Portfolio Construction Using Fundamental Analysis

The foundation of Modern Portfolio Theory was laid by Markowitz in 1951. He began with the simple premise that since almost all investors invest in multiple securities rather than one, there must be some benefit in investing in a portfolio of securities. He measured riskiness of a portfolio through variability of returns and showed that investment in several securities reduced this risk. His work won him the Nobel Prize for Economics in 1990. Markowitz‘s work was extended by Sharpe in 1964, Lintner in1965 and Mossin in 1966. Sharpe shared the Nobel Prize for Economics in 1990 with Markowitz and Miller for his contribution to the Capital Asset Pricing Model (CAPM). This model breaks up the riskiness of each security into two components - the market related risk which cannot be diversified called systematic risk measured by the beta coefficient and another component which can be eliminated through diversification called unsystematic risk. The Markowitz model is extremely demanding in its data needs for generating the desired efficient portfolio. It requires N (N+3)/2 estimates (N expected returns + N variances of returns + N*(N-1 )/2 unique covariance‘s of returns). Because of this limitation the single index model with less input data requirements has emerged. The Single index model requires 3N+2 estimates (estimates of alpha for each stock, estimates of beta for each stock, estimates of variance σei2 for each stock, estimate for expected return on market index and an estimate of the variance of returns on the market index σm2) to use the Markowitz optimization framework. The single index model assumes that co-movement between stocks is due to movement in the index. The basic equation underlying the single index model is: Ri = ai + βi*Rm where Ri = Return on the ith stock ai = component of security i‘s that is independent of market performance

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Portfolio Construction Using Fundamental Analysis

βi= coefficient that measures expected change in R given a change in Rm i Rm = rate of return on market index The term ai in the above equation is usually broken down into two elements ai which is the expected value of ai and ei which is the random element of ai. The single index model equation, therefore, becomes: Ri = αi + βi*R + ei m Single index model has been criticized because of its assumption that stock prices move together only because of common co-movement with the market. Many researchers have found that there are influences beyond the market, like industry-related factors, that cause securities to move together.

Fundamental analysis of a business involves analyzing its income statement, financial statements, its management, competitive advantages, its competitors and markets. The analysis is performed on historical and present data, with the goal to make financial projections. One of the primary assumptions of fundamental analysis is that the price on the stock market does not fully reflect a stock‘s ―real‖ value. Intrinsic value is defined to be the present value of all future net cash flows to the company. The intrinsic value of an equity share depends on a multitude of factors. The earnings of the company, the growth rate and risk exposure of the company have a direct bearing on the price of the share. These factors in turn rely on the host of other factors like economic environment in which they function, the industry which they belong to, and finally companies‘ own performance. The fundamental school of thought appraised the intrinsic value of shares through:   Economic Analysis Industry Analysis

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Portfolio Construction Using Fundamental Analysis

Company Analysis

1.2.1 Economic Analysis
The level of economic activity has an impact on investment in many ways. If the economy grows rapidly, the industry can also be expected to show rapid growth and viceversa. When the level of economic activity is low, stock prices are low, and when the level of economic activity is high, stock prices are high reflecting the prosperous outlook for sales and profits of the firms. The analysis of macroeconomic environment is essential to understand the behavior of the stock prices. The commonly analyzed macro-economic factors are as follows: A. Gross Domestic Product: 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 expenditure on goods and services and net export of goods and services. The growth rate of economy points out the prospects for the industrial sector and return investors can expect from investment in shares. The higher growth rate is more favorable to the stock market. B. Savings and investment: It is obvious that growth requires 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 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.

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Availability of cheap fund encourages speculation and rise in price of shares. then the real rate of growth would be very little. Inflation: Along with the growth of GDP. Tax relief given to savings encourages savings. balanced budget is highly favorable to the stock market. F. Hence. Surplus budget may result in deflation. thereby. A decrease in interest rate implies lower cost of finance for firms and more profitability. E. If there is a mid level of inflation. The demand in the consumer product industry is significantly affected. If the deficit increases. if inflation also increases. The Balance of payment: The balance of payment is the record of a country‘s money receipts from and payments abroad. The tax structure: Concessions and incentives given to a certain industry encourage investment in that particular industry. Alliance Business Academy 4 . A deficit budget may lead to high rate of inflation and adversely affect the cost of production. BOP is the measure of the strength of rupee on external account. The type of tax exemption has an impact on the profitability of the industries. D. The difference between receipts and payments may be surplus or deficit. Interest rates: The interest rate affects the cost of financing to the firms. Budget: The budget draft provides an elaborate account of the government revenues and expenditures. G.Portfolio Construction Using Fundamental Analysis C. it is good to the stock market but high rate of inflation is harmful to the stock market. More money is available at a lower interest rate for the brokers who are doing business with borrowed money. the rupee may depreciate against other currencies.

This would lead to buoyancy in the stock market. industry-wide growth. A wide network of communication system is a must for the growth of the economy.2. The volatility of the foreign exchange rate affects the investment of the foreign institutional investors in the Indian Stock Market. Monsoon and Agriculture: Agriculture is directly and indirectly linked with the industries. Each industry has differences in terms of its customer base. H. A favorable balance of payment renders a positive effect on the stock market. When the monsoon is bad . by providing labor and demand for products. Regular supply of power without any power cut would boost the production. Infrastructure facilities: Infrastructure facilities are essential for the growth of industrial and agricultural sector. literacy and geographic location. Demographic factors: The demographic data provides details about the population by age. Population. Learning about how the industry works will give an investor a deeper Alliance Business Academy 5 . The population by age indicates the availability of able work force. 1. J. market share among firms. competition. I. occupation. Agriculture and hydroelectric production would suffer. Banking and financial sectors should also be sound enough to provide adequate support to industry and agriculture. This is needed to forecast the demand for the consumer goods. affects the industry and stock market.Portfolio Construction Using Fundamental Analysis affecting the cost of imports. regulation and business cycles. They cast a shadow on the share market.2 Industry Analysis Industry analysis is a type of investment research that begins by focusing on the status of an industry or an industrial sector. A good monsoon leads to higher demand for input and results in bumper crop.

Pioneering development: . each linked to a distinct stage of an industry's evolution. Industry Life Cycle Model: This model is a useful tool for analyzing the effects of an industry's evolution on competitive forces. The industry builds its productive capacity as sales grow at an increasing rate as the industry attempts to meet excess demands. Profit Alliance Business Academy 6 . the industries sales growth declines because of shifts in demand or growth in substitutes.During this stage which is probably the longest stage. we can identify five industry environments. c. Thus. b. Stabilization and market maturity: . Competition produces tight profit margins. the industry experiences modest sales growth and very small or negative profit margins and profits. Rapid accelerating growth: .Portfolio Construction Using Fundamental Analysis understanding of a company's financial health. Mature stage: . The profit margins are very high. and the firms involved incur major development costs. Using the industry life cycle model. The Industry life cycle analysis and Porter‘s 5 forces model for competitive advantage are common valuation techniques. d. The market for the industry‘s product or service during this time period is small.During this rapid growth stage.At this stage of maturity. a.During this start up stage. the industry growth rate declines to the growth rate of aggregate economy or its industry segment. and the rate of return on capital eventually becomes below the competitive level. further sales growth may be above normal but it no longer accelerates.The success in stage2 has satisfied most of the demands of the industry goods and services. which the profit margin begin to decline to normal levels. A. a market develops for the product or service and demand becomes substantial. Deceleration of growth and decline: . The rapid growth of sales and the high profit margins attract competitors to the industry. e. which causes an increase in supply and lower price.

The easier it is for new companies to enter the industry. If one supplier has a large enough impact to affect a company's margins and volumes.This is how much pressure suppliers can place on a business. the more cutthroat competition there will be. B.What is the likelihood that someone will switch to a competitive product or service? If the cost of switching is low. existing loyalty to major brands. c.Portfolio Construction Using Fundamental Analysis margins continue to be squeezed. Alliance Business Academy 7 . which is a threat to the company. then they hold substantial power. Power of Buyers: . If substitutes are similar. Threat of New Entrants: . then it can be viewed in the same light as a new entrant. government regulations etc act as barriers to entry. Porter’s Five Forces Model This model identifies five competitive forces that shape every single industry and market. When there are very few suppliers of a particular product or there are no substitutes or switching to another (competitive) product is very costly. b. The main issue is the similarity of substitutes. d. If one customer has a large enough impact to affect a company's margins and volumes. Power of Suppliers: . Availability of Substitutes: .This is how much pressure customers can place on a business. These forces help us to analyze everything from the intensity of competition to the profitability and attractiveness of an industry. while others serve millions. and some firms experiences low profits or even losses. In general. Some companies serve only a handful of customers. then they hold substantial power. Factors that can limit the threat of new entrants such as high fixed cost. then this poses to be a serious threat. it's a red flag (a negative) if a business relies on a small number of customers for a large portion of its sales because the loss of each customer could dramatically affect revenues. a. the supplier is powerful and vice versa.

1. Companies can only grow by stealing customers away from competitors. volume flexibility and variety Alliance Business Academy 8 .This describes the intensity of competition between existing firms in an industry.delivery speed. Competitive advantage of the company: Competitive advantage (CA) is a position that a firm occupies in its competitive landscape. no dominant firm.and keep it.Portfolio Construction Using Fundamental Analysis e. A highly competitive market might result from:    Many players of about the same size. They are:A. Competitive advantages vary from situation to situation and from time to time. Some basic examples of CAs can be divided in 4 main global areas:     Cost . Competitive Rivalry: . Little differentiation between competitor‘s products and services. A company's long-term success is driven largely by its ability to maintain a competitive advantage . The risk and return associated with the purchase of the stock is analyzed to take better investment decision. The present and future are affected by a number of factors.High quality and consistent quality Time . on time delivery and development speed Flexibility .3 Company Analysis In the company analysis the investor assimilates the several bit of information related to the company and evaluates the present and future value of stock.Low cost operations Quality .customization.2. A mature industry with very little growth.

Efficient use of fixed assets with a raw materials. It makes sense . D. the revenue will also be stable. Operating efficiency: The operating efficiency of a company directly affects the earnings of a company. labor and management would lead to more income from sales. E. The company‘s sales might have increased but its earnings may decline due to the rise in costs.e. The management of the firm should efficiently plan. This leads to internal fund generation for the expansion of the Alliance Business Academy 9 . Some believe that management is the most important aspect for investing in a company. The debt may be in the form of debentures and term loans from financial institutions. earnings do not always increase with the increase in sales. using debt financing along with equity financing. Earnings of the company: Sales alone do not increase the earnings but the costs and expenses of the company also influence the earnings of the company. If a firm has stable operating ratio. The basic objective of management is to attain the stated objectives of the company for the good of the equity share holders. An expanding company that maintains high operating efficiency with a low break-even point earns more than the company with high break-even points. the public and the employers. Capital structure: The equity holders‘ return can be increased manifold with the help of financial leverage. i.even the best business model is doomed if the leaders of the company fail to properly execute the plan. actuate and control the activities of the company. Good management depends on the quality of the manager. Management: Good and capable management generates profit to the investors. Further.Portfolio Construction Using Fundamental Analysis B. organize. The effect of financial leverage is measured by computing leverage ratios. C.

H. Historical financial statements help to predict the future. one of the most important questions that should be asked is: What exactly does the company do? This is referred to as a company's business model – it's how a company makes money. you don't know what the drivers are for future growth. Financial analysis: The best source of financial information about a company is its own financial statements. along with corporate laws and regulations. making it more difficult for anyone to conduct unethical and illegal activities Good corporate governance is a situation in which a company complies with all of its governance policies and applicable government regulations in order to look out for the interests of the company's investors and other stakeholders. and you leave yourself vulnerable to being blindsided. A growing company should have low operating ratio to meet the growing demand for its product. G. The statement gives the historical and current information about the company‘s operations. Unless you understand a company's business model. directors and stakeholders. The current information Alliance Business Academy 10 . You can get a good overview of a company's business model by checking out its website. F. These policies are defined and determined in the company charter and its bylaws. Business Model: Even before an investor looks at a company's financial statements or does any research. The purpose of corporate governance policies is to ensure that proper checks and balances are in place. Financial statement analysis is the study of a company‘s financial statement from various viewpoints. Corporate Governance: Corporate governance describes the policies in place within an organization denoting the relationships and responsibilities between management.Portfolio Construction Using Fundamental Analysis firm. This is a primary source of information for evaluating the investments prospects in the particular company‘s stock.

Some of the most legendary investors think long-term and value. rewards of fundamental analysis is the development of a thorough understanding of the business. very long-term. C.Portfolio Construction Using Fundamental Analysis aids to analyze the present status of the company.4 Strengths Of Fundamental Analysis A. Fundamental analysis can help uncover companies with valuable assets. demographic. Value Spotting: Sound fundamental analysis will help identify companies that represent good value. an investor will be familiar with the key revenue and profit drivers behind a company. After such painstaking research and analysis. but less tangible. Business Acumen: One of the most obvious. B.2. A good understanding can help investors avoid companies that are prone to shortfalls and identify those that continue to deliver. And also the ability to identify and predict long-term economic. stable earnings and staying power. Earnings and earnings expectations can be potent drivers of equity prices. Alliance Business Academy 11 . Long-term trends: Fundamental analysis is good for long-term investments based on long-term trends. The two main statements used in analysis are:  Balance sheet Profit and loss account 1. Even some technicians will agree to that. technological or consumer trends can benefit patient investors who pick the right industry groups or companies. a strong balance sheet.

This can get quite time consuming and limit the amount of research that can be performed. the only question is how much so. and hence Wall Street. Industry/Company Specific: Valuation techniques vary depending on the industry group and specifics of each company. is wrong. 1. a different technique and model is required for different industries and different companies. When this happens. even on a worst case. This is not to say that there are not misunderstood companies out there. C. However. Time consuming models often produce valuations that are contradictory to the current price prevailing on Wall Street. a best-case valuation and a worst-case valuation. subtle misrepresentation and concealment are common. an experienced and skilled analyst may be able to detect such Alliance Business Academy 12 . but it can be extraordinarily time consuming. Fundamental analysts are generally aware of this and use sensitivity analysis to present a base-case valuation.Portfolio Construction Using Fundamental Analysis 1. Often.5 Weakness Of Fundamental Analysis A. Time Constraints: Fundamental analysis may offer excellent insights. but it is quite brash to imply that the market price. Any changes to growth or multiplier assumptions can greatly alter the ultimate valuation.2. For this reason.6 Obstacles in the way of a successful Fundamental Analysis: A. most models are almost always bullish. B. Subjectivity: Fair value is based on assumptions.2. Inadequacies or incorrectness of data: An analyst has to often wrestle with inadequate or incorrect data. While deliberate falsification of data may be rare. the analyst basically claims that the whole street has got it wrong.

because of such delay. likewise overvaluations arising from unjustified optimism and misplaced enthusiasm may endure for unreasonable lengths of time. Alliance Business Academy 13 . Irrational market behavior: The market itself presents a major obstacle to the analyst. under valuations may persist for extended periods. their trades) solely on the price and volume movements of securities. Using charts and a number of other tools. in some instances. C. As Benjamin Graham put it. new forces may emerge. In an environment characterized by discontinuities. The slow correction of under or overvaluation poses a threat to the analyst. they trade on momentum. Accordingly. ―The particulars danger to analyst is that. While it is possible to use both techniques in combination. he too is likely to be misled by them into drawing wrong conclusions. B. not caring about the fundamentals. the past record is a poor guide to future performance. Future uncertainties: Future change are largely unpredictable more so when the economic and business environment is buffeted by frequent winds of change.2. all news about a company already is priced into a stock.Portfolio Construction Using Fundamental Analysis ploys and cope with them. more precisely. Before the market eventually reflects the values established by the analyst.7 Criticisms of Fundamental Analysis The biggest criticisms of fundamental analysis come primarily from two groups: proponents of ―technical analysis‖ and believers of ―efficient market hypothesis‖. Put simply. new determining factors may supervene before the market price adjusts itself to the value as he found it‖ 1. technical analysts base their investments (or. and therefore a stock‘s price movements give more insight than the underlying fundamental factors of the business itself. However. one of the basic tenets of technical analysis is that the market discounts everything. On account of neglect or prejudice .

