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Security Analysis & Portfolio Management

Recommended TextSecurity Analysis & Portfolio Management

Donald Fisher, Ronald Jordan

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What is an investment?

• We all – Earn Money– Spend Money

• Sometimes we – Have More money than we want to spend– Want to spend more than we have money

• We solve these problems by– Saving Excess– Borrowing Deficit

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What is an investment?• In our day to day communications we use this word loosely in 3

angles– Economic

• Commitment of funds to add to the net capital stock of the economy like buildings, plants and machinery etc

– Layman• Commitment of funds for a future benefit, not necessarily for a return

– E.g., To purchase a Car

– Financial• Commitments of funds for a future return

• Key Points in Financial Investment– Defer Present Consumption– For a higher level of future consumption

• Can be done using Physical Assets or Financial Assets

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Why Study Investments?

• Most individuals make investment decisions to manage their wealth– Need sound framework for managing it

• Essential part of a career in the field– Security Analyst– Portfolio Manager– Certified Financial Planner

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Investment Vs Speculation• Are these synonymous?

– Every Investment is speculative to some extent• Speculate:

– Derived from the Latin root • Speculare = to look out

• The difference is in the “Expectations”• Investment:

– Done with the expectation that the past will continue into the future• Fixed Deposits will continue to give interest as in the past• House will continue to give returns in the form of rents

• Speculation:– Done with the expectation that the past will NOT continue into the future and some

changes will definitely happen• Increase in the price of shares in a very short period• Abstract Art being valued higher once the artist becomes well known• House price will appreciate due to an airport project coming up at Panvel

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Invt vs Speculation

• Time Period– Investor: Good and Consistent Rate of Return for a

long period of time– Speculator: Large returns over a short period of time

due to changes in the outlook• Psychological Attitude

Investor: Cautious, Conservative, OptimisticSpeculator: Daring, Rebellious

• Which is Riskier?– Investment or Speculation??

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Bulls & Bears

• Two Categories of Speculators– Bulls:

• Buys the security with the expectation of selling the same at a higher price in the near future

– Bears:• Sellsthe security at a higher price with the expectation of

buying the same at a lower price in the near future

– Bullish Tendency results in the security prices going ___

– Bearish View results in the security prices going ____

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Investment vs Gambling

• Gambling:– Has high degree of

• Unpredictability• Element of Chance• High Risk• High Returns• Excitement is a key factor

– Key Distinguishing Factor• You cannot Consciously Lose in Gambling.

– E.g.,• Card Games, Roulettes, Lotteries, Horse Races

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Characteristics of Investments• 4 key characteristics of any investment

– Return– Risk – Safety– Liquidity

• Return:– All investments are characterised by expectation of return– It can be in two forms

• Income ( yield )– Dividend– Interest

• Capital Appreciation– Difference between Sale Price and Purchase Price

– Diff types of invts carry diff rates of returns• Nature of investment• Maturity Period• Market Demand

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Characteristics of Investments

• Risk– Inherent to any investment

• Compared to Speculation it should be ______– loss of capital– delay in repayment of capital– non-payment of interest– variability of returns

– Risk of an investment is determined by • the investment’s maturity period • repayment capacity • nature of return commitment

– The risk is nothing but • a reflection of the uncertainty surrounding the cash flow

– Willingness to pay– Ability to pay

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Characteristics of Investments• Safety

– Other side of Risk– Certainty of the Return Of the Capital

• In full• In time

– Determined by the reputation of the borrower– Bonds issued by the Government– Public Sector Banks and other Institutions– Reputed Corporates like Tatas, Birlas etc

• Liquidity– An investment that can be sold

• Without loss of time• Without loss of money

Is a liquid investment– A market place helps in increasing liquidity of securities

• FDs , MF Hussain’s Art, Real Estate • Shares, Debentures, • Cash?

• An investor prefers – maximisation of expected return – minimisation of risk– safety of funds and liquidity of investments

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Investment Process

• Investment Process is governed – Knowledge about fundamentals of Investment– By two key facets• Risk• Return• The trade off between these two

• Security Analysis and Portfolio Management are two steps in the investment process

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Investment Decision Process

• Two Step Process– Security Analysis and Valuation• Necessary to understand security characteristics• Top Down and Bottom Up Approach

– Portfolio Management• Selected securities are viewed as a single unit• How efficient financial markets are in processing new

information?• How and when should it be revised?• How should portfolio performance be measured?

