In this series of revision posts, we ask your AB Maximus CFA® Program exam trainers to give you quick tips and essential advice for different chapters in the curriculum. Handy for revision or simply for a last minute review to make sure you’re thoroughly prepared – don't miss the chance to brush up on your knowledge and do a little extra prep!
3 must-know concepts are: the construction and use of indices, the top-down analysis framework, and intrinsic value.
1. The construction and use of indices
Stock and bond market indices include a portfolio of stocks, selected by a committee, which are meant to represent the entire market, a particular industry or an investment theme. These stocks can change over time to reflect the current economy.
Index values measure the statistical change of the investments in a market or sector, and can be constructed in many ways. The 3 most common methods are:
Indices measure and replicate the performance of a broad market, asset class or investment theme by tracking the performance of companies within the index. The index value can act as an indicator of daily performance, market movements and trends, and the investing sentiment towards particular companies or industries.
Remember that investors cannot invest directly in an index. Instead, they do this through mutual funds and exchange-traded funds (ETFs) that have portfolios similar to the index.
2. The top-down analysis framework
To identify investment opportunities across countries, industries or securities, students should use the top-down analysis framework to pick stocks. Start with the health of the world economy and look at both developed and developing countries’ GDP. In addition, be mindful of current affairs and political decisions that may affect the economy’s stability and potential investment opportunities (Eg. Trump Presidency and Brexit etc).
Next, observe the local economy and the market health through indicators such as interest rates, inflation and employment. Then, analyse the indices through fundamental analysis (eg. price-to-earnings, price-to-sales and dividend yields ratios) to determine their health.
Next, determine which sectors to focus investments in by analysing each sector using fundamental and technical analysis. The current state of the sector and its future potential for growth should be considered, as well as factors such as population distribution and ESG (Environment Social and Corporate Governance) factors.
For buying individual stocks, investors should do fundamental analysis on measurements such as price/earnings to growth ratio, return on equity and dividend yield, while considering the future potential for growth. On the other hand, technical analysis on the long-term weekly charts and daily charts inform the investor about the best entry and exit price.
3. Intrinsic value
Intrinsic value is estimated through the discounted cash flow model so as to allow investors to identify stocks that are over or undervalued. This accounts for the time value of money through free cash flow and the weighted average cost of capital.
Students often forget: the importance of qualitative judgment of a stock’s value.
It is important to note that intrinsic value (a quantitative value) is not an infallible estimation of value. Remember that investment success is both a science and an art – simply relying on figures is not an accurate representation of how companies work in the real world.
An analysis of qualitative factors such as management competency, corporate governance and market behavior – which are essential to a company’s success and therefore investor returns – is as important as quantitative analysis. Without considering qualitative analysis, an investor may misinterpret the true value of a stock.
A practical tip is: Remember to consider the future state of the asset and market when investing.
Most students simply consider the present short term pricing of a particular stock or asset, and then make a recommendation. However, a truly astute investor not only looks at today’s prices, but also factors in an analysis of whether the future outlook for the asset is positive or negative.
You need market inefficiency to get opportunities, and efficiency for these opportunities to turn into returns. As Benjamin Graham said: “The market is a voting machine in the short run, but it's a weighing machine in the long run.”
A great study resource is: reports, studies and newspapers.
In order to make good recommendations and observe how financial theory interacts with financial markets, reading extensively is important. From these sources, distill information that is relevant to investing decisions. Most importantly, learn from the mistakes made by other investors.
For example, ComfortDelgro was a defensive stock with free cash flows and good dividend yields, which only lasted while it had a monopoly over the taxi service. This model was heavily affected by the disruption of the market by car-sharing services Uber and Grab since 2016, and many investors were slow to cut their long positions in the stock.
About the author
Tolmas Wong, CFA is the AB Maximus trainer for Equity Investment. He is currently Director (Sales), Private Clients Services at CIMB Securities & an adjunct lecturer at the Singapore Management University. He has held positions at United Overseas Bank, Citicorp Vickers and Schroder Securities, and was a board member of CFA® Society Singapore and the Asian Securities Analysts Federation.