Investment Analysis & Portfolio Management ELEVENTH EDITION FRANK K. REILLY University of Notre Dame KEITH C. BROWN University of Texas at Austin SANFORD J. LEEDS University of Texas at Austin Australia Brazil Mexico Singapore United Kingdom United States Investment Analysis & Portfolio © 2019, 2012 Cengage Learning, Inc.
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Printed in the United States of America Print Number: 01 Print Year: 2018 To my best friend & wife, Therese, and the greatest gifts and sources of our happiness, Frank K. III, Charlotte, and Lauren Clarence R. II, Michelle, Sophie, and Cara Therese B., Lisa, Kayleigh, Madison J., Francesca, and Alessandra —F. To Sheryl, Alexander, and Andrew, who make it all worthwhile —K.
To Jenny, Jay, John, and Genet, who bring meaning and happiness to my life. Brief Contents Preface xi Acknowledgments xvii About the Authors xxi PART 1 The Investment Background 1 CHAPTER 1 The Investment Setting 3 CHAPTER 2 Asset Allocation and Security Selection 33 CHAPTER 3 Organization and Functioning of Securities Markets 69 CHAPTER 4 Security Market Indexes and Index Funds 95 PART 2 Developments in Investment Theory 123 CHAPTER 5 Efficient Capital Markets, Behavioral Finance, and Technical Analysis 125 CHAPTER 6 An Introduction to Portfolio Management 171 CHAPTER 7 Asset Pricing Models 209 PART 3 Valuation and Management of Common Stocks 249 CHAPTER 8 Equity Valuation 251 CHAPTER 9 The Top-Down Approach to Market, Industry, and Company Analysis 295 CHAPTER 10 The Practice of Fundamental Investing 343 CHAPTER 11 Equity Portfolio Management Strategies 379 PART 4 Valuation and Management of Bonds 421 CHAPTER 12 Bond Fundamentals and Valuation 423 CHAPTER 13 Bond Analysis and Portfolio Management Strategies 465 PART 5 Derivative Security Analysis 517 CHAPTER 14 An Introduction to Derivative Markets and Securities 519 CHAPTER 15 Forward, Futures, and Swap Contracts 559 CHAPTER 16 Option Contracts 603 iv Brief Contents v PART 6 Analysis and Evaluation of Asset Management 645 CHAPTER 17 Professional Portfolio Management, Alternative Assets, and Industry Ethics 647 CHAPTER 18 Evaluation of Portfolio Performance 693 Appendix A The CFA® Charter 741 Appendix B Code of Ethics and Standards of Professional Conduct 743 Appendix C Interest Tables 745 Appendix D Standard Normal Probabilities 749 Comprehensive References List 750 Glossary 762 Index 774 Contents Preface. xi The Importance of Asset Allocation 44 Acknowledgments. xvii Investment Returns after Taxes and Inflation 46, Returns About the Authors.
xxi and Risks of Different Asset Classes 46, Asset Allocation Summary 48 The Case for Global Investments 49 PART 1 The Investment Background 1 Relative Size of U. Financial Markets 50, Rates of Return on U. and Foreign Securities 51, Risk of Diversified CHAPTER 1 Country Investments 51 The Investment Setting. 3 Historical Risk-Returns on Alternative Investments 56 What Is an Investment? 3 World Portfolio Performance 56, Art and Antiques 59, Investment Defined 4 Real Estate 60 Measures of Return and Risk 5 Chapter 2 Appendix: Measures of Historical Rates of Return 5, Computing A.
