SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

Unit 1: BASICS OF INVESTMENTS

Investments- Meaning. Differences between Investment, Trading and Speculation. Process of
making and Managing Investments. Investment Goals and Constraints

Unit 2: INVESTMENT ALTERNATIVES

Non-marketable Financial Assets, Money Market Instruments, Fixed Income Securities, Equity
Shares, Mutual Funds, Derivatives, Life Insurance Policies, Real Estate, Precious and Valuable
items.

Unit 3: STOCK SELECTION AND PORTFOLIO CONSTRUCTION

Stock Selection: Fundamental Analysis - Economy Analysis, Industry Analysis. Company
Analysis and Stock Valuation. Technical Analysis. Efficient Market Hypothesis. Portfolio
Construction Theories-
Markowitz Theory, Sharpe's Single Index Model, Capital Asset Pricing Model, Arbitrage
Pricing Theory.

Unit 4: BONDS
Pricing of Bonds, Returns on Bonds, Risks associated with Bonds, Duration and Modified
Duration. Bond Portfolio Construction-Immunization Strategy.

Unit 5: MUTUAL FUNDS

Mutual Funds-Net Asset Value. Mutual Fund Returns-Dividend payment plan, Dividend
Reinvestment Plan, Bonus Plan and Growth Plan. Mutual Fund Evaluation - Sharpe's Measure.
Treynor's Measure. Jensen's Measure
 UNIT 1: BASICS OF INVESTMENTS

Investment is the employment of funds on assets with the aim of earning income
or capital appreciation Investment has two attributes, namely, time and risk
INVESTMENT OBJECTIVES

(a) Short-term high priority objectives: Some investors have high priority
towards achieving certain objectives in short time. For example: high priority to
buy a house.
(b) Long-term high priority objectives: Some investors look forward and invest
on the basis of objectives of long-term needs. They want to achieve financial
independence in long period. For example, investing for post-retirement period
or education of child, etc.
(c) Low priority objectives: These objectives have low priority in investing. These
objectives are not painful. After investing in high priorities assets, investors can
invest in these low priority assets. For example, provision for tour, domestic
appliance, etc.
(d) Money making objectives: Investors put their surplus money in this kind of
investment. Their objective is to maximize wealth. Usually, the investors invest
in shares of companies which provides capital appreciation apart from regular
income from dividend.

ELEMENTS OF INVESTMENT
(a) Return: Investors buy or sell financial instruments in order to earn return on
them. The return on investment is the reward to the investors. The return includes
both current income and capital gains or losses, which arises by the increase or
decrease of the security price.
(b) Risk: Risk is the chance of loss due to variability of returns on an investment.
In case of every investment, there is chance of loss. It may be loss of interest,
dividend or principal amount of investment. However, risk and return are
inseparable. Return is a precise statistical term and it is measurable. But the risk is
not precise statistical term.
(c) Time: Time is an important factor in investment. It offers several different
courses of action. Time period depends on the attitude of the investors who follows
a ‘buy and hold’ policy. As time moves on analysts believe that conditions may
change and investors may revaluate expected return and risk for each investment.

SPECULATION
Speculation involves trading a financial instrument involving high risk, in
expectation of significant returns. The motive is to take maximum advantage from
fluctuations in the market. Description: Speculators are prevalent in the markets
where price movements of securities are highly frequent and volatile.
GAMBLING
A gamble is a very short-term investment in a game or chance. The time horizon
involved in gambling is shorter than speculation and investment. Rational people
gamble for fun, not for income.Gambling employs artificial risk whereas
commercial risk is present in the other two Risk and return are not found , negative
outcomes are expected in gambling

Differences between Gambling, Speculation, Investment

THE INVESTMENT PROCESS

The investment process involves a series of activities leading to the purchase of
securities or other investment alternatives. The investment process can be divided
into five stages: (1) framing of the investment policy. (ii) investment analysis,
(iii) valuation, (iv) portfolio construction, and (v) portfolio evaluation.

