Portfolio Selection

Write an essay on Financial Information Management.

The portfolio theory (Markowitz 1952) in his paper “Portfolio Selection,”, says that it is possible to create an optimum portfolio which offers the maximum return for the amount of risk taken.

In this assignment we apply the portfolio theory concept to a set of 5 stocks namely Easy Jet, Unilever, Merlin Entertainment, Marks & Spencer, and Royal Mail. By running a Monte Carlo simulation, we select and assign stocks to a hypothetical £100,000 portfolio; followed by an analysis on the individual stocks.

We ran a Monte Carlo simulation (on Easy Jet, Unilever, Merlin Entertainment, Marks & Spencer, and Royal Mail) with 1000 iterations based on the ROE TTM and Beta of the stock to come up with the optimum portfolio – minimum Beta with maximum returns (Brealey, Myers & Allen 2011). The optimal portfolio in this case comprises Easy Jet – 50% weightage, Unilever – 40% weightage, and Merlin Entertainment 10% weightage (we have used approximations for the sake of simplicity). Marks & Spencer and Royal Mail received a minor weightage, so we choose to leave them out of the portfolio. 

Scatter plot for TTM (Trailing Twelve Month) Returns and Beta of the stockSource: Reuters, DigitalLook 

	Cl. Price 8 Jul, ’16 in GBp	No of shares	Investment in GBP	Weight	Beta	ROE TTM
EasyJet	1070	4673	50000	50%	0.54	28.3%
Marks & Spencer	317.3	0	0	0%	0.91	12.3%
Merlin Entertainments	459.5	2176	10000	10%	0.89	20.2%
Royal Mail	486.3	0	0	0%	1.01	5.6%
Unilever	3651.5	1095	40000	40%	0.62	33.8%
Portfolio value			100000	100%	0.61	29.7%

Easy Jet is a British short haul budget airline, operating on approximately 800 routes spanning across 30 countries in Europe, with a fleet of 240 aircrafts. According to Goldman Sachs, in the recent years, European Low Cost Carriers (LCC’s) have and would continue to gain market share for short haul flights from legacy carriers. The major beneficiary of this trend has been low cost carriers such as Easy Jet and Ryanair (Mann 2016).

Further, these airlines continue to benefit from strong European travel trends. According to European Travel Commission, tourist arrivals increased 5% in 2015 in Europe. Air traffic was strong with Revenue Passenger per Kilometre (RPK), increasing 5.2% in 2015 y-o-y and Air capacity increasing by 4% on an avg. in 2015. A key driver of this growth was strong intra-European travel, a category which is a forte of short haul airlines like Easy Jet. For 2016, the report forecasts a 3.2% increase in European inbound travel. For 1H16 ended 31 March, 2016, Easy Jet’s passengers grew 7.4%, continuing the trend from 2015 which marked a 6% growth in passengers (European Travel Commission 2016).

Lower Oil prices also are playing a major role to curtail the costs (Tovey 2015), which are being passed on to customers. According to Easy Jet’s latest half yearly report 31 March, 2016, cost per seat declined 5%, and fares to customers decreased 6% in 1H16 y-o-y, while forward bookings were in line with last year. In 2015, cost per seat decreased 3.4% given favourable oil prices and currency movement.

Portfolio

Financials: Easy jet reported strong set of financials with revenues in 2015 reaching £4.7 bn, up 3.5% from 2014, and the basic EPS growing by 21.5% in 2015. The consensus expects the revenues to grow 2.1% in FY16 ending September 30, despite the impact of terrorism, EU instability and Brexit (Reuters 2016).

Valuation: Easy Jet is trading at a PE ratio of 8.5x vs. industry at 13.5x, according to Reuters. Since the stock is undervalued, it may be good time to buy the stock, given positive outlook and strong fundamentals.

Risks: Brexit could impact travel to and from UK (Bryan 2016), and the company plans to up a company in Europe (Martin 2016). Currency fluctuations could be a drag on profitability. Terrorism attacks and immigration crisis could mute the growth of travel to certain areas. Volatility in commodity prices could impact the profitability of the firm.

