1- Mohammad Aljobair
2- Faisal Alrajhi
3- Nawaf Alamer
4- Saud Alrajhi
The portfolio weights for each month are affected by a combination of reasons such as the previous month’s market performance, experts’ opinions, the business financial structure, expected performance, and the level of risk in each business, as well as the risk appetite of the investor. When an investor has a high-risk appetite, he/she undertakes an investment with high returns but equally high risks. On the contrary, if he/she is risk averse, he/she participates in low risk and low return investments. This paper illustrates an investor’s decisions over a period of 11 months, starting from January to December 2017. The analysis is done using Capital Asset Pricing Model (CAPM).
The capital asset pricing model (CAPM) was developed by William Sharpe (1964) and John Lintner (1965) (Chincarini & Kim, 2006). This model shows the relationship between the systemic risks and the expected returns on assets. As a result, this model is used to calculate the cost of capital, establish the expected returns on assets, and to price risky securities. The capital asset pricing model is founded on the idea that investors get compensation from the time value of their money and the risks which they undertake (Hull, 2015). The risk-free rate (rf) represents the time value for money, while compensation for risk is calculated by multiplying the risk measurement (beta) with the market premium (rm-rf). The market rate is referred to as rm. Accordingly, the CAPM model is calculated as follows:
Er= rf= B(rm-rf) (Coleman & Litterman, 2012)
rf= risk-free rate
rm= Expected market return
Er= Expected return on the specific asset.
The investment in January was largely based on the risk status of the companies that make the team’s portfolio. During this month, we focused on the debt-to-equity ratio, the return on equity (ROE), and the profit margins from each company. The debt-to-equity ratio for investment A, B, C, D, and E were 12.18, 2.8, 0.31, 0.467, and 0.256 respectively. Therefore, investment A and B were highly risky since they were highly financed through debt. However, investment A had a high return on equity and profit margin of 7% and 6.2% respectively. These high returns indicate that an aggressive investor should not be concerned about company A’s massive debts.
The return on equity ratios were 7%, 0.7%, 4%, 20.8%, and 6.7% for investment A, B, C, D, and E respectively. In this regard, companies A, D, and E have high shareholder value, while investments B and C have the least. The profit margins for investments A, B, C, D, and E were 6.2%, 1.3%, -6%, 25.5%, and 4% respectively. Therefore, company A, D, and E are the best performing while B and C are underperforming. Based on this information, the team acquired more shares on company A, D, and E since they have the highest returns. Of the $1 million available, 15% was used in investment A, 35% was used in investment D, while 30% was used in investment E. Although investment A had high returns and profit margins, less capital was invested on it than in E due to its high-debt-to-equity ratio. The least investment was made in company B since it is high-risk, it has a high debt-to-equity ratio of 2.8 and a low return on equity of just 0.7%.
The team’s investment’s decision for February were made based on analysts’ recommendations. Obviously, the investment made in February were based on the historical recommendation provided by the analysts in January. The experts used a scale of 1 to 5 to assess the suitability of an investment. In this case, an investment with a rating of 1 is a strong sell while one with a rating of 5 is a strong buy. As of January, company’s A, B, C, D, and E had a rating of 3.741, 3.286, 4.379, 4.056, and 3 respectively. According to the analysts, the most suitable investments were C, A, and D. In light of this, the team ensured that it invested 35%, 13%, and 15%, of its capital in D, C, and A respectively. The reasons for the much lower investments in A and C than what was invested in D is because company A has a high debt-to-equity ratio, which is risky. Also, although C is a low-risk investment, the company has a low return-on-equity.
The team made huge investments in company E since it had a low debt to equity ratio. Moreover, its return on equity was high. Capital E also has a high market capitalisation and has diversified its investments. Therefore, it is fairly stable in its operations. The least investment was in company B because of its low return on equity and its high debt to equity ratio.
In March 2017, the team invested 0.21, 0.07, 0.15, 0.23, and 0.34 of its capital in company A, B, C, D, and E respectively. Majorly the team’s investment decisions were informed by the business opportunities in these companies and analyst’s recommendations. With regards to analyst’s recommendations, the company used the opinions formed in February to establish its March strategic decisions. According to experts, company A, B, C, D, and E had a rating of 3.643, 3.37, 4.357, 4.029, and 2.862 respectively in February. The experts regarded companies C, D, and A to be the most attractive for investment.
The team decided to invest most of its $1 million capital in company A and D since they had the highest return on equity and profit margins. 21% of the capital was invested in A and 23% in D. Although the experts were of the opinion that company E was not attractive, the team still invested a large portion of its capital in the company due to low debt to equity ratio and high return on equity in the business. The characters of company E enabled the company to hedge risks present in companies that have high debt levels.
The team invested 0.23, 0.1, 0.2, 0.25, and 0.22 of its capital in company A, B, C, D, and E respectively. According to experts opinions, company A, B, C, D, and E had a rating of 3.621, 3.444, 4.357, 4.118, and 2.933 respectively in March. In this regard, experts viewed investment B and E as being the least attractive. Accordingly, investments in company B, C, D, and A were the most attractive.
In light of this, the team reduced its investment in company E from 34% of its capital to 22%. However, the company increased its investments in A to 23% so that it could enjoy the high return on equity in the business. The team also ensured that it had a high capital stake in investment C and D due to their positive ratings in March.
