Security Analysis And Portfolio Managment

SECURITY ANALYSIS & PORTFOLIO
MANAGEMENT
UNIT – 1 : INVESTMENT
Definition of Investment

Investment involves making of a sacrifice in the present with the hope of deriving future
benefits. Investment has many meanings and facets. The two most important features of
an investment are current sacrifice and future benefit.

Why Invest?

We invest in order to improve our future welfare. Funds to be invested come from assets
already owned, borrowed money, and savings or foregone consumption. By foregoing
consumption today and investing the savings, we expect to enhance our future
consumption possibilities. Anticipated future consumption may be by other family
members, such as education funds for children or by ourselves, possibly in retirement
when we are less able to work and produce for our daily needs. Regardless of why we
invest, we should all seek to manage our wealth effectively, obtaining the most from it.
This includes protecting our assets from inflation, taxes and other factors.

Nature of Investment Decisions

Investment decisions are premised on an important assumption that investors are
rational and hence prefer uncertainty. They are risk averse which implies that they
would be unwilling to take risk just for the sake of risk. They would assume risk only if
an adequate compensation is forthcoming. And the dictum of ‘rationality’ combined
with the attitude of ‘risk aversion’ imparts to investment their basic nature. The question
to be answered is: how best to enlarge returns with a given level of risk? Or how best to
reduce risk for a given level of return? Obviously, there would be several different levels
of risk and different associated expectations of return. The basic investment decision
would be a trade-off between risk and return.
The Investment Process
A typical investment decision undergoes a five step procedure which, in turn, forms the
basis of the investment process. These steps are:
1. Determine the investment objectives and policy.
2. Undertake security analysis.
3. Construct a portfolio.
4. Review the portfolio.
5. Evaluate the performance of the portfolio.
6.
Investment Objectives and Policy

Rameshwar Patel/ Pacific Institute of management

The investor will have to work out his objectives first and then evolve a policy with the
amount of investible wealth at his command. Hence, the objectives of an investor must
be defined in terms of risk and return.

The next step in formulating the investment policy of an investor would be the
identification of categories of financial assets he/she would be interested in.

Security Analysis

This step would consist of examining the risk-return characteristics of individual
securities or groups of securities identified under step one. The aim here is to know if it
is worthwhile to acquire these securities for the portfolio. And there are two broad
approaches to finding out the ‘mispriced status’ of individual securities. One approach is
known as ‘technical analysis’. The second approach is known as ‘fundamental approach’.

Portfolio Construction

This consists of identifying the specific securities in which to invest and determining the
proportion of the investor’s wealth to be invested in each.

Portfolio construction address itself to three major problems via., selectivity, timing,
and diversification. The related questions would be: which specific shares/debentures to
buy, when to buy, and how best to combine then in a way that risk is reduced to a
minimum for a given level of expected return.
Investment versus speculation
Basis Investment Speculation
Type of contract Creditor Ownership
Basis of acquisition Usually by outrightOften-on-margin
purchase
Psychological attitude Cautious andDaring and careless
of participants conservative
Reasons for purchase Scientific analysis ofHunches, tips “inside
intrinsic worth dope", etc.
Quantity of risk Small Large
Stability of income Very stable Uncertain and erratic
Length of commitment Comparatively long-term For a short time only
Source of income Earnings of enterprise Change in market price

Investment versus Gambling speculation


Speculation typically lasts longer than gambles but are briefer than investments. A
speculation usually involves the purchase of a salable asset in hopes of making a quick
profit from an increase in the price of the asset which is expected to occur within a few
weeks or months. Those involved in speculations are reluctant to refer to this activity as
speculation because they dislike the connotations of the word; they prefer to refer to
speculations as investment activities.

A gamble is usually a very short-term investment in a game of chance. The holding
period for most gambles can be measured in seconds. That is, the result of so-called
investments is quickly resolved by the roll of the dice or the turn of a card. Such
activities have planning horizons that are far too brief to do the research that should
precede any investment activity.

Speculation is not the same as gambling and the two should never be confused. The
difference between speculation and gambling is that in gambling, artificial and
unnecessary risks are created whereas in speculation the risks already exist and the
question is simple – who shall bear them? Gambling is a far cry from the carefully
planned research and scientific procedure which underlies the best speculative practice.
The gambler plays rumours, tips, hunches and other unreliable intuitions which should
not play any but a negative role in the trained speculator’s process. Speculation is a
reasoned anticipation of future conditions. It does not rely upon hearsay or labels. It
attempts to organise the relevant knowledge as a support for judgements. It is as
legitimate and moral as any other form of risk-taking business activity.