Covariance 67 Mean Historical Returns 7, Calculating Expected Rates of B. Correlation 67 Return 10, Measuring the Risk of Expected Rates of Return 12, Risk Measures for Historical Returns 14 CHAPTER 3 Determinants of Required Rates of Return 14 Organization and Functioning of Securities The Real Risk-Free Rate 15, Factors Influencing the Markets. 69 Nominal Risk-Free Rate (NRFR) 16, Risk Premium 18, Risk Premium and Portfolio Theory 20, Fundamental What Is a Market? 70 Risk versus Systematic Risk 21, Summary of Required Characteristics of a Good Market 70, Decimal Pricing 71, Rate of Return 21 Organization of the Securities Market 71 Relationship between Risk and Return 22 Primary Capital Markets 72 Movements along the SML 22, Changes in the Slope of Government Bond Issues 72, Municipal Bond Issues 72, the SML 23, Changes in Capital Market Conditions or Corporate Bond Issues 72, Corporate Stock Issues 73, Expected Inflation 24, Summary of Changes in the Private Placements and Rule 144A 74 Required Rate of Return 26 Secondary Financial Markets 74 Why Secondary Markets Are Important 75, Secondary Chapter 1 Appendix: Computation of Variance and Standard Bond Markets 75, Financial Futures 75, Secondary Equity Deviation 30 Markets 76, Exchange Market-Makers 78 CHAPTER 2 Classification of U. Secondary Equity Markets 78 Primary Listing Markets 78, The Significant Transition of Asset Allocation and Security Selection.
Equity Markets 80 Individual Investor Life Cycle 34 Alternative Types of Orders Available 85 The Preliminaries 34, Investment Strategies over an Market Orders 85, Limit Orders 86, Special Orders 86, Investor’s Lifetime 35, Life Cycle Investment Goals 36 Margin Transactions 86, Short Sales 88, Exchange Merger The Portfolio Management Process 37 Mania 90 The Need for a Policy Statement 38 Understanding and Articulating Realistic Investor Goals CHAPTER 4 38, Standards for Evaluating Portfolio Performance 39, Security Market Indexes and Index Funds. 95 Other Benefits 39 Uses of Security Market Indexes 96 Input to the Policy Statement 40 Differentiating Factors in Constructing Market Investment Objectives 40, Investment Constraints 42 Indexes 97 Constructing the Policy Statement 44 The Sample 97, Weighting Sample Members 97, General Guidelines 44, Some Common Mistakes 44 Computational Procedure 97 vi Contents vii Stock Market Indexes 97 an Individual Investment 174, Variance (Standard Price-Weighted Index 98, Value-Weighted Index 99, Deviation) of Returns for a Portfolio 175, Standard Unweighted Index 101, Fundamental Weighted Index Deviation of a Portfolio 180, A Three-Asset Portfolio 187, 102, Style Indexes 102, Global Equity Indexes 103 Estimation Issues 188 Bond Market Indexes 107 The Efficient Frontier 189 U. Investment-Grade Bond Indexes 109, High-Yield The Efficient Frontier: An Example 189, The Efficient Bond Indexes 109, Global Government Bond Indexes 109 Frontier and Investor Utility 191 Composite Stock–Bond Indexes 109 Capital Market Theory: An Overview 193 Comparison of Indexes over Time 110 Background for Capital Market Theory 193, Developing Correlations between Monthly Equity Price Changes 111, the Capital Market Line 193, Risk, Diversification, and the Correlations between Monthly Bond Index Returns 111 Market Portfolio 197, Investing with the CML: An Example 200 Investing in Security Market Indexes 112 Chapter 6 Appendix: Chapter 4 Appendix: Stock Market Indexes 119 A. Proof That Minimum Portfolio Variance Occurs with Equal Investment Weights When Securities Have Equal PART 2 Developments in Variance 207 Investment Theory 123 B.
