SECURITY ANALYSIS AND

PORTFOLIO MANAGEMENT

Semester – VI
B.com

Student Workbook

Edition: 2020
#44/4, District Fund Road, Behind Big Bazaar, Jayanagar 9th Block, Bengaluru, Karnataka 560069

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 Module: 1

INVESTMENT AND INVESTMENT SCHEMES

1.1 Meaning
1.2 characteristics and objectives of investment
1.3 Types and alternatives
1.4 choice of evaluation
1.5 investment v/s speculation, investment v/s gambling
1.6 Importance of Investment
1.7 Factors Influencing the Investment Decision
1.8 Qualities for Successful Investment
1.9 Bank Deposits
1.10 Post-Office Deposit Schemes
1.11 Money Market Instruments
1.12 Bonds or Fixed Income Securities: Govt. Securities, RBI Relief Bonds, Private
sector Debentures, Public Undertakings Bonds
1.13 Preference Shares
1.14 Equity Shares
1.15 Mutual Fund Schemes
1.16 Life Insurance Schemes
1.17 Real Estate
1.18 Summary

Learning Objectives:

 To understand and describe various investment alternatives

 To learn the concept of risk and return involved in the investments.
 To understand the various factors influencing the investment decisions.

1.1 Investment – Meaning:

 Investment is putting money into something with the expectation of profit. The word
originates in the Latin "vestis", meaning garment, and refers to the act of putting things
(money or other claims to resources) into others' pockets.
 The term "investment" is used differently in economics and in finance. Economists refer
to a real investment (such as a machine or a house), while financial economists refer to a
financial asset, such as money that is put into a bank or the market, which may then be
used to buy a real asset.
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Financial meaning of investment:

 Financial investment involves of funds in various assets, such as stock, Bond, Real
Estate, Mortgages etc.
 Investment is the employment of funds with the aim of achieving additional income or
growth in value.
 It involves the commitment of resources which have been saved or put away from current
consumption in the hope some benefits will accrue in future. Investment involves long
term commitment of funds and waiting for a reward in the future.
 From the point of view people who invest their finds, they are the supplier of Capital and
in their view investment is a commitment of a person s funds to derive future income in
the form of interest, dividend, rent, premiums, pension benefits or the appreciation of the
value of their principal capital.
 To the financial investor it is not important whether money is invested for a productive
use or for the purchase of second hand instruments such as existing shares and stocks
listed on the stock exchange.
 Most investments are considered to be transfers of financial assets from one person to
another.

Economic meaning of investment:

 Economic investment means the net additions to the capital stock of the society which
consists of goods and services that are used in the production of other goods and services.
Addition to the capital stock means an increase in building, plants, equipment and
inventories over the amount of goods and services that existed.
 The financial and economic meanings are related to each other because investment is a
part of the savings of individuals which flow into the capital market either directly or
through institutions, divided in new and second hand capital financing. Investors as
suppliers

1.2 Basic Investment Objectives

Investment triangle - three compromising objectives

Security

Liquidity

Yield

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Any investment decision will be influenced by three objectives security, liquidity and yield. A
best investment decision will be one, which has the best possible compromise between these
three objectives.

Security:

Central to any investment objective, we have to basically ensure the safety of the principal. One
can afford to lose the returns at any given point of time but s/he can ill afford to lose the very
principal itself. By identifying the importance of security, we will be able to identify and select
the instrument that meets this criterion. For example, when compared with corporate bonds, we
can vouch safe the safety of return of investment in treasury bonds as we have more faith in
governments than in corporations. Hence, treasury bonds are highly secured instruments. The
safest investments are usually found in the money market and include such securities as Treasury
bills (T-bills), certificates of deposit (CD), commercial paper or bankers' acceptance slips; or in
the fixed income (bond) market in the form of municipal and other government bonds, and in
corporate bonds

Liquidity:

Because we may have to convert our investment back to cash or funds to meet our unexpected
demands and needs, our investment should be highly liquid. They should be en cashable at short
notice, without loss and without any difficulty. If they cannot come to our rescue, we may have
to borrow or raise funds externally at high cost and at unfavourable terms and conditions. Such
liquidity can be possible only in the case of investment, which has always-ready market and
willing buyers and sellers. Such instruments of investment are called highly liquid investment.

Yield:

Yield is best described as the net return out of any investment. Hence given the level or kind of
security and liquidity of the investment, the appropriate yield should encourage the investor to go
for the investment. If the yield is low compared to the expectation of the investor, s/he may
prefer to avoid such investment and keep the funds in the bank account or in worst case, in cash
form in lockers. Hence yield is the attraction for any investment and normally deciding the right
yield is the key to any investment.

Return:

Investors always expect a good rate of return from their investments. Rate of return cold be
defined as the total income investor receives during the holding period stated as a percentage of
the purchasing price at the beginning of the holding period.

Return = (End Period Value – Beginning period value) + Dividend / Beginning period value x
100

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Return = (Capital Appreciation + Dividend) / Purchase Price x 100

Risk:

Risk of holding securities is related with the probability of actual return becoming less than the
expected return. The word risk is synonymous with the phrase variability of return. An
investment whose rate of return varies widely from period to period is risky than whose return
that does not change much. Every investor likes to reduce the risk of his investment by proper
combination of different securities.

Hedge against inflation:

Since there is inflation in almost all the economies, the rate of return should ensure a cover
against the inflation. The return rate should be higher than the rate of inflation; otherwise the
investor will have loss in real terms. Growth stock would appreciate in their values overtime and
provide a protection against inflation. The return thus earned should assure the safety of the
principal amount, regular flow of income and be hedge against inflation.

Relationship:

 There is a trade-off between risk (security) and return (yield) on the one hand and
liquidity and return (yield) on the other.
 Normally, higher the risk any investment carries, the greater will be the yield, to
compensate the possible loss. That is why, fly by night operators, offer sky high returns
to their investors and naturally our gullible investors get carried away by such returns and
ultimately lose their investment. Highly secured investment does not carry high coupon,
as it is safe and secured.
 When the investment is illiquid, (i.e. one cannot get out of such investment at will and
without any loss) the returns will be higher, as no normal investor would prefer such
investment.
 These three points, security, liquidity and yield in any investment make an excellent
triangle in our investment decision-making. Ideally, with given three points of any
triangle, one can say the centre of the triangle is fixed. In our investment decision too,
this centre the best meeting point for S, L and Y is important for our consideration.
 However, if any one or two of these three points are disturbed security, liquidity and
yield in any investment the centre of the triangle would be disturbed and one may have to
revisit the investment decision either to continue the investment or exit the investment.
 All these points security, liquidity and yield are highly dynamic in any market and they
are always subject to change and hence our investor has to periodically watch his/her
investment and make appropriate decisions at the right time.

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  If our investor fails to monitor her / his investment, in the worst circumstances, s/he may
lose the very investment.
 Thus, we will return to our original statement - A best investment decision will be one,
which has the best possible compromise between these three objectives security,
liquidity and yield.

Secondary Objectives:

Tax Minimization:

An investor may pursue certain investments in order to adopt tax minimization as part of his or
her investment strategy. A highly-paid executive, for example, may want to seek investments
with favourable tax treatment in order to lessen his or her overall income tax burden. Making
contributions to an IRA or other tax-sheltered retirement plan, such as a 401(k), can be an
effective tax minimization strategy.

Marketability / Liquidity:

Many of the investments we have discussed are reasonably illiquid, which means they cannot be
immediately sold and easily converted into cash. Achieving a degree of liquidity, however,
requires the sacrifice of a certain level of income or potential for capital gains. Common stock is
often considered the most liquid of investments, since it can usually be sold within a day or two
of the decision to sell. Bonds can also be fairly marketable, but some bonds are highly illiquid, or
non-tradable, possessing a fixed term. Similarly, money market instruments may only be
redeemable at the precise date at which the fixed term ends. If an investor seeks liquidity, money
market assets and non-tradable bonds aren't likely to be held in his or her portfolio.

CHARACTERISTICS OF GOOD INVESTMENT

a. Objective fulfilment

An investment should fulfil the objective of the savers. Every individual has a definite objective
in making an investment. When the investment objective is contrasted with the uncertainty
involved with investments, the fulfilment of the objectives through the chosen investment avenue
could become complex.

b. Safety

The first and foremost concern of any ordinary investor is that his investment should be safe.
That is he should get back the principal at the end of the maturity period of the investment. There
is no absolute safety in any investment, except probably with investment in government
securities or such instruments where the repayment of interest and principal is guaranteed by the
government.

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c. Return

The return from any investment is expectedly consistent with the extent of risk assumed by the
investor. Risk and return go together. Higher the risk, higher the chances of getting higher return.
An investment in a low risk - high safety investment such as investment in government securities
will obviously get the investor only low returns.

d. Liquidity

Given a choice, investors would prefer a liquid investment than a higher return investment.
Because the investment climate and market conditions may change or investor may be
confronted by an urgent unforeseen commitment for which he might need funds, and if he can
dispose of his investment without suffering unduly in terms of loss of returns, he would prefer
the liquid investment.

e. Hedge against inflation

The purchasing power of money deteriorates heavily in a country which is not efficient or not
well endowed, in relation to another country. Investors, who save for the long term, look for
hedge against inflation so that their investments are not unduly eroded; rather they look for a
capital gain which neutralizes the erosion in purchasing power and still gives a return.

f. Concealabilty

If not from the taxman, investors would like to keep their investments rather confidential from
their own kith and kin so that the investments made for their old age/ uncertain future does not
become a hunting ground for their own lives. Safeguarding of financial instruments representing
the investments may be easier than investment made in real estate. Moreover, the real estate may
be prone to encroachment and other such hazards.

h. Tax shield

Investment decisions are highly influenced by the tax system in the country. Investors look for
front-end tax incentives while making an investment and also rear-end tax reliefs while reaping
the benefit of their investments. As against tax incentives and reliefs, if investors were to pay
taxes on the income earned from investments, they look for higher return in such investments so
that their after tax income is comparable to the pre-tax equivalent level with some other income
which is free of tax, but is more risky.

1.3 Investment Alternatives

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Non-marketable Financial Assets:

A good portion of financial assets is represented by non-marketable financial assets. A

distinguishing feature of these assets is that they represent personal transactions between the
investor and the issuer. For example, when you open a savings bank account at a bank you deal
with the bank personally. In contrast when you buy equity shares in the stock market you do not
know who the seller is and you do not care. These can be classified into the following broad
categories:

 Post office deposits

 Company deposits
 Provident fund deposits
 Bank deposits

Investment Risk and Return Characteristics

The chart below provides some examples of common types of investments classified according
to their potential return and investment risk.

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1.4 Investment Alternative: Choice of Evaluation

For evaluating an investment avenue, the following attributes are relevant,

 Rate of return
 Risk
 Marketability
 Tax Shelter
 Convenience

Rate of return

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The rate of return on an investment for a period (which is usually a period of one year) is defined
as follows:

Rate of Return = Annual Income + (End price - Beginning Price) / Beginning Price

Rate of Return = Current Yield + Capital Gain/Losses Yield

= {Annual Income/ Beginning Price} + {(End price - Beginning Price) /

Beginning Price}

Risk

The rate of return from investments like equity shares, real estate, silver and gold can vary rather
widely. The risk of an investment refers to the variability of its return; how much do individual
outcomes deviate from the expected value? A simple measure of dispersion is the range of
values, which is simply the difference between the highest and lowest values.

Marketability

An investment is considered highly marketable or liquid it can be easily transacted with low
transaction cost and low price variation. A finance manager looks for more liquid investments
when the funds are available for the short period. Liquidity is always given a preference because
it helps the managers remain flexible. The liquidity of a market may be judged in terms of its
depth, breadth and resilience. Depth refers to the existence of buy as well as sells orders around
the current market price. Breadth implies the presence of such order in substantial volume.
Resilience means that new orders emerge in response to price changes.

Tax Shelter

Some investments provide tax benefits; others do not. Tax benefits are of the following three
kinds:

 Initial tax benefit - An initial tax benefit refers to the tax relief enjoyed at the time of
making the investment.
 Continuing tax benefit - A continuing tax benefit represents the tax shield associated
with the periodic returns from the investment.
 Terminal tax benefit - A terminal tax benefit refers to relief from taxation when an
investment is realized or liquidated.

Convenience

Convenience means ease of investment. When an investment can be made and looked after
easily, we consider it as convenient investing. For example, it is easy to invest in equity shares
compared to real estate because real estate involves a lot of documentation and legal
requirements.

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1.5 Investors and speculators:

Investors:

The investors buy the securities with a view to invest their savings in profitable income earning
securities. They generally retain the securities for a considerable length of time. They are assured
of a profit in cash. They are also called genuine investors.

Speculators:

The speculators buy securities with a hope to sell them at a profit in future. They do not retain
their holdings for a longer period. They buy the securities with the object of selling them and not
to retain them. They are interested only in price differentials. They are not genuine investors.

Differences between investors and speculators:

Factors Investor Speculator

Time Plans for a longer time horizon.
Horizon His holding period may be from
one year to few years.
Risk Assumes moderate risk
Return Likes to have moderate rate of
return associated with limited risk.
Decision Considers fundamental factors
and evaluates the performance of
the company regularly.
Funds Uses his own funds and avoids
borrowed funds
Plans for a very short period.
Holding period varies from few
days to month.
Willing to undertake high risk.
Like to have high returns for
assuming high risk.
Considers inside information,
heresays and market behaviour.
Uses borrowed funds to
supplement his personal
resources.

Speculation:

Speculation refers to the buying and selling of securities in the hope of making a profit from
expected change in the price of securities. Those who engage in such activity are known as
speculators.

A speculator may buy securities in expectation of rise in price. If his expectation comes true, he
sells the securities for a higher price and makes a profit. Similarly a speculator may expect a
price to fall and sell securities at the current high price to buy again when prices decline. He will
make a profit if prices decline as expected. The benefits of speculation are:

1. It leads to smooth change and prevents wide fluctuations in security prices at different times
and places

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2. Speculative activity and the resulting effect in the prices of securities provided guidance to the
public about the market situation

Differences between speculation and gambling:

No Speculation
1 It is based on knowledge and
foresight
2 It is a lawful activity
3 It performs economic functions
4 Speculators bears the risk of loss on
the basis of logical reasoning
Gambling
It is based on chance of events happening
It is an illegal activity
It has no benefits to offer to the economy
Gamblers bear the risk of loss on the basis of
blind and reckless expectation.

1.6 Importance of Investment

Investment decisions require special attention because of the following reasons:

 They influence the firm’s growth in the long run.
 They affect the risk of the firm.
 They involve commitment of large amount of funds.
 They are irreversible, or reversible at substantial loss.
 They are among the most difficult decisions to make.

1. Growth
The effects of investment decisions extend into the future and have to be endured for a longer
period than the consequences of the current operating expenditure. A firm’s decision to invest in
long term assets has decisive influence on the rate and direction of its growth. A wrong decision
can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion
of assets will result in heavy operating costs to the firm. On the other hand inadequate
investment in assets would make it difficult for the firm to compete successfully and maintain its
market share.

2. Risk
A long-term commitment of funds may also change the risk complexity of the firm. If the
adoption of an investment increases average gain but causes frequent fluctuations in its earnings,
the firm will become more risky. Thus, investment related decisions shape the basic character of
a firm.

3. Funding

Investment decisions generally involve large amount of funds, which make it imperative for the
firm to plan its investment programmers very carefully and make an advance arrangement for
procuring finances internally or externally.

4. Irreversibility

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Most Investment decisions are irreversible. It is difficult to find a market for such capital items
once they have been acquired. The firm will incur heavy losses if such assets are scrapped.

5. Complexity
Investment decisions are among the firm’s most difficult decisions. They are an assessment of
future events, which are difficult to predict. It is really a complex problem to correctly estimate
the future cash flows of an investment. Economic, political, social and technological forces cause
the uncertainty in cash flow estimation. Knowledge

1.7 Factors Influencing Investment Decision

1. Investment Policy (Decision): The government or the investor before proceeding into
investment formulates the policy for the systematic functioning. The essential ingredients of the
policy are the investible funds, objectives and knowledge about the investment alternatives and
market.

2. Investible funds: The entire investment procedure revolves around the availability of
investible funds. The fund may be generated through savings or from borrowings. If the funds
are borrowed, the investor has to be extra careful in the section of investment alternatives. The
return should be higher than the interest he pays. Mutual funds invest their owner’s money in
securities.

3. Objectives: The objectives are framed on the premises of the requirement of return, need for
regularity of income, risk perception and the need for liquidity. The risk taker’s objective is to
earn high rate of return in the form of capital appreciation, whereas the primary objective of the
risk averse is to safeguard the principal.

4. Knowledge: The knowledge about the investment alternatives and markets plays a key role in
the policy formulation. The investment alternatives range from security to real estate. The risk
and return associated with investment alternatives differ from each other. Investment in equity is
high yielding but has more risk than the fixed income securities. The tax sheltered schemes offer
tax benefits to the investors.

The investor should be aware of the stock market structure and the functions of the brokers. The
mode of operation varies among BSE, NSE and OTCEI. Brokerage charges are also different.
The knowledge about the stock exchanges enables him to trade the stock intelligently.

1.8 Qualities for Successful Investing

The game of investment, as any other game, requires certain qualities and virtues on the part of
the investors, to be successful in the long run. What are these qualities? While the lists prescribed
by various commentators tend to vary, the following qualities are found on most of the lists.
a. Contrary thinking
b. Patience
c. Composure
d. Flexibility and openness
e. Decisiveness

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Before we dwell on these qualities, one point needs to be emphasized upon. Cultivating these
qualities distinctly improves the odds of superior performance but does not guarantee it.

