459

466
466
474
475
476 CHAPTER 1
476
478
478
479 INTRODUCTION TO INVESTMENT
AND SECURITIES

481
481
492 he government, corporate entities, financial institutions and individuals alike, invest their money
493
S06 T fruitfully. 'nvest or perish' is the adage of the day. What, therefore, is investment?
508
508 CHAPTER OBJECTIVES
T o understand the meaning of investment
To describe the nature of securities market
To explain the process of investment
To get an idea of investment planning and various types of securities
511
511
Investing in various types of assets is an interesting activity that attracts people from all walks of life,
513
irrespective of their occupation, economic status, education and family background. A person who has more
520
money than he needs for immediate consumption can be said to be a potential investor. The investor who
520
has extra cash can invest it in securities or in other assets like gold or real estate, or he could simply deposit
520
it in his bank account. Companies that have extra income may invest their money to expand existing firms
521 or undertake new ventures. All these activities, in a broader sense, mean inestment.
521
INVESTMENT
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. In the process of investment, the present consumption
523 is sacrificed to get a return in the future. The sacrifice that has to be borne is certain but the return in the
523 future may be uncertain. This attribute of investment indicates the risk factor. The risk is undertaken with
530 a view to reaping returns from investment. For the layperson, investment means a monetary commitment.
532 A person's commitment to buy a flat or a house for his personal use may be an investment from his point
532 of view. This, however, cannot be considered as actual investment because it involves sacrifice but does not
535 yield any financial retum.
536 To the economist, investment is the net addition made to the nation's capital stock that consists of goods
and services that are used in the production process. A net addition to the capital stock means an increase
537 in buildings, equipment or inventories. These capital stocks are used to produce other goods and services.
551 Financial investment is the allocation of money to assets that are expected to yield some gains over a
period of time. It is an exchange of financial claims such as stocks and bonds for money. They are expected
to yield returns and experience capital growth over the years.
 Management
Portfolio
2 Security
Analysis
and
the savings of the
indivi Introduction to Investment and Securities 3
Because, low
cach other. Even thouoh
gh
economic meanings are
related to
be used in
economic
investment.
they are risks are present in investment activity. Risk and return
Financial and investments to investment
made on securities. trade-off is not found in gambling and negative
financial outcomes are expected. On the other hand,
the capital
market as
only with
the financial
during investment, the analysis of risk and return is carried out,
into concerned
as a result of which positive returns are
related to each
other, we are
risk
expected by investors. Finally, financial analysis does not reduce the
short-term gain, Snen proportion involved in gambling.
SPECULATION risk in the hope
of achieving
a profit fro on
the business
expectation
of making Price INVESTMENT OBJECTIVES
about talking up with the
Speculation is selling
actividies
a stock for
its dividend The main objectives of investment are:
person buys be
and
involves buying
essentially with an example. If a rise in the
near future and the
Maximizing the return
fluctuadons. This
can be explained
with the anticipation of
a price between speculation and inpe of Minimizing the risk
investor. If he buys
line
termed as an The dividing
termed a speculator.
he would be dividends and capital
appreciation.
selling it at a gain, stocks for diferent. The
investor is interested Other subsidiary objectives are:
thin because people buy investment is
isvery involved in speculation and concemed with direct benefits
nro Maintaining liquidity
The time factor He is primarily retum. În simple terme Hedging against inflation
rate of returm for a longer period. an abnormal
consistently good is interested in getting The speculator's invecte Increasing safety
the long-un. The speculator normal returm in the short-un. tments
by securities in retun than the
Saving tax
investor wants a higher rate of
short-ierm. The investor constantl.
are made for a and its price movement. Maximizing the Return
more interested
in market action movement. He is not worried
The speculator is the speculator
evaluates the price d Investors always expect a good rate of return from their investments. The
evaluates the worth
of security, whereas the total income the investor receives during the
rate of return could be defined as
the investor holding period, stated as a percentage of the purchasing
factors like his counterpart, woula iike to assume greater rict
price at the beginning of the holding period.
about fundamental and renurn. The speculator
to match the risk financial transaction. The negative short
Tbe investor would try of incurring loss in a
refers to the possibility involved in the investmen
than the investor. Risk investors. The risk factor nent End period value Beginning period value
more than the + Dividend
term fluctuations
affect the speculators
the factors related
with the concerned company's Return= 100
investor buys the stock after studying Beginning period value
is also limited. The invest in securitdes where his prizicipal would be
The investor likes to
stock. This limits the risk exposure.
The rate of return is stated semi-annually or
safe. annually to help compare the different investment
alternatives. If it is a stock, the investor gets the dividend as well as the among
Table 1.1 Diference between
investor and speculator
Market return of the stock indicates the capital appreciation as returns.
price appreciation for the particular stock. If a particular share
Speculator is bought in 2011 at 50 and sold in 2012 at
vestor T60, and the dividend yield is 75, then the return would be
Plans for a very short period. Holding period varies calculated as shown below:
Plans for a longer time horizo.
Time horzon
one year to few years. from few days to months.
His holding period may be from Capital appreciation and dividend
Assumes moderale risk Wiling to undertakehigh risk. Return=
Hisk X 100
Like to have high returns for assuming high risk. Purchase price
Retum Likes to have moderate rate of return associated with
imited risk
Considers fundamental factors and evaluates the Considers inside information, heresays and market
Decision
behaviour. Return= x 100 =30%
periormance ofthecompanyregulay Uses borrowed funds to supplement his personal
50
Funds Uses his own funds and avoids borowed funds.
resources.
Minimizing the Risk
The risk of holding securities is related to the probability of the actual returm becoming less than the
expected
return. The word 'risk' is synonymous with the
GAMBLING AND INVESTMENT phrase 'variability of return'. Investment risk is just as
important as measuring its expected rate of return because minimizing risk and maximizing the rate of returm
A gamble is usually a ery short-term investment in a game or chance. Gambling is different from are interrelated
speculation and investment. Firs1, the time horizon involved in gambling is shorter than in speculation and
objectives in investment management. An investment whose rate of return varies widely from
one period to another is considered riskier than one whose returm does
not change much. Every investor likes
nvestnent. The results are determined by the roll of a dice or the nurm of a card. Secondly, people gamble to reduce the risk of his investment by proper combination of different securities. Investors, however, differ in
to entertain themselves.
Earning an income from gambling is a secondary factor. Thirdly, the risk their attitude towards risk.
in gambling is different from that of investment. Gambling employs artificial risks, whereas
conu
 Securities 5
Introduction to Investment and
Management
Portolio
and
4Security
Analysis
d e t e r m i n e s

