MPT Associates (MPTA) is an investment advisory firm that makes asset allocation and stock selection recommendations for its clients. MPTA currently manages three portfolios: X, Y, and Z. Portfolio X is the mean-variance efficient market portfolio. Portfolio Y is the portfolio of risky assets with minimum variance. Portfolio Z consists exclusively of 90-day Treasury bills. The three portfolios have the following characteristics:
Expected return for Portfolio X =15%
Standard deviation of returns for Portfolio X = 20%
Expected return for Portfolio Y = 7%
Standard deviation of returns for Portfolio Y = 5%
Expected return on Portfolio Z = 5%
Recently, MPTA was contacted simultaneously by two clients: Danielle Burk and Derek Kitna. Burk and Kitna have known each other since college and are both currently working for the same company.
Burk currently owns a $100,000 portfolio which she is holding in her Roth IRA retirement account. Her investment strategy is a passive approach. Her retirement portfolio has the following risk-return characteristics:
Expected return on Burk's portfolio = 10%
Standard deviation of returns on Burk's portfolio = 12%
Kitna requests advice from MPTA on the proper valuation of two stocks that he is considering. Kitna is interested in determining the fair value of shares of Long
Drives, Inc. (LDI), a manufacturer of state-of-the-art golf clubs, and of Cell Chip Technologies (CCT), a manufacturer of cell phone chip processors. MPTA maintains a database of analyst forecasts and finds that the I -year consensus analyst forecast return for the CCT stock equals 15% and the LDI stock equals 13%
.
After lengthy conversations with both Burk and Kitna, MPTA decides to advise both of them to use the capital market line, security market line, and capital asset pricing mode! as their primary analytical tools.
MPTA's senior executives are analyzing trends in asset pricing over the past several decades. They conclude that in the period 1998-1999, there was a bubble in stock prices. Stock prices subsequently corrected, however, from 2000-2001. They believe that the downward trend in stock prices from 2002-2003 was an overcorrection; that is, prices fell significantly below fundamental values.
MPTA executives have been discussing the use of the Treynor-Black model with the investment consultants, Benesh Associates. The advisors at Benesh recommend that each investor be allocated a combination of a passive portfolio and an actively managed portfolio, depending on the investor's risk and return preferences. In his presentation on the Treynor-Black model, David Benesh, the principal at Benesh Associates, makes the following statements:
Statement 1: With respect to the actively managed portfolio, the Treynor-Black model will allocate more funds to securities with large alphas and low systematic risk.
Statement 2; The capital asset pricing model assumes that short selling of securities is unrestricted and that unlimited borrowing at the risk-free rate is allowed. If these assumptions are violated, then the relationship between expected return and beta might not be linear. Unlike the theoretical capital asset pricing model, the
Treynor-Black model avoids this problem because it does not consider short positions in securities.
In further discussion, Benesh recommends that MPTA consider subscribing to the investment newsletters of two independent equity analysts: Jack Nast and
Elizabeth Tackacs. Their alphas, residual risk, and correlation between forecasted and realized alphas arc provided in the table below.
Kitna has hired MPTA to evaluate the CCT stock and to make a valuation recommendation. In order to determine if the CCT stock is undervalued, overvalued, or properly valued, MPTA must first determine the appropriate value for the CCT beta. Given a CCT beta of 1.5, what is the conclusion that MPTA should make about the value of CCT based on the consensus analyst forecast of CCT returns?
Danyela
2 weeks, 3 days ago