Pavia. October – December 2014 Asset and Portfolio Management

1. Pavia. October – December 2014 Asset and Portfolio Management

2. Program: phases of an efficient investment’s process • Define Investor’s characteristics and goals • Strategic Asset Allocation • Studying Market’s behavior • Forecasting Returns • Macroeconomic Analysis • Fundamental Analysis • Portfolio’s Construction • Risk Budget Approach • Optimization • Tactical Asset Allocation • Tactical Risk Management (ex ante) • Technical Analysis • Fund selection • The process • The model for selection • Control and Reporting • Risk Management (ex post) • Performance Analysis

3. 1. Investor’s characteristics and goals

4. 1 – Define investor’s characteristics and goals • It is very important to define: • Risk Profile • Time Horizon • Approach (benchmark vs Total Return) • Constraints: • Investible universe (equities, bonds, credits, etc) • Type of underlying (stocks, mutual funds, Etf, Hedge Funds) • Maximum / minimum exposure • Define correctly investor’s characteristics is fundamental: if you make a mistake at this level is very difficult that the investor will be satisfied, even if you will be right in forecast returns • Responsability: Private Banker

5. 1 – Investment’s approach • Benchmark driven: the investor choose an index of the market (benchmark), the goal oh the fund manager is try to bet the index (over performance) • The strategic asset allocation is actually delegated to the benchmark chosen • The asset managers stay concentrated to tactical asset allocation and fund (security) selection • NO volatility control over time • The hope is that without volatility constraints over long time period the investor get higher returns (Is that true?) • Total Return: without a benchmarkasset managers try to maximize expected return given a certain level of risk (Value at Risk). The goal is to achieve extra return vs risk free with a define level of risk (volatility) • The asset manager control all the process: dynamic asset allocation and fund (security) selection. • Flexible approach, with 2 explicit goals: • volatility control and capital protection (stability of returns) • over performance vs risk free (o risk free + X basis points)

6. 2. Strategic Asset Allocation

7. Phases of Strategic Asset Allocation • 1 – Define Investible universe on a global basis: • Monetary Instruments • Government bond (1-3 years, 3-5 years, 5-10 years) • Corporate Bond (Investment Grade and High Yield) and Emerging Markets Bonds • Global Equity (Europe, USA, Japan, Asia ex Japan, Emerging) • Commodities 2 – Studying Markets Behavior • Analysis of Assets classes over a defined time horizon (usually 2 / 5 years, weekly frequency) • Calculation of annualized statistical indicators (DNA of different Assets Classes) • Expected returns • Standard deviations • Correlations (matrix of interaction among financials activities) • 3 – Studying economic and markets environment • Macroeconomic analysis • Fundamental Analysis • 4 – Portfolio’s construction • Risk Budget Approach (Risk’s constraints and allocation) • Optimization (Mean Variance and Black and Litterman)

8. 2. Strategic Asset Allocation Investible Universe and market’s behavior

9. Driver Exposure Underlying 1 - Investible Universe Role Strategical Tactical MonetaryUnstruments < 12 mesi Euro Capital Protection Short Terms Bonds Risk Budget Views • GovernmentBonds • US • Germany Passive Mutual Funds ETFs Risk Budget Views Decorelation • Bonds with spreads • PIGS • Corporate Bonds (IG) Active Mutual Funds ETFs Risk Budget Views Carry RiskyAssets • Global Equitis • Commodities • Corporate HY / Emerging Bonds Views Dynamic Risk Management Risk Budget Active Mutual Funds ETFs ExtraReturn

10. 2 - Markets behavior: what the history tells us • Markets seem «crazy» and irrational in the short term, but this is not true if we consider a longer time horizon: • Each financial activity has owns characteristics (DNA), in terms of • Returns (annualized) • Volatility (annualized) • Interaction with the others (correlation). • In particular the interaction between different assets is more important than the features of a single one. Each portfolio’s risk-return profile is not equivalent to the sum of all the risk-return profiles of the portfolio’s assets (the importance of diversification!). • Markets behavior often express recurring rules • Is on the basis of those rules and those characteristics that is possible to set up solid and efficient portfolios (strategic component).

