FIN 320: Fall 2020

Individual Project

Data: The data you need to complete this project can be obtained from any financial web site (e.g., http://finance.yahoo.com). Another useful data source is Ken French’s Data Li- brary (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data library.html).

I. Portfolio Construction: Three Stock Portfolios

Suppose you had $100,000 to invest. Construct three stock portfolios, where each portfolio contains at least 5 stocks:

1. A “na ̈ıve” portfolio: Construct a portfolio without utilizing any investment principles. Please discuss briefly (Discussion 1) how you constructed the na ̈ıve” portfolio. Please limit your discussion to one page of double-spaced text.

2. A “practical” portfolio: use the ideas discussed in Peter Lynch’s book to construct a second portfolio. Explain clearly (but briefly) the ideas which motivated your decisions. You must at least indicate the chapters and/or the page numbers from the text. For full credit, you must indicate the “rules” (e.g., buy small stocks, never buy stocks with high analyst coverage, etc.) you derived from Peter Lynch’s ideas. Please limit your discussion (Discussion 2) to 3 pages of double-spaced text.

3. A “theoretical” portfolio: Applying the basic concepts from portfolio theory, construct a theoretical stock portfolio. For simplicity, use the stocks from the “na ̈ıve” and the “practical” portfolios to perform this analysis. You can use the mean-variance analysis or you can construct the theoretical portfolio by simply observing the correlations among the stocks in the “na ̈ıve” and the “practical” portfolios.

After obtaining the theoretical portfolio, compute the correlation matrix separately for each of the three (na ̈ıve, practical, and theoretical) portfolios and attach the results as Exhibit 1. Please discuss briefly (Discussion 3) how you constructed the theoretical portfolio and comment on the structure of the three correlation matrices. Please limit your discussion to one page of double-spaced text.

For each stock in the three portfolios, provide the following information:

1. Name of the company,

2. Ticker symbol,

3. Stock price at the end of the most recent month,

4. Return in the most recent month,

5. Annual return in 2019,

6. Number of analysts covering the stock,

7. Consensus analyst recommendation, and

8. Price-To-Earnings (P/E) ratio using the price and earnings information from the most recent quarter.

Present this information in a tabular form (Exhibit 2) so that I can easily compare the key characteristics of your portfolios.

II. Risk Measurement

Compute the following three risk measures for each of your three portfolios: 1. Total risk (or portfolio variance), 2. Systematic risk, and 3. Idiosyncratic risk using CAPM.

You can use either daily, weekly or monthly data to compute these risk measures. Please justify your choice and mention clearly the time-period you used to estimate the three risk measures. Attach your calculations and results as Exhibit 3. Please highlight the final results.

III. Performance Evaluation

Compute the following performance measures for each of your three portfolios: 1. Mean monthly return, 2. Sharpe ratio,

3. Relative Sharpe ratio (SR of a portfolio relative to the SR of the market), 4. Jensen’s alpha, 5. Four-factor alpha, 6. Treynor-Mazuy ratio,

7. M2 measure, and

8. T2 measure.

You can use either daily, weekly or monthly data to obtain the performance measures. Please justify your choice and mention clearly the time-period you used to estimate the three performance measures. Attach your calculations and results as Exhibit 4. Please highlight the final results.

IV. Additional Discussions

In light of your findings, please discuss your views on:

1. Benefits of security selection, i.e., can investors successfully pick stocks? (Discussion 4);

2. Relation between portfolio diversification and portfolio performance, i.e., does diversification lead to better risk-adjusted performance? (Discussion5);

3. Market efficiency, i.e., are financial markets efficient or inefficient? (Discussion 6).

Please limit each of your discussions to one page of double-spaced text.

Note: Please prepare your report in a professional manner because 10% of the grade for the project will be based on your presentation style. Please attach additional material (data, formulas, calculations, etc.) in an appendix and only present your discussions and exhibits in the main part. Obviously, the appendix is optional.

