INVESTMENTS : AN OVERVIEW gs LEARNING OUTCOMES 2 LBB At, After reading this chapter you will be able to > Understand the concept of investment > Differentiate financial investment from real investment > Know various features and objectives of investment > Differentiate between investment and speculation > Analyse investment environment > Understand investment decision process > Differentiate between direct and indirect investing Investment is the backbone of any economy. Savings of an economy must be channelized into productive mvestiment togenerate income. The higher t ‘inves in.an economy the greater will be its gross naiion- al income and economic growth. A conducive business environment is essential for boosting investment and investors confidence. In fact the pri- mary source of funds for investment in an economy is household savings. These savings are channelised into productive investment avenues to gen- ¢rate more income. An individual may keep his savings in a bank account or invest in financial and/or real assets. In India savings bank account does not provide high interest income. Therefore the investors, who wish to earn higher returns, have to explore other avenues for investment such as equity shares, bonds, gold, property etc. Hence the need for financial literacy on the Part of individual investors. This chapter provides an overview of the tc concept of investment, investment decision process and investment environment. 1ees ENVESTMENTS : AN OVERVIEW 1.1 INVESTMENTS < The term investment implies employment of current fu ; ap nds to ¢, mensurate reiurn in future. trim tecan ies sacrifice of current gogo Com, for expected income ta future because the amount whichis trope Ption Current Consumption is saved and invested. An investor foes consumption and invests his savings in i ir i future consumption. always guarantee higher ft ways guarantee 'S i Hence the environment o vestment is quite uncertain, We eee, facing a VUCA (Volatile, Uncertain, Complex, Ambiguous) envisesefact ihe context of investments: ORE in ‘In 1986, Microsoft Corporation first offered its stocks to pub ; ublic and yj in 10 vears, the stocks value had increased over S000% TP the sam With, Worlds of Wonder also offered its stock to public and ten Years later company was defunct i The word ‘investment’ connotes different meanings to different peop To a layman, it may mean purchase of shares: bonds or other financiy instruments. To an economist implies purchase of fixed producninsee (Capital assets) Such as plat and machinery. To a businessman as ‘wel, investment refers to purchase of fixed assets such as land, building, lant, machinery etc. = Irrespective of its context, the word investment requires commitment of funds in some assets at Present so as to be able to generate higher income in future. 1.2 FINANCIAL INVESTMENT vs. REAL INVESTMENT! Depending upon the type of asset, all the investments can be classified as financial or real investment : err e cial investments investment of funds in financial assets. Finan- cfafassets are claims over some real/ physical assets. The examples of financial assets are shares, bonds, mutual fund units etc, The return tancial assets are shares, eed of Gnancial investment is in the form of interest, dividend and/ot appreciation in value. Real Investment (or Economic Investment) is investment in real assets OF physical assets. Real assets aré those long term [or xed) assets which are used in the production process, The examples o real assets are plant, machinery, equipments, building etc. An individual investor invests in financial assets and commodity assets eg gold, silver etc.). Now-a-days real estate investment has also becom’ 3 OBJECTIVES OF INVESTMENT Para 1.3 important part of individual investor's Portfolio. Real estate is investment. ine house/ commercial properties to get income in the form of rent and/or capital gain due to price appreciation. Security analysis and portfolio management is primarily concerned with westment in securities, A security, as defined under “The Securities ontracts (Regulation) Act, 1956" include the following — (0 shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate; i) derivative; i) units or any other instrument issued by any collective investment scheme to the investors in such schemes; ‘eceipt as defined in clause (zg) of section 2 of the Securiti- sation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (54 of 2002); (1) units or any other such instrument issued to the investors under any mutual fund scheme; (vi) any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned tosuch entity, and acknowledging beneficial interest of such investor insuch debt or receivable including mortgage debt, as the case may be; (vi), Government securities; (vit) such other instruments as may be declared by the Central Govern- ment to be securities; and w) (ix) rights or interests in securities. This book primarily deals with investment in financial assets or securities, Individual investors make investment keeping in mind certain objectives. After all they forego current Consumption in order to avail of higher income and hence consumption in future. The ultimate objective of investment is saan risk and maximize return. However due to the fact that risk sad retarn move hand-in-hand, itis not always possible to get very high ey “ry low risk. Other objectives which are kept into mind while '8 investment may be regular income, tax benefits, safety of capital. aCO INNES EMIENTS : AN OVERVIEW An investor's investment objectives depend upon in turn depends on his age, marital status, family reg and investment experience, The fol lowing is the list of ¢, BS e kept in mind while making investment. Y-Bitiem--Total return from an investment is the main obj in mind while making inves i pet making investmentin particular asset, Beet ey “wants to maximise total return given the ints Trees naximise total retur constr; in Westoy tolerance, investment horizon ete. fj/ oo. sh termeg Pag tk (i). Regular income or stability of Income i (i Regul Som : especial, old aged and retired persons may have theo ton regular income or stability oFincome from the invest oeeONe of ihey prefer fixed income securities over equity shares tor (GLapltal Appreciation: Another objectveofinvestmentma be appreciation or growth of capital Young peopler shay ee etl regular income andt-can take risk may have the Sieg aa appreciation and prefer equity shares and real estate oe come securities. ~ oo edin (jax Benefits : Some people invest in securities so as avail ~~ benefits attached to it. Investment in mutualfundsin India or wate guided by the objective of tax benefits. : y In every investment, safety of capital should be x-Safety of Capit eves ~~ the primary objective. Other objectives can be achieved only When capital is safe, 1.3.1 Features (or Factors\attecting lnvestmént) | Coxtiva Every investment possesses certain common features or factors. These are explained below - sy etars Every investment is expected to provide certain rate of return over aper- odin future. Return is the income generated by ivesiment sxprsied 6 od in future. Return is the income i is a percentage of the cost oF investment. For example if a person uy equity share at a cost of Rs.100.and gets Rs.10 as di dentarthe end year; hs retur me = 1en0 the year, his return on shi e759 <100= 10% flere we a : change in share price at the end of the year. Ifthe share price alsoin 0+ (105-100) to Rs.105 then his return would be 12*005: ) 100 = 158%: OBJECTIVES OF INVESTMENT Para 1.3, ments have different returns depending on their reasury bill (T-bills) and govt. securities carry {iriras Compared to équity shares. ae can also be calculated as holding period return, annu- . Detailed discussion about returns is given in Chapter 3. Ae isk is defined as variability in expected return, Jf return from an invest- jnent is certain, fixed and 100% sure then there iS no risk attached to it. Generally, Government sect k-free. However fecent sovereign debt crisis (in which European Countries government failed to repay the public debt) casts doubt on government securities being risk free. Risk can be calculated as standard deviation of the expected returns from an investment. Different individuals have different risk taking abili- ties For example young entrepreneurs may take higher risk than old aad retired people: Theréfore investment must be done_keeping in mind the the investors. Hence risk assessment is an integral part of portfolio management. ‘jiybiquidity (is the ‘moneyness” of investment ie. the ease with which investment can be converted into cash with no or little risk of loss of capital. Some assets jghly li 2 itsetc.) and some are It is important to mention here that the fevelopment and effi ancial markets depends to a great extent on the liquidity of the securities traded in it. “A related aspect is marketability ie. the ease with which an asset can be bought or sold. An asset may be highly marketable but less liquid (e.g. dis- tress sale of property). For being marketable it is important that there is a ready market for the security, where it can be bought or sold. $oPax Benefits “Some of the investments provide tax benefits to inverters. Section 80C of provides Certain investment alternatives (e.g. PPENSC Equity Linked Savings Schemes etc.) which qualify for deduction from taxable income upto Rs. 1,50,000. Assessment of tax benefits is important while undertaking investment because it affects the actual effective return from investment. For example Rural Electrification Corporation (REC) has come out with tax-free bonds at a coupon rate of 8.12% p.a. for 10 years. It implies that tLPara 1.4 INVESTMENTS : AN OVERVIEW interest income from these