une case,
time and
child

cost
children's
ti
nvolved in
e
Investment Process
option
as it a house, auion
Maintaining Liquidity investment
like
purchasing
necessitate
redemn
important
aspect ofany
While
certain
expenses
medical
expenses
an
is an intocash.
such as
Ligudhty
it liquidity stment could be converted
could he Portfolio
the
investment
emergencies
provides investment
Investment
Portfolio
ofthe liquid on. Valuation
Converting planned, investment
be
reasonably of Ifa porion Stocks are Analysis Construction Evaluation
ec,
can
1be
marketability
facilities. a p p r e c i a t i o t h e y
Policy
and trading
emergencies.
premanurely.
meet
n v e s t m e n t
marketing investor to and capital Ocks
depends upon the dividends
illiquid
Liquidity oftime, it helps through group are
without
much loss
adequate
returns
stocks in
the
z Market
into cash market by providing
more liquid,
whereas
Investible fund Intrinsic value . Diversification Appraisal
good
command a Junior are
Objectives Industry Future value Selection and Revision
Nifty and Nifty
in the Sensex, rise in prices
and 6n.
n Knowledge Company allocation
against a the
Hedging against Inlation to protect inflation, otheru
against
inflation
than the
rate of rwise, he
values overti
cover
a be higher
should ensure
should in their Figure 1.1 Stages of the investment process
The rate ofreturaof money. The rate of return
would appreciate
and
Growth stocks sarety of
the principal amo.
purchasing
value
loss in real
terms.
should
assure tne nount,
will experience thus earned be extra careful in the selection of investment alternatives. He must make sure that the returns are higher
investor
inflation. The return
against inflation. than the interest he pays. Mutual funds invest their stockholders' money in securities.
provide protection be a hedge against
of income and
regular flow
Risk atffects not only the Objectives The objectives are framed on the premises of the required rate of return, need for regular
retum
Increasing Safety affected by different types of risks.
investment avenue should
he income, risk perception and the need for liquidity. The risk taker's objective is to earn a high rate of return
is differently selected
Each investmeat option inestment itself.
The
it will be difficult to renree in the form of capital appreciation, whereas the primary objective of the risk-averse is the safety of principal.
but also renun ofthe not under the legal
framework,
the safet
investment
on
framework. If it is Though approved of by law,
the legal and regulatory
grievances, if any. Approval
of the law itself
adds a flavour of safety.
Investments made
with the government asu Knowledge Knowledgeabout investment alternatives and markets plays a key role in policy fornmulation.
the principal differs
from one mode of
investment to another.
of view,
investments can be ranked as followe. Investment alternatives range from security to real estate. The risk and return associated with investment
alternatives differ from each other. Investment in equity is high-yielding but faces
From the safety point convertible debentures, eauit
more risk than fixed
more than with a private party.
safety debentures,
non-convertible quity income securities. Tax sheltered schemes offer tax benefits to the investors.
deposits, government bonds, UTI units,
bank
financial companies. The investor should be aware of the stock market structure and functions of the brokers. The modes
shares and deposits with non-banking of operations are different in the Bombay Stock Exchange (BSE), National Stock
Exchange (NSE), and
Over-the-Counter Exchange of India (OTCE). Brokerage charges are also different.
Saving Tax attract different tax rates. The tax rate Knowledge about stock
Tax is unavoidable. Different income
levels and investment options exchanges enables an investor to trade the stock intelligently.
investment for a specific option.
Certain investments offer tax incentives. The
may vary with the period of
investor tries to minimize the tax outlow and
maximize tax returns. Security Analysis
Securities to be bought are scrutinized through market,
of investment policy.
industry and company analyses after the formulation
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: () framing of the investment policy, Market analysis The stock market mirrors the
general economic scenario. The
product and inflation is reflected in stock prices.. Recession in the economy resultsgrowth
in gross domestic
ci) investnent analysis, (i) valuation, iv) portfolio construction, and (y) portfolio evaluation. Figure 1.1 in a bear market. Stock
explains the stages of the investment process. 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.
Framing of the Investment Policy
For
systematic functioning, the government or investor, formulates the investment policy before proceeding Industry analysis Industries that contribute to the output of major segments of the
to invest. The essential ingredients of the policy are investible funds, objectives and knowledge about growth rates' overall contribution to economic economy vary in their
activity. Some industries
investment alternatives and the market. expected to continue in their growth. For example, the information grow faster than the GDP and are
a higher grOwth rate than the GDP in 1998. The economic technology industry has experienced
avestible funds The entire investment industry have to be analysed. significance and the growth potential ot the
Funds may be generated procedure revolves around the availability of investible
through or savings from borrowings. If unu
the funds are borrowed, the investor nas Company analysis The purpose of
The
company analysis is to help the investors make better decisions.
company's earnings, profitability, operating efficiency,
capital structure and management have to be
 Introduction to investment and Securities 7
Management