11. 2 - Markets behavior: the numbers Analysis of Financial’s Activities (DNA)

12. 3 – Studying economic and markets environment • To improve returns for units of risk over time is important to consider also yours views of economic and market environment • To estimate correctly dynamics in financials markets is important to: • Identify a series of investment’s themes (risks factors) that consistently drive returns across global markets and asset classes (long-term valuation, short-term momentum, fund flows, risk premium, macroeconomic policy) • Identify metrics able to describe each investment theme (growth, inflation, multiple, volumes, etc) • Compare owns expectations of the evolution of each risk factor with markets expectations • Basically there are two main disciplines for strategic exposures • Macroeconomics analysis – studying economic cycle • Fundamental Analysis – studying asset’s value and earnings cycle

13. 3 – Risk factors for markets forecasting Metrics:Growth, Inflation, cash Policy Tool:Macroeconomic analysis Macroeconomic Metrics:Multiples (PE, PB, DY), Fair Value (DDM, DCF), Fed Model (B/E Yield) Tool:Fundamental analysis Valuation Metrics:Earnings growth, margins, revenues Tool:Fundamental analysis, quantitative analysis Earnings cycle Liquidity Metrics:cash policy, yield curve, M1 / M2, foreingns reserves, companies cash flows Tool:Macro research, balance sheet analysis Momentum Metrics:Price Momentum, volumes, RSI Tool: Technical analysis

14. 2. Strategic Asset Allocation Macroeconomic Analysis

15. 3 – Macroeconomic Analysis • Economic Cycle Analysis • Economic Clycle and Market Trend • Expectations Role

16. Economic Cycle: Introduction Definition: alternation of phases (expansion – contraction) characterized by a different pathos in the economic activity Key Variables for markets: • Gross Domestic Product  economic growth • Inflation  prices increase • Economic Policy: cash and fiscal

17. Economic Cycle: GDP • Definition: sum of the markets values of all final goods and services domestically produced in a country in a given year • Components: C + I + G + (X-M) • C = Consumption • I = Investments • G = Government Spending • (X-M) = Net exports • Periodical: quarterly looking at other, more frequent, indicators is necessary

18. GDP: Consumption • Components: durable goods + non durable goods + services • Leading indicators: • Labour market indicators: • Unemployment rate (monthly) • jobless claims (weekly) • nonfarm payrolls (monthly) • Personal income (monthly) • Durable good orders (monthly) • Real estate market indicators: • Price (monthly) • Housing starts (monthly) • Consumer Confidence USA (monthly) • U. of Michigan’s index of Consumer Sentiment USA (monthly) • Consumer Confidence EU (monthly) Real indicators Sentiment indicators

19. GDP: Investments • Components: residential investments + capital expenditures + inventories • Leading indicators: • Industrial production (monthly) • Retail sales (monthly) • New orders (monthly) • Philadelphia Fed USA (monthly) • Chicago Purchasing Manager USA (monthly) • ISM: PMI manufacturing, services and composite (monthly) • Sentix, Zew and IFO EU (monthly) Real indicators Sentiment indicators

20. Inflation • π = (Pt- Pt -1) / Pt -1 • π >0 and increasing Inflation • π >0 and decreasing Disinflation • π <0  Deflation • Indicators: • GDP deflator (quarterly) • Consumer Price Index (monthly) • Producer Price Index (monthly) • For each indicator there are general data and core data (ex food & energy) There are rate-numbers Only the percentage variations are important

21. USA consensus Fonte Bloomberg - Pagina ECFC

22. EU consensus Fonte Bloomberg - Pagina ECFC

23. Economic calendar Fonte Bloomberg – Pagina WECO

24. Economic cycle and market’s returns

25. Economic cycle and trend of the market: role of macroeconomic analysis • Eurosystem Staff forecast for year 2006 Data ex post, 2006 • Eurosystem Staff forecast for year 2007Data ex post, 2007 • Eurosystem Staff forecast for year 2008Data ex post, 2008 • Expectations change and they adapt themselves to new events and data (adaptive expectations) • The aim does not consist in becoming infallible forecasters • The speed of adaptation to new evidences is the matter