1.8.1 Contrary Thinking

Investors tend to have herd mentality and follow the crowd. Two factors explain this behaviour.
First, there is a natural desire on the part of human beings to be a part of a group. Second, in a
complex field like investment, most people do not have enough confidence in their own
judgment. This impels them to substitute others’ opinion for their own.

Following the crowd behaviour, however, often produces poor investment results. Why? If
everyone fancies a certain share, it soon becomes overpriced.

Given the risk of imitating others and joining the crowd, you must cultivate the habit of contrary
thinking. This may be difficult to do because it is so tempting and convenient to fall in line with
others. Perhaps the best way to resist such a tendency is to recognize that investment requires a
different mode of thinking than what is appropriate to everyday living.

1.8.2 Patience
As a virtue, patience is strangely distributed among investors. Young investors, with all the time
in the world to reap the benefits of patient and diligent investing, seem to be the most impatient.
They look for instantaneous results and often check prices on a daily basis. Old investors, on the
other hand, display a high degree of patience even though they have little change of enjoying the
fruits of patience.

The game of investment requires patience and diligence. In the short run, the factor of luck may
be important because of randomness in stock price behaviour, which may be likened to the
Brownian motion in physics. In the long run, however, the investor’s performance depends
mainly on patience and diligence, because the random movements tend to even out.

1.8.3 Composure
Rudyard Kipling believed that for becoming a mature adult one should keep ones head when all
around you are losing theirs. The ability to maintain composure is also a virtue required to be
successful investor. Conscious of this, as an investor you should try to (a) understand your own
impulses and instincts towards greed and feat; (b) surmount these emotions that can warp your
judgment; and (c) capitalize on the greed and fear of other investors.

1.8.4 Flexibility and Openness

Nothing is more certain than change in the world of investments. Macro-economic conditions
change, new technologies and industries emerge, consumer tastes and preferences shift,
investment habits alter, and so on. All these development have a bearing on industry and
company prospects on the one hand and investor expectations on the other.

Barton M. Briggs opines “Flexibility of thinking and willingness to change is required for the
successful investor. In the stock market, in investing, there is nothing permanent expect change.

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The investment manager should try to cultivate a mix of healthy skepticism, open-mindedness,
and willingness to listen”.

1.8.5 Decisiveness
An investor often has to act in face of imperfect information and ambiguous signals. Investment
decisions generally call for reaching conclusions on the basis of inadequate premises. To succeed
in the investment game, the investor should be decisive. If he procrastinates, he may miss
valuable opportunities; if he dillydallies, he may have to forego gains.

Decisiveness does not mean rashness. Rather, it refers to an ability to quickly weigh and balance
a variety of factors (some well understood and some not-so-well understood), form a basic
judgment, and act promptly. It reflects the ability to take decisions, after doing the necessary
homework of course, without being overwhelmed by uncertainties in the investment situation.

1.9 NON-MARKETABLE FINANCIAL ASSETS

Bank deposit

Bank deposits consist of money placed into banking institutions for safekeeping. These deposits
are made to deposit accounts such as savings accounts, checking accounts and money market
accounts. The account holder has the right to withdraw deposited funds, as set forth in the terms
and conditions governing the account agreement.

1. Current account

Features

- Current account are opened to run a business.

- It is non-interest bearing bank account

- It needs a higher minimum balance to be maintained as compared to the savings account.

- Penalty is charged if minimum balance is not maintained.

- It charges interest on the short-term funds borrowed from the bank.

2. Savings Bank Account

Features

- The main objective of SB accounts is to promote savings.

- There is no restrictions on the number & amount of deposits.

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- Withdrawals are allowed subject to certain conditions.

- Money can be withdrawn either by cheque or slip of the respective bank.

- The rate of interest payable is very nominal on savings account. At present it is between 4% to
6% p.a. in India.

3. Fixed Deposit Account

Features

- Tenure ranges between six months to 10 years.

-Guaranteed Returns.
-Interest income monthly, quarterly or annually.
-Reinvest interest income and gain the influence of compounding.
-Partial or full withdrawal facility is available with penalty interest rates.
-Loan against deposits.
-Senior citizens get higher coupon rates in the range of 0.25 -1.00 %.

Non banking financial corporation

• The Non-Banking Financial Companies (NBFCs) are the financial institutions that offer
the banking services, but does not comply with the legal definition of a bank, i.e. it does
not hold a bank license, accept deposit as part of saving .

Types of NBFC

• Investment Company

• Equipment Leasing Company

• Hire-Purchase Company

• Housing Finance Company

• Chit Fund Company

Although, the non-banking financial companies do not hold the bank license and are restricted to
take any public deposits their operations are covered under the banking regulations and are
regulated by the Reserve Bank of India.

1.10 Postal savings schemes:

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• Kisan vikas patra (KVP)

• National saving certificate

• Post office monthly saving scheme

• Senior citizen scheme

• Post office time deposit

• Public providend fund

• Sukanya yojana

1. Kisan vikas parta (KVP)2014

• Kisan Vikas Patra is a saving certificate scheme which was first launched in 1988 by
India Post.

• It was successful in the early months but afterwards the Government of India set up a
committee under supervision of Shayamla Gopinath which gave its recommendation to
the Government that KVP could be misused.

• Hence the Government of India decided to close this scheme and KVP was closed in
2011.

• The new government re-launched it in 2014.

FEATURES

Investment Limitations

KVP certificates are available in the denominations of Rs 1000, Rs 5000, Rs 10000 and
Rs 50000. The minimum amount that can be invested is Rs 1000. However, there is no
upper limit on the purchase of KVPs.

Tax Benefits

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 Kisan Vikas Patra does not offer any income tax benefits to the investor. However,
withdrawals are exempted from Tax Deduction at Source (TDS) upon maturity.

Interest Income.

The amount(Principal) invested in Kisan Vikas Patra would get doubled in 115 months
.The rate of interest is 7.5%. for Oct 2017 to Dec 2017

Withdrawal

The amount of KVP can be withdrawn after 115 months (9years and 7 months).The
maturity period of a KVP is 2 years 6 months(30 months). Premature encashment of the
KVP certificate is not permissible.

The certificates can only be encashed in event of the death of the holder or forfeiture by
a pledge or on the order of the courts.

Passbook facility

available

Kisan Vikas Patra can be purchased by :

 An adult in his own name, or on behalf of a minor

 A Trust

 Two adults jointly

2. Post office time deposit

Interest rate changes every annual year.

Interest data details

Period Rate

1 yr. Account 7.10%

2 yr. Account 7.20%

3 yr. Account 7.40%

5 yr. Account 7.90%

o Account may be opened by individual.

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 o Account can be opened by cash/ Cheque and in case of Cheque the date of realization of
Cheque in Govt. account shall be date of opening of account.

o Nomination facility is available at the time of opening and also after opening of account.

o Account can be transferred from one post office to another.

o Any number of accounts can be opened in any post office.

o Account can be opened in the name of minor and a minor of 10 years and above age can
open and operate the account.

o Joint account can be opened by two adults.

o Premature withdrawal is possible but after 6months, but will get only the amount invested
in the beginning, interest will be given @ the maturity.
o Interest payable annually but calculated quarterly.
o Initial deposit INR. 200/- and in multiples of INR. 200/- thereafter, no maximum limit.
o Minor after attaining majority has to apply for conversion of the account in his name.
o The investment under 5 Years TD qualifies for the benefit of Section 80C of the Income
Tax Act, 1961 from 1.4.2007
o Single account can be converted into Joint and Vice Versa.

>for accounts opened before 1-Dec-2011

-no interest is paid if deposit is withdrawn within 1 year.

- for deposits withdrawn after 1 year, 2% lower interest will be paid than the specified rate.

>for accounts opened on or after 1-Dec-2011

- no interest is paid if deposit is withdrawn within 6 months.

- If withdrawn between 6 months to 1 year , simple interest rate of post office savings
scheme(whichever is applied @ that time) will be paid.

- If deposits withdrawn after 1 year, interest rate is 1% less than specified interest rate.

3. National Savings Certificate (1 June, 2005)

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 FEATURES

• Types:

NSC VIII & NSC IX(discontinued in Dec 2015)

• Tax

To get tax benefits , you have to invest upto 1.5 Lakhs, to claim the benefits of 80c
deductions.

• Small amount

You can invest as small as 100 or multiples of 100.

• Interest rate

Currently the rate is 8%. P.A.

Previously it was 7.6% , revises every quarter.

• Maturity

5years & 10years

• Access

Can purchase from any post office & transfer to any Post Office.

• The Scheme specially designed for Government employees, Businessmen and other
salaried classes who are Income Tax assesses.

• No maximum limit for investment

• Certificates can be kept as collateral security to get loan, banks & NBFC’s accept NSC.

• Trust, NRI and HUF cannot invest.

• Fixed income, Rate of interest 8.0%.

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• Investor can nominate a family member (even a minor).

• Premature withdrawal is not possible however they accept it in the exceptional cases
(demise of investor)

4. Monthly income scheme certificate (MISPO):

• Account may be opened by individual.

• Account can be opened by cash / Cheque and in case of Cheque the date of realization of
Cheque shall be date of opening of account.

• Nomination facility is available at the time of opening and also after opening of account.

• Account can be transferred from one post office to another. Any number of accounts can
be opened in any post office, subject to maximum investment limit by adding balance in
all accounts. Can open more than one account.

• Account can be opened on behalf of a minor and a minor of 10 years and above age can
open and operate the account.

• Minor after attaining majority has to apply for conversion of the account in his name.

• Joint account can be opened by two or three adults. All joint account holders have equal
share in each joint account. Single account can be converted into Joint and Vice Versa.

• No TDS, To get tax benefits, you have to invest upto 1.5 Lakhs, to claim the benefits of
80c deductions.

• Resident of India can invest & NRI cannot enjoy this benefit.

• You can collect monthly income directly from PO, or transfer it to your Savings Account.
Can reinvest in same corpus for double benefit for another 5 years.

• 7.7% per annum payable monthly.5% as bonus on maturity.

• Maturity period is 5 years from 1.12.2011.

Amount investable:

• Single INR. 1500/-INR 4.5 lakh your monthly income will be 2888 annual is 34650 on
4.5 L.

• Joint INR. 1500/-INR 9 lakh 2 or 3 people.

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• For minor it cannot exceed 3lakhs.

How to open a POMIS

• open a PO savings account

• Collect POMIS appli form.

• submit, with copy of your ID, residential proof, 2 passport size photo.

Early withdrawal

• Before 1 year - zero benefits

• between 1 to 3yrs – 2% penalty

• between 3 to 5yrs - 1 % penalty.

5. Sukanya samriddhi scheme:

- Girl child savings account, which was launched in 2015, by 2017 more than 1.26 crore
accounts have been opened, amounting to 19,183.

New rules:

- Minimum amount to be deposited is 250 which was 1000 rs before, max-1,50,000.

- annual minimum deposit is also lowered to 250 from 1000. which was effective from
July 6, 2018.

- A legal Guardian/Natural Guardian can open account in the name of Girl Child.

- only one account in the name of one girl child and maximum two accounts in the name
of two different Girl children.

- Account can be closed after completion of 21 years

- Account can be opened up to age of 10 years only from the date of birth. For initial
operations of Scheme, one year grace has been given. With the grace, Girl child who is
born between 2.12.2003 & 1.12.2004 can open account up to 1.12.2015.

- Interest rate is revised every quarter, fetches an interest of 8.1% p/a.

- No TDS

- 15yrs term.

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- Partial withdrawal allowed, after the holder attaining the age of 18 to meet educational or
marriage expenses, the limit is 50%.

- Normal premature closure will be allowed for the marriage purpose , if she attains age of
18.

6. Senior citizen scheme:

• An individual of the age of 55 years or more but less than 60 years who has retired
under VRS can open account subject to the condition that the account is opened within
one month of receipt of retirement benefits and amount should not exceed the amount of
retirement benefits.

• HUF & NRI cant invest,

• Maturity period is 5 years. interest 8.46%

• A depositor may operate more than one account in individual capacity or jointly with
spouse (husband/wife).

• Joint account can be opened with spouse only and first depositor in Joint account will be
the investor.

• There shall be only one deposit in the account in multiple of INR.1000/- maximum not
exceeding INR 15 lakh. Individual or joint

• Can be opened by cash if its less than 1 lakh, if more its cheque.

• In case of Cheque, the date of realization of Cheque shall be date of opening of account.

• Nomination facility is available at the time of opening and also after opening of account.

• Account can be transferred from one post office to another

• Any number of accounts can be opened in any post office subject to maximum
investment limit by adding balance in all accounts.

• In case of SCSS accounts, quarterly interest shall be payable on 1st working day of April,
July, October and January. It will be applicable at all Post Offices.

• Quarterly interest of SCSS accounts standing @ Post offices can be credited in any
savings account standing at any other post offices.

• After maturity, the account can be extended for further three years within one year of the
maturity by giving application in prescribed format.

22
• In such cases, account can be closed at any time after expiry of one year of extension
without any deduction.

• Investment under this scheme qualifies for the benefit of Section 80C of the Income Tax
Act, 1961 from 1.4.2007.

7. Public Provident Fund Account

• Deposits can be made in lump-sum or in 12 installments

• Maturity period is 15 years but the same can be extended within one year of maturity for
further 5 years and so on.

• Premature closure is not allowed before 15 years.

• Interest is completely tax-free.

• Withdrawal is permissible every year from 7th financial year from the year of opening
account.

• Loan facility available from 3rd financial year.

• 8.0% per annum, Initial investment 100rs

8. Company Deposit

• deposit placed by investors with companies for a fixed term carrying a prescribed rate of
interest 8.0 to 12.5% (if term is more than 5 years 9.0%, senior citizen normal +0.25 %)
limited to 12.5%, 2-3% higher than normal bank rates. Penalties will be higher than bank
FD for premature withdrawal .

• types: cumulative & non-cumulative(half yearly or annually)

• minimum 5000 to 25000, maximum

• term is not less than 12 months & not more than 5 years as per RBI regulations.

• Financial institutions and Non-Banking Finance Companies (NBFCs) also accept such
deposits

• Deposits thus mobilized are governed by the Companies Act under Section 58A

• It is an unsecured investment.

• Company has to be compulsorily credit rated (NOF more than 200 lakhs

• No tax benefits.

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 • As of 5 June, 2019 ICICI pays highest 9.33%

1.11 Money market instrument

Debt instruments which have a maturity of less than one year at the limit of issue are called
money market instruments. These instruments are highly liquid and have negligible risk. The
major money market instruments are treasury bills, certificates of deposit, commercial paper, and
reports.

Treasury Bills
Treasury bills are the most important money market instruments. They represent the obligations
of the Government of India which have a primary tenor like 91 days and 364 days. They are sold
on an auction basis every week in certain minimum denominations by the Reserve Bank of India.
They do not carry an explicit interest rate (or coupon rate). Instead, they are sold at a discount
and redeemed at par. Hence the implicit yield of a Treasury Bills is a function of the size of the
discount and the period of maturity.

Certificates of Deposits
Certificates of deposits (CDs) represent short term deposits which are transferable from one
party to another. Banks and financial institutions are the major issuers of CDs. The principal
investors in CDs are banks, financial institutions, corporate and mutual funds. CDs are issued in
either bearer or registered form. They generally have a maturity of three months to one year. CDs
carry a certain interest rate.

CDs are a popular form of short-term investment for companies for the following reasons: (i)
Banks are normally willing to tailor the denominations and maturities to suit the needs of the
investors. (ii) CDs are generally risk-free. (ii) CDs generally offer a higher rate of interest than
Treasury bills or term deposits.

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Commercial Paper
A commercial paper represents short-term unsecured promissory note issued by firms that are
generally considered to be financially strong. A Commercial paper usually has a, maturity period
of 7 to 365 days. It is sold at a discount and redeemed at par. Hence the implicit rate is a function
of the size of discount and the period of maturity. Issued in denominations of 5 lakh or multiples
thereof. Maturity should not go beyond the date up to which the credit rating of the issuer is
valid.
Anyone can invest.

Commercial Bills
Commercial bill is a short-term, negotiable and self-liquidating instrument with minimum risk. It
enhances the liability to make payment within a fixed date when goods are bought on credit.
Bills of exchange are negotiable instruments drawn by the seller (drawer) on the buyer (drawee)
or the value of goods delivered to him. Such bills are called trade bills. When trade bills are
accepted by commercial banks, they are called commercial bills. The bank discounts this bill by
keeping a certain margin and credits the proceeds. Banks can also get such bills re-discounted by
financial institutions such as UTI, LIC, GIC, ICICI, etc. the maturity period of these bills varies
from 30 days, 60 days or 90 days, depending on the credit extended in the industry.

A commercial bill can be a:

i. Demand bill or a Usance bill,
ii. Clean bill or documentary bill;
iii. Inland bill or foreign bill.

1.12 Bonds or Fixed Income Securities

Bonds or debentures represent long-term debt instruments. The issuer of a bond promises to pay
a stipulated stream of cash flows. This generally comprises periodic interest payment over the
life of the instrument and principal payment at the time of redemptions(s).

Government Securities
Debt securities issued by the central government, state government, and quasi-government
agencies are referred to as government securities or gilt-edged securities.

Government securities have maturities ranging from 3-20 years and carry interest rates that
usually vary between 8 and 10 percent. Even though these securities carry some tax advantages,
they have traditionally not appealed to individual investors because of low rates of interest and
long maturities and somewhat illiquid retain markets. They are typically held by banks, financial
institutions, insurance companies, and provident funds mainly because of certain statutory
compulsions.

