Basic IntroductionInvestment Analysis

Lecture: 4

Course Code: MBF 702

Recap

Our earlier lectures have introduced us about investment analysis and defined the concept of a security. It has looked at the securities that are traded and where they are traded. In addition, it has begun the development of the concepts of risk and return that characterize securities. The fact that these are related - an investor cannot have more of one without more of another - has been stressed. This theme will recur throughout the book. The chapter has also emphasized the role of uncertainty in investment analysis. This, too, is a continuing theme.

Outline

• Investment process• Buying and selling• Markets• Characteristics of good market• Classification of market• Investment companies• Intermediaries• Brokers• Summary

Investment Process

The investment process is description of the steps that an investor should take to construct and manage their portfolio. These proceed from the initial task of identifying investment objectives through to the continuing revision of the portfolio in order to best attain those objectives.

The steps in this process are:

• Determine Objectives: Investment policy has to be guided by a set of objectives. Before investment can be undertaken, a clear idea of the purpose of the investment must be obtained. The purpose will vary between investors. Some may be concerned only with preserving their current wealth. Others may see investment as a means of enhancing wealth. What primarily drives objectives is the attitude towards taking on risk. Some investors may wish to eliminate risk as much as is possible, while others may be focussed almost entirely on return and be willing to accept significant risks.

Investment Process

• Choose Value: The second decision concerns the amount to be invested. This decision can be considered a separate one or it can be subsumed in the allocation decision between assets (what is not invested must either be held in some other form which, by definition, is an investment in its own right or else it must be consumed).

• Conduct Security Analysis: Security analysis is the study of the returns and risks of securities. This is undertaken to determine in which classes of assets investments will be placed and to determine which particular securities should be purchased within a class. Many investors find it simpler to remain with the more basic assets such as stocks and fixed income securities rather than venture into complex instruments such as derivatives. Once the class of assets has been determined, the next step is to analyze the chosen set of securities to identify relevant characteristics of the assets such as their expected returns and risks. This information will be required for any informed attempt at portfolio construction.

Investment process

• Portfolio Construction: Portfolio construction follows from security analysis. It is the determination of the precise quantity to purchase of each of the chosen securities. A factor that is important to consider is the extent of diversification. Diversifying a portfolio across many assets may reduce risk but it involves increased transactions costs and increases the effort required to manage the portfolio.

• Evaluation: Portfolio evaluation involves the assessment of the performance of the chosen portfolio. To do this it is necessary to have some yardstick for comparison since a meaningful comparison is only achieved by comparing the return on the portfolio with that on other portfolios with similar risk characteristics.

Buying and selling

A fundamental step in the investment process is the purchase and sale of securities. There is more to this than is apparent at first sight. An order to buy or sell can take several forms, with characteristics that need to be determined by the investor. A variety of brokers with different levels of service, and corresponding fees, compete to act on the investor’s behalf. Some brokers are even prepared to loan funds for the investor to purchase assets.

The discussion begins with a discussion of the markets on which securities are traded. The role and characteristics of brokers are then described. Following this, the focus turns to the purchase of common stock since it is here that there is the greatest variety of purchasing methods. The choice of method can affect the return on a portfolio just as significantly as can the choice of asset so the implications for returns are considered.

Markets

Securities are traded on markets. A market is a place where buyers and sellers of securities meet or any organized system for connecting buyers and sellers.

Markets are fundamental for the trading of securities.

Markets can have a physical location such as the Karachi Stock Exchange, New York Stock Exchange or the London International Financial Futures Exchange. Both of these have a trading floor where trade is conducted. It is not necessary for there to be a physical location. Stock Exchange once possessed a physical location, but now trade is conducted through a computer network that links dealers. The Nasdaq Stock Market also has no location but relies on a network to link dealers. Recent innovations such as internet-based markets also have no physical location.

Characteristics of good market

A good market has the following characteristics:• Timely and accurate information is available on the price and volume of past

transactions and the prevailing bid and ask prices.

• It is liquid, meaning an asset can be bought or sold quickly at a price close to the prices for previous transactions (has price continuity), assuming no new information has been received. In turn, price continuity requires depth.

• Transactions entail low costs, including the cost of reaching the market, the actual brokerage costs, and the cost of transferring the asset.

• Prices rapidly adjust to new information; thus, the prevailing price is fair because it reflects all available information regarding the asset.

Characteristics of good market

Efficient market

This means that orders are executed and transactions are settled in the fastest possible way

Transparency

Investor make informed and intelligent decision about the particular stock based on information

Listed companies must disclose information in timely, complete and accurate manner to the Exchange and the public on a regular basis

Required information include stock price, corporate conditions and developments dividend, mergers and joint ventures, and management changes etc

Classification of market

Markets can be classified in a number of different ways. Each classification draws out some important aspects of the role and functioning of markets.

Primary and secondary markets Call and contionous Auction and over the counter Money and capital

The Hierarchy of Markets

Money market

Government bond market

Corporate bonds & equities

Asset backed securities & derivatives

Gov’t T Bills

Classification of marketPrimary and Secondary Markets

• Primary markets are security markets where new issues of securities are traded. When a company first offers shares to the market it is called an initial public offering. If additional shares are introduced later, they are also traded on the primary market. The price of shares is normally determined through trade but with new shares there is no existing price to observe. The price for initial public offerings has either to be set as part of the offer, or determined through selling the shares by tender or auction.

• Secondary markets are markets where existing securities are resold. The Karachi, London and New York stock exchanges are both primarily secondary markets.

• The role of the primary market in helping to attain economic efficiency is clear: the primary market channels funds to those needing finance to undertake real investment. In contrast, the role of the secondary market, and the reason why so much attention is paid to it, is probably less clear.