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Fundamental of Investment

• Expected Return and Realized Return– Expected return is not usually the same as realized

return• Risk: – The possibility that the realized return will be

different from the expected return

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The Tradeoff Between ER & Risk

Risk0

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ER

ER

-Investors manage risk at a cost : lower expected Returns-Any level of expected return and risk can be attained

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Security Analysis• What are Securities?

– Investments:• Commitment of funds for future return• Hence funds are used by another party

– How are these funds transferred from one party to another within the legal framework?• By various Financial Instruments like

– Equity Shares– Preference Shares– Bonds– Debentures– Warrants– Promissory Note?

– These financial instruments are called Securities.• Securities Contracts Regulation Act, (1956) • Securities are financial instruments that have been created to represent a legal

obligation to pay a sum in future in return for the current receipt of value. They should be quoted and transferable.

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Security Analysis• To make an informed investment an analyst has to

– Make a study of the alternative avenues of investment– their risk and return characteristics

– make proper projection or expectation of the risk and return of the alternative investments under consideration.

– He has to tune the expectations to his preferences of the risk and return for making a proper investment choice.

• The process of analysing the individual securities and the market as a whole and estimating the risk and return expected from each of the investments with a view to identifying undervalued securities for buying and overvalued securities for selling is both an art and a science and this is what is called security analysis.

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Security Analysis

• How to do this?– projection of future dividend or earnings flows– forecast of the share price in the future – estimating the intrinsic value of a security based on the

forecast of earnings or dividends.– Also any forecast has to take into account

• the trends and the scenario in the economy • in the industry to which the company belongs • the strengths and weaknesses of the company itself

– its management, promoters’ track record, – financial results,– projections of expansion, diversification, tax planning etc.

– The Security Analyst aims at such a total picture

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Portfolio Management

• What is a portfolio?– A portfolio is a combination of various assets and / or instruments of

investments. – The combination may have different features of risk and return,

separate from those of the components. – The portfolio is built up out of the wealth or income of the investor

over a period of time, with a view to suit his risk or return preferences

• The portfolio analysis is thus an analysis of the risk-return characteristics of individual securities in the portfolio and changes that may take place in combination with other securities due to interaction among themselves and impact of each one of them on others

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Portfolio Management• Portfolio management includes

– Objectives and Constraints– Choice of the Asset Mix– Formulation of Strategy– selection of securities – Portfolio construction– revision of portfolio– evaluation and monitoring of the performance of the portfolio.

• Why to manage portfolios?– Risk Return Profile varies with every individual

• For a 22 year old well educated individual• For a 60 year old retiree

– For the same individual, it varies over a period of time• By portfolio management, we try to

– Maximise Returns for a given risk level– Minimise Risk for a given Return level

• For optimal returns, a rigorous Risk-Return Analysis of all Securities in a portfolio as a basket is required.

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Factors affecting Portfolio Management Process

• Uncertainty in returns• Quick Market Adjustments• Investment Opportunities• Types of Investors

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Common Errors in Investment Management

• Inadequate Idea about return and risk• Biased formulation of investment policy• Naïve extrapolation of the past• Simultaneous switching• Love for cheap securities• Over diversification or Under diversification• Wrong attitude towards losses and profits• Tendency to speculate

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Asset Classification• Economy is a bundle of the quality and quantity of assets in the economy

– US: Roads, Railways, Airways, Power, – Compare with Myanmar

• Assets are of two kinds– Real Assets

• Physical Assets– Used to generate activity– Buildings, Plant, Machinery

• Intangible Assets – Holds the social fibre– Goodwill, Patents, Copyrights, Royalties

– Financial Assets• Cash• FDs• Debentures• Foreign Currency Reserves

– Financial Assets help Real Assets to generate activity

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Asset Classification• Financial Assets

– Regulated by the Govt– Smoothen trade and facilitiates transactions– Used as a standard measure of valuation– Represent current and future values of physical and intangible assets.

