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SECURITY ANALYSIS & PORTFOLIOMANAGEMENT

Hitesh Shah


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Industry analysisIndustry

A group of firms produsing reasonably similar products

which serve the same needs of common set of buyers.

E.g. Cement industry, cotton industry.


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Industry life cycle

Product has life cycle. They have identified four stagesin the life of a product,

Introduction stages, Growth stages, Maturitystages,Decline stages

Same way in industry is also said to have a life cycle.

Pioneering stage The expansion stage

The stagnation stage

Deca sta e


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The technological advances in one industry can effectthe growth of another industry. The jute industrybegan to decline when alternate and cheaper packingmaterial came in to use.

The first step in industry analysis, therefore, is todetermine the stage of growth through which theindustry is passing.


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Pioneering stage

In this stage a new industry where the technology as wellas product are relatively new and have not reached astate of perfection.

Many companies compete with each other vigorously. Aslarge no. of companies attempt to capture their share ofmarket, these arises high business mortality rates.

Weak firms are eliminated and lesser number of firmssurvive in the pioneering stage.


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Therefore investment in companies in an industry thatin an industry that is in the pioneering stage is highlyrisky.

Industries in the pioneering stage are called sunrise

industries.

Telecomunications,computersoftware,informationtechnology,etc.are examples of sunrise industries in

India at present.


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Expansion stage The second stage of expansion or growth. The industry

now includes only those companies that have survivedin the pioneering stage. These companies continue to

become stronger. Each companies finds a market foritself and develops its own strategies to sell andmaintain its position in the market.

Investors can get high returns at low risk becausedemand exceeds supply in this stage.

Companies will earn increasing amount of profit andpay attractive dividends.


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Stagnation stage The growth of the industry stabilizes. The ability of

industry to grow appears to have been lost. Sales maybe increasing but at a slower rate than that

experienced by competitive industries or by the overalleconomy.

Two important reasons for this transaction are changein social habits and development of improvedtechnology. Eg. B/W TVs during eighties.

An investor should dispose of his holdings in anindustry which begins to pass from the expansion

stage to the stagnation stage because what is to follows


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Decay stage

This occurs when the products of the industry are nolonger in demand. New products and newtechnologies have come to the market. Customershave changed their habits, style and liking. As a resultthe industry becomes obsolete and gradually cease toexist.

An investor should get out of the industry before theonset of the decay stage.


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An industry usually exhibits low profitability in thepioneering stage, high profitability in the growth orexpansion stage, medium but steady profitability inthe stagnation or maturity stage and declining

profitability in decay stage. The classification of industries under this approach is

general pattern. There can be exceptions to thisgeneral pattern.

Careful analysis is needed to detect such exception.


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Industry characteristics

Demand and supply gap: excess supply reduces theprofitability of industry through a decline in the unitprice realization.

on the contrary insufficient supply tends to improvethe profitability through higher unit price realization.

The gap between demand and supply in industry isfairly a good indicator of its short-term and long termor mediumterm prospective.


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Competitive conditions in the industry:

New entrants to an industry increase the capacity inan industry. These new entrants may face certainbarriers to their entry. The barriers to entry may arise

because of product differentiation, absolute costadvantage or economy of scale.

Permanence:

It is very important phenomenon related to theproducts and technology used by the industry. If ananalyst feel that the need for a particular industry willvanish in short period or the rapid technological

changes would render the products obsolete within a


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Labour conditions:

Where the labour union are very powerful. If thelabour in particular industry is rebellious and is

inclined to resort to strikes frequently the prospects ofthat industry cannot become bright.

Attitude of the government:

The government may encourage the growth of certainindustries and can assist such industries throughfavorable legislation. On the contrary the governmentmay look with disfavor on certain other industries.

In India this has been the ex erience of alcoholic


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Supply of raw materials:

Some industries may have no difficulty in obtainingthe major raw materials as they may have to depend ona few manufacturers within the country or on importsfrom outside the country or

Cost structure:

It includes fixed cost and variable cost. Lower the fixed cost relative to the variable cost lower

would be the break even point. lower break even pointprovide the higher margin of safety.