(i) Framing of the Investment Policy

For systematic functioning, the government or investor, formulates the
investment policy before proceeding to invest. The essential ingredients of the
policy are investible funds, objectives and knowledge about investment
alternatives and the market.
• Investible funds: The entire investment procedure revolves around the
availability of investible funds. Funds may be generated through savings
or from borrowings. If the funds are borrowed, the investor has to be extra
careful in the selection of investment alternatives. He must make sure that
there higher than the interest he pays
 • Objectives: The objectives are framed on the premises of the required rate
of return, need for regular income, risk perception and the need for
liquidity. The risk taker's objective is to care a high rate of in the form of
capital appreciation, whereas the primary objective of the risk-merse is the
safety of principal
• Knowledge: Knowledge about investment alternatives and markets plays a
key role in policy formulation Investment alternatives range from security
to real estate. The risk and return associated with investment alternatives
differ from each other
(ii) Security Analysis
Securities to be bought are scrutinized through market, industry and company
analyses after the formulation of investment policy.
• Market analysis: The stock market mirrors the general economic
scenario. The growth in gross domestic product and inflation is
reflected in stock prices. Stock prices may fluctuate in the short-run but
in the long-run, they move in trends, i.e., either upwards or downwards.
The investor can fix his entry and exit points through technical analysis.
• Industry analysis: Industries that contribute to the output of major
segments of the economy vary in their growth rates' overall contribution
to economic activity. Some industries grow faster than the GDP and are
expected to continue in their growth.
• Company analysis: The purpose of company analysis is to help the
investors make better decisions. The company's earnings, profitability,
operating efficiency, capital structure and management have to be
screened. These factors have a direct bearing on stock prices and
investors' returns.
(iii) Valuation
Valuation helps the investor determine the return and risk expected from an
investment in common stock. The real worth of the share is compared with the
market price, and investment decisions are then made
Future value the future value of securities can be estimated by using a simple
statistical technique like trend analysis. The analysis of the historical behaviour
of price enables the investor to predict the future
(iv) Construction of a Portfolio
A portfolio is a combination of securities. It is constructed in a manner so as to
meet the investor's goals and objectives. The investor should decide how best to
reach the goals with the securities available. The investor tries to attain maximum
return with minimum risk. Towards this end, he his portfolio and allocates funds
among the securities
• Diversification: The main objective of diversification is the reduction of risk
in the form of loss of capital and income. A diversified portfolio is
comparatively less risky than holding a single portfolio.
• Debt and equity diversification: Debt instruments provide assured returns with
limited capital appreciation. Common stocks provide income and capital gain
but with a flavour of uncertainty. Both debt instruments and equity are
combined to complement each other.
• Industry diversification: Industries' growth and their reaction to government
policies differ from each other. Banking industry shares may provide regular
returns but with limited capital appreciation. Information technology stocks
yield higher returns and capital appreciation. Thus, industry diversification is
needed, and it reduces the risk.
• Company diversification: Securities from different companies are purchased to
reduce the risk. Technical analysts suggest that investors buy securities based
on price movement. Fundamental analysts suggest the selection of financially
sound and investor-friendly companies.
• Selection: Securities have to be selected based on the level of diversification,
industry and company analyses. Funds are allocated for selected securities.
Selection of securities and the allocation of funds seal the construction of
portfolio.
(v) Evaluation
A portfolio has to be managed efficiently. Efficient management calls for
evaluation of the portfolio. This process consists of portfolio appraisal and
revision.
• Appraisal: The return and risk performance of security varies from time
to time. The variability in returns of securities is measured and
compared. Developments in the economy, industry and relevant
companies from which stocks are bought have to be appraised. The
appraisal warns of the loss and steps can be taken to avoid such losses.
• Revision: It depends on the results of the appraisal. Low-yielding
securities with high risk are replaced with high-yielding securities with
low risk factor. The investor periodically revises the components of the
portfolio to keep the return at a level.
 UNIT 2
INVESTMENT ALTERNATIVES
NON-MARKETABLE FINANCIAL ASSETS
The financial instruments which are not transferable or saleable are known as
non-marketable financial assets. The investors can invest in these instruments but
they cannot transfer or sell the instruments. A good portion of the financial assets
of individual is held in the form of non-marketable financial assets like bank
deposits, post office deposits, company deposits, and provident fund deposits. A
distinguishing feature of these assets is that they represent personal transactions
between the investor and the issuer. The important non-marketable financial
assets held by investors are briefly described below.
1. Post office saving schemes
2. Public provident fund
3. Deposit with banks
4. Life insurance policy
Post Office Saving Scheme
The main financial services offered by the Department of Posts are the Post Office
Savings Bank. It is the largest and oldest banking service institution in the
country. The Department of Posts operates the Post Office Savings Scheme
function on behalf of the Ministry of Finance, Government of India. The Post
offices provide a number of savings schemes like the Savings Account Schemes,
Recurring Deposit Schemes, Time Deposit Schemes, Public Provident Fund
Schemes, Monthly Income Schemes, National Savings Certificates, Kisan Vikas
Patras, and Senior Citizens, and Savings Scheme
Public Provident Fund
PPF is a 30-year-old statutory scheme of the Central Government started with the
objective of providing old age income security to the unorganized sector workers
and self-employed persons. Any individual (salaried or non-salaried) can open a
PPF account. He may also subscribe on behalf of a minor, HUF, AOP and BOI.
Even NRIs can open PPF account. Reasonably attractive interest rate. Tax
exemption on investment made in PPF. Withdrawal facility available at certain
intervals which also avoids frequent withdrawals.
Bank Deposits
By opening a bank account and depositing money into that account, one can make
a bank deposit. There are various kinds of bank accounts: current account, savings
account, and fixed deposit account. Commercial and cooperative banks accept
deposits from public in the form of current account which bears no interest,
savings accounts which bear interest varying from 2.5% to 7.00% per annum, and
fixed deposits of varying maturities. There are two types of returns that can be
derived from investments, that is income and capital gains.
Money Market Instruments
The term “money market” refers to the market for short-term requirement and
deployment of funds. Money market instruments are those instruments, which
