24495234 security analysis portfolio management

8/4/2019 24495234 Security Analysis Portfolio Management

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SECURITY ANALYSIS & PORTFOLIOMANAGEMENT

SECURITY :- Investments in capital markets is in variousfinancial instruments, which are all claims on money. These

instruments may be of various categories with differentcharacteristics. These are called Securities in market place.Securities Contracts Regulation Act, 1956 has defined thesecurity as inclusive of shares, scrips, stocks, bonds, debenturestock or any other markatable instruments of a like nature in or ofany debentures of a company or body corporate, the government

and semi-government body etc. It includes all rights & interests inthem including warrants and loyalty coupons etc., issued by anyof the bodies, organisations or the government. The derivatives ofsecurities and Security Index are also included as securities. SECURITY ANALYSIS :- Security Analysis involves theprojection of future dividend or earnings flows, forecast of the

share price in the future and estimating the intrinsic value of asecurity based on forecast of earnings or dividends.Modern Security Analysis relies on the fundamental analysis ofthe security, leading to its intrinsic worth and also risk-returnanalysis depending on the variability of the returns, covariance,safety of funds and the projections of the future returns.


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PORTFOLIO :- A combination of securities with different risk-return profile will constitute the portfolio of the investor. Thusportfolio is a combination of assets and/or instruments ofinvestments.

The combination may have different features of risk & return,separate from those of components.

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

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

Modern Portfolio theory postulates that maximisation of returnand/or minimisation of risk will yield optimal returns and the

choice and attitudes of investors are only a starting point forinvestment decision and that vigrous risk return analysis isnecessary for optimisation of returns.


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INVESTMENT SCENARIO

Investment activity involves the use of funds or savings foracquisition 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 commensuratewith the risk profile of the investment. The true investor isinterested 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 inconsistent performance than is the investor & is moreinterested in the abnormal, extremely high rate of returnthan the normal moderate rate. Furthermore, the speculatorwants to get these returns in a short span of time &switchover to other opportunities.

Speculator adds to the markets liquidity as he is frequentlyturning over his portfolio. Thus, the presence of speculatorprovides a market for securities, the much required depth &

breadth for expansion of capital markets.


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INVESTMENT CATEGORIES

Investments generally involve

A) Real Assets (Physical Assets) :- They are tangible, materialthings such as buildings, automobiles, plant and machinery etc.

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

One of the distinguishing features of Real Assets & Financial Assetsis the degree of liquidity. Liquidity refers to the ease of

converting an asset into money quickly, conveniently and at littleexchange cost. Real Assets are less liquid than financial assets,largely because real assets are more heterogeneous, oftenpeculiarly adapted to a specific use, and yield benefits only in co-operation with other productive factors. In addition to it thereturns of real assets are frequently more difficult to measure

accurately, owing to absence of broad, ready, and activemarkets.


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FINANCIAL ASSETS

Financial Assets can be categorised according to their source of

issuance (public or private) and the nature of the buyers 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. Theycall for fixed periodic payments, called interest and eventual

repayment of the amount borrowed, called the principal. The interestpayment stated as a percentage of the face value or maturity value isreferred to as the nominal or coupon rate.

Institutional Deposits & Contracts:- Demand & Time deposits,Certificate of Deposits, Life Insurance policies, Contributions toPension Funds. Title cant be transferred to a third party.

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


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Long term securities include Treasury Notes (one to ten yearmaturity) and Treasury Bonds (maturities of ten to thirtyyears), which bear interest.

Private Issues:- Private debt issues are offered by corporationsengaged in mining, manufacturing, merchandising and serviceactivities. The most common short-term privately issued debtsecurities are Commercial Paper. CP is unsecured promissorynote from 30 to 270 days maturity. These securities are issued to

suppliment bank credit and are sold by companies of primecredit standing. Bankers acceptances are issued in internationaltrade. They are of high quality having maturities from ninetydays 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 anissuer within the country of issue in that countrys currency- e.g.Sony Corp selling yen-denominated bonds in Tokyo.


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Foreign bonds are issued in the currency of the countrywhere they are sold but sold by a borrower of differentnationality. E.g. A dollar denominated bond sold in Newyorkby 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 timedeposits 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 otherrepresenting direct equity investment through the capital markets.

Investment Through Institutions :- These investments involve acommitment of funds to an institution of some sort that in returnmanages the investment for the investor.

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


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Common stock holders receive a return based on twosources- Dividends & Capital Gains.Preferred stock is called a hybrid security because it hasfeatures of both common stock & bonds.

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

International Equities :- Foreign Stocks offer diversification possibilitiesbecause correlation with domestic stocks is much lower in case offoreign stocks than any other domestic stock. These could be acquireddirectly at foreign stock exchanges by purchase of depository receipts

( ADRs, GDRs ). International equities face the same currency risks asin foreign bonds.

OPTIONS & FUTURES

These instruments of investment derive their value from an underlyingsecurity (stock, bond or basket of securities). Thus they are so calledas derivatives.

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


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

Financial futures represent a firm legal commitment between a buyerand seller, where they agree to exchange something at a specifiedprice at the end of a designated period of time. The buyer agrees totake delivery and the seller agrees to make delivery. Futures are

available either on stocks (stock futures) or basket of stocks (indexfutures). Futures on fixed-income securities (e.g. Treasury Bonds) arecalled 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 ofmortgages or the indirect purchase of mortgage backed securities.Real estate pools that are similar to mutual funds are called RealEstate Investment Trusts (REITs). They are available for diversifieddebt & equity ownership in pools of property of various types.


