, government policies Interest rate risk Market Risk Changing sentiments of investors As John Train says, Stock market moves in cycle and investor get wonderful bargains every few years and have a chance to sell again at ridiculously high prices a few years later Cycles are caused by mass psychology
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TYPES OF RISK
Macro vs micro External vs internal Systematic vs unsystematic risk Systematic risk non-diversifiable risk
Market risk liquidity, equity, currency and commodity Interest rate risk Purchasing power risk variation in real returns due to inflation

## Unsystematic risk diversifiable

Business risk variability of operating profit fixed cost, variable cost. Proportion of fixed cost to total costs decides business risk Financial risk proportion of debt to total capital decides financial risk

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## Total Risk = Systematic Risk + Unsystematic Risk

SYSTEMATIC RISK
Systematic risk arises on account of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. This part of risk cannot be reduced through diversification. It is also known as market risk. Investors are exposed to market risk even when they hold welldiversified portfolios of securities.

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UNSYSTEMATIC RISK
Unsystematic risk arises from the unique uncertainties of individual securities. It is also called unique risk. These uncertainties are diversifiable if a large numbers of securities are combined to form well-diversified portfolios. Uncertainties of individual securities in a portfolio cancel out each other. Unsystematic risk can be totally reduced through diversification.
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## SYSTEMATIC AND UNSYSTEMATIC RISK

AND NUMBER OF SECURITIES

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=

=1

=1

)2 ( )2

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## SECURITY MARKET LINE

Movements along SML If an investments risk changes due to change in source of risk, it will move along the SML. If firm increase the financial leverage by selling large bond issue, it will move up / down the SML. SML doesnt change but the position of asset change Change in slope of SML Slope of SML is given by E(Rm) Rf which is nothing but risk premium which changes causing change in SML slope. One indication is yield spread between Bbb and Aaa. Changes in Rf SML will shift parallel due to change in expected real growth, a change in market conditions or a change in the expected rate of inflation
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INVESTMENT FRAMEWORK
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WARREN BUFFET

WARREN BUFFET
Great businesses enjoy the following characteristics: Simplicity - they are easily understood, and straightforward to manage Strong business franchises - they benefit from 'economic goodwill', i.e. the ability to keep raising prices above the level of inflation Predictability - their earnings can confidently be projected into the future High returns on capital - achieved without resorting to creative accounting or excessive debt. This is even more important than headline earnings. Strong cash generation - they throw off cash and do not require heavy reinvestment in assets simply to stay in business, enabling them instead to invest the cash in pursuit of even greater profits. Devotion to shareholder value - the management has a significant amount of its own capital tied up in the business, and thinks of shareholders as fellow owners whose interests are identical to their own. Estimate the intrinsic value of the business. Price is what you pay, value is what you get. Allow a sufficient 'margin of safety' between the two, so that, in effect, you are paying 50p or 60p for 1 of value. That way, you will still be able to make a good return if your estimates err on the high side.

22 Ignore the gyrations of the stock market. Buffett has said that, after buying a stock, he would not care if the market shut down altogether for ten years, since he is sufficiently confident of the intrinsic value of his holdings that he does not need the market to confirm it for him.

WARREN BUFFET
Key sayings "Rule Number One: Never lose money. Rule Number Two: Never forget Rule Number One." "I would sooner buy a great business at a fair price than a fair business at a great price." "When a management with a reputation for brilliance tackles a business with a reputation for poor economics, it is the reputation of the business that stays intact.

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T ROWE PRICE
Cyclical investor in long-term growth companies, buying at the bottom of the business cycle and selling at the top. In later life, Price switched to a more value-driven style, investing in steady-growth, oil and gold stocks Method and guidelines Like people, companies pass through three phases in their life cycle: Growth Maturity Decadence Look for companies in the earliest identifiable phase of growth. This growth is of two kinds: Cyclical - growth in unit volumes of sales and in net earnings, which peaks at progressively higher levels at the top of each succeeding business cycle. These stocks are ideal for investors looking for capital gains during the recovery stage of the business cycle Stable - growth in unit volumes and in net earnings, which persists through the downturn in the business cycle. These stocks are suitable for investors who need relatively stable income.