Classification of marketPrimary and Secondary Markets

Two important roles for the secondary market that can be identified:

• Liquidity: One of the aspects that will be important for the purchaser of a new security is their ability to sell it at a later date. If it cannot be sold, then the purchaser is making a commitment for the lifetime of the asset. Clearly, given two otherwise identical assets an investor would prefer to own the one which can most easily be traded. Thus new securities would have a lower value if they could not be subsequently traded. The existence of a secondary market allows such trading and increases the liquidity and value of an asset.

• Value: Trading in assets reveals information and provides a valuation of those assets. The assignment of values guides investment decisions by showing the most valuable uses for resources and helps in the attainment of economic efficiency. Without the secondary market this information would not be transmitted.

Classification of marketPrimary and Secondary Markets

The main function of the stock market are:

(a) To bring the companies and investors together, so that:

• Investors can put risk capital into companies;• Companies can value the capital that they raise to invest in new

capital projects.

(b) To provide investors with a means of selling their investment, should they wish to do so, by offering a ready market in the buying and selling of existing shares and loan stock.

Classification of marketCall and Continuous

A second way to classify markets is by the nature of trading and the time periods at which trading can take place.

In a call market trading takes place at specified times. Those who wish to trade are called together at a specific time and trade for a limited period. A single price is set that ensures the market clears. This can cause significant movements in price from one trading time to the next, so call markets can have provisions to limit movement from the initial price.

In a continuous market there is trading at all times the market is open. Requests to buy and sell are made continuously. Trade is often facilitated by market makers who set prices and hold inventories.

Classification of marketAuction and Over-the-Counter

In an auction market buyers and sellers enter a bidding process to determine the trading price of securities. This typically takes place at a specified location. The New York Stock Exchange is the primary example of an auction market.

An over-the-counter market involves direct negotiation between broker and dealers over a computer network or by telephone. The market will have a network of dealers who make a market and are willing to buy and sell at specified prices. They earn profit through the spread: the difference between the price at which they will buy and the price at which they will sell (the latter being higher). Nasdaq is considered to be an over-the-counter market.

Classification of marketMoney and Capital

• The money market is the market for assets with a life of less than 1 year. This includes money itself and near-money assets such as short term bonds.

Money market funds are investment companies that acquire highquality, short-term investments (referred to as money market instruments), such as T-bills, highgrade commercial paper (public short-term loans) from various corporations, and large CDs from the major money center banks.

• The capital market is the market for assets with a life greater than 1 year such as equity and long-term bonds.

Investment Companies

An investment company sells shares in itself to raise funds to purchase a portfolio of securities. The motivation for doing this is that the pooling of funds allows advantage to be taken of diversification and of savings in transactions costs. Many investment companies operate in line with a stated policy objective, for example on the types of securities that will be purchased and the nature of the fund management.

Forms of investment companies

A unit trust is a registered trust in which investors purchase units. A portfolio of assets is chosen, often fixed-income securities, and passively managed by a professional manager. The size is determined by inflow of funds. Unit trusts are designed to be held for long periods with the retention of capital value a major objective.

Investment Companies

The closed-end investment trust issue a certain fixed sum of stock to raise capital. After the initial offering no additional shares are sold. This fixed capital is then managed by the trust. The initial investors purchase shares, which are then traded on the stock market.

An open-end investment company (or mutual fund) continues to sell shares after the initial public offering. As investors enter and leave the company, its capitalization will continually change. Money-market funds hold money-market instrument while stock and bond and income funds hold longer-maturity assets.

A hedge fund is an aggressively managed portfolio which takes positions on both safe and speculative opportunities. Most hedge funds are limited to a maximum of 100 investors with deposits. They trade in all financial markets, including the derivatives market.

Intermediaries

• Brokerage houses

• Stock brokers • Advisors

Hand in Hand stockbrokers Trust company

Brokers

• On most markets, such as the New York and London Stock Exchanges, an individual investor cannot trade on the market directly. Instead they must employ the services of a broker who will conduct the trade on their behalf. This section discusses brokers and the services offered by brokerages.

• A broker is a representative appointed by an individual investor to make transactions on their behalf. The reward for a broker is generated through commission charged on the transactions conducted. This can lead to incentive problems since it encourages the broker to recommend excessive portfolio revision or churning. The accounts of individual investors at a brokerage are dealt with by an account executive. Institutional investors deal through special sections of retail brokerage firms

• Brokerage firms can be classified according to the services offered and the resulting level of fee charged.

Brokers

Traditional brokerages, now called full-service brokers, offer a range of services including information, investment advice and investment publications. They conduct the trading business of the clients and aim to guide them with their investment decisions. In addition to earning income from commissions, full-service brokers also generate revenue from a range of other activities. Amongst these are trading on their own account, commission from the selling of investment instruments such as mutual funds and payment for participation in initial public offerings.

• Discount brokers offer fewer services and charge lower fees than full-service brokers. Effectively, they do not provide advice or guidance or produce publications. Their major concentration is upon the execution of trading orders. Many discount brokers operate primarily internet-based services.

Brokers

Before common stock can be through a broker it is first necessary to open an account with a brokerage. This can be done by either physically visiting the brokerage, by telephone or directly by the internet. It is necessary that some personal details are given to the broker.

When opening an account at a brokerage, an investor has a choice between the two types of account. A cash account requires that the investor provides the entire funds for any stock purchase. In contrast, a margin account with a broker allows the investor to borrow from the broker to finance the purchase of assets. This allows a portfolio to be partly financed by using borrowed funds.

Summary

Trading is a necessary act in portfolio construction and management. Securities can be traded in a number of ways through brokers offering a range of service levels. These trading methods have been described