SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

SECURITY :- Investments in capital markets is in various financial instruments, which are all claims on money. These instruments may be of various categories with different characteristics. These are called ‘Securities’ in market place.Securities Contracts Regulation Act, 1956 has defined the security as inclusive of shares, scrips, stocks, bonds, debenture stock or any other markatable instruments of a like nature in or of any debentures of a company or body corporate, the government and semi-government body etc. It includes all rights & interests in them including warrants and loyalty coupons etc., issued by any of the bodies, organisations or the government. The derivatives of securities and Security Index are also included as securities. SECURITY ANALYSIS :- Security Analysis involves the projection of future dividend or earnings flows, forecast of the share price in the future and estimating the intrinsic value of a security based on forecast of earnings or dividends. Modern Security Analysis relies on the fundamental analysis of the security, leading to it’s intrinsic worth and also risk-return analysis depending on the variability of the returns, covariance, safety of funds and the projections of the future returns.

•PORTFOLIO :- A combination of securities with different risk-return profile will constitute the portfolio of the investor. Thus portfolio is a combination of assets and/or instruments of investments. The combination may have different features of risk & return, separate from those of components.

PORTFOLIO MANAGEMENT :- Security Analysis is only a tool for efficient portfolio management.

Traditional Portfolio theory aims at the selection of such securities that would fit in well with the asset preferences, needs and choices of the investor.

Modern Portfolio theory postulates that maximisation of return and/or minimisation of risk will yield optimal returns and the choice and attitudes of investors are only a starting point for investment decision and that vigrous risk return analysis is necessary for optimisation of returns.

INVESTMENT SCENARIO Investment activity involves the use of funds or savings for

acquisition of assets & further creation of assets. INVESTMENT VS. SPECULATION

An investment is a commitment of funds made in the expectation of some positive rate of return commensurate with the risk profile of the investment. The true investor is interested in a good rate of return, earned on a consistent basis for relatively long period of time.

The speculator seeks opportunities promising very large returns, earned quickly. Speculator is less interested in consistent performance than is the investor & is more interested in the abnormal, extremely high rate of return than the normal moderate rate. Furthermore, the speculator wants to get these returns in a short span of time & switchover to other opportunities.

Speculator adds to the market’s liquidity as he is frequently turning over his portfolio. Thus, the presence of speculator provides a market for securities, the much required depth & breadth for expansion of capital markets.

INVESTMENT CATEGORIES

Investments generally involve – A) Real Assets (Physical Assets) :- They are tangible,

material things such as buildings, automobiles, plant and machinery etc.

B) Financial Assets :- These are pieces of paper representing an indirect claim to real assets held by someone else.

One of the distinguishing features of Real Assets & Financial Assets is the degree of liquidity. Liquidity refers to the ease of converting an asset into money quickly, conveniently and at little exchange cost. Real Assets are less liquid than financial assets, largely because real assets are more heterogeneous, often peculiarly adapted to a specific use, and yield benefits only in co-operation with other productive factors. In addition to it the returns of real assets are frequently more difficult to measure accurately, owing to absence of broad, ready, and active markets.

FINANCIAL ASSETS

Financial Assets can be categorised according to their source of issuance (public or private) and the nature of the buyer’s commitment (creditor or owner). Accordingly different financial assets are –

DEBT INSTRUMENTS These are issued by government, corporations and individuals &

represent money loaned rather than ownership to the investor. They call for fixed periodic payments, called interest and eventual repayment of the amount borrowed, called the principal. The interest payment stated as a percentage of the face value or maturity value is referred to as the nominal or coupon rate.

Institutional Deposits & Contracts:- Demand & Time deposits, Certificate of Deposits, Life Insurance policies, Contributions to Pension Funds. Title can’t be transferred to a third party.

Government Debt Securities :- These are the safest and most liquid securities. The short-term securities have maturities of one year or less and include Treasury Bills with maturities of 91 days to one year.

Long term securities include Treasury Notes (one to ten year maturity) and Treasury Bonds (maturities of ten to thirty years), which bear interest.

Private Issues:- Private debt issues are offered by corporations engaged in mining, manufacturing, merchandising and service activities. The most common short-term privately issued debt securities are Commercial Paper. CP is unsecured promissory note from 30 to 270 days maturity. These securities are issued to suppliment bank credit and are sold by companies of prime credit standing. Banker’s acceptances are issued in international trade. They are of high quality having maturities from ninety days to one year.