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Company analysis

Porters model of five competitive factors

Ratio analysis Financial statement analysis

Other variables analysis

Risk measurement


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Peters models of five

competitive forces


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Threat of new entrants:

Determinants :

Economies of scale

Brand identity

Capital requirements

Absolute cost advantages

Government policy

Product differences

Switching cost


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Threat of substitute product and services

Determinants:

Relative price performance of substitute

Switching cost

Customer propensity to substitute


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Bargaining power of suppliers

Determinants

Differentiation of inputs

Switching cost of suppliers

Presence of substitute input

Supplier concentration

Importance of volume to supplier

Cost relative to total purchases

Cost differential of input quality differentiation


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Customer bargaining power

Determinants

Bargaining strength

Customer concentration

Customer volume

Customer switching costs

Customer information

Ability to backward integrate

Substitute products


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Existing rivalry

Determinants

Company growth

Intermittent over capacity Brand visibility

Concentration

Diversity of competitors

Fixed costs

Product differences


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Financial statement analysis Balance sheet Profit & loss a/c

To provide reliable financial information about changein net resources of enterprise that result from profitdirected activity

It assist in estimating the earning potential of theenterprise.

It provide information about the change in economicresources and obligations.

It also disclose, to the extent ossible, other


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Is the firm in a position to meet its currentobligations?

What sources of long term finance are employed bythe firm and what relationship between them?

How efficiently does the firm use its assets?

Are the earning of the firm adequate

Investors consider the firm profitable and safe?

It does not give the exact answer of this questions butit indicate what can be expected in future.


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The content of the statements differ according tothe nature of business of the company. Broadly, the

tools that are used for company analysis can bedistinguished in terms of whether they aremanufacturing companies, financial servicecompanies, trading companies or multinational

companies.

Manufacturing companies:-

Performance ratio Leverage ratio , liquidity ratio,Turnover days of inventory , collection period.

Profitability ratio ROE, Return on total assets, netprofit ratio and pay out ratio etc.


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Trading companies

Balance sheet ratio Current ratio , quick ratio , debt equityratio.

Profitability ratio ROI, net profit ratio , dividend pay outratio etc.

Value ratio Book value per share, EPS, Yield ratio.

Service companies.

Profitability ratio ROI, Return on capital, net profit ratioand dividend pay out ratio etc.

Liquidity ratio - Current ratio , quick ratio.

Leverage ratio Debt equity ratio.

Value ratio Book value per share, EPS, Yield ratio.


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Performance ratio Net int. margin/ total assets , Profitmargin = Net profit/ Total Income.

Assets Quality : GrossNPAs/ Gross advances,

GrossNPAs/Total assets , Provision for loans &investments/Total Assets. Etc.


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Ratio analysis Liquidity ratios concerned with the short term

solvency of the concern or its ability to meet financialobligation on their due dates.

Activity ratios concerning efficiency of managementof various assets by the concern.

Leverage ratios concerning stake of the owners in the

business in relation to outside borrowings or long termsolvency.

Coverage ratios concerned with the ability of thecompany to meet fixed commitments such as intereston term loans and dividend on preference shares and


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Companys market share

Capacity utilization

Modernization and expansion plan Order book position

Availability of raw materials

Other variables:


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Assessment of risk:

Degree of total leverage

DTL = contribution

profit before tax(PBT)Operating leverage

DOL = contribution

earning before interest& tax(EBIT)

Financial leverage

DFL = profit before tax(PBT)


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Technical analysis The technical analysis believes that share prices are

determined by the demand and supply forcesoperating in the market.

That are influenced by a number of fundamentalfactors as well as certain psychological or economicalfactors. some of them are not quantified.

the combined effect of all these factors is reflected onthe movement of the share prices.