Savings Bonds
A popular instrument, RBI Saving Bonds has the following features:
 Individuals, HUFs, and NRIs can invest in these bonds.
 The minimum amount of investment is Rs 1,000. There is no upper limit.

25
  The maturity period is five years from the date of issue.
 There are two options: the cumulative option and the non-cumulative option.
 The interest rate is 7.75 percent per annum, payable half-yearly. Under the cumulative
option, 7 years tenure.
 Issued on Jan 10th.
 The interest earned is taxable. The bonds are exempt from wealth tax without any limit.
 The bonds are issued in the form of Bond Ledger Account or in the form of Promissory
Notes. Bond Ledger Account can be opened in the name of the investors at the receiving
offices (designated offices of banks) and at the Public Debt Offices of RBI. Bonds in the
form of Promissory Notes are issued only at RBI offices.
 The bonds are transferable. The Bond Ledger Account is transferable, wholly or in part,
by execution of a prescribed transfer deed. Promissory Notes are transferable by
endorsement and delivery.
 Nomination facility is available.
 The bonds can be offered as security to banks for availing loans.

Private Sector Debentures

Akin to promissory notes, debentures are instruments meant for raising long-term debt. The
obligation of a company towards its debentures holders is similar to that of a borrower who
promises to pay interest and principal at specified times.

The important features of debenture are as follows:

 When a debenture issue is sold to the investing public, a trustee is appointed through a
deed. The trustee is usually a bank or a financial institution. Entrusted with the role of
protecting the interest of debenture holders, the trustee is responsible for enquiring that
the borrowing firm fulfills its contractual obligations.
 Typically, debentures are secured by a charge on the immovable properties, both present
and future, of the company by way of an equitable mortgage.
 All debentures issued with a maturity period of more than 18 months must be necessarily
credit-rated. Further, for such debenture issues, a Debenture Redemption Reserve (DRR)
has to be created. The company should create a DRR equivalent to at least 50 percent of
the amount of issue before redemption commences.
 Previously the coupon rate (or interest rate) on debentures was subject to a ceiling fixed
by the Ministry of Finance. No such ceiling applies now. A company is free to choose the
coupon rate. Further, the rate may be fixed or floating. In the latter case it is periodically
determined in relation to some benchmark rate.
 Earlier the average redemption period for non-convertible debentures was about seven
years. Now there is no such restriction. A company has the freedom to choose the
redemption (maturity) period.

Public Sector Undertaking Bonds

Public Sector Undertaking (PSUs) issues debentures that are referred to as PSU bonds. There are
two broad varieties of PSU bonds: taxable bonds and tax-free bonds. While PSUs are free to set
the interest rates on taxable bonds, they cannot offer more than a certain interest rate on tax-free
bonds which is fixed by the Ministry of Finance. More important, a PSU can issue tax-free bonds
only with the prior approval of the Ministry of Finance.

26
In general, PSU bonds have the following investor-friendly features: (a) there is no deduction of
tax at source on the interest paid on these bonds, (b) they are transferable by mere endorsement
and deliver, (c) there is no stamp duty applicable on transfer, and (d) they are traded on the stock
exchanges. In addition, some institutions are ready to buy and sell these bonds with a small price
difference.

1.13 Preference Shares

Preference shares represent a hybrid security that exhibits some characteristics of equity shares
and some attributes of debentures.

The salient features of preference shares are as follows:

 Preference shares carry a fixed rate of dividend. Till recently, the maximum rate of
dividend payable on preference shares was 14 percent per annum. This has now been
relaxed.
 Preference dividend is payable only out of distributable profits. Hence, when there is
inadequacy of distributable profits, the question of paying preference dividend does not
arise.
 Dividend on preference shares is generally cumulative. Dividend skipped in one year has
to be paid subsequently before equity dividend can be paid.
 Preference shares are redeemable- the redemption period is usually 7 to 12 years.
Currently preference dividend is tax-exempt.

1.14 Equity Shares:

Equities are a type of security that represents the ownership in a company. Equities are traded
(bought and sold) in stock markets. Alternatively, they can be purchased via the Initial Public
Offering (IPO) route, i.e. directly from the company. Investing in equities is a good long-term
investment option as the returns on equities over a long time horizon are generally higher than
most other investment avenues. However, along with the possibility of greater returns comes
greater risk. Equity shares are classified into the following broad categories by stock market
analysts:

 Blue chip shares

Shares of large, financially strong and well – established companies which have stood up
against all odds and which have a good profitability and dividend track record are called
blue chip shares. The volumes of trading in these stocks are high and they enjoy any time
liquidity in the e xchange. HLL, ITC and Reliance are the example of such shares.
 Growth shares
These are the shares that have out-performed others in the industry. Shares of such
companies grow at a faster rate than others in terms of sales and profitability. Infosys,
Wipro and NIIT are the current example of growth shares. These shares may be fairly
priced or over priced as investors buy these fancied stocks on expectation of even further
growth. Sometimes the expected growth may not take place due to adverse internal and

27
 external factors, but generally these stocks give quick returns as compared to the value
stocks.
 Income shares
In a dual purpose fund, a share that is entitled to a portion of a firm's ordinary income is
referred as Income share. Dual purpose funds issue two types of shares: income shares
and capital shares, which are entitled to appreciation on the firm's investments
 Cyclical shares
These shares are in commodity companies and their prices depend on the cyclical
fluctuations of the economy. If they economy is doing well, they appreciate otherwise
their prices would fall. Cement, Steel and Petrochemical shares fall under this category.
 Speculative shares
These shares tend to fluctuate widely in short span of time on expectations of some major
deal in the parent company. For example, if market expects a foreign tie – up, a merger or
even an acquisition; the prices of these shares rise to dizzy heights but may fall equally
abruptly, if the expected turn of events do not takes place.
 Turn Around Shares
These are the shares of those companies which have large accumulated losses but which
show signs of recovery or making profits. At present, SAIL and Mafatlal Industries are
the examples of such shares.
 Defensive Shares
These stocks are generally neutral to business cycle. These have low fluctuations in their
prices and are fairly stable. If you expect a downtrend in the economy, it may be a good
idea to pick up a defensive stock, so that your portfolio value may not erode. At present,
FMCG and Pharma stocks fall into this category.

Rights of Equity Shareholders

As owners of the company, equity shareholders enjoy the following rights.
 Equity shareholders have residual claim to the income of the firm.
 Equity shareholders elect the board of directors and have the right the vote on every
resolution placed before the company.
 Equity shareholders enjoy the pre-emptive right which enables them to maintain their
proportional ownership by purchasing the additional equity shares issued by the firm.
As in the case of income, equity shareholders have a residual claim over the assets of the
company in the event of liquidation.

1.15 Mutual Funds:

Mutual funds offer various investment schemes to investors. UTI is the oldest and the largest
mutual fund in the country. Unit Scheme 1964, Unit Linked Insurance Plan 1971, Master Share,
Master Equity Plans, Master gain, etc. are some of the popular schemes of UTI. A number of

28
commercial banks and financial institutions have set up mutual funds. Recently mutual funds
have been set up in the private sector also

Instead of directly buying equity shares and/or fixed income instruments, you can participate in
various schemes floated by mutual funds which, in turn, invest in equity shares and fixed income
securities.

A mutual fund is made up of money that is pooled together by a large number of investors who
give their money to a fund manager to invest in a large portfolio of stocks and / or bonds

Mutual fund is a kind of trust that manages the pool of money collected from various investors
and it is managed by a team of professional fund managers (usually called an Asset Management
Company) for a small fee. The investments by the Mutual Funds are made in equities, bonds,
debentures, call money etc., depending on the terms of each scheme floated by the Fund. The
current value of such investments is now a day is calculated almost on daily basis and the same is
reflected in the Net Asset Value (NAV) declared by the funds from time to time. This NAV
keeps on changing with the changes in the equity and bond market. Therefore, the investments in
Mutual Funds is not risk free, but a good managed Fund can give you regular and higher returns
than when you can get from fixed deposits of a bank etc.

There are three broad types of mutual fund schemes:

 Equity schemes
 Debt schemes
 Balanced schemes

1.16 Life Insurance:

In a broad sense, life insurance may be viewed as an investment. Life insurance is a contract
between the policy holder and the insurer, where the insurer promises to pay a designated
beneficiary a sum of money (the "benefits") upon the death of the insured person. Depending on
the contract, other events such as terminal illness or critical illness may also trigger payment. In
return, the policy holder agrees to pay a stipulated amount (the "premium") at regular intervals or
in lump sums. The important types of insurance policies in India are:

 Endowment assurance policy

 Money back policy
 Whole life policy
 Term assurance policy

1.17 Real Estate:

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The most important asset for individual investors is generally a residential house. In addition to
this, the more affluent investors are likely to be interested in other types of the real estate, like
commercial property, agricultural land, semi-urban land, and time share in a holiday resort.

Residential House
A residential house represents an attractive investment proposition for the following reasons:
 The total return (rental savings plus capital appreciation) from a residential house is
satisfactory.
 Loans are available from various quarters for buying/constructing residential property.
 For wealth tax purpose, the value of a residential property is reckoned at its historical cost
and not at its present market price.
 Interest on loans taken for buying/constructing a residential house is tax-deductible
within certain limits.
 Ownership of a residential property provides psychological satisfaction.

Due to these advantages, a residential property (independent house or flat) represents the most
important part of the portfolio for the bulk of investors. Further, they may be interested in buying
some semi-urban land and/or a share in some holiday home project because they involve
relatively modest outlays.

Precious Objects:

Precious objects are items that are generally small in size but highly valuable in monetary terms.
Some important precious objects are:

 Gold and silver

 Precious stones
 Art objects

Gold

 The 'yellow metal' is a preferred investment option, particularly when markets are
volatile. Today, beyond physical gold, a number of products which derive their value
from the price of gold are available for investment. These include gold futures and gold
exchange traded funds.

1.18 Summary
 Financial investment is the allocation of money to assets that are expected to yield some
gain over a period of time. The various objectives of investment are increasing the rate of
return, reducing the risk, hedge against inflation, etc.
 The investment avenues available can be categorized into various types such as: Non-
marketable financial assets, equity shares, bonds, money market instruments, Mutual
funds, life insurance schemes, Precious objects and financial derivatives.
 The various attributes for evaluating an investment option are: Rate of return, Risk,
Marketability, Tax shelter and Convenience.

30
  An investor plans investment for a longer time horizon with moderate risk. A speculator
plans investment for a very short term with very high risk. Some of the factors
influencing investment decision are: Investment policy, objectives, knowledge, etc.
 The qualities for a successful investment are: Contrary thinking, Patience, Composure,
Flexibility and openness, Decisiveness.

1.19 Terminal Questions

Section A - 2 Marks Questions

1. What is meant by investment?
2. State the economic and financial meaning of investment
3. State two objectives of investment
4. Give the meaning of risk and return
5. What if difference between investment and speculation?
6. What are the investor’s objectives in investing his funds?

Section B – 5 Marks and 14 Marks Questions

1. What are the factors influencing investment decisions?
2. What is meant by investment? What are the qualities of a successful investment?
3. What are the objectives of investment? Discuss the various investment alternatives
available for an investor.

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 Module : 2

Fundamental Analysis

2.1 Economic Analysis- introduction and meaning

2.2 Economic forecasting-Forecasting techniques-Economic Indicators
2.3 Industry Analysis : Industry classification
2.4 Industry life cycle
2.5 Company Analysis meaning and Measuring Earnings
2.6 Forecasting Earnings
2.7 Applied Valuation Techniques
2.8 Graham and Dodds investor ratios
2.9 Porter’s five force model
2.10 Summary

Learning Objectives:

 To understand the basic concept of fundamental analysis and its factors

 To understand the meaning and factors of Economic analysis
 To understand the meaning and factors of Industry analysis
 To learn the various stages of industry life cycle.

FUNDAMENTAL ANALYSIS

Fundamental analysis is used to determine the intrinsic value of the share by examining the
underlying forces that affect the well-being of the economy, Industry groups and companies.
Fundamental analysis is to first analyse the economy, then the Industry and finally individual
companies. This is called as top down approach.

 The actual value of a security, as opposed to its market price or book value is called
intrinsic value. The intrinsic value includes other variables such as brand name,
trademarks, and copyrights that are often difficult to calculate and sometimes not
accurately reflected in the market price. One way to look at it is that the market
capitalization is the price (i.e. what investors are willing to pay for the company and
intrinsic value is the value (i.e. what the company is really worth).

32
 Top-Down Approach of Fundamental Analysis
 At the economy level, fundamental analysis focus on economic data (such as GDP,
Foreign exchange and Inflation etc.) to assess the present and future growth of the
economy.
 At the industry level, fundamental analysis examines the supply and demand forces for
the products offered.
 At the company level, fundamental analysis examines the financial data (such as balance
sheet, income statement and cash flow statement etc.), management, business concept
and competition.

2.1 ECONOMIC ANALYSIS

Economic analysis occupies the first place in the financial analysis top down approach. When the
economy is having sustainable growth, then the industry group (Sectors) and companies will get
benefit and grow faster. The analysis of macroeconomic environment is essential to understand
the behaviour of the stock prices.

The analysis of macroeconomic factors are as follows:

a. Gross domestic product (GDP): GDP indicates the rate of growth of the economy. GDP
represents the aggregate value of the goods and services produced in the economy. GDP consists
of personal consumption expenditure, gross private domestic investment and government

33
expenditure on goods and services and net export of goods and services. The estimates GDP are
available on an annual basis.

b. Savings and investment: It is obvious that growth required investment which in turn requires
substantial amount of domestic savings. Stock market is a channel through which the savings of
the investors are made available to the corporate bodies. Savings are distributed over various
assets like equity shares, deposits, mutual fund units, real estate and bullion. The saving and
investment patterns of the public affect the stock to a great extent.

c. Inflation: A long with the growth of GDP, if the inflation rate also increases, then the real rate
of growth would be very little. The demand in the consumer product industry is significantly
affected. The industries which come under the government price control policy may lose the
market, for example Sugar. The government control over this industry, affects the price of the
sugar and thereby the profitability of the industry itself.

d. Interest rates: The interest affects the cost of financing to the firms. A decrease in interest
rate implies lower cost of finance for firms and more profitability. More money is available at a
lower interest rate for the brokers who are doing business with borrowed money. Availability of
cheap fund encourages speculation and rise in the price of shares.

e. Budget: The budget draft provides an elaborate account of the government revenues and
expenditures. A deficit budget may lead to high rate of inflation and adversely affect the cost of
production. Surplus budget may result in deflation. Hence, balanced budget is highly favourable
to the stock market.

f. The tax structure: Every year in March, the business community eagerly awaits the
Government’s announcement regarding the tax policy. Concessions and incentives given to a
certain industry encourage savings. The Minimum Alternative Tax (MAT) levied by the Finance
Minister in 1996 adversely affected the stock market.

g. The balance of payment: The balance of payment is the record of a country’s money receipts
from and payments abroad. The difference between receipts and payments may be surplus or
deficit. Balance of payment is a measure of the strength of rupee on external account. If the
deficit increase, the rupee may depreciate against other currencies, thereby, affecting the cost of
imports.

h. Monsoon and agriculture: Agriculture is directly and indirectly linked with the industries.
For example, Sugar, Cotton, Textile and Food processing industries depend upon agriculture for
raw-material. Fertilizer and insecticide industries are supplying inputs to the agriculture. A good
monsoon leads to higher demand for impute and result in bumper crop. This would lead to
buoyancy in the stock market. When the monsoon is bad, agricultural and hydel power
production would suffer. They cast a shadow on the share market.

34
i. Infrastructure facilities Infrastructure facilities are essential for the growth of industrial and
agricultural sector. A wise network of communication system is a must for the growth of the
economy. Regular supply of power without any power cut would boost the production. Banking
and financial sectors also should be sound enough to provide adequate support to the industry
and agriculture. Good infrastructure facilities affect the stock market favourably. In India even
though infrastructure facilities have been developed, still they are not adequate.

j. Demographic factors The demographic data provides details about the population by age,
occupation, literacy and geographic location. This is needed to forecast the demand for the
consumer goods. The population by age indicates the availability of able work force. The cheap
labour force in India has encouraged many multinationals to start their ventures. Indian labour is
cheaper compared to the Western labour force. Population, by providing labour and demand of
products, affects the industry and stock market.

2.2 ECONOMIC FORECASTING:

The common techniques used are analysis of key economic indicators, diffusion index, surveys
and econometric model building. These techniques help him to decide the right time to incest and
the type of security he has to purchase i.e. stocks or bonds or some combination of stocks and
bonds.

2.2.1 ECONOMIC INDICATORS

The economic indicators are statistics about the economy that indicate the present status,
progress or slow-down of the economy. They are capital investment, business profits, money
supply, GNP, interest rate, unemployment rate, etc. The economic indicators are grouped into
leading, coincidental and lagging indicators. The indicators are selected on the following criteria

 Economic significance
 Statistical adequacy
 Timing
 Conformity

The leading indicators:

The leading indicators indicate what is going to happen in the economy. It helps the investor to
predict the path of the economy. The popular leading indicators are the fiscal policy, monetary
policy, productivity, rainfall, capital investment and the stock indices. The fiscal policy shows
what the government aims at and the fiscal deficit or surplus has an effect on the economy.