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RISK & RETURN

Risk in holding securities is generally associated with the possibilitythat realised returns will be less than that were expected. Some risksare external to the firm & cant be controlled, thus affect large numberof securities (Systematic Risk). Other influences are internal to thefirm & are controllable to a large degree (Unsystematic Risk).

Systematic Risk refers to that portion of total variability in returncaused 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 orindustry. E.g. Factors such as management capability, consumerpreferences, labour strikes etc.

SYSTEMATIC RISK

Market Risk:- This risk is caused due to changes in the attitudes ofinvestors toward equities in general, or toward certain types or groupsof securities in particular. Market risk is caused by investor reaction totangible as well as intangible events. The tangible events includepolitical, social and economic environment.


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

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

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

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

deflationUNSYSTEMATIC RISK

Unsystematic risk is that portion of total risk that is unique orpeculiar to a firm or industry. Factors such as managementcapability, consumer preferences and labour strikes can cause

unsystematic variability of returns for a companys stock.


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Business Risk :- This risk is a function of the operatingconditions faced by a firm and the variability theseconditions inject into the operating income and expecteddividends. Business risk can be divided into two broad

categories- external & internal.

Internal Business Risk :- This risk is largely associated with theefficiency with which a firm conducts its operations within thebroader operating environment imposed upon it.

External Business Risk :- It is the result of operating conditionsimposed upon the firm by circumstances beyond its control.Govt. policies with regard to monetary & fiscal matters canaffect revenues thro the effect on the cost & availability offunds.

Financial Risk :- This risk is associated with the way in which acompany finances its activities. The substantial debt funds,preference shares in the capital structure of the firm createshigh fixed-cost commitments for it. This causes the amount ofresidual earnings available for common-stock dividends morestressed.


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RETURN

Investors want to maximise expected returns subject totheir 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 anticipatethey will earn over some future period.

Return in a typical investment consists of two components. The basiccomponent is the periodic cash receipt on the investment, either in theform of interest or dividends. The second component is the change in theprice of the asset commonly called capital gains or loss. This element ofreturn is the difference between the purchase price and the price at whichthe asset can be sold.

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

Purchase price of asset

Total return can be either positive or negative.


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BETA

Beta is a measure of non-diversifiable risk. It shows howthe 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 its beta.

It is calculated by relating the returns on a security with thereturns for the market. Market return is measured by theaverage return of a large sample of stocks, such as stock index.

The beta for overall market is equal to 1.00 and other betas areviewed in relation to this value.

Measure of beta is helpful in assessing systematic risk andunderstanding the impact market movements can have on thereturn expected from a share of stock. Decreases in the marketreturns are translated into decreasing security returns. Stockshaving beta more than one will be more responsive & that lessthan 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


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CAPITAL ASSET PRICING MODEL

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

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

RL= a + Rm

RL= Estimated return on i stock

a = expected return when market risk is zero

= Measure of stocks sensitivity to the market index

Rm = Return on market index


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The equation for CAPM is,Ri = Rf+ i (Rm Rf)

Ri is the required return

Rf is risk-free return

Rm is the average market return

i is the measure of systematic risk which is non-

diversifiable


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SECURITY MARKET LINE (SML)

Re

turn

% 0.5 1.0 1.5RISK

(BETA)

0

Risk Less Return

Y

X

When CAPM is drawn graphically, weget SML. If the investor wants todecide on an investment with anexpected return he would know the

level of risk, he has preferred to take,he would know the expected returnfrom this chart. The investor has toassess whether it is worth taking alevel of risk, if he has a target returnwhich involves that risk, as he is

assumed to be generally risk averse.Thus, CAPM & SML help the investor inevaluating risk for a return, in makingany investment decision. The principleof higher the risk, higher the return isembodied in this model.


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ALPHA

Alpha is an indicator of expected return when market return iszero. 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 marketmoves up or down.


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FUNDAMENTAL ANALYSIS : INDUSTRY ANALYSIS

At any stage in the economy, there are some industries which aregrowing while others are declining. The performance of companies will

depend among other things upon the state of the industry as a wholeand the economy. If the industry is prosperous, the companies, withinthe industries may also be prosperous although a few may be in a badshape. The performance of a company is thus a function not only of theindustry and of the economy, but more importantly, on its ownperformance. The share price of the company is empirically found to

depend up to 50% on the performance of the industry and theeconomy. The economic and political situation in the country has thusa bearing on the prospects of the company. Following factors areconsidered in the industry analysis.

Product Line & stage in the life cycle

Raw Material and Inputs, utilities Capacity Installed & utilised

Industry Characteristics

Demand & Market


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Pricing & government controls on prices, distribution

Control on Imports & exports

Government Policy with regard to Industry

Taxation Policy & incentives offered

Labour & other Industrial problems.

Prospects of growth

Protection or Tariff preferences

Quality of Management

Levels of R&D.

IMPORTANCE OF INDUSTRY ANALYSIS

The performance of the companies will depend upon the stateof the industry as a whole.

Through industry analysis future projections of growth will gethighlighted.

24495234 security analysis portfolio management

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