• Cash– The main financial Asset– Regulated in India by FM & RBI

• To match the demand and supply for cash

• Financial assets are different from physical and intangible assets. – Monetary value,– Divisibility – Convertibility– Reversibility – Liquidity– Cash flow.

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Financial Markets

• A place / system where financial instruments are exchanged

• Financial Instruments– Claim Instruments• Fixed Claim Instruments

– Short Duation < 1 year: Traded in Money Markets– Long Duration > 1 year: Traded in Capital Markets

• Residual or Equity Claim

– Currency Instruments• Forex Market

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Financial Markets

Securities Market

National Markets

Domestic Segment

Capital Market

Equity Market

Primary Market

Secondary

Market

Spot

Market

Derrivative

Market

Debt Market

Money Market

Foreign Segment

International Markets

Forex Market

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Financial Markets

• Securities Market– Marketplace wherein securities are traded– Can be classified further into• National Markets• International Markets

– Geography is becoming history• Technological innovations• Agreements between different exchanges

– In NSE you can trade securities of different countries like that of US etc

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Financial Markets

• National Markets– Confined to a country’s geography– Cater to the financial requirements of the country– Foreign players entry allowed subject to them

meeting the regulations in force– Each national market has a regulatory authority– The authority imposes guidelines for smooth

operations of the market

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Financial Markets• International Market

– Also known as offshore market– Certain countries do not discriminate between the instruments issued in

its country vis a vis those issued elsewhere– Such markets are called international markets– Euromarket

• Firms listed in one country can issue their instruments in other countries too

• Domestic Market– Caters exclusively to firms registered in the country– Controlled by a regulatory authority

• In India, RBI and SEBI are the regulators– Some domestic markets like that of US, UK, Germany are called Advanced Mkts– Emerging: BRIC Countries– Frontier Mkts: Really at the edge markets

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Financial Markets• Money Markets

– Trades in Short Term Debt• Debt is a Fixed Income Security

– Wholesale Markets• Small values are not exchanged• Only big players like banks, FIs Govt and Corporates operate• Exchange surplus funds with the prevailing interest rate ( also called

call rate)• Duration: 1 day, 1 week, 1 month, 6 months or 1 year• Money exchanges through account transfer between the players

– The money market can be differentiated into the• call market, treasury bill market, inter-bank market, • certificate of deposit market, repo market, commercial paper market• inter corporate deposit market, and commercial bills market

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Financial Markets• Capital Markets

– Exchange both• Long Term fixed claim Securities• Residual / Equity claim Securities

– Main Role• Match players who need funds with who have excess funds• Also provide liquidity to the financial instruments thus adding tremendous value• Market also indirectly does a valuation exercise on the security for the risk

assumed by the investor

– Returns are of two types• Claim on the instrument

– Can be fixed or residual– Return is either Nil or Positive– Fixed Claim Instruments show hardly any variation in returns– Residual Claim ones show fluctuating returns, thus exposing investors to risk

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Financial Markets• Trading Returns from Security

– The capital gain / loss from selling / buying of the security• Debt Market

– Instruments which have » A Fixed Claim» More than 1 year maturity» E.g., Debentures, Bonds

– Secured Debt» Secured by assets» Less Risky

– Unsecured Debt» No asset backing» Higher risk of non repayment

– What is Mortgage debt? Secured or Unsecured?– Redeemable Debt

» Debt that is repaid at maturity is redeemable» Will be stated at the time of debt issue

– Irredeemable Debt» Debt that is rolled over at maturity

– Convertible Debt» Original Debt Instrument will be converted to another financial instrument at

maturity– Non Convertible Debt

» Repaid at the end of maturity period

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Financial Markets

• Debt Classification based on type of claim– Fixed Claim:

• Usually the interest payment made by the issuer• % fixed at the time of issue

– Flexi Claim• Can change interest rate depending on the economic

conditions• Linked to Inter Bank Offer Rates like LIBOR

– Zero Coupon• No regular interest• Offer price and value additions determine the yield

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Financial Markets• Equity Markets

– Bestow ownership to the equity holders– Claim is residual in nature

• i.e., owners will have a claim in the profits and not a fixed rate or periodic payment as in debt instrument

