Actuarial Investment

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Actuarial Investment

• Shane Whelan
• L527

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Principal Economic Influences on Investment
Markets
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The Obvious Point

• General price level in market set by supply
  demand
• Shift in supply or demand higher/lowers level of
  market (yield, ex ante return expectations)
• Demand for capital assets is very price elastic
  as many close substitutes
• In general think of supply and demand factors
  when justifying current levels and anticipating
  future price changes.
• Note that demand in the market can generally
  change faster than supply.

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Factors Affecting Short-Term Interest Rates

• Generally set by central banks (through repo rate
  and signalling)
• To control inflation hence high i and strong
  exchange rate
• To maximise economic growth hence low i and
  weak exchange rate
• To maintain independence hence needs to remain
  esteemed
• Over long term we note the close relationship
  between inflation and short-term interest rates
  hence level of inflation a key driver.
• Rates naturally correlated with business cycle as
  demand for credit increases (relative to supply)
  in up periods and is weak in down periods.

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Factors Affecting Long-Term Interest Rates

• Inflation
• as bond investor wants compensation for its
  expected level.
• Inflation risk premium
• As bond investor wants compensation for
  uncertainty in inflation outlook.
• The level of short-term interest rates
  especially for short bonds
• but are they too low to keep check of inflation
  or too high so recession imminent?
• The exchange rate as demand can come from
  overseas investors
• And other yield curvesespecially the long
  treasury

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Factors Affecting Long-Term Interest Rates

• Governments fiscal position and its funding
  policy (supply).
• Institutional cashflow on demand side
• Regulation changes
• Retail trends
• Investment policy alternative investments
• Any economic news in its affect on
• inflation, exchange rate, short-term interest
  rates,
• or any other factor that affects long-term
  interest rates.

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The Credit Yield Spread

• To judge corporate yields one needs to consider
  all the factors affecting the underlying yield
  curve plus anything that affects the probability
  of default
• Hence economic/business cycle in general.
• Corporate and sector profitability in particular.

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Level of the Equity Market

• Demand for equities is highly dependent on
  expectations the expectations of future
  corporate profitability and
• Expectations of real interest rates as the lower
  they are the better for equities as higher
  value and stimulus to economic activity.
• Perceptions of risk the equity risk premium
• Real growth of economy the tide that raises all
  boats.
• Inflation as creates uncertainty and, often,
  higher taxes (the tax wedge).
• Currency a factor that works in many directions
  but a weak domestic currency is generally a good
  for equity market.

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Level of the Equity Market

• Other influences
• Supply privatisations, share buybacks, rights
  issues
• Demand tax incentives to save, institutional
  flow of funds
• Political climate stability preferred
• Overseas equity markets especially the US as
  increasingly one world
• Alternative investments

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The Property Market

• Economic factors can be considered as affecting
  the property market through
• Rental market - occupational demand
• Development cycle supply side
• Investment market capitalises rental value.

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The Property Market

• Occupational Demand
• Tied to buoyancy of economy in sector/region.
  Look at employment figures.
• Course of real interest rates
• Stuctural changes in demand for property move
  to industrial/office parks in suburbs
• Supply Side
• Lag in coming on stream they come like buses
  and create a cycle in the property market.
• Restrictions on planning permission
• But fixity of location and a segmented market
  mean supply/demand disequilibria can persist in
  regions for some time (5-10 years)

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The Property Market

• Property Investment Market
• Good inflation hedge (if frequent rent reviews)
• Real yields as they move up then property
  values fall and vice versa.
• Other factors institutional cashflow, property
  co.s and international consortia. The exchange
  rate has an affect through the latter.

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Factors affecting Relative Valuation of
Individual Equities
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Factors affecting Relative Valuation of
Individual Equities

• We looked at key determinants in the overall
  level of equity market.
• Q. But why would one share be cheaper than
  another on P/E, dividend yield or other
  measures?
• A. Supply demand for shares (yes trivially) but
  with demand so elastic and it resting on ex ante
  return expectations..
• Within equity markets, valuation differences due
  to different expectations on future
  capital/income gowth from shares (i.e, firms
  future profitability)
• Or different risk (i.e., a greater certainty on
  future profit stream).