bonds will be exempt from tax. Ifa ‘ is in 30% tax bracket then the effective pre-tax interest rate wud © Would Vid) be (vi) Hedge against Inflation A good investment should provide hedge aga A ood i uid provi le hes agi the .. risk or inflation, The investor must ensure that the rue SE her than the prevaling inflation rate, Tene™eA . y making investment, otherwise he is worse of, Fores ihe prevailing inflation rate is 8%, the investor should look for "BCH A . stteny investment will go down Inflation erodes purchasing power of hence hedge against inflation is an important consideration in invert shares are considered to bea good hedge. againstinfayn tion because of their varying return. Itis expected thatin times of inflati shares generate higher return. On the other hand fixed income sel like bonds re not a good hedge agains inflaton duc tothe fact that interest incomes are fixed and do not increase in times of rising inflation (vil) Safety of Capital Safety of capital should come first. The investor must secure his principg) amount which he invests. That.is, he should not be impressed by vee, rate of return on an investment if the amount invested is not safe, For this credit rating agencies play an important role in providing bond-ratings Generally bonds which have lower than AAA ratings are considered to be not so safe. For example many NBFCs come out with fixed deposit schemes at an attractive interest rate but safety of investment is less. 1.4 SPECULATIONS Speculation is investment in an asset that offers a potentially large rejum but is also very risky; a reasonable probability that the investment will produce a loss. If can be defined as the assumption of considerable ris in obtaining commensurate gain. Considerable risk means that the risks sufficient to affect the decision. Commensurate gain means a highs ue remium. Speculative assets are high risk-high return assets. 2n¢ Should be neared jn with caution. Generally large investors “hold spect lative assets so as to make quick gains. Stock market is identified with.two types of speculators - eee il ula Bull speculators expect while bear spec me Geen psd. rust be nt ere at speculation, Perse Rather itis essential for smooth functioning of stock market an ust be noted here that the same asset can be held by an investor for Investment and by the other for speculation. For example shares of RIL, if held by a small investor for long term, amounts to investment, but if it by an FI for making quick return over short run then its implies ion. speculation vs. Investment Investment and speculation can be distinguished on the following grounds: Basis of Investment ‘Speculation Difference x [atime horizon | Long, generally exceeding | Short_may be as short as y= _| one Fear ea P Risk [Low to Moderate Very high — Low to moderate and consis- 3, Retum (expected) » tent Very high and inconsistent 4 Funds Here own funds are used for | Speculators also _ borrow ; investment | funds and/or d0—“irgin c — trading [5 income Dividend, Interest etc ‘Change in price of asset 6.) Source of | Fundamental factors of the | Herd instincts, inside infor- | Information _| company are analysed mation etc. Gombling Gambling is a game undertaken for someone's excitement eg. horse race, aid games, lotteries. Here although the winner makes big niétiey but that caanot be Classified as return because that is not consistent or regular. Gambling is a zero sum game - someone’s loss is other party's gain. It is pucely by chance that one party wins over the other. Therefore gambling is highly uncertain and may involve complete loss of funds put in it. Have you ever thought that in a bull market everybody is making profit and become happy. Then why is it that in a bear market everybody is. sad? In that market also bear speculators make profit. Hint : In a bull market, investors net worth increases while in a bear ‘market company’s market capitalization fallsand hence investors wealth cline. Only speculators make money in such a market.5 INVESTMENTS AN OVERVIEW Para 1. 1.5 RISK RETURN TRADE OFF In order to i _ s bec: re is a positive : a and te move together. Let us assume that there are ‘wo secu available in the market. Security A and B. Both the securities have same level of risk but security A has higher return. In such a case every invest will sell security B and instead invest in security A. There will be selgg Bressure on security B which will drive its price downwards and hart the cos of investment wll be lower. Since return from an investments negatively related with the cost of investment, the returns from. Security wilrise Delinein purchase price wilresltin higher return from Seeugy 8. On the other hand there will be heavy demand for security A and ig would push its price upward. Increase in price will result in higher cont of investment and hence lower returns from security A. This process at come toan end when thereturns from both security A and B become equa, IF the risk level of two securities is same then both of them must provide same return, otherwise investors will never chose to buy: Security providing less return. Hence ‘Me c er Kk. This return from an investment must be commensurate with the risk of that. investment. If returns are abnormally higher there will be mad rushfor that security and if returns are abnormally lower then no investor will choose that security. Hence investors must always make investment decisionsafter careful consideration of Risk-Return Tradeoff. A variety of securities are available in capital markets which have different return-risk relationships or Rein rik radeot a show Table: able: ye as ee 380 TABLE4 RETURN RELATIONSHIP OF DIFFERENT dar ‘TYPES OF INVESTMENTS wy eS NM Treasury bills Very low Bonds and debentures | Low Preference shares Medium Equity shares High a INVESTMENT ENVIRONMENT. ‘The return from an investment has two components Lob rewurn whic he time value of money. + pighjaee ompensation = is common for all the y investment including a risk free asset like Trea- Para 1.6 n for assuming tisk. 1 investment is esimentis premium that { Required Return from an Investment = Risk free return + Risk premium ce depending upon his risk return investor may select an investment depe An investes. He may select equity shares if he is willing to assume higher Pry for higher expected returns. On the other hand a retired person, who vvants lower risk, may select to invest in bonds and debentures. w AgEINVESTMENT ENVIRONMENT i ronment implies various types of securities which are TRSTHDE for investment and the entire mechanism or process through which these securities can be bought or sold. The investment environment comprises of three main aspects - securiti (also referred as financial assets or financial instruments); securities m: kets (e. financial market) and intermediaries in securities markets: The, investment environment now a days is characterized ag VUCA (Volatile, Uncertain, Complex, Ambiguous). i, Securities? An investor can invest ina variety of securities such as equity shares, Bonds; debentures, derivatives, rmutual funds, exchange trade funds et¢-One may also invest in commodities and bullions (such as gold and other precious metals), However, here we areprimarily concerne¢ withinvestmentsin financial assets or securities as defined under Sec 2(h)of Securities Contracts (Regulation) Act, 1956, The term securit; means that the holder of the security has a claim to receive futur benefits under certain conditions. These securities may be transferre from one owner to the other without much difficulty. Various type of securities can be classified into the following categories oon basis of their peculiar features as well aor rela ell as risk return relationshipsINVESTMENTS. AN OVERVIEW (or capital gains), is not obligatory on the sto” the company to declare dividends every year and the Mount of dividends, if any, may also vary from year to year, Henog cauitysharesarealsoreferedtoas varableincomeseeyguet and do not promise fixed return. Due to variability in ren ails shares are highly risky: securities. They may generates very high return or very high loss during the investmen; hori. zon. Worldwide equity shares are expected to generate higher retums (as they have higher risk) over long term, bh fndsand debentures: Bonds and debenturesare fixed Bideand dba ait TOU (Owe You) of the borane arises out of alendiig Borrowing contract wherein, the boro er(or the issuer of the bond) promises to pay a fixed amoun of interest to the lender (or the bond Holder) periodically ang repays the loan either periodically or at. maturity. Most of the bonds and debentures are redeemed at maturity only and; they carry a fixed coupon rate or fixed rate of interest. Bonds aiiay be corporate bonds or government bonds, short term bonds or longterm bonds, secured bonds or unsecured bonds etc. Bonds and debentures may also be convertible or non-convertible, Since bonds and debentures carry a fixed rate of interest, their future benefits are known in advance, Therefore they have relatively lower risk than equity shares, At the same time they generate rélati _AxArveasiity Bil? Treasury bills are the securities issued by 7” Central Government in the context of a lending- borrowing contract. An investor in Treasury bills actually lends money to the central government. This type of security carries min- imum (or negligible risk) risk oF non-payment of the amount is Promised. Hence thé default risk in case of Treasury bills is negligible. These bills are issued at discount and redeemed at par and hence the rate of return is known with certainty in the very beginning of the investment, Because of this feature, Treasury billsare also referred to and used as "Risk free asst inresearch