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Financial Analysis and Investment

Student’s Name

University of Leicester

Date
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Introduction

Investment in equity securities involves risk and return trade-off that investors should

consider. Risk includes systematic and unsystematic risks. Unsystematic risk can be eliminated

by establishing a diversified portfolio hence systematic risk is the most critical risk consideration

in equity investment decisions (Fabozzi, Focardi and Kolm, 2010). A diversified portfolio should

have stocks from unrelated industries to eliminate unsystematic risk. For any given portfolio, the

weights of the individual stocks can be varied to meet various objectives (Fabozzi, Focardi and

Kolm, 2010). This report evaluates minimum-risk and maximum-return portfolios derived from a

portfolio of seven FTSE 100 stocks.

Portfolio Selection

The portfolio selected consists of seven stocks from the FTSE 100 index. The FTSE 100

index consists of large-cap companies which are suitable for investments due to the lower risk

involved as compared to small and medium-cap companies. The seven stocks were selected from

seven different industries; retail, insurance, electricity, beverage production, mining, media, and

banking. These are some of the best performing sectors with leading companies experiencing

growth in revenues and profits over the last few financial years. The stocks are Tesco, Diageo,

BHP, SSE, HSBC, ITV, and AVIVA. Tesco is UK’s largest retailer. It is profitable and its

operating profits increased by 28% in the last quarter of the year ended February 2018 (Butler,

2018). Thus, it is the most suitable stock in the retail industry. Diageo is a global company with

popular brands such as Johnnie Walker, J&B, among others. Global beverage sales are rising,

and this saw the company’s operating profits increase by 3.7% in the year ended 30 June 2018

(Symon, 2018). SSE, HSBC, ITV and AVIVA are also the leading and best-performing stocks in

their respective industries.

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The portfolio is well-diversified since the stock are drawn from seven different industries.

Diversification is beneficial since it reduces the portfolio’s risk. Diversification eliminates or

reduces unsystematic risk associated with stocks (Fabozzi, Focardi and Kolm, 2010). If a

portfolio is diversified, the portfolio’s risk is lower than the risk of individual stocks. The

variance-covariance matrix shown in Appendix 1 indicates that the covariance between the

stocks’ returns is low with most covariance below 5%. The low covariance indicates that the

portfolio is well-diversified. A high covariance indicates that the stocks’ returns are strongly

correlated. The correlation of stock returns is usually higher for stocks selected from the same

industry or sector (Northington and Gerard, 2011). Therefore, a portfolio of stocks from

unrelated sectors has a lower risk than a portfolio of stocks from the same or related industries.

Performance of Individual Stocks

As illustrated in Table 1 below, the average monthly return on Tesco’s stock for the ten-

year period between 15th November 2008 and 2018 was -0.077%. ITV had the highest average

monthly return of 0.549%, followed by Diageo with 0.404%. SSE stock had the lowest average

monthly return of 0.014%. During the same period, the average monthly return on the FTSE 100

index was 0.206%. This indicates that only ITV and Diageo outperformed the market index

during the period. The FTSE 100 index outperformed Tesco, BHP Group, HSBC and AVIVA

stocks.

ITV had the highest standard deviation (4.463%) indicating that its monthly stock returns

were the most volatile of the seven stocks included in the portfolio. The standard deviation of

AVIVA’s stock returns was 3.588% while that of Tesco was 2.898%. Diageo had the lowest

standard deviation of monthly returns during the period indicating that it has the lowest risk of

the seven stocks included in the portfolio (Northington and Gerard, 2011). The standard
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deviation of the monthly returns ion the FTSE 100 index was 1.568%. This is lower than that of

any of the seven stocks indicating that all the seven stocks had greater variability of returns than

the market index (DeFusco, 2011).

The sharp ratio measures the risk-adjusted performance of the stocks and the index

(Brigham and Houston, 2016). It is essential since it balances the two main objectives in

investment management; maximising returns and minimising risk (DeFusco, 2011). As shown in

Table 1 below, Diageo had the highest Sharp ratio with 0.2216, followed by ITV with 0.1155.

The Sharp ratios of Tesco and HSBC were negative indicating that their average monthly returns

were less than the risk-free return. The Sharp ratio for the FTSE 100 index was 0.11. It shows

that only Diageo and ITV had better risk-adjusted performance than the market index.