The coincidental indicators:

The coincidental indicators indicate what the economy is. The coincidental indicators are gross
national product, industrial production, interest rates and reserve funds. GDP is the aggregate

35
amount of goods and services produced in the national economy. The gap between the budgeted
GDP and the actual GDP attained indicates the present situation. If there is a large gap between
the actual growth and potential growth, the economy is slowing down. Low corporate profits and
industrial production show that the economy is hit by recession.

The lagging indicators:

The changes that are occurring in the leading and coincidental indicators are reflected in the
lagging indicators. Lagging indicators are identified as unemployment rate, consumer price index
and flow of foreign funds. These leading, coincidental and lagging indicators provide an insight
into the economy s current and future position.

DIFFUSION INDEX

Diffusion index is a composite or consensus index. The diffusion index consists of leading,
coincidental and lagging indicators. This type of index has been constructed by the National
Bureau of Economic Research in USA. But the diffusion index is complex in nature to calculate
and the irregular movements that occur in individual indicators cannot be completely eliminated.

2.2.2 FORECASTING TECHNIQUES

1. Anticipatory surveys:

 Expert Opinion
o Delphi Technique: A systematic forecasting method that involves structured
interaction among a group of experts on a subject
 Cross-Impact Analysis: Analysis of high importance and high probability
 Multiple scenario: building of pictures of alternative futures.
2. Trend Analysis method: based on time series

 Trend Extrapolation: analyse and fit time series data( Linear quadratic or s shaped growth
curves)
 Trend correlation: It also know as barometric or indicator approach.
o Leading Indicators: To know the economic direction in advance eg., rainfall
o Coincidental Indicators: Economic factors reaching approximately at the same
time as the economy. Ex: GNP, Interest rates
o Lagging Indicators: Economic factors reaching their peaks or troughs after the
economy has already reached its own. Ex: Unemployment and inventory debtors.

3. Diffusion Indexes: It is an indicator of spread of an expansion.

 Composite or consensus Index: It combines several indictors into one single measure. Eg:
Diffusion Index: No of members in the set in the same direction / Total no of members in
the set

36
  Component Evaluation Index: It measures the breadth of the movement within a
particular series.

4. Monetary Indicators: Deals with money supply, corporate profits, interest rates and stock
prices sprinkle observed.

5. Econometric Model: It explains past economic activity by deriving mathematical equation.

Eg., Disposable Income Inventories.

6. Opportunistic model:

 Hypothesis of total demand: Deals with environmental decisions as war or peace

 Test of consistency and comparison: Measure the internal consistency and comparing
with other projections.

2.3 Industry Analysis:

An industry is a group of firms that have similar technological structure of production and
produce similar products. For the convenience of the investors, the broad classification of the
industry is given in financial dailies and magazines. Companies are distinctly classified to give a
clear picture about their manufacturing process and products. The table 12.4 gives the industry
wise classification given in Reserve Bank of India Bulletin.

Table 12.4 Industry Groups

S. No Industries
1 Food products
2 Beverages, Tobacco and Tobacco products
3 Textiles
4 Wood and wood products
5 Leather and leather products
6 Rubber and plastic products
7 Chemical and chemical products
8 Non-metallic mineral products
9 Basic metals, Alloys and metal products
10 Machinery and Machine tools
11 Transport equipment and parts
12 Other Miscellaneous manufacturing industries

The table 12.4 shows that each industry is different from the other. Textile industry is entirely
different from the steel industry or the power industry in its product and process.

These industries can be classified on the basis cycle i.e. classified according to their reactions to
the different phases of the business cycle.

They are classified into growth, cyclical, defensive and cyclical growth industry.

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 Industry

Growth Cyclical Defensive Cyclical Growth

a. Growth industry: The growth industries have special feature of high rate of earning and
growth in expansion, independent of the business cycle. The expansion of the industry mainly
depends on the technology logical change. For instance, inspite of the recession in the Indian
economy in 1997-98, there was spurt in the growth of information technology industry. It defied
the business cycle and continued to grow. Likewise in every phase of the history certain
industries like colour televisions, pharmaceutical and telecommunication industries have shown
remarkable growth.

b. Cyclical Industry: The growth and the profitability of the industry move along with the
business cycle. During the boom period they enjoy growth and during depression they suffer a
set-back. For example, the white goods like fridge, washing machine and kitchen range products
command a good market in the boom period and the demand for them slackens during the
recession.

c. Defensive Industry: Defensive industry defies the movement of the business cycle. For
example, food and shelter are the basic requirements of humanity. The good industry withstands
recession and depression. The stocks of the defensive industries can be held by the investor for
income earning purpose. They expand and earn income in the depression period too, under the
government’s umbrella of protection and are counter cyclical in nature.

d. Cyclical growth industry: This is a new type of industry that is cyclical and at the same time
growing. For example, the automobile industry experience periods of stagnation, decline but they
grow tremendously. The changes in technology and introduction of new model help the
automobile industry to resume their growth path.

2.4 INDUSTRY LIFE CYCLE

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 Industry life cycle:

The industry life cycle theory is generally attributed to Julius Grodensky. The life cycle of the
industry is separated into four well defined stages such as

 Pioneering stage
 Rapid growth stage
 Maturity and stabilization stage
 Declining stage
a. Pioneering stage: The prospective demand for the product is promising in this stage and the
technology of the product is low. The demand for the product attracts many producers to produce
the particular product. There would be severe competition and only fittest companies survive this
state. The producers try to develop brand name, differentiate the product and create a product
image. This would lead to non-price competition too. The serve competition often leads to the
change of position of the firms in term of market shares and profit. In this situation, it is difficult
to select companies for investment because the survival rate in unknown.

b. Rapid growth stage: This stage starts with the appearance of surviving firms from the
pioneering stage. The companies that have withstood the competition grow strongly in market
share and financial performance. The technology of the production would have improved
resulting ion low cost of production and good quality products. The companies have stable
growth rate in this stage and they declare dividend to the shareholders. It is advisable to invest in
the shares of these companies. The pharmaceutical industry has improved its technology and the
top companies in this sector are giving dividend to the shareholders. Likewise power industry
and telecommunication industry can be cited as example of expansion state. In this stage the
growth rate is more than the industry’s average growth rate.

c. Maturity and stabilization stage: In the stabilization stage, the growth rate tends to moderate
and the rate of growth would be more or less equal to the industrial growth rate or the gross
domestic product growth rate. Symptoms of obsolescence may appear in the technology. To keep
going, technological innovation in the production process and products should be introduced.
The investors have to closely monitor the events that take place in the maturity stage of the
industry.

39
d. Declining Stage: In this stage, demand for the particular products and the earning of the
companies in the industry decline. Now-a-days very few consumers demand black and white
T.V. Innovation of new products and changes in consumer preferences lead to this state. The
specific feature of the declining stage is that even in the boom period, the growth of the industry
would be low and decline at a higher rate during the recession. It is better to avoid investing in
the shares of the low growth industry even in the boom period. Investment in the shares of these
types of companies leads to erosion of capital.

2.5 Company Analysis:

In the company analysis the investor assimilates the several bits of information related to the
company and evaluates the present and future values of the stock. The risk and return associated
with the purchase of the stock is analysed to take better investment decision. The valuation
process depends upon the investors’ ability to elicit information from the relationship and inter-
relationship among the company related variables. The present and future values are affected by
a number of factors and they are given in Fig. 12.1

2.5.1 Factors affecting values of the company:

1. The competitive edge of the company: Major industries in India are composed of hundreds
of individual companies. In the information technology industry even though the number of
companies is large few companies like Infosys/Cognizant/Wipro control the major market share.
Like-wise in all industries, some companies rise to the position of eminence and dominance. The
large companies are successful in meeting the competition. Once the companies obtain the
leadership position in the market, they seldom lose it. Over the time they would have proved
their ability to withstand competition and to have sizeable share in the market. The
competitiveness of the company can be studied with the help of

 The market share

 The growth of annual sales
 The stability of annual sales

a. The market share: The market share of the annual sales helps to determine a company’s
relative competitive position within the industry. If the market share is high, the company would
be able to meet the competition successfully. In the information technology industry, NIIT and
Tata InfoTech topped the list in terms of sales in 1997. While analyzing the market share, the
size of the company also should be considered because the smaller companies may find it
difficult to survive in the future. The leading companies of today’s market will continue to lead
at least in the near future. The companies in the market should be compared with like product
groups otherwise, the results will be misleading. A software company should be compared with
other software companies to select the best in that industry.

40
b. Growth of Sales: The Company may be a leading company, but if the growth in sales is
comparatively lower than another company, it indicates the possibility of the company losing the
leadership. The rapid growth in sales would keep the shareholder in a better position than one
with the stagnant growth rate. The company of large size with inadequate growth in sales will
not be preferred by the investors. Growth in sales company of large size with inadequate growth
in sales will not be preferred by the investors. Growth in sales is usually followed by the growth
in profits. Investor generally prefers size and the growth in sales because the large size
companies may be able to withstand the business cycle rather than the company of smaller size.

The growth in sales of the company is analysed both in rupee terms and in physical terms.
Physical term is very essential because it shows the growth in real terms. The rupee term is
affected by the inflation. Companies with diversified sales are compared in rupee terms and
percentage of growth over time.

2.5.2 Measuring earning/Forecasting Earning:

Sales alone do not increase the earning but the costs and expenses of the company also influence
the earning of the company. Further, earnings do not always increase with the increase in sales.
The company’s sales might have increased but its earnings per share may decline due to the rise
in costs. The rate of change in earning differs from the rate of change of sales. Sales may
increase by 10% in a company but earning per share may increase only by 5%. Even though
there is a relationship between sales and earnings, it is not a perfect one. Sometimes, the volume
of sales may decline but the earnings may improve due to the rise in the unit price of the article.
Hence, the investor should not depend only on the sales, but should analyse the earning of the
company.

Capital Structure: The equity holders’ return can be increased manifold with the help of
financial leverage, i.e. using debt financing along with equity financing. The effect of financial
leverage is measured by computing leverage ratios. The debt ratio indicates the position of the
long term and short term debts in the company finance. The debt may be in the form of
debentures and term loans from financial institutions.

Preference Shares: In the early days the preference share capital was never a significant source
of capital. At present, many companies resort to preference shares. The preference shares induct
some degree of leverage in finance. The leverage effect of the preference shares is comparatively
lesser than the debt because the preference share dividends are not tax deductible.

Debt: Long term debt is an important source of finance. It has the specific benefit of low cost of
capital because interest is tax deductible. The leverage effect of debt is highly advantageous to
the equity holders.

Management: Good and capable management generates profit to the investors. The
management of the firm should efficiently plan, organize, actuate and control the activities of the
company. The basic objective of management is to attain the stated objectives of company for
the good of the equity holders, the public and the employees. If the objectives of the company

41
are achieved, investors will have a profit. A management that ignores profit does more harm to
the investors than one that over emphasises it.

Operating efficiency: The operating efficiency of a company directly affects the earning of
company. An expanding company that maintains high operating efficiency with a low break-
even point earns more than the company with high break-even point. If a firm has stable
operating ratio, the revenues also would be stable. Efficient use of fixed assets with raw
materials, labour and management would lead to more income from sales. This leads to internal
fund generation for the expansion of the firm.

Operating leverage: If the firm’s fixed cost is high in the total cost the firm is high in the total
cost the firm is said to have a high degree of operating leverage. Leverage means the use of a
lever to raise a heavy object with a small force. High degree of operating leverage implies, other
factors being held constant, a relatively small change in sale result in a large change in return on
equity.

2.5.3 Tools:

a. Income statement

It gives past records of the firm that forms a base for making predictions of the firm.

b. Balance sheet

It shows the assets and liabilities of a firm along with shareholder s equity

c. Statement of Cash flows

It shows how a company's cash balance changed from one year to the next

d. Ratio Analysis

It makes intra firm and inter firm comparisons.

1. Profitability Ratios:

a. Return on Investment:

Earnings before interest and taxes / Total Assets

b. Leverage Ratios:

Debt Equity Ratio=Total Debt / Equity

c. ROE Analysis

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ROE= PBT * PAT* NS* TA
___ ____ ___ ___
NS PBT TA NW

Non-Financial Indicators:

1. Business of the company

2. Top Management

3. Product range

4. Diversification

5. Foreign collaboration

6. Availability of cost of inputs

7. Research and development

8. Governmental regulations

9. Pattern of shareholding and listing

2.6 Forecasting Earnings

1. Identification of variables:

a. Operations and Earnings - Operating cycle of a firm starts with cash converted into inventory

ROI= EBIT / Investment

b. Financing& Earnings

 Debt financing: Provide leverage to common share holders

 Equity financing: Equal shares

2. Selecting a Forecasting method:

a. Traditional method

 Earnings model: Analysis EAT & EBT

 Market share: Consists of tracking historical record and net income
 Projected Financial statements: Projection of earnings

43
b. Modern methods:

 Regression analysis – It is the measure of the average relationship between two or more
variable in terms of the original units of the data
 Correlation analysis - It is to reduce the range of uncertainty of our prediction
 Trend analysis - It refers to collecting information and attempting to spot a pattern
 Decision trees - It used to forecast earnings as security values.

2.7 APPLIED VALUATION TECHNIQUES:

Although the raw data of the Financial Statement has some useful information, much more can
be understood about the value of a stock by applying a variety of tools to the financial data.

1. Earnings per Share EPS

2. Price to Earnings Ratio P/E
3. Projected Earnings Growth PEG
4. Price to Sales P/S
5. Price to Book P/B
6. Dividend Payout Ratio
7. Dividend Yield
8. Book Value per share
9. Return on Equity

1. Earnings per Share

The overall earnings of a company is not in itself a useful indicator of a stock's worth. Low
earnings coupled with low outstanding shares can be more valuable than high earnings with a
high number of outstanding shares. Earnings per share is much more useful information than
earnings by itself. Earnings per share (EPS) is calculated by dividing the net earnings by the
number of outstanding shares.

EPS = Net Earnings / Outstanding Shares

For example: ABC company had net earnings of $1 million and 100,000 outstanding shares for
an EPS of 10 (1,000,000 / 100,000 = 10). This information is useful for comparing two
companies in a certain industry but should not be the deciding factor when choosing stocks.

2.Price to Earnings Ratio

The Price to Earnings Ratio (P/E) shows the relationship between stock price and company
earnings. It is calculated by dividing the share price by the Earnings per Share.

P/E = Stock Price / EPS

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In our example above of ABC company the EPS is 10 so if it has a price per share of $50 the P/E
is 5 (50 / 10 = 5). The P/E tells you how many investors are willing to pay for that particular
company's earnings. P/E's can be read in a variety of ways. A high P/E could mean that the
company is overpriced or it could mean that investors expect the company to continue to grow
and generate profits. A low P/E could mean that investors are wary of the company or it could
indicate a company that most investors have overlooked.

Either way, further analysis is needed to determine the true value of a particular stock.

3. Projected Earnings Growth Rate-PEG Ratio

A ratio used to determine a stock's value while taking into account earnings growth. The
calculation is as follows:

PEG Ratio = Price-Earning Ratio / Annual EPS Growth

PEG is a widely used indicator of a stock's potential value. It is favoured by many over the
price/earnings ratio because it also accounts for growth. Similar to the P/E ratio, a lower PEG
means that the stock is more undervalued.

4. Price to Sales Ratio

When a company has no earnings, there are other tools available to help investors judge its
worth. New companies in particular often have no earnings, but that does not mean they are bad
investments. The Price to Sales ratio (P/S) is a useful tool for judging new companies. It is
calculated by dividing the market cap (stock price times number of outstanding shares) by total
revenues. An alternate method is to divide current share price by sales per share. P/S indicates
the value the market places on sales. The lower the P/S the better the value.

5.Price to Book Ratio

Book value is determined by subtracting liabilities from assets. The value of a growing company
will always be more than book value because of the potential for future revenue. The price to
book ratio (P/B) is the value the market places on the book value of the company. It is calculated
by dividing the current price per share by the book value per share (book value / number of
outstanding shares). It is also known as the "price-equity ratio".

45
P/B = Share Price / Book Value per Share

6. Dividend Yield

Some investors are looking for stocks that can maximize dividend income. Dividend yield is
useful for determining the percentage return a company pays in the form of dividends. It is
calculated by dividing the annual dividend per share by the stock's price per share. Usually it is
the older, well-established companies that pay a higher percentage, and these companies also
usually have a more consistent dividend history than younger companies. Dividend yield is
calculated as follows:

7. Dividend payout ratio

Dividend payout ratio is the fraction of net income a firm pays to its stockholders in dividends:

The part of the earnings not paid to investors is left for investment to provide for future earnings
growth. Investors seeking high current income and limited capital growth prefer companies with
high Dividend payout ratio. However investors seeking capital growth may prefer lower payout
ratio because capital gains are taxed at a lower rate. High growth firms in early life generally
have low or zero payout ratios. As they mature, they tend to return more of the earnings back to
investors. Note that dividend payout ratio is calculated as EPS/DPS. Calculated as:

46
The payout ratio provides an idea of how well earnings support the dividend payments. More
mature companies tend to have a higher payout ratio. In the U.K. there is a similar ratio, which is
known as dividend cover. It is calculated as earnings per share divided by dividends per share.

8. Return on Equity

Return on equity (ROE) is a measure of how much, in earnings a company generates in a time
period compared to its shareholders' equity. It is typically calculated on a full-year basis (either
the last fiscal year or the last four quarters). Expanded Definition When capital is tied up in a
business, the owners of the capital want to see a good return on that capital. Looking at profit by
itself is meaningless. I mean, if a company earns $1 million in net income, that's okay. But its
great if the capital invested to earn that is only $2.5 million (40% return) and terrible if the
capital invested is $25 million (4% return). Return on investment measures how profitable the
company is for the owner of the investment. In this case, return on equity measures how
profitable the company is for the equity owners, a.k.a. the shareholders.

