RSM336-Checklist-for-Midterm-Winter2024-Weeks 1-5

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Winter2024 1 Checklist for RSM 336 Mid-Term Test The mid-term is a 90-minute test. Date: Tuesday, February 13, 2024 Start Time: 11:00 am (Arts & Science time: test starts 10 minutes past the hour) Room: EX100, Exam Centre, 255 McCaul St. • This is a closed-book test. A formula sheet will be provided. You are allowed a non- programmable calculator. Keep a copy of this checklist as it will also be useful to help you study for the final exam which will be cumulative, covering all course material. The mid-term exam will cover materials from Class 1 to the end of Class 5. In preparing for the exam, the class notes and required readings are important. You are advised to use this checklist to review the class notes and required readings carefully in preparation for the mid-term. Please note that the videos posted as required readings are testable. There is no guarantee that every part of every question will be covered by this checklist. Textbook practice questions will help you to learn the material. It should be very helpful to practice with the sample exam posted on Quercus. It is recommended that you practice this test under the same conditions as the actual mid-term test, i.e. closed book and using a 90-minute time limit in one sitting. Class 1: Overview of Three Asset Classes, ETFs • Know the main types of money market securities and that they are sold at a discount. • Understand why the default premium (i.e., yield spread between BAs or CP and default-free Treasury bills) may be a good indicator of investor sentiment. • Be aware of inflation risk for bonds and the default risk of corporate bonds. • Be aware of the differences in sector composition between the S&P/TSX and the S&P 500 Indices, and their impact on index performance. Understand the difference between market cap weighted and price weighted stock market indices. • Know how and why objectives and constraints differ for different types of investors. Understand the importance of an investment policy statement. • Understand the difference between defined benefit and defined contribution pension plans. Be able to explain the implications for (i) employers (ii) employees. How might a company’s decision to provide a DB pension plan for its employees impact its financial strength and equity valuation? Understand how interest rate changes affect pension liabilities and why this is important.

Winter2024 2 • Be able to describe the impact of defined benefit pension liabilities and an employer’s responsibility to pay them on the equity valuation of the employer’s company. • Understand bid-ask spreads, market orders, and limit orders. • Be comfortable with what is going on when you buy on margin or short-sell a stock. Be able to do basic calculations on margins and margin calls. Know how to calculate the price at which you will receive a margin call. • Know what ETFs are, the different types of ETFs and their advantages and disadvantages, relative to investing in mutual funds, closed end funds, or individual securities. Understand that the number of ETF shares changes based on investor demand through the creation and redemption process. Know best practices for trading ETFs and determinants of liquidity for ETFs. • Understand how mutual funds work. NAV, MER & other concepts. Understand the difference between funds that have no load and funds that have loads – front-end load vs back-end load – and the implications of each. Class 2: Investment Strategies; Technical Analysis • Understand the difference between active & passive management, top down vs bottom up, and fundamental vs technical analysis. • Understand how investors may use information on short interest. Understand the terms “short squeeze” and “days to cover”. • Understand indexing and style investing: i.e. active, passive, small cap, large cap, value and growth styles. GARP. Dividend yield, dividend growth, dividend aristocrats. Momentum. Market sentiment & contrarian investing. • What is industry sector rotation and why does it work? • Know how strategies may be implemented using ETFs and using individual securities. • Understand the idea of contrarian investing and empirical evidence for contrarian investing; be able to explain it. • Know the basics of technical analysis (TA): the rationale, the tools, and technical trading rules. Understand the difference between fundamental analysis and TA. Understand why TA is in conflict with the efficient market hypothesis (EMH). • Know how bullish and bearish signals are generated. Be able to describe the trading range break-out trading rules and explain the notion of resistance and support levels (why there are forces that make it difficult for the price to break through these levels). • Have a general idea about market sentiment, short interest, and moving averages. Know how to interpret these technical indicators. For the short interest in particular be able to interpret it in two different ways: bullish because investors must ultimately cover their short sales, or bearish because investors have negative views in the stock.