have a maturity period of less than one year. The most active part of the money
 market is the market for overnight and term money between banks and
institutions (called call money) and the market for repo transactions. All of these
are discounted instruments, i.e., they are issued at a discount to their maturity
value and the difference between the issuing price and the maturity/face value is
the implicit interest. These are also completely unsecured instruments. One of the
important features of money market instruments is their high liquidity and
tradability. A key reason for this is that these instruments are transferred by
endorsement and delivery and there is no stamp duty or any other transfer fee
levied when the instrument changes hands. Another important feature is that there
is no tax deducted at source from the interest component
(i) Call Money Market: Call money means the amount borrowed and lent by
commercial banks for a very short period i.e. for one day to a maximum of two weeks.
It is also called as interbank call money market, because the participants in the call
money market are mostly commercial banks. Call money market is the core of the
Indian money market, which supply short term funds. Call money market plays an
important role in removing the routine fluctuations in the reserve position of the
individual banks and improving the functioning of the banking system in the country.
(ii) Treasury Bill Market: For meeting its short-term financial commitments
government issues these bills. The treasury bills market is a market, which deals in
treasury bills issued by the Central Government for a short period of not more than
365 days. It is a permanent source of funds for the government. Regular treasury bills
are sold to the banks and public, which are freely transferable.
(iii) Commercial Bill Market: Commercial bills are important device for providing
short-term finance to the trade and industry. Commercial bill market deals in
commercial bills issued by the firms engaged in business. These bills are generally
issued for a period of three months. After acceptance, the bill becomes a legal
document. Such bills can be transferred from one person to another by endorsement.
The holder of the bill can discount the bills in a commercial bank for cash.
(iv)Certificate of Deposit Market: Certificate of deposit market deals with the
certificate of deposits issued by commercial banks. A certificate of deposit is a
document of title to a time deposit. The minimum amount of investment should not
be less than Rs. one lakh and in the multiples of 1 lakhs thereafter. The maturity period
of CDs issued by banks should not be less than seven days and not more than one
year. They are freely transferable by endorsement and delivery. Certificate of deposits
provide greater flexibility to an investor in the deployment of their short-term funds.
(v) Commercial Paper Market: Commercial paper refers to unsecured promissory
notes issued by credit worthy companies to borrow funds on a short-term basis.
Commercial papers will be issued in denominations of 5 lakhs or multiples thereof.
They are transferable by endorsement and delivery. Maturity period of commercial
paper lies between 7 days and 365 days.
(vi)Collateral Loan Market: This market deals with loans, which are backed by
collateral securities. Commercial banks provide short-term loan against
government securities, share and debentures of the government etc. Capital
Market: Capital market is a market that specializes in trading long-term and
relatively high-risk securities. A financial asset with a maturity of more than one
year is part of the capital market. It is a market for long-term capital. The capital
market provides long-term debt and equity finance for the government and the
corporate sector. Capital market comprises two segments namely the new issue
market and secondary market. The various constituents of capital market are viz.
equity market, dept market, government securities market, mutual funds etc
Gilt-edged Securities
Gilts are bonds issued by certain national governments. The term is of British
origin, and originally
referred to the debt securities issued by the Bank of England, which had a gilt (or
gilded) edge.
Hence, they are called gilt-edged securities, or gilts for short. The term “Gilt
Account” is also a term used by the Reserve Bank of India to refer to a constituent
account maintained by a custodian bank for maintenance and servicing of
dematerialized Government Securities owned by a retail customer
Bonds or Fixed Securities
A debt investment in which an investor loans money to an entity (corporate or
governmental) that borrows the funds for a defined period of time at a fixed
interest rate. Bonds are used by companies, municipalities, states and US and
foreign governments to finance a variety of projects and activities. Bonds are
commonly referred to as fixed-income securities and are one of the three main
asset classes, along with stocks and cash equivalents.
Mutual Fund
Mutual funds are money-managing institutions set up to professionally invest the
money pooled in from the public. These schemes are managed by Asset
Management Companies (AMCs), which are sponsored by different financial
institutions or companies. Mutual Fund is an ideal investment vehicle where a
number of investors come together to pool their money with common investment
goal. Each Mutual Fund with different type of schemes is managed by respective
Asset Management Company (AMC). An investor can invest his money in one
or more schemes of Mutual Fund according to his choice and becomes the
unitholder of the scheme. The invested money in a particular scheme of a Mutual
Fund is then invested by fund manager in different types of suitable stock and
securities, bonds and money market instruments
Life Insurance
Life insurance is a contract between the policyholder and the insurer, where the
insurer promises to pay a designated beneficiary a sum of money (the “benefits”)
upon the death of the insured person. Depending on the contract, other events such
as terminal illness or critical illness may also trigger payment. In return, the
policyholder agrees to pay a stipulated amount (the “premium”) at regular intervals
or in lump sum.
Investment In Real Estate
The real estate sector in India is of great importance. Further, real estate
companies are coming up with various residential and commercial projects to
fulfil the demand for residential and office properties in Tier-II and Tier-III cities.
Real estate is a legal term. that encompasses land along with improvements to the
land, such as buildings, fences, wells and other site improvements that are fixed
in location—immovable. Real estate law is the body of regulations and legal
codes which pertain to such matters under a particular jurisdiction and include
things such as commercial and residential real property transactions.
Investment In Precious Metals
A precious metal is a rare, naturally occurring metallic chemical element of high
economic value. Chemically, the precious metals are less reactive than most
elements, have high lustre, are softer or more ductile, and have higher melting
points than other metals. Historically, precious metals were important as
currency, but are now regarded mainly as investment and industrial commodities.
The best-known precious metals are the coinage metals gold and silver. While
both have industrial uses, they are better known for their uses in art, jewellery and
coinage. Other precious metals include the platinum group metals: ruthenium,
rhodium, palladium, osmium, iridium, and platinum, of which platinum is the
most widely traded. Radioactive polonium, radium, actinium and protactinium,
are not considered precious due to the health risk they pose.
 UNIT 3
STOCK SELECTION AND PORTFOLIO CONSTRUCTION