The "average" is taken over the time period being calculated and is equal to "the sum of the
beginning equity balance and the ending equity balance, divided by two."

9.Book Value per Share

A measure used by owners of common shares in a firm to determine the level of safety
associated with each individual share after all debts are paid accordingly.

Should the company decide to dissolve, the book value per common indicates the dollar value
remaining for common shareholders after all assets are liquidated and all debtors are paid. In
simple terms it would be the amount of money that a holder of a common share would get if a
company were to liquidate.

2.8 Grahm and Dodds Investor ratios:

The strategy of selecting stocks that trade for less than their intrinsic values. Value investors
actively seek stocks that are undervalued by the market. Typically, value investors select stocks
with lower-than-average price-to-book or price-to- earnings ratios and/or high dividend yields.

47
The Price to Earnings Ratio (PE ratio) is the primary valuation ratio used by most equity
investors. It is a measure of the price paid for a share relative to the annual net income or profit
earned by the firm per share. The Graham & Dodds price-to-earnings ratio, commonly known as
CAPE or Shiller P/E, is a valuation measure usually applied to stocks or equity markets. It is
defined as price divided by the average of ten years of earnings.

Compare prices with average earnings across multiple years (taking into account inflation) to
derive a cyclically-adjusted P/E ratio (also known as CAPE).

Value of a share is determined by its present value of its future income. Focus on: Operations,
Financing and Earnings Models based on : Earnings model [RoI] and Market share Modern
Methods: Applied valuation Techniques – Regression and Correlation analysis, Trend analysis,
Decision Trees

2.9 Porter’s five forces model:

→ Porter's Five Forces is a model of analysis that helps to explain why different industries are
able to sustain different levels of profitability. This model was originally published in
Porter's book, "Competitive Strategy: Techniques for Analyzing Industries and Competitors"
in 1980. The model is widely used, worldwide, to analyze the industry structure of a
company as well as its corporate strategy. Porter identified five undeniable forces that play a
part in shaping every market and industry in the world. The forces are frequently used to
measure competition intensity, attractiveness and profitability of an industry or market.
→ Competition in the Industry
→ The importance of this force is the number of competitors and their ability to threaten a
company. The larger the number of competitors, along with the number of equivalent
products and services they offer, dictates the power of a company. Suppliers and buyers seek
out a company's competition if they are unable to receive a suitable deal.
→ Potential of New Entrants Into an Industry
→ A company's power is also affected by the force of new entrants into its market. The less
money and time it costs for a competitor to enter a company's market and be an effective
competitor, the more a company's position may be significantly weakened.
→ Power of Suppliers
→ This force addresses how easily suppliers can drive up the price of goods and services. It is
affected by the number of suppliers of key aspects of a good or service, how unique these
aspects are and how much it would cost a company to switch from one supplier to another.
The fewer number of suppliers, and the more a company depends upon a supplier, the more
power a supplier holds.
→ Power of Customers
→ This specifically deals with the ability customers have to drive prices down. It is affected by
how many buyers, or customers, a company has, how significant each customer is and how
much it would cost a customer to switch from one company to another. The smaller and more
powerful a client base, the more power it holds.
→ Threat of Substitutes

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→ Competitor substitutions that can be used in place of a company's products or services pose a
threat. For example, if customers rely on a company to provide a tool or service that can be
substituted with another tool or service or by performing the task manually, and this
substitution is fairly easy and of low cost, a company's power can be weakened.

2.12 Summary:

 The intrinsic value of any equity share depends on a multimedia of factors. The earning
of the company, the growth rate and the risk exposure of the company has a direct
bearing on the price of the share.
 The fundamental school of thought appraised the intrinsic value of shares through
Economic Analysis, Industry Analysis and Company Analysis.

 The factors of macro-economic analysis are: GDP, Savings and investment, inflation,
interest rate, budget, demographic factors, etc. The economic indicators are selected on
the basis of some criteria such as Economic significance, Statistical adequacy, Timing
and Conformity.

 An industry is a group of firms that have similar technological structure of production

and produce similar products. For the convenience of the investors, the broad
classification of the industry is given in financial dailies and magazines. Industry can be
classified into growth, cyclical, defensive and cyclical growth industry.

 Various stages of Industrial life cycle are: Pioneering stage, Rapid growth stage, Maturity
and stabilization stage and declining stage.

 In the company analysis the investor assimilates the several bits of information related to
the company and evaluates the present and future values of the stock. Factors affecting
values of a company are the competitive edge of the company, etc.

Terminal Questions:

Section A – 2 Marks Questions

1. What is meant by fundamental analysis?
2. What are the economic indicators of the economy?
3. What is meant by Diffusion Index?
4. What are the four stages of Industry Life Cycle?
5. What is meant by Company Analysis?
6. What is economic forecasting? Discuss the various forecasting techniques.
7. Industry Lifecycle exhibits the status of Industry and gives the clue to entry and exit for
investors: Elucidate
8. What is meant by Financial Analysis?

Section B – 5 Marks & 14 Marks Questions

49
 1. What is meant by Economic Analysis? Discuss the commonly analyzed macro-economic
factors.
2. What is meant by industry Analysis? Explain the industry classification on basis of
Business Cycle.
What is meant by Company analysis? Explain are the various factors that affect present and
future values of the company.

Reference:
1. Donald E.Fischer & Ronald J.Jordan, Security Analysis & Portfolio Management, PHI
Learning / Pearson Education., New Delhi, 6th edition, 2008.
2. Prasannachandra, Investment analysis and Portfolio Management, Tata McGraw Hill, 2008.
3. Reilly & Brown, Investment Analysis and Portfolio Management, Cengage Learning, 8th
edition, 2008.
4. S. Kevin, Securities Analysis and Portfolio Management, PHI Learning, 2008.
5. Bodi, Kane, Markus, Mohanty, Investments, 6th edition, Tata McGraw Hill, 2007.
6. V.A.Avadhan, Securities Analysis and Portfolio Management, Himalaya Publishing House,
2008.
7. V.K.Bhalla, Investment Management, S.Chand & Company Ltd., 2008.

50
 Module : 3

TECHNICAL ANALYSIS

3.1 Introduction-assumption- Fundamental Analysis v/s Technical Analysis

3.2 Technical tools- Dow theory
3.3 Technical tools
3.4 Market Indicators
3.5 Oscillators
3.6 Chart and types of chart
3.7 Candle stick
3.8 Chart patters
3.9 Efficient Market theory (Random walk theory)
3.10 Efficient Market theory essence

3.1 Technical analysis and fundamental analysis:

1. Fundamental analysts analyses the stock based on the specific goals of the investors. They
study the financial strength of corporate, growth of sales, earning and profitability. They also
take into account the general industry and economic conditions.
The technical analysts mainly focus the attention on the past history of prices. Generally
technical analysts choose to study two basic market data-price and volume.

2. The fundamental analysts estimate the intrinsic value of the shares and purchase them when
they are undervalued. They dispose the shares when they are overpriced and earn profits.
They try to find out the long term value of shares.
Compared to fundamental analysts, technical analysts mainly predict the short term price
movement rather than long term movement. They are not committed to buy and hold policy
3. Fundamentalists are of the opinion that supply and demand for stocks depend on the
underlying factors. The forecasts of supply and demand depend on various factors.
Technicians opine that they can forecast supply and demand by studying the prices and
volume of trading.

In both the approaches supply and demand factors are considered to be critical. Business,
economic, social and political concern affects the supply and demand for securities. These
underlying factors in the form of supply and demand come together in the securities’ market to
determine security prices.

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Fundamental analysis v/s technical analysis:

The share price movement is analysed broadly with two approaches, namely, fundamental
approach and the technical approach. Fundamental approach analyses the share prices on the
basis of economic, industry and company statistics. If the price of the share is lower than its
intrinsic value, investor buys it. But, if he finds the price of the share higher than the intrinsic
value he sells and gets profit. The technical analyst mainly studies the stock price movement of
the security market. If there is an uptrend in the price movement investor may purchase the scrip.
With the onset of fall in price he may sell it and move from the scrip. Basically, technical
analysts and the fundamental analysts aim at good return on investment.

Technical analysis:

It is a process of identifying trend reversals at an earlier stage to formulate the buying and selling
strategy. With the help of several indicators they analyse the relationship between price-volume
and supply-demand for the overall market and the individual stock.

Assumptions:

1) The market value of the scrip is determined by the interaction of supply and demand.

2) The market discounts everything. The price of the security quoted represents the hopes,
fears and inside information received by the market players. Inside information regarding
the issuing of bonus shares, and right issues may support the prices. The loss of earning
and information regarding the forthcoming labour problem may result in fall in price.
These factors may cause a shift in demand and supply, changing the direction of trends.

3) The market always moves in trend. Except for minor deviations, the stock prices move in
trends. The price may create definite patterns too. The trend may be either increasing or
decreasing. The trend continues for some time and then it reverses.

4) Any layman knows the fact that history repeats itself. It is true to the stock market also.
In the rising market investors’ psychology has up beats and they purchase the shares in
greater volumes, driving the prices higher. At the same time, in the down trend they may
be very eager to get out of the market by selling them and thus plunging the share price
further. The market technicians assume that past prices predict the future.

3.2 Technical tools: Dow Theory

3.3 Technical tools:

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Generally used technical tools are, Trend, trend reversal, Primary trend volume of trading, short
selling, odd lot trading, bars and line charts, moving averages and oscillators. In this section
some of the above mentioned tools are analysed.

Trend:

Trend is the direction of movement. The share prices can either increase or fall or remain flat.
The three directions of the share price movements are called as rising, falling and flat trends.
The point to be remembered is that share prices do not rise or fall in a straight line. Every rise or
fall in price experience a counter move. If a share price is increasing, the counter move will be a
fall in price and vice-versa. The share prices move in zigzag manner.

The trend lines are straight lines drawn connecting either the tops or bottoms of the share price
movement. To draw a trend line, the technical analyst should have at least two tops or bottoms.

Trend reversal:

The rise or fall in share price cannot go on forever. The share price movement may reverse its
direction. Before the change of direction, certain pattern in price movement emerges the change
in the direction of the trend is shown by violation of the trend line. Violation of the trend line
means the penetration of the trend line. If a scrip price cuts the rising trend line from above, it is
a violation of trend line and signals the possibility of fall in price. Like-wise if the scrip pierces
the trend line from below, this signals the rise in price.

Primary trend:

The security price trend may be either increasing or decreasing. When the market exhibits the
increasing trend, it is called bull market. The bull market shows three clear-cut peaks. Each
peak is higher than the previous peak; the bottoms are also higher than the previous bottoms.
The phases leading to the three peaks are revival, improvement in corporate profit and
speculation. The revival period encourages more and more investors to buy scrips, their
expectations about the future being high. In the second phase, increased profits of corporate
would result in further price rise. In the third phase, prices advance due to inflation and
speculation. The below figure shows three phases of bull market.

53
The reverse is true with the bear market. Here, the first phase of fall starts with the abandonment
of hopes. The chances of prices moving back to the previous high level seemed to be low. This
would result in the sale of shares. In the second phase, companies are reporting lower profits
and dividends. This would lead to selling pressure. The final phase is characterized by the
distress sale of shares. During the bear phase of 1996, in the Bombay Stock Exchange more
than 2/3 of stocks were inactive. Most of the scrips were sold below their par values. The
figures13.3 gives the bear market. Here the tops and bottoms are lower than the previous ones.
The bull and beat phases of the Indian stock market are given in below Figure

54
The secondary trend:

The secondary trend or the intermediate trend moves against the main trend and leads to
correction. In the bull market the secondary trend would result in the fall of about 33-66% of the
earlier rise. In the bear market, the secondary trend carries the price upward and corrects the
main trend. The correction would be 33% to 66% of the earlier fall. Intermediate trend corrects
the overbought and oversold condition. It provides the breathing space to the market. Compared
to the time taken for the primary trend, secondary trend is swift and quicker. The figure shows
the secondary movement.

3.4 Indicators:
Technical indicators are used to find out the direction of the overall market. The overall market
movement affects the individual share price. Aggregate forecasting is considered to be more

55
reliable than the individual forecasting. The indicators are price and volume of trade. The
volume of trade is influenced by the behaviour of price.

Volume of trade: Dow gave special emphasis on volume. Volume expands along with the bull
market and narrows down in the bear market. If the volume falls with rise in price or vice-versa,
it is a matter of concern for the investor and the trend may not persist for a longer time.
Technical analyst used volume as an excellent method of confirming the trend. The market is
said to be bullish when small volume of trade and large volume of trade follow the fall in price
and the rise in price.

Large rise in price or large fall in price leads to large increase in volume.
Large volume with rise in price indicates bull market and the large volume with fall in price
indicates bear market. If the volumes decline for five consecutive days, then it will continue for
another four days and the same in true in increasing volume.

The Breadth of the Market:

The breadth of market is the term often used to study the advances and declines that have
occurred in the stock market. Advances mean the number of shares whose prices have increased
from the previous days’ trading. Declines indicate the number of shares whose prices have
fallen from the previous days’ trading. This is easy to plot and watch indicator because data are
available in all business dailies.

The net difference between the number of stock advanced and decline during the same period is
the breadth of the market. A cumulative index of net difference measures the market breadth.
The following table gives the breadth of the market.

Table 13.1 Breadth of the Market-Bombay Stock Exchange

Day Advance Declines Net Breadth BSE

Index
21-02-00 1486 774 712 712 5876.89
22-02-00 1310 966 344 1056 5883.33
23-02-00 898 1225 -327 729 5642.46
24-02-00 1108 1091 17 746 5810.17
25-02-00 931 1279 -348 398 5623.08

Short Sales:
Short selling is a technical indicator known as short interest. Short sales refer to the selling of
shares that are not owned. The bears are the short sellers who sell now in the hope of purchasing
at a lower price in the future to make profits. The short sellers have to cover up their positions.

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Short positions of scrips are published in the business newspapers. When the demand for
particular share increases, the outstanding short positions also increase and it indicates future
rise of prices. These indications cannot be exactly correct, but they show the general situations.

Odd Lot Trading:

Shares are generally sold in a lot of hundred. Shares, sold in smaller lots, fewer than 100 are
called odd lot. Such buyers and sellers are called odd lotters. Odd lot purchase to odd lot sales
(Purchase % sales) is the odd lot index. The increase in odd lot purchase results in an increase in
the index. Relatively more selling leads to fall in the index. It is generally considered that the
professional investor is more informed and stronger than the odd lotters. When the professional
investors dominate the market, the stock market is technically strong. If the odd lotters dominate
the market, the market is considered to be technically weak. The notion behind is that odd lot
purchase is concentrated at the top of the market cycle and selling at the bottom. High odd lot
purchase forecasts fall in the market price and low purchases/sales ratios are presumed to occur
toward the end of bear market.

Moving Average:
The market indices do not rise or fall in straight line. The upward and downward movements are
interrupted by counter moves. The underlying trend can be studied by smoothening of the data.
To smooth the data moving average technique is used.

The word moving means that the body of data moves ahead to include the recent observation. If
it is five day moving average, on the sixth day the body of data moves to include the sixth day
observation eliminating the first day’s observation. Likewise it continues. In the moving average
calculation, closing price of the stock is used.

Table 13.2 Calculation of Five-Day Moving Average for Reliance’s Stock

Day Price Average

Feb 4, ‘99 255 -
6 261 -
7 269 266.2
8 273 270.8
11 273 272.8
12 278 273.2
13 271 274.0
14 271 273.8

The moving averages are used to study the movement of the market as well as the individual
scrip price. The moving average indicates the underlying trend in the scrip. The period of

57
average determines the period of the trend that is being identified. For identifying short-term
trend, 10 day to 30 day moving averages are used. In the case of medium term trend 50 day to
125 day are adopted. 200 day moving average is used to identify long term trend.

Index and stock price moving average: Individual stock price is compared with the stock
market indices. The moving average of the stock and the index are plotted in the same sheet and
trends are compared. If NSE or BSE index is above stock’s moving average line, the particular
stock has bullish trend. The price may increase above the market average. If the Sensex or Nifty
is below the stock’s moving average, the bearish market can be expected for the particular
stock.

If the moving average of the stock penetrates the stock market index from above, it generates
sell signal. Unfavourable market condition prevails for the particular scrip. If the stock line
pushes up through the market average,

3.5 Oscillators:
Oscillators indicate the market momentum or scrip momentum. Oscillator shows the share price
movement across a reference point forms the extreme to another. The momentum indicates:

→ Overbought and oversold conditions of the scrips or the market.

→ Signaling the possible trend reversal.
→ Rise of decline in the momentum.

Generally, oscillators are analyzed along with the price chart. Oscillators indicate trend reversals
that have to be confirmed with the price movement of the scrip. Changes in the price should be
correlated to changes in the momentum, and then only buy and sell signals can be generated.
Actions have to be taken only when the price and momentum agree with each other. With the
daily, weekly or monthly closing prices oscillators are built. For short term trading, daily price
oscillators are useful.

3.6 Charts:
Charts are the valuable and easiest tools in the technical analysis. The graphic presentation of the
data helps the investor to find out the trend of the price without any difficulty. The charts also
have the following uses
a. Spots the current trend for buying and selling.
b. Indicates the probable future action of the market by projection
c. Shows the past historic movement
d. Indicates the important areas of support and resistance.