and
Portolo The apprecins

6 Secunty
Analyss
and investors
reurns. m a r O n of
stock prices high product
bearing on A company
witn a
share Appraisal The return and risk performance ofsecurity varies from time to time. The variability in returns
a direct
factors bave of the
company.
of securities is measured and compared. Developments in the economy, industry and relevant companies
screened.
These performance appreciation.
of the
is a
function
form of capital from which stocks are bought have to be appraised. The appraisal warns of the loss and steps can be taken
stock value in the
wealth far investors to avoid such losses.
create
IS able to in comme
from an
investment
monsstock
expected Revision It depends on the results of the appraisal. Low-yielding securities with high risk are replaced
Vabation
and risk
the return
value of
the share and
d o.
price earning
securities
with low risk factor. The investor periodically revises the components of the
determine

Valoation helps
the investor

share is
measured through the book
shares.
Stock market
analysts have
nriped
with high-yielding
to keep the return at level.
The intrinsic value of the be adopted
to value
the
15 compared
with the market
and portfolio a
models also can worth of the share
Sumple
discounting
value shares.
The real INVESTMENT PLANNING
to
advanced models
many
decisions are then made. Investment planning has the 'raté of return' ingredient at its core, thus making the approach a litle narrow.
statistical technigue
ivestment
by using simple
a e like funds on one or more assets over a period. The investment
of securities
can be estimated
investor
enables the
to predict the future Investment planning
means commitment of
planning process involves several steps such as the following:
Futare vaine
Tbe funure value behaviour of price
the historical
of Setting investment goals
trend analysis. The analysis
Understanding the risk appetite
valuc. Designing an investment portfolio
Portfolio so as to meet
the investor's oon .Evaluating the markets and investment avenues
of a constructed in a
manner
Construction
of securities. It is Tha
with the securities available. he
A portolio is a combination
how best to reach the goals Investment planning helps to:
investor sbould decide ne aiversifies his portfolio
ena,
The lowards this
and objectives. minimum risk. Identify the financial goals ofthe investor
maximum retum with
investor uries to atain Derive the maximum benefit from investments
the securiies.
and allecates funds among Choose he right investment options
and income, A Decide upon the
optimal investment strategy
Diversification
in the form of loss of capital
diversification is the reduction of risk are available
Maintain a balance between risk and returns
The main objective of portolio. Several modes
less risky than bolding single
a
diversified portfolio is comparatively optimal combination of risk and return to suit the requirements of an investor
o diversify a portíolio. It is possible to arrive at an

through prudent planning.

assured returns with limited capital appreciation.
Debt instrumenis provide
Debt and equity diversification Both debt instruments Aspects of Investment Planning
but with a flavour of uncertainty.
Common stocks provide income and capital gain Investment planning mainly involves the following aspects:
and equity are combined to complemeat each other Identification of financial needs and goals
differ from each Choice ofinvestment options
and their reaction to government policies
Industry diversification Industries' growth Information Investment approaches
regular returns but with limited capital appreciation.
other. Banking industry shares may provide
appreciation, but their growth potential in the post-global
technology stocks yield higher reurns and capital ldentification of financial needs and goals
crisis years was unpredictable. Thus, industry diversification is needed, and
it reduces the risk.
Sound investment planning requires notclear
a
understanding of financial needs and goals. A good investment
Company diversification Securities from different companies are purchased to reduce the risk. Technical for a long-term retirement plan may be a suitable investment for higher education expenses of children.
analysts suggest that investors buy securities based on price movement. Fundamental analysts suggest the Financial need or goal determines the tenure of the investment or investment horizon. All investment needs
and goals are classified into short-tem (less than 1 year), medium-term (more than 1 year) and long-term
selection of financially sound and investor-friendly companies. more than 5 years). The example in Table 1.2 gives the financial goals of an ordinary investor.

