Security Analysis and Portfolio Management

ByDr. Vinita Kalra

Investment

• Movement of funds from Surplus Sector to Deficit Sector

• When a person has more money than he requires for current consumption, he would be a potential investor.

• Definition: “The process of sacrificingsomething now for the purpose of gainingsomething later.”

Dimensions of Investment

• Sacrifice – Today

• Gain – Later

• Time

Different views..

• Layman – Monetary Commitment

• Economist – Net Addition made to the nation’s capital stock that consists of goods and services that are used in the production process.

• Financial investment is the allocation of money to assets that are expected to yield some gain over a period of time.

Features of Investment

• Return

• Risk

• Time Period

• Liquidity / Marketability

• Safety

Objectives of Investment

• Maximization of Return1. Annual Income (Dividend, Interest etc)2. Capital Appreciation

• Minimization of Risk

• Liquidity

• Hedge against Inflation

• Tax Considerations

Other…

• Near-Term High Priority Goals

• Long-Term High Priority Goals

• Low Priority Goals

• Entrepreneurial or Money - Making Goals

Features of an Ideal Investment

• Safety

• Liquidity

• Regularity and Stability of Income

• Stability of Purchasing Power

• Capital Appreciation

• Tax Benefits

• Legality

Types of Investors

• Individuals

• Institutions1. Insurance Companies2. Mutual Funds3. Banks4. FII

Investment Constraints

• Risk Tolerability

• Liquidity / Marketability

• Investors Age

• Need for Regular Income

• Tax Liability / Exemption

Errors While Investing

• Inadequate comprehension of return and risk.• Vaguely formulated investment policy.• Naive extrapolation of the past.• Cursory decision-making.• Simultaneous Switching• Misplaced love for cheap stocks.• Over diversification and under-diversification.• Buying shares of familiar companies• Wrong attitude toward losses and profits.• Tendency to speculate.

Investment vs. SpeculationBasis Investment Speculation

1. Time Horizon Plans for a longer time horizon

Plans for a very short period

2. Holding Period From 1 year to few years Varies from few days to months

3. Risk Assumes moderate risk Willing to undertake high risk

4. Return Likes to have moderate rate of return

Likes to have high rate of return

5. Decision Basis Considers fundamental factors and evaluates the performance of the company regularly

Considers inside information, hearsays and market behavior

6. Funds / Leverage Uses his own funds and avoids borrowed funds

Relies on borrowed funds to supplement his personal resources

Investment vs. Gambling• Gambling is a very short term investment in a game.

• Time horizon is shortest.

• Results are determined by the roll of dice or turn of a card.

• Entertainment is primary, Earning income is secondary.

• Employs artificial risks while investment involves commercial risk.

• No risk-return trade-off; Negative outcomes are expected.

• Financial analysis does not reduce the risk proportion involved in gambling

Approaches to Investment Decision Making

• Fundamental Approach

• Psychological Approach

• Academic Approach

• Eclectic Approach

Fundamental Approach• Most commonly advocated.• There is an intrinsic value of a security and this

depends upon the underlying fundamental factors.

• Intrinsic value is based on EIC analysis.• At any given point of time, there are some

securities for which the prevailing market price would differ from the intrinsic value.

• Sooner or later, the market price would fall in line with the intrinsic value.

• Superior returns can be earned by buying under-valued securities & selling over-valued securities.

Psychological Approach

• Stock prices are guided by emotions rather than reason.

• Prices are influenced by the psychological mood of the investors.

• Investors use some form of technical analysis with a view to develop trading rules aimed at profit making.

• Based on certain persistent and recurring patterns of price movements.

• Uses a variety of tools like bar chart, point and figure chart, moving averages analysis etc…

Academic Approach

• Believes that stock markets are reasonable efficient in reacting quickly and rationally to the flow of information.

• Stock prices reflect intrinsic value very well.

• Prices behavior corresponds to random walk. Successive price changes are independent.

• There is a positive relationship between risk and return.

• Expected return from a security is linearly related to its systematic risk.

Eclectic Approach

• Based on all the three different approaches.

• Fundamental approach is helpful in establishing basic standards and benchmarks.

• Technical analysis is useful in broadly gauging the prevailing mood of the investors.

• Despite many instances of misprices securities, there appears to be a fairly strong correlation between risk and return.

Investment Process

Investment Policy

1. Investible Funds

2. Objectives

3. Knowledge

Analysis

1. Market

2. Industry

3. Company

Valuation

1. Intrinsic Value

2. Future Value

Portfolio Construction

1. Diversification

2. Selection & Allocation

Portfolio Evaluation

1. Appraisal2. Revision

Sources of Investment Information

• International Affairs

• National Affairs

• Industry Information

• Company Information

• Stock Market Information