Reuters Consensus ratings: Buy (6), outperform (7), Hold (9), Underperform (2) and Sell (1) 

With a presence in almost 190 countries, Unilever PLC is one of the largest consumer goods company in the world operating in Food, Home Care, Personal care products and Refreshments. The Foods segment includes soups (knorr), snacks, sauces, margarines and spreads. The Homecare segment includes a variety of cleaning products such as Surf. While, the personal care segment has popular skin care and hair brands like Dove, Lux, Axe, etc., the Refreshment segment has ice cream and beverages like Magnum, Lipton, Ben &j Jerry’s under its umbrella. Unilever has close to 400 brands all over the globe.

With majority of revenues coming from developing/ emerging markets, Unilever can prove to be a safe bet after Brexit and EU instability (Wild 2016). For FY15, Unilever reported underlying sales growth of 4.1%, with emerging markets reporting 7.1% growth, while developed markets were flat. Although, pricing increased in emerging markets, we saw a deflationary trend in developed markets which was offset by volume growth. The trend continued in 1Q16 with emerging markets underlying sales growth of +8.3%, vs developed markets which were slightly negative with -0.3% (underlying price growth of -1.3%). The company has shown resilient revenue growth of 3.34% from 2006 to 2015 (including the recession phase), according to company’s financials.

The outlook for Unilever looks promising with exposure to emerging markets and income levels improving in China and India (Stephens 2016). With increasing uncertainty around the EU, Unilever could attract investors as it is a perfect mix of defensive and growth stock. The Brexit impact on Unilever would be largely limited (Trefis 2016) as it has localised its manufacturing plants, in turn reducing the transportation costs, and hedged against FX impact.

Easy Jet (Buy, Portfolio weight 50%)

Unilever is also working on cost savings program called Zero based budgeting (Neff 2016) which is on track to produce €1bn p.a. savings by 2018. The company will introduce new “functional models” to decrease the costs for internal marketing and other staffing, and better alignment of headcount costs with revenue centres.

Unilever has had a history of giving healthy dividends, which amounted to €3.3 bn in 2015, a 4.5% increase over the previous year. If we compare this with 2006, Unilever has increased its dividend at annualised rate of 6.7% per annum to 2015, according to company’s financials.

Financials: The consensus estimates collected by the company as on July 8 expect the underlying sales growth to increase +4.1% and acquisitions to account for +0.4% for FY16, to be offset by -4.5% FX impact. Although, the revenues are expected to be flat, the core operating margin is expected to improve by 0.4 percentage points, driving an EPS growth of 2.9% for FY16.

Valuation: Unilever trades at PE of 25x and has an ROE of 33.75%, according to Reuter’s data. This compares with Nestle at 26.9x and ROE of 13.7%. We are convinced to add Unilever to the portfolio, as it is a defensive stock with a diversified portfolio, given the economic uncertainty in EU.

Risks: Adverse impact of Brexit could lead to higher import/export tariffs in Europe (Bloom 2016), which could adversely impact the company’s operations and top line. Instability in EU could lead to deflationary trends and negatively impact the pricing of goods sold. Currency fluctuations could also hamper the profitability of the company.

Reuters Consensus rating: Buy (2), outperform (8), Hold (6), Underperform (2) and Sell (1) 

Merlin Entertainment was formed in 1999, and is the World’s second biggest visitor attraction operator after Walt Disney. It operates some of the most popular sites like Madame Tussauds, The Eye Brand, LEGOLAND Parks and theme parks like Alton Towers, Heide Park, Chessington World of Adventures, and Warwick Castle to name a few. It has a market cap of c. £4.7 bn and £1.3 bn in revenues in 2015.

Since the Brexit vote, the GBP has been weakening against the Euro. Merlin could stand to gain from Brexit, as a weakening GBP is good for leisure travel and tourism to UK (Farrel 2016). According to Barclay’s analyst Vicki Stern, “We consider Merlin to be one of the least negatively affected Leisure stocks following the ‘leave’ vote”. Further, the Barclays analyst has increased the revenue forecast by 2.5% post the referendum. He also added that the correlation between UK theme park visitation and UK consumer confidence was weak, and should not impact Merlin (Ferguson 2016).