Investment Alternatives
Equity
Preference shares
Debentures
Bonds or fixed income securities
 Government securities
 Savings bonds
 Private sector debentures
 PSU bonds
 Preference shares
Money market instruments
 Treasury bills
 Certificates of deposits
 Commercial paper
 Repos
Non-marketable financial assets
 Bank deposits
 Post office time deposits (POTD)
 Monthly income scheme of the post office (MISPO)
 Kisan Vikas Patra (KVP)
 National savings certificate
 Company deposits
 Employees provident fund scheme
 Public provident fund scheme
Real estate


 Residential House
 Sources of Housing Finance
 Features of Housing Loans
 Guidelines for Buying a Flat
 Commercial Property
 Agricultural Land
 Suburban Land
 Time Share in a Holiday Resort
Precious objects
 Gold and Silver
 Precious Stones
 Art Objects
Insurance policies
 Endowment Assurance
 Money Back Plan
 Whole Life Assurance
 Unit Linked Plan
 Term Assurance
 Immediate Annuity
 Deferred Annuity

Investments and Innovation
Technology
 Advancements in computing power and Internet technology
 More complete and timely information delivery
Globalization
 Domestic firms compete in global markets
 Performance in regions depends on other regions
 Causes additional elements of risk
 Globalization continues and offers more opportunities
 Securitization continues to develop
 Derivatives and exotics continue to develop
 Strong fundamental foundation is critical
 Integration of investments and corporate finance


SYSTEMATIC RISK


Systematic Risk ( Non – Diversifiable Risk)
• Caused by the external factors
• Uncontrollable
• Affects the market as whole
Unsystematic Risk (Diversifiable Risk )
• Specific factors related to the particular industry or a company

Market Risk :
• Portion of total variability of return caused by the alternate forces caused by bull
and bear markets.
• Forces affect the market are tangible and intangible events
• Tangible Events are real events such as earthquakes, war, e.t.c.
• Example Pokhran Blast on May13, 1998 resulted in fall of sensex by 162 points.
• Intangible events related to market psychology.
• Example ,in 1996 recession in economy resulted in fall of share prices
• These factors are beyond the control of corporate.

Interest Rate Risk :
• Variation in single period rates of return caused by fluctuations in market
interest rate.


• This will affects commonly price of bonds, debentures and stocks.
• Caused by changes in gov’t monetary policy, interest rates of treasury bills and
gov’t bonds.
• Rise or fall in the interest rate affects the cost of borrowings
Purchasing Power Risk :
• Probable loss in the purchasing power of returns to be received.
• Inflation is the reason behind the loss of purchasing power.
• Inflation is of 2 types
1. Demand-Pull Inflation
2. Cost-Pull Inflation
Systematic Risk Unsystematic Risk
Other  Market Risk  Unique Risk
Names  Non-  Diversifiable
diversifiable Risk
Risk
Examples  Government tax  A firm’s
cut technical wizard
 Interest rate leaves
rises  A competitor
enters a firm’s
product market

Beta(b): Measure of Market Risk
• if b = 0
– asset is risk free
• if b = 1
– asset return = market return
• if b > 1
– asset is riskier than market index
 b<1
– asset is less risky than market index
– The higher the degree of systematic risk (b), the higher the return
expected by investors.

UNSYSTEMATIC RISK


It stems from managerial inefficiency, technological change in the production
process, availability of raw materials, changes in the consumer preference and
labor problems
 It differs from industry to industry.
 Technological changes affect the information technology industry more than that
of consumer product industry.
CLASSIFICATION
• BUSINESS RISK
• FINANCIAL RISK

BUSINESS RISK
 It arises from the inability of the firm to maintain its competitive edge and the
growth or the stability of the earnings.
 Variation that occurs in the operating environment is reflected on the operating
income and expected dividends

BUSINESS RISK
• INTERNAL BUSINESS RISK
• EXTERNAL BUSINESS RISK

INTERNAL BUSINESS RISK
 Fluctuations in the sales
 R&D
 Personnel Management
 Fixed cost
 Single Product

EXTERNAL BUSINESS RISK
 Social and regulatory factors
 Political risk
 Business Cycle

FINANCIAL RISK
 It refers to the variability of the income to the equity capital due to the
debt capital
 Financial risk In a company is associated with the capital structure of
the company
 Capital structure of the company consists of equity funds and
borrowed funds

Unit II: Security Analysis - Fundamental Analysis - Analysis Industry Analysis - Investments
in Industry - Company Analysis.