• Claim in profits is given in the form of dividends• Decided by the Corporate in its general body meeting• Dividends can be Annual, Quarterly, Extra-ordinary• Dividend can be cash dividend or share dividend• Additional returns in form of bonus shares

– Two Major types• Preference Equity

– Preference on dividend payment– Face value payment when firm goes into liquidation

• Common Equity

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Equities

• Equity Invt via Institutions– Investment Company

• The firm manages the investment• Provides professional fund management• Adequate diversification• Requires less supervision and knowledge

– Annuities• Tax benefits• Done by the employer automatically• Equity angle as the proceeds from the fund are invested in the capital market

– Insurance policies• Tax benefits• Insurance company invests the money in the capital market

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Equities• Direct equity investments

– Common Stock:• Represents an ownership position• Owners have voting power

– Elect the BOD– Right in the earnings after all expenses and obligations are paid out

• Risk of receiving nothing if earnings are insufficient to cover obligations• Stock owners expect returns based on 2 sources

– Dividends: If the firm earns sufficient money AND the BOD deems it proper to declare a dividend– Capital Gains: From an advance in the market price of the common stock:

» Happens due to growth in per share earnings» Earnings do not grow smoothly month on month» Stock prices highly volatile» Careful analysis in

• Selection of securities to buy and sell• Timing of the investment decisions

• Common stock has no maturity date at which fixed value will be realised• Use fundamental analysis to evaluate common stock

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Equities

• Stock Splits– We read about stock splits all the time

• What happens?

– Firm ends up with more shares outstanding• Shares sell at a lower price• Have a lower par value

– Then why do?• Stock prices have gone to high levels that trading does not

happen as earlier• Volume declines and investor interest subsides• To overcome this, managements declare stock split

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Equities

• Stock Split– Suppose ABC Corp has 1 Million Common Stock equity Outstanding.– Par Value Rs. 10/- per share and the current Mkt Price is Rs. 100/-

share– Investors want to purchase in lots of atleast 100 shares.– Min invt needed: Rs. 10000/-– To reduce invt load, Management declares 2 for 1 Split.;

• Now 2 million shares are outstanding• Par value is Rs. 5/- share• For 100 shares, the amount needed would be Rs. 5000/- ( in theory)• What will happen to EPS?

– Other popular ratios• 3 for 2, 5 for 4

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Equities• Stock Dividends

– In addition to cash dividends, investors receive stock dividends• Result is same as a stock split• He receives more shares.• Typically stated in % terms; 20% stock dividend

– Means 20% increase in no of shares outstanding

• No change in the par value– Firm transfers amounts from retained earnings to the capital stock account for par value of the

newly issued stock

– Our firm with 1 Mil shares outstanding of Rs 10/- par share declares a 50% stock dividend• Retained earnings is reduced by Rs. 50 lacs (500000 x 10)• Common Stock account is increased likewise

– Paying dividends ( cash or stock ) reduces firm’s ability to• Pay future dividends• Investment in new ventures• Stock splits do not have this dis advantage

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Equities• Classification

– Blue Chips• These are stocks of high quality,• Financially strong companies which are usually the leaders in their industry.• They are stable and matured companies. They pay good dividends regularly and

the market price of the shares does not fluctuate widely. • Examples are stocks of Colgate, P&G, Unilever, Tata Motors

– Growth Stocks: • Growth stocks are companies whose earnings per share is grows faster than the

economy and at a rate higher than that of an average firm in the same industry. • Often, the earnings are ploughed back with a view to use them for financing

growth. • They invest in research and development and diversify with an aggressive

marketing policy. • They are evidenced by high and strong EPS. • Examples are ITC, Cognizant, Google, Facebook etc

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Equities• Income Stocks:

– A company that pays a large dividend relative to the market price is called an income stock.

– They are also called defensive stocks. – Drug, food and public utility industry shares are regarded as income stocks. – Prices of income stocks are not as volatile as growth stocks.

• Cyclical Stocks: – Cyclical stocks are companies whose earnings fluctuate with the business cycle.– Cyclical stocks generally belong to infrastructure or capital goods industries

such as general engineering, auto, cement, paper, construction– Their share prices also rise and fall in tandem with the trade cycles.