studies. esearch studies INVESTMENT ENVIRONMENT Para 1.6 number of new securities rketover the pasttwo de- funds, exchange traded derivatives and commox ity backed sect deep e| ective investment schemes, 1 bonds, catastrophe bonds, collective inves : REITS (Real Estate Investment Trusts) etc. These securities have enriched the investment environment and provided a variety of choice to the investors. . Securities Market: ; +e earties market bring together the buyer and seller of securities ad provide operational mechanism to facilitate the exchange of ancurities,Anetficient and developedsecurit marketisaprerequiste forincreased investmentin securities. There are many types in which ecurities market can be classified. The basic Cassia isnt GFrimeattenureof securities. On the basis of tiie securities market is classified as - Capital Market and Money Market. Capital marke themarket for longterm financial investment and instruments (more than one year), while money market deals with short term securities (one year ores) Capital marke! primarily deals with equity shares, long term bonds and debentures, while money market deals with Treasury bills shortterm debts suchas commercial paper, certificates of deposits etc. Capital Market in India is further classified into the following two segment - Equity Market and Wholesale Debt Market. I Capital Market ‘Money Market Itisthe market forlong term capital It is the market for short term instruments suchas equity shares, | financial instruments. having debt ete. Theseinstrumentshavea | maturity in less than | year, These period of 1 year or more. instruments are certificates of deposits, commercial papers, Treasury bills etc. 2 | Capital market can be further sub- | Money market canbe sub-divided divided into the following three into the following segments— peck (0 Treasury bills market ( Equity market (i) Wholesale Debt market Derivatives market (i Commercial papers market (di Certificate of Deposits market Call money market 3 Capi al market instruments have medium liquidity except equit and derivatives, at ervatves, | Money market instruments have very high liquidity aPara 1.6 INVESTMENTS : AN OVERVIEW a 4 Capital market is used by Participants for the purpose of ing unds or capital for medium | borro to long term term, wi range from overnig ayear 5] The rates of return in capital] The rates of retum in mom market is relatively high due to lowduetoshor, longer maturity period 6 | Capital market is essential for overall growth of the economy sential for ty in the A security market can be further classified as Primary market or Secondary market. Primary market is the market ‘Where new secuiitieS areisstes for the first time; while secondary marketprovides the platform where existing (or second hand) securities are bought or sold. A well functioning primary market is essential for the growth of investments in an economy. At the same time a transparent and _ efficient secondary market that ensures speedy transfer of ownership of securities, is a prerequisite for investment in a particular security, For example in India, secondary market for bonds is not properly developed and hence growth in bond market in Indiaislagging behind as compared to growth in other countries bond markets, Every security is characterized by market intermediaries which are Positioned between the buyer and seller of securities. Stock exchange, its brokers and sub-brokers act as market intermediariesin secondary market, Ditterence between primary and secondary market ‘Primary Market No. ie 1 [Meaning iG is a market where new | It is the market for trad- securities are issued for | ing of already issued and thefirst time by an existing | existing securities. or new company. Price deter- | Theissuer company itself | Priceof securitiesis deter- mination decides the price of securi- | mined by the interplay of | ties for the first time using | market forces of demand thebook buildingmethod. | and supply operating at It can decide the amount | the stock exchange. of premium also, 13 INVESTMENT DECISION PROCESS Para 1.7 [si | Baste Primary Market Secondary market No. ‘3 | Variability in | Prices (the issue price) of | Prices of securities vary 3 Yodeas | securtes are fixed. | onthe basis of mene ” and supply forces. 4 [Buying and|The new securities are] The buying and selling of 4 | Selingpartis | sold by the company and securities usually happens involved _| bought by investors. _| between investors. [5 | Financing for | Primary market is a plat- | Thereisnofund raising by 5 Business” form for companies to| companies because there isno issue of securities in raise finance for expan- sion, diversification, etc. secondary market. Only trading of existing secu- rities is done here. -|Primary market directs the flow of funds to pro- in capital formation. Secondary markets pro- vide liquidity to investors, ductive use in business, | thereby indirectly leading thereby directly resulting | to capital formation. - | Main intermediaries oper- ating in primary market underwriters, registra toissue, collection banks, - | Secondary market hasin- | termediarieslike brokers, are merchant bankers, | sub-brokers, etc. r etc. iii Regulation of securities Market: —TitenmacUomuld » Zn investment environment arid hence securities market is well regulated. Securities market is not a laissez faire market but ade- quatély regulated by regulatory bo Exchange Board of India), RBI (Rese! such as SEBI (Securities and e bank of India), Department of Company affairs, Ministry of nance etc. The multiplicity of reg- ulatory agencies sométiiies prove detrimental to the growth and efficient regulation of securities market. Hence recently there is a move towards reducing the number of regulatory bodies in India. On 28" September 2015, Forwards markets Commission has been merged with SEBI. LJANVESTMENT DECISION PROCESS The process of investment broadly comprises 1. Setting up the investment policy 2. Building up an inventory of securities 3. Performing security analysis of the following steps :I a tory of Securities : This step involy, +s buil Ing up a list of alrayaitable securities wherein an investor a ¢ hs investment. Depen upon investment oblectivgs and inv the Securities may be filtered. For a is to receive regular income at +h do not pay regular dividends where an investo: 3. Performing Security Analysis’: Once an inventory or list of available securities has been made, the next ston ie fon these securities primarily : acteristics: This is known decision. There are various approaches of security valuation - Fun- damental analysis, Technical analysis and Efficient Market Hypothesis (EMH). As per fundamental analysis, in the long term, the price of a security is equal to its intrinsic value or true worth. Intrinsic value of a security is the present value Of alll future cash inflows associated with the security. Hence the investor first calculates the intrinsic value of the sect 15 that there may be many feasible portfolios by combining various securities in different Proportions, but all of them may not be Portfolio for the investor, one needs to consider risk reters preferences of the investor. For example for a young person, pho is willing to undertake risk to maximize return ge may have an optimal portfolio comprising 70% of equity and 30%EST AN OVERVIEW d, old aged in, equity and 90% bon, ‘The fifth ste ion, i Pininvestm vis} ent decision Process : ists of the tition of the Vious vt changes “investment.en It. er the investment objectives of the investor ma ertime and h, ence there is a need to revise the origi. ~~ i Performance Evaluation and Step in the investment Proces; ofthe portfolio. tin, Portfolio has discussion abo} rm: ut portfolio Perf; in Chapter 10, ‘Ormance e: decision Process, as explained above, on his own.sg Panics, — pension —_ funds, Somporations, charities, educational tablishments, etc. easy job. It requires formulation of varieny of strategies by pee Sie foorone“sUMENL strategy. Th € parti x sophy into practice is knee vestors are as follows: rn Exhibit 4 he investors following this strategy seek relatively rvalued stocks will eventually earn undervalued stocks as they believe that the underv; strong returns in future, The locus of investing money in ‘value investing philosophy’ revolves around d dividend yield- market to book value.and price-eatnings ratig. As the: investors following this strategy seek high yield so they select companies having high ividend yi low_market_ to book value ratia or low price-earnings ratio, They thoroughly analyse the economic cycle and select those sectors which are undervalued 's of these sectors is more as compared by the market. The intrinsis rese sec d_payout strategy to cope uw to the market price. These stocks follow high divi 1e slowina of the market. The believers of this Philosophy enjoy high ise in va S si re. With the slow momentum. current income in terms of dividend and also expects rise in value of stocks in fi 2. Growth Investing Philosophy: The growth stock investing philosophy implies that s. The investors the locus of investing money revolves around the gi select the stock on the basis of-high growth in earnings. Investors following ‘growth investing philosophy’ believe that the companies having above average earning growth oyer a period of time-tendto provide above average returns to investors‘They calculate historic: ates of stock: . stocks and an terms of ret 7 : Philosophy choose i rae ¢ t sturns. They believe that the historical grown eet ak in future also. They do not bother abou Saree uth trend yi pe s z , ‘Size of com mi : n . any edium or large companies having high earnings growth m Mi here is that investors following this philosophy. yee he Poin’ tends to