Unit II: Security Analysis
Security Analysis and Investment Decision
Investment decision-making is an important area probing further.
Investment decision-making being continuous in nature should be attempted
systematically. Broadly approaches are suggested in the literature. These are:
fundamental analysis and technical analysis.

FUNDAMENTAL ANALYSIS
← ECONOMIC ANALYSIS
← INDUSTRY ANALYSIS
← COMPANY ANALYSIS


Macro Economic Analysis


The analysis of the following factors indicates the trends in macro economic changes
that effect the risk and return on investments.
 Money supply
 Industrial production
 Capacity utilisation
 Unemployment
 Inflation
 Growth in GDP
 Institutional lending
 Stock prices
 Monsoons
 Productivity of factors of production
 Fiscal deficit
 Credit/Deposit ratio
 Stock of food grains and essential commodities
 Industrial wages
 Foreign trade and balance of payments position
 Status of political and economic stability
 Industrial wages
 Technological innovations
 Infrastructural facilities
 Economic and industrial policies of the government
 Debt recovery and loans outstanding
 Interest rates
 Cost of living index
 Foreign investments
 Trends in capital market
 Stage of the business cycle
 Foreign exchange reserves
Macroeconomic Analysis
The government employs two broad classes of macroeconomic policies, viz. demand-
side policies and supply-side policies.
Fiscal Policy
Fiscal policy is concerned with the spending and tax initiatives of the government. It is
the most direct tool to stimulate or dampen the economy.
Monetary Policy
The main tools of monetary policy are:
 Open market operation
 Bank rate
 Reserve requirements
 Direct credit controls

Economic Forecasting


Economic forecasting is a must for making investment decision. Forecasting techniques
can also be divided and categories: Short-term forecasting techniques and Long-term
forecasting techniques.
Techniques used
 Economic indicators
 Diffusion index
 Surveys
 Economic Model Building

Industry Analysis
Industry Analysis
Some of the useful bases for classifying industries from the investment decision-point of
view are as follows:
 Growth Industry
 Cyclical Industry
 Defensive Industry
Based on the stage in the life cycle, industries are classified as follows:
 Pioneering stage
 Fast growing stage
 Security and stabilization stage
 Relative decline stage
IMPORTANCE OF INDUSTRY ANALYSIS
i. Firms in each different industry typically experience similar levels of risk
and similar rates of return. As such, industry analysis can also be useful in
knowing the investment- Worthiness of a firm.
ii. Mediocre stocks in a growth industry usually outperform the best stocks in
a stagnant industry. This points out the need for knowing not only company
prospects but also industry prospects.
CLASSIFICATION OF INDUSTRIES
There are different ways of classifying industrial enterprises.
i. Classification by Reporting Agencies
ii. Classification by Business Cycle
KEY INDICATORS IN ANALYSIS
The analyst is free to choose his or her own indicators for analyzing
the prospects of an industry. However, many commonly adopt the
following indicators.
A. Performance factors like
 Past sales
 Past earnings
B. Environment factors like
 Attitude of government
 Labour conditions
 Competitive conditions
 Technological progress
C. Outcome factors like
 Industry share prices


 Price earnings multiples with reference to these key factors,
evaluations shall be done to identify.
 Strengths and weaknesses
 Opportunities and threats
ANALYTICAL FRAMEWORKS
Industry life-cycle stages (product life cycle theory)
 Pioneering Stage (Introduction)
 Expansion Stage (Growth)
 Stagnation Stage (Maturity)
 Decay Stage (Decline)
FORECASTING METHODS
The techniques for analyzing information about industry within a time framework are
briefly explained in this section.
1. The market profile
2. Cumulative methods
a) Surveys
b) Correlation and Regression analysis
c) Time series analysis

Conditions and profitability
Profitability depends upon the state of competition prevalent in the industry. Cost
control measures adopted by its units and the growth in demand for its products.
Profitability is another area that calls for a thorough analysis on the part of investors. No
industry can survive in the long run if it is not making profits. This requires thorough
investigation into various aspects of profitability. However, such an analysis can begin
by having a bird's eye view of the situation. In this context, ratio analysis has been found
quite useful.
Industry Analysis factors
The securities analyst will take into consideration the following factors into account in
assessing the industry potential in making investments.
 Post-sales and earnings performance
 The government's attitude towards industry
 Labour conditions
 Competitive conditions
 Performance of the industry
 Industry share prices relative to industry earnings
 Stage of the industry life cycle
 Industry trade cycle
 Inventories build-up in the industry
 Investors' preference over the industry
 Technological innovations
Techniques of Industry Analysis
 End Use and Regression Analysis
 Input Output Analysis
Company Analysis
Need for Company Analysis