Derivation of Investment Weights That Will Give Zero Variance When Correlation Equals 1.00 207 CHAPTER 5 CHAPTER 7 Efficient Capital Markets, Behavioral Asset Pricing Models. 209 Finance, and Technical Analysis. 125 The Capital Asset Pricing Model 209 Efficient Capital Markets 126 A Conceptual Development of the CAPM 210, The Why Should Capital Markets Be Efficient? 126, Security Market Line 211 Alternative Efficient Market Hypotheses 127, Tests and Results of Efficient Market Hypotheses 128 Empirical Tests of the CAPM 218 Stability of Beta 218, Relationship between Systematic Behavioral Finance 142 Risk and Return 219, Additional Issues 219, Summary of Explaining Biases 143, Fusion Investing 144 Empirical Results for the CAPM 220 Implications of Efficient Capital Markets 144 The Market Portfolio: Theory versus Practice 221 Efficient Markets and Fundamental Analysis 144, Efficient Markets and Portfolio Management 146 Arbitrage Pricing Theory 223 Using the APT 224, Security Valuation with the APT: An Technical Analysis 148 Example 226, Empirical Tests of the APT 228 Underlying Assumptions of Technical Analysis 149 Multifactor Models and Risk Estimation 229 Advantages of Technical Analysis 151 Multifactor Models in Practice 230, Estimating Risk in a Challenges to Technical Analysis 152 Multifactor Setting: Examples 235 Challenges to the Assumptions of Technical Analysis 152, Challenges to Specific Trading Rules 152 Technical Trading Rules and Indicators 153 PART 3 Valuation and Management Contrary-Opinion Rules 154, Follow the Smart Money of Common Stocks 249 155, Momentum Indicators 156, Stock Price and Volume Techniques 157, Efficient Markets and Technical CHAPTER 8 Analysis 163 Equity Valuation. 251 Important Distinctions 251 CHAPTER 6 Fairly Valued, Overvalued, and Undervalued 251, An Introduction to Portfolio Management.
171 Top-Down Approach versus Bottom-Up Approach 252 Some Background Assumptions 171 An Introduction to Discounted Cash Flow and Relative Risk Aversion 172, Definition of Risk 172 Valuation 254 The Markowitz Portfolio Theory 172 The Foundations of Discounted Cash Flow Valuation 255, Alternative Measures of Risk 173, Expected Rates of The Constant Growth Model 256, The No-Growth Model Return 173, Variance (Standard Deviation) of Returns for 259, Multistage (or Two-Stage) Growth Assumption 260 viii Contents Discounted Cash Flow 261 Calculating Intrinsic Value 330 Method #1: The Dividend Discount Model 261, Method Some Additional Insights on Valuation—For Individual #2: Free Cash Flow to Equity—The Improved DDM 265, Companies 330, Analyzing Growth Companies 331 Method #3: Discounted Cash Flow (FCFF) 272 Lessons from Some Legends 335 Relative Valuation 279 Some Lessons from Lynch 335, Tenets of Warren Buffett Implementing Relative Valuation 280, Relative Valuation 335, Tenets of Howard Marks 336 with CSCO 283, Advantages of Multiples 285, Disadvantages of Multiples 285 CHAPTER 10 Ratio Analysis 285 The Practice of Fundamental Investing. 343 Growth Rate of Sales 286, Gross Margins 286, Operating Margins 286, Net Margins 287, Accounts Receivable Initial Public Offerings 344 Turnover 287, Inventory Turnover 287, Net PP&E Why Go Public 344, The IPO Process 344, Underpricing Turnover 287, Debt as a Percentage of Long-Term Capital 347, Market Stabilization 349, Reasons for Underpricing 287, Changes in Reserve Accounts 288, Operating 349, Bookbuilt Offering versus Auction 351, Longer-Term Earnings/GAAP Earnings 288 Performance of IPOs 352 The Quality of Financial Statements 288 Buy-Side Analysts and Sell-Side Analysts 353 Balance Sheet 288, Income Statement 289, Footnotes 289 Sell-Side Analysts 353, Buy-Side Analysts 354, Financial Analyst Forecasting Literature 355, Snap Inc. IPO and Moving on to Chapter 9 289 Analysts 356 Chapter 8 Appendix: Derivation of Constant-Growth Dividend Capital Allocation 357 Discount Model (DDM) 293 The Seven Places That Capital Can Be Allocated 357, Dividends versus Repurchases 362, What Do Investors CHAPTER 9 Want to See? 363 The Top-Down Approach to Market, Industry, and Corporate Governance 363 Company Analysis .