have high systematic a id unssemaii a Ts i me ‘ ps j el meen selects ay i 1 such phil : Capitalisation Phi Patinopiy i Known ag S. Technical Investing Philosophy: : Investors investing as per technical philosophy believe that the A full Sines current market price of security fully reflectsallinforman™ p y fully cn but the price movements are not tolally random ‘They examine past market da, in order to look for the visual patterns in trading activities to make buy or/and se decisions. They mainly focus on internaLmarket daiai-e. price and volume whereas in ‘fundamental investing philosophy’ the main focus is on factors relating to econgmy, industry and company. Investors give importance to ‘what’ not to ‘why’. When an investor takes decision purely on the basis of past data relating to earnings then she/ he is following “Technical growth stock investtnent philosophy’. This philosophy is a particular case 4 iy: Investors foll fundamental investing philosophy believe that the market is logical to a large extentlesving litle space for psychological aspetts. They evaluate fundamental/basic factors relating to the economy, the industry and the company. They employ fundamentat-analysis to determine whether a secugity is worth buying, holding or selling. J 5. Contrarian Investing Philosophy: An investor follows contrarian investing philosophy when she/he takes such investment decisions that are contrary/opposite to the market majority. It simply means that she/he is buying when others are selling or vice versa. o INVESTMENT ANALYSIS There are ample investment avenues all over the world where investor can put their money in the expectation of earnings depending upon their risk tolerance level. Investment is a decision to deploy one’s money after the analysis of economy, industry and company. The/analysis»of iifferent avenues for deploying money is the key factor that differentiates the investmentfrom gamblingvand speculation. The nature of investment analysis is as follows: 1. Investment analysis is based on th - investor, The plan for invesument_is made by settin : 0? risk, deciding appropriate a ai a iate fiversificatio: 2. a analysis are the risk and refurn,/ 3. The scope of investment analysis is the study of return, risk, Jiquidity tax sheluer and expediency.aly: Calet the future, a Score OF INVESTMENT Anavy: Evaluation wiz. risk, return, own investme: as follows: (i) Dispersion (ii) Variance (iii) Standard deviation Beta ovr: The rate of return of a security refers to current yield in combination oly capital yield. The current yield is the ratio of annual income to beginning/initial pric of security. Capital yield is the ratio of difference between ending price and beginning Price divided by beginning price. So, the rate of return can be split into two parts. Thi splits of rate of returns are as follows: faite yet = Antu Income {eaves vis, Beginning priceCurrent yietq= Endiny Rate of NUNN & curre, Nt yield + Capital yield So, Rate of return = Annual Income. Endin, nual me | IB Price ~ Beginning Price Beginning Price Beginning Price Price at the beginning Of the year: 7120 Dividend paid at the end of the year: 24,89 Price at the end Of the year: 132 The current yield on thi Example: So, the rate Of return is: 4% + 10% = 14% Or, the rate of return is: 4.80/120 4 (132-120)/120 = 14% shelter refers to tax benefits that are available in case of some tal tives, timer . These benefits may be initial, continuing or terminal. The ‘enjoyed at the i i i returns are contin: uing tax benefit as in the case of dividend income in the hands of shareholders. The terminal tax benefits refer to the benefits associated at the time of realisation of in vestment as withdrawals from public Provident fund. Spacuidiny: Another perspective for evaluation of security is in term Of its liquidity or marketability. Liquidity refers to Scope of quick transaction with low transaction cost and negligible price change between two Successive transactions. It depends upon the number of buy orders as well as sell orders around current Price of the security. The transaction cost in Indian stock market inckudes brokerage, depository charges, stock exchange transaction charges, SEBI turnover fees, securities transaction tax and stamp duty.x Investment Management IN stock market is thron, ed b es may } Bed by investors pursuing ¢ tbo M. brondly divided nto tour caer aa ection. Making 48 follows: Psychological A fundamental ay insic value a Taam heer, ens a cert ea d rsjrelating to th ; his intrinsic value py be higher, lower or equal to marker cea pe ar] in SES at some give ‘urrent market value of a ecard ee Bee! 8 Ho oad ver the period of time the market price of security will fall in tune with the pa hae eae Can arn good amount of returns by buying undervalued securities ana ing overvalued securities. The undervalued securities mean those securities whose intrinsic fall drastically. The stock valuation that is established on the basis Of fie miss psychology is liable «6 change Violently if that psychology is based on large number of ignorant individuals. The main reason behind violent behaviour may be sudden fluctuation of opinion due to factors that do not make much difference in prospective yield. So, the stock value depends on the ‘optimistic and pessimistic psychological mood of investors resulting into certain persistent and recurring Patterns of price movement. A variety of tools can be used in technical analysis like moving average analysis, bar chart, point and figure chart and breadth of market analysis. | 3. Theoretical Approach ' 0 ous theories of capital structure that are studied by the academic { community through comparatively sophisticated methods of examination. Thi “approach is based on the belief that stock price reflects the intrinsic value fairly well due to practical efficiency in responding promptly and reasonably to the flow of information. This means that the current market pricé of security is equal to intrinsic value. So the stock price behaviour is like a random walk as past price behaviour cannot be used to predict future price behaviour. The successive Price changes are independent. The expected return from the security is associated linearly tot Ms systematic risk or market risk or non-diversifiable risk. As we know that there is a positive relationship between risk and return in a capital market.ae ONS 4. Hybrid Approach Ge The hybrid approach is a combination of all the three approaches discussed above. The pasic belief of hybrid approach is based on the following points: (a) Fundamental analysis is vital in forming a basic standard and benchmark but the total dependency on this analysis is not cher ished as there are some uncertainties associated chit, One should view the fundamental analysis with caution as very excessive refinement and complexity are associated with it. (b) Technical analysis is based on the comparative strength of supply and demand forces gauging the current mood of investors. But the total dependency on technical indicators can result into dangerous situation that might turn out in uncontrollable issue as there is high degree of unpredictability in mood of the investors. The problem is the reality of stock market, as its behaviour is neither speculative as the psychological approach indicates nor well planned as theoretical approach recommends. Hybrid approach reacts rationally and it is quite efficient to the flow of information but there are some deficiencies also as it is not perfect. There are some instances that the securities are mispriced based on this approach but still there appears to be quite strong association between risk and return. The operational implications of this approach starts with ascertaining the value by conducting fundamental analysis. The state of market psychology is also assessed by technical analysis. Now it’s time to combine the result of fundamental and technical analysis to know which securities are worth buying, worth disposing of or worth selling. CO Investment AVENUES Nowadays, investors have ample avenues to part their money in the expectation of some benefits. The investment alternatives may be classified as: 1. Non-marketable financial assets like banks deposits, company deposits, post office deposits and provident deposits 2. Bonds 3. Equity shares 4, Money market instruments like commercial papers, treasury bills, certificate of deposi future 5. Life insurance policies 6. Real estate 7. Financial derivatives 8. Precious objects. These avenues are discussed further in detail in Chapter 2 of this book. © Missteps TAKEN BY INVEsToRS — “WHAT NOT TO DONE” rel The knowledge and awareness TTOTS th ces of better invests iu of typi ypical errors boost the chan iter a mmitted by investors that result into tl i i . e failure of investSettlement j nt is a ty iT fi ul@sandseen ree Way process which involves legal transfer of titl devised aeg utes or other assets on the seitlement date. NSCCL hat vous casement date, NSC shortages, bad delve ane watous exceptional tutions Hie ea Rese — = oma Objections, auction settlement ete” panelled 13 clearing banks to provide banking service, trading menibers and has siablished ooo both the es . 