By examining past shares price movements futureshare prices can be accurately predicted.


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Dow theory

It was formulated by the Charles h. dow who was theeditor of the wall street general in U.S.A. During 1900-1902

Charles dow formulated a hypothesis that the stockmarket does not move on random bases but hisinfluence by three distinct cyclical trend that guide its

direction.

The market has three movements and this movementare simultaneous in nature.

1. Primary movements


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1. Primary movement.

large range cycle that carries entire ups and down ofmarket.

this is the long term trended of market it usually lastmore than one year and may it last for several year. Itcan be either bullish market or bearish market.

2. Secondary Reactions:

these trends are intermediate, corrective reactions tothe primary trend.

these reactions typically last for one three months.


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Minor movement.

these are day to day fluctuations in the market . Theminor movements are not significant and have a noanalytical value as they are very short duration.

The price movements in the market can be identifiedby means of line chart.

In these chart closing prices of shares or closing valueof market index may be floated against thecorresponding trading days.

These chart helps in identifying primary secondary


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Bullish trend bull market is upward moving market1. the prices would advance with the revival of

confidence in the future of business.

2. price would advance due to improvement incorporate earning

3. price advance due to inflation and speculation so in

line chart would execute formation of three peaks.Each peaks would be follow by a bottom formed bythe secondary reaction. Each peaks would be higherthan previous peaks. Each successive bottom would

be higher than previous bottom .


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Bearish trend: bearish market is downward moving market.

These also having three phases.

1) Prices begin to fall due to abandonment of hopes

2)Investor begin to sell there shares. In second phasecompany start reporting lower profit and lowerdividends. These causes further fall in prices due to

increase selling pressure.

3)Price fall still further due to distress selling.

Bearish market would be indicated by the formation of

lower tops and lower bottoms


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Dow theory laid emphasis on volume of transactionsalso.

Theory also make certain assumptions which havebeen referred as hypothesis of the theory.

1. The market discounts everything.

2. Price moves in trends.

3. History tends to repeat itself.


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1. The Market Discounts Everything

A major criticism of technical analysis is that it onlyconsiders price movement, ignoring the

fundamental factors of the company. However, technical analysis assumes that, at any

given time, a stock's price reflects everything thathas or could affect the company - includingfundamental factors.

Technical analysts believe that the company'sfundamentals, along with broader economic factors

and market psychology, are all priced into the stock,
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2. Price Moves in Trends

In technical analysis, price movements are believed tofollow trends. This means that after a trend has beenestablished, the future price movement is more likely tobe in the same direction as the trend than to be againstit. Most technical trading strategies are based on thisassumption.


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3. History Tends To Repeat Itself

Another important idea in technical analysis is thathistory tends to repeat itself, mainly in terms ofprice movement. The repetitive nature of pricemovements is attributed to market psychology; inother words, market participants tend to provide aconsistent reaction to similar market stimuli over time.

Technical analysis uses chart patterns to analyze

market movements and understand trends.

Although many of these charts have been used formore than 100 years, they are still believed to be

relevant because they illustrate patterns in price


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Trends and trend reversal


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Trend and reversals

Raising trend (Bullish trend)

Falling trend (Bearish trend)

Reversal trend


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Reversal

A change in the direction of a price trend. On a pricechart, reversals undergo a recognizable change in theprice structure.

An uptrend, which is a series of higher highs andhigher lows, reverses into a downtrend by changing toa series of lower highs and lower lows.

A downtrend, which is a series of lower highs andlower lows, reverses into an uptrend by changing to aseries of higher highs and higher lows.

Also referred to as a "trend reversal", "rall " or


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The Importance of TrendIt is important to be able to understand and identifytrends so that you can trade with rather than againstthem.

Two important sayings in technical analysis are "thetrend is your friend" and "don't buck the trend,


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Charts:

A chart is simply a graphical representation of aseries of prices over a set time frame.

Chart Properties

There are several things that you should be awareof when looking at a chart, as these factors canaffect the information that is provided.