Table 1: Individual Stock performance

Tesco Diageo BHP GroupSSE HSBC ITV AVIVA FTSE 100—PRICE INDEX
Average -0.077% 0.404% 0.151% 0.014% 0.027% 0.549% 0.074% 0.206%
STDEV 2.898% 1.823% 3.649% 1.857% 2.759% 4.463% 3.588% 1.568%
Variance 0.08398% 0.03324% 0.13314% 0.03448% 0.07613% 0.19916% 0.12871% 0.02458%
Sharp Ratio -0.0381 0.2216 0.0321 -0.0107 -0.0026 0.1155 0.0112 0.1100

Analysis of the Portfolios

Base Portfolio

The base portfolio assigns equal weights to each of the seven stocks. Therefore, the

weight of each stock in the portfolio is 14.26%. As shown in Table 2 below, the expected return

on the base portfolio is 0.163% with a standard deviation of 1.889%. The corresponding sharp

ratio for the portfolio is 0.0864 indicating that the portfolio would generate a return of 8.64% in

excess of the risk-free rate per unit of standard deviation or total risk.

The regression model between the portfolio and the market index is used to determine the

portfolio’s beta. Beta is a measure of the portfolio’s systematic risk in relation to that of the
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market (Brigham and Houston, 2016). Systematic risk is the most critical in investment decisions

since it indicates the amount of risk that cannot be eliminated through diversification (Brigham

and Houston, 2016). Standard deviation measures total risk, which includes both systematic and

unsystematic risk. Thus, Beta is more reliable than the standard deviation in equity investment

decisions (Brigham and Houston, 2016). As shown in Appendix, the coefficient of UKGTB in

the model is 0.0576. This implies that the beta for the base portfolio is 0.0576. It shows that the

portfolio’s systematic risk is 5.76% that of the market. It shows that as the market risk changes

by 1%, the portfolio’s risk changes by 0.0576%. It implies that the base portfolio has a lower

systematic risk than the overall market’s systematic risk (Reilly, Brown and Leeds, 2011). The F

statistic for the regression model is 322.94, and the corresponding Significance F is 2.588E-35.

The Significance F is lower than 5% indicating that the coefficient of the model is statistically

significant and is a reliable measure of the base portfolio’s systematic risk (Beta).

Table 2: Portfolios’ returns and Risk 𝜎 𝜇

𝜇
Base Portfolio Min Risk Max ER Max ER with all stocks
𝜎
P 0.163% 0.157% 0.549% 0.522%
P 1.889% 1.409% 4.444% 4.231%
Psharp 0.0864 0.1112 0.1236 0.1234

Minimum Risk Portfolio

One of the goals of investment management is to minimise risk associated with an

investment. Some investors are more interested in preserving the value of the initial investment

than maximising the return on the investment (Correia et al., 2015). A minimum-risk portfolio

gives higher weights to stocks that have the lowest standard deviation (Correia et al., 2015). In

this case, the target portfolio standard deviation is 2.579%. The objective is to ensure that the

portfolio’s risk (standard deviation) is less than 2.579%. Having a target standard deviation is

important since it shows the maximum risk an investor is willing to take. Besides, it is important
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to balance between risk and return since lower risk is associated with lower returns. As shown in

Table 3, the minimum-risk portfolio that meets that target standard deviation comprises six of the

seven stocks in the portfolio. The portfolio includes Tesco, Diageo, BHP Group, SSE, HSBC

Bank, and AVIVA. SSE has the highest weight with 42%, followed by Diageo with 37%. The

weights of Tesco, BHP Group, HSBC, and AVIVA are 7%, 2%, 9% and 3% respectively.