3 ivity with both the dep tories for electronic settlement of securition et eee the depe Clearing Clearing is the process of determination of obligati i arin, igations, after whi: obligations are discharged by settlement, a NSCCL has two categories of clearing members: tradin, memb custodians. ° Trading members can trade on a proprietary basis or trade for their clients, Allproprietary trades become the member's obligation forsettlement. Where trading members’ trade on behalf of their clients they could trade for ne. mal clients or for clients who would be settling through their custodians, The whole trading process at NSE can be summarised in Fig 2.1. nen einem . FIG 2.1: TRADING PROCESS AT NSE ; trade details are sent from the exchange to the NCCI. (real-time and end-of-day trade file). ‘The NSCCL notifies the consummated trade details to clearing jon, bers/custodrans, who affirm back. Based on te-affirmati ; the NSCCL applies multilateral netting and determines obligations. STOCK INDICES Para 2,3, securities (the NSCCL advises the ca aia £ depository ta debi ‘pool account of the clistodians/CMs and Y.ta debit-the depository does so). ws and credit its account, and the 7. Pay-in of funds (the NSCCL advi > NSC ises the clearing banks to debi aecount(G) OF the custodians/CMs and credit its acensoeestt Me clearing banks do so), Ne rA US account, andthe 8, Pay-ut Of securities (the NSCCL advises the. depository to credit pool account of the custodians/CMs and debit ite account and the depository does so). 9. Pay-out of funds (the NSCCL advises the account(s) of the custodians/CMs a clearing banks do so). 10. Depository informs the custodians/CMs through DPs. 11. Clearing banks inform the custodians/CMs, he clearing banks to credit ind debit its account, and the 2.3 STOCK INDICES An Index is used to give information about the price movements of prod- ucts in the financial, commodities or any other markets. Financial indices are constructed to measure price movements of stocks, bonds, T-bilis and other forms of investments. Stock market indices are meant to capture the overall behaviour of equity markets. A stock market index is created by selecting a group of stocks that are representative of the whole market or a specified sector or segment of the market. An Index is calculated with reference to a base period and a base index value. Stock market indices are useful for a varlety of reasons - Some of them are: They provide a historical comparison of returns on money invested in the stock market against other forms of investments such as gold or debt. * They can be used as a standard against which to compare the per- formance of an equity fund. © Itis a lead indicator of the performance of the overall economy or 4 sector of the economy. i~~ MARKET 2.40 REGULA The Sec LATION OF SecuRITIES MaRKEr iN INDIA (sep ” « Securities and Exchange Board o (Seay Capital market 1988 as an adn 12, 1992 in accordance : Board of India Act, 1992 ne han Management of the Board The Board of SEBI consists of members, nam (@) a Chairman (4) two members from amongst the officials of the dealing with Finance (0) one member from amongst the officials of the Reserve Bank (A five other members of whom at least three shall be th whole, members to be appointed by the central Government. **time Functions of SEBI Central Governmeny Section 11 of SEBI Act lays down that it shall be the duty of SEBIto protect the interests of the investors in securities and to promote the development of, and to regulate the securities markets by such measures as it thinks fit. To achieve the aforementioned objectives, the Board may undertake the following measures: © regulating the business in stock exchanges and any other securities markets; © registering and regulating the working of stock brokers, sub-brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers and such other intermediaries who may be associated with securities markets in any manner; registering and regulating the working of the depositories, partici- pants, custodians of securities, foreign institutional investors, ct o rating agencies and such other intermediaries as the Board may, by notification, specify in this behalf; TIES MARKET IN INDIA Para 2.44 he working of venturi e capital fund, ‘mes including mutual funds, 34 egulatory organisations; i fraudulent and unfair trade practices relat tosecurities promoting investors’ education and tr termediaries of securities market . oe calling for information from, undertaking inspection, conducting inquiries and audits of the stock exchanges, mutual funds, other persons associated with the securities market intermediaries and self-regulatory organizations in the securities market performing such functions and exercising such powers under the provisions of the Securities Contracts (Regulation) Act, 1956 (42 of 1956), as may be delegated to it by the Central Government: levying fees or other charges for carrying out the purposes of this section; inspection of any book, or register, or other document or record of any listed public company or a public company which intends to get its securities listed on any recognised stock exchange; © conducting research for the above purposes; performing such other functions as may be prescribed. 2.4A.1 Reforms introduced by SEBI SEBI has come a long way since its inception as an institution regulating the Indian Capital Markets. It has initiated a lot of reforms to make the market safer for investors. The following are the major policy initiatives taken by SEBI since its inception : (a) Control over Issue of Capital : A major initiative of liberalisation was the repeal of the Capital Issues (Control) Act, 1947 in May 1992. In the interest of investors, SEBI issued Disclosure and Investor Protection (DIP) guidelines. The guidelines allow issuers, complying with the eligibility criteria, to issue securities at market determined rates. The market moved from merit based to disclosure based regulation. . .fu “Ga 5:33 a Coins (J Tre issuer shalt comply with al the applicable guidance, regulations intetaid from oe Securities Contracts (Regulations) Act 1956. © secuities contacts (Regulation) Rules 1957 © secures and Exchange Board of india Act 1992" @ 201 any oer circular, ctarcations, quidetines issued by the appropriate authority. © compares 2013956 2. Permission to Use the Name of BSE Listing Process n Issuer Companys Prospectus ‘Companies have to take prior approval from BSE to use the name of BSE in their prospectus or offer {for sale documents before filing the same with the concerned office ofthe Registrar of Companies ‘8, Submission of Letter of Application A Letter of Application need to be submitted to all the stock exchanges where they want to get it listed before fling to the Concerned ROC 4, Allotment of Secutties ‘As per the Listing Agreement, a company is required to complete the allotment of securities within 30 {days of the date of closure ofthe subscription list to the public 5. Trading Permission After the completion of allotment, within 7 working days, the issuer Company has to complete the formalities for trading at all the stock exchanges, where the securities are to be listed 6. The requirement of 1% Security ‘Companies have to deposit 1% of the issue amount with the designated stock exchange before the issue opens, 7. Listing Fees Alllisted companies are required to pay to BSE, an Annual Listing Fees by 30" April of every financial year ‘8. Compliance withthe Listing Agreement ‘When companies get listed at stock exchanges, whether itis BSE/NSE Listing Process they are required to enter into an agreement which is called the listing Agreement under which they are required to file certain compliances and disclosures which are given by listing Agreement, filing wiich the company may face some disciplinary action, including suspension/delisting of securities Under listing agreements, all the terms and conditions are written on the basis of which the company has to perform like © Provide facie for direct transfer regiatation,aub division, and concolidation of securities; © seraproper notices ofthe closure of transfer books and record dates, forward 6 copies of Annual Reports, Balance Sheets and Profit and Loss Accounts to BSE © wfc shareholding pattems and financial results on a quarterly basis; a Co any cing upon the Causes of Risks or Sources of Risks, we can clay Total Risk of a Security as Systematic Risk and Unsystematic Rig ty 3.4 SYSTEMATIC RISK Systematic risk is that part of total risk which is caused by factors bey the control of a specific company or individual, Systematic risk is Caused), factors such as economic, political, socio, cultural etc. All the inv, : or securities are subject to systematic risk and therefore it is NOn-divery fiable risk. Systematic risk cannot be diversified away by holding a | number of securities. This risk cannot be diversified away even by holding an efficient portfolio of assets, Systematic risk primarily includes ~ marke risk, interest rate risk, purchasing power risk and exchange rate risk. (a) Market Risk Market risk is caused due to herd-mentality of investors ie. the tendency of investors to follow the direction of the market. Hence market risks Market price changes is the most Prominent source of risk in a securit. (b) Interest Rate Risk Interest rate risk arises due to changes in market interest rate. This P* marily affects fixed income securities because bond prices are invers related to market interest rate. An increase in market interest rate oe bond prices to fall and vice versa. In fact, interest rate risk has two oe f components - Price Risk and Reinvestment tisk, Both these risks ae opposite directions. If price risk is negative (ie. fall in price), reinves —~~ ALS eriod. The investors who do NOt want 10 unde vere invest in bonds and debentures because risk ie hig relatively lower than that in equity shares due fore investment, the investor me lixed A risk should also 10 fixed come Securities ig y Cd return, Ho ‘Sl consider the valuation vields mat pe , ind ris, of these fixed income securities 10 avoid erroneous invesiin Z ent decision, Fixed income securities provide q fixed amount of re of the securities and hence the issuer has 10 bear a fixed cost oblis (ol! a _ ; _ S eg gation, In