Selection Securities have to be selected based on the level of diversification, industry and company Table 1.2 Typical financial goals of an ordinary investor
analyses. Funds are allocated for selected securities. Selection of securities and the allocation of funds sea
the construction of portfolio. Expected Cost
Financial Goals at today'spricesin ) Timeframe Investment Horizon
Evaluation Personal laptop O.6 lakh 3 months Shor-term
A portfolio has to be managed efficiently. Eficient management calls for evaluation of the Daughter's school admission 0.25 lakh 6 months Short-tem
process consists of portfolio appraisal and revision. portfolio. 1m Son's education 2.5 lakh 1-2 years Medium-term
Contd...
 stroducton t rvegment arnet Seetutpe

.The Reserve Rank of Inha iseues government dated securities, treasury bills and bonls
Munal furd companies issue munua! Aund units. Many mutuai Aund companies ure subsudiaries of
Long serm financial instinutiont and hanks

Long-erm
12-15 18 Bayer The buyer segmcent consistx of domestic institutional investors, corporate entities, banks. petso
LongHem funds, mutual funds. retail imvestors and oreign instirutional investors whe are registered with the Securities
and Euwhange Berard of Indha (SEB)
goals. For
imestment
aptions
optaon
depends upm
financial

he cannot
erample
cdchoe Market intermediaries A wide range of market intermediaries participate in the primary and secondary
Choioe of investmer
three months,
chnr a the rngtu lapucp n markets Merchant hankers, clearing and settling houses, credit rating agencies, epositories, debenture
exem. h purchase
fa
to invest for his daa
daughter'
a iange kor fnd1ng the Similarty, il
he wants
trusices, hanks and brokers act as market intermediaries at various levels
inestor
warts t eS
inck- penod. 0-ycar bond may,
A 0-year bond
Oe
whck ha has a threr vear honds kr
the nexi 0 ycas.
veste one-yeat
after E vearn te cann
invest n
investtrmen
a
balanxe d throe things Regulators The smooth functioning of any market lies in the hands of egulators. The securities market also
Tus. he ryhi for the following
ihe ca,
haA: is g requires regulation reasons:
.It inolves a huge inflow and outflow of funds
Lgurdry
.The naure and the quantum of issue of securities differ widely among companies. This necessitates the
Ris prescription of issue norms.
Raur
Proper functioning of the secondary market is essential
Iwestment proeche straicgy.
The ability to manage risks denend, Investors' interests have to be protected.
unvestmiet
age, ctc. Higher the rissk
determines hs
riså
aniry uo oNerate ivestment,
The anvestr's knowiedgr about
and respxnsibilsty,
largety on the ieve af nco
adopt the following
Many peapie
approaches: The securitics market is mainly regulated by the Ministry of Finance, the Reserve Bank of tntha and SEB
cd carng a tar and has limited risk,
retura.
the pesthiiny bonds, etc.,
hgter s
on secured dehentures,
cmsrvave aporad
concentrates
bonds and selects a fundamentally strona
strong SECURITIES
n mutual funds,
A
A moderakc p a c t kocuses
o snvestung Various types of securities are traded in the market. Securities broadhy represent evidence to property
nGAnics uiry. Starcs,
ctr returms. They like speculative rights. A security prowides a claim on an asset and any fuure cash flows the asset may generate. We
(above-verage)
Ivestors takr major risks am
vestaents to have high commonly think of securities as shares and bonds. According to the Securities Contracts Regulation Act
aovemems
stares an foliaw t r
markct 1956, securities include shares, scrips, stocks, bonds, debentures and oher marketable products hke
cuity
securities of incorporaled companies, other body corporates or the governnment. Securities are classified on
SECURITIES MARKET market is where the basis of return and he source of issue. On the basis of income, they may be classified as fixed or variadle
market. The
money
Th securtcs marke is broadiy catcgorued nio he money and capital income securities. In the case of fixed income security, the income is fixed at the üme of the issue itself.
of markets for the following
coe-year matur1ty are traded. Ii is a collection Bonds, debentures and preference shares fall into this category. Sources of issue may be government,
shon cr securnaes af ies t n
moncy, reasury bills,lerm
commercial bills, certificate of semi-
nstruments-all moty, ncnace money, repos, etc.
governmenm and corporate. The incomes of variable securities change from one year to another. Dividends
cerufcates, inter-corporate deposits, swaps,
depwsis, commerciui paprs, snict-tburk particpatioo bonds and debentures are traded.
of companies' equity shares can be cited as an example of this. Corporates generally raise funds through
Thc captal mariet is wtere kong ueTm securities such as cquity shares,
fixed and variable income securities like equity shares, preference shares and debennures
market. In the primary market,
The cagptal markt is futher divided o primary market and secondary
securities are traded in the secondary market.
sccurities are issued for the first tume, nd issued
Lqulty Shares
Equity shares are commonly refered to as common stock or ordinary shares. Even though the terms
Perticipents of the Secuties Martet shares' and 'stocks' are interchangeably used, there is a difference between them. The share capital of a
The paricipanis f the securitues market are iised below company is divided into a number of small units of equal value called shares. The term 'sock' mcans the
The issuer ggregate of a member's fully paid-up shares of equal value merged into one fund. lt is a set of shares pur
The buyer together in a bundle. The 'stock' is expressed in terms of money and not as many shares. Stock can be
Market internediaries divided into fractions of any amount and such fractions may be transferred like shares.
The fegulators Share certificate means a certificate under the common seal of the comupany spevitying the Dumber of
Issuer The shares held by any member. A share certificate provides the prima facie evidence of tile of the members
following issuers are in the securites
market to such shares. This helps the shareholder to deal easily in the market. It enables him to sell bis shares by
Corporate etities issue cquity shares and debentures, while financial institutions and publie sEc
enterprises issue equity shures as well as bonds. showing marketable title.
 Management introduction to Investment and Securities 11
Portfolio
and
Analys1s
10 Secunty