The result is an opportunity for value investors to profit by taking a position on an inflated/deflated price and getting out when the price is later corrected by the market.2.3 VALUATION In selecting stocks that trade for less than their intrinsic value. 1. Press releases don't happen by accident and are an important PR tool for companies. They believe the market always overreacts to good and bad news. are usually in disagreement with both fundamental and technical analysts. The efficient market hypothesis contends that it is essentially impossible to produce market-beating returns in the long run. value investors actively seek stocks of companies with sound financial statements that they believe the market has undervalued. any opportunities for excess returns derived from fundamental (or technical) analysis would be almost immediately whittled away by the market‘s many participants. The rationale for this argument is that.Portfolio Construction Using Fundamental Analysis Followers of the efficient market hypothesis. through either fundamental or technical analysis. There is nothing wrong with this and the research can still be of great value. since the market efficiently prices all stocks on an ongoing basis. Alliance Business Academy 14 . but it should be approached with caution. making it impossible for anyone to meaningfully outperform the market over the long term. Investors should become skilled readers to weed out the important information and ignore the hype. 1. but should be read with a healthy degree of skepticism to separate the facts from the spin.8 Conclusion Fundamental analysis can be valuable. Corporate statements and press releases offer good information. We all have personal biases and every analyst has some sort of bias. however. causing stock price movements that do not correspond with their long-term fundamentals.

Portfolio Construction Using Fundamental Analysis 1.  Contingent claim valuation: A contingent claim or option is an asset that pays off only under certain contingencies.1 Valuation Approaches  Discounted cash flow valuation: This approach has its foundation in the ―present value‖ rule. income tax rate. It is based on the philosophy that every asset has an intrinsic value that can be estimated. The discount rate will be a function of the riskiness of the estimated cash flows. with higher rates for riskier assets and lower rates for safer projects. The 4 step DCF valuation Technique Step 1—Forecast Expected Cash Flow: the first order of business is to forecast the expected cash flow for the company based on assumptions regarding the company's revenue growth rate. growth and risk. net operating profit margin. book value or sales.3. Alliance Business Academy 15 . based upon its characteristics in terms of cash flows.  Relative valuation: Estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings. and incremental working capital requirement. A) Discounted Cash Flow Valuation In discounted cash flow valuation. if the value of the underlying asset exceeds a prescribed value for a call option or is less than the prescribed value for a put option. cash flows. fixed investment requirement. the value of an asset is the present value of the expected cash flows on the asset. Option pricing models are used to measure the value of assets that share option characteristics. where the value of any asset is the present value of expected future cash flows on it.

and other short-term liabilities to get Value to Common Equity.Portfolio Construction Using Fundamental Analysis Step 2—Estimate the Discount Rate: the next order of business is to estimate the company's weighted average cost of capital (WACC). is based upon an asset‘s fundamentals. Disadvantages of DCF valuation  Since it is an attempt to estimate intrinsic value. Step 4—Calculate Intrinsic Stock Value: we then subtract the values of the company's liabilities—debt. it requires far more inputs and information than other valuation approaches. divide that amount by the amount of stock outstanding to get the per share intrinsic stock value Advantages of DCF Valuation  Since DCF valuation.  If good investors buy businesses. These inputs and information are not only noisy (and difficult to estimate). it brings you face to face with the assumptions you are making when you pay a given price for an asset. and understand its business. preferred stock. To that we add the value of Short-Term Assets on hand to get the Corporate Value.  DCF valuation forces you to think about the underlying characteristics of the firm. rather than stocks (the Warren Buffet adage). but can be manipulated by the savvy analyst to provide the conclusion he or she wants. it should be less exposed to market moods and perceptions. We also use the WACC to calculate the company's Residual Value. Alliance Business Academy 16 . If nothing else. done right. which is the discount rate that's used in the valuation process Step 3—calculate the Value of the Corporation: the company's WACC is then used to discount the expected cash flows during the Excess Return Period to get the corporation's Cash Flow from Operations. discounted cash flow valuation is the right way to think about what you are getting when you buy an asset.

to find every stock in a market to be overvalued.Portfolio Construction Using Fundamental Analysis  In an intrinsic valuation model. B) Free cash flow to firm (FCFF) A Firm is composed of all its claimholders and includes. in addition to equity investors. bondholders and preferred stockholders. There are two ways in which these cash flows can be calculated. which should yield an equivalent number. One way is to accumulate the cash flows to different claimholders to the firm. FCFF = EBIT (1-tax rate) + Depreciation – Capital Expenditures – Working Capital Needs A firm with free cash flows to the firm growing at a stable growth rate can be valued using the following model: Value of firm = FCFF1 / (WACC . Thus. it is possible in a DCF valuation model. The other approach. FCFF = Free cash flows to equity + interest expense (1. The cash flows to the firm are therefore the accumulated cash flows to all these claimholders. FCFF= Expected free cash flow to firm for next year WACC= Weighted average cost of capital Alliance Business Academy 17 .tax rate) + Principal Repayments – New Debt Issues + Preferred Dividends. there is no guarantee that anything will emerge as under or overvalued. starts with the earnings before interest and taxes.gn) Where. Estimating Cash flows to the Firm The cash flows to the firm are those cash flows left over after meeting operating expenses and taxes but before making payments to any claimholders.

Investors are solely concerned with level and uncertainty of future wealth Separation of financial and production sectors. Assumptions of CAPM            All investors have rational expectations. given that asset's non-diversifiable risk. No inflation and no change in the level of interest rate exist. Thus.Portfolio Construction Using Fundamental Analysis gn= Growth rate in FCFF (forever) 1.CAPITAL ASSET PRICING MODEL The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset. Alliance Business Academy 18 .4 CAPM. Fixed quantity of assets. The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk). Perfectly efficient capital markets. The Risk-free borrowing and lending rates are equal. Risk-free rates exist with limitless borrowing capacity and universal access. production plans are fixed. often represented by the quantity beta (β) in the financial industry. if that asset is to be added to an already well-diversified portfolio. A. Returns are distributed normally. There are no arbitrage opportunities. as well as the expected return of the market and the expected return of a theoretical risk-free asset.

D. E(Ri) – Expected return of security i Rf – Risk Free Return Rm – Market return βi – Beta of the security C. Risk and Diversification The risk of a portfolio comprises systematic risk. The Risk Free Asset The risk-free asset is the (hypothetical) asset which pays a risk-free rate. B. it is also uncorrelated with any other asset (by definition: since its variance is zero). market risk.i. Systematic risk refers to the risk common to all securities . hence all investors have the same expectations about security returns for any given time period. The riskfree asset has zero variance in returns (hence is risk-free).S&P 500) E. Market Return The expected market rate of return is usually measured by looking at the arithmetic average of the historical returns on a market portfolio (ex. and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk.e. also known as undiversifiable risk. Unsystematic risk can be diversified away to smaller levels by including a greater Alliance Business Academy 19 . Unsystematic risk is the risk associated with individual assets. Formula E (Ri) = Rf + [E (Rm) – Rf ]βi Where. It is usually proxied by an investment in short-dated Government securities.Portfolio Construction Using Fundamental Analysis  Perfect information.

5 MEANINGS OF VARIOUS PERFORMANCE MEASURES A. Investors are often advised to pick investments with high Sharpe ratios. The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the excess return (or Risk Premium) per unit of risk in an investment asset or a trading strategy. the asset with the higher Sharpe ratio gives more return for the same risk. less predictability. must be linked to its riskiness in a portfolio context .Sharpe originally called it the "reward-to-variability" ratio in before it began being called the Sharpe Ratio by later academics and financial professionals. portfolio risk is represented by higher variance i." In the CAPM context. the return that compensates for risk taken. Sharpe measure = (Average rate of return on portfolio p – Average rate of return on a risk – free investment) / Standard deviation of return of portfolio p B. that is. When comparing two assets each with the expected return E[R] against the same benchmark with return Rf.i. better the performance Alliance Business Academy 20 . Higher the Treynor ratio. the required return on an asset. A rational investor should not take on any diversifiable risk. The Sharpe ratio is used to characterize how well the return of an asset compensates the investor for the risk taken.e. Sharpe Ratio: This ratio was developed by William Forsyth Sharpe in 1966. its contribution to overall portfolio riskiness as opposed to its "stand alone riskiness. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor 1.Portfolio Construction Using Fundamental Analysis number of assets in the portfolio (specific risks "average out"). Therefore. as only non-diversifiable risks are rewarded within the scope of this model.e. Treynor Ratio: The Treynor ratio (sometimes called reward-to-volatility ratio) relates excess return over the risk-free rate to the additional risk taken. however systematic risk instead of total risk is used.

Treynors measure = (Average rate of return on portfolio p – Average rate of return on a risk. The measure was first used in the evaluation of mutual fund managers by Michael Jensen in the 1970's. To calculate alpha. The market return. This model is used to adjust for the level of beta risk. the following inputs are needed:     The realized return (on the portfolio). D. Jensen's alpha (or Jensen's Performance Index. the Treynor measure implicitly assumes that the portfolio is well diversified. As systematic risk is measure of risk. Jensen's alpha = Portfolio Return . The risk-free rate of return. His measure is: Alliance Business Academy 21 . often in conjunction with the Sharpe ratio and the Treynor ratio.(Risk Free Rate + Portfolio Beta * (Market Return . other security.free investment)/ Beta of portfolio p C. so that riskier securities are expected to have higher returns. Jensen Measure: In finance. or portfolio over the security's required rate of return as determined by the Capital Asset Pricing Model.Portfolio Construction Using Fundamental Analysis under analysis. and The beta of the portfolio. ex-post alpha) is used to determine the excess return of a stock.Risk Free Rate)) Alpha is still widely used to evaluate mutual fund and portfolio manager performance. Fama’s measure: Fama proposed a measure of net selectivity based on the total risk of the portfolio.

Alliance Business Academy 22 .Portfolio Construction Using Fundamental Analysis [Return earned on portfolio + Standard deviation of portfolio/ standard deviation of market return*(Market return – Risk free return)] Fama measure of net selectivity reflects the difference between the return earned on the portfolio and the return posited by the capital market line.

Lintner in1965 and Mossin in 1966. Many researchers have found that there are influences beyond the market. there must be some benefit in investing in a portfolio of securities. He measured riskiness of a portfolio through variability of returns and showed that investment in several securities reduced this risk. that cause securities to move together. like industry-related factors. Markowitz‘s work was extended by Sharpe in 1964. It requires N(N+3)/2 estimates(N expected returns + N variances of returns + N*(N-1 )/2 unique covariance‘s of returns). Because of this limitation the single index model with less input data requirements has emerged. estimates of beta for each stock.the market related risk which cannot be diversified called systematic risk measured by the beta coefficient and another component which can be eliminated through diversification called unsystematic risk.1 INTRODUCTION The foundation of Modern Portfolio Theory was laid by Markowitz in 1951. estimate for expected return on market index and an estimate of the variance of returns on the market index σm2) to use the Markowitz optimization framework. Sharpe shared the Nobel Prize for Economics in 1990 with Markowitz and Miller for his contribution to the Capital Asset Pricing Model (CAPM). Single index model has been criticized because of its assumption that stock prices move together only because of common co-movement with the market. The Single index model requires 3N+2 estimates (estimates of alpha for each stock. estimates of variance σei2 for each stock. This model breaks up the riskiness of each security into two components . Alliance Business Academy 23 . The Markowitz model is extremely demanding in its data needs for generating the desired efficient portfolio. His work won him the Nobel Prize for Economics in 1990.Portfolio Construction Using Fundamental Analysis 2. He began with the simple premise that since almost all investors invest in multiple securities rather than one. The single index model assumes that co-movement between stocks is due to movement in the index.

observed that a multiperiod portfolio model provides significant advantages over traditional single-period approaches-especially for long-term investors. Faaland. Bawa. John M. and jacob. Such a framework can enhance risk adjusted performance and help investors evaluate the probability of reaching financial goals by linking asset and liability policies. The ranking procedures simplified the computations necessary to determine an optimum portfolio. examined alternative solution procedure to achieve the objective of chossing 'n' securities from a universe of 'm' securities in order to maximise the portfolio's excess-return-to Beta ratio. while individual return and risks are important. et al. more commonly called as EPG approach to portfolio optimization. (1977). showed that the construction of optimal portfolio could be simplified by using simple ranking procedures when returns followed a stable distribution and the dependence structure had any of several standard forms.. it was shown that upper bounds could be dealt within a more complex fashion that shares many of the features of ranking procedures of standard single index model. The paper concluded with computational experience on problems with 'n' ranging from 10 to 200 and 'm' from 500 to 1245. Edwin J. are among the prominent researchers. what matters finally is the return and risk of the portfolio. et al..2 REVIEW OF LITERATURE: Elton. (1981). They presented a new method for selecting optimal portfolios when upper bound constraints on investments in individual stocks were present and when the variance-covariance matrix of returns possessed a special structure such as that implied by standard single index model. who have worked on Sharpe's Single Index Model. (1979). (2003).3 STATEMENT OF PROBLEM Investors generally hold a portfolio of securities to take advantage of diversification. Extending their previous work. Bruce H. Mulvey. Nancy l. 2.Portfolio Construction Using Fundamental Analysis 2. Vijay S. et al. In constructing a portfolio fundamental analysis can be used to select Alliance Business Academy 24 ..

To construct a portfolio of banking stocks which are undervalued.6 OPERATIONAL DEFINITION OF CONCEPTS  Fundamental Analysis: A method of evaluating a stock by attempting to measure its intrinsic value. 2. In many cases it is seen that securities trade above their intrinsic value especially in the recent times because of boom in stock market. Alliance Business Academy 25 . construction of portfolio based on the analysis and to check the significant difference between returns of the portfolios. To identify stocks in banking sector which trade for less than their intrinsic value.Portfolio Construction Using Fundamental Analysis securities or Sharpe single index model can be used to construct an optimal portfolio. to the financial conditions and management of companies. as a result investors pay more to purchase them and the returns are not up to the mark. Fundamental analysts study everything from the overall economy and industry conditions. 2.5 SCOPE OF THE STUDY Scope of the research is confined to valuation of selected Banking stocks.4 OBJECTIVES OF THE STUDY      To undertake study of banking sector. Hence the study entitled:-―Portfolio construction using fundamental analysis‖ 2. To find if there is a significant difference in mean returns of portfolio constructed using fundamental and optimization approach. To construct a portfolio of banking stocks using Sharpe single index model.