India, fixed income securities are the most Preferred investmeny : for retired people and conservative (or more risk averse) i want to have a fixed source of income at low risk, 4,1 BOND FUNDAMENTALS Bond Abond is a security that is issued in connection witha borrowing arrange- ment. The bond is JOU (I owe you) of the borrower. Itimplies that the issuer of the bond, usually a company or government, has an obligation to pay some periodic amount (say interest) as well as the borrowed amount (or principal amount) to the holder of the bond, venue to the holder] ‘Ment option ‘RVestors who | A bond is a security that is issued in connection with a borrowing ar- [rangement |Is there any difference between debenture and bond? Yes. A debenture is a debt security which is not secured by specific assets of theissuer company. A Bond, on the other handis a debt security which is secured by the specified assets of the issuer company. Bonds are IOUs between the borrower (issuing corporation) and lender (the bondholder). However in India, both the terms are used interchangeably. Typically nds are issued by public sector enterprises and financial institutions. Features of a Bond Every bond has certain features which describe it. Some common features ofa bond are given below: (1) Face Value or Par Value : Every bond has some basic denomination (ay Rs.1000 or Rs.100) on the basis of which interest (or coupon) is Paid. The issue price of the bond may be same as its face value or rent from its face value. When issue price is higher than face Value of the bond, it is said to be issued ‘at premium’, When issue Price of bond is lower than its face value then it is said to be issued aPara 4.1 FIXED INCOME SECURITIES - VALUATION YIELDS & Risks ‘at discount’, However interest (or coupon) on the bong j ‘ ! is calculated on the par value of the bond irrespective of itg teat (2) Coupon Rate: Coupon rateis the rate of interest paid tothe bona on the face value ofthe bond. Itis fixed in advance and is pe tl the bond agreement. Unless specified otherwise, the coupon a bond never changes throughout the life of the bond. The ttt payments are also referred as coupon payments. Coupon, rate like any other interest rate say 10% p.a. Thus coupon rate gt the fixed return which the bondholder will et at fixed interyae® every year) from the date of issue till maturity. ay (8) Maturity Period : It is the time horizon for which bond is issue the bondholder. The issuer of the bond is required to pay intereg.” bbond during this period and redeem bonds at the end ofthis png Bonds can have long term maturity such as 10 years or 15 yearyq short term maturity say 1 year or 3 years ete. (4) Redemption Value : Its the value of the bond paid by the company to the bondholder at the time of maturity. Redemption value canty higher than, lower than or equal to the face value of bond. Ifredenp. tion value is higher than bond face value it is termed as redemption at premium. If redemption value is lower than the bond face vale, it is referred to as redemption at discount. When redemption vae is equal to the face value of the bond, it is termed as redemptions par. The redemption value of the bond is also specified in the bond agreement. (5) Bond Indenture : It refers to all those terms and conditions agreed upon by the issuer of the bond and bondholder. It is a contract bit ween the issuing corporation and the bondholder. It covers numb of items specifying all the features of the bond such as - coupea rate, mode and frequency of interest payments, redemption pric. maturity date, collateral, siaking fund, priority of payment in time of liquidation etc. There are three parties to a bond indenture: issuing corporation, the bond trustee and bondholder. (6) Collateral : Bonds may be secured by some asset or security. Colt eral is the asset or security against which bonds are issued. we company defaults in the payment of interest or repayment of value, the bond trustee can dispose of this asset or security tore* the amount for bondholders. ol (7) No Voting Rights : Bondholders of acompany donot have any a voting rights in normal circumstances. Bondholders are cr TYPES OF BONDS, 31 Para 4.2 a company and hence in special cases they may have some repre- gentation on the board of management of the company, priority in Payment in times of liquidation : Since bondholders are Freditors of the company they have prior claim over the assets of the company in times of liquidation. The claims of bondholders are settled first and then the claims of preference shareholders and equity Shareholders are settled. (@) 42 TYPES OF BONDS ‘cond’ is a generic term which signifies a fixed income security. It must pond! rere that in India, bonds and debentures terms are used inter- or angeabl. Depending upon different types of bond features, we can fay bonds into various categories. Some commonly available bond one are discussed below : (1) Convertible and Non-Convertible Bonds (or debentures) Convertible bonds (or debentures) may be Fully convertible bonds or Partly convertible bonds. Fully convertible bonds (debentures) are the bonds which are fully converted into equity shares after a specified period. The bond- holder gets fixed interest income till the time bond remains as bond and after conversion these bonds become equity shares eligible for equity dividend and other rights of equity shareholders. There is no redemption value of the bonds as they are redeemed by converting them into equity shares. For example, a company issues a convertible 10% bond having face value of Rs. 100. The bond and is fully con- vertible into five shares of face value Rs. 20 each after five years. In this case the bondholder will get interest income of Rs.10 every year for five years. After five years the bond will be converted into five eer of the company and the bondholder of the company a ay ee ip nights. Whether the bondholder makes a of conversion if mateo nat ec mae price of the share at the time more than Re 20 0 ose share at the time of conversion is Then Rs. 20, say 5.25 the bondholder stands to gain because theothe nara value o his five equity shares would be Rs. 125. On happens tobe Ret a et price of the share at the time of conversion Value of five shares en ‘bondholders stand to lose as the market Partly cons ss 's would be Rs. 75. apattot he toe bonds (or debentures) are those bonds for whic Alter a specifin) Gr aee of the bond is converted into equity share ime and the balance remains as. pure bonds to be(2) (3) (4) sometimes ; of SPN to the SSuey on Jy immediately ang there ig” the lock in periog, Hence gre outflow. After that it can bene TISCO (Tata Tron and Steg 7 1992, As the name Suggests be redeemed by the i. period known as mat premium, par or have infinite tim » Tede, Ssuin, turity discoun ¢ horizo te Irredee ed Mable bonds” CaN be Continues , 7 bonds throughout the life of the ¢ pany ori’ on irredeemable decides to redeem the bonds, Irredeemable bonds time company toas Perpetual Bonds. In Teal practice j phenomenon. Secured and Unsecured Bonds Secured bonds are the bo some asset (e.g. land, buildin; bond trustee. If the Company fails to Pay int cipal amount, then the asset is sold to reco terest or Tepay the prin- of unsecured bonds no such asset is kept ver such amount. In case Callable and Putable Bonds The peculiar feature of these bonds is that the bond indenture has call option’ (in case of callable bond) or a ‘put option’ (in case of Putable bond) . Call option is the right of the issuer company to cal ot or redeem bonds after a specified period but before maturity. Gener ally the company exercises its right to redeem or ‘call cea market interest rate declines and becomes less than coupon cay at case it makes sense for the issuer company to redeem cart ae ; Coupon rate bearing bonds and issue a new series o With lower og, tion upon rate. Since these bonds are callable at the opnow to buy this bond but will not get any interest (or coupons) for five years. At the end of fifth year the bondholder will receive Rs 100. The net gain to the bondholder will be the difference between ay.) eK LE, Call er thinne he ae 7 bond is available at a lower cee other things being equa tt rice of the share at the time of Panta Icic is a lower price in the mark. Aual a cay il PU IFCD of a company ‘Onversion/maturi T Ltd, issued a seri arket than a allay a DF pany having face vah TOy por example call opti series of Callable bonds in the yan e™al bye® ice of Rs. 95. After 3 years this debenact 100 is issued option after 3 years, 1 Year 2093 on Ported into 10 equity shares of face ete 18 compulsory con Puttable bonds, on the other hand, have a “tha Sebenture holder will pay RS, 95 joy nego BS: 0 each, Hence the the right of the bondholder to ask for nates eet Pat ony getany interest (9 £OUpons) For three year Atihe ona et Period but before maturity, The comme mPtion after a spect the debenture holder will receive ten equity share nasot third year bonds on which put ont, ee comPany is obliged to rege ie and will become a shareholder enjoying al rights aes omee™y erally bondlgcsPut option is exercised by the bondnlegee™ th and voting. The net gain (orloss)to the debentte ene cuiaends fi i e rate goes up and Eecmereen al Pree cs en market ia difference Enema Hered neha ae fue pe ts ms . antly higher than tl i . Suppose the market price happens to b ther, In such a case it makes sense for the bondholda. ne ne coupon Tate Pe holding periodreturnon his ZIFCD wile oo pine canes - el g \ ; 31iLe, (120: a anving lower coupon rate redeemed and instead buyet The effective annualized return will be 8.09% P.a(1+0.2631)' - 14, of bonds having higher coupon rate. Sine eg taney On the other hand ifthe market ofthe share happens tate