• Stock analysis is a very detailed study of the stocks of the company with
respect to two broad parameters namely, fundamental analysis and
technical analysis.
• This detailed study helps in understanding the right time to enter and exit
the markets as well as the correct holding period for the stocks.
• This analysis is not limited to the individual stocks but also the economy
and the industry as a whole to determine if it is on an upward trend or an
adverse one.

Stock analysis

Fundamental Analysis Technical Analysis

FUNDAMENTAL ANALYSIS
Fundamental analysis is primarily concerned with determining the intrinsic
value or the true value of a security. For determining the security’s intrinsic
value, the details of all major factors (GNP, industry sales, firm sales and
expense etc) are collected or an estimates of earnings per share may be
multiplied by a justified or normal prices earnings ratio. After making this
determination, the intrinsic value is compared with the security’s current market
price. fundamental analysis comprises:
1. Economic Analysis
2. Industry Analysis
3. Company Analysis

ECONOMIC ANALYSIS
It is very important to assess the state of the economy of making investment. If a
recession is likely or undergoing the stock market is affected at certain times. On
the other hand the stock market is also affected at certain times. This status of an
economic activity has a major impact on overall stock market. Therefore, it is
very important for the investor to assess the state of the economy and
its impact on the stock market
Factors of Economic Analysis
• Gross Domestic Product
The GDP represents the aggregate monetary value of the goods and services
produced in the economy during a specified period. Although GDP is usually
calculated on an annual basis, quarterly estimates an also available. The common
equation for the calculation of GDP is:
GDP Consumption + Investment + Exports - Imports
The growth rate of GDP points out the prospects for the industrial sector and the
return investors can expect from an investment in shares. A decline in the GDP
indicates a potential economic slowdown. A high GDP growth rate is
advantageous to the stock market
• Savings and Investment
Growth requires investment, which in turn, requires a considerable amount of
domestic savings. Growth in savings naturally leads to more investments. High
capital investment means possibility of more production, more demand and
supply, better prices in the future and consequently, higher business profits and a
positive outlook for the stock market. Savings are distributed over different assets
like equity shares, deposits, mutual fund units, estate, and bullion. The primary
market is a channel through which the savings of investors are made available to
corporate bodies. Over the years, household and private corporate savings have
increased and in turn gross domestic investment has also increased
• Inflation
Inflation refers to a situation where too much money is chasing to few goods.
Inflation indicates a rise in the price of goods and services. Along with the growth
of GDP if the inflation rate also increases, then the real rate of growth would be
very low Inflation and stock markets he a very close relationship. If there is
inflation, the stock market is adversely affected. The price of stock is directly
related to the performance of the company. Inflation typically results in the
following
• High raw material cost
• Non-availability of cheap credit due to rise in interest rates
• Low earnings
These factors have a negative impact on the stock price and market return. If there
is a mild level of inflation, it is good for the stock market but high rates of inflation
are harmful.
• Interest Rates
Interest rates have a direct impact on the economy. The base rate of banks affects
the cost of borrowed funds. The base rate is the minimum rate of interest at which
banks lend to anyone. It is the floor rate below which they will not allow banks
to lend. A decrease in the interest rate implies low cost of finance for firms and
more profitability. An increase in lending rates affects negatively firms which
depend on banks for their working capital and growth requirements
• Budget and Fiscal Deficit
The budget draft provides a detailed account of government revenues and
expenditures. A deficit budget may lead to a high rate of inflation and adversely
affect the cost of production surplus budget may results deflation. A balanced
budget is highly favourable to the stock market. Fiscal deficit is the difference
between the government's total receipts (excluding borrowing) and expenditure.
• Balance of Payments
The balance of payments is the record of a country's money receipts from abroad
and payments to foreign countries. The difference between receipts and payments
may be a surplus or a deficit. Balance of payments is a measure of the strength of
the rupee on the external account. If the deficit increases, the rupee value may
depreciate against other currencies, thereby affecting the cost of imports.
Industries involved in the exports and imports are markedly affected by changes
in the foreign exchange rate. The volatility of the foreign exchange rate affects
the investment of the foreign institutional investors in the Indian stock market. A
favourable balance of payments has a positive effect on the stock market
• Foreign Direct Investment
According to the International Monetary Fund (IMF), the of foreign direct
investment (FDI) includes different elements, namely, equity capital, reinvested
earnings of foreign companies, inter-company debt transactions, short- and long-
term loans, financial leasing, trade credits, investment made by foreign venture
capital investors, and so on. FDIs help in the upgrading of technology, skills, and
managerial capabilities and bring much needed capital into the economy. They