• Discount Stocks: – Discount stocks are those that are quoted or valued below their face values.– These are the shares of sick units.

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Equities

• Under Valued Stock: – Under valued shares are those, which have all the potential to

become growth stocks, have very good fundamentals and good future, but somehow the market is yet to price the shares correctly.

• Turn Around Stocks: – Turn around stocks are those that are not really doing well – Market price is well below the intrinsic value mainly because

the company is going through a bad patch – Is on the way to recovery with signs of turning around the

corner in the near future. – Examples: Bharti Airtel, BHEL, Thermax, Bluestar

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Equities• Primary market

– The primary market is the doorway for corporate enterprises to enter the capital market.

– The issues of new securities are offered to the public through the primary market.

– The sale is made at a value predetermined by the firm issuing the security.– The securities have a face value, which is the denomination in which it is

divided. – For instance, an instrument could have a face value of Re 1, Rs. 5, Rs. 10, or Rs.

100 in India.– This denomination determines the number of units of the security that are

offered to the public. – The price at which the security is offered to the public is the offer price of the

instrument. – This price could be equal to or greater or lesser than the face value.

• When the offer price is greater than the face value, the offer is said to be at a premium.

• When the offer price is less than the face value, the offer is at a discount. • When the two prices are equal, the offer is at par.

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Equities• Secondary market

– The secondary market refers to the exchange of securities that have been listed through the primary market.

– The price at which it is traded in the capital market is the market price of the instrument.

– It is the secondary market that offers tradability to the financial instruments.

– The number of financial instruments participating in the secondary market hence, cannot exceed the number of financial instruments recorded through the primary market.

– The secondary market also comes under the regulatory authorities of the market and the main role of the regulator in the secondary market is to safeguard the interest of players in the market.

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Equities

• Secondary Market– Both individuals and institutions can take part in the secondary

market. – Brokers and depositories are the main intermediaries in this

market, who transact business on behalf of the investors.– The brokers can appoint a network of subbrokers to mobilise

investors participation in the market. – Depositories help in scripless trading by holding investor accounts

in electronic media.– Over a period of time, the secondary market has grown in size and

in terms of efficiency. – The secondary market may be further sub-divided into the spot

market and derivative market.

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Equities• Spot market

– Spot market denotes the current trading price of financial instruments. – In the context of time, the spot market may range from one day, two days,

or a week. – The transactions in the spot market are settled immediately, that is, on the

immediate settlement date. – Each market specifies the type of settlement to be made— a rolling

settlement or a fixed day settlement. – The rolling settlement, according to the specific exchange, will be T+1, T+3,

or T+5. – A T+1 rolling settlement indicates that trading entered on day T will be

settled for cash on day T + 1– The fixed day settlement will be on a specific day of a week, say the

workingThursday or Friday of a week.

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Equities• Derivative market

– The derivative market is a futures market.– Trade takes place here with the intention to settle it at a later date.– The derivative market has forward, futures, options, or other derivative

instruments trading. – Forward trade helps in the exchange of instruments in the future at prices

or rates determined in the present.– Forward contracts involve an obligation and are legally binding on the

parties who have entered into a forward agreement. – However, forward contracts have the disadvantage of inflexibility of timing.– They are conducted on a one-to-one basis between parties who initially

entered into the agreement. – A forward contact cannot be surrendered or liquidated as easily as the

other derivative instruments.

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Equities• Futures:

– A future contract is an agreement by one participant to either buy or sell a financial instrument at a predetermined date in the future at a predetermined price.

– The basic function of the futures trade is to enable the market participants to hedge against the risk of adverse price movement / volatility in the market.

– A contract to buy, say, 100 shares of Reliance Industries at Rs. 900/- per share three months later, is a futures contract.

– The price at which the financial instrument is transferred at a later date (in this case, Rs. 900/-) is called the futures price.

– The time stated in the contract in which the contract will be enforced (three months hence) is called the delivery date/expiry date.

– Futures contacts are derivatives since they are based on financial instruments that are traded in the capital market.

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Equities• Options

– Gives the holder of thevcontract the choice to buy or sell a financial asset. – Options can takevthe form of equity options or index options. – Equity options such as Infosys call options may have a strike price of Rs.