leosbees redeemable at the option of the bondholder, the bondholyns i eer ea Prnilceed Position. Hence other things being equal a puttable ig, | €) Deep Discount Bonds (DDBs): is available at a higher price in the market than a normal b i mi | DDBis.a non convertible zero coupon bond issued at a heavy dis: (8) Zero Coupon Bonds (or Zero Interest Fully Convertible Debent count and redeemable at par after a specified period. The return on ZIFCD) tures. a DDBis calculated as the difference between the redemption. price As the name suggests, a zero coupon bonds does no (or face value) and the discounted ssue price. Normally the matarty sy rt i coupon rate and hence no interest is paid/received on such Pow FN ee eee Sanat tao aatte coupon bond say 20 or Gqupon rate and hence no interest pa eciv ch bonds nore years. In Jan 1994, Sardar Sarovar Narmada Nigam Limited the benefit tothe bondholder is difference between the vedere Se a cov atan ari USeTa SE c , t fe redemption rice of Rs. 3600 maturing after 20 years at face value. Although the Price and issue price. For example a Zero Coupon bond having face ers had an option to get redeaption at the end of 7, 118 cr value of Rs. 100 is issued at a price of Rs. 95. The redemption is due 15! years at a price of Rs. 12500, 25000 and Rs. 50000 respectivels after 5 years at face value. Hence the bondholder will pay Rs. $5 7 K his bond ws the holding pericd If the bondholder holds this bond up to 20 years the holding period return will be 296% i.e. (110000-3600)/3600 which means that the annualized return will be 18.64% { Le. (1+29.6)¥ -1}. the redemption value Rs. 100 and issue price ie. Rs. 95. The holding | The return of a zero coupon bond or DDB can also be calculated period return will be 5.26% ie. (100-95)/95. The effective annualized using the following formula: return will be 1.03% p.a. {(1+0,0526)'-1} | B=RV/ (1+k). 4.1) Zero Interest Fully Convertible Debentures (ZIFCD) are those 2210 i i ible into _ 4 coupon debentures which are compulsorily fully convertil RV= Redemption val equity shares at the expiry of a specified period (not exceeding three | n= Years t iption vi lue (or future value) years) from the date of issue as per SEBI guidelines. These a = 's to maturity tures are also issued at discount and for the intervening period = | Where B = issue price of the bond (or present value) annualized return to be calculated. debenture holder does not arn any ares come a aie For example these debentures are convertible into equity shares mack Inthe case ay ‘ i loss to the debenture holder depends upon the a issued by SSNNL above we have net gain or 600 = 1to0co ee —_ aK= 18.64% (7) Tax Free Bonds Another popular Popular type of bonds especially j bonpanies in India, is tax free bonds: Interest i Bonds issued by central government of a country are often referre toas sovereign bonds or treasury bonds. Treasury bonds do net have any call or put option. Most of the Treasury bonds are in the formot Zero coupon bonds ie. they do not have any explicit ‘coupon rate, 0a the other hand, bonds issued by a company are termed ve corporate bonds. They generally have a call option or put option, (10) Municipal Bonds Bonds issued by state and local government are termed as municipal bonds. These bonds are not very popular in India due to high risk Further, not many local governments issue these bonds in Indiz. | (11) Floating Rate Bonds This is a new innovation in bond market. Floating rate bonds dow have a fixed coupon rate. In this case coupon rate is linked t0 a base interest rate such as Repo rate or MIBOR (Mumbai tes Offer Rate). A change in Repo rate (or MIBOR) will cause a cits coupon rate hence interest income from this bond will be fluc rather than fixed and constant. For example if a company | 143 BOND VaLuaTion, time when Reporateis 7.5%, then teen ra" 88 Repo rate + However if Repo rate is inere announcement by RBI then the bondholder il gain. On the othe at to 7% then the bondholder will get ewa a floating rate bond may not be advisable in (eon a Of 10% Thus rates are expected to decline in near future Inverse Floaters Bonds: (12) example in the above case if the coupon rateie i ¥ Repo rate +3%-. If at presente Repo rates 750; thereat coupon rate will be 10.5%, If repo rate increases to 8% the coupon rate will become 10% (ie. decline by 05%) and if repo tare declines to 7% then coupon rate will be 11% (ie. up by 0.5%), These bonds are good in times when the investor expects a decline in base rate. International Bonds There are two categories of international bonds- Foreign bonds and Euro bonds. Foreign bondsare issued by a borrower from country other than the one in which bond is sold. These bonds are dene. minated in the currency of the country in which itis marketed. Eg ifa German firm sells dollar denominated bonds in US, the bond considered a foreign bond. These bonds are given colourful names based on the countries in which they are marketed. Foreign bonds in US: Yankeebonds, in Japan- Samurai bonds, in UK- Bulldog bonds Euro bonds, on the other hand are issued in the currency of one country but sold in other national markets. E.g. Eurodollar bonds are dollar denominated bonds sold outside the US, Euro yen bonds are yen denominated bonds selling outside Japan, Euro sterling bonds are Pound sterling denominated bonds sold outside UK. 4.3 BOND VALUATION (OR VALUATION OF A FIXED INCOME SECURITY) Inerder ‘o invest in bond market, one should understand how bonds are “ued. Let us first understand the concept of valuation, (13)oo EQUITY ANALYSIS - FUNDAMENTAL ANALYSIS 5 LEARNING OUTCOMES After reading this chapter you will be able to understand different approaches to security valuation-Fundamen- tal analysis, Technical analysis and Efficient Market Hypothesis. > Differentiate between top down approach and bottom upapproach of fundamental analysis » explain EIC framework. > Highlight the importance of fundamental analysis > Identify various economy wide factors and Perform Economic analysis y \dentify various industry wide factors and Perform Industry analysis » Identify various company level factors and Perform company analysis ” Explain the limitations of fundamental analysis 7 ae a wide range of securities as available in financial hoe of simplicity these securities can be divided i ixed i ities i.e. res; We discuss curities ie, equity shares. In the previous chapter rniden about fixed income securities Le. bonds aaa debentures and “dae tion models for their pricing. The peculiar feature of bonds \ellpredio ‘esis that the cash inflows from theses can be very ~-Atled in advance because they have a fixed rate of interest income. erence ~ 2075,2 FUNDAMENTAL ANALYSIS ‘emise that j or fair value of an equit{ Share is equal to its i y the Ion value oF an asset is the present a Ta Sat earnings) from that asset. In case of an equity share it w present value all expected future earnings (in the Form of 0° & tal gain etc.) from that share because equity shares expected earnings from an equity share depend upor have inpriteng 8 arte ig na Variety of gS, . Ther analysis involves in-depth analysis of all possible ince nay on company’s profitability and Future prospects and hene wee (theoretical or Fair price). ~~~ Se Fundamental analysts forecast, among other things, fur sconomy's GDP Future ge and earnings of a large m oy LE level og tb and earnings of a Targe mumber of companies. Even NaESr TR BFE Coriverged To estimate the expected Cash inflows from the these companies. There can be two approaches to fundamentay 84 Top down approach and Bottom up approach. # ental nah, lop down approach # With this approach the financial analysts involved in making forecasts for the economy, then for the inde ee firfally for the companies. The industry forecasts are based on the face of The sconiomy. Further a company’s forecasts are baseTonthetina of the economy as well as the concerned industry. ‘Bottom up approach: Jn case of bottom up approach, fundamental ay. lysts forecast the prospécts of the companies first, then for the industis and in the last forecast for the economy. Such bottom up forecastinigmy unknowingly involve inconsistent assumptions. Forecasts ‘Of the econom is DF no use if it is done after company forecasts because ultimately its the expected cash inflows from the company’s share that will be useli finding out the intrinsic value of a share. Henée in practice, Top down approach is widely used! to'pertes Fundamental analysis. . a The various factors of interest in fundamental analysis can be oa sified into three categories - economy wide factors, Industry wide and Company wide factors. Hence we have }- Economic Analysis 2 Industry Analysis } Company Analysis BIC FRAMEWORK. oe ara 5.3 _down approach of fundamental analysis ‘is OP mework, where E imps econo Tae Teterred tolls A Company level analysi ies iment pecision Making using Fundamental Analysis “ewe have foree of a company and make an fof the futures cash inflows from a security or share, we calculate Value of the security or share and compare it with the matket sic value is more than current market price of share then itis underpriced and hence an investor should buy it.On the other the she intrinsic value is less than current price, the share is over priced ran ence, the holder of the share should sell it and a prospective investor angtyd not BUY 5741C Fl sjainedabove EICrameworkisthe Top éown approach of Fundamental ewe ‘wherein an analyst makes a forecast about the economy wide analy jst and then performs Industry analysis and finally Company level factor fis three level analysis covers a wide range of various economy ana}sndustry wide and company- wide factors as discussed below: MEWORK 53.1 Economic Analysis fore performing