They include the time scale, the price scale andthe price point properties used.


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The most basic of the four charts is the line chartbecause it represents only the closing prices over a setperiod of time. The line is formed by connecting theclosing prices over the time frame. Line charts do not

provide visual information of the trading range for theindividual points such as the high, low and openingprices. However, the closing price is often considered tobe the most important price in stock data compared to

the high and low for the day and this is why it is the onlyvalue used in line charts.

Line Chart
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Bar Charts

The bar chart expands on the line chart byadding several more key pieces of informationto each data point.

The chart is made up of a series ofverticallines that represent each data point. Thisvertical line represents the high and low forthe trading period, along with the closingprice. The close and open are represented onthe vertical line by a horizontal dash.
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The opening price on a bar chart is illustrated by the

dash that is located on the left side of the vertical bar.Conversely, the close is represented by the dash on theright.

Generally, if the left dash (open) is lower than the right

dash (close) then the bar will be shaded black,representing an up period for the stock,whichmeans it has gained value.

A bar that is colored red signals that the stock hasgone down in value over that period. When this isthe case, the dash on the right (close) is lower than thedash on the left (open).


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The candlestick chart

The candlestick charting pattern is one that anyexperienced trader must know. As Japanese rice tradersdiscovered centuries ago, investors' emotions

surrounding the trading of an asset have a major impacton that asset's movement. Candlesticks help tradersto gauge the emotions surrounding a stock, andthus make better predictions about where that

stock might be headed.


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In the chart you see the "long black body" or "long

black line". The long black line represents a bearishperiod in the marketplace. During the trading session,the price of the stock was up and down in a wide rangeand it opened near the high and closed near the low of

the day.

By representing a bullish period, the "long whitebody", or "long white line"-(in the EBAY chart below,

the white is actually gray because of the whitebackground) is the exact opposite of the long black line.Prices were all over the map during the day, but the stockopened near the low of the day and closed near the high.


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Spinning tops are very small bodies and can be eitherblack or white. This pattern shows a very tight tradingrange between the open and the close, and it isconsidered somewhat neutral.

Doji lines illustrate periods in which the opening andclosing prices for the period are very close or exactly thesame. You will also notice that, when you start to lookdeep into candlestick patterns, the length of the

shadows can vary.
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point and figure chart

The point and figure chart is not well known or usedby the average investor but it has had a long history ofuse dating back to the first technical traders. This typeof chart reflects price movements and is not asconcerned about time and volume in the formulationof the points.

When first looking at a point and figure chart, you will

notice a series of Xs and Os. The Xs represent upwardprice trends and the Os represent downward pricetrends. There are also numbers and letters in the chart;these represent months, and give investors an idea of

the date.
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Chart pattern

Support pattern

Resistance pattern

Reversal pattern

Continuation pattern


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Support patternA support level is the price at which buyers are

expected to enter the market in sufficient numbers totake control from sellers.

The market has a memory. When price falls to a newLow and then rallies, buyers who missed out on thefirst trough will be inclined to buy if price returns tothat level. Afraid of missing out for a second time, they

may enter the market in sufficient numbers to takecontrol from sellers. The result is a rally, reinforcingperceptions that price is unlikely to fall further andcreating a support level.
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Resistance patternA resistance level is the price level at which sellers are

expected to enter the market in sufficient numbers totake control from buyers.

When price makes a new High and then retreats,sellers who missed the previous peak will be inclinedto sell when price returns to that level. Afraid ofmissing out a second time, they may enter the market

in numbers sufficient to overwhelm buyers. Theresulting correction will reinforce market perceptionsthat price is unlikely to move higher and establish aresistance level.
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Strength of Support/Resistance Some support and resistance levels are more important

than others. The significance of the support level isidentifiable by:

the number of times that the level has been respected;

the amount of volume that has been traded near thelevel;

whether the level is old or new - recent levels havegreater significance;


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Reversal pattern

Support levels, once penetrated, frequently becomeresistance levels and vice versa.