in two
forms. form. whichever is earlier, such shares should be offered first to existing shareholders in proportion to the capital
cerificate is available issued in
the physical
The share certificates are electronic
form. paid up on the shares held by them at the date of such offer. This pre-emptive right can be forfeited by
share the
form issuedin shareholders through a special resolution. The shareholder can renounce right shares in favour of his
-

Paysical cerificates are

Companiee
share
(2) of the
form Section 85
1956 nominee. He may renounce allis or part of the shares offeredInto him. Right shares may be partly paid. The
-

Demat

according to

Equity
shareholders
have the following
meetingsof the
rights
company. minimum subscription limit prescribed for right
issues. the event of the company failing to receive
90 per cent subscription, the company has to return the entire money received. SEBI has, at present,
at the general body
Right to
vote
of the company. removed this limit. Right issues are regulated under the provisions of the Companies Act and SEBI.
. control the
management
dividends and
bonus
shares.
of the com
2. Right to the fom of case ot winding up ompany.
in all claims in
in profits of
3. Right to share residual after
repayment Bonus Shares
the new capital.
4. Right to claim
on
of issue of set aside.
A bonus share is the distribution of shares in addition to cash dividends to existing shareholders. Bonus
in the matter in the rights
Right of pre-emption with audited
S.
to court in case of any
discrepancy
copies of annual
accounts along

cal
shares are issued to
existing shareholders without any payment of cash. The aim of a bonus share is to
6. Right to apply
receive a copy of the statutory report,
annual meeing
wnen a company fails to
capitalize the free
reserves. The bonus issue is made out of free reserves built from genuine profit or share
7. Right to to call an premium collected in cash only. The bonus issue can be made only when all partly paid shares are fully
govermment
the central
to
8. Right to apply general meeting. paid-up.
extraordinary
meeting Law Board for calling an The declaration of the bonusissuehas a favourable impact on the psychology of shareholders. They take
the Company
9. Right to apply debt only to the
it as an indication of high future profits. Bonus shares are declared by directors only when they expect a
shareholders are liable to pay
the company's xtent of
erte

rise in the profitability of the concern. The issue of bonus shares enables shareholders to sell shares and get
the equity advantages.
The main advantages are:
In a limited company, shares have certain capital gains while retaining their original shares.
their share in the paid up
capital. Equity
Capital appreciation Preference Stock
Limited liability The characters of the preferred stock are hybrid in nature. Some of its features resemble the bond and others
Free tradability the equity shares. Like the bonds, their claims on the company's income are limited, and they receive a fixed
Tax advantages (in
certain cases)
dividend. n the event of liquidation of the company, their claims on the assets of the firm are also fixed. At
Hedge against inflation
the same time, like the equity, it is a perpetual liability of the corporate. The decision to pay a dividend on
the preferred stock is at the discretion of the Board of Directors. In the case of bonds, payment of interest
Sweat Equity (Amendment) Ordinance, 1998, The rate is mandatory.
instrument introduced in the Companies
Sweat equity is a new equity sweat equity. However, it should The dividend received by the preferred stock is treated on par with the dividend received from the
79A of the Companies Act, 1956 allows the issue of
newly inserted Section cannot form a new class of equity
issued by the company. It equity share for tax purposes. These shareholders do not enjoy any of the voting powers, except when any
be issued out of a class equity
of shares already
all limitations, restrictions and provisions
applicable to equity shares resolution affects their rights.
shares. Section 79A (2) explains that
forms a part of the equity share capital.
equity
are applicable t weat equity. Thus,
sweat
Cumulative preference shares Here, the cumulative total of all unpaid preferred dividends must be paid
before dividends are paid on the common equity. Unpaid dividends are known as arrearages-these do not
Non-voting Shares
additional dividends instead of voting rights. Even eam interest. The non-payment of dividend only continues to grow. The
Non-voting shares carry no voting rights. They carry arrearages accrue only for a limited
the Finance Ministry number of years and not indefinitely. Generally three years of arrears accrue and the accumulative feature
the idea widely discussed in 1987, it was only in the year 1994 that
though was
in
announced certain broad guidelines for the issue of non-voting
shares.
in bonus issues. Non-voting
ceases after three years. But the dividends arrearscontinue if no such provision is given in the Articles
of Association. In case of liquidation, no arrears of dividends are payable unless a provision is made in the
Shareholders in possession of non-voting shares have the right to participate
for two Articles of Association.
shares can also be listed and traded in stock exchanges. If non-voting shares are not paid dividends
this to a maximum of 25 per
years, shares would automatically get voting rights. The company can issue
cent of the voting stock. The dividend on non-voting shares would have to be 20 per cent higher than the Non-cumulative shares As the name suggests, thethedividend does not accumulate. If the company earns
dividend on woting shares. All rights and bonus shares for non-voting shares have to be issued in the form no
profit inadequate
or
profit in a particular year, company does not pay dividend. If the preference
a

