Systematic Risk Analysis in Portfolio Construction Case Study on Nairobi Securities Exchange

A project report by by Daniel C. Ndung’u, submitted to the Chandaria School of Business, United States International University Africa.The general objective of this study was to select stocks and construct portfolio of securities in the Nairobi Securities Exchange (NSE) through the use of beta as a basis. The specific objectives of this study were to determine betas of companies quoted on the NSE, determine how the beta of individual security affects the expected security return, determine how the beta of individual security influences portfolio selection and attempt to use the Capital Asset Pricing model (CAPM) in NSE. The study used casual design taking on a correlation research approach because the study involved quantitative analyses of the strength of relationships between two or more variables, in this study the strength and direction of the relationship between securities returns and market returns. The study involved observation technique as the data collection method. Data was obtained from NSE and Central Bureau of Statistics. The sample size used for this study was 42 securities of the listed companies in the NSE for the period January 2001 to December 2006. The study found that securities beta in NSE range between 3.207 and -0.664. Most of the securities had a beta greater than the market (i.e. greater than 1). British American Tobacco, Athi River Mining, Crown Berger, E.A Portland and Olympia Capital Holdings had the highest betas respectively. Limuru Tea, Kapchorua Tea, Uniliver, E.A Cables, Mumias Sugar Company and Car and General had the lowest betas respectively. Finance and investment sectors had the highest betas of greater than 1 while the other sectors had betas of less than 1. Alternative sector had the lowest beta. Commercial sector had a beta very close to 1 similar to the market. The study concluded that there was a positive correlation between beta and securities returns. High positive beta value securities e.g British American Tobacco had the highest returns while low beta value securities e.g. Limuru Tea, had the lowest returns. Using CAPM, the security with the highest beta of 3.207 was British American Tobacco which also had the highest expected return of 59%. Limuru Tea with the lowest beta of -0.664 also had the lowest expected return of -12%. Portfolio construction using beta was achieved by calculating excess return to beta ratio. The portfolio included 20 securities selected and weighted in the portfolio with securities with highest returns and lowest risk allocated the highest weight in the portfolio. The portfolio had a return of 46 %, and beta of 1.134. The constructed portfolio return was high compared to the market return which was 19% and the risk was reduced. There was a positive correlation between market returns and individual securities returns; high individual returns were reflected during the period of high market return measured by the market index. Economic growth as measured by GDP growth was positively correlated with market returns, this implies that GDP growth was positively correlated with securities returns.The study recommends that fund managers, wealth managers and individual investors should include beta as a consideration in their investment decision. The use of beta will help in selecting securities and construction of different portfolios for different investors with different attitude toward risk. During forecasted positive economic growth the study recommends the selection of high beta stocks to provide high returns and selection of low beta stocks when macroeconomic turbulence is forecasted. Further research should come up with the most accurate way of calculating beta within a long period and include the recently listed companies in Nairobi Securities Exchange. Arbitrage Pricing Model that seeks to subdivide beta risk into different components and returns assessed from the sensitivity of a stock to each component should be studied for stocks in NSE