The market logic is fairly simple: buyers who purchase

near a support level, only to see price fall, are likely tosell in order to recover their losses, when price ralliesto near their break-even point. The support level thenbecomes a resistance level.

Likewise, stockholders who sell when price approachesa resistance level will be disappointed if pricepenetrates the level and continues to rise. They will beinclined to buy if price returns to near the supportlevel, fearin that the ma miss out a second time.


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The most common of these are:

Head and shoulders top and bottom

Double top and bottom

Rounding top and bottom Broadening formation

Rising and falling wedge


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Head and shoulders top

The Head and Shoulders Top is one of the mostcommon, and reliable, forms of reversal pattern. Theshape consists of a left shoulder followed by a head

and then a right shoulder.


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The left shoulder is formed after an extensive

increase in price, usually supported by high volume.The shoulder rounds as the price dips slightly, usuallyon lower volume. This dip is the start of the neck lineand the head is about to form.

The head is formed with heavy volume on the risingpart of the head and less volume on the falling part.Prices then fall to somewhere near the same level as

the low of the left shoulder. It does not have to be atexactly the same level and could be slightly higher orlower, but definitely below the top of the left shoulder.


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The right shoulder is formed by a rally in the price to

a level roughly equal with that of the left shoulder.Again it can be slightly higher or lower but definitelybelow the high achieved by the head.

Once the right shoulder has started to form you candraw in a "neckline" across the bottoms createdbetween the left shoulder and head and the head andright shoulder. When the price falls from the right

shoulder and breaks through the neckline the Headand Shoulders Top formation has been confirmed andit is your signal to consider selling the share.


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Head and shoulders bottomA Head and Shoulders Bottom is the inverse of a Head

and Shoulders Top, and it signifies a reversal from adowntrend to an uptrend

The main difference between this and the Head and

Shoulders Top is in thevolume pattern associatedwith the share price movements.

The volume should pick up as the prices increase from

the bottom of the head and then increase even moreon the rally which follows the right shoulder. If theneckline is broken but volume is low.


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Double top

Double Tops appear on a chart in the shape of theletter "M" and are quite common.

A peak price is reached before a small decline, whichcauses the valley between the Double Tops, and then

the price rallies again to a peak roughly equal to thelevel of the first. The price then falls away on a newdowntrend.

Correctly predicting a Double Top can be tricky.This is because a simple uptrend, with each new waveof buying interspersed with minor reactions and profittaking, will appear as if it is making a Double Top

formation. However, as you can see in the chart below,


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Once you reach the point shown by the end of the line

on the chart above, you cannot be sure if the DoubleTop formation will be confirmed and the price willdrop away, or if the price will again rally and theuptrend will stay in force. In roughly 90% of cases you

will find that the Double Top is, indeed, a fake and theuptrend will stay in force.

Volume is important in determining whether a true

Double Top formation is being created or if it is goingto be a fake. Look at the volumes associated with bothof the peaks.

If the volume associated with the first peak is greater

than that associated with the second peak, this


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If the volume accompanying the second rise is the

same as that accompanying the first, or even greater, itis likely that the uptrend will continue.

The time span taken to create the Double Top

formation can also help determine the likelyprogression of the price data.

If the two tops are fairlyclose together in terms oftime, it may well be a consolidation period, a pause forbreath, before the rally continues.

If the peaks are separated over a longer period andthe valley between the two peaks is deep it is more

likely to turn into a genuine Double Top.


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Double bottom

A double bottom is the opposite of a double top andappears as a letter "W" on a chart.

The formation of a double bottom and the indicators

of the reversal are much the same as for a double top,but the volume patterns are different. A true doublebottom will show more volume on the second rally upthan on the first rally.

If it's the other way round - low volume on the secondrally - you may not be looking at a double top at all,but at a continuing downtrend.