also help in providing employment opportunities. Inflow of capital helps the
economy grow and has a positive impact on the stock market.
• Demographic Factors
Demographic data provide details about the population by age, occupation,
literacy, and geographic location. This is needed to forecast the demand for
consumer goods. The population by age indicates the availability of a skilled
workforce. The cheap labour force in India has encouraged many multinationals
to launch their ventures. Indian labour is cheaper compared to its Western
counterpart. Population, by providing employees and demand for products,
affects industry and the stock market.
• Economic Forecasting
To estimate stock price changes, an analyst must look at the macroeconomic
environment and the factors peculiar to the industry he is concerned with.
Economic activities affect corporate profits, investor attitudes, and share prices.
A fall in the GDP or a slowdown in economic growth may lead to a fall in
corporate

INDUSTRY ANALYSIS
Industry analysis is the study of industries which are on the upswing or growing.
The ideal
investment is the investment in the growing industry. There are certain industries
which are growing
in India. The investor should know the industry classification used in the
economy. It is also necessary to know the characteristics, problems and practices
in different industries. A careful analysis of growth of industries will help to select
few industries for investments. The competitive position of industries is also
affected due to high labour cost, change in social habits, government regulations
and automation

INDUSTRY LIFE CYCLE ANALYSIS

Many industrial economists believe that the development of almost every
industry may be analysed in terms of following stages
1. Pioneering stage: During this stage, the technology and product is relatively
new. The prospective demand for the product is promising in this industry. The
demand for the product attracts many producers to produce the particular product.
This led to severe competition and only fittest companies survive in this stage.
The producers try to develop brand name, differentiate the product and create a
product image. This would lead to non-price competition too. The severe
competition often leads to change of position of the firms in terms of market share
and profit.
2. Rapid growth stage: This stage starts with the appearance of surviving firms
from the pioneering stage. The companies that beat the competition grow strongly
in sales, market share and financial performance. The improved technology of
production leads to low cost and good quality of products. Companies with rapid
growth in this stage, declare dividends during this stage. It is always advisable to
invest in these companies.
3. Maturity and stabilization stage: After enjoying above-average growth, the
industry now enters in maturity and stabilization stage. The symptoms of
technology obsolescence may appear. To keep going, technological innovation in
the production process should be introduced. A close monitoring at industries
events is necessary at this stage.
4. Decline stage: The industry enters the growth stage with satiation of demand,
encroachment of new products, and change in consumer preferences. At this stage
the earnings of the industry are started declining. In this stage the growth of
industry is low even in boom period and decline at a higher rate during recession.
It is always advisable not to invest in the share of low growth industry.
CLASSIFICATION OF INDUSTRY
Industry means a group of productive or profit-making enterprises or
organizations that have a similar technically substitute goods, services or source
of income. Besides Standard Industry Classification (SIC), industries can be
classified on the basis of products and business cycle i.e. classified according to
their reactions to the different phases of the business cycle.
These are classified as follows:
1. Growth Industries: These industries have special features of high rate of
earnings and growth in expansion, independent of the business cycle. The
expansion of the industry mainly depends on the technological change or an
innovative way of doing or selling something. For example-in present scenario
the information technology sector have higher growth rate. There is some growth
in electronics, computers, cellular phones, engineering, petro-chemicals,
telecommunication, energy etc.
2. Cyclical Industries: The growth and profitability of the industry move along
with the business cycle. These are those industries which are most likely to benefit
from a period of economic prosperity and most likely to suffer from a period of
economic recession. These especially include consumer goods and durables
whose purchase can be postponed until persona; financial or general business
conditions improve. For example- Fast Moving Consumer Goods (FMCG)
commands a good market in the boom period and demand for them slackens
during the recession.
3. Defensive Industries: Defensive industries are those, such as the food
processing industry, which hurt least in the period of economic downswing. For
example- the industries selling necessities of consumers withstands recession and
depression. The stock of defensive industries can be held by the investor for
income earning purpose. Consumer nondurable and services, which in large part
are the items necessary for existence, such as food and shelter, are products of
defensive industry.
4. Cyclical-growth Industries: These possess characteristics of both a cyclical
industry and a growth industry. For example, the automobile industry experiences
period of stagnation, decline but they grow tremendously. The change in
technology and introduction of new models help the automobile industry to
resume their growing path.