Unilever (Buy, Portfolio Weight 40%)

In June 2015, the Smiler tragedy at Alton Towers took place where two visitors lost their legs (BBC 2015). This resulted in closure of the park and reduced number of visitors, impacting the revenues and profitability. Merlin’s total visitor’s growth was flat in 2015 due to the tragedy at Alton Towers, which was also detrimental to the profits as operating profit margin declined to 22.8% from 24.9% in 2014. However, from 2011-15, visitors grew at a CAGR of 7.8% while revenues grew at 10% CAGR on constant currency basis.

Valuation: Merlin trades at a forward PE consensus (DigitalLook 2016) of 22.5 and EPS growth of 15%. This compares fairly to Walt Disney trading at a PE of 20.7 and EPS growth of 13%. We prefer buying the stock and allocating 10% in the portfolio given the depreciation in GBP and its impact on the company.   

Risks: Terrorism and recent shooting in Florida could impact the new sites in Orlando. Tragedies like Smiler can pose a threat to visitor numbers to these theme parks. Reduction on leisure spending due to macro uncertainty/Brexit could lead to revenue decline. Unfavourable movement of currency could impact the volume/visitor growth. 

Reuter’s consensus rating: Buy (4), Outperform (2), Hold (5), Underperform (0), Sell (0). 

M&S has been struggling with its clothing line, and has been impacted by deteriorating consumer confidence in the UK. The clothing and home goods same store sales for M&S declined 8.9% for 13 weeks to 2 July, vs. analyst estimate of 5% decline (Jarvis 2016). Further, M&S is in the retail industry, which could be adversely impacted by the Brexit. We choose to exclude this stock from the portfolio.

Royal Mail is facing a structural decline in letter deliveries given the advent of E-Mail and other forms of communication. Also, the company is cautious due to high transformation costs and a slowdown in continental Europe (Pfanner 2016). Also, if trade agreements are revised post Brexit, we could see a decline in the parcels delivery in and out of the UK. 

Conclusion 

As we discussed, the optimum portfolio which diversifies our risks and gives maximum returns consists of EasyJet, Unilever and Merlin out of the 5 Stocks. Although, the Brexit fear surrounds all the companies, we believe that our selected companies could be in a position to sail through these tough and volatile times. 

References: 

1. . Markowitz 1952, ‘Portfolio Selection’, Journal of Finance, March, vol. 7, no. 1, pp. 77–91. 

Brealey,R, Myers,S, Allen,F 2011, Principles of Corporate Finance, 10^th edn, Mc-Graw Hill Irwin, New York. 

Merlin Entertainment

Tovey, A 2015, ‘Cheaper flights on easyJet as oil price cuts airline’s fuel bill’, The Telegraph, 27 January, viewed 14 July 2016, <https://www.telegraph.co.uk/finance/newsbysector/transport/11371657/Cheaper-flights-on-easyJet-as-oil-price-cuts-airlines-fuel-bill.html > 

Martin, B 2016, ‘EasyJet presses ahead with plans to set up European company’, The Telegraph, 1 July, viewed 14 July 2016,<https://www.telegraph.co.uk/business/2016/07/01/easyjet-presses-ahead-with-plans-to-set-up-european-company/> 

European Travel Commission 2016, ‘European Tourism in 2015: Trends & Prospects’, viewed 14 July, 2016,

<https://www.etc-corporate.org/reports/european-tourism-2015-trends-and-prospects-(q4-2015)> 

‘easyJet plc’s (EZJ) “Buy” Rating Reaffirmed at Goldman Sachs’ 2016, American Banking and Market News, 27 June,  viewed 14 July 2016, <https://www.americanbankingnews.com/2016/06/27/easyjet-plc-ezj-stock-rating-reaffirmed-by-goldman-sachs/> 

Mann, H 2016, ‘Goldman Sachs names stocks with 60% upside’, Interactive Investor, 13 January, viewed 14 July, <https://www.iii.co.uk/articles/288090/goldman-sachs-names-stocks-60-upside> 

Bryan, V 2016, ‘Brexit uncertainty could impact air traffic demand: ACI Europe’, Reuters, 7 July, viewed 14 July 2016, <https://www.reuters.com/article/us-britain-eu-airports-idUSKCN0ZN116?type=companyNews > 

Bloom, D 2016, ‘Brexit will make ICE CREAM more expensive warns Unilever boss’, Mirror, 7 June, viewed 14 July 2016, < https://www.mirror.co.uk/news/uk-news/brexit-make-ice-cream-more-8135773> 