WACC is calculated by multiplying the cost of each capital component by its proportional weighting and then summing. but are also more risky investments. Alliance Business Academy 26 . FCFF = EBIT (1-tax rate) + Depreciation – Capital Expenditures – Working Capital Needs  Weighted Average Cost Of Capital: A calculation of a firm's cost of capital that weights each category of capital proportionately. Intrinsic value can be thought of as the discounted stream of net cash flows from an asset  Beta: A statistical measure of the relative volatility of a stock. The beta for the market is 1. It is measure of systematic risk of a stock  Free cash flow to Firm: The cash flows to the firm are those cash flows left over after meeting operating expenses and taxes but before making payments to any claimholders. and firm specific factors. Stocks with betas above 1. Stocks with a beta below 1.Portfolio Construction Using Fundamental Analysis  Intrinsic value: The economic value of a company or its common stock based on internallygenerated cash returns.0 tend to move in the opposite direction of the market. or other security in comparison with the market as a whole.  Single index model: A model of stock returns that decomposes influences on returns into a systematic factor. fund.0 are more responsive to the market.00. as measured by the return on the broad market index.

NSE India .  Method of Sampling: The sampling technique followed for the study is non-probabilistic judgmental sampling. Ministry of Bankings. Investopedia.rediffmail etc. Money.7 RESEARCH METHODOLOGY  Type of Study: The research conducted is a Analytical study. It may involve relating the interaction of two or more variables.  Type of Data: Data required for this study was secondary data which was collected from various secondary sources like capital line Database. BSE .Portfolio Construction Using Fundamental Analysis 2. Then the level of significance between the return of portfolios constructed through fundamental Alliance Business Academy 27 . Economy watch. The samples were collected based on certain criteria which suited the research objective  Sample Size: The sample consists of 10 companies of the banking industry selected on the basis of the research objective  Techniques of Analysis: The Value growth FCFF model is used to find the intrinsic value of the selected banking stocks. In this project a study is conducted to determine the level of significance in portfolio mean returns constructed through fundamental analysis and Sharpe single index model. The return and risk aspects were then compared between the two portfolios. This is followed by selecting stocks to construct an optimum portfolio using past share price data through the Sharpe‘s optimization model. then as portfolio is constructed using these undervalued stocks.

E.) in the difference in the portfolios‘ mean returns is found to be SE ( x  y )   (x  y ) i 1 i i k 2 si 2   ( xi  yi )( x j  y j )(Covij ) n Using this for sample formula for standard error (S. The test statistics is t cal  x y SE ( x  y ) The independent sample and dependent sample t-test do not apply in this case as the portfolios have the same underlying securities. like all Value-growth models.).8 LIMITATIONS OF THE STUDY  The FCFF valuation model. 2. Alliance Business Academy 28 . The standard error (S.Portfolio Construction Using Fundamental Analysis analysis and through Sharpe‘s optimization model was determined. : There is significant difference between the returns of the two portfolios. is sensitive to assumptions about the expected growth rate. a test of equality /difference of portfolio mean returns is constructed.E. The following test is used to check the hypothesis Test for equality /difference of mean portfolio returns Ho H1 : There is no significant difference between the returns of the two Portfolios.

It gives a brief introduction of the Banking industry.Portfolio Construction Using Fundamental Analysis  The practical limitations are selecting an appropriate discount rate and estimating the future cash flow. test for equality/ difference of mean portfolio returns. free cash flow to firm method.  Chapter 4: Data Analysis This chapter includes all the relevant calculations for valuation of banking stocks. Investment in Indian Banking industry. Capital Asset Pricing Model and some definitions of various performance measures is given. scope of the research. objectives of the study. It also includes the methodology for portfolio construction based on Sharpe‘s optimization model and the test for equality/ difference of mean portfolio returns. the sources and tools of data collection. A brief note on the valuation approaches.  Chapter 2: Research Design This chapter includes the statement of problem. sampling type and size. limitations of the study. Alliance Business Academy 29 . the strengths and weaknesses of fundamental analysis. 2. factors to be considered for economy. It gives a brief introduction to fundamental analysis.  Chapter 3: Industry Analysis This chapter covers the industry profile. techniques of analysis. operational definitions and an overview of the chapter scheme. Indian Banking industry overview. riches of Indian Banking. methodology of research. This chapter includes history of Banking. industry and company analysis.9 OVERVIEW OF CHAPTER SCHEME  Chapter 1: Theoretical Background This chapter covers the Theoretical background of the study.

Alliance Business Academy 30 .Portfolio Construction Using Fundamental Analysis  Chapter 5: Summary of findings . Conclusions and Suggestions This chapter gives the summary of findings of the study. conclusions and suggestions.

1 THE INDIAN ECONOMY 3. Overview The Indian economy. The balance of payments (BoP) for the first half of 2008-09 reflected a widening of the current account deficit and moderation in capital flows.1. albeit with some moderation in recent months. so far.1 Macroeconomic And Monetary Developments In 2008-09 The highlights of macroeconomic and monetary developments during 2008-09 are: A. offset partially by an acceleration in investment demand. Continued high growth in time deposits enabled the banking system to sustain the credit expansion while the non-banking sources of funds to the commercial sector declined. witnessed heightened volatility subsequently reflecting the knockon effects of the disruptions in the international financial markets and the uncertainty that followed. Net capital inflows reduced sharply and remained volatile during 2008-09 with foreign direct investment inflows showing an increase. industrial growth has decelerated sharply and services sector is slowing. so far. Financial markets in India. This necessitated the Reserve Bank to undertake a series of measures to inject Alliance Business Academy 31 .Portfolio Construction Using Fundamental Analysis 3. during the second quarter vis-à-vis the first quarter of 2008-09. which. after exhibiting strong growth during the second quarter of 200809. while portfolio investments recording a substantial outflow. has been somewhat lower than the comparable period of 2007-08. The economic slowdown. has experienced moderation in the wake of the global economic slowdown. Although agricultural outlook remains satisfactory. The growth of non-food credit remained high during 2008-09. was primarily driven by a moderation of consumption growth and widening of trade deficit. The total flow of resources from banks and other sources to the commercial sector during 2008-09. by and large. remained orderly from April 2008 to mid-September 2008.

Alliance Business Academy 32 . Liquidity conditions turned around and became comfortable from mid-November 2008.0 per cent during AprilNovember 2008-09 (9. debt waiver for farmers and pre-election expenditure. According to the First Advance Estimates. In India.9 per cent as compared with 9.0 per cent during April-November 2007-08). deterioration in global financial markets and slowing down in domestic demand.Portfolio Construction Using Fundamental Analysis rupee and foreign exchange liquidity from mid-September 2008 onwards. On the positive side. Output According to estimates released by the Central Statistical Organisation (CSO) in November 2008.0 million tonnes.6 per cent during the second quarter of 2008-09 as compared with 9. 2009. The manufacturing sector recorded growth of 4.8 per cent during April-November 2007-08) and the electricity sector recorded growth of 2.3 million tonnes (Fourth Advance Estimates) as compared with that of 121. B.3 per cent during the corresponding quarter of 2007-08.2 per cent during April-November 2007-08. factors include expected increase in consumption demand mainly reflecting rise in basic exemption limits and tax slabs.9 per cent (7. On the macroeconomic front. The easing of international oil prices and commodity prices may help in softening the inflationary pressure. inflation measured as year-on-year variation in the wholesale price index (WPI) has declined sharply since August 2008 and was at 5. Headline inflation has declined in major economies since July/August 2008. reflecting deceleration in growth of industry and services. the downside risks for economic growth emanate from global economic slowdown. the kharif foodgrains production during 2008-09 was placed at 115.0 million tonnes during the previous year. The Ministry of Agriculture has set a target for foodgrains production for 2008-09 at 233. the real GDP growth was placed at 7.6 per cent as of January 10. The index of industrial production during April-November 2008-09 recorded year-onyear expansion of 3. Sixth Pay Commission awards.

Aggregate Demand Aggregate demand in the Indian economy is primarily domestically driven. corporation tax and customs duties owing to economic slowdown. particularly. growth decelerated in respect of cargo handled at major ports and other indicators of civil aviation excluding export cargo. On the other hand. was primarily driven by a moderation of consumption growth and widening of trade deficit. The net cash outgo on account of the two supplementary demand for Alliance Business Academy 33 . offset partially by an acceleration in investment demand. the revenue deficit and fiscal deficit were placed higher than those in AprilNovember 2007 both in absolute terms and as per cent of budget estimates (BE) primarily on account of higher revenue expenditure. was higher than a year ago on account of higher revenue expenditure. On the other hand.Portfolio Construction Using Fundamental Analysis Available information on the leading indicators of services sector activity during AprilOctober 2008-09 indicate some acceleration in growth in respect of several indicators such as railway revenue earning and freight traffic and export cargo handled by civil aviation as compared with the corresponding period of 2007-08. defence. C. social services and plan grants to States/Union Territories. The economic slowdown. the government consumption expenditure accelerated during the same period. Tax revenue as per cent of BE was lower than a year ago on account of lower growth in income tax. cement and steel. growth of tax revenue is likely to decelerate in the coming months of 2008-09 due to moderation in economic activity. subsidies. though exports have been gaining progressively higher importance in recent years. commercial vehicles. during the second quarter vis-à-vis the first quarter of 2008-09. Aggregate expenditure as per cent of BE. While expenditure is slated to increase on account of the fiscal stimulus measures undertaken by the Government to address the problem of economic slowdown. According to the latest information on Central Government finances for 2008-09 (AprilNovember). other economic services.

During 2008-09 (up to January 13. 1. particularly crude oil prices. This. special bonds amounting to Rs. The widening of trade deficit during April-September 2008 could be attributed to higher import payments reflecting high international commodity prices. Higher increase in expenditure in relation to sales growth was primarily on account of rising input costs. led by increase in software exports and private transfers. respectively. Sales performance of select non-Government non-financial public limited companies in the private corporate sector during the first two quarters of 2008-09 was impressive.093 crore. D.44. The External Economy India‘s balance of payments position during the first half of 2008-09 (April-September) reflected a widening of trade deficit resulting in large current account deficit.48. in turn.Portfolio Construction Using Fundamental Analysis grants is placed at Rs. Net surplus under invisibles remained buoyant.000 crore have been issued to oil marketing companies and fertiliser companies. Net capital inflows reduced sharply and have remained volatile during 2008-09 so far. and moderation in capital flows. will be reflected in the nonattainability of the deficit targets for 2008-09 as envisaged in the Union Budget 2008-09.14. profits performance was subdued as compared with 2007-08. Merchandise trade deficit recorded a sharp increase during April-November 2008 on account of higher crude oil prices for most of the period and loss of momentum in exports since September 2008. 2009). interest expenses and large provisioning towards mark to market (MTM) losses on foreign exchange related transactions which exerted pressure on profits. however. The surplus in the capital account moderated during April-September 2008 reflecting increased gross capital outflows on the back of global financial turmoil.000 crore and Rs. The large increase in merchandise trade deficit during April-September 2008 led to a significant increase in the current account deficit over its level during April-September 2007. While the net inward FDI (net direct investment by foreign investors) remained buoyant reflecting Alliance Business Academy 34 .

2 billion a year ago.152 crore) on January 2. According to the provisional data released by DGCI&S. 2009 as compared with 24.6.777 crore) on January 2. net outward FDI (net direct investment by Indian investors abroad) also remained high during April-September 2008.0 per cent (Rs. was 19. commercial borrowings. year-on-year (y-o-y).5 billion over the level at end-March 2008.6 per cent (Rs.6 per cent (Rs. was estimated at around US $ 85 billion as at end-March 2008. the revised short-term debt (below one year) comprising sovereign debt. including changes due to valuation losses.91. E. The rise in oil imports was primarily due to the elevated international crude oil prices. Alliance Business Academy 35 .2 per cent (Rs. while the volume of oil imports moderated. 2009 lower than 22. Growth in broad money (M3). NRI deposits.Portfolio Construction Using Fundamental Analysis relatively strong fundamentals of the Indian economy and continuing liberalisation measures to attract FDI. oil and lubricants (POL) imports. largely due to the rise in petroleum. The gross capital inflows were higher on account of higher FDI inflows and NRI deposits during the period.5 per cent. Monetary Conditions Monetary and liquidity aggregates that expanded at a strong pace during the first half of 2008-09 showed some moderation during the third quarter reflecting the decline in capital flows and consequent foreign exchange intervention by the Reserve Bank.944 crore) a year ago. As of January 16. Aggregate deposits of banks.4 billion from US $ 53. 6. 2009. expanded 20. In terms of residual maturity.21. Merchandise trade deficit during April-November 2008 widened to US $ 84.768 crore) a year ago. short-term trade credit and others maturing up to March 2009. 7.2 billion declined by US $ 57.49. India‘s merchandise exports during April-November 2008 increased by 18.36. foreign exchange reserves at US $ 252. 6. y-o-y.7 per cent while imports recorded a higher growth of 32.

The contagion also spilled over to the emerging markets. Non-food credit by scheduled commercial banks (SCBs) was 23.6 per cent. arrest the plunge in asset prices and shore up the confidence in the international banking system. as on January 16.5.0 per cent as compared with 21. reserve money growth was 18.6 per cent a year ago. y-o-y. Adjusted for the first round effect of the changes in CRR. Reserve money growth at 6.6 per cent a year ago.Portfolio Construction Using Fundamental Analysis The growth in bank credit continued to remain high. and downturn in headline inflation. necessitated the Reserve Bank to ease its monetary policy since mid-September 2008. y-o-y.655 crore) a year ago. As a result. 2009 from 22. the financial market conditions remained far from normal during the period October-December 2008. authorities in several countries embarked upon an unprecedented wave of policy initiatives to contain systemic risk. The pressure on financial markets mounted with the credit spreads widening to record levels and equity prices crashing to historic lows leading to widespread volatility across the market spectrum.9 per cent (Rs. 2009 was much lower than that of 30.645 crore). triggered by the collapse of Lehman Brothers followed by the failure of a number of other financial firms across countries.79. which saw broad-based asset price declines amidst depressed levels of risk appetite.0 per cent (Rs. The turmoil transcended from credit and money markets to the global financial system more broadly. Liquidity conditions tightened significantly in India between mid-September and October 2008 emanating from adverse international developments and some domestic Alliance Business Academy 36 . The intensification of global financial turmoil and its knock-on effect on the domestic financial market. While these initiatives did help in restoring some level of stability.3.01. Added to this. F. there was a significant deterioration in the global economic outlook. Financial Markets The crisis in global financial markets deepened since mid-September 2008. as on January 2.