of non-voting shares only. and equity shares are fully paid while winding up a company, non-cumulative shareholders have no further
ights to have claims in the surplus. If a provision is made in the Articles of Association for such claims
Right Shares they have the right to claim.

Shares offered existing shareholders at a price by the company are called right shares. They are offered
to

to shareholders
as a
mater of legal If a public company ants to increase its subscribed capital by
right. Convertible preference shares The convertibility feature makes the preference share more atractive
a
investment security. The conversion feature is almost identical to that of the bonds. These preference shares
way of 1uing shares after two years from its date of formation or oné
year from the date of first allotment,
 Portfollo
Management introduction to Investment and Securities 13
and shares
12 Security
Analysis quasi-equity This gives
specified period
and are with the security and
convertible as equity
shares at the end of
potential
the
increase in
equity
value, along
stability .Indenture An indenture is a trust deed between the company issuing debentures and the debenture trustee
who represents the debenture holders. The trustee takes the
are
a d d i t i o n a l privilege
of sharing the responsibility of protecting the interest of
the debenture holders and that the company fulfils contractual
ensures
the
of income.
to IKSue redecmable prefe banks, insurance companies or firm
obligations. Financial institutions,
Articles of
AssOCiation
therence attorneys act as trustees to the investors. In the indenture, the terms
shares If a provision
in the shares can onlyin
be done only in the
following of agreement, description of debentures, rights of the debenture holders, those of the
preference
of the
redemption issuing company
Redeemable
be issued.
However, and responsibilities of the company are clearly specified.
is available, it can

shares
conditions: fully paid-up.which otherwise be available for dictei bution of Types of debentures
shares are made would
The partly paid-up created from profits,
for the purpose.
are classified on the basis of
Debentures security and convertibility:
T h e fund for
redemption is issue of shares or out of the c o s
of a fresh out of the profits Secured or unsecured debenture
dividends or out
of the proceeds it should be paid
has to be paid on redemption, Fully convertible debenture
l f a premium redeemed sharee. Partly convertible debenture
nominal value of the should
share premium account.
to the
a sum equal
W h e n redemption
is made out of profits, account.
Non-convertible debenture
reserve
the capital redemption
be transferred to on Occasions like windino Secured orunsecured debenture A secured debenture is secured by a lien on the
shares are not
redeemable except
introduction of Section 80A assets. In thecase of default, the trustee can take hold of
company's specific
shares These 1988. The the the specific asset on behalf of the debenture
Irredeemable preference till 15 June
these shares were permitted
holders. Secured debentures in the Indian market include a charge on and future immovable assets
the business. In India,
present
of the company.
an end to them.
Companies Act, 1956 put When the debentures are not protected by a security,
were introduced by
the govemment in 1984 they are known as unsecured or naked debentures.
(CCPS) These from three vear Debentures in the American capital market mean unsecured bonds, while bonds could be secured or
Cumulative convertible
preference shares the gestation period
cent during unsecured. Unsecured debentures find it difficult to attract investors because of the risk involved in them.
return of 10 per
share gives a regular
According to guidelines, CCPS Can
This preference as per the agreement. Debentures are generally rated by credit rating agencies.
five years and is then
converted into equity
new projects, (b)
expansion or diversification of
following purposes: (a) setting up of requiremente
modernization, and (d) working capital
issued for any of the
normal capital expenditure
for Fully convertible debenture This type of debenture is converted into equity shares of the
existing projects, (c) because the rate of interest was very low and the gain thar the expiry of a specific period. The conversion is carried out company on
interest of investors according to the guidelines issued by SEBI.
CCPS failed to attract the profitable functioning of the equity The FCD carries a lower rale of
conversion into equity also depended upon interest than other types of debentures because of the attractive
could be received from the convertibility into equity shares.
feature of