COMPANY ANALYSIS
The industry analysis helps to select few industries for investment in securities.
There are many
companies in an industry. There are thousands of listed companies from computer
software industry.
Therefore, an investor has to select few companies for investment

The Study Of Financials Statements

Financial statement means a statement or document which explains necessary
financial information. Financial statements express the financial position of a
business at the end of accounting period (Balance Sheet) and result of its
operations performed during the year (Profit and Loss Account). In order to
determine whether the financial or operational perrformance of company is
satisfactory or not, the financial data are analyzed. Different methods are used for
this purpose. The main techniques of financial analysis are:
1. Comparative Financial Statements
2. Trend Analysis
3. Common Size Statement
4. Fund Flow Statement
5. Cash Flow Statement
6. Ratio Analysis
1) Comparative Financial Statements: In comparative financial statement, the
financial statements of two periods are kept by side so that they can be compared.
By preparing comparative statement the nature and quantum of change in
different items can be calculated and it also helps in future estimates. By
comparing with the data of the previous years it can be ascertained what type of
changes in the different items of current year have taken place and future trends
of business can be estimated.
2) Trend Analysis: In order to compare the financial statements of various years
trend percentages are significant. Trend analysis helps in future forecast of
various items on the basis of the data of previous years. Under this method one
year is taken as base year and on its basis the ratios in percentage for other years
are calculated. From the study of these ratios the changes in that item are
examined and trend is estimated. Sometimes sales may be increasing
continuously and the inventories may also be rising. This would indicate the loss
of market share of a particular company’s product. Likewise sales may have an
increasing trend but profit may remain the same. Here the investor has to look
into the cost and management efficiency of the company.
3) Common Size Statement: Common size financial statements are such
statements in which items of the financial statements are converted in percentage
on the basis of common base. In common size Income Statement, net sales may
be considered as 100 percent. Other items are converted as its proportion.
Similarly, for the Balance sheet items total assets or total liabilities may be taken
as 100 percent and proportion of other items to this total can be calculated in
percentage.
4) Fund Flow Statement: Income Statement or Profit or Loss Account helps in
ascertainment of profit or loss for a fixed period. Balance Sheet shows the
financial position of business on particular date at the close of year. Income
statement does not fully explain funds from operations of business because
various non-fund items are shown in Profit or Loss Account. Balance Sheet shows
only static financial position of business and financial changes occurred during a
year can’t be known from the financial statement of a particular date. Thus, Fund
Flow Statement is prepared to find out financial changes between two dates. It is
a technique of analyzing financial statements. With the help of this statement, the
amount of change in the funds of a business between two dates and reasons
thereof can be ascertained. The investor could see clearly the amount of funds
generated or lost in operations. These reveal the real picture of the financial
position of the company.
5) Cash Flow Statement: The investor is interested in knowing the cash inflow
and outflow of the enterprise. The cash flow statement expresses the reasons of
change in cash balances of company between two dates. It provides a summary
of stocks of cash and uses of cash in the organization. It shows the cash inflows
and outflows. Inflows (sources) of cash result from cash profit earned by the
organization, issue of shares and debentures for cash, borrowings, sale of assets
or investments, etc. The outflows (uses) of cash results from purchase of assets,
investment redemption of debentures or preferences shares, repayment of loans,
payment of tax, dividend, interest etc. With the help of cash flow statement the
investor can review the cash movement over an operating cycle. The factors
responsible for the reduction of cash balances in spite of increase in profits or
vice versa can be found out.
6) Ratio Analysis: Ratio is a relationship between two figures expressed
mathematically. It is quantitative relationship between two items for the purpose
of comparison. Ratio analysis is a technique of analyzing financial statements. It
helps in estimating financial soundness or weakness. Ratios present the
relationships between items presented in profit and loss account and balance
sheet. It summaries the data for easy understanding, comparison and
interpretation.