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American Greetings

This year American Greetings is demonstrating to naysayers that the greeting card space is not dead. The company has accelerated top-line [growth] through a combination of organic growth and acquisitions, and year-to-date revenues are trending well ahead of our forecast. However, the growth has come at a cost that is also far greater than we had anticipated . . . In Q3 marketing, spending increased by a surprising $10 million . . . The company also accelerated investment spending in the digital space to support the growth of recently launched cardstore.com. In addition, [American Greetings] has incurred . . . incremental expenses this year to roll out new doors in the dollar-store channel.

—Jeff Stein, Managing Director, Northcoast Research

It was New Year’s Day 2012, and the weather was unseasonably warm in Cleveland, Ohio, headquarters for American Greetings Corporation (AG). But while temperatures were up, the same could not be said of AG’s share price, which had been cut in half over the previous several months to a year-end closing price of $12.51 (Exhibit 45.1).

At times of low equity valuation, AG management historically had turned to share buybacks. With current valuation levels, management was considering going into the market with a $75 million repurchase program. The repurchase was to be funded from AG’s operating profit and cash reserves. The decision hinged on how the future of the enterprise was expected to play out. If the share price reasonably reflected bleak prospects for AG, management should preserve cash for future needs. If, on the other hand, AG stock was simply temporarily out of favor, the buyback plan presented a prudent defensive strategy.

American Greetings

With $1.7 billion in revenue, AG was the second-largest greeting card publisher in the United States. To meet the changing times, AG sold greeting cards as both paper products through traditional retail channels and electronic products through a number of company websites. In addition to gift cards, AG marketed gift wrap, candles, party goods, candles, and other giftware. To strengthen its business, the company owned and maintained the following major brands: American Greetings, Carlton Cards, Gibson, Recycled Paper Greetings, Papyrus, and DesignWare. AG owned the rights to a variety of popular characters, including Strawberry Shortcake, the Care Bears, Holly Hobbie, the Get Along Gang, and the Nickelodeon characters. The company was able to generate additional revenue by licensing the rights to these characters. Overall, management positioned AG as a leader in social expression products that assisted “consumers in enhancing their relationships to create happiness, laughter, and love.”1

The company had a long affiliation with the founding Sapirstein family. Shortly after immigrating to the United States in 1905, Jacob Sapirstein, a Polish entrepreneur, launched a business distributing German manufactured postcards in Cleveland with the help of his young family. Eventually the business leadership was passed on to Jacob’s oldest son, Irving Stone, then to Irving’s son-in-law, Morry Weiss. In 2003, Morry’s sons, Zev and Jeffrey Weiss, were appointed as CEO and president, respectively. Morry Weiss continued to serve as chairman.

Despite the strong family affiliation, AG was widely held in the public equity markets, with more than 11,000 shareholders, including large positions by such institutional investors as the British investment fund MAM Investments (10.6% of AG shares) and U.S. funds Dimensional Fund Advisors (10.5%), BlackRock (7.9%), and LSV Asset Management (6.7%). Dividend payments to investors had been on an upward trend in recent years, rising from 12 cents per share in 2004 to 56 cents in 2010.

Exhibits 45.2 and 45.3 provide AG’s detailed financial statements. Since AG’s fiscal year ended in February, the figures for 2011, for example, included results through February 2012, so remained estimates for the remaining two months.

EXHIBIT 45.2 | American Greetings Income Statement, December 20111 (in millions of dollars)

Greeting Cards

Two players, Hallmark and AG, dominated the U.S. greetings card industry. Hallmark, privately held by the Hall family, was the larger of the two, with total worldwide revenue at $4 billion. From its headquarters in Kansas City, Missouri, Hallmark had aggressively expanded its business internationally with operations in more than 100 countries. Hallmark maintained licensing agreements with independent Hallmark Gold Crown retail stores that marketed Hallmark products and owned ancillary businesses such as Crayola (the crayon maker) and the Hallmark Channel cable network. Other card companies, such as Avanti Press, Blyth, CSS Industries, and Deluxe had found successful niches in the $6 billion U.S. greeting card market.