For earning profits, investors apply a simple and common sense decision rule of
maximization. That is:
 Buy the share at a low price
 Sell the share at a high price
The real test of an analyst’s competence lies in his ability to see not only the forest but
also the trees. Superior judgment is an outcome of intelligence, synthesis and inference
drawing. That is why, besides economic analysis and industry analysis, individual
company analysis is important.
FRAMEWORK OF COMPANY ANALYSIS
The two major components of company analysis are:
i. Financial
ii. Non-financial

WherePio = Value of share i
Dit = Dividends of share I in the t th period
K1 = Equity capitalization rate
Git = Growth rate of dividends of share I (a constant)
This value is obtained by stock analysts y multiplying the ‘i’ the stock’s normalized
earnings per share (e) with price-earnings ratio or earnings multiplier (m)
Pio = eio. Mio
WherePio = Value of share ‘I’
eio = Earning of share ‘c’
mio = Earnings multiplier of share ‘i’
Earnings Analysis
We will now discuss differences in accounting procedures.
1. Sales – Revenue Recognition Principle
2. Inventory
3. Depreciation

Accounting Income Effect on Balance Sheet
A balance sheet is a summary of account balance carried after the appropriate closing of
the books. Income statements deal with flows, whereas balance sheet deals with stocks.


The impact of inflation should be considered to make the balance sheet items realistic.
Measures suggested are.
a) Assets side:
1. Report marketable securities at current value.
2. Inventory should be valued at replacement cost.
3. Land and natural resources to be shown at net realizable value (current
market price-future development, selling or interest costs.
4. Plant & machinery at replacement cost.
5. Goodwill
6. R & D expenses
b) Liabilities side:
1. Debt. In future, at the time of maturity it is repaid in cheaper money units
(rupees). It is a gain to shareholders.
1. Deferred taxes.
2. Retained earnings.
Forecasting Earnings
It is necessary to estimate a stock’s future income because the value of the share is the
present value of its future income. This can be done by focussing on:
a) Identification of variables: Basically changes in income result from
changes in:
i) Operations of the business and (ii) In the financing of the business.
b) Determining the extent of change method: Different methods of
forecasting earnings are available. The two categories into which the methods fall.
1. Earlier methods
 Earnings methods
 Market share/profit margin approach (breakeven
analysis)
2. Modern techniques
 Regression and correlation analysis
 Trend analysis (time series analysis)
 Decision trees
 Simulation
Determining earnings – Multiplier (P/E) Ratio
The analysts followed rules of thumb to normalize P/E ratios.
1. They compared current actual P/E with what they considered
normal for the stock in question.
2. They compared price times estimated future earnings (1 to 3 years out)
with what they considered normal for the stock in questions.
3. They compared the multiplier and growth or earnings of individual
stocks with industry group multiple and earnings growth.

Dividend Discount Model of Valuation
In determination of the P/E ratio, the factors to be considered are
 Capitalization rate (K)


 Growth rate of dividend stream (g) and
 Dividend pay-out ratio (d/e)
Comparative P/E Approach
Comparative or relative valuation makes use of the average P/E of market or industry to
determine the P/E for an individual stock. The procedure is as follows:
i. Determine the market P/E using dividend discount model.
ii. Determine the market pay back period based on earnings growth rate
of market. (How many years it takes to obtain market P/E at the given growth
factor?)
iii. Assign P/E to the stock based on its growth rate and market payback
period.
iv. Make adjustments for dividend pay out ratio and earnings volatility.
v. Find volume of stock by multiplying normal earnings with the
determined P/E.
GROWTH STOCKS
Characteristics of growth stocks: The following features help identify growth
stocks.
I. Substantial and steady growth in EPS
II. Low current DPS, because retained earnings are high and reinvested.
III. High returns on book value
IV. Emphasis on R & D
V. Diversification plans for strategic competitive advantage
VI. Marketing competence and edge.
VII. Benefits: Investment in growth stocks would benefit investors in many ways.
VIII. 1. The market value goes up at a rate much faster than the rate of
inflation.
IX. 2. Higher capital gains.
X. 3. Long range tension free holding without any need for sell & buy
operations and associated problems.
XI. Valuation: The investor interested in growth shares can either employ (1)
Comparative P/E ratios approach or (2) Dividend Discount model for valuation
of the stocks.
XII. Guidelines for Investment
XIII. The following guidelines will be helpful to investors interested in growth stocks.
XIV. 1. Tuning is not very important, but with appropriate timing one may be able
to pick up shares at the threshold of high growth rate.
XV. 2. Choice of stock should not be based on simple factor. Multiple criteria
using different appraisal techniques may be employed.
XVI. 3. It is better to diversify investment in growth stocks industry-wise. Because
different industries grow at different by evening out differences.
XVII. 4. One should hold the stock for more than 5 years to gain advantage.