Table 3: Portfolio Weights

𝜎 𝜇
base Minimize Maximize ER Max ER with all stocks
Risk ER Max ER with all stocks
Target No 2.759% 0.027% No
Asset Weight Weight Weight Weight
Tesco 0.14 0.07 0.00 0.010
Diageo 0.14 0.37 0.00 0.010
BHP Group 0.14 0.02 0.00 0.010
SSE 0.14 0.42 0.00 0.010
HSBC 0.14 0.09 0.00 0.010
ITV 0.14 0.00 1.00 0.940
AVIVA 0.14 0.03 0.00 0.010
TOTAL 1.00 1.00 1.00 1.00

As shown in Table 2 above, the expected return on the minimum-risk portfolio is 0.157%

while the standard deviation is 1.409%. The portfolio’s Sharp ratio is 0.1112. The expected

return and standard deviation of this portfolio are lower than those of the base portfolio. This

indicates the risk-return trade-off (Correia et al., 2015). An attempt to lower the portfolio’s risk

leads to a reduction in the expected return on the portfolio. However, the minimum-risk portfolio

has a higher Sharp ratio than that of the base portfolio. It shows that the minimum-risk portfolio

would generate a higher risk-adjusted performance than the base portfolio.

A regression analysis of the minimum-risk portfolio and the UKGTB returns is shown in

Appendix 3. The slope of the regression model is 0.6440 indicating that the Beta for the

minimum-risk is 0.6440 (Reilly, Brown and Leeds, 2011). It shows that as the market returns
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change by 1%, the returns on the min-risk portfolio change by 0.644% (Correia et al., 2015). It

shows that the systematic risk of the min-risk portfolio is about 36% less than that market’s

systematic risk. The Beta value for this portfolio is higher than that of the base portfolio

indicating that it has a greater systematic risk than that of the base portfolio (Correia et al., 2015).

Maximum Return Portfolio

This portfolio seeks to maximise the return on the portfolio. It serves a risk-seeker who is

willing to take any amount of risk provided he/she earn the maximum return possible. In a max-

return portfolio, stocks with the highest expected returns must have the highest weights in the

portfolio (DeFusco, 2011). In this case, ITV has the highest expected return of all the seven

stocks. The condition set for this portfolio is that the expected return must be greater than or

equal to 0.027%. As shown in Table 3 above, the max-return portfolio consists of ITV stock

only. Table 2 shows that the expected return on this portfolio is 0.549%, which is the average

return on ITV stock. The portfolio’s standard deviation is 4.44%, and the Sharpe ratio is 0.1236.

Compared to the other two portfolios, the max-return portfolio has the highest expected

return, standard deviation as well as the Sharp ratio. It shows that the max-return portfolio

generates the highest risk-adjusted return of the three portfolios (DeFusco, 2011). The regression

model for the max-return portfolio and the UKGTB is shown in Appendix 4. The slope of the

model is 1.4738 suggesting that the portfolio’s Beta is 1.4738. The Beta indicates that as the

market returns vary by 1%, the returns on the max-ER portfolio change by 1.47% (DeFusco,

2011). This implies that the portfolio’s systematic risk is 47% greater than that of the market.

Compared to the other portfolios, the max-ER portfolio has the greatest systematic risk hence it

is suitable for risk-seekers.

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A potential problem with the max-ER portfolio is that it is not diversified at all. This

defeats the purpose of forming a portfolio by selecting stocks from different industries or sectors.

In this case, the portfolio’s return will be affected by unsystematic risk specific to the media

sector or industry. To diversify unsystematic risk, a portfolio was created with the condition that

each of the seven stocks should be at least 1% of the total portfolio. The portfolio that maximises

total return and satisfies the condition comprises is shown in the last column of Table 3 above.

94% of the portfolio is ITV stock while the weight of each of the six remaining stocks is 1%. As

indicated in Appendix 2, the expected return on this portfolio is 0.522% with a standard

deviation of 4.231%. The portfolio’s Sharp ratio is 0.1234. The expected return is higher than

that of the base and min-risk portfolios but lower than that of the maximum-ER portfolio. Its

standard deviation is less than that of the max-ER portfolio but higher than that of the min-risk

portfolio. The portfolio’s expected Sharp ratio is less than that of the max-ER but higher than

those of the base and min-risk portfolios. It shows that the max-ER portfolio would generate a

higher risk-adjusted performance than that of a portfolio comprising all the seven stocks.

Conclusion

The analysis above generates portfolios that can give the lowest possible risk and the

highest possible return. The min-risk portfolio is composed of six stocks with Diageo and SSE

constituting 79% of the total portfolio. ITV stock is not included in the minimum-risk portfolio.