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The charts do not lie but interpretation differs from analyst to analyst according to their skills and
experience. A leading technician, James Dines said, “Charts are like fire or electricity. They
brilliant tools if intelligently controlled and handled but dangerous to a novice”.

4.4.1 Point and Figure Charts:

Technical analyst to predict the extent and direction of the price movement of a particular stock
or the stock market indices uses point and figure charts. This PF charts are of one-dimensional
and there is no indication of time or volume. The price changes in relation to previous prices are
shown. The change of price direction can be interpreted. The charts are drawn in the ruled paper.
The following figure 4.6 shows the P and F Chart.

Figure 4.6

The prices are given in the left of the figure as shown. The numbers represent the price of the
stock at –point interval. The interval of price changes can be 1,2,3,5 or 10 points. It depends on
the analyst’s preference. Further, it depends upon the stock price movement. Higher points are
chosen for high priced stocks and vice versa. Only whole number prices are entered. In figure
13.14, the initial price 53 was entered in column 1 as X. The next mark X will be made only if
the stock moves up to 55. As long as the price moves up, the Xs are drawn in the vertical
column. Here the stock price has moved to 57. When the stock price declines by two points or
more than chartist records, the change by placing the ‘o’ in the next column. Then the
movements are interpreted. The trend reversals can be spotted easily.

The figure 4.7 shows the trend reversals in the point and figure chart.

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 Figure 4.7

As long as the price moves between points A and B, there is little indication of price rise. As the
price penetrates the resistance level, it generates a buy signal. The market may turn out to be
bullish. Likewise when the price pierces down the support level C indicates that the stock should
be sold and the market may turn out to the bearish.

In spite of the simplicity in drawing the PF charts, they have some inherent disadvantages also.
1) They do not show the intra-day price movement.
2) Whole numbers are only taken into consideration. This may result in the loss of
information regarding the minor fluctuations.
3) Volume is not mentioned in the chart. Volume and trend of transactions are an important
guide to make investment decision. In a bull market, price rise is accompanied by high
volume of trading. The bear market is related to low volume of trading.
4.4.2 Bar Charts:
The bar chart is the simplest and most commonly used tool of a technical analyst. To build a bar
a dot is entered to represent the highest price at which the stock is traded on that day, week or
month. Then another dot is entered to indicate the lowest price on that particular date. A line is
drawn to connect both the points a horizontal nub is drawn to mark the closing price. Line charts
are used to indicate the price movements. The line chart is a simplification of the bar chart. Here
a line is drawn to connect the successive closing prices

2.11 Chart patterns:

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Charts reveal certain patterns that are of predictive value. Chart patterns are used as a supplement
to other information and confirmation of signals provided by trend line. Some of the most widely
used and easily recognizable chart patterns are discussed here.

2.11.1 V Formation:

The name itself indicated that in the ‘V’ formation there is a long sharp decline and a fast
reversal. The ‘V’ pattern occurs mostly in popular stocks where the market interest changes
quickly from hope to fear and vice-versa. In the case of inverted ‘^’ the rise occurs first and
declines. There are extended ‘V’s. In it, the bottom or top moves more slowly over a broader
area.

2.11.2 Tops and bottoms:

Top and bottom formation is interesting to watch but what is more important, is the middles
portion of it. The investor has to buy after up trend has started and exit before the top is reached.
Generally tops and bottoms are formed at the beginning or e.x. of the new trends. The reversal
from the tops and bottoms indicate sell and buy signals.

Double top and bottom This type of formation signals the end of one trend and the beginning
of another. If the double top is formed when a stock price rises to certain level, falls rapidly,
again rises to the same height or more, and turns down. Its pattern resembles the letter ‘M’. The
double top may indicate the onset of the bear market. But the results should be confirmed with
volume and trend.

In a double bottom, the price of the stock falls to a certain level and increase with diminishing
activity. Then it falls again to the same or to a lower price and turns up to a higher level. The
double bottom resembles the letter ‘W’. Technical analysts view double bottom as a sign for
bull market. The double top and bottom figures are given below with illustrations.

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2.11.3 Head and shoulders:

This pattern is easy to identify and the signal generated by this pattern is considered to be
reliable. In the head and shoulder pattern there are three rallies resembling the left shoulder, a
head and a right shoulder A neckline is drawn connecting the lows of the tops. When the stock
price outs the neckline from above, it signals the bear market.

The upward movement of the price for some duration creates the left shoulder. At the top of the
left shoulder people who bought during the uptrend begin to sell resulting in a dip. Near the
bottom there would be reaction and people who have not bought in the first uptrend start buying
at relatively low prices thus pushing the price upward. The alternating forces of demand and
supply create new ups and lows. The following figures explain the head and shoulders pattern.

Inverted head and shoulders Here the reverse of the previous pattern holds true. The price of
stock’s falls and rises that makes a inverted right shoulders. As the process of fall and rise in
price continues the head and left shoulders are created. Connecting the tops of the inverted head
and shoulders gives the neckline. When the price pierces the neckline from below, it indicated
the end of bear market and the beginning of the bull market. These patterns have to be confirmed
with the volume and trend of the market.

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2.11.4 Triangles:

The triangle formation is easy to identify and popular in technical analysis. The triangles are of
symmetrical ascending, descending and inverted.

Symmetrical Triangle This pattern is made up of series of fluctuations, each fluctuation smaller
than the previous one. Tops do not attain the height of the previous tops. Likewise bottoms are
higher than the previous bottoms. Connecting the lower tops that are slanting downward forms a
symmetrical triangle. Connecting the rising bottom, which is slanting upward, becomes the lower
trend line. It is not easy to predict the breakaway either way. The symmetrical triangle does not
have any bias towards the bull and bear operators. It indicates the slow down or temporary halt in
the direction of the original trend. A probability of the original trend to continue after the
completion of the triangle is always there.

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Ascending triangle here, the upper trend line is almost a horizontal trend line connecting the
tops and the lower trend line is a rising trend line connecting the rising bottoms. When the
demand for the scrip overcomes the supply for it, then there will be a break out. The break will
be in favors of the bullish trend. This pattern is generally spotted during an up move and the
probability of the upward move is high here.

Descending triangle here, connecting the lower tops forms the upper trend line. The upper trend
line would be a falling one. The lower trend line would be almost horizontal connecting the
bottoms. The lower line indicates the support level. The possibility for a downward breakout is
high in this pattern. The pattern indicates that the bear operators are more powerful than the bull
operators. This pattern is seen during the downtrend.

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3.7 Candlestick Chart:

According to records, the Candlestick Chart is the oldest of price prediction charts. In the 1700s,
people used candlesticks to forecast rise prices. During this era in Japan, use of candlestick
charts helped Munehisa Homma, a rice merchant from Sakata, make a fortune and become a
prominent rice trader. The application of candlesticks helped him execute more than 100
consecutive winning trades. To create a candlestick chart, one needs four elements, namely,
open, high, low and closing prices for a given period. This is explained as follows:

When the candle body is white, it indicates the closing price is higher than the opening price, and
shows a bullish trend. A black body indicates that the closing price is lower than the open price
and shows a bearish trend the following figure shows the candlestick chart for NSE.

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The above figure shows different kinds of candlesticks with long and short shadows. Some of
them are explained below.

Kinds of Candlestick:

A white or Black candlestick with a small body indicates not much

price movement and consolidation of stock price.

A long white body in a candle shows that the closing price is

higher than the opening price, and a bullish trend. A long black
body in a candle bearish trend.

A white candlestick with a long body and without shadow is a

called a ‘White Marubozu’. This shows that the opening price is
equal to the low price, and the closing price is equal to the high
price, and that there is buying pressure in the market. It may lead
to a bullish trend. A black candlestick with a long body and
without a shadow is a ‘Black Marubozu’. This shows that the
opening price is equal to the high price, and the closing price is
equal to the low price, and there is selling pressure in the market. It
may lead to a bearish trend.

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 Spinning top Spinning tops are candlesticks with a small real body
and a long upper and lower shadow. It represents indecision of the
traders. The white or black small real body shows little price
movement from open to close. The long shadows at both the ends
indicate that both bulls and bears were active during the trading
session. If it appears after a long advance or long white
candlestick, it shows weak bulls and a probable change in trend.
Likewise, if it appears after a long decline or long black
candlestick, it indicates weak bears and a probable change in trend.

The candlestick with a long lower shadow, small body, and no or

very little upper shadow is a hammer. The lower shadow must be
at least twice the length of the real body. This candlestick pattern
must happen in the context of a downtrend. This shows that the
market is ‘hammering’ out a bottom. Hammers at the bottom
signal a bullish revival. A similar candlestick with a black body is
a hanging man. The hanging man indicates a bearish reversal
pattern that can occur at the top or resistant level. It signals that
selling pressure is beginning to increase. These patterns require
confirmation. Confirmation may be a downward gap or long black
candlestick with heavy volume.

The inverted hammer, after a decline or downtrend, indicates a

potential trend reversal or Hammer and support levels. After a
decline, the long upper shadow shows buying pressure during the
trading session. An inverted hammer followed by a bullish gap or
long white candlestick with heavy volume gives bullish
confirmation. The formation of shooting star after an advance
indicates a bearish reversal pattern or resistance level. A
downward gap or long black candlestick with heavy volume gives
a confirmation for bearish trend.

Doji appears when the closing price and opening price are equal to
one another. Dojies are neutral patterns and indications and are
based on preceding price and future confirmation. Doji is used
both for the singular and plural. Doji with a long upper shadow
and short lower shadow signals bearish trend, if it occurs in a bull
market. Doji with a on upper and long lower shadows signals
bullish trend, if it appears in a bearish market.

3.9 Efficient Market Theory

Efficient market theory states that the share price fluctuations are random and do not follow any
regular pattern. Meanwhile technical analysts see meaningful patterns in their charts. This raises

67
the questions as to whether the intrinsic value of stocks has any meaning. Are they related to the
security prices? The following section explains the process that determines the security price.

Basic Concepts: Before understanding the theory certain concepts and phrases like market
efficiency, liquidity traders and information traders should be understood.

Market Efficiency: The expectations of the investors regarding the future cash flows are
translated or reflected on the share prices. The accuracy and the quickness in which the market
translates the expectation into prices are termed as market efficiency. There are two types of
market efficiencies:
a. Operational efficiency
b. Information efficiency

a. Operational Efficiency: At stock exchange operational efficiency is measured by factors like

time taken to execute the order and the number of bad deliveries. Investors are concerned with
the operational efficiency of the market. But efficiency market hypothesis does not deal with this
efficiency.

b. Informational efficiency: It is measure of the swiftness or the market’s reaction to new

information. New information in the form of economic reports, company analysis, political
statements and announcement of new industrial policy is received by the market frequently. How
does the market react to this? Security prices adjust themselves very rapidly and accurately. They
never take a long time to adjust to the new information. For instance the announcement of bonus
shares of any company would result in a hike in price of that stock. Like-wise major changes in
the policy decisions of the Government are also reflected in the stock index movement.

Liquidity Traders: These traders’ investment and resale of shares depend upon their individual
fortune. Liquidity traders may sell their shares to pay their bills. They do not investigate before
they invest.

Information Traders: Information traders analyze before adopting any buy or sell strategy.
They estimate the intrinsic value of shares. The deviation between the intrinsic value and the
market value makes them enter the market. They sell if the market value is higher than the
intrinsic value and vice-versa. The buying and selling of the shares through the demand and
supply forces bring the market price back to its intrinsic value selling of the shares through the
demand and supply forces bring the market price back to its intrinsic value.

The Random-Walk Theory

In 1900, a French mathematician named Louis Bachelier wrote a paper suggesting that security
price fluctuations were random. In 1953, Maurice Kendall in his paper reported that stock price

68
series is a wandering one. They appeared to be random; each successive change is independent
of the previous one. In 1970, Fama stated that efficiency markets fully reflect the available
information. If markets are efficient, securities’ process reflect normal returns for their level of
risk. Fama suggested that efficient market hypothesis can be divided into three categories. They
are “weak form”, the “semi-strong form” and the “strong form”. The level of information being
considered in the market is the basis for this segregation. The figure 4.16 shows the market
efficiency level.

Figure 4.16

Weak Form of EMH:

The type of information used in the weak form of EMH is the historical prices. According to it,
current prices reflect all information found in the past prices and traded volumes. Future prices
cannot be predicted by analyzing the price from the past. Everyone has the access to the past
prices, even though some people can get these more conveniently than other. Liquidity traders
may sell their stocks without considering the intrinsic value of the shares and cause price
fluctuations. Buying and selling activities of the information traders lead the market price to
align with the intrinsic value.

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 Figure 4.17

The dotted line represents the intrinsic value. The intrinsic value changes at times, t and t+1. In
the weak form of market the price of the stock and its intrinsic value diverges substantially.

In the weak efficient market short term traders may earn a positive return. On an average, short
term traders will not outperform the blind folded investor picking stock with a dart. That is
traders may earn by the naïve buy and hold strategy while some may incur loss, the average buy
and hold strategy cannot be beaten by the chartist. Many studies of the market analysts have
proved the weak form of the EMH. Empirical tests of the weak form are presented here.

Semi-Strong Form:
The semi-strong form of the efficient market hypothesis states that the security price adjusts
rapidly to all publicly available information. In the semi-strongly efficient markets, security
prices fully reflect all publicly available information. The prices not only reflect the past price
data, but also the available information regarding at the earning of the corporate, dividend, bonus
issue, right issue, right issue, mergers, acquisitions and so on. In the semi-strongly efficient
market a few insiders can earn a profit on a short run price changes rather than the investors who
adopt the naïve buy and hold policy.

In the case of a competitive market, price is fixed by the supply and demand force. The price at
the equilibrium level of the supply and demand represents the consensus opinion of the market.
The intrinsic value of the stock and the equilibrium price are the same. Whenever, a new
information quickly, a new price would come out of it(sentence not clear). If the market has to be
semi-strongly efficient, timely and correct dissemination of information and assimilation of new
are needed. Only then, the market can reflect all the relevant information quickly. It is stated that
the stock markets in US strongly supports the semi-strong hypothesis because the prices adjust
rapidly to the new information.

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 Strong Form:
The strong form EMH states that all information is fully reflected on security prices. It represents
an extreme hypothesis which most observers do not expect it to be literally true. The strong form
of the efficient market hypothesis maintains that not only the publicly available information is
useless to the investor or analyst but all information is useless. Information whether it is public
or inside cannot be used consistently to earn superior investors’ return in the strong form. This
implies that security analysts and portfolio managers who have access to information more
quickly than the ordinary investors would not be able to use it to earn more profits.

3.10 The Essence of the Theory:

According to the theory, the successive price changes or changes in return are independent and
these successive price changes are randomly distributed. Random Walk Model argues that all
publicity available information is fully reflected on the stock prices and further the stock prices
and further the stock prices instantaneously adjust themselves to the available new information.
The theory mainly deals with the successive changes rather than the price or return levels.

According to them, the market may have imperfections like transaction cost and delays in
disseminating relevant information to all market investors but these sources of inefficiency may
not result in excess returns above the normal or equilibrium returns. The equilibrium a return is
defined as the return earned by naïve buys and hold strategy.

The investors should note that the random theory says nothing about the relative price change
that is the changes that are occurring across the securities. Some securities may outperform
others. Again, it does not make any remark on the decomposing of price into market, industry or
firm factors. All these factors are concerned with the absolute price changes and not with the
relative prices.

The prices may move at random but this does not indicate that there would not be any upward or
downward, movements in the price. The random walk hypothesis is entirely consistent with the
upward and downwards movements of the stock prices.

4.8 Summary
 Technical Analysis is a process of identifying trend reversals at an earlier stage to
formulate the buying and selling strategy.
 Commonly used technical tools are, Trend, trend reversal, Primary trend volume of
trading, short selling, odd lot trading, bars and line charts, moving averages and
oscillators. In this section some of the above mentioned tools are analyzed.
 Charts are the valuable and easiest tools in the technical analysis. The graphic
presentation of the data helps the investor to find out the trend of the price without any
difficulty.

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  A leading technician, James Dines said, “Charts are like fire or electricity. They brilliant
tools if intelligently controlled and handled but dangerous to a novice”.
 Chart patterns are used as a supplement to other information and confirmation of signals
provided by trend line. Commonly used chart patterns are V Formation, Tops and
Bottoms, Head and Shoulders, Triangles, Flags and Pennant.
 The technical analysts mainly focus the attention on the past history of prices. Generally
technical analysts choose to study two basic market data-price and volume.
 Fundamental analyst’s analyses the stock based on the specific goals of the investors.
They study the financial strength of corporate, growth of sales, earning and profitability.
They also take into account the general industry and economic conditions.
 Efficient market theory states that the share price fluctuations are random and do not
follow any regular pattern.

4.9 Terminal Questions

Section A - 2marks questions
1. What do you mean by technical analysis?
2. List out various technical tools?
3. What is meant by Trend?
4. What do you mean by Primary trend?
5. What do you mean by short selling?

Section B - 5 marks questions

1. What are the assumptions of technical analysis?
2. Explain any five technical tools?
3. Write a note on oscillators?
4. What are the differences between fundamental and technical analysis?
5. Write a note on efficient market approach?

Section C - 14 marks questions

1. Explain in detail various technical tools?
2. Write a note on charts and its patterns?
3. Write in detail about efficient market approach?

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 Module: 4

 Introduction to CAPM theory and assumptions

 Beta calculation with problems
 Problems on CAPM

Learning Objectives

After reading this chapter, students should

➢ Understand the concept of CAPM.