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T ROWE PRICE
Concentrate on industry leaders. These can usually be identified by their competitive advantages, including: Outstanding management Leading-edge research and development Patents, licenses and other legally enforceable product rights Relative protection from government regulation Low labor costs, but good labor relations These advantages usually go hand-in-hand with A strong balance sheet A high return on capital (at least 10%) High profit margins Consistently above-average earnings growth. If these financial ratios are improving, that is often a good indicator that the company is still in its growth phase. 25

T ROWE PRICE
Key sayings "Even the amateur investor who lacks training and time to devote to managing his investments can be reasonably successful by selecting the best-managed companies in fertile fields for growth, buying their shares and retaining them until it becomes obvious that they no longer meet the definition of a growth stock. Growth stocks' can be defined as shares in business enterprises that have demonstrated favorable underlying long-term growth in earnings and that, after careful research study, give indications of continued secular growth in future...Secular growth extends through several business cycles, with earnings reaching new high levels at the peak of each subsequent major business cycle..."

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PHILIP A FISHER
Ultra long-term buy-and-hold investor in technology growth stocks Method and guidelines Concentrate your attention and your cash on young growth stocks. In order to identify and research promising prospects, read everything you can lay your hands on, from trade journals to brokers' reports interview those in the know, such as managers and employees, but especially suppliers, customers and competitors, who will be more forthcoming visit various company sites if you can, and not just the headquarters.

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PHILIP A FISHER
Before you buy, make sure you get satisfactory answers to 15 key questions: Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years? Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited? How effective are the company's research and development efforts in relation to its size? Does the company have an above average sales organization? Does the company have a worthwhile profit margin? What is the company doing to maintain or improve profit margins? Does the company have outstanding labour and personnel relations? Does the company have outstanding executive relations? Does the company have depth to its management? How good are the company's cost analysis and accounting controls? Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition? Does the company have a short-range or a long-range outlook in regard to profits? In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth? Does the management talk freely to investors about its affairs when things are going well, but 'clam 28 up' when troubles and disappointments occur? Does the company have a management of unquestionable integrity?

PHILIP A FISHER
Key sayings "I don't want a lot of good investments; I want a few outstanding ones." "The greatest investment reward comes to those who by good luck or good sense find the occasional company that over the years can grow in sales and profits far more than industry as a whole." "The business 'grapevine' is a remarkable thing. It is amazing what an accurate picture of the relative points of strength and weakness of each company in an industry can be obtained from a representative cross-section of the opinions of those who in one way or another are concerned with any particular company." "If the job has been correctly done when a common stock is purchased, the time to sell it is - almost never."
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SOME MORE
Benjamin Graham Margin of Safety John Keynes Market Psychology John Templeton Bargain hunter (In 1939, when World War II began in Europe, the 26-year-old investor borrowed \$10,000 and bought 100 shares each in 104 companies that were selling at \$1 a share or less, including 34 in bankruptcy. A few years later, he made large profits on 100 of the companies; four turned out to be worthless) Peter Lynch Openness and flexibility

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## COMMON TRAITS OF GREAT INVESTORS

Compiled by John Train He is realistic He is intelligent to the point of genius He is utterly dedicated to his craft He is disciplined and patient He is a loner Most of them started as value investor but later focused on growth.. Which gave them multi baggers..focus on good businesses and not price..

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BOOKS RECOMMENDED
Intelligent Investor Benjamin Graham Security Analysis Benjamin Graham Peter Lynch Beat the street

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## FOOD FOR THOUGHT

Why wind mill stopped in just 5 yrs Why the airplane crashed Reliance Power ON, Stock market OFF Why the infrastructure burst Why micro-finance went bankrupt.. Can a Pizza remain hot for next 5-10 yrs History is the best teacher in stock market

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TIME ALLOCATION
Common 70% - gathering data 20% - Analysis 10% - execution Ideal 20% - gathering data 80% - Analysis & Thinking <1% - execution

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## POWER OF COMPOUNDING (CONSISTENTLY)

Financial Co. 2000 2012 ; Rs 30 Rs 500

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## POWER OF COMPOUNDING (CONSISTENTLY)

Consumption Co. 2000 2012 ; Rs 7 Rs 220

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## POWER OF COMPOUNDING (CONSISTENTLY)

Financial Co Pharma Co Consumption Co Oil & Gas Co Start Yr 2000 2000 2000 2004 End Yr 2012 2012 2012 2012 Initial Price Current Price Multibagger 30 500 16x 5 500 100x 7 220 30x 15 160 11x CAGR 26% 47% 33% 34%

What looks multi bagger over the years is actually a result of consistent compounding over the years Even if we are able to grow at 25% CAGR for 10 yrs, it would result in 10 bagger whereas growing at 7% (post tax FD rate) would result in just 2 bagger

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