The long-term debt contracts cosist of two basic promises- i) To pay regular interest ii) To redeem the principal at maturity.The long-term debts are in the form of bonds, Debentures,

Convertible bonds, Mortgage Bonds, Collateral Trust Bonds.International Bonds-International domestic bonds are sold by an

issuer within the country of issue in that country’s currency- e.g. Sony Corp selling yen-denominated bonds in Tokyo.

Foreign bonds are issued in the currency of the country where they are sold but sold by a borrower of different nationality. E.g. A dollar denominated bond sold in Newyork by Sony Corp is called Yankee bond. Yen denominate bond sold by IBM in Tokyo is called Samurai bond.

Company Deposits – Large corporate time deposits in commercial banks are often of certain minimum amounts for a specified time period. Unlike time deposits of individuals, these CDs are negotiable; i.e. They can be sold to & redeemed by third parties.

EQUITY INSTRUMENTSThese instruments are divided into two categories – one

representing indirect equity investment through institutions and the other representing direct equity investment through the capital markets.

Investment Through Institutions :- These investments involve a commitment of funds to an institution of some sort that in return manages the investment for the investor.

Direct Equity Investments :- Equity investments are either in common stock or preferred stock. The holders of common stock are the owners of the firm, have the voting power, can elect the BOD and carry right to the earnings of the firm after all expenses & obligations have been paid and also carry a risk of losing earnings in case of losses.

Common stock holders receive a return based on two sources- Dividends & Capital Gains. Preferred stock is called a ‘hybrid security’ because it has features of both common stock & bonds.

In the event of liquidation, preferred stockholders get their stated dividends before common stockholders.

International Equities :- Foreign Stocks offer diversification possibilities because correlation with domestic stocks is much lower in case of foreign stocks than any other domestic stock. These could be acquired directly at foreign stock exchanges by purchase of depository receipts ( ADRs, GDRs ). International equities face the same currency risks as in foreign bonds.

OPTIONS & FUTURESThese instruments of investment derive their value from an

underlying security (stock, bond or basket of securities). Thus they are so called as derivatives.

An option agreement is a contract in which the writer of the option grants the buyer of the option the right to purchase from or sell

to the writer a designated instrument at a specified price (or receive a cash settlement) within a specified period of time. Call options are options to buy & put options are options to sell.

Financial futures represent a firm legal commitment between a buyer and seller, where they agree to exchange something at a specified price at the end of a designated period of time. The buyer agrees to take delivery and the seller agrees to make delivery. Futures are available either on stocks (stock futures) or basket of stocks (index futures). Futures on fixed-income securities (e.g. Treasury Bonds) are called interest-rate futures.

REAL ESTATE Investments in real estate can be direct one as a owner or indirect

as a creditor. Debt participation is also offered by direct acquisition of mortgages or the indirect purchase of mortgage backed securities. Real estate pools that are similar to mutual funds are called Real Estate Investment Trusts (REITs). They are available for diversified debt & equity ownership in pools of property of various types.

RISK & RETURN

Risk in holding securities is generally associated with the possibility that realised returns will be less than that were expected. Some risks are external to the firm & can’t be controlled, thus affect large number of securities (Systematic Risk). Other influences are internal to the firm & are controllable to a large degree (Unsystematic Risk).

Systematic Risk refers to that portion of total variability in return caused by factors affecting the prices of all securities. Economic, Political and sociological changes are the sources of systematic risk.

Unsystematic Risk is the portion of total risk that is unique to a firm or industry. E.g. Factors such as management capability, consumer preferences, labour strikes etc.

SYSTEMATIC RISKMarket Risk:- This risk is caused due to changes in the attitudes of

investors toward equities in general, or toward certain types or groups of securities in particular. Market risk is caused by investor reaction to tangible as well as intangible events. The tangible events include political, social and economic environment.

Intangible events are related to market psychology. Market risk is usually touched off by a reaction to real events leading to emotional instability of investors.

Interest-Rate Risk :- It refers to the uncertainty of future market values and of the size of future income, caused by fluctuations in the general level of interest rates.

The root cause of interest rate risk is fluctuating yield on government securities.

Purchasing-Power Risk :- Purchasing power risk refers to the impact of inflation or deflation on an investment. Rising prices of goods & services are associated with inflation & that falling with deflation

UNSYSTEMATIC RISKUnsystematic risk is that portion of total risk that is unique or

peculiar to a firm or industry. Factors such as management capability, consumer preferences and labour strikes can cause unsystematic variability of returns for a company’s stock.

Business Risk :- This risk is a function of the operating conditions faced by a firm and the variability these conditions inject into the operating income and expected dividends. Business risk can be divided into two broad categories- external & internal.

