Security Analysis & Portfolio Management

Recommended Text Security Analysis & Portfolio Management Donald Fisher, Ronald Jordan

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

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

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, Optimistic Speculator: 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

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 investments 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 Hussains 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

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

ER
14 12 10 8 6 4 2 0 Risk ER

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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 Nave 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 Secondary Market Debt Market Money Market Forex Market International Markets Foreign Segment

Primary Market

Spot Market

Derrivative 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 countrys 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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 Money Markets

Financial 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 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

Debt Market

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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 firms 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.

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