Wild, R 2016,‘‘Brexit-proof’ your portfolio with Unilever plc, Supergroup plc, Dignity plc and Mediclinic International plc!’, The Motley Fool, 24 June, viewed 15 July 2016, <https://www.fool.co.uk/investing/2016/06/24/brexit-proof-your-portfolio-with-unilever-plc-supergroup-plc-dignity-plc-and-mediclinic-international-plc/> 

Neff, J 2016, ‘Unilever Will ‘Zero Base’ Marketing Budgets in Belt Tightening Move’, Advertising Age, 20 January, viewed 14 July 2016, <https://www.adageindia.in/marketing/cmo-strategy/unilever-will-zero-base-marketing-budgets-in-belt-tightening-move/articleshow/50646630.cms> 

Stephens, P 2016, ‘3 stocks with 30% upside: Unilever plc, Sports Direct International plc and WM Morrison Supermarkets plc’, The Motley Fool, 7 July, viewed 14 July, < https://www.fool.co.uk/investing/2016/07/07/3-stocks-with-30-upside-unilever-plc-sports-direct-international-plc-and-wm-morrison-supermarkets-plc/ > 

Trefis, 2016, ‘How Might The Brexit Impact Unilever?’, Forbes, 28 June, viewed 14 July 2016, <https://www.forbes.com/sites/greatspeculations/2016/06/28/how-might-the-brexit-impact-unilever/#741cb25f4029> 

Pfanner, E 2016, ‘Brexit Pamphlets, Ballots Set to Deliver Boost to Royal Mail’, Bloomberg, 19 May 2016, viewed 13 July 2016, <https://www.bloomberg.com/news/articles/2016-05-19/-brexit-pamphlets-ballots-set-to-deliver-boost-to-royal-mail> 

Farrel, S 2016, ‘Brexit business fears overblown, says Merlin chief’, The Guardian, 25 February, viewed 15 July 2016, <https://www.theguardian.com/business/2016/feb/25/brexit-business-fears-overblown-says-merlin-chief > 

Ferguson, A 2016,‘Merlin could conjure up some post-Brexit profits’, News.Markets, 28 June 2016, viewed 15 July 2016, <https://news.markets/shares/merlin-conjure-post-brexit-magic-barclays-20593/> 

‘Alton Towers rollercoaster crash causes Merlin profit warning’ 2015, BBC News, 27 July, viewed 14 July 2016,<https://www.bbc.com/news/business-33672357> 

Jarvis, P 2016, ‘Marks and Spencer sales slumped ahead of Brexit vote’, Independent, 7 July, viewed 14 July, < https://www.independent.co.uk/news/business/news/marks-and-spencer-sales-food-brexit-eu-referendum-marc-bolland-a7124336.html > 

Unilever PLC 2016, Reuters, viewed 14 July 2016, <https://in.reuters.com/finance/stocks/analyst?symbol=ULVR.L > 

Merlin Entertainments 2016, DigitalLook, viewed 14 July 2016, < https://www.digitallook.com/equity/Merlin_Entertainments > 

easyJet PLC 2016, Reuters, viewed 14 July 2016, <https://www.reuters.com/finance/stocks/analyst?symbol=EZJ.L> 

Royal Mail PLC 2016, Reuters, viewed 14 July 2016, <https://www.reuters.com/finance/stocks/analyst?symbol=RMG.L >Marks and Spencer Group PLC 2016, Reuters, viewed 14 July 2016,  <https://uk.reuters.com/business/quotes/analyst?symbol=MKS.L >

 easyJet plc 2015, ‘Results for the twelve months ended 30 September 2015’, 17 November 2015, viewed 14 July 2016 < https://corporate.easyjet.com/~/media/Files/E/Easyjet-Plc-V2/pdf/investors/results-centre/2015/2015-full-year-results.pdf > 

easyJet plc 2016, ‘Results for the six months ended 31 March’, 10 May 2016, viewed 14 July 2016 <https://corporate.easyjet.com/~/media/Files/E/Easyjet-Plc-V2/pdf/investors/results-centre/2016/2016-half-year-results-statement-v2.pdf> 

Unilver 2016, ‘Analyst’s consensus’, 8 July 2016, viewed 14 July, < https://www.unilever.com/investor-relations/results-and-publications/analysts-consensus/ >