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PERs and their relationship with the Economic
Cycle

• Economy on stable sustainable growth path
• Range of PER across sectors/within sectors
  unusually narrow. Industries with high barriers
  to entry and high profit margin rated most
  highly.
• Economy heads toward recession
• Historic PERs of cyclical companies fall (as
  price falls before anticipated E falls).
  Defensive companies maintain stable PER.
• In Recession with poor outlook
• Historic PERs of cyclicals have now risen (as E
  fell) but are still below defensives.
• The Green Shoots of Recovery Spotted
• Marked price rise all round with now PER of
  cyclical ahead of defensives.

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Hence

• We have to normalise P/E for stage in economic
  cycle when comparing inter-sector.
• Might attempt to calculate a normalised P/E ratio
  based on normalised earnings (i.e., averaged
  over cycle).

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Share Valuation Generally Part of A Structured
Analysis

• Top down have a consistent view of
• Global economic outlook
• Domestic economic outlook
• Industry outlook
• Then specific firm in industry
• As opposed to bottom up which is to select
  individual stocks without economic framework

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Two Ways to Value A Share

• Fundamental Analysis
• try to assess the true (or fundamental) value of
  a share by discounting the expected proceeds from
  holding the share indefinitely and also pricing
  its riskiness. If fundamental value above market
  price then buy, otherwise sell.
• An aspirational methodnot feasible in practice
  as too complicated.
• Comparative Analysis
• look at current market prices of all similar
  shares (e.g., same sector) and overweight the
  cheapest looking one(s) and underweight the
  dearest looking one(s) as value fund manager
  would say
• or, if growth fund manager, then try to identify
  companies with an sustainable competitive edge
  not reflected in current price.

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Fundamental Analysis

• Problem is to estimate for each future year the
  profits of company or its dividend (if DDM used).
• Needs stylised model of operation of company how
  it adds value and potential of market. Sometimes
  a formal forecast of turnover, cost of sales,
  hence operational profit then interest on debt,
  tax, etc. to after tax profit.
• Discount them at appropriate risky rate to NPV
  which is compared with current share price.

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Comparative Analysis

• Compare and contrast key financial ratios of
  company with others
• P/E, dividend yield, P to EBITA, P to Free Cash
  Flow, Earnings cover (E/D), dividend cover (D/E).
• Level of gearing
• Level of liquidity
• Profit growth and variability
• Growth in Net Asset Value
• Note there is another way to time the
  purchase/sale of shares, which does not rest in
  putting an intrinsic value on them.
• Or rather, takes the pragmatic line that they are
  intrinsically worth what you can get for them.
• This alternative method is known as technical
  analysis. Technical analysis, and its rationale,
  with be presented as a case study later.

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Qualitative Factors Affecting the Relative
Valuation of Share

• Competition (pricing power, barriers to entry)
• Prospects for growth of sector/company within
  sector
• Management ability especially in times of
  change.
• Quality of products
• Input costs
• Level of investment (retained profit other)

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Sources of Information on Individual Companies

• Stockbroker reports
• The financial press, Bloomberg/Reuters, etc.
• The trade press
• Companies published accounts and public
  statements by company
• Visit to company/discussions with company
  management
• Discussions with competitors
• The listing stock exchange
• Statutory information that company must provide.

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More Factors Affecting Relative Valuation (esp.
between asset classes)

• We treated, in broad terms, investors
  expectations on risk rewardinternal factors
• Must consider factors external to outlook for
  share/asset type
• investor income flow
• investor preferences (or better, natural
  habitats)
• alternatives

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Demand Factors Affecting Relative Valuation

• Institutional cashflow plays significant role in
  price determination
• Especially when cashflow into/out of vehicles
  with little latitude for fund manager in what to
  invest.
• Investors natural habitat in market (in terms of
  matching securities, level of risk tolerance,
  etc) can change with change in regulatory regime,
  tax regime or liability profile.

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Demand Factors Affecting Relative Valuation

• Uncertainty in political climate
• Go for gold
• Fashion or sentiment change
• Companies marketing/investor education

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Supply Factors affecting relative valuation

• Share issues
• Bond issues
• Technology

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ConcludesPrincipal Economic Influences on
Investment Markets Individual Shares