Of Stock Prices and the Random Walk...

Why analysis of securities ?

23 July 2002 98.5 million shares traded on BSE and 142.6 million shares on NSE valuing Rs.
14.29 billion and Rs. 25.23 billion respectively.

So why do people invest in securities – simple, to make money and to help them in this activity
are scores of analysts, strategists and portfolio managers all doing one thing: trying to beat the
market. Analysts are hired to identify undervalued stocks. Strategists are hired to predict the
direction of the market and various sectors. Portfolio managers are hired to put it all together and
outperform their benchmark, i.e. the stock index.

Approaches to security analysis

To make the money making business more scientific a few approaches to security analysis have
been developed over time.

A. Fundamental Analysis : It is basically the examination of underlying forces that affects the
interests of the economy, industrial sectors and companies.

B. Technical Analysis : It is examination of past price and volume movements to forecast

the future price movements

C. Random Walk Theory : The basic premise is that price movements are totally random as
the present day price incorporates all past information and trends hence all predictive
analysis is futile.

A. Fundamental Analysis

This is done at three levels – economy, industry and company.

At economy level fundamental analysis focuses on the economic indicators of the country to
assess the present and future growth of the economy. In a growing economy just like in a tide
almost all industries and companies benefit and grow. On the other hand in an economy in
recessionary phase usually all sectors suffer. Major economic indicators include the interest
rates, GDP growth rate, inflation, purchasing power etc.

At industry level, it requires selection of the right industry given the economic conditions. For
example in a growing economy certain sectors are likely to benefit more than the others like
information technology, biotech and cyclical stocks.In a contracting economy an investor may
opt for more stable and income-oriented companies like consumables and other FMCG
stocks. *Factors like government attitude, competition level, threat of potential entrants,
cost structure may be looked into.*Also analysis of the demand and supply forces and
barriers to entry of new entrants into the industry may be looked into.

Within an industry the next task is identifying the company. For that a number of factors are
looked into, say, the company’s competitive advantage, its market share, the quality of
leadership and top management, the future prospects of the company, control over certain
 important strategic sources of raw material, the labour relations and last but not the least the
financials of the company.

In analysing the financial data the most popular source of information are its financial
statements – the balance sheet and the income statement. The factor to be calculated is the
intrinsic value of the company i.e. its networth. Also we can make use of key financial ratios
like the GP ratio, debt-equity ratio, return on capital employed, current ratio, asset turnover
ratio, debtors turnover ratio, the interest coverage ratio, the debt-service ratio, price earning
ratio, EPS (basic and diluted) etc.

Advantages

• Its good for predicting long term trends

• Value investing is possible
• Development of business acumen

Disadvantages

• Time constraints
• Valuation techniques vary from industry to industry
• Complex for the layman
• Subjective

B. Technical Analysis

Technical analysis is a method of evaluating securities by studying the statistics generated by

market activity – movements of past prices, and volume. Technical analysts look for patterns and
indicators on stock charts that will determine a stock’s future performance. Technical analysis can
include volume or open interest figures along with the study of price action. The following
theorems put forth by Dow laid the foundation for technical analysis:

• Price discounts everything: This is based on the belief that the market price reflects the sum
knowledge of all the market participants and should form the basis for analysis.
• Price movements are not totally random: This is based on the observation that there are
some periods when prices trend and some periods when they don’t. So it would be possible
to identify a trend, investment or trade based on the trend and make money as the trend
unfolds.
• What is more important than why: Technical analysts are concerned with the current price
and the history of the price movement. They believe that it is best to concentrate on what the
price is and not on why the price is what it is.

Technical analysis uses a top-down approach that begins with a broad-based macro analysis and
breaks down to a more micro perspective. This consists of a broad market analysis through the
major indices, a sector analysis and finally an individual stock analysis to identify the strongest
and weakest stocks within each of the selected groups.

Advantages

• Focus on price – the most basic of profit or loss indicators

• A pictorial representation of the trend using point and figure charts or bar-charts which lends
lucidity to the layman investor
• The method concentrates more on the ‘when to buy’ question thus ensuring maximization of
profits

Disadvantages

• The technique is open to interpretation

• The results could be affected by the personal prejudices of the analyst
• There is a lag between the trend actually creeping in and its identification. This could result in
the miscalculation of the time for the buy or sell call.

C. Random Walk Theory

The basic premise of the theory is that the present day prices incorporate all past trends of price
movement and hence cannot be used to predict future prices and profit from that. Deriving its
name from the book ‘A Random Walk Down Wall Street’ by Malkiel the fans of the theory contend
that the information flow in the market is efficient so that all information and past prices are
reflected today making any exercise in prediction and analysis useless.

Malkiel goes a step further and questions the validity of both fundamental and technical analysis
on the above-mentioned grounds and is emphatic in his belief that any profits using these
theories are more a stroke of luck than sleight of hand.

Prices have no memory, therefore past and present prices cannot be used to predict future prices
The adjustment to this new information is so fast that it is impossible to profit from it. Furthermore,
news and events are also random and trying to predict these (fundamental analysis) is also a
lesson in futility.

Advantages

• It is the simplest of the three for a layman to comprehend.

• It is one of the oldest stock pricing theories and still finds favour with a set of investors.

Disadvantages

• The theory propounds ‘buy and hold’ as the best strategy. However the equity investor is
looking for higher returns given the higher risk status.
• In 1978 Society of Investment Analysts Journal in which he explained that The Efficient
Market Hypothesis contains a logical flaw. The American economists Grossman and Stiglitz
were also exploring the issue around the same time and in 1980 published "On the
Impossibility of Informationally Efficient Markets" in the American Economic Review. Their
point was that markets cannot be efficient by accident. If they are efficient, then it is because
of information and research. These activities have costs, but there is no incentive to pay for
this research unless it can be used to make higher returns.
• In a truly efficient ( frictionless and costless) market all information would be incorporated in
the market price eliminating any profit opportunities. Unfortunately, such an ideal situation
does not exist. Evidence suggests that active fund mangers under-perform the index, even
before allowing for their higher management fees. The constant attempt to out-perform their
peers leads managers to regularly switch the shares that they own. This creates costs.
 Assuming stamp duty of 0.1%, brokerage costs of 0.2%, and bid-ask spreads of 0.1%; it
costs 0.4% every time shares are traded.

Conclusion
Fundamental analysis answers the question ‘What to buy’ while technical analysis focuses on
‘when to buy’. Thus the two methods are usually used in conjunction. On the other hand Random
Walk is a direct contradiction to both these theories. It holds that in an efficient market any
predictive analysis is a waste of time as the present day prices already incorporate all
information.

In the present day scenario we find that it is the big institutional investors who, to a large extent,
influence the market price. Even these investors make use of the tools prescribed by the above-
mentioned theories.

- Chetan Jain
- Kashif Afaq
- Rajadhyaksha Narayanan
- Tanvi Gupta

References :

- Security Analysis and Portfolio Management; Fischer and Jordan

- A Random Walk Down Wall Street - Makeil
- Stockchart.com
- A Non-Random Walk Down Dalal Street – Derry Pickford