Debentur bonds and any other securities

"Debenture includes debenture stock, Partly convertible debenture This debenture consists of two parts, namely convertible and non-convertible.
According to the Companies Act 1956, assets of the company or no.
Debentures are generally The convertible
of the company, whether constituting a charge on the portion can be comverted inio shares after a specific period. Here, the investor has the
note for raising loan capital. The company advantage of convertible and non-convertible debentures blended into one debenture. For
issued by the private sector companies as a long-temm promissory example, Procter and
A bond is an alternative form of debenture in India Gamble had issued fully converible debenture (FCD) of {200 each to its
promises to pay interest and principal as stipulated. bonds. 1he characteristic features of debentures are can get a share for 65 with the face value of R10 after 18
existing shareholders. The investor
issue
Public sector companies and financial institutions months from alloument (as in August 1997).
as follows:
certificate of indebtedness by the company, specifying the date of redemption and Non-convertible debenture Non-convertible debentures do not confer any
Form It is given as a option on the holder to convert
the debentures into equity shares and are redeemed at the
rate of interest. expiry of the specified period.
Interest Rate of interest is fixed at the time of the issue itself, which is known as the contractual or
of the debenture and may be paid BOND
coupon rate of interest. Interest is paid as a percentage of the par value
A bond is a long-term debt instrument that
annually, semi-annually or quarterly. The company is legally bound to pay the interest rate. promises to pay a fixed annual sum as interest for a specified
Redemption As stated earlier, the redemption date would be specified in the issue itself. The matnunty period of uime. The basic features of the bonds are given below:
period may range from 5 to 0 years in India. They may be redeemed in instalments. Redemptions Bonds bave face a value. This is known as par value. The bonds
may be issued at par, or at a discount.
done through the creation ofa sinking fund by the company. A trustee in charge of the fund buys t The interest rate is fixed. It may sometimes vary as in the case
of a floating rate bond. The interest is
debennures either from the market or from owners. Creation of the sinking fund eliminates the risk of paid semi-annually or annually and is known as the coupon rate. The interest rate is specified
in the
facing financial difficulty at the time of redemption because redemption requires a huge sum. Buy-tack certificate.
provisions help the company to redeem debentures at a special price before the maturity date. The maturity date of the bond is usually specified at the time of issue, except in the
special price is usually higher than the par value of the i bonds.
case
of perpenual
debenture
 15
and Portfolio Management Introduction to Investment and Securities
14 Security Analysis
value or at a premium.
be at par
bonds. It may
Theredemption value is
also stated in the
are traded, the market may be at
value may
par, a a
Capital indexed bonds In the capital indexed bond, the principal amount of the bond is adjusied tor
When they be the same. inflation for every year. For example, an investment of 1000 in inflation indexed bods earns the investor
Bonds are traded in
the stock market. value need not
discounted. The market
value and redemption a semi-annual interest income for a five-years' period. The re-selling of the principal amount is done
premum or
semi-annually based on the wholesale price index (WPI) movements. The principal amount of the bond is
bond is secured by
tne
real assets ofthe issuer, In case adjusted for inflation for each of the years. A coupon rate of 6 per cent is worked on the inflation-adjusted
unsecured bonds The secured
Secured bonds and the oniy security.
issuer may be
bond, the name and fame of an principal.
of the unsecured The bond is advantageous because it gives the investor more returns by taking inflation into account.
manure or never
mature are called pemeh
that do not the bond The investor enjoys the benefit of a return on his principal, which is equal to the average inflation between
redeemable bonds Bonds is redeemedafter a specific period
Perpetual bonds and bonds,
interest alone would be paid. In redeemable the issue (purchase) and maturity period of the instrument. The investor has to keep the instrument for the
bonds. The entire five-year period, to avail the benefit of inflated principal amount.
of time. The redemption value specified
is by the issuer.
If the investor wants to exit early, he can do it through the secondary market. The value of the principal
rale bonds, the interest rate i
In fixed interest
Fixed interest rate bonds and oating
interest rate bonds rates change accordino repayment is adjusted by the Index Rate (IR), which is announced by the RBI two weeks prior to the
interest rate bonds, the
inlerest repayment of the principal. The IR is worked out as follows:
whereas in the floating Inddia ISSUed floating interest rat
fixed at the time of the issue, Bank of
or example, in December
1993 the State IR Reference WPI as in Aug 2002/Base WPI
to already fixed norms. fixCd depoSit rates to provide
and five years Financial instirutions, insurance companies firm attorneys act
bonds worth 500 crore, pegging the interest rate with its three banks, or as trustees to the
In the indenture, the terms of agreement, description of debentures, rights of debenture holders and of
investors
built-in yield flexibility to the investors
the issuing company, and responsibilities of the company are specified clearly. Rates change according to
fäce value is repaid at maturity.
The origin already fixed norms.
sell at a discount and the
Zero coupon bonds These bonds Market The high value of the
US govemment
of this type of bond can be
traced to the US Security
from investing their money in govemment
security. Big brokerage companies Warrants
security prevented investors in large quantities and sold them A warant is a bearer document of title to buy a specified number of equity shares at a specified price
Pierce and others purchased government securities
like Merrill Lynch, berween the purchase cost and face value
in smaller denominations-at a
discounted rate. The difference
the bond, the
Warrants can usually be exercised
over a number of years. The life periods of warrants are long. Warrants
for the investor. Since the investor does not receive any interest on are offered to makethe bond or preferred stock offering more attractive. Bonds may have a low interest rate
of the bond is the gain
loss of interest to the investor. The discounted value is along them belp
conversion price is suitably arranged
to protect the
but the warrants offered with enjoy the equity appreciation value. Warants are
the investor
detachable-the investor can sell them separately to be traded in the market.
calculated using the formula:
the
The person who holds warant cannot enjoy the benefits of the equity holder before the conversion
of the warrant. The price at which the warrants are converted is called exercise price. The exercise
Face value of the bond price
Present value = is always greater than the current market price of the respective equity at the time of issue of the warant.
(1 +Ry" When warrants are issued along with host securities and are detachable, they are known as detachable
warrants. In some cases, the warrants can be sold back to the company before the
R interest rate and n = number of years.
expiry date. These are
known as puttable warrants. Naked warrants are issued separately and not with host securities. The investor
has the option to convert them into bonds or equities.
For example, a zero coupon bond with a face value of kS0,000 that manures in 20 years' time would be