26. Economic cycle and trend of the market: role of macroeconomic analysis • Building an own main scenario • It is important to have a central scenario and an alternative one based on the analyzed indicators • Adapting the scenarios to the evidences • The scenarios can change through time due to new data and new events • Rebuilding and monitoring what the market incorporates • Every moment the market incorporates a specific scenario of growth-inflation • The market is one of the best forecaster (the best?), efficient and conservative • Are the markets the reflection of the economy, or the opposite? During last years often the opposite has been often true (see currencies) • Analyzing and understanding if and why yours and market’s scenarios differ one from another • In order to find investment’s opportunities it is necessary to identify the differences between your own scenario and the one incorporated by the market

27. Expectations’ role: what the market incorporates • Growth: yield curve spread corporate sectors’ trends (cyclical – defensive) • Inflation: break even inflation commodities • Cash policy: future on Fed Funds and on Eonia 2 years yields

28. 2. Strategic Asset Allocation Fundamental Analysis

29. Fundamental Analysis • Introduction to fundamental analysis • Valuation’s methods: • DCF e DDM • Multiples • Conclusions

30. Introduction to fundamental analysis • Valuation process: analyze the relationship between Value and Price of financials assets • Issue: identify the “theoretical fair value” of an asset that should be different, at least temporarily, than the market price. • By selecting assets undervalued is possible to get extra returns compare to the market’s average. • When is used • Security Selection (equities, bonds, real assets)… • Asset Selection • Generally speaking in the active management • Is useful only if: • The investment’s time horizon is medium/long • The investment process is structured and disciplined

31. Intruduction to fundamental analysis • Fundamental analysis works better in inefficient markets,where markets price often differs from fair value • Should anyway be used also in efficient markets. Markets becomes efficient for the action of many investors looking for returns and undervaluation, therefore there are possibilities of temporaries inefficiencies also in efficient markets • Valuation is not objective. Every valuation model depends on inputs and estimations that we put into the valuation’s process • The valuation’s process is much more important than the result (fair value). A transparent and coherent process is helpful in order to better understanding the value’s drivers of financials assets

32. Valuation’s methodologies • Discounting cash flows • DDM (Dividend Discount Model). Is the simplest methodology. It allows to estimate the equity value as the Net Present Value (NPV) of the future Cash Flow to equity (dividends) • DCF (Discounted Cash Flow). Is the methodology most complete. It allows to estimate the value of the Firm (equity + debt) as the Net Present Value (NPV) of future cash flow to firm • Multiples • PE (Price to Earnings) • PB (Price to Book) • PS (Price to Sales) • PEG (Price to Earnings Growth) • Fed Model (relative valuation equity – bond)

33. Valuation’s methodologies - DDM e DCF • DDM:Equity value • DCF:Firm Value (Equity + Debt) Equity Value Firm (EV) Value Ke= Cost of Equity n = life of the asset CFe= Cash flow to Equity (dividends) WACC= Weighed Average Cost of Capital n = life of the asset CFf = Cash flow to firm

34. Firm Value and DFC • Value drivers in a DCF model: • Cash flows to firm (CF), that depends on: • Sales Growth • Profitability – Margins (EBITDA & EBIT margins) • Investments for future growth (CAPEX) • Net Working Capital variations (NWC) • Discount rate: Weighted Average Cost of Capital (WACC) • Terminal value of the firm

35. Value drivers in DCF Model: Sales Growth • There are 3 options for estimating sales growth: • Compare growth estimations with historical data • Make assumptions on market growth and market’s share expectations • Compare growth estimates with analyst estimates • Estimating sales growth needs: • Good knowledge of company history and sector perspective • Keep in touch with analyst and company management • High level of discipline making our assumptions

36. Value drivers in DCF Model: Margins and Capex Spending There are 3 options for estimating margins • Compare estimates with historical data • Compare estimates with competitors • Compare estimates with analysts assumptions Capex spending shows how the company invest for future growth and consist of 2 elements: • Net Capex: shows how much the company invests in new equipment in addition to what is necessary to maintain the efficiency of the existing facilities. • Non Cash Working Capital: allows us to consider the level of inventories and the policy regarding accounts receipts and payments (rise in inventories means drain in cash flow).