In May 2017, the team invested 0.23, 0.11, 0.19, 0.23, and 0.24 of its capital in company A, B, C, D, and E respectively. The April 2017 experts’ opinions were relied in informing the team about its investment decisions. In April, the analysts gave company A, B, C, D, and E a rating of 3.621, 3.444, 4.31, 4.029, and 2.933 respectively. Therefore, they were of the view that company C, D, and A were the most viable investments. On the other hand, they viewed company E as the least attractive.
Our team made its most investments in company A, D, and E. Company A had high return on equity and profit margin, which would enable the business to make a lot of profits. Similarly, the team invested a lot in company D due to its low debt-to-equity ratio and high return on equity and profit margins. The team’s primary reason for investment in E was to hedge its risks. Company E has a high-profit margin and low-level use of debt in its operations.
In June 2017, the team invested 0.15, 0.07, 0.25, 0.37, and 0.16 in company A, B, C, D, and E respectively. The team’s decisions were mainly due to the performance of these companies and the experts’ opinions. According to experts opinions received in May 2017, company A, B, C, D, and E have a rating of 3.621, 3.519, 4.241, 3.97, and 3 respectively. In this regard, company A, C, and D are the most attractive. Company E is the least attractive for investment.
The team made most of its investments in company C and D since they are the most attractive. Additionally, these companies have a low debt-to-equity ratio and are therefore safe investments. The team also reduced its stake in company A and B due to the high debt to equity ratios in these companies. When compared to May, the team reduced its investment in company E due to its unattractiveness when compared to the other available stocks.
In July, the team invested 0.3, 0.11, 0.16, 0.23, and 0.2 of its capital in company A, B, C, D, and E respectively. The team’s decisions were based on analyst’s information issued in June and the second quarter earnings of the companies. In June, the analysts gave company A, B, C, D, and E a rating of 3.621, 3.462, 4.241, 3.97, and 3.129 respectively. Therefore, they were of the opinion that company C, D, and A are the most attractive. In the second quarter, all companies had an increase in their earnings except company E, which had a slight decrease. The earnings for company A, B, C, D, and E were 2.55, 1.49, 0.91, 1.5, and 0.78 respectively.
Based on this information, the team made most of its investment in company A and D since they had the highest earnings. The team also increased its stake in B due to its attractive earnings. Despite company E making low earnings in the second quarter, the team still increased its investments in it to hedge its risks. Noteworthy, company E has a low debt to equity ratio and high return on equity ratio. The analysts’ expectations did not have a great variation from the actual performance of the companies.
In August 2017, the team invested 0.24, 0.08, 0.21, 0.25, and 0.22 of its capital in company A, B, C, D, and E respectively. The team used the analysts’ views in July to determine its investment pattern. According to the experts, company A, B, C, D, and E had a rating of 4.077, 3.583, 4.143, 4.063, and 3.067 respectively. Therefore, the analysts were of the opinion that company A, C, and D are the most attractive.
The team ensured that it made huge investments in company A, C, and D, in accordance with experts’ advice. However, it still made a slight reduction in its investment in company A, because of its high risk due to its high debt to equity ratio. Noteworthy, the team also increased its stake in company E to hedge its risk and benefit from the high return on equity in the company.
In September 2017, the team’s investment was 0.28, 0.09, 0.2, 0.15, and 0.28 for company A, B, C, D, and E respectively. These investments was based on the performance of these companies and the recommendations. For September, the company relied on the August views of the analysts in which they gave company A, B, C, D, and E a rating of 4.037, 3.667, 4.214, 4, and 3.067 respectively. In this regard, the analysts were of the opinion that company A, C, and D were the most attractive.
Based on the information that the company had, it made major investments in company A, C, and E. The high investments in company A and B were mainly due to the expectations of making high incomes, which was in line with the analysts’ opinions. However, the team still made a lot of investments in E to hedge its risk, since this company has a low debt to equity ratio and a high return on equity.
In October, the team made an investment of 0.15, 0.21, 0.19, 0.23, and 0.22 in company A, B, C, D, and E respectively. The team’s decisions were influenced by analysts’ recommendations and the performance of each company. According to the analysts, company A, B, C, D, and E had a rating of 4.037, 3.72, 4.241, 4.063, and 3.067 respectively. Therefore, company A, C, and D were the most attractive.
The team decided only to invest 0.15 of its capital in company A since it had a high debt to equity ratio, which made it a high-risk investment. The company also increased its investments in C and D since these companies had a high return on equity and low risks since they had a low debt to equity ratio. Finally, the company increase its investment in E to hedge its risks.
In November 2017, the team invested 0.2, 0.22, 0.23, 0.21, and 0.12 of its capital in company A, B, C, D, and E respectively. Generally, the team’s decisions were based on the strategies of the individual companies and their historical performances. Noteworthy, there was no any analysts’ recommendation during this period.
The teams’ decision to have a high investment in A was because of the organization’s high return on equity. Similarly, its high investment in D was due to the organization low debt to equity ratio and high return on equity and profit margins. The team also increased its investment in company B to benefit from the company’s future increase in value. Currently, company’s B value has fallen due to a decrease in global economic growth, which has led to a decline in the demand for its products. Therefore, the acquisition of the company’s stock will enable the team to make a lot of income once they increase their value in the future. The group also increased its investments in C due to the prospects of the company having a high performance in its new renewable energy sector and its diversified business operations.
Chincarini, L., & Kim D. (2006). Quantitative equity portfolio management: An active approach to portfolio construction and management. New York, NY: McGraw-Hill.
Coleman, T., & Litterman, B. (2012). Quantitative risk management, + website: A practical guide to financial risk. Hoboken, NJ: Wiley.
Hull, J. (2015). Risk management and financial institutions (4th ed.). Hoboken, NJ: Wiley.