G. Interest rates in the collateralised segments of the money market moved in tandem with but remained below the call rate during the third quarter of 2008-09. The Reserve Bank swiftly initiated a series of measures. which was pursued by most central banks since September 2008. which had increased initially. reflecting the knock-on effects of the disruptions in the international financial markets. Indian equity markets witnessed downswings quite in line with trends in major international equity markets.Portfolio Construction Using Fundamental Analysis factors. In the foreign exchange market. Yields in the government securities market also came to soften during the third quarter 2008-09. In the credit market. Price Situation The accommodative monetary policy. Indian rupee generally depreciated against major currencies. which helped to assuage liquidity conditions. well capitalised and well regulated. Headline inflation moderated in major economies since July/August 2008 on account of the marked decline in international energy and commodity prices as well as slowdown in Alliance Business Academy 37 .Financial markets in India came under pressure since mid-September 2008. Accordingly. while reassuring the market that the Indian banking system continued to be safe and sound. money markets in India came under some pressure mirroring the impact of capital outflows and redemption pressures faced by mutual funds and other investors. aimed at mitigating the adverse implications of the recent financial market crisis on economic growth and employment. started declining in December 2008. The pressure on money markets was reflected in call rates breaching the upper bound of Liquidity Adjustment Facility (LAF) corridor but settling back within the corridor by November 2008. lending rates of scheduled commercial banks. This necessitated the Reserve Bank to undertake a series of measures to inject rupee and foreign exchange liquidity from mid-September 2008 onwards.

based on the year-on-year changes in wholesale price index (WPI). notably in Asia.6 per cent as on January 10. This reflected the reduction in the price of petrol by Rs. milk. oil cakes. 2009 reflecting falling demand in the Organisation for Economic Co-operation and Development (OECD) countries as well as some developing countries. Amongst major groups. The year-on-year increase in manufactured products Alliance Business Academy 38 . fruits.6 per cent a year ago.6 per cent on January 10. 2008 as well as decline in the prices of freely priced petroleum products in the range of 30-65 per cent since August 2008. 2009 from 4.3 a barrel as on January 22. The WTI crude oil prices have eased from its historical high of US $ 145. This mainly reflected increase in the prices of food articles.9 per cent on January 10. oilseeds. 2008 to 5. also moderated to 5. raw cotton. metals and food. The recent decline in WPI inflation was driven by decline in prices of minerals oil. year-on-year.3 per cent) as on January 10. following the economic slowdown.5 per cent a year ago and (it was 9. 2 per litre effective December 6.3 a barrel level on July 3. After remaining at elevated levels for an extended period. 2009 as compared to an intra-year peak of 18. 2008. edible oils. increased to 11.9 per cent in mid-August 2008 but remained higher than 4. Metal prices eased further during the third quarter of 2008-09. primary articles inflation. 2009.9 per cent on August 2. year-on-year. 5 per litre and diesel by Rs. 2008 to around US $ 42. The fuel group inflation turned negative (-1. and eggs. Manufactured products inflation.Portfolio Construction Using Fundamental Analysis aggregate demand emerging from the persistence of financial market turmoil following the US sub-prime crisis.0 per cent on August 2.7 per cent at endMarch 2008). fish and meat as well as non-food articles such as oilseeds and raw cotton. 2009 as compared with the peak of 11. declined sharply from an intra-year peak of 12. especially in China. reflecting weak construction demand in OECD countries and some improvement in supply. especially of wheat. iron and steel. In India inflation. global commodity prices declined sharply since the second quarter of 2008-09 led by decline in the prices of crude oil.

Portfolio Construction Using Fundamental Analysis

prices was mainly driven by sugar, edible oils/oil cakes, textiles, chemicals, iron and steel and machinery and machine tools. Inflation, based on year-on-year variation in consumer price indices (CPIs), increased further during November/December 2008 mainly due to increase in the prices of food, fuel and services (represented by the ‗miscellaneous‘ group). Various measures of consumer price inflation were placed in the range of 10.4-11.1 per cent during November/December 2008 as compared with 7.3-8.8 per cent in June 2008 and 5.1-6.2 per cent in November 2007.

H. Macroeconomic Outlook
The various business expectations surveys released recently reflect less than optimistic sentiments prevailing in the economy. The results of Professional Forecasters‘ Survey conducted by the Reserve Bank in December 2008 also suggested further moderation in economic activity for 2008-09. According to the Reserve Bank‘s Industrial Outlook Survey of manufacturing companies in the private sector, the business expectations indices based on assessment for OctoberDecember 2008 and on expectations for January-March 2009 declined by 2.6 per cent and 5.9 per cent, respectively, over the corresponding previous quarters. The global economic outlook has deteriorated sharply since September 2008 with several countries, notably the US, the UK, the Euro area and Japan experiencing recession. In India too, there is evidence of a slowing down of economic activity. Unlike in the advanced countries where the contagion of crisis spread from the financial to the real sector, in India the slowdown in the real sector is affecting the financial sector, which in turn, has a second-order impact on the real sector. On the positive side factors include expected increase in consumption demand mainly reflecting rise in basic exemption limits and tax slabs, Sixth Pay Commission awards, debt waiver for farmers and pre-election expenditure.

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Portfolio Construction Using Fundamental Analysis

WPI inflation has fallen sharply driven by falling international commodity prices especially those of crude oil, steel and selected food items, although, some contribution has also come from the slowing domestic demand. Going forward, the outlook on international commodity prices indicate further softening of domestic prices.

Financial sector reforms were initiated as part of overall economic reforms in the country and wide ranging reforms covering industry, trade, taxation, external sector, banking and financial markets have been carried out since mid 1991. A decade of economic and financial sector reforms has strengthened the fundamentals of the Indian economy and transformed the operating environment for banks and financial institutions in the country. The sustained and gradual pace of reforms has helped avoid any crisis and has actually fuelled growth. As pointed out in the RBI Annual Report 2001-02, GDP growth in the 10 years after reforms i.e. 1992-93 to 2001-02 averaged 6.0% against 5.8% recorded during 1980-81 to 1989-90 in the pre-reform period. The most significant achievement of the financial sector reforms has been the marked improvement in the financial health of commercial banks in terms of capital adequacy, profitability and asset quality as also greater attention to risk management. Further, deregulation has opened up new opportunities for banks to increase revenues by diversifying into investment banking, insurance, credit cards, depository services, mortgage financing, securitisation, etc. At the same time, liberalisation has brought greater competition among banks, both domestic and foreign, as well as competition from mutual funds, NBFCs, post office, etc. Post-WTO, competition will only get intensified, as large global players emerge on the scene. Increasing competition is squeezing profitability and forcing banks to work efficiently on shrinking spreads. A positive fallout of competition is the greater choice available to consumers, and the increased level of sophistication and technology in banks. As banks benchmark themselves against global

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Portfolio Construction Using Fundamental Analysis

standards, there has been a marked increase in disclosures and transparency in bank balance sheets as also greater focus on corporate governance.

3.2.2 Definition of Banking
Financial institutions may be defined as economic agents specialising in the activities of buying and selling at the same time financial contracts and securities. Banks may be seen as a subset of the financial institutions, which are retailers of financial securities: they buy the securities issued by borrowers and they sell them to lenders. A bank is an institution whose current operations consist in granting loans and receiving deposits from the public. Definition of "Banking" as per the Banking Regulation Act, 1949 says-"banking" means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdraw able by cheque, draft, order or otherwise". The Act defined the functions that a commercial bank can undertake and restricted their sphere of activities Dr. Paget in Law of Banking states, ―No one and no body, corporate or otherwise, can be a banker who does not: i. ii. iii. Conduct Current Accounts Pays cheques drawn on himself Collects cheques for his customers

A bank is therefore ―Any company that transacts the business of banking in India‖. Negotiable Instrument Act. Banker: Banker is ―Any person acting as a banker‖ Negotiable Instrument Act. A bank is a business which provides financial services, usually for profit. The name bank derives from the Italian word banco, desk, used during the Renaissance by Florentines bankers, who used to make their transactions above a desk covered by a green tablecloth.

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and what level of interest it charges in its lending activities. investors have demanded a more stable revenue stream and banks have therefore placed more emphasis on transaction fees. Some banks (called Banks of issue) issue banknotes as legal tender. This difference is referred to as the spread between the cost of funds and the loan interest rate. Currently in most jurisdictions commercial banks are regulated and require permission to operate. profitability from lending activities has been cyclic and dependent on the needs and strengths of loan customers. and have influenced economies and politics for centuries. the primary purpose of a bank was to provide liquidity to trading companies. Operational authority is granted by bank regulatory authorities and provides rights to conduct the most fundamental banking services such as accepting deposits and making loans. for example: selling insurance products. In history. Banks advanced funds to allow businesses to purchase inventory. Commercial lending today is a very intense activity. and collected those funds back with interest when the goods were sold. In recent history. primarily loan fees but also including service charges on array of Alliance Business Academy 42 . Traditional banking services include receiving deposits of money. A bank generates a profit from the differential between what level of interest it pays for deposits and other sources of funds. not consumers. there are also financial institutions that provide selected banking services without meeting the legal definition of a bank. A commercial bank is usually defined as an institution that both accepts deposits and makes loans. Many banks offer ancillary financial services to make additional profit. lending money and processing transactions. the banking industry only dealt with businesses. with banks carefully analysing the financial condition of its business clients to determine the level of risk in each loan transaction. Historically.Portfolio Construction Using Fundamental Analysis A commercial bank accepts deposits from customers and in turn makes loans based on those deposits. Banks have a long history. investment products or stock broking. Banking services have expanded to include services directed at individuals and risks in these much smaller transactions are pooled. For centuries.

50 Crores....Portfolio Construction Using Fundamental Analysis deposit activities and ancillary services (international banking. This brought 80% of the Alliance Business Academy 43 . This brought one-third of the banking segment under the direct control of the Government of India. State Bank of India was obliged to open an accepted number of branches within 5 years in unbanked centers. Government subsidised the bank for opening unremunerative branches in non-urban centres. SBI was to act as the principal agent of the RBI and handle banking transactions of the Union & State Governments throughout India. The step was in fact in furtherance of the objectives of supporting a powerful rural credit cooperative movement in India and as recommended by the "The All-India Rural Credit Survey Committee Report. insurance. Mrs. the Punjab National Bank Ltd. the Bank of India Ltd.3 Initial Phase of Nationalisation When the country attained independence Indian Banking was exclusively in the private sector. Rest of the banks were exclusively regional in character holding deposits of less than Rs. there were five big banks each holding public deposits aggregating Rs. when the then Prime Minister of India. the Central Bank of India Ltd. etc. and for diverse other public purposes" to form State Bank of India. In addition to the Imperial Bank. the Bank of Baroda Ltd. But the major process of nationalisation was carried out on 19th July 1969. when Imperial Bank of India was Nationalized in that year for the stated objective of "extension of banking facilities on a large scale. foreign exchange. and the United Commercial Bank Ltd. One more phase of nationalisation was carried out in the year 1980.). wire transfers. investments. when seven more banks were nationalised. The seven banks now forming subsidiaries of SBI were nationalised in the year 1960. viz. more particularly in the rural and semi-urban areas. 3.2.100 Crores and more. However. Government first implemented the exercise of nationalisation of a significant part of the Indian Banking system in the year 1955. lending activities still provide the bulk of a commercial bank's income. 1954".Indira Gandhi announced the nationalisation of 14 major commercial banks in the country.

for:  Ensuring soundness of the system by fixing benchmark standards for capital Alliance Business Academy 44 . i.e. In a totally de-regulated and globalised banking scenario. Supervisory role is also shifting more towards off-site surveillance rather than on-site inspections.2. The country entered the second phase.Portfolio Construction Using Fundamental Analysis banking segment in India under Government ownership. The focus has clearly shifted from micro monitoring to macro management. Chronology of Salient steps by the Government after Independence to Regulate Banking Institutions in the Country 1949 : Enactment of Banking Regulation Act. De-regulation of interest rates and moving away from issuing operational prescriptions have been important changes.4 Regulatory and Legal Environment The advent of liberalization and globalization has seen a lot of changes in the focus of Reserve Bank of India as a regulator of the banking industry. a The role of regulator would be critical strong regulatory framework would be needed. the phase of Nationalised Banking with emphasis on Social Banking in 1969/70. The focus of inspection is also shifting from transaction-based exercise to risk-based supervision. 3. 1955(Phase I) : Nationalisation of State Bank of India 1959(Phase II) : Nationalisation of SBI subsidiaries 1961 : Insurance cover extended to deposits 1969(Phase III) : Nationalisation of 14 major banks 1971 : Creation of credit guarantee corporation 1975 : Creation of regional rural banks 1980(Phase IV) : Nationalisation of seven banks with deposits over 200 crores.

Bank Failures. have themselves a debt-equity ratio far too adverse than their borrowers! In simple words. Banks indulge in continuous lending and Alliance Business Academy 45 . and Bank Regulation. At such times. which constantly judge their borrowers on debt-equity ratio. to the domestic macro economy. and to other countries.’ (George G.Portfolio Construction Using Fundamental Analysis adequacy and prudential norms for key performance parameters. Creation of an institutional framework to protect the interest of depositors. etc. `A bank fails economically when the market value of its assets declines below the market value of its liabilities. And since it is not their money (shareholders‘ stake) on the block. Regulating the entry and exit of banks including cross-border institutions. In fact. A. the bank cannot expect to pay all of its depositors in full and on time. their appetite for risk needs to be controlled. they earn by taking risk on their creditors‘ money rather than shareholders‘ money. Kaufman. it is an irony that banks. provisioning. so that the market value of its capital (net worth) becomes negative. The Need for Regulation Banking is one of the most heavily regulated businesses since it is a very highly leveraged (high debt-equity ratio or low capital-assets ratio) industry. Bank Failures and Systemic Risk The wonder of banking (a financial innovation that seems to create money out of nothing) has had its inglorious moments beginning from the times of John Law and his Banque Royale in 1720 right upto the recent failures of co-operative banks in Gujarat and Maharashtra in India. B. Adoption of good corporate governance practices.     Adoption of best practices especially in areas like risk-management. 1995) There is a risk that the failure of one bank may spill over to other banks and possibly even beyond the banking system to the financial system as a whole. disclosures. credit delivery. Systemic Risk.

it is settlement risk that propagates bank defaults. especially when the payment and receipt of funds are not simultaneous i.to avoid settlement exposures. and need to pay other banks for third-party transfers. when funds are disbursed before they are received. for if that was the only purpose. in other transactions. it is payment versus payment. whether on account of net settlement procedures or difference in time zones. Thus. it is delivery versus payment.in domestic currency and foreign exchange transactions --. it would impose a narrow banking system. regulators cannot be concerned solely with the safety of the banking system. However. banks are particularly susceptible to systemic risk. Coexistent with this primary Alliance Business Academy 46 .5 Goals And Tools For Bank Regulation And Supervision The main goal of all regulators is the stability of the banking system. This is recognized as systemic risk. credit is extended by one bank to another. which in turn can transmit the shock to the corresponding chain of banks. If final settlement of net outstanding balances at each participating bank is made only at the dayend (net settlement) there is a possibility of an intra-day or daylight overdraft which might lead to default by some banks if their anticipated funds position at the end of the day is not realized. currency. tend to be very tightly financially interconnected with each other. This risk is being addressed by the Real Time Gross Settlement (RTGS) where large value domestic transactions and Continuous Linked Settlement (CLS) for foreign exchange transactions worldwide in major currencies are settled on a one to one basis.e. The essence is to eliminate time lag between the two legs of a transaction. to and from each other. For transactions in securities. C. The central idea is to complete both legs of any large transaction simultaneously --.2. in which checkable deposits are fully backed by absolutely safe assets – in the extreme. Settlement risk could possibly result from defaults in the payments clearing process.Portfolio Construction Using Fundamental Analysis borrowing. Settlement Risk At the granular level. As a result. 3. and shocks at any one bank are viewed as likely to be quickly transmitted to other banks. and therefore.