37. Value drivers in DCF Model: Discount rate • Discount Rate = weighted average cost of capital (WACC) • WACC = • Cost of equity =return required by investors to invest into the firm compare to risk free • Cost del debt = rate of interest paid by the firm on own debt • Depends on credit profile of the firm • Is calculated by using financials indicators of rating’s agencies • = Financial leverage

38. DCF: estimation of cost of equity • Cost of equity is calculated using the CAPM (Capital Asset Pricing Model) • K = Rfr + (Beta * RP) • K = Cost of equity (expected return) • Rfr = Risk-free rate • Beta • RP = Risk Premium • Exemple: ENI • Risk Free = 3.5% • Beta = 1 (Bloomberg) • Risk Premium = 4.5% (should be different but on average stay between 4% and 5%) • Cost of equity for ENI = 3.5% + 1*4.5% = 8%

39. DCF: estimation of WACC • WACC = • exemple: ENI • Cost of Equity = 8% • Cost of Debt = 6% • Cost of Debt after tax = 6% x (1- 45%) = 3.3% • Debt = 16.3 bn € (al 31/12/2007) • Equity = 42.9 bn € (al 31/12/2007) • WACC == 8% x 0.72 + 3.3 % x 0.28 = 6.68% • Note: Leverage and WACC • Se ENI would have debt of 3 x Ebitda ~ 90 bn € • WACC == 8% x 0.32 + 3.3% x 0.68 = 4.8% Tax Rate

40. DCF: ratios that affects cost of equity

41. Debt risk

42. Return Bond asset return Rfr = Free Risk asset return α = risk premium L = liquidity premium (same qualities securities) 42

43. Risk Definition: returns’ variability around expected medium return Rational investor theory: given two securities that offer the same expected return, investors will prefer the less risky one Risk types in fixed interest bonds’ market Credit risk Market risk Liquidity risk Instruments for risk evaluation Rating (credit) Duration (market) 43

44. Credit risk : Rating Definition: evaluation of a potential borrower's ability to repay debt 44

45. Market risk: Duration Definition: Measure of the sensitivity of the asset's price to interest rate movements It is a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows Fixed interest and zero coupon bonds Formula P = Price C = Cash flows (coupon and debt) r = Interest rate N = Time to maturity (yearly, quarterly,…) 45

46. Liquidity risk Definition: lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss > Liquidity < Costs (market debt) < Tempi Instruments to evaluate the liquidity of a fixed income asset Exchanges’ scale on the secondary market Emission size Market makers’ number Bid/Ask spread Quotations’ transparency 46

47. Value drivers in DCF Model: Terminal Value We are at the last step of our DCF Model There are 2 options to calculate terminal value: • Liquidation Value. Usually is calculated using multiples: what kind of multiple shall we consider on sales, Ebidta, etc. to sell our company? Better methodology for fast growing company or restructuring stories • Stable Growth. The alternative is to estimate the appropriate stable growth level for the future. Better methodology for mature companies for which there is good visibility on growth rate

48. Relative valuation - Multiples 1/3 • The value of financials asset should be estimated by putting in relation the price and a series of fundamentals indicators. • Multiples allows relative valuation, looking at how the markets is pricing similar assets (peer comparison). • Markets inefficiencies among similar assets are easier to get and exploit. Using multiples it is possible to compare different assets over time. • It is important to remember that multiples should change over time, given the same fundamentals, according to some factors: • Liquidity • Earnings cycle • Sentiment • There are different type of multiples: • earnings • book value • sales • normalized for growth (Price Earnings Growth) • relative (Fed Model)

49. Relative valuation - Multiples 2/3 • Multiples of earnings • Price-earnings ratioorPE:ratio between price and EPS (earnings per share) • PE Forward (earnings estimated for the next 12 months) • PE Trailing (on realized earnings in the last 12 months) • Multiples of operating earnings • Enterprise Value / EBITDA o EBIT (*) • Cash Earnings multiples • Price/Cash Flow (earnings + amortization) • *Ebitda = Earnings Before Interest Taxes Depreciation & Amortization • *Ebit = Earnings Before Interest Taxes

50. Relative valuations – Multiples 3/3 • Multiples on Book Value (BV) • Price / Book value:ratio between price and the value of own capital • Enterprise Value (EV) / Capital: ratio between (Equity + Debt) and Capital • Multiples on sales • Enterprise Value (EV) / Sales: ratio between EV and sales • Multiples normalized for growth • PEG = PE / Expected Growth Rate. Allows to compare peers normalizing multiple for the growth factor • Realative multiples • Fed Model: Bond Yield (10Y) – equity Yield (Earnings / Price). Express relative valuation between equity and bond markets