Estimation of Future Price


Before attempting to discuss the approach that can be adopted for company level
analysis, let us about the objective of investor and how it can be quantified. It is to
reiterate the proposition that an investor looks for increasing his returns from the
investment. Returns are composed of capital gains and a stream of income in the form
of dividends. Assuming he has equity shares for a period of one year (known as holding
period), i.e., he sells it at the end of the year, the total returns obtained by him would be
equal to capital gains plus dividends received at the end of the year.
WhereR1 = (P1 – P1–1) + D t
P1 = Price of the share at the end of the year
P1–1 = Price of the share at the beginning of the year
D1 = Dividend received at the end of the year
R1 = Return for the holding period, t

Quantitative Analysis
This approach helps us to provide a measure of future value of equity share based on
quantitative factors. The methods commonly used under this approach are
 Dividend discounted method, and
 Price-earnings ratio method
Forecasting Earnings per Share
Traditional Methods of Forecasting EPS
Under the traditional approach the following methods of forecasting are adopted.
1. ROI approach
2. Market share approach
3. Independent estimates approach

Unit III: Technical Analysis – Concept and Tools of Technical Analysis. Technical Analysis Vs.
Fundamental Analysis.


Unit III: Technical Analysis
Introduction to technical analysis and assumptions
The methods used to analyze securities and make investment decisions fall into two very
broad categories: fundamental analysis and technical analysis.
What is Technical Analysis?
Technical analysis is a method of evaluating securities by analyzing the statistics
generated by market activity, such as past prices and volume. Technical analysts do not
attempt to measure a security's intrinsic value, but instead use charts and other tools to
identify patterns that can suggest future activity.
Basic Technical Assumptions
The basic and necessary assumptions regarding the technical analysis:
1) The Market Discounts Everything
2) Price Moves in Trends
3) History Tends To Repeat Itself

TECHNICAL V/S FUNDAMENTAL ANALYSIS
Several ways the technician acts:
1. Technicians believe that behind the fundamentals are important factors
2. Technicians act on the what not the why
3. Technicians are not committed to a buy-and-hold policy
4. Technicians do not separate income from capital gains
5. Technicians act more quickly to make commitments and to take profits and
losses
6. Technicians recognize that the more experience one has with the technical
indicators, the more alert one becomes to pitfalls and failure of investing
7. Technicians insist that the market always repeats
8. Technicians believe that breakouts from previous trends are important signals
9. Technicians recognize that the securities of a strong company are often weak and
those of a weak company may be strong
10. Technicians use charts to confirm fundamentals

Distinctions between Fundamental and Technical Analysis


S.No. Fundamental Technical
1. His perspective is long-term in nature. HeHis outlook is short-term oriented. He is
is conservative in his approach. He actsaggressive. He acts on ‘what is’.
on ‘What should be’.
2. He adopts a buy-and hold policy. He doesHe believes in making a quick buck. He
not usually expect any significant increasesnuffles his investments quite often
in the value of his investments in lessrecognizing and foresees changes in stock
than a year. prices.
3. He considers total gain from equityHe does not distinguish between current
investment consists of current yield byincome and capital gains. He is interested in
way of dividends and long-term gains byshort-term profits.
way of capital appreciation.
4. He forecasts stock prices on the basis ofHe forecasts security prices by studying
economic, industry and companypatterns of supply of and demand for
statistics. The principal decision variablessecurities. Technical analysis is study of stock
take the form of earnings and dividends.exchange information.
He makes a judgment of the stock’s value
with a risk-return.
5. He uses tools of financial analysis andHe uses mainly charges of financial variables
statistical forecasting techniques besides some quantitative tools.


Security Analysis And Portfolio Managment

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