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Rounding tops and bottoms

A Rounding Top forms an "n" shape on a chart, and aRounded Bottom a "u" shape.

It can be difficult to separate a Rounded Bottom from a

consolidation pattern (i.e. one where the pricecontinues to decrease or stay level), but the clue, asalways, is in volume.

In a true Rounded Bottom, the volume decreases asthe price decreases, which signifies an easing ofselling pressure. As the price movement becomesneutral and goes sideways you will see that there is

very little trading activity and volumes are very low.


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The theory behind this reversal pattern is when youget five small reversals they are usually followed by amore substantial change.

So in the example below, you have:

Reversal 1: change from rise to fall

Reversal 2: change from fall to rise

Reversal 3: change from rise to fall

Reversal 4: change from fall to rise

Broadening formations


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In a Broadening Top, reversal 3 must occur at a higher

level than reversal 1, and reversal 5 must be higherthan reversal 3. Reversal 4 must occur at a lower levelthan reversal 2.

The underlying idea behind this reversal pattern isthat the market is almost out of control andlacking support from well-informed investors.

The smart money is bearish on the stock, but it keepson getting bounced upwards by other investors.Volume is also erratic during this period and does nothelp with the interpretation of the charts.


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Wedge formations

If you draw trend lines along both the bottom andtop of a share price chart, you will sometimes get atrend channel and you'll sometimes get a wedge shapesimilar to the one below.

According to the theory, if the wedge is pointingupwards, as in our example, the share price will fallwhen the price line cuts across the lower line of the

wedge. If the wedge is pointing downwards (a falling wedge),

the share price will rise when the price line cuts acrossthe upper line of the wedge.


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If the wedge is level - in other words not pointing up

or down - then this is a 'consolidation' pattern and youcan expect the trends to continue. (i.e. no reversal)

Notice that wedge formations take place over a period

of 3-4 weeks. This is because they occur as reversals ofintermediate and minor trends. They will not be seen,except in unusual circumstances, as reversals to amajor market trend.


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Continuation patterns indicate that the price action

described by the pattern is merely a pause in theprevailing trend and that upon breaking out of thepattern the price trend will continue in the samedirection. We will look at the following patterns that

imply trend reversals: Flags, Rectangles, Triangles, andWedges.


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Flag


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Rectangle


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TrianglesTriangles are continuationformations.Three flavors:

Ascending

DescendingSymmetricalTypically, triangles shouldbreak out about half to three-quarters of the way through

the formation.


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Flags


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Elliott Wave Theory

Elliott Wave Theory interprets market actions in termsof recurrent price structures obedient to the Fibonaccisequence.

Basically, Market cycles are composed of two majortypes of Wave : Impulse Wave and Corrective Wave.For every impulse wave, it can be sub-divided into 5 -

wave structure (1-2-3-4-5), while for corrective wave, itcan be sub-divided into 3 - wave structures (a-b-c).


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Surfer's Waves within Wave

An important feature of Elliott Wave is that they arefractal in nature. 'Fractal' means market structure arebuilt from similar patterns on a larger or smaller scales.

Therefore, we can count the wave on a long-term yearlymarket chart as well as short-term hourly marketchart.


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This theory is based on the principle that action is

followed by reaction.

This theory used for predicting the future pricechanges and deciding the timing of investment.


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indicators

Mathematical indicators

Market indicators


98/101

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Mathematical indicators

Moving average

1.simple moving average

2.exponential moving average

Factor = 2

n 1

EMA=(clo. Price- previous EMA)* factor previous EMA

Oscillators

Rate of chan e indicators ROC


99/101

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Rate of change indicators

ROC= current price

price n period ago-1

Relative strength index

RS= average gain per day

average loss per day

RSI=100-[100/(1 RS)]


100/101

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Market indicators

Breath of the market

Short interest

Odd-lot index

Mutual fund cash ratio


101/101

Conclusion

Information is prettythin stuff, unlessmixed with

experience.

sapm module 2

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