Capital adequacy is deemed to control risk appetite of the bank by aligning the incentives of bank owners with depositors and other creditors. it is outside the scope of this report to elaborate upon. Involves directing banks to produce accurate. banks need to take risks to be in business despite a probability of failure.Portfolio Construction Using Fundamental Analysis concern is the need to ensure that the financial system operates efficiently. Though very interesting. As we have seen. insurance underwriting.  Restrictions on domestic and foreign bank entry: The assumption here is that effective screening of bank entry can promote stability. Alliance Business Academy 47 .  Deposit Insurance: Deposit insurance schemes are to prevent widespread bank runs and to protect small depositors but can create moral hazard (which means in simple terms the propensity of both firms and individuals to take more risks when insured).  Information disclosure & private sector monitoring: Includes certified audits and/or ratings from international rating agencies. The twin supervisory or regulatory goals of stability and efficiency of the financial system often seem to pull in opposite directions and there is much debate raging on the nature and extent of the trade-off between the two. comprehensive and consolidated information on the full range of their activities and risk management procedures. and real estate investment. `providing institutions with the flexibility that may lead to failure is as important as permitting them the opportunity to succeed‘.  Capital Adequacy: Capital serves as a buffer against losses and hence also against failure. let us take a look at the list of some tools that regulators employ:  Restrictions on bank activities and banking-commerce links: To avoid conflicts of interest that may arise when banks engage in diverse activities such as securities underwriting. Instead. Alan Greenspan puts it very succinctly. In fact.

 Mandated liquidity reserves: To control credit expansion and to ensure that banks have a reasonable amount of liquid assets to meet their liabilities. Further. Some of these issues are addressed in the recent amendment Bill to the Banking Regulation Act introduced in the Parliament.Portfolio Construction Using Fundamental Analysis  Government Ownership: The assumption here is that governments have adequate information and incentives to promote socially desirable investments and in extreme cases can transfer the depositors‘ loss to tax payers! Government ownership can.  Enabling legislation for sharing of credit information about borrowers among lending institutions. promote financing of politically attractive projects and not the economically efficient ones. such as. regulation and supervision of these institutions will get a new direction. Also as the co-operative banks are expected to come under the direct regulatory control of RBI as against the dual control system in vogue. the expected integration of various intermediaries in the financial system would add a new dimension to the role of regulators. The present definition of banking under Banking Regulation Act would require changes. Alliance Business Academy 48 .  Abolition of SICA / BIFR setup and formation of a National Company Law Tribunal to take up industrial re-construction. at times. The integration of various financial services would need a number of legislative changes to be brought about for the system to remain contemporary and competitive. The need for changes in the legislative framework has been felt in several areas and steps have been taken in respect of many of these issues.  Loan classification. Integration of the financial system would change the way we look at banking functions. provisioning standards & diversification guidelines: These are controls to manage credit risk.

Role of Indian Banks‘ Association would become more pronounced as a self regulatory body. This is all the more relevant in the context of the stated policy of RBI to move away from micro-management issues. The Association would also be required to act as a lobbyist for getting necessary legislative enactments and changes in regulatory guidelines. In the emerging banking and financial environment there would be an increased need for self-regulation. Development of benchmarks on risk management.Portfolio Construction Using Fundamental Analysis if banking institutions and non-banking entities are to merge into a unified financial system While the recent enactments like amendments to Debt Recovery Tribunal (DRT) procedures and passage of Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act. accounting practices. valuation of assets. it is expected that CDR setup would gain more prominence making NPA management somewhat easier. In the recent past. With the borrowers gaining confidence in the mechanism. to ensure that recovery of dues by creditors is possible within a reasonable time. It is expected that the issue of giving statutory backing for CDR system will be debated in times to come. 2002 (SARFAESI Act) have helped to improve the climate for recovery of bank dues. It would be necessary to give further teeth to the legislations. Lenders‘ Liability. their impact is yet to be felt at the ground level. etc. Development of best practices in various areas of banks‘ working would evolve through self-regulation rather than based on regulatory prescriptions. corporate governance. Corporate Debt Restructuring has evolved as an effective voluntary mechanism. Here again. disclosures. Alliance Business Academy 49 . This has helped the banking system to take timely corrective actions when borrowing corporates face difficulties. common benchmarks could be evolved. The procedure for winding up of companies and sale of assets will also have to be streamlined. would be areas where IBA would be required to play a more proactive role. customer charter. HR practices and training needs of the banking personnel would assume greater importance in the coming days.

World Bank – ―Corporate governance is about promoting corporate fairness. There are two levels of accountability – of management to the Board and of the Board to the Shareholders.Portfolio Construction Using Fundamental Analysis Talking about shared services. As stated by J. provided the following three basic principles are followed: Management should be free to drive the enterprise forward with the minimum interference and maximum motivation. When we talk about adoption of International accounting practices and reporting formats it is relevant to look at where we stand and the way ahead. besides strengthening the capital base accordingly. transparency and accountability‖. This would essentially involve adoption of judgmental factors in the classification of assets. based on Banks‘ estimation of the future cash flows and existing environmental factors. The main task is to ensure the continued competence of management.  In order to enlist the confidence of the global investors and international market players. any business is doomed to decline. Good Corporate Governance is not a straight jacketed formula or process. creation of common database and conducting research on contemporary issues to assess anticipated changes in the business profile and market conditions would be areas where organizations like Indian Banks‘ Association are expected to play a greater role. In future. Corporate Governance will guide the way Banks are to be run. Accounting practices being followed in India are as per Accounting Standards set by the Institute of Chartered Alliance Business Academy 50 . particularly those who have gone public. the banks will have to adopt the best global practices of financial accounting and reporting.Wolfensohn. for without adequate and effective drive. will have to meet global standards over a period of time. President. Evolution of Corporate Governance being adopted by banks. there are many ways of achieving it as international comparisons demonstrate.  Management should be accountable for the effective and efficient use of this freedom.

introduction of innovative products and delivery channels have pushed risk management to the forefront of today‘s financial landscape. Many Indian banks desirous of raising resources in the US market have adopted accounting practices under USGAAP and we expect more and more Indian Financial entities to move in this direction in the coming years. Ability to gauge the risks and take appropriate position will be the key to Alliance Business Academy 51 . by and large. increasing deregulation. banks in India are guided by the Reserve bank of India guidelines issued from time to time. Now these are. although it would mean greater disclosure and tighter norms. there have been moves for convergence of accounting standards under IAS and USGAAP and this requires the standard setters to agree on a single. 3.6 Risk Management Risk is inherent in any commercial activity and banking is no exception to this rule. high-quality answer. Of late. etc. It is expected that banks would migrate to global accounting standards smoothly in the light of these developments. There are certain areas of differences in the approach under the two main international accounting standards being followed globally. Considering that US forms 40% of the financial markets in the world compliance with USGAAP has assumed greater importance in recent times. Rising global competition. While a separate standard is available for financial entities under IAS. one issue which is likely to be discussed in the coming years is the need for a common accounting standard for financial entities.2. in line with the Accounting Standards of ICAI and other regulatory bodies. Companies are required to follow disclosure norms set under the Companies Act and SEBI guidelines relating to listed entities.Portfolio Construction Using Fundamental Analysis Accountants of India (ICAI). are governed by RBI guidelines. It is understood that ICAI is seized of the matter. ICAI has not so far come out with an Indian version in view of the fact that banks. It is pertinent to note that Accounting Standards of ICAI are based on International Accounting Standards (IAS) being followed in a large number of countries. In the Indian context. Both in respect of Accounting Practices and disclosures.

Building up a proper risk management structure would be crucial for the banks in the future. banks had to primarily deal with credit or default risk. interest rate risk. would become more pronounced in the coming days as we have technology as a new factor in today‘s banking. More detailed and more frequent reporting of risk positions to banks‘ shareholders will be the order of the day. The complex mathematical models programmed into risk engines would provide the foundation of limit management. External users of financial information will demand better inputs to make investment decisions. Under Basel II accord. Operational risk. Besides regulatory requirements. Traditional risk management techniques become obsolete with the growth of The derivatives and off-balance sheet operations. capital allocation will be based on the risk inherent in the asset. which had always existed in the system. effective risk managers will prosper and risk averse are likely to perish. risk advisory bureaus and risk reviewers. with passage of time. we have to deal with a whole range of market related risks like exchange risks. computation of risk-adjusted return on capital and active management of banks‘ risk portfolio. risk analysis. The implementation of Basel II accord will also strengthen the regulatory review process and. Risk return will be assessed for new business opportunities and incorporated Alliance Business Academy 52 . It can be said that risk takers will survive. coupled with diversifications. In the regulated banking environment. The risk management process will be fully integrated into the business process. Banks would find the need to develop technology based risk management tools.Portfolio Construction Using Fundamental Analysis success. There will be an increase in the growth of consulting services such as data providers. Risk management functions will be fully centralized and independent from the business profit centres. etc. expansion in E-banking will lead to continuous vigilance and revisions of regulations. As we move into a perfect market economy. the review process will be more and more sophisticated. These reviews will be intended to provide comfort to the bank managements and regulators as to the soundness of internal risk management systems. capital allocation would also be determined by the market forces. Measurement of risk exposure is essential for implementing hedging strategies.

. new risk management software. market and operational and so on will be combined. The legal environment is likely to be more complex in the years to come. Banks will also have to deal with issues relating to Reputational Risk as they will need to maintain a high degree of public confidence for raising capital and other resources.Portfolio Construction Using Fundamental Analysis into the designs of the new products. Common facilities could be considered for development of risk Alliance Business Academy 53 . Systems and internal controls would be crucial to ensure that this risk is managed well. sustain and maximise shareholders‘ wealth. may become patentable. All risks – credit. The bank of the future has to be a total-risk-enabled enterprise. this could offer the potential for realizing commercial gains through licensing. Technology related risks will be another area where the operating staff will have to be more vigilant in the coming days. opaqueness in operations and shortcomings in services. performance measurement. Risks to reputation could arise on account of operational lapses. which addresses the concerns of various stakeholders‘ effectively. The demand for Risk Adjusted Returns on Capital (RAROC) based performance measures will increase. RAROC will be used to drive pricing. Advances in risk management (risk measurement) will lead to transformation in capital and balance sheet management. For some banks. the risk awareness levels of line functionaries also will have to increase. As the audit and supervision shifts to a risk based approach rather than transaction orientation. Innovative financial products implemented on computers. reported and managed on an integrated basis. portfolio management and capital management. Dynamic economic capital management will be a powerful competitive weapon. Risk management has to trickle down from the Corporate Office to branches or operating units. The challenge will be to put all these capabilities together to create. Risk management is an area the banks can gain by cooperation and sharing of experience among themselves. user interfaces etc.

Needless to add.2. the NPA levels are expected to come down significantly. in India) Development Banks (EXIM Bank SIDBI. etc. As a result.7 Types of Banks There are various types of banks which operate in our country to meet the financial requirements of different categories of people engaged in agriculture. profession.Portfolio Construction Using Fundamental Analysis measurement and mitigation tools and also for training of staff at various levels. 3. there will be adequate cover through provisioning for impaired loans. business. NABARD) Commercial Banks a) b) c) Public Sector Banks Private Sector Banks Foreign Banks a) b) c) Co-operative Banks Primary Credit Societies Central Co-operative Banks State Co-operative Banks Alliance Business Academy 54 . with the establishment of best risk management systems and implementation of prudential norms of accounting and asset classification. On the basis of functions. the quality of assets in commercial banks will improve on the one hand and at the same time. the banking institutions in India may be divided into the following types: Types of Banks Specialized Banks Central Bank (RBI.

It is therefore known as the banker‘s bank. when needed. as follows:  It must have paid-up capital and reserves of an aggregate value of not less than an amount specified from time to time. Central Bank A bank which is entrusted with the functions of guiding and regulating the banking system of a country is known as its Central bank. regulating their circulation in the country by different methods. Now-a-days some of the commercial banks are also providing housing loan on a long-term basis to individuals. There are also many other functions of commercial banks. commercial banks also give medium-term and long-term loan to business enterprises. Commercial Banks Commercial Banks are banking institutions that accept deposits and grant short-term loans and advances to their customers. In addition to giving short-term loans. and Alliance Business Academy 55 . The Reserve Bank of India is the central bank of our country. No other bank than the Central Bank can issue currency. 1934 a scheduled bank. Such a bank does not deal with the general public. In addition. B. The Central Bank maintains record of Government revenue and expenditure under various heads. It also advises the Government on monetary and credit policies and decides on the interest rates for bank deposits and bank loans. The Central Bank provides guidance to other banks whenever they face any problem. According to Bank of India Act. Another important function of the Central Bank is the issuance of currency notes. subject to fulfillment of the following conditions laid down in Section 42 (6) of the Act. maintain deposit accounts of all other banks and advances money to other banks.Portfolio Construction Using Fundamental Analysis A. which are discussed later in this lesson. It acts essentially as Government‘s banker. foreign exchange rates are also determined by the central bank. is entitled to facilities of refinance from RBI.

RBI is authorized to exclude the name of any bank from the Second Schedule if the bank. c) Foreign Banks: These banks are registered and have their headquarters in a foreign country but operate their branches in our country. Bank of Baroda and Dena Bank etc. These banks are registered as companies with limited liability. having been given suitable opportunity to increase the value of paid-up capital and improve deficiencies. Development Credit Bank Ltd. Standard & Chartered Bank etc. ICICI Bank. primary urban cooperative banks. ING Vysya Bank. American Express Bank. The classification of commercial banks into scheduled and nonscheduled categories that was introduced at the time of establishment of RBI in 1935 has been extended during the last two or three decades to include state cooperative banks. Some of the foreign banks operating in our country are Hong Kong and Shanghai Banking Corporation (HSBC). Alliance Business Academy 56 .Portfolio Construction Using Fundamental Analysis  It must satisfy RBI that its affairs are not being conducted in a manner detrimental to the interests of its depositors. For example: The Jammu and Kashmir Bank Ltd. Citibank. goes into liquidation or ceases to carry on banking activities Types of Commercial banks: a) Public Sector Banks: These are banks where majority stake is held by the Government of India or Reserve Bank of India. b) Private Sectors Banks: In case of private sector banks majority of share capital of the bank is held by private individuals. The number of foreign banks operating in our country has increased since the financial sector reforms of 1991. and RRBs. Examples of public sector banks are: State Bank of India. Corporation Bank.. etc. HDFC Bank.