Introduction

Investors are interested in knowing the systematic risk when they search for efficient portfolios.
They would like to have assets with low beta co-efficient i.e. systematic risk. Investors would opt
for high beta co-efficient only if they provide high rates of return. The risk averse nature of the
investors is the underlying factor for this behavior. The capital asset pricing theory helps the
investors to understand the risk and return relationship of the securities. It also explains how
assets should be priced in the capital market.

The CAPM Theory

Markowitz, William Sharpe, John Lintner and Jan Mossin provided the basic structure for the
CAPM model. It is a model of linear general equilibrium return. In the CAPM theory, the
required rate return of an asset is having a linear relationship with asset’s beta value i.e.
undiversifiable or systematic risk.

Assumptions

1. An individual seller or buyer cannot affect the price of a stock. This assumption is the basic
assumption of the perfectly competitive market.

2. Investors make their decisions only on the basis of the expected returns, standard deviations
and co variances of all pairs of securities.

3. Investors are assumed to have homogenous expectations during the decision-making period.

4. The investor can lend or borrow any amount of funds at the riskless rate of interest. The
riskless rate of interest is the rate of interest offered for the treasury bills or Government
securities.

5. Assets are infinitely divisible. According to this assumption, investor could buy any quantity
of share i.e. they can even buy ten rupees worth of Reliance Industry shares.

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6. There is no transaction cost i.e. no cost involved in buying and selling of stocks.

7. There is no personal income tax. Hence, the investor is indifferent to the form of return either
capital gain or dividend.

8. Unlimited quantum of short sales is allowed. Any amount of shares an individual can sell
short.

Lending and Borrowing

Here, it is assumed that the investor could borrow or lend any amount money at riskless rate of
interest. When this opportunity is given to the investors, they can mix risk free assets with the
risky assets in a portfolio to obtain a desired rate of risk-return combination.

Rp = Portfolio return

Xf = the proportion of funds invested in risk free assets

Xf = the proportion of funds invested in risky assets

Rf = Risk free rate of return

Rm = Return on risky assets

According to CAPM, all investors hold only the market portfolio and riskless securities. The
market portfolio is a portfolio comprised of all stocks in the market. Each asset is held in
proportion to its market value to the total value of all risky assets. For example, if Reliance
Industry share represents 20% of all risky assets, then the market

portfolio of the individual investor contains 20% of Reliance industry shares. At this stage, the
investor has the ability to borrow or lend any amount of money at the riskiness rate of interest.

Security Market Line

The risk-return relationship of an efficient portfolio is measured by the capital market line. But,
it does not show the risk-return trade off for other portfolios and individual securities. Inefficient
portfolios lie below the capital market line and the risk-return relationship cannot be established
with the help of the capital market line. Standard deviation includes the systematic and
unsystematic risk. Unsystematic risk can be diversified and it is not related to the market. If the
unsystematic risk is eliminated, then the matter of concern is systematic risk alone. This
systematic risk could be measured by beta. The beta analysis is useful for individual securities
arid portfolios whether efficient or inefficient.

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 When an additional security is added to the market portfolio, an additional risk is also added to
it. The variance of a portfolio is equal to the weighted sum of the co-variances of the individual
securities in the portfolio.

If we add an additional security to the market portfolio, its marginal contribution to the variance
of the market is the covariance between the security’s return and market portfolio’s return. If the
security i am included, the covariance between the security and the market measures the risk.
Covariance can be standardized by dividing it by standard deviation of market portfolio coy
im/σm. This shows the systematic risk of the security. Then, the expected return of the security i
is given by the equation:

Ri – Rf = (Rm – Rf/σm) Coy im/σm

This equation can be rewritten as follows

Ri – Rf = Coy im/σ2m (Rm – Rf)

The first term of the equation is nothing but the beta coefficient of the stock. The beta coefficient
of the equation of SML is same as the beta of the market (single index) model. In equilibrium, all
efficient and inefficient portfolios lie along the security market line. The SML line helps to
determine the expected return for a given security beta. In other words, when betas are given, we
can generate expected returns for the given securities. This is explained in fig.

If we assume the expected market risk premium to be 8% and the risk free rate of return tube
7%, we can calculate expected return for A, B, C and D securities using the formula

E(Ri)= Rf + ßi[E(Rm)-Rf]

If beta for ß = 1

If beta for = 1

= 7 + 1 (8)

= 15%

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Security A

Beta = 1.10

E(R) =7+1.10(8)

= 15.8

Security B

Beta = 1.20

E(R) = 7 + 1.20(8)

= 16.8 = 16.6

Security C

Beta = .7

E(R) = 7 + .7(8)

=12.6

Empirical Tests of the CAPM

In the CAPM, beta is used to estimate le systematic of the security and reflects the future
volatility of the stock in relation to the market. Future volatility of the stock is estimated only
through historical data. Historical data are used to plot the regression line or the characteristic

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line and calculate beta. If historical betas are stable over a period of time, they would be good
proxy for their ex-ante or expected risk.

Robert A. Levy, Marshall B. Blume and others have studied the question of beta stability in
depth. I calculated betas for both Individual securities and portfolios. His study results have
provided the following conclusions

(1) The betas of individual stocks are unstable; hence the past betas for the individual securities
are not good estimators of future risk. (2) The betas of portfolios of ten or more randomly
selected stocks are reasonably stable, hence the portfolio betas are good estimators of future
portfolio volatility. This is because of the errors in the estimates of individual securities’ betas
tend to offset one another in a portfolio.

Various researchers have attempted to find out the validity of the model by calculating beta and
realized rate of return. They attempted to test (1) whether the intercept is equal to i.e. risk free
rate of interest or the interest rate offered for treasury bills (2) whether the line is linear and pass
through the beta = 1 being the required rate of return of the market. In general, the studies have
showed the following results.

(1) The studies generally showed a significant positive relationship between the expected return
and t systematic risk. But the slope of the relationship is usually less than that of predicted by the
CAPM. (2) The risk and return relationship appears to be linear. Empirical studies give no
evidence of significant curvature in the risk/return relationship,. (3) The attempts of the
researchers to assess the relative importance of the market and company risk have yielded
definite results. The CAPM theory implies that unsystematic risk is not relevant, but
unsystematic and systematic risks are positively related to security returns. Higher returns are
needed to compensate both the risks. Most of the observed relationship reflects statistical
problems rather than the true nature of capital market.

(4) According to Richard Roll, the ambiguity of the market portfolio leaves the CAPM
untestable. The practice of using indices as proxies is loaded with problems. Different indices
yield different betas for the same security. (5) If the CAPM were completely valid, i4 should
apply to all financial assets including bonds. But, when bonds are introduced into the analysis,
they do not fall on the security market line.

Present Validity of CAPM

The CAPM is greatly appealing at an intellectual level, logical and rational. The basic
assumptions on which the model is built raise, some doubts in the minds of the investors. Yet,
investment analysts have been more creative in adapting CAPM for their uses.

(1) The CAPM focuses on the market risk, makes the investors to think about the riskiness of the
assets in general. CAPM provides basic concepts which are truly of fundamental value.

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(2) The CAPM has been useful in the selection of securities and portfolios. Securities with higher
returns are considered to be undervalued and attractive for buy. The below normal expected
return yielding securities are considered to be overvalued and Suitable for sale.

(3) In the CAPM, it has been assumed that investors consider only the market risk. Given the
estimate of the risk free rate, the beta of the firm, stock and the required market rate of return,
one can find out the expected returns for a firm’s security. This expected return can be used as an
estimate of the cost of retained earnings.

(4) Even though CAPM has been regarded as a useful tool to financial analysts, it has its own
critics too. They point out, when the model is ex-ante, the inputs also should be ex-ante, i.e.
based on the expectations of the future. Empirical tests and analyses have used ex-post i.e. past
data only. (5) The historical data regarding the market return, risk free rate of return and betas
vary differently for different periods. The various methods used to estimate these inputs also
affect the beta value. Since the inputs cannot be estimated precisely, the expected return found
out through the CAPM model is also subjected to criticism.

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 Module-5
Portfolio Management

Learning Objectives
5.1 Meaning of Portfolio Management
5.2 Importance of Portfolio Management
5.3 Portfolio Analysis
5.4 Portfolio Selection
5.5 Portfolio Management Process
5.5.1Objectives
5.5.2 Constraints
5.6 Selection of Asset Mix
5.7 Formulation of Portfolio Strategy
5.8 Selection of Securities
5.9 Portfolio Revision
5.10 Performance Evaluation
5.11 Performance Measure
5.11.1 Sharpe’s Performance Index
5.11.2 Treynor’s Performance Index
5.11.3 Jensen’s Performance Index
5.12 Summary
5.13 Terminal Questions

Learning Objectives
 To learn about the meaning and importance of Portfolio Management
 To understand the Portfolio Management Process and formulation of Portfolio strategy
 To understand the mode of selection of securities
 To understand the concept and applicability of performance evaluation and performance
index.

5.1 Meaning of Portfolio Management

Portfolio Management guides the investor in a method of selecting the best available securities
that will provide the expected rate of return for any given degree of risk and also to mitigate
(reduce) the risks. It is a strategic decision which is addressed by the top-level managers.

5.2 Importance of Portfolio Management

1. Portfolio management presents the best investment plan to the individuals as per their
income, budget, age and ability to undertake risks.

2. Portfolio management minimizes the risks involved in investing and also increases the
chance of making profits.

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3. Portfolio managers understand the client’s financial needs and suggest the best and unique
investment policy for them with minimum risks involved.

4. Portfolio management enables the portfolio managers to provide customized investment

solutions to clients as per their needs and requirements.

5.3 Portfolio Analysis

Portfolio analysis is a systematic way to analyze the products and services that make up an
association's business portfolio. Portfolio analysis helps you decide which of these products and
services should be emphasized and which should be phased out, based on objective criteria.

5.4 Portfolio Selection

Portfolio selection is a process by which one chooses the securities, derivatives, and
other assets to include in a portfolio. In making securities selections, one considers the risk,
the return, the ethical implications, and other factors affecting both of the individual securities
and the portfolio as a whole.

Selection of Portfolio

The selection of portfolio depends on the various objectives of the investor. The selections of
portfolio under different objectives are dealt subsequently.

Objectives and Asset Mix

If the main objective is getting adequate amount of current income, sixty per cent of the
investment is made on debts and 40 per cent on equities. The proportions of investments on debt
and equity differ according to the individual’s preferences. Money is invested in short term debt
and fixed income securities. Here the growth of income becomes the secondary objective and
stability of principal amount may become the third. Even within the debt portfolio, the funds
invested in short term bonds depends on the need for stability of principal amount in comparison
with the stability of income. If the appreciation of capital is given third priority, instead of short
term debt the investor opts for long term debt. The maturity period may not be a constraint.

Growth and Income and Asset Mix

Here the investor requires a certain percentage of growth in the e received from his investment.
The investor’s portfolio may consist of 60 to 100 percent equities and 0 to

40 percent debt instrument. The debt portion of the portfolio may consist of concession regarding
tax exemption. Appreciation of principal amount is given third priority. For example computer
software, hardware and non-conventional energy producing company shares provide good
possibility of growth in dividend.

Capital Appreciation and Asset Mix

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Capital appreciation and asset mix Capital appreciation means that the value of the original
investment increases over the years. Investment in real estate’s like land and house may provide
a faster rate of capital appreciation but they lack liquidity. In the capital market, the values of the
shares are much higher than their original issue prices. For example Satyam Computers, share
value was ` 306 in April 1998 but in October 1999 the value was ` 1658. Likewise, several
examples can be cited. The market capitalisation also has increased. Next to real assets, the stock
markets provide best opportunity for capital appreciation. If the investor’s objective is capital
appreciation, 90 to 100 per cent of his portfolio may consist of equities and 0-10% of debts. The
growth of income becomes the secondary objective.

Safety of Principal and Asset Mix

Usually, the risk averse investors are very particular about the stability of principal. According to
the life cycle theory, people in the third stage of life also give more importance to the safety of
the principal. All the investors have this objective in their mind. No one likes to lose his money
invested in different assets. But, the degree may differ. The investor’s portfolio may consist more
of debt instruments and within the debt portfolio more would be on short term debts.

Risk and Return Analysis

The traditional approach to portfolio building has some basic assumptions. First, the individual
prefers larger to smaller returns from securities. To achieve this goal, the investor has to take
more risk. The ability to achieve higher returns is dependent upon his ability to judge risk and his
ability to take specific risks. The risks are namely interest rate risk, purchasing power risk,
financial risk and market risk. The investor analyses the varying degrees of risk and constructs
his portfolio. At first, he establishes the minimum income that he must have to avoid hardships
under most adverse economic condition and then he decides risk of loss of income that can be
tolerated. The investor makes a series of compromises on risk and non-risk factors like taxation
and marketability after he has assessed the major risk categories, which he is trying to minimize.

Diversification

Once the asset mix is determined and the risk and return are analysed, the final step is the
diversification of portfolio. Financial risk can be minimized by commitments to top-quality
bonds, but these securities offer poor resistance to inflation. Stocks provide better inflation
protection than bonds but are more vulnerable to financial risks. Good quality convertibles may
balance the financial risk and purchasing power risk. According to the investor’s need for
income and risk tolerance level portfolio is diversified. In the bond portfolio, the investor has to
strike a balance between the short term and long term bonds. Short term fixed income securities
offer more risk to income and long term fixed income securities offer more risk to principal.

5.5 Portfolio Management Process

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The first step in the portfolio management process is to specify the investment policy which
summarizes the objective, constraints, and preferences of the investor. The investment policy
may be expressed as follows:
i. Objectives
a. Return requirements
b. Risk tolerance
ii. Constraints and Preferences
a. Liquidity
b. Investment horizon
c. Taxes
d. Regulations
e. Unique circumstances

Specification of Investment Objectives and Constraints:

5.5.1 Objectives:
The commonly stated investment goals are:
a) Income: To provide a steady stream of income through regular interest/dividend payment.
b) Growth: To increase the value of the principal amount through capital appreciation.
c) Stability: To protect the principal amount invested from the risk of loss.

Since income and growth represent two ways by which return is generated and stability implies
containment or even elimination of risk, investment objectives may be expressed more succinctly
in terms of return and risk, As an investor, you would primarily be interested in a higher return
(in the form of income and/or capital appreciation) and a lower level of risk. However, return and
risk typically go hand in hand. So you have to ordinarily bear a higher level of risk in order to
earn a higher return. How much risk you would be willing to bear to seek a higher return
depends on your risk disposition. Your investment objective should state your preference for
return relative to your distaste for risk.

You can specify your investment objectives in one of the following ways:
a. Maximize the expected rate of return, subject to the risk exposure being held within a certain
limit (the risk tolerance level).
b. Minimize the risk exposure, without sacrificing a certain expected rate of return (the target
rate of return).

Risk Assessment
Financial advisers, mutual funds, and brokerage firms have developed risk questionaries’ to help
investors determine whether they are conservative, moderate, or aggressive. Typically, such risk
questionnaires have 7 to 10 questions to gauge a person’s tendency to make risky or conservative
choices in certain hypothetical situations. While these risk questionnaires are not precise, they
are helpful in getting a rough idea of an investor’s risk tolerance. A specimen risk tolerance
questionnaire is given in Exhibit 20.2.

5.5.2 Constraints

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In pursuing your investment objective, which is specified in terms of return requirement and risk
tolerance, you should bear in mind the constraints arising out of or relating to the following
factors:

a. Liquidity: Liquidity Refers to the speed with which an asset can be sold, without
suffering any discount to its fair market price. For example, money market instruments are
the most liquid assets, whereas antiques are among the least liquid. Taking into account your
cash requirements in the foreseeable future, you must establish the minimum level of ‘cash’
you want in your investment portfolio.

b. Investment Horizon: The investment horizon is the time when the investment or part
thereof is planned to be liquidated to meet a specific need. For example, the investment
horizon may be ten years to fund a child’s college education or thirty years to meet
retirement needs. The investment horizon has an important beating on the choice of assets.

c. Taxes: What matters finally is the post–tax return from an investment. Tax considerations
therefore have an important bearing on investment decisions. So, carefully review the tax
shelters available to you and incorporate the same in your investment decisions.

d. Regulations: While individual investors are generally not constrained much by law,
institutional investors have to conform to various regulations. For example, mutual funds in
India are not allowed to hold more than 10 percent of the equity shares of a public company.

e. Unique Circumstances: Almost every investor faces unique circumstances. For example,
an individual may have the responsibility of looking after ageing parents. Or, an endowment
fund may be precluded from investing in the securities of companies making alcoholic
products and tobacco products.

5.6 Selection of Asset Mix

Based on your objectives and constraints, you have to specify your asset allocation, that is, you
have to decide how much of your portfolio has to be invested in each of the following asset
categories:
a. Cash
b. Bonds
c. Stocks
d. Real estate
e. Precious metals
f. Other

 The first important investment decision for most individuals is concerned with their education
meant to build their human capital.

 The most significant asset that people generally have during their early working years is their
earning power that stems from their human capital. Purchase of life and disability insurance
becomes a pressing need to hedge against loss of income on account of death or disability.

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 The first major economic asset that individuals plan to invest in is their own house. Before
they are ready to buy the house, their savings are likely to be in the form of bank deposits and
money market mutual fund schemes. Referred to broadly as ‘cash’, these instruments have
appeal because they are safe and liquid.