Meaning of Technical Analysis

Technical analysis involves a study of market-generated data like prices and
volumes to determine the future direction of price movement. It is a process of
identifying trend reversal at an earlier stage to formulate the buying and selling
strategy. With the help of several indicators, the relationship between price –
volume and supply-demand is analyzed for overall market and individual stocks.
The basic premises, on which technical analysis is formulated, are as follows:
1. The market value of the scrip is determined by the interaction of demand and
supply.
2. Supply and demand is governed by numerous factors, both rational and
irrational. These factors include economic variables relied by the fundamental
analysis as well as opinions, moods and guesses.
3. The market discounts everything. The price of the security quoted represents
the hope, fears and inside information received by the market players. Insider
information regarding the issuance of bonus shares and right issues may support
the prices. The loss of earnings and information regarding the forthcoming labor
problem may result in fall in price. These factors may cause a shift in demand and
supply, changing the direction of trends.
4. The market always moves in the trends except for minor deviations.
5. It is known fact that history repeats itself. It is true to stock market also. In the
rising market, investors’ psychology has upbeats and they purchase the shares in
great volumes driving the prices higher. At the same time in the down trend, they
may be very eager to get out of the market by selling them and thus plunging the
share price further. The market technicians assume that past prices predict the
future.
Tools of Technical Analysis
Generally used technical tools to analyze the market data are as follows:
Dow theory
Originally proposed in the late nineteenth century by Charles H Dow, the editor
of Wall Street Journal, the Dow theory is perhaps the oldest and best-known
theory of technical analysis. Dow developed this theory on the basis of certain
hypothesis, which are as follows:
a. No single individual or buyer or buyer can influence the major trends in the
market. However, an individual investor can affect the daily price movement by
buying or selling huge quantum of particular scrip.
b. The market discounts everything. Even natural calamities such as earth quake,
plague and fire also get quickly discounted in the market. The world trade center
blast affected the share market for a short while and then the market returned back
to normalcy.
c. The theory is not infallible and it is not a tool to beat the market but provides a
way to understand the market. Explanation of the Theory Dow described stock
prices as moving in trends analogous to the movement of water.
He postulated three types of price movements over time:
(1) major trends that are like tide in ocean,
(2) intermediate trends that resemble waves,
(3) short run movements that are like ripples.
Followers of the Dow theory hope to detect the direction of the major price trend
(tide) known as primary trend, recognizing the intermediate movements (waves)
or secondary trends that may occasionally move in the opposite direction. They
recognize that a primary trend does not go straight up, but rather includes small
price declines as some investors decide to take profits. It means share prices don’t
rise or fall in a straight t manner. Every rise or fall in price experiences a counter
move. If a share price is increasing, the counter move will be a fall in price and
vice-versa. The share prices move in a zigzag manner. The trend lines are straight
lines drawn connecting either the top or bottoms of the share price movement. To
draw a trend line, the analyst should have at least two tops or bottoms.
Primary Trend
The price trend may be either increasing or decreasing. When the market exhibits
the increasing trend, it is called bull market. The bull market shows three clear-
cut peaks. Each peak is higher than the previous peak and this price rise is
accompanied by heavy trading volume. Here, each profit taking reversal that is
followed by an increased new peak has a trough above the prior trough, with
relatively light trading volume during the reversals, indicating that there is limited
interest in profit taking at these levels. And the phases leading to the three peaks
are revival, improvement in corporate profit and speculation. The revival period
encourages more and more investors to buy scrips, their expectations about the
future being high. In the second phase, increased profits of corporate would result
in further price rise. In the third phase, prices advance due to inflation and
speculation.
Secondary Trend
The secondary trend moves against the main trends and leads to the correction.
In the bull market, the secondary trend would result in the fall of about 33-66
percent of the earlier rise. In the bear market, the secondary trend carries the price
upward and corrects the main trend. Compared to the time taken for the primary
trend, secondary trend is swift and quicker.
Minor Trends
Minor trends are just like the ripples in the market. They are simply the daily
price fluctuations. Minor trend tries to correct the secondary price movement. It
is better for the investor to concentrate on the primary or secondary trends than
on the minor trends
The efficient market hypothesis (EMH)
Efficient market theory states that the price fluctuations are random and do not
follow any regular pattern. Fama suggested that efficient market hypothesis can
be divided into three categories.
They are: (1) the weak form,
(2) The semi strong form,
(3) The strong form.
The level of information being considered in the market is the basis for this
segregation.
Weak form of EMH
The weak form hypothesis says that the current prices of stocks already fully
reflect all the information that is contained in the historical sequence of prices.
Therefore, there is no benefit in examining the historical sequence of prices
forecasting the future. This weak form of the efficient market hypothesis is
popularly known as the random-walk theory. Clearly, if this weak form of the