2790/- at a premium of Rs. 190 with the expiry date of one month. – The premium is the amount that is given to the writer of the contract for

giving the buyer the right to sell the Infosys share at the future date for the agreed price.

• Derivative instruments are called so because these financial instruments derive their value from the price of the underlying asset.

• These instruments are traded in a physical stock exchange through brokers.

• Derivative instruments are used to a large extent to reduce the risk in the underlying asset price.

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Non Corporate Investments• Deposits with Banks

– Savings Deposits• Low Interest Rates• Can be called anytime

– Fixed Deposits• Higher Interest Rates• Can be withdrawn only on the maturity date

– Flexi Deposits• Have characteristics of both the above• Penalty when withdrawn prematurely

– Advantages• Highest level of Security• Practically riskless if in PSU Banks• Insurance cover upto Rs. 1 lakh per account

– Disadvantages• Low rates of returns• Might not keep pace with inflation

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Non Corporate Investments• Company Fixed Deposits:

– Many companies have come up with fixed deposit schemes to mobilize money for their needs.

– The company fixed deposit market is a risky market and ought to be looked at with caution.

– RBI has issued various regulations to monitor the company fixed deposit market. • E.G., Sahara

– Credit rating services are available to rate the risk of company fixed deposit schemes.

– The maturity period varies from three to five years. – Fixed deposits in companies have a high risk since they are unsecured, but they

promise higher returns than bank deposits.– Fixed deposit in non-banking financial companies (NBFCs) is another investment

avenue open to savers.– NBFCs include leasing companies, hire purchase companies, investment

companies, chit funds, and so on.

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Non Corporate Investments

• Post Office Deposits and Certificates:– The investment avenues provided by post offices are

non-marketable.– Most of the savings schemes in post offices enjoy tax

concessions.– There are a variety of post office savings certificates

that cater to specific savings and investment requirements of investors.

– It is a risk free, high yielding investment opportunity. – Liquidity is an issue as they are non marketable

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Non Corporate Investments• Provident Fund Scheme:

– Provident fund schemes are deposit schemes, applicable to employees in the public and private sectors.

– In addition to the statutory provident fund, there is a voluntary provident fund scheme that is open to any investor, employed or not.

– This is known as the Public Provident Fund (PPF). Any member of the public can join the PPF, which is operated by the State Bank of India

• Equity Linked Savings Schemes (ELSSs):– Investing in ELSSs gets investors a tax rebate of the amount invested.– ELSSs are basically mutual funds with a lock-in period of three years.– ELSSs have a risk higher than PPF and NSCs, but have the potential of giving higher

returns.• Pension Plan:

– Certain notified retirement/pension funds entitle investors to a tax rebate.– UTI, LIC, and ICICI are some financial institutions that offer retirement plans to

investors.

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Non Corporate Investments• Government and Semi-Government Securities:

– Government and semi-government bodies such as the public sector undertakings borrow money from the public through the issue of government securities and public sector bonds.

– These are less risky avenues of investment because of the credibility of the government and government undertakings.

– The government issues securities in the money market and in the capital market.– Money market instruments are traded in the Wholesale Debt Market (WDM) trades and retail

segments. – Instruments traded in the money market are short term instruments such as treasury bills and

repos. – The government also introduced the privatisation programme in many corporate enterprises and

these securities are traded in the secondary market.

• Mutual Fund Schemes:– The Unit Trust of India is the first mutual fund in the country. – A number of commercial banks and financial institutions have also set up mutual funds.– Mutual funds have been set up in the private sector also.

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Real Assets• REAL ASSETS

– Investments in real assets are also made when the expected returns are very attractive. – Real estate, gold, silver, currency, and other investments such as art are also treated as

investments since the expectation from holding of such assets is associated with higher returns.• Real Estate:

– Buying property is an equally strenuous investment decision.– Real estate investment is often linked with the future development plans of the location. – It is important to check the value while deciding to purchase a movable/immovable property

other than buildings.

• Bullion Investment: – The bullion market offers investment opportunity in the form of gold, silver, and other metals. – Specific categories of metals are traded in the metals exchange. – The bullion market presents an opportunity for an investor by offering returns and end value in

future. – On several occasions, when the stock market failed, the gold market provided a return on

investments.