industry level analysis and firm level analysis and Beta fo en ings iti irtant to analyze the broad forec s dividends and earnings it is impoi evonomic environment in which it operates. Economic analysis is the study of various economy wide factors influenc- ing stock market viz. Gross Domestic Product (GDPY growth rate, inflation’ iaigyinterest rate, exchange rate, balance of payment) fiscal deficit and budgetary provisions, infrastructure eté” An important aspect of economic analysis now a days is the political environment Specially jn an emerging market like India. Political stability is a necessary requirement for stable and growing Hinancial market of that country. Further, issues such as corfuption, lawand order, economic policies étc. are of pertinent use for economic analysi jotamic analysis is a useful tool to understand the general di eqoromy and deciding about the right time to invest. T securities f y large and institutional investors whose portfolio comprises of Civronm etn S buy or sell? Hence fundamental and technical | mutually exclusive. They are complementary and awise investment decision requires both - invest -ie.thetightgs and right time of investment. herightkingge, ™ Eundamental analysis determing, intr ‘ fence the investment decisions base 8 yy analysis is done for a relatively longer period. Teeyo" funda used to predict stock prices in near future Hence al useful in shortterm investment making such ae go am (2), Emphasis. In case of fundamental analysis * economic, industry and company Fundament market Forces or investor beh: a share will change only if there is a change in th factors. Technical analysis, on the other h ese fun, land, ig based movement of prices as determined by demand sei \dameniy 2 marly Hence investors’ behaviour does affect technicalanareey times thas been shown that in stock market, investors des beh rationally. Investors are irrational and are subject toa mane nce, los, vavioun behavioural biases such as- overconfidence, regret avoida: aversion etc. Hence anew area of research in finance ie. Beh; Finance has recently been developed. or short term traders in the market. As explained above there are many points of differences between unis mental analysis and technical analysis. These two approaches 0° secur valuation are fundamentally different. But it doesnot mean that fundamentl and technical analysis are mutually exclusive. They are complementays a wise investment decision requires both - ic. the right kind of securiis and right time of investment. F ental se pnn a ‘can be used wisely" decideabout the right time to buy or sell." 6.3 BASIC TENETS (PROPOSITIONS) OF TECHNICAL ANAl tions premises or Pron hich fundamentals are rel 3 ehese Pe faniciat® Ly5i5 Technical analysis is based on certain tenets, Technicians donot consider valuein the sensein which funds it.The technicians believe that forces of demand and supp!) in the patterns of price and volume trading, By examina/on terns they predict whether prices will move up or down. TOOLS OF TECHNICAL aNALysi5 a Para 6.4 «price fluctuations reflect logical Nenets Or Premises of technical anstaee ahd bas he price of a security is determined by the forces operating in a market prices tend to move in trends over lon, ion of market prices, emotional forces. The demand and supply '8 term. This long term trend price fluctuations reflect logical and emotional forces price movements, whatever their caus. some period of time and can be detectey The trends in security prices may reverse due t supply- he changes in demand and supply can be predicted wellin advane tinh the help of charts and technical moc men adsanee Hence the real task of a Technical analyst is to i Identify the trend and ©, once in force persist for ‘0 shift in demand and ii Recognize when one trend comes to an end and prices start moving in the opposite direction. Forthis technical analyst uses a number of charts, patterns and technical indicators which are discussed below. It must be noted that charts are the basic tools for technical analysis, 6.4 TOOLS OF TECHNICAL ANALYSIS Technical analysis can be performed both at the market level and at in- dividual company level using various types of charts, ratios, patterns or indicators. Here we will examine market indicators and individual stock indicators separately. 64.1 Charts ot ae. Point and Figure Chart and Candlestick chart. I vt be well ee are useful both in the analysis of individtial securities Stare varies mace movement analysis. On a particular day, the price of a Peticular stock wes: It is difficult to plot all the prices prevailing for a PES are of intone, Particular day. Therefore generally the following four interest to an investor- Open, High, Low and Close. aOpen Price : Open pri on a particular day. High price : High price is the highest price traded on a particular day. Low price: Low price is the lowest Ty, at which the share ‘ty hay ‘¢ at which the shar; bey on a particular day. Teas been ig Close price: Close price is the price at which trading on a sh Mt a particular day. ee a There are various types of charts which are used in technical tty i Line chart aly. i, Bar chart i. Bar chart of prices with volume iv. Point and figure chart v. Candlestick chart These charts are explained below: i. Line Chart : On a line chart X axis shows the time or numbe y days/week. On ¥ axis stock prices are shown. On a line chart yj closing prices of a stock are shown. They are connected With ex, other successively with straight lines as shown in Fig 61. The si prices on five days are Rs. 14,15,14,17 and 12, Line Chart FIG 6.1 - LINE CHART fT anythin Although line chart is convenient to draw, it does not Ca i the intraday volatility of the stock price. It shows only 1 ce and not other prices such as high price, low price or P@ the price at which the trading on athe, Y} st at | Point and Figure Chart of a in a particular day and hence if bar len, Prey be regarded as a signal of incre itmiiced every day and closing and openi oh some signs such as - or X. In Fig 6.2 igths increase overtime, ig stock volatility. One bar ing prices may be depicted as-o a bar chart is shown using the stock price data given in the following table. Day | High | Low | Close 1 15 6 14 2 17 9 3 19 2 4 18 6 [os 14 10 a Time Wis a chart mite lordecrs tat uP Of X and O's. X is placed for increase and O ‘ock price. A buy signal is implied when X lines are X [ang UP after every O line. If O lines are going down after every e then a sell signal is triggered. In this chart the axis do notiv. movement of prices irrespe rt S! Show ve of the quan, Sane the Chan ee ‘ Eg. A stock’s price over the past 30 da corde ee ‘ny 28, 26,25, 35, 37, 0, 42,38, 35, 37,39, 4, 34, 29 od a9 36, 39, 41, 45, 43, 42, 40, 38. 25,37, 49,382 38,2. The point and figure chart will appear as shown in jy 186, oy 3s % x % ROX xO %O XO %0 x0 * 80 0 Oxo xO x © o ° FIG 6.3: POINT AND FIGURE CHART It must be noted that whenever there is a change in price X or O are placed. The columns are changed when there is a change in die, tion ie. from increasing prices if the price starts declining then ve switched to second column and indicator O. After that the; pricestars increasing therefore we shifted to third column and put X signs fx every increase. The main advantage of such a chart pattern is that it can compress large volumes of data in a small group which can be used in analyss Candlesticks Charts As the name suggests this chart type shows a candle for every be price movements. It is a chart pattern which shows four, prin close, high and low. If close price is lower than open price ei box is filled with black colour otherwise left empty. An increase, dark candlesticks are bearish indicators. On X axis we meas ide and on Y axis we measure stock prices. This chart pation Pra a bird's eye view as to the movement of stack prices - bo! and inter day. 8 © OF TECHNICAL ANALYSIS, Para 6.4 tn Fig. 64, candlesticks are shown for 1 the following 5 days FIG 6.4: CANDLESTICKS CHART PATTERN v, Priceand Volume Chart: Price—volume chart shows the high, lowand close price of share along with its volume in the same chart. The utility of this chart is that it provides information about the volume of trading regarding that share besides showing the relevant prices, Price and volume chart for the data given in the following table can be depicted as shown in Fig 6.5. rere aaa (@n.000) : 1 10000 6 2 (000 9 3 15000 19 12 14 fs 14000 2B 16 17 “3 | 17000 14 10 12y TOOLS oF TPC Naty puydaring secondary corrections #= a Tast for Tong. By doing so the investor would by jowprices and in the longterm he can exper, increase due to bull market. Minor trends are day to day fluct market index and are of nouse in deciding about narket index di a : i rs price the general direction of the mack ; taich provide indicators "ete market. It covers the following theories o¢ is the long term trend over a Period lasting or more than one year. This trend sets s the overall direction of the market. If primary trend is upward then bull market s {operation whereas if primary trends downwar i Market is bearish. | FIG 6.6 : BULL MARKET (DOW THEORY) few mont , os . f. Intermediate trend, on the other hand lasts for a few ay | Bear Market : As Per Dow theory a bull market is in operation when ihe operate in the oppesite direction of primary dwil® ——-*ESSNE high points we Ione the previous lows and suc- the primary trend is upward then ete | care Ow points are also lower than the previous low point ‘This Ind VICE VETSA, TI . nr ; downward shovenient a VEEVETSE daunwany or t004 with the help of Fig. 67 Here, primary trend i trends are also known as ‘secondary corretttons” | Ward sloping. The intermediate trend is the period of increase