Mintel, the industry analyst firm, maintained that the overall greeting card market had contracted by 9% since 2005 and that the contraction would continue (Exhibit 45.4). Mintel’s best-case scenario called for a 4% market decline over the next four years; its worst-case called for a 16% decline. The market contraction was thought to be driven by the substitution for greeting cards of other forms of social expression products, due to the ease of such alternative forms as smart phones, electronic social networking, and digital imaging, the last of which affected the traditional Christmas card market in particular. The rapid expansion of social media networks such as Facebook provided even stronger challenges to electronic cards. An industry survey found that the social media substitution was particularly acute in a younger demographic (Exhibit 45.5). Analysts expected the trend to continue as the ease of digital communication substituted for traditional forms of social expression.

The industry had responded to the substantive technological shift with important market innovations. Both Hallmark and AG had created an extensive collection of electronic cards that made it easy for customers to send

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cards electronically. Card manufacturers maintained websites that allowed consumers to purchase paper greeting cards on the Internet via computer or smart phone and have the physical cards delivered directly to the recipient. Kiosks had been placed in retail stores that allowed customers to create custom cards. Distribution had expanded to build a substantive presence in the expanding dollar-store retail channel, where greeting cards were reported to be a top-selling item.

Despite the trends, large numbers of people continued to buy greeting cards. In a recent survey, 52% of U.S. respondents had purchased a greeting card in the past three months. This figure was down from 59% who had responded affirmatively in 2006.2

Valuation

With an end-of-year close of $12.51 per share, AG’s PE ratio was at 6 times, its enterprise value to EBITDA ratio at 3.5 times, and its market-to-book ratio was below 1. All these valuation ratios were at the bottom of AG’s group of comparable companies. Exhibit 45.6 contains financial details and business descriptions for the AG-comparable group. AG’s management believed its valuation suggested an opportunity, but low levels also demonstrated substantial concern by the capital market regarding the prospects of the company. For example, equity analysts at Standard and Poor’s maintained a hold recommendation on the stock, claiming the following:

We see [AG’s 2012] sales increasing 2.5% to $1.73 billion. . . . We see demand benefitting from increased promotional spending in a more stable economic environment as the company pursues growth within the discount distribution channel . . . acquisitions . . . [and] international sales . . . We expect margins to narrow . . . reflecting a shift in customer mix toward the discount channel, increasing marketing costs to spur demand, distribution expansion costs, and expenses related to plans to move AG’s headquarters building. While we believe channel migration will result in a permanent negative margin shift, we do not believe transition costs related to expanded distribution efforts will be a factor in the long term.3

EXHIBIT 45.6 | Comparable Firms, End of 2011 (in millions of dollars except share price)

Orly Seidman, a Value Line analyst, held a more optimistic view, expecting steady margins and steady long- term growth:

The company has been improving the product pipeline. Management should continue to follow consumer and societal trends to better brand its offerings. It has shifted its focus from its core segment to pursue noncard

merchandise. Product innovation, stronger retail partnerships, and sell-diversified portfolio ought to drive customer interest in its goods. Technological enhancements will likely remain key to its long-term approach. Over the past few quarters, [AG] rolled out several complementary interactive products (i.e., mobile apps) and should continue to bolster its digital position.4

It was clear that there was substantial disagreement regarding the future growth trajectory and operating margins for the company. Over the past several years, revenue growth had been near to below zero. In 2011, however, revenue growth was anticipated to be more than 7% (Exhibit 45.7). Similarly, operating margins, which had been abnormally low two to five years previously, had improved to 9% recently. The marginal tax rate for AG income was 39%.

A bullish view held that AG would be able to maintain operating margins at 9% and achieve long-term ongoing revenue growth of 3%. A bearish view held that AG’s prospective revenue growth would be near zero into the future and that margins would continue to erode to a long-term rate of 5%. The expectation was that recent investments and ongoing electronic product substitution would generate some future working capital efficiency for AG, but there was little evidence that fixed asset turnover would improve. Exhibit 45.8 details the specific assumptions for the two scenarios.

Management understood that returns and growth were challenging to achieve in early 2012. Yields on U.S. Treasury bills and bonds were at historic lows of 0.1% and 2.8%, respectively (Exhibit 45.9). In such an environment, investors would richly reward returns of even small magnitudes.

EXHIBIT 45.9 | Capital Market Data

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