 Once the investment in house is made and reasonable liquidity in the form of ‘cash’ is
maintained to meet expected and unexpected expenses in the short run, the focus shifts to
planning for the education of children, providing financial security to the family, saving for
retirement, bequeathing wealth to heirs, and contributing to charitable activities. In this
context ‘stock’ and ‘bonds’ become important. Very broadly, we define them as follows:
‘Stocks’ include equity shares (which in turn may be classified into income shares, growth
shares, blue-chip shares, cyclical shares, speculative shares, and so on) and units/shares of
equity schemes of mutual funds (like Master shares, Birla Advantage, and so on).

‘Bonds’, defined very broadly, consist of non-convertible debentures of private sector

companies, public sector bonds, gilt – edged securities, RBI Savings Bonds, units/shares of debt
– oriented schemes of mutual funds, National Savings Certificates, Kisan Vikas Patras, bank
deposits, post office savings deposits, fixed deposits with companies, deposits in provident fund
and public provident fund schemes, deposits in the Senior Citizen’s Savings Scheme, and so on.
The basic feature of these investments is that they earn a fixed or near – fixed return.

5.7 Formulation of Portfolio Strategy

After you have chosen a certain asset mix, you have to formulate an appropriate portfolio
strategy. Two broad choices are available in this respect, an active portfolio strategy or a passive
portfolio strategy.

I. Active Portfolio Strategy

An active portfolio strategy is followed by most investment professional and aggressive investors
who strive to earn superior returns, after adjustment for risk. The four principal vectors of an
active strategy are:
1. Market timing
2. Sector rotation
3. Security selection
4. Use of a specialized concept

1. Market Timing: This involves departing from the normal (or strategic or long run) asset mix
to reflect one’s assessment of the prospects of various assets in the near future. Suppose your
investible resources for financial assets are 100 and your normal (or strategic) stock – bond mix
is 50:50. In the short and intermediate run however you may be inclined to deviate from your
long – term assets mix. If you expect stocks to outperform bonds, on a risk – adjusted basis, in
the near future, you may perhaps step up the stock components of your portfolio to say 60 or 70
percent. Such an action, of course, would raise the beta of your portfolio. On the other hand, if
you expect bonds to outperform stocks, on a risk – adjusted basis, in the near future, you may
step up the bond component of your portfolio to 60 percent or 70 percent. This will naturally
lower the beta of your portfolio.

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Market timing is based on an explicit or implicit forecast of general market movements. The
advocates of market timing employ a variety of tools like business cycle analysis, moving
average analysis, advance – decline analysis, and econometric models. The forecast of the
general market movement derived with the help of one or more of these tools is tempered by the
subjective judgment of the investor. Often, of course, the investor may go largely by his market
sense.

2. Sector Rotation: The concept rotation can be applied to stocks as well as bonds. It is,
however, used more commonly with respect to the stock component of the portfolio where it
essentially involves shifting the weightings for various industrial sectors based on their assessed
outlook. For example, if you believe that cement and pharmaceutical sectors would do well
compared to other sectors in the forthcoming period (one year, two years, or whatever), you may
overweight these sectors, relative to their position in the market portfolio. Put differently, your
stock portfolio will be tilted more towards these sectors in comparison to the market portfolio.

With respect to bonds, sector rotation implies a shift in the composition of the bond portfolio in
terms of quality (as reflected in credit rating), coupon rate, and term to maturity, and so on. For
example, if you anticipate a rise in interest rates you may shift from long – term bonds to
medium – term or even short – term bonds. Remember that a long – term bond is more sensitive
to interest rate variation compared to a short – term bond.

3. Security Selection: It is perhaps the most commonly used vector by those who follow an
active portfolio strategy, security selection involves a search for under – priced securities. If you
resort to active stock selection, you may employ fundamental and/or technical analysis to
identify stocks which seem to promise superior returns and concentrate the stock component of
your portfolio on them. Put differently, in your portfolio such stocks will be overweighed relative
to their position in the market portfolio. Likewise, stocks which are perceived to be unattractive
will be underweighted relative to their position in the market portfolio.

As far as bonds are concerned, security selection calls for choosing bonds which offer the highest
yield to maturity at a given level or risk.

4. Use of a Specialized Investment Concept: A fourth possible approach to achieve superior

returns is to employ a specialized concept or philosophy, particularly with respect to investment
in stocks. As Charles D. Ellis put is, a possible way to enhance returns “is to develop a profound
and valid insight into the forces that drive a particular sector of the market or a particular group
of companies or industries and systematically exploit that investment insight or concept”. Some
of the concepts that have been exploited successfully by investment practitioners are:
i. Growth stocks
ii. Value stocks
iii. Asset – rich stocks
iv. Technology stocks
v. Cyclical stocks

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The advantage of cultivating a specialized investment concept or philosophy is that it will help
you to:
(a) focus your efforts on a certain kind of investment that reflect your abilities and talents,
(b) avoid the distractions of pursuing other alternatives, and
(c) Master an approach or style through sustained practice and continual self – critique. As
against these merits, the great disadvantage of focusing exclusively on a specialized concept
or philosophy is that it may become obsolete. The changes in market place may cast a
shadow over the validity of the basic premise underlying the investment philosophy.

II. Passive Strategy

The active strategy is based on the premise that the capital market is characterized by
inefficiencies which can be exploited by resorting to market timing or sector rotation or security
selection or use of a specialized concept or some combination of these vectors.

The passive strategy, on the other hand, rests on the tenet that the capital market is fairly efficient
with respect to the available information. Hence, the search for superior returns through an active
strategy is considered futile.

Operationally, how is the passive strategy implemented? Basically, it involves adhering to the
following two guidelines:
1. Create a well- diversified portfolio at a pre – determined level of risk.
2. Hold the portfolio relatively unchanged over time, unless it becomes inadequately
diversified or inconsistent with the investor’s risk – return preferences.

5.8 Selection of Securities

1. Selection of Bonds (Fixed Income Avenues): You should carefully evaluate the following
factors in selecting fixed income avenues.
a. Yield to maturity as discussed previously, the yield to maturity for a fixed income avenue
represents the rate of return earned by the investor if he invests in the fixed income avenue and
holds it till maturity.
b. Risk of default to assess the risk of default on a bond, you may look at the credit rating of
the bond. If no credit rating is available, examine relevant financial ratios (like debt – to –
equity ratio, times interest earned ratio, and earning power) of the firm and assess the general
prospects of the industry to which the firm belongs.
c. Tax shield in yesteryears, several fixed income avenues offered tax shield; now very few do
so.
d. Liquidity If the fixed income avenue can be converted wholly or substantially into cash at a
fairly short notice, it possesses liquidity of a high order.

2. Selection of Stocks (Equity Shares): Three broad approaches are employed for the selection
of equity shares: technical analysis, fundamentals analysis, and random selection. Technical
analysis looks at price behaviour and volume data to determine whether the share will move up
or down or remain trendless. Fundamental analysis focuses on fundamental factors like the
earning level, growth prospects, and risk exposure to establish the intrinsic value of a share. The
recommendation to buy, hold, or sell is based on a comparison of the intrinsic value and the

86
prevailing market price. The random selection approach is based on the premise that the market
is efficient and securities are properly priced.

5.9 Portfolio Revision

Irrespective of how well you have constructed your portfolio, it soon tends to become inefficient
and hence needs to be monitored and revised periodically. As Robert D. Arnott says “Portfolios
do not manage themselves. Nor can weather the ages unaltered. With each passing day,
portfolios that we carefully crafted yesterday become very less – than – optimal. Change is the
investor’s only constant.”

Over time several things are likely to happen. The asset allocation in the portfolio may have
drifted away from its target; the risk and return characteristics of various securities may have
altered; finally, the objectives and preferences of the investor may have changed.

Given the dynamic development in the capital market and changes in your circumstances, you
have to periodically monitor and revise portfolio. This usually entails two things, viz. portfolio
rebalancing and portfolio upgrading.

1. Portfolio Rebalancing: Portfolio rebalancing involves reviewing and revising the portfolio
composition (i.e. the stock – bond mix). There are three basic policies with respect to portfolio
rebalancing: buy and hold policy, constant mix policy, and portfolio insurance policy.

Under the buy and hold policy, the initial portfolio is left undisturbed. It is essentially a ‘buy and
hold’ policy. Irrespective of what happens to relative values, no rebalancing is done. The constant
mix policy calls for maintain the proportions of stocks and bonds in line with their target value.
The Portfolio insurance policy calls for increasing the proportions of stocks when the portfolio
appreciates in value and decreasing the exposure to stocks when the portfolio depreciated in
value. The basic idea is to ensure that the portfolio value does not fall below a floor level.

2. Portfolio Upgrading: While portfolio rebalancing involves shifting from stocks to bonds or
vice versa, portfolio upgrading calls for re-assessing the risk – return characteristics of various
securities (stocks as well as bonds), selling over – priced securities, and buying under – priced
securities. It may also entail other changes the investor may consider necessary to enhance the
performance of the portfolio.

5.10 Performance Evaluation

The key dimensions of portfolio performance evaluation are rate of return and risk. This section
looks at the measures of rate.

Rate of Return: The rate of return from a portfolio for a given period (which may be defined as
a period of one year) is measured as follows:
Dividend income  Terminal value  Intial Value
Initial value

To illustrate the calculation of the rate of return, let us look at the following data:

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 Particulars Rs.

Initial market value of the portfolio Rs.1,00,000

Dividend and interest income received toward Rs.10,000

the end of the year

Terminal market value of the portfolio Rs.1,05,000

The rate of return on this portfolio is simply:

10,000  (1,05,000  1,00,000)
 0.15or15 percent
1,00,000

Risk: The risk of a portfolio can be measured in various ways. The two most commonly used
measures of risk are: variability and beta.
a. Variability: The Bank Administration Institute of the US recommended the use of
variability (as measured by the mean absolute deviation) of the quarterly rates of return of the
portfolio. Sharpe and others have also advocated the use of variability. However, their
preferred measure of variability is standard deviation.

b. Beta: A measure of risk commonly advocated is beta. The beta of a portfolio is computed
the way the beta of an individual security is computed. To calculate the beta of a portfolio,
regress the rate of return of the portfolio on the rate of return of a market index. The slope of
this regression line is the portfolio beta. Remember that it reflects the systematic risk of the
portfolio.

Performance Measure

5.10.1 Markowitz Theory

Most people agree that holding two stocks is less risky than holding one stock. For example,
holding stocks from textile, banking, and electronic companies is better than investing all the
money on the textile company’s stock. But building up the optimal portfolio is very difficult.
Markowitz provides an answer to it with the help of risk and return relationship.

Assumptions

The individual investor estimates risk on the basis of variability of returns i.e. the variance of
returns. Investor’s decision is solely based on the expected return and variance of returns only.

For a given level of risk, investor prefers higher return to lower return. Likewise, for a given
level of return investor prefers lower risk than higher risk.
The Concept

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In developing his model, Markowitz had given up the single stock portfolio and introduced
diversification. The single security portfolio would be preference if the investor is perfectly
certain that his expectation of highest return would turn out to be real. In the world of
uncertainty, most of the risk averse investors would like to join Markowitz rather than keeping a
single stock, because diversification reduces the risk. This can be shown with the help of the
following illustration.

Take the stock of ABC company and XYZ company. The returns expected from each company
and their probabilities of occurrence, expected returns and the variances are given. The
calculation procedure is given in the table.

*Treynor’s Performance Index

The Treynor Index is a measure with which you may measure the performance of your portfolio
over a given period of time. The important aspect of the Treynor Index is that this performance
indicator takes into consideration the risk of the portfolio.

In order to use the Treynor Index, you must know three things; the portfolio return, the risk-free
rate of return, and the beta of the portfolio. For the risk-free rate of return, you may use the
average return (over the period of time) of some government bond or note. The beta of the
portfolio is a measure of the systematic risk of the portfolio. Using the beta, rather than the
standard deviation (as in the Sharpe Index), you are assuming that the portfolio is a well
diversified portfolio. If you are looking at the return of a mutual fund, this figure is typically
available from the fund company itself (this and other measures are also available from the
American Association of Individual Investors' Guide to Mutual Funds).

For those of you who want to know the formula for the index;

Treynor = (Portfolio Return - Risk-Free Return) / Beta

Let's use the same example information. A portfolio manager achieved a return of 15.0%, his
portfolio had beta measurement of 1.1 and the market achieved a return of 14.6% vs. a risk free
rate of return of 7%.
Index = (.15 - .07) / 1.1 = 0.0727
To compare, another portfolio manager achieved a return of 13.5% with a beta of .81. The
Treynor index for this portfolio manager is:
Index = (.135 - .07) / 0.81 = 0.0802

This means that the 2nd portfolio manager outperformed the first portfolio manager on a risk-
adjusted basis.

* Jensen’s Performance Index

The Jensen Performance Index is used to determine if the Required Return, calculated using the
Capital Asset Pricing Model, is realized. The Capital Asset Pricing Model is used to determine

89
the required rate of return (in order to assume the level of risk and the Jensen Performance index
is used to see if the calculation yielded the results that you thought that it would.

n order to use the Jensen Performance Index, you will need the following; the realized return (on
the portfolio), the market rate of return, the tax-free rate of return and the beta of the portfolio.

For those of you who want to know the formula for the index;

Jensen’s = Portfolio Return - [Risk-free return + (Market Return - Risk-free Return) * Beta]

As an example, a portfolio manager achieved a return of 15.0%, his portfolio had beta
measurement of 1.1 and the market achieved a return of 14.6% vs. a risk free rate of return of
7%.

To calculate the Jensen Index:

Alpha = .15 - [ .07 + (.146 - .07) * 1.1 ] = -.0036

A negative number indicates inferior performance as compared to the risk.

Summary

➢ Markowitz developed algorithms to minimise portfolio risk. Diversification reduces the

unsystematic risk component of the portfolio.

➢ The level of risk exposure is measured with the help of the standard deviation of the returns.
The expected return is the weighted sum of the expected returns of the portfolio, the weights
being the probabilities of their occurrence.

➢ If securities with less than perfect positive correlation between their price movements are
combined risk can be reduced considerably. The risk would be nil or the standard deviation
would be zero if two securities have perfect negative correlation. Risk cannot be reduced if the
securities have perfect positive correlation.

➢ Many portfolios may be attainable. But some portfolios are attractive because they give
more return for the same level of risk or same return with lesser level of risk. These portfolios
form the efficient frontier.

➢ Utility curves of the investor decide the most efficient portfolio.

➢ In the levered portfolio investor is permitted to borrow and lend. Risk free assets are also
added with risky assets and it would minimise risk.

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*Treynor’s Performance Index

The Treynor Index is a measure with which you may measure the performance of your portfolio
over a given period of time. The important aspect of the Treynor Index is that this performance
indicator takes into consideration the risk of the portfolio.

In order to use the Treynor Index, you must know three things; the portfolio return, the risk-free
rate of return, and the beta of the portfolio. For the risk-free rate of return, you may use the
average return (over the period of time) of some government bond or note. The beta of the
portfolio is a measure of the systematic risk of the portfolio. Using the beta, rather than the
standard deviation (as in the Sharpe Index), you are assuming that the portfolio is a well
diversified portfolio. If you are looking at the return of a mutual fund, this figure is typically
available from the fund company itself (this and other measures are also available from the
American Association of Individual Investors' Guide to Mutual Funds).

For those of you who want to know the formula for the index;

Treynor = (Portfolio Return - Risk-Free Return) / Beta

Let's use the same example information. A portfolio manager achieved a return of 15.0%, his
portfolio had beta measurement of 1.1 and the market achieved a return of 14.6% vs. a risk free
rate of return of 7%.
Index = (.15 - .07) / 1.1 = 0.0727
To compare, another portfolio manager achieved a return of 13.5% with a beta of .81. The
Treynor index for this portfolio manager is:
Index = (.135 - .07) / 0.81 = 0.0802

This means that the 2nd portfolio manager outperformed the first portfolio manager on a risk-
adjusted basis.

* Jensen’s Performance Index

The Jensen Performance Index is used to determine if the Required Return, calculated using the
Capital Asset Pricing Model, is realized. The Capital Asset Pricing Model is used to determine
the required rate of return (in order to assume the level of risk and the Jensen Performance index
is used to see if the calculation yielded the results that you thought that it would.

n order to use the Jensen Performance Index, you will need the following; the realized return (on
the portfolio), the market rate of return, the tax-free rate of return and the beta of the portfolio.

For those of you who want to know the formula for the index;

Jensen’s = Portfolio Return - [Risk-free return + (Market Return - Risk-free Return) * Beta]

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As an example, a portfolio manager achieved a return of 15.0%, his portfolio had beta
measurement of 1.1 and the market achieved a return of 14.6% vs. a risk free rate of return of
7%.

To calculate the Jensen Index:

Alpha = .15 - [ .07 + (.146 - .07) * 1.1 ] = -.0036

A negative number indicates inferior performance as compared to the risk.

Summary

➢ Markowitz developed algorithms to minimise portfolio risk. Diversification reduces the

unsystematic risk component of the portfolio.

➢ The level of risk exposure is measured with the help of the standard deviation of the returns.
The expected return is the weighted sum of the expected returns of the portfolio, the weights
being the probabilities of their occurrence.

➢ If securities with less than perfect positive correlation between their price movements are
combined risk can be reduced considerably. The risk would be nil or the standard deviation
would be zero if two securities have perfect negative correlation. Risk cannot be reduced if the
securities have perfect positive correlation.

➢ Many portfolios may be attainable. But some portfolios are attractive because they give
more return for the same level of risk or same return with lesser level of risk. These portfolios
form the efficient frontier.

➢ Utility curves of the investor decide the most efficient portfolio.

➢ In the levered portfolio investor is permitted to borrow and lend. Risk free assets are also
added with risky assets and it would minimise risk.

92