Winter2024 3 • Know how to construct a momentum strategy (i.e., a strategy of buying winners and selling losers). Be able to describe the moving average oscillator trading rule and understand the idea. • Understand that the return on a security should compensate the investor for risk. Class 3: Fundamental Analysis of Equities • Know basics about fundamental analysis. In particular, know the difference between fundamental analysis and technical analysis. Understand the intrinsic value of a stock, margin of safety, and the relevance to the current market price. • Understand that it is not sufficient to calculate the intrinsic value of a stock. It is important to understand the market’s expectations for the drivers of the company’s business. “The narrative and the numbers”. To obtain an edge, an analyst identifies where their view differs from the market expectation and identifies the time frame over which the expectation is expected to be realized. An analyst needs also to identify risks to their forecast and markers along the way to identify if their investment thesis is developing as expected. • Know and understand the risks and uncertainties in fundamental analysis. Know the difference between a good company and a good stock investment. • Dividend discount models are a good topic for numerical/technical questions. Make sure that you know the Gordon model, the multi-stage DDM, and how to use them. • Know the three methods used to determine the intrinsic value of a stock: 1. Dividend discount models (DDM) 2. Valuation by comparables (using P/E & other ratios) 3. Free Cash flow to Equity (FCFE) (know the key inputs). • Understand the impact of the company life cycle on firm characteristics and valuation, i.e. changing growth rates and the impact on risk, CAPM beta, payout ratios, ROE, P/E. • Understand the determinants of ROE using the DuPont System and how to use DuPont ratios to analyze how a company generates ROE. Understand the relationship between retention ratios, dividend payout ratios, and future sustainable growth of the company. Understand also the importance of trends over time and the ways a company can attain and sustain a competitive advantage. • In addition to the dividend discount models (DDMs) approach, there is a “relative valuation” approach. Know how this approach works and why it is more popular in practice. For the P/E multiple approach in particular, understand the effect of changes in growth, inflation, and the required risk premium on the P/E ratio. What does the P/E ratio imply about the market’s expectation for future growth? Understand the pitfalls of P/E analysis. • What is the PEG ratio and how is it useful?

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Winter2024 4 • Understand the importance of finding a comparable company and know why one may need to adjust when companies have very different fundamentals, e.g. different leverage, dividend payout ratios, etc. Class 4: Factor Investing; Smart Beta • Understand the CAPM, what it means, and its applications. • Know the equation for the CAPM: E(r i ) − r f = β i[E(r M ) − r f ] and what the CAPM implies in terms of the expected return and Beta graph; understand the Security Market Line etc. Where do overvalued & undervalued securities plot on the SML? • Know the exact definition of beta, the regression technique for estimating the beta, and be comfortable with scatter plots of excess security returns against excess market returns. • Understand the main idea of running a regression, the intercept & slope, and what t-statistics and R 2 tell us in evaluating the estimation results. This is a review of ECO220. • Understand why alpha ( α ) represents risk-adjusted return. Understand the implications of alpha being non-zero. • Know the limitations of CAPM beta. It is unstable, and explains little of the actual return earned on a stock • What is “Smart Beta” and why does it appeal to investors? Understand the important factor models, including Low Volatility, Momentum, Liquidity, Quality, Value & Size. What is a multifactor strategy? • Fama and French three-factor model is a specific example of a factor model. Fama and French postulate that there are a “size” factor and a “book -to- market” factor that people care about. Supposedly, these two empirical variables should proxy for two common risk factors that CAPM has missed. In contrast to CAPM, any security that has high positive correlation with the size factor or the book-to- mark factor is risky and it must earn higher returns, even if it has low market beta. • Jensen’s alpha is used in evaluation of portfolio performance. A positive alpha means that the portfolio earned on average a rate of return higher than the rate of return that is required for the risk it is undertaking. We use asset pricing models to tell us the required returns on assets or portfolios of assets. Most notably, we may use CAPM or Fama-French three-factor model. • Note that multifactor models, e.g. the empirically successful Fama-French three- factor model, have the same important applications as CAPM, such as performance evaluation, portfolio selection, cost of equity estimation, and studies of anomalies. • Understand the process of extracting valuable insights from large datasets by identifying patterns, trends, and relationships to inform decision-making and predictions, as the core of data mining. Establish the importance of theoretical underpins as opposed to spurious relationships.

Winter2024 5 Class 5: How Markets React to News, Costco Case, Risk Management • Understand the issues raised in the Costco case. How do we define a “good quality” company? What is a defensive stock? • The mosaic theory is an important concept in equity analysis; it is where an analyst pieces together a conclusion using publicly available information and non-material public information. Contrast with trading on material non-public information (insider trading which is illegal). • Understand how changes in the discount rate affect the valuation of stocks and bonds. Know how bonds and stocks react (in general) to unexpected inflation. Understand that prices react only if there is a surprising component to the release of economic data or earnings. The news report itself, bad or good, often does not generate price changes if it was expected by investors. • Understand that the equity risk premium (ERP) varies over time and is related to investor risk aversion – the ERP is higher when investors are more risk averse. • Risk management is an important part of investing. Correct position sizing of the stocks within your portfolio and diversification across industries and asset classes are key to successful investing. A focus on minimizing losses and taking losses quickly and protecting capital leads to long-term success. • Understand how a trailing stop works. Understand the rationale for portfolio rebalancing and be able to apply this in practice. • Understand the implications of market downturns (volatility) for portfolio performance, the prospect of successful market timing, and the likelihood of successfully timing the market. Capital Markets Review Quiz – this material is in scope for the mid-term test.

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