Development Banks Business often requires medium and long-term capital for purchase of machinery and equipment. for using latest technology. central co-operative banks and state co-operative banks. They also undertake other development measures like subscribing to the shares and debentures issued by companies. As regards banking business. The operations of each society are restricted to a small area so that the members know each other and are able to watch over the activities of all members to prevent frauds. in case of under subscription of the issue by the public. Such financial assistance is provided by Development Banks.Portfolio Construction Using Fundamental Analysis C. Co-operative Banks People who come together to jointly serve their common interest often form a cooperative society under the Co-operative Societies Act. b) Central Co-operative Banks: These banks operate at the district level having some of the primary credit societies belonging to the same district as their Alliance Business Academy 57 . These banks are organized at three levels. a) Primary Credit Societies: These are formed at the village or town level with borrower and non-borrower members residing in one locality. When a co-operative society engages itself in banking business it is called a Co-operative Bank. Any co-operative bank as a society is to function under the overall supervision of the Registrar. D. village or town level. Co-operative Societies of the State. They are primary credit societies. district level and state level. Industrial Finance Corporation of India (IFCI) and State Financial Corporations (SFCs) are examples of development banks in India. the society must follow the guidelines set and issued by the Reserve Bank of India. The society has to obtain a license from the Reserve Bank of India before starting banking business. or for expansion and modernization. Types of Co-operative Banks There are three types of co-operative banks operating in our country.

The aim and focus of SIDBI is to promote. They mobilize funds and help in its proper channelisation among various sectors. loan on easy terms can be available through SIDBI.Portfolio Construction Using Fundamental Analysis members. It gives guidance about the opportunities for export or import. Specialized Banks There are some banks. are called specialized banks. SIDBI and NABARD are examples of such banks. primary credit societies) and function as a link between the primary credit societies and state cooperative banks. c) State Co-operative Banks: These are the apex (highest level) co-operative banks in all the states of the country. If a person Alliance Business Academy 58 . c) National Bank for Agricultural and Rural Development (NABARD): It is a central or apex institution for financing agricultural and rural sectors.e. These banks provide loans to their members (i. use of new technology and market activities. E. The bank grants loans to exporters and importers and also provides information about the international market. finance and develop small-scale industries. EXIM bank can provide you the required support and assistance. EXIM Bank. The money reaches the individual borrowers from the state co-operative banks through the central co-operative banks and the primary credit societies. It also finances modernization of small-scale industrial units. They engage themselves in some specific area or activity and thus. which cater to the requirements and provide overall support for setting up business in specific areas of activity. the risks involved in it and the competition to be faced. a) Export Import Bank of India (EXIM Bank): If you want to set up a business for exporting products abroad or importing products from foreign countries for sale in our country. etc.. b) Small Industries Development Bank of India (SIDBI): If you want to establish a small-scale business unit or industry.

  Primary functions Secondary functions A. Primary functions The primary functions of a commercial bank include:   Accepting deposits Granting loans and advances a) Accepting deposits The most important activity of a commercial bank is to mobilize deposits from the public. People who have surplus income and savings find it convenient to deposit the amounts with banks. NABARD can provide credit. funds deposited with bank also earn interest. If the rate of interest is higher.8 Functions Of Commercial Banks The functions of commercial banks are of two types. 3. cottage and village industries handicrafts and allied economic activities in rural areas. Thus. deposits with the bank grow along with the interest earned. b) Grant of loans and advances The second important function of a commercial bank is to grant loans and advances.2. in the field of agriculture. etc. small-scale industries. Such loans and advances are given to members of the public and to the business community at a higher rate of interest than allowed by banks on various deposit Alliance Business Academy 59 . both short-term and long-term. Depending upon the nature of deposits.Portfolio Construction Using Fundamental Analysis is engaged in agriculture or other activities like handloom weaving. fishing. especially. to co-operative credit. through regional rural banks. There is also safety of funds deposited with the bank. It provides financial assistance. public are motivated to deposit more funds with the bank.

important document and securities by providing safe deposit vaults or lockers. Providing reports on the credit worthiness of customers. Secondary functions In addition to the primary functions of accepting deposits and lending money. traveler‘s cheque. banks perform a number of other functions.   Providing customers with facilities of foreign exchange dealings.    Collecting and supplying business information. B. pay order. especially for professional courses. for making payment for purchase of goods. These are as follows.Portfolio Construction Using Fundamental Analysis accounts. machinery. Undertaking safe custody of valuables. and from one branch to another branch of the bank through cheque. etc. etc. Providing consumer finance for individuals by way of loans on easy terms for purchase of consumer durables like televisions. demand draft.   Issuing letters of credit. vehicles etc. Transferring money from one account to another. Alliance Business Academy 60 . The rate of interest charged on loans and advances varies according to the purpose and period of loan and also the mode of repayment. which are called secondary functions.  Standing guarantee on behalf of its customers. refrigerators.  Educational loans to students at reasonable rate of interest for higher studies.

9 Indian Banking Sector Reforms The transformation of the banking sector in India needs to be viewed in light of the overall economic reforms process along with the rapid changes that have been taking place in the global environment within which banks operate. Hence. and there was little price discovery in terms of the cost of money. the banking sector.Portfolio Construction Using Fundamental Analysis 3. Latin America and elsewhere have accentuated these pressures. interest rates. India embarked on a strategy of economic reforms in the wake of a serious balance-ofpayments crisis in 1991. Recent banking crises in Asia. changes in corporate behavior such as growing disinter mediation and increasing emphasis on shareholder value. improved financial viability and institutional strengthening. our own increasing exposure to international competition and. with banks being the mainstay of financial intermediation. The efficiency and productivity enhancing function of the financial system was severely handicapped.. a widespread financial sector reform effort has been underway since 1991. the deregulation of financial services internationally. a central plank of the reforms was reform in the financial sector and. As you are aware. The objective of the banking sector reforms was to promote a diversified. efficient and competitive financial system with the ultimate objective of improving the efficiency of resources through operational flexibility. widespread use of administered and variegated interest rates. Alliance Business Academy 61 . the financial system in India by the late 1980s was characterized by dominant government ownership of banks and financial institutions. Thus. financial markets were not really functioning. although a great degree of financial deepening had indeed taken place and financial savings had increased continuously.e. The global forces of change include technological innovation. equally important. i. and financial repression through forced financing of government fiscal deficits by banks and through monetization.2.

income recognition.  Government equity in banks has been reduced and strong banks have been allowed to access the capital market for raising additional capital. asset classification. etc. thus releasing more lendable resources which banks can deploy profitably. Interest rates on deposits and lending have been deregulated with banks enjoying greater freedom to determine their rates.  Adoption of prudential norms in terms of capital adequacy.2. Alliance Business Academy 62 .1 Chart showing of Transformation Initiatives Needed for Banks 3. provisioning.10 Major Reform Initiatives Some of the major reform initiatives in the last decade that have changed the face of the Indian banking and financial sector are:  Interest rate deregulation. investment fluctuation reserve. exposure limits.Portfolio Construction Using Fundamental Analysis Chart No: 3.  Reduction in pre-emptions – lowering of reserve requirements (SLR and CRR).

.  New areas have been opened up for bank financing: insurance.  New private sector banks have been set up and foreign banks permitted to expand their operations in India including through subsidiaries. and banks with a good track record of profitability have greater flexibility in recruitment.Portfolio Construction Using Fundamental Analysis  Banks now enjoy greater operational freedom in terms of opening and swapping of branches. leasing. Full convertibility for deposit schemes of NRIs introduced. liquidity adjustment facility for meeting day-to-day liquidity mismatch. interest rate swaps. asset management.g. forward rate agreements.  Several new institutions have been set up including the National Securities Depositories Ltd.. mutual funds and corporates have been liberalized.  New instruments have been introduced for greater flexibility and better risk management: e. infrastructure financing. MFs and corporates can now undertake FRAs with banks. cross currency forward contracts. factoring. etc. gold banking. credit cards. Banks have also been allowed to set up Offshore Banking Units in Special Economic Zones. Credit Information Bureau India Ltd. The overseas investment limit for corporate has been raised to 100% of net worth and the ceiling of $100 million on prepayment of external commercial borrowings has been removed. besides of course investment banking.  Indians allowed to maintain resident foreign currency (domestic) accounts. Central Depositories Services Ltd. Alliance Business Academy 63 .  Limits for investment in overseas markets by banks. Clearing Corporation of India Ltd. forward cover to hedge inflows under foreign direct investment..

 Adoption of global standards. RBI has introduced Risk Based Supervision of banks (against the traditional transaction based approach). Best international practices in accounting systems. etc. asset classification. etc. market risk and operational risk. The definition of priority sector has been widened to include food processing and cold storage. Prudential norms for capital adequacy.  RBI guidelines have been issued for putting in place risk management systems in banks. Structured Financial Messaging Solution. corporate governance.  The limit for foreign direct investment in private banks has been increased from 49% to 74% and the 10% cap on voting rights has been removed. selected lending through NBFCs. software upto Rs 1 crore. housing above Rs 10 lakh.Portfolio Construction Using Fundamental Analysis  Universal Banking has been introduced.  Technology infrastructure for the payments and settlement system in the country has been strengthened with electronic funds transfer. payment and settlement systems. Banks have specialized committees to measure and monitor various risks and have been upgrading their risk management skills and systems. Negotiated Dealing System and move towards Real Time Gross Settlement. With banks permitted to diversify into long-term finance and DFIs into working capital. Risk Management Committees in banks address credit risk. income recognition and provisioning are now close to global standards. guidelines have been put in place for the evolution of universal banks in an orderly fashion. Centralized Funds Management System.  Credit delivery mechanism has been reinforced to increase the flow of credit to priority sectors through focus on micro credit and Self Help Groups. In addition. Alliance Business Academy 64 . the limit for foreign institutional investment in private banks is 49%. are being adopted.

Automated Teller Machine Banks have now installed their own Automated Teller Machine (ATM) throughout the country at convenient locations. Debit Card Banks are now providing Debit Cards to their customers having saving or current account in the banks. A Serious Frauds Office is proposed to be set up. The customers can use this card for purchasing goods and Alliance Business Academy 65 .2. In most banks now a day‘s human or manual teller counter is being replaced by the Automated Teller Machine (ATM). settlement of stock deals will be completed in two trading days after the trade is executed. E-banking (Electronic Banking) With advancement in information and communication technology. Banking activity carried on through computers and other electronic means of communication is called ‗electronic banking‘ or ‗e-banking‘. C. in most of the branches you see computers being used to record banking transactions.11 Value Added Services By Banks A. customers can deposit or withdraw money from their own account any time.e. SEBI has reduced the settlement cycle from T+3 to T+2 from April 1. CDs are allowed only in dematerialized form. Information about the balance in your deposit account can be known through computers. taking the Indian stock trading system ahead of some of the developed equity markets. Stock exchanges will set up trade guarantee funds. Fresh investment in CPs.Portfolio Construction Using Fundamental Analysis  Wide ranging reforms have been carried out in the area of capital markets. Let us now discuss about some of these modern trends in banking in India. B. 3. banking services are also made available through computer. Fungibility of ADRs and GDRs allowed. Retail trading in Government securities has been introduced on NSE and BSE from January 16. Now. 2003 i. 2003. By using this.

Credit Card Credit cards are issued by the bank to persons who may or may not have an account in the bank. D. E. Net Banking With the extensive use of computer and Internet. make banking transactions like. The amount paid through debit card is automatically debited (deducted) from the customers‘ account. As more and more people are now using mobile phones.Portfolio Construction Using Fundamental Analysis services at different places in lieu of cash. etc. by using telephone. banks have now started transactions over Internet. F. He can make payments for bills. fixed deposits. Alliance Business Academy 66 . etc. Phone Banking In case of phone banking. In mobile phone a customer can receive and send messages (SMS) from and to the bank in addition to all the functions possible through phone banking. phone banking is possible through mobile phones. Banks allow certain credit period to the credit cardholder to make payment of the credit amount. The customer having an account in the bank can log into the bank‘s website and access his bank account. credit cards are used to make payments for purchase. give instructions for money transfers. Just like debit cards. collection and payment of bills. fixed deposits and collection of bill. a customer of the bank having an account can get information of his account. Interest is charged if a cardholder is not able to pay back the credit extended to him within a stipulated period. This interest rate is generally quite high. demand draft. so that the individual does not have to carry cash. money transfers.

2.2 Chart showing of challenges facing Indian Banking Industry A. These multiple changes happening one after other has a ripple effect on a bank (Refer fig.Portfolio Construction Using Fundamental Analysis 3.) trying to graduate from completely regulated sellers market to completed deregulated customers market. This is particularly important because with dilution in banks‘ equity. Chart No. 3.12 Challenges Ahead The banking industry in India is undergoing a major transformation due to changes in economic conditions and continuous deregulation. Alliance Business Academy 67 . Improving profitability: The most direct result of the above changes is increasing competition and narrowing of spreads and its impact on the profitability of banks. The challenge for banks is how to manage with thinning margins while at the same time working to improve productivity which remains low in relation to global standards.

greater attention will need to be paid to reducing transaction costs. developing a cadre of specialists and introducing technology driven management information systems. banks are upgrading their credit assessment and risk management skills and retraining staff. and technology plays a crucial role in managing these risks. Sharpening skills: The far-reaching changes in the banking and financial sector entail a fundamental shift in the set of skills required in banking. Customers have become very demanding and banks have to deliver customized products through multiple channels. To meet increased competition and Alliance Business Academy 68 . market risk and operational risk. In addition to being exposed to credit risk. C. Reinforcing technology: Technology has thus become a strategic and integral part of banking. The pressure to undertake extensive computerization is very real as banks that adopt the latest in technology have an edge over others. In this context. which will be heightened as controls on the movement of capital are eased. allowing customers access to the bank round the clock. This will require tremendous efforts in the area of technology and for banks to build capabilities to handle much bigger volumes. with falling spreads.Portfolio Construction Using Fundamental Analysis analysts and shareholders now closely track their performance. driving banks to acquire and implement world class systems that enable them to provide products and services in large volumes at a competitive cost with better risk management practices. Risk management: The deregulated environment brings in its wake risks along with profitable opportunities. the business of banks would be susceptible to country risk. D. B. rising provision for NPAs and falling interest rates. Thus.

focusing on the observance of standards will help smooth integration with world financial markets.Portfolio Construction Using Fundamental Analysis manage risks. G. foreign exchange. E. etc. Alliance Business Academy 69 . the twin pillars of the banking sector i. will need to be carefully nurtured and built. In such a scenario.. banks will have to strive to attract and retain customers by introducing innovative products.e. banks will need to put in place a code for corporate governance for benefiting all stakeholders of a corporate entity. In today‘s globalised world. treasury. This includes best practices in the area of corporate governance along with full transparency in disclosures. Greater customer orientation: In today‘s competitive environment. F. banks have to be conscious of their responsibilities towards corporate governance. the demand for specialized banking functions. human resources and IT will have to be strengthened. development banking. International standards: Introducing internationally followed best practices and observing universally acceptable standards and codes is necessary for strengthening the domestic financial architecture. enhancing the quality of customer service and marketing a variety of products through diverse channels targeted at specific customer groups. using IT as a competitive tool is set to go up. Corporate governance: Besides using their strengths and strategic initiatives for creating shareholder value. Following financial liberalisation. risk management. as the ownership of banks gets broad based the importance of institutional and individual shareholders will increase. Thus. Special skills in retail banking.