efficient market hypothesis is true, it is a direct repudiation of technical analysis.
If there is no value in studying past prices and past price changes, there is no value
in technical analysis. As we saw in the preceding chapter, however, technicians
place considerable reliance on the charts of historical prices that they maintain
even though the efficient-market hypothesis refutes this practice.
Empirical tests of the weak form
Over the years an impressive literature has been developed describing empirical
tests of random walk (Paul H. Cootner, 1967). This research has been aimed at
testing whether successive or lagged price changes are independent. In this
section we will review briefly some of the major categories of statistical
techniques that have been employed in this research, and we will summarize their
major conclusions. These techniques generally fall into two categories: those that
test for trends in stock prices and thus infer whether profitable trading systems
could be developed and those that test such mechanical systems directly.
Although certain of these studies were conducted many years ago, they are the
basis upon which research on the efficient-market theory has been based, and are
included here to provide the necessary conceptual basis for the theory and its
evolution.
Semi strong form of EMH
The semi strong form of the efficient-market hypothesis says that current prices
of stocks not only reflect all informational content of historical prices but also
reflect all publicly available knowledge about the corporations being studied.
Further-more, the semi strong form says that efforts by analysts and investors to
acquire and analyze public information will not yield consistently superior returns
to the analyst.
Examples of the type of public information that will not be of value on a
consistent basis to the analyst are corporate reports, corporate announcements,
information relating to corporate dividend policy, forthcoming stock splits, and
so forth. In effect, the semi strong form of the efficient market hypothesis
maintains that as soon as information becomes publicly available, it is absorbed
and reflected in stock prices. Even if this adjustment is not the correct one
immediately, it will in a very short time be properly analyzed by the market. Thus,
the analyst would have great difficulty trying to profit using fundamental analysis
Strong form of EMH
we have seen that the weak\ form of the efficient-market hypothesis maintains
that past prices and past price changes cannot be used to forecast future price
changes and future prices. Semi strong form of the efficient-market hypothesis
says that publicly available information cannot be used to earn consistently
superior investment returns. Some studies that tend to support the semi strong
theory of the efficient-market hypothesis were cited. Finally, the strong form of
the efficient-market hypothesis maintains that not only is publicly available
information useless to the investor or analyst but all information is useless.
Specifically, no information that is available, be it public or ‘inside’, can be used
to earn consistently superior investment returns. The semi strong form of the
efficient-market hypothesis could only be tested indirectly- namely, by testing
what happened to prices on days surrounding announcements of various types,
such as earnings announcements, dividend announcements, and stock-split
announcements. To test the strong form of efficient-market hypothesis, even
more indirect methods must be used. For the strong form, as has already been
mentioned, says that no information is useful. This implies that not even security
analysts and portfolio managers who have access to information more quickly
than the general investing public are able to use this information to earn superior
returns. Therefore, many of the tests of the strong form of the efficient market
hypothesis deal with tests of mutual-fund performance.
The efficient-market hypothesis and mutual-fund performance
It has often been said that large investors such as mutual funds perform better in
the market than the small investor does because they have access to better
information. Therefore, it would be interesting to observe if mutual funds earned
above-average returns, where these are defined as returns in excess of those that
can be earned by a simple buy-and-hold strategy. The results of such an
investigation would have interesting implications for the efficient market
hypothesis.
Researchers have found that mutual funds do not seem to be able to earn greater
net returns (after sales expenses) than those that can be earned by investing
randomly in a large group of securities and holding them. Furthermore, these
studies indicate, mutual funds are not even able to earn gross returns (before sales
expenses) superior to those of the native buy-and-hold strategy. These results
occur not only because of the difficulty in applying fundamental analysis in a
consistently superior manner to a large number of securities in an efficient market
but also because of portfolio over diversification and its attendant problems- two
of which are high book-keeping and administrative costs to monitor the
investments, and purchases of securities with less favorable risk-return
characteristics. Therefore, it would seem that the mutual-fund studies lend some
credence to the efficient-market hypothesis a particular date at the close of year.
Income statement does not fully explain funds from operations of business
because various non-fund items are shown in Profit or Loss Account. Balance
Sheet shows only static financial position of business and financial changes
occurred during a year can’t be known from the financial statement of a particular
date. Thus, Fund Flow Statement is prepared to find out financial changes
between two dates. It is a technique of analyzing financial statements. With the
help of this statement, the amount of change in the funds of a business between
two dates and reasons thereof can be ascertained. The investor could see clearly
the amount of funds generated or lost in operations. These reveal the real picture
of the financial position of the company.