On the other hand, the maximum-expected return portfolio contains the stock of ITV only. The

analysis further indicates that the max-return portfolio has the highest expected return, standard

deviation and Sharp ratio. The portfolio has the highest expected risk-adjusted performance of all

the possible portfolios. However, the max-return portfolio would not diversify unsystematic risk

since it has only one stock. Limiting that weights of the six other stocks to 1% each can give a
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more diversified portfolio. However, the expected return, standard deviation and Sharp ratio will

be lower than those of the max-expected return portfolio. Therefore, each investor should vary

the weights of each stock in the portfolio to maximise his/her specific investment objectives.
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References

Brigham, E. and Houston, J. (2016). Fundamentals of financial management. 9th ed. Cengage

Learning.

Butler, S. (2018). Tesco beats forecast with 28% rise in annual profits. [online] the Guardian.

Available at: https://www.theguardian.com/business/2018/apr/11/tesco-reports-28-rise-in-

profits-for-last-quarter [Accessed 10 Dec. 2018].

Correia, C., Flynn, D., Uliana, E., Wormald, M. and Dillon, J. (2015). Financial management.

Lansdowne: Juta.

DeFusco, R. (2011). Quantitative investment analysis. Hoboken, NJ: Wiley.

Fabozzi, F., Focardi, S. and Kolm, P. (2010). Quantitative Equity Investing: Techniques and

Strategies. John Wiley & Sons,.

Northington, S. and Gerard, G. (2011). Finance. New York: Ferguson's.

Reilly, F., Brown, K. and Leeds, S. (2011). Investment analysis & portfolio management. 10th

ed. Cengage Learning.

Symon, K. (2018). Diageo reports 3.7% rise in operating profits to £3.7bn. [online]

businessInsider. Available at: https://www.insider.co.uk/company-results-forecasts/diageo-

shares-profits-johnnie-walker-12982233 [Accessed 10 Dec. 2018].

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APPENDICES
Appendix 1: Covariance Matrix
Variance Covariance Matrix
X^TX
Tesco Diageo BHP Group SSE HSBC ITV AVIVA
Tesco 10.34% 2.45% 3.92% 1.20% 1.24% 2.35% 1.02%
Diageo 2.45% 3.89% 2.40% 1.11% 2.06% 2.24% 1.31%
BHP Group 3.92% 2.40% 15.58% 0.85% 4.93% 1.83% 3.17%
SSE 1.20% 1.11% 0.85% 4.03% 0.91% 1.07% 1.57%
HSBC 1.24% 2.06% 4.93% 0.91% 8.91% 8.16% 6.79%
ITV 2.35% 2.24% 1.83% 1.07% 8.16% 23.30% 12.00%
AVIVA 1.02% 1.31% 3.17% 1.57% 6.79% 12.00% 15.06%

Appendix 2: Regression – Base Portfolio and UKGTB

SUMMARY OUTPUT

Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations

ANOVA
SS MS F Significance F
Regression 0.030869 0.030869 322.9436 2.58798E-35
Residual 0.011088 9.56E-05
Total 0.041957

Standard Error t Stat P-value Lower 95%

Intercept 0.000906 -0.54329 0.587974 -0.00228556
X Variable 1 0.057611 17.97063 2.59E-35 0.921202392

Appendix 3: Regression – Minimum-Risk Portfolio and UKGTB

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.714403
R Square 0.510371
Adjusted R Square
0.50615
Standard Error
0.009938
Observations 118

ANOVA
df SS MS F Significance F
Regression 1 0.011943 0.011943 120.9142 1.05597E-19
Residual 116 0.011457 9.88E-05
Total 117 0.0234

Coefficients
Standard Error t Stat P-value Lower 95%
Intercept 0.000121 0.000921 0.131881 0.895307 -0.001701796
X Variable 10.643958 0.058562 10.9961 1.06E-19 0.527967917
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Appendix 4: Regression – Max-ER Portfolio and UKGTB

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.517973
R Square 0.268296
Adjusted R Square 0.261989
Standard Error 0.03835
Observations 118

ANOVA
df SS MS F Significance F
Regression 1 0.062556 0.062556 42.53415975 1.88965E-09
Residual 116 0.170603 0.001471
Total 117 0.233159

Coefficients
Standard Error t Stat P-value Lower 95%
Intercept 0.002607 0.003552 0.734033 0.464409885 -0.004428003
X Variable 1 1.473807 0.225981 6.521822 1.88965E-09 1.026223095