At the same time reduced corporate credit off take thanks to sluggish economy has resulted in large number of competitors battling for the same pie. Alliance Business Academy 70 . The deregulation of the industry coupled with decontrol in interest rates has led to entry of a number of players in the banking industry. customer retention calls for customized service and hassle free. J. flawless service delivery. adding new channels with lucrative pricing and freebees to offer. and decontrolled interest rate and liberalized norms for foreign exchange. I. There are multiple choices. Diffused Customer loyalty: This will definitely impact Customer preferences. New rules: As a result. Banks need to access low cost funds and simultaneously improve the efficiency. Banks are transforming to universal banking. as they are bound to react to the value added offerings. the market place has been redefined with new rules of the game.Portfolio Construction Using Fundamental Analysis H. Efficiency: This in turn has made it necessary to look for efficiencies in the business. squeeze on spread and have to give thrust on retail assets K. specifically retail credit. Given the relatively low switching costs. the wallet share is reduced per bank with demand on flexibility and customisation. Customers have become demanding and the loyalties are diffused. operational flexibility. The banks are facing pricing pressure. Deregulation: This continuous deregulation has made the Banking market extremely competitive with greater autonomy. Natural fall out of this has led to a series of innovative product offerings catering to various customer segments.

as employees are made to adapt to changing conditions. Acceptance of technology is slowly creeping in but the utilization is not maximised. Misaligned mindset: These changes are creating challenges. (e. trade services) Alliance Business Academy 71 .Portfolio Construction Using Fundamental Analysis L. M.2. process and technology to reduce the fixed costs and the cost per transaction Focusing on fee based income to compensate for squeezed spread.13 Strategic Options With Banks To Cope With The Challenges Leading players in the industry have embarked on a series of strategic and tactical initiatives to sustain leadership. There is resistance to change from employees and the Seller market mindset is yet to be changed coupled with fear of uncertainty and Control orientation. The focus of people will be on doing work but not providing solutions. The major initiatives include:      Investing in state of the art technology as the back bone of to ensure reliable service delivery Leveraging the branch network and sales structure to mobilize low cost current and savings deposits Making aggressive forays in the retail advances segment of home and personal loans Implementing organization wide initiatives involving people. Competency Gap: Placing the right skill at the right place will determine success. The competency gap needs to be addressed simultaneously otherwise there will be missed opportunities. 3.g.CMS. on escalating problems rather than solving them and on disposing customers instead of using the opportunity to cross sell.

therefore. not just survive. banks need to go beyond peripheral issues and tackle significant issues like improvements in profitability. in the changing environment. Competition is going to be tough and with financial liberalisation under the WTO. efficiency and technology.14 Conclusion The face of banking is changing rapidly. These are some of the issues that need to be addressed if banks are to succeed.2. banks in India will have to benchmark themselves against the best in the world. while achieving economies of scale through consolidation and exploring available cost-effective solutions.Portfolio Construction Using Fundamental Analysis  Innovating Products to capture customer ‗mind share‘ to begin with and later the wallet share 3. Alliance Business Academy 72 . For a strong and resilient banking and financial system.

This is followed by selecting stocks to construct an optimum portfolio using past share price data through the Sharpe‘s optimization model. DATA ANALYSIS & INTERPRETATION The Two growth FCFF model is used to find the intrinsic value of the selected Banking stocks. The return and risk aspects are then compared between the two portfolios. Then the level of significance between the return of portfolio constructed through fundamental analysis and portfolio constructed through Sharpe‘s optimization model is determined. 1) Allahabad Bank 2) Andhra Bank 3) Bank of Baroda 4) Bank of India 5) Bank of Maharashtra 6) Corporation Bank 7) IDBI Bank 8) Indian Bank 9) Indian Overseas Bank 10) Oriental Bank of Commerce Alliance Business Academy 73 . The Two Stage growths Free Cash Flow to Firm Model is used for valuating the following companies.Portfolio Construction Using Fundamental Analysis 4.

RBI surrendered its 100% stake to GOI . gn = Growth rate after the terminal year forever 4. pervasive growth and unbounded prosperity and Bank has been actively engaged in providing a major thrust to financing of Small & Medium Enterprises (SMEs). it brought down GOI holding to 72% and the post- Alliance Business Academy 74 .Portfolio Construction Using Fundamental Analysis The Two-stage FCFF Model The two stage FCFF model is designed to value a firm which is expected to grow much faster than a stable firm in the initial period and at a stable rate after that. 1995.1 EVALUATION OF IDBI BANK LTD A Development Financial Institution (DFI) transformed into a full-service commercial bank and named as Industrial Development Bank of India Ltd (IDBI). It was incorporated as a wholly owned subsidiary of Reserve Bank of India (RBI) in the year of 1964. Value = PV of FCFE + PV of terminal price The terminal price is generally calculated using the infinite growth rate model. Pn =FCFF n+1/r-gn Where. The bank helping to build a modern and industrially buoyant India and supporting the dreams of Corporate India to its fruition in every possible way for over 44 years and bank reaching out over a broader operating canvas as a new generation full service commercial bank IDBI focusing on industrial and economic development of the country and inclusive banking. In 1976 IDBI came under the holding of Government of India (GOI) by the way of RBI's transfer. The Bank made its Initial Public Offer (IPO) in July. The Model The value of any stock is the present value of the FCFE per year for the extraordinary growth period plus the present value of the terminal price at the end of the period.

companies could get single-point assistance pertaining to origination and implementation of CDM projects. 2008 (Previous year Rs. It was also awarded the Special Award for "Best Internet Bank for Corporate Customers" and for the "IT Team of the Year" by Institute For Development and Research in Banking Technology (IDRBT) in the same year and the RBI coffered the 'Bilingual House Magazine' Award for the Bank's house journal 'Shree Vayam'. 15. The bank will have a 65 per cent stake in the asset management company (AMC) with IDBI Capital holding the remaining share. its wholly-owned subsidiary. The banks odyssey has just begun. as well as advisory services on generation and trading of carbon emission reductions (CERs). As of 2007.00 per Equity Share of Rs. the Bank has totally 432 branches.1%. Dividend of Rs.Portfolio Construction Using Fundamental Analysis capital restructuring to 58. As of April 2008 IDBI Fortis launched Life insurance business through joint venture with Federal Bank and Fortis NV. pervasive growth and unbounded prosperity.10/. The Bank won the coveted "Outstanding Achiever of the Year Award-2006" under both Corporate and Individual categories at the Indian Banks' Association (IBA) Awards 2006 organized by IBA and Trade Fares & Conferences International (TFCI) . In the quest for inclusive banking. after life insurance venture gets off the ground.each for the year ended 31st March. 18 extension counters and 523 ATMs spread across 255 cities. IDBI Bank will set up a mutual fund subsidiary with IDBI Capital markets.each) is recommended.10/. Under this arrangement. Alliance Business Academy 75 . reflects its effort to spread its wings across the country.00 per Equity Share of Rs. 20. The Bank has entered into fourth tie-up for trading in carbon credits with Sumitomo of Japan as on July 2007. IDBI transferred its International Finance Division to Export-Import Bank of India in the year 1982.

The beta coefficient is a key parameter in the capital asset pricing model (CAPM).1 Calculation of Beta BETA .93 17. The formula for the Beta of an asset within a portfolio is.5 Ratios Debt-Equity Ratio ROG-Capital Employed (%) RONW (%) ROG-Gross Sales (%) Payout (%) Previous year 6.4 20.2. It measures the part of the asset's statistical variance that cannot be mitigated by the diversification provided by the portfolio of many risky assets.95 14.99 7.37 17.19 26. stock ) Var Market Alliance Business Academy 76 . because it is correlated with the return of the other assets that are in the portfolio.76 4.Portfolio Construction Using Fundamental Analysis Table No.74 26.44 11. 4.1 Table showing important Ratios of IDBI Bank Ltd 31st 2008 10. Beta  Co var(market.2 PORTFOLIO CONSTRUCTION USING FUNDAMANTAL ANALYSIS 4.Beta is a measure of a stock's volatility in relation to the market.

2 Table showing beta calculation Particulars Variance of market Covariance(market. Firm‘s WACC is the overall required return on the firm as a whole.2. each of which is weighted by its respective use in the given situation. stock) beta Value 3.common stock.25 3. bonds and any other longterm debt . WACC is the average of the costs of these sources of financing.are included in a WACC calculation.216 4.2 Calculation of Weighted Cost of Capital WACC – It is firm's cost of capital in which each category of capital is proportionately weighted. All capital sources .95 1. 4.Portfolio Construction Using Fundamental Analysis Table No. WACC is calculated by multiplying the cost of each capital component by its proportional weight and then summing: WACC = (E / V)*RE + (D / V)*RD *(1-TC) Where: Ke = cost of equity Kd = cost of debt E = market value of the firm's equit D = market value of the firm's debt V=E+D Alliance Business Academy 77 . preferred stock.

09 9.3 Table showing calculation of WACC Particulars Cost of equity Market value of equity (Crores) Proportion of Equity Cost of debt Book value of debt (Crores) Proportion of Debt WACC Value 10.49 0.91 9.612.14 crore.3 Calculation of Capital Expenditure Capital Expenditure .(CAPEX) are expenditures creating future benefits. 112.16% 3. 4.56 0. Alliance Business Academy 78 .32% 4.Portfolio Construction Using Fundamental Analysis Tc = corporate tax rate Table No. Formula: CAPEX= (Increase in Fixed Assets) + (Increase in Capital Work-in-progress) – (Increase in Investments) – (Increase in depreciation) The CAPEX was directly taken from the Capitaline database and for the current year capex for IDBI bank Ltd is Rs.877.24% 38. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life that extends beyond the taxable year.2.

The proportion of each of the undervalued stock to be included is determined by assigning weights to the expected future growth rates of the companies.2.750 50.800 Valuation Price 62.732 70.203 80.345 372.450 22.031 22.721 147.800 189.4 FCFF Evaluation Free Cash Flow to Firm model is used to value companies to be included in the portfolio.650 229. The Stocks which are undervalued are only considered in the portfolio construction using fundamental analysis.Portfolio Construction Using Fundamental Analysis 4.265 233. A.663 170.965 61.500 88.202 Name of the Stock Allahabad Bank Andhra Bank Bank of Baroda Bank of India Bank of Maharashtra Corporation Bank IDBI Bank Indian Bank Indian Overseas Bank Oriental Bank of Commerce Remarks Undervalued Undervalued Overvalued Undervalued At par Overvalued Undervalued Undervalued Undervalued Undervalued The above table compares the stock price of the companies as on 8th April 2008 with the stock price determined as per the valuation (Intrinsic Value).500 244. 4. the above mentioned FCFF procedure used for valuing IDBI BANK LTD was used for each of the other nine Banking companies mentioned in the table and the results are mentioned below. Results of FCFF Valuation Table No. These weights are used to calculate the Portfolio return and beta.4 Table showing results of valuation SI No 1 2 3 4 5 6 7 8 9 10 Stock Price as on 8/4/2009 45.500 117.310 105.200 53.350 48. Alliance Business Academy 79 .

12388 0.01064 0.02948 0.01002 0.01669 0.14608 0.959 1.1156 0.1239 0.081 0.145 0.14564 0.16862 0.11421 0.1188 0.15611 0.1748 0. 4.0601 0.12519 0.12996 1.13282 1.04133 SI No 1 2 3 4 5 6 7 Company Name Expected Weights Return 0.943 1.214 1.14439 0.00745 0.11882 0.18984 0.041 Alliance Business Academy 80 .Portfolio Construction Using Fundamental Analysis The stocks of Bank of Baroda.003 1.20471 0. B.022 0.867 0.216 0.0771 Sum 0.5 Table showing the expected returns and beta for portfolio constructed using fundamental analysis Proportionate Beta Portfolio Expected of Beta Return Stock 0. The Portfolio returns are the sum of the expected returns of each individual stock.000 Allahabad Bank Andhra Bank Bank of India IDBI Bank Indian Bank Indian Overseas Bank Oriental Bank of Commerce The Expected returns on each stock of the portfolio are calculated by multiplying the expected return the company with the weights or proportion of each stock to be included in the portfolio.13137 0.01730 0. Bank of Maharastra & Corporation bank are overvalued and remaining stocks are undervalued. Expected returns on portfolio constructed using fundamental analysis Table No. The beta of the portfolio is 1.42% The Beta of the portfolio is also calculated by summing up the product of the individual stock beta and their respective weights.02264 0. The expected return on the portfolio is found to be 11.

The method also stresses on portfolio optimisation.3 PORTFOLIO CONSTRUCTION BASED ON SHARPE’S SINGLE INDEX MODEL Every investor faces the dilemma. The excess return to beta ratio measures the additional return on a security (excess of the risk free asset return) per unit of systematic risk or nondiversifiable risk. 2. Proceed to calculate Ci for all stocks according to the ranked order using the following formula2 m Ci   2  cj 2 j 2 1  m  2  cj ( Ri  Rf )  j The cumulative values of Ci start declining after a particular Ci and that point is taken as the cut-off point and that stock ratio is the cut-off ratio C. which is an important component of the portfolio selection process. Besides. which provides the highest rate of return for the lowest risk that the investor is willing to take. Alliance Business Academy 81 . Steps for finding the stocks to be included in the optimal portfolio are: 1. objectives and risk tolerance of the investor. Simple Sharpe Portfolio optimisation model enables the investor to find a portfolio that best meets the goals. 4. 3. Rank them from the highest to the lowest.1 Sharpe’s Excess Return To Beta Ratio It is a single number that measures the desirability of any stock to be included in the optimal portfolio. the investor has to decide how much to invest in each scrip. It helps to select a set of scrip‘s. Find out the ―excess return to beta‖ ratio for each stock under consideration. of which scrip‘s to select for his portfolio to get adequate return.Portfolio Construction Using Fundamental Analysis 4.3.

56% 8.16% 4.71% Sei2 8.50% 6. A.766 0.86% 0.20% 6.03% 4.204 βi 0.10% 11.301 8.48% -0. the more is the desirability of the stock to be included in the portfolio.16% 6.003 1. RANKING OF STOCKS ACCORDING TO EXCESS RETURN TO BETA Table No.797 1.70% Rank 3 6 5 1 10 9 2 8 4 7 Alliance Business Academy 82 .39% -1. 4.01% 11.959 1.468 8.88% 7.17% -1.104 1.214 0.808 10. Stocks are ranked by excess return to beta (from the highest to the lowest).531 16.022 ERTB 5.011 10.37% 8.462 8.845 12.216 0.83% 17.6 Table showing ranking of stocks according to excess return to beta (ERTB) SI. No 1 2 3 4 5 6 7 8 9 10 STOCKS Allahabad bank Andhra Bank Bank of Baroda Bank of India Bank of Maharastra Corporation bank IDBI bank Indian bank Indian overseas bank Oriental bank of Commerce Ri 11.08% 14.26% 1.Portfolio Construction Using Fundamental Analysis Excess return to beta = (Ri – RF) / i Where: Ri = expected return on stock i Rf = return on risk free asset i = expected change in the rate of return on stock i associated with a 1% change in the market return.046 11.669 14.867 0.63% -9.943 1. The higher the excess return to beta ratio.

2 Determination Of Cutoff Rate C* Cut-off rate of ‗i‘ stock can be calculated using the simple formula –  Ci   2 m 2  cj  j2 2 1  m  2  cj  ( Ri  Rf )  j Where: m2 = variance in the market index cj2 = unsystematic risk Ri – Expected return of the stock Rf – Risk free return Alliance Business Academy 83 .3.Portfolio Construction Using Fundamental Analysis 4.