Internal Business Risk :- This risk is largely associated with the efficiency with which a firm conducts it’s operations within the broader operating environment imposed upon it.

External Business Risk :- It is the result of operating conditions imposed upon the firm by circumstances beyond it’s control. Govt. policies with regard to monetary & fiscal matters can affect revenues thro’ the effect on the cost & availability of funds.

Financial Risk :- This risk is associated with the way in which a company finances it’s activities. The substantial debt funds, preference shares in the capital structure of the firm creates high fixed-cost commitments for it. This causes the amount of residual earnings available for common-stock dividends more stressed.

RETURNInvestors want to maximise expected returns subject to their tolerance for risk. It is the motivating force and the principal reward in the investment process.

Realised Return :- It is the return which is actually earned. Expected Return :- It is the return from an asset that investors

anticipate they will earn over some future period.Return in a typical investment consists of two components. The

basic component is the periodic cash receipt on the investment, either in the form of interest or dividends. The second component is the change in the price of the asset – commonly called capital gains or loss. This element of return is the difference between the purchase price and the price at which the asset can be sold.

Total Return = Income + Price Change = Cash payments received + Price change over the

period Purchase price of assetTotal return can be either positive or negative.

BETABeta is a measure of non-diversifiable risk. It shows how

the price of a security responds to market forces. In effect, the more responsive the price of a security is to changes in

the market, the higher will be it’s beta.

It is calculated by relating the returns on a security with the returns for the market. Market return is measured by the average return of a large sample of stocks, such as stock index. The beta for overall market is equal to 1.00 and other betas are viewed in relation to this value.

Measure of beta is helpful in assessing systematic risk and understanding the impact market movements can have on the return expected from a share of stock. Decreases in the market returns are translated into decreasing security returns. Stocks having beta more than one will be more responsive & that less than one will be less responsive to the market movements.

Measure of Beta = % Price change of a scrip return

% Price change of the Market

Index Return

CAPITAL ASSET PRICING MODEL

CAPM uses the concept of Beta to link risk with return. Using CAPM, investors can assess the risk- return trade-off in any investment decision.

Beta is a measure of non-diversifiable risk ( Systematic Risk). It shows how the price of a security responds to changes in market prices. The equation for calculation of beta is,

RL= a + β Rm

RL= Estimated return on i stock

a = expected return when market risk is zero

β = Measure of stock’s sensitivity to the market index

Rm = Return on market index

The equation for CAPM is,Ri = Rf + βi (Rm – Rf) Ri is the required return Rf is risk-free return

Rm is the average market return βi is the measure of systematic risk which is non-diversifiable

SECURITY MARKET LINE (SML)

Retu

rn%

0.5 1.0 1.5

RISK (BETA)

0

Risk Less Return

Y

X

When CAPM is drawn graphically, we get SML. If the investor wants to decide on an investment with an expected return he would know the level of risk, he has preferred to take, he would know the expected return from this chart. The investor has to assess whether it is worth taking a level of risk, if he has a target return which involves that risk, as he is assumed to be generally risk averse. Thus, CAPM & SML help the investor in evaluating risk for a return, in making any investment decision. The principle of higher the risk, higher the return is embodied in this model.

ALPHA

Alpha is an indicator of expected return when market return is zero. It suggests an estimate of return if the market is flat i.e. neither going up nor going down. Combining the alpha & the beta we can predict the return on security if the market moves up or down.

FUNDAMENTAL ANALYSIS : INDUSTRY ANALYSIS

At any stage in the economy, there are some industries which are growing while others are declining. The performance of companies will depend among other things upon the state of the industry as a whole and the economy. If the industry is prosperous, the companies, within the industries may also be prosperous although a few may be in a bad shape. The performance of a company is thus a function not only of the industry and of the economy, but more importantly, on it’s own performance. The share price of the company is empirically found to depend up to 50% on the performance of the industry and the economy. The economic and political situation in the country has thus a bearing on the prospects of the company. Following factors are considered in the industry analysis.

Product Line & stage in the life cycle Raw Material and Inputs, utilities Capacity Installed & utilised Industry Characteristics Demand & Market

Pricing & government controls on prices, distributionControl on Imports & exportsGovernment Policy with regard to IndustryTaxation Policy & incentives offeredLabour & other Industrial problems.Prospects of growthProtection or Tariff preferencesQuality of ManagementLevels of R&D.

IMPORTANCE OF INDUSTRY ANALYSIS The performance of the companies will depend upon the state

of the industry as a whole. Through industry analysis future projections of growth will get

highlighted.