01 10.20% 12.006 0.301 1.004 0.08% 0.01% 6.026 0.010 0.104 0.031 0.010 0.016 0.001 0.84 8.71% 6.031 0.53 8.808 10.020 If we see in the above table only five stocks has more that excess return to beta and for other securities excess return to beta is less than Ci.118 0.8% 8.46 14.001 0. Alliance Business Academy 84 .021 0.102 0.102 0.20 16.089 0.220 0.216 0.032 0.036 R A N K Security Ri Sei2 Beta (Ri Rf)Bi/ Sei2 ∑(Ri Rf)Bi/ Sei2 β2/Sei2 ∑(β2/ Sei2) 1 2 3 4 5 6 7 8 9 10 Bank of India IDBI Bank Allahabad Bank Indian overseas Bank Bank of Baroda Andhra Bank Oriental Bank of Commerce Indian Bank Corporation Bank Bank of Maharastra 17.101 0.031 0.032 0.4% 14.773 0.04 8.400 0.005 0.032 0.024 0.917 0.005 0.Portfolio Construction Using Fundamental Analysis Table No.309 0.943 1.766 0.007 0.797 0.214 1.112 0.029 0.003 1.022 0. 4.037 0.001 0.867 1.10% 7.032 0.071 0.024 0.034 0.001 0.8% 11. So cut – off rate is fixed at 0.959 0.669 8.118 0.073 0.7 Table showing the calculation of the cut-off rate Ci = (Sm2∑(R iRf)Bi/Sei 2)/( 1 + Sm2∑Bi2 /Sei2 ) 0.027 0.716 0.5% 11.614 0.057 0.513 C*= 0.468 11.091 0.847 0.037 and only five stocks are included in the portfolio.5% 11.034 0.

Zi = i/ei2 [(Ri – RF)/I – C*] In the above formula the second expression determines the relative investment in each security.31% 20.0101 47. The first determines the weight of each security in the portfolio so that they sum to 1.83% 12.0020 0.216 0.27% 15.468 11.003 1.00% Alliance Business Academy 85 .011 10.0007 0.214 1.88% 11.531 8.0016 0.845 1.48% 14. the next step is to determine the weight of each security to be included in the portfolio as follows Wi = Zi /  Zj Where.8 Table showing weightage of different stocks in the portfolio Ranks Security Ri Sei2 Beta Z=(β/Var)*((( Ri-Rf)/β)-C*) Weight in %(X) 1 2 3 4 5 Bank of India IDBI bank Allahabad bank Indian overseas bank Bank of Baroda 17.56% 11.30% 6.60% 10.104 0. This ensures full investment.0010 0.0048 0.462 14.867 1.53% 100. Table No: 4.3 Determination of Optimal Portfolio Once the securities to be included in the portfolio are decided.3.50% 11.Portfolio Construction Using Fundamental Analysis 4.

9 Table showing portfolio return and beta Weight in % (X) 47.83% 12.4 Expected Returns On Portfolio And Beta Of Portfolio Table No.94% 1.21 1.246 0.48% 14.01% The Expected returns on each stock of the portfolio are calculated by multiplying the Average daily returns of the company with the weights or proportion of each stock to be included in the portfolio.60% 10.53 8.27% 15.88% 11.131 1 2 3 4 5 Bank of India IDBI bank Allahabad bank Indian overseas bank Bank of Baroda 17.84 1.53% 100.30% 6.22% 0.072 1. The Portfolio return is the sum of the average daily returns of each individual stock.10 8.22 0.77% 15. Here the portfolio return is 15.27% 2.3.103 0.80% 1.574 0. 4.50% 11.00% Ranks Security Ri Sei2 Beta Ri*X β*X 0.00 1.47 11.46 14.56% 11.The Beta of the portfolio is calculated by summing up the product of the individual stock beta and their respective weights.Portfolio Construction Using Fundamental Analysis 4.131 Alliance Business Academy 86 .135 0. The beta of the portfolio is 1.01% .01 10.87 1.31% 20.

10 Table showing performance of portfolio constructed using fundamental analysis Measure Mean Return Standard Deviation Beta Sharpe Ratio Treynor‘s Ratio Jensen‘s Measure Fama‘s Measure Value 0.43%.  Beta for this portfolio is exactly 1 which indicates the volatility of the portfolio is exactly to the market index.19 which indicates that the excess returns are the results of the excess risk (standard deviation) which the investor can bear.2643 0.4 COMPARISON OF RISK AND RETURN OF PORTFOLIO’S CONSTRUCTED USING FUNDAMENTAL ANALYSIS AND SHARPE SINGLE INDEX MODEL Table No.17 0. Alliance Business Academy 87 .  Sharpe measure of fundamental portfolio is 0.190 0.Portfolio Construction Using Fundamental Analysis 4.0000 0.17 Interpretation of portfolio constructed using fundamental analysis  Portfolio constructed using fundamental analysis was expected to give a return of 26. 4.188 0.9850 1.

 Fama‘s alpha of fundamental portfolio has positive value which indicates that the portfolio has outperformed its benchmark index.50%. Alliance Business Academy 88 .Portfolio Construction Using Fundamental Analysis  Treynor‘s ratio of fundamental portfolio is 0. 4.27 Interpretation of portfolio constructed using Sharpe optimization model  Portfolio constructed using Sharpe optimization model was expected to give a return of 36. Measure Mean Return Standard Deviation Beta Sharpe Ratio Treynor‘s Ratio Jensen‘s Measure Fama‘s Measure Value 0.3650 0.11 Table showing performance of portfolio constructed using Sharpe optimization model.  Jensen‘s measure of fundamental portfolio has positive value which indicates that the portfolio has beat the market.27 0.9856 1.29 0.188 that of which could have been earned on a riskless investment per each unit of market risk (Beta). Table No.287 0.188 which indicates that excess return of 0.0005 0.

190 0.0000 0.  Sharpe measure of Sharpe optimization model is 0.  Jensen‘s measure of Sharpe optimization model has positive value which indicates that the portfolio has beat the market.9856 1.3650 0.  Fama‘s alpha of Sharpe optimization model has positive value which indicates that the portfolio has outperformed its benchmark index.287 that of which could have been earned on a riskless investment per each unit of market risk (Beta).27 Alliance Business Academy 89 .Portfolio Construction Using Fundamental Analysis  Beta for this portfolio is 1.188 0.17 0.12 Table showing performance of two portfolios Measure Mean Return Standard Deviation Beta Sharpe Ratio Treynor‘s Ratio Jensen‘s Measure Fama‘s Measure Value 0.2643 0.287 0.29 0.0005 which indicates the volatility of the portfolio is more than the market index.27 0. Table No.287 which indicates that excess return of 0.17 Value 0.29 which indicates that the excess returns are the results of the excess risk (standard deviation) which the investor can bear. 4.9850 1.0005 0.  Treynor‘s ratio of Sharpe optimization model is 0.

 Fama‘s measure indicates that portfolio constructed as per Sharpe optimization portfolio has out performed its bench mark index by 27% and where as fundamental has outperformed its benchmark index by 17%.  Sharpe ratio for portfolio constructed using Fundamental analysis has been less that the Sharpe portfolio which means that the Sharpe portfolio has given more positive returns for every unit risk.  The standard deviation and beta of both the portfolio is more or less similar to each other. given it beta as per the capital asset pricing model which is reflected by Jensen‘s alpha where as portfolio constructed using Fundamental analysis has given lesser return. Sharpe single index model portfolio  Portfolio constructed as per Sharpe optimization model has higher return compare to that of portfolio constructed using fundamental analysis.  Portfolio constructed as per Sharpe has higher Treynor‘s ratio compare to that of fundamental which indicates the returns earned in excess of that which could have been earned on riskless investment per unit of market risk. : Difference in returns from the two portfolios. 4. Alliance Business Academy 90 .  Portfolio constructed as per Sharpe optimization portfolio has given excess return that what was supposed to be earned .Portfolio Construction Using Fundamental Analysis Interpretation of Portfolio constructed using fundamental analysis vs.5 TEST FOR EQUALITY/DIFFERENCE OF MEAN OF PORTFOLIO H0 H1 : No difference in returns from the two portfolios.

000606156 1499 t – Test interpretation .From the analysis we can see that there is significant difference between the risk and returns of the two portfolios constructed using fundamental analysis and single index model and also t. 4.test shows that there is significant difference between the returns of these two portfolios.000829486 1499 0.001078723 0. the results were as follows: Table No.030986682 1.061973364 1. Alliance Business Academy 91 .Portfolio Construction Using Fundamental Analysis Using the paired-sample t-test to test for difference in mean returns.867883872 0.96154882 Fundamental Portfolio Return 0.645871463 0.961133306 0 1498 1.13 Table showing t-Test: Paired Two Sample for Means Particulars Mean Variance Observations Pearson Correlation Hypothesized Mean Difference df t Stat P(T<=t) one-tail t Critical one-tail P(T<=t) two-tail t Critical two-tail Sharpe Portfolio Return 0.001489784 0.

Press releases don't happen by accident and are an important PR tool for companies. Fundamental analysis helps in identifying the stocks that are undervalued and thus helps in finding the true worth of the stocks and thereby yielding very good returns in the long term in relation to short term returns that can be obtained through optimization models.Portfolio Construction Using Fundamental Analysis Conclusion: Fundamental analysis can be valuable. Investors should become skilled readers to weed out the important information and ignore the hype. Corporate statements and press releases offer good information. but should be read with a healthy degree of skepticism to separate the facts from the spin. Alliance Business Academy 92 . But Fundamental analysis alone may not sufficient to build a good portfolio various others factors like global cues should be considered before including a particular sector stock in the portfolio.We all have personal biases and every analyst has some sort of bias. but it should be approached with caution . There is nothing wrong with this and the research can still be of great value.

conclusions elicited and suggestions made. to construct a portfolio of Banking stocks using Sharpe single index model. to construct a portfolio of Banking stocks which are undervalued. The objectives of the study were. to find if there is a significant difference in portfolio mean returns of these portfolios.2 SUMMARY OF FINDINGS  The banking index has grown at a compounded annual rate of over 51 per cent since April 2001 as compared to a 27 per cent growth in the market index for the same period. so as to increase the returns of the portfolio and to study the attractiveness of banking sectors for investors to invest in stocks of banking companies. From the data collected findings are drawn.1 INTRODUCTION This study entitled “Portfolio construction using fundamental analysis” was carried from investors‘ point of view to address the problem associated with selecting the right stocks to be included in the portfolio. 5. to study and analyze Banking sector. Alliance Business Academy 93 .  The standard deviation and beta of both the portfolio is more or less similar to each other.  Sharpe ratio for portfolio constructed using Fundamental analysis has been less that the Sharpe portfolio which means that the Sharpe portfolio has given more positive returns for every unit risk.  Portfolio constructed as per Sharpe optimization model has higher return compare to that of portfolio constructed using fundamental analysis. Data required for the study was collected through various secondary sources. This study was carried out to know the stocks which are undervalued or which can be included in the portfolio. which were selected based on non-probabilistic judgmental method. to identify stocks in Banking sector which trade for less that their intrinsic value.Portfolio Construction Using Fundamental Analysis 5. Sample size is 10 Banking companies stocks.

Portfolio Construction Using Fundamental Analysis

Portfolio constructed as per Sharpe has higher Treynor‘s ratio compare to that of fundamental which indicates the returns earned in excess of that which could have been earned on riskless investment per unit of market risk.

Portfolio constructed as per Sharpe optimization portfolio has given excess return that what was supposed to be earned , given it beta as per the capital asset pricing model which is reflected by Jensen‘s alpha where as portfolio constructed using Fundamental analysis has given lesser return.

 Fama‘s measure indicates that portfolio constructed as per Sharpe optimization
portfolio has out performed its bench mark index by 27% and where as fundamental has outperformed its benchmark index by 17%.

 t-test at 95% confidence level shows that there is a significant difference between
the mean returns of the portfolio constructed by using Sharpe single index model and Fundamental analysis.

Objective 1 – To undertake study of banking sector Study shows that banking sector has been playing an important role in growth of Indian economy. Indian banks have compared favourably on growth, asset quality and profitability with other regional banks over the last few years. The banking index has grown at a compounded annual rate of over 51 per cent since April 2001 as compared to a 27 per cent growth in the market index for the same period. Policy makers have made some notable changes in policy and regulation to help strengthen the sector. These changes include strengthening prudential norms, enhancing the payments system and integrating regulations between commercial and co-operative banks.

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Portfolio Construction Using Fundamental Analysis

Objective 2 – To identify stocks in Banking sector which trade for less than their intrinsic value. The Stocks which are trading less than their intrinsic value are only considered in the portfolio construction using fundamental analysis. Out of ten stocks considered for the study, three banks namely Bank of Baroda, Bank of Maharastra & Corporation bank are overvalued and remaining stocks are undervalued. Objective 3 – To construct portfolio of Banking stocks which are undervalued Based on the increase in the price of the stocks the weightage has been assigned to the stocks to construct the portfolio and the expected return on the portfolio is found to be 11.42%. The Beta of the portfolio is also calculated by summing up the product of the individual stock beta and their respective weights. The beta of the portfolio is 1.041. Objective 4 – To construct a portfolio of Banking stocks using Sharpe single index model The Expected returns on each stock of the portfolio are calculated by multiplying the Average daily returns of the company with the weights or proportion of each stock to be included in the portfolio. The Portfolio return is the sum of the average daily returns of each individual stock. Here the portfolio return is 15.01% .The Beta of the portfolio is calculated by summing up the product of the individual stock beta and their respective weights. The beta of the portfolio is 1.131. Objective 5 – To find if there is a significant difference in portfolio mean returns constructed using fundamental and optimization approach t-test shows that there is a significant difference between the mean returns of the portfolio constructed by using Sharpe single index model and Fundamental analysis.

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Portfolio Construction Using Fundamental Analysis

5.4 SUGGESTIONS Suggestions For Banks
 The banking industry is need to focus on consolidation, implementation of BaselII norms, risk management, corporate governance, funding the economic growth with inclusion and creating global brands.  Apart from technical aspects, intangible aspects like goodwill, social and ethical responsiveness do influence banks‘ performance so bank should concentrate on these aspects as well.

Suggestions For Investors
 Since the stocks markets are declining in India investors should carefully look at the fundamentals of the company, industry, economy and pick the stocks which are undervalued.  Before investing in Stock markets it very important to know the International cues that could have impact on stock markets apart from the fundamentals of company, industry and economy.  While making projections for variables like sales and operating margin which are the value drivers of companies one should exercise due caution in projection as these values could have high impact on value of firm.

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Alliance Business Academy 97 . I also got useful insights into the limitations of valuation models. Indian Banking industry. Industry Analysis. and various performance measures of portfolio. wherein I learned about history of Banking. This study also helped me to learn about paired t-test to test the equality\difference in mean returns of the portfolio. Relative valuation etc. This study gave a lot of knowledge and will be helpful in my future endeavors. I also got useful insights into Indian Banking Industry.Portfolio Construction Using Fundamental Analysis MY LEARNING This Research Project has given me great insight into valuation approaches and construction of portfolios. I also learned about portfolio construction using single index model. I also learned about Fundamental Analysis where in I learned about Economy Analysis. Company Analysis and also the obstacles in a successful fundamental Analysis along with the weakness of fundamental Analysis. I came to know about various approaches to valuation of stocks like Discount cash flow valuation.

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