sold at 5, 185 to give a return of 12 per cent per annum. Advantages of warrants
The merit of this bond is that the company does not have the burden of servicing the debt during the Warants make non-convertible debentures and other debentures more attractive and acceptable.
ion neriod of the project. The repayment could be adusted to all after the
Debentures, along with warrants, are able to create their own market and reduce the company's
This could result in considerable cost savings for the company. completion of the project.
dependence on financial institutions and mutual funds.
A s the exercise of warrants takes
Deen discount bondsA deep
discoum bong anoDer om
s
of zeno place at a future date, cash flow and the capital structure of the
coupon bond. The bonds are sold at a company can be planned accordingly.
large discount on their nominal value and interestis not paid on them. Also,
difference between the maturity value and the issue priceesserves as an
they manure at par value. The The cost of debt is reduced if warrants are attached to it. Investors are
willing to accept a lower interest
may range from interest return. The rate in anticipation of enjoying capital
honds' maturity three years to 25 years or more. IDBI first deep discount appreciation
of value at a later date.
equity
bonds in India inp 1992 with varying mahurity period optione
uith varying mahunty penod options. Later, issued deep discount Warrants provide a high degree
ICICI in 1997 of leverage to the investor.
He can sell the warrant in the market, convert
bonds with four optional marurity periods. Early redemption issued deep discount it into stocks or allow it to lapse. But if the conversion is compulsory, investors have to shell out money
and 18h year.
option is
provided at the end of the 6, from their
12 pockets even if the price of the share falls.

Warants are liquid

before exercising them.
and they are traded in stock exchanges. Hence, the investor can sell the warrants
 Portfolio Management
16 Securty Analysis and
share certificates
Introduction to Investment and Securities 17
warants and
between share
Table 1.3 Difference Indian magazines like Business World and Fortune
Share Certificates India also review international events.
financial institutions like the IME, the World Bank and the Asian International
ShareWarrants Issued by pubicand prvale
companies their own survey reports. Development Bank periodically publish
Issued by a public imited company
No need to be contained in the Articles of Association
Association
Need or the provision in the Ardicles of is not needed National affairs The growth of the national economy and
Central govemmentapproval political eventswithin the nation influence
Should be approved by the central govermmernt
paid-up shares investment decisions. Pblitical events are covered by the
shares Share certificatesareissuedtofuly and partly Fortune India, The Week, etc. Economic events and their newspapers, magazines like India Today, Outlook,
Share warants are issued to fully paid-up in the Financial Express, the Economic Times and Businessimplications
on securities markets are
Transfer of share
certiticates Would be complete only it
Line. The RBI Bulletin and annual
analysed
give
macro-economic indicators like GDP, GNP, inflation, reports
Transler of share warants requires no registrabion a wide range of information regarding
egistered
instruments and industrial production, capital markets, development in the agricultural
Share certficates are notconSidered negonable The Centre for Monitoring Indian Economy (CMIE)
banking sectors and balance of payment.
Share warants are negotiable instruments publishes reports about macro-economic factors.
The Economic Survey of India and reports of
companies also provide information regardingthe economy,
industry and other sector.
STOCK DERIVATIVES value or one or more underlvino
derived from the Industry information Information about the industry is needed to identify industries that
instrument whose value is of derivative instruments are perform better
A stock derivative is an etc. Common examples than the national economy as a whole. Financial newspapers regularly
stocks indices, bring out industrial studies for the
securities. It can be bonds, stocks,
benefit of investors. Experts' opinions about industries are available in Business India, Business Today and
furures and options. an index. Index
futures are traded in the
underlying asset is Dalal Street. The CME also publishes data on industries.
future contracts where the
Index futures are

Sensex and Nifty. to buy or sell an asset)

contract certain rights (rights Company information A source of company information must be developed to facilitate company analysis.
confer on the buyer of the
Options are contracts that date. The buyer of the option has the right but not The BSE, NSE and OTCEI provide details about listed companies on websites. Almost all financial journals
on or before a pre-specified
for predetermined price
a carry out company analysis and even suggest enter, exit and stay hints for the particular company stock.
obligation to exercise the option.
the Forbes India Magazine, the Eeonomic Tümes, Financial Express, Business Sandard and India Today provide
The popular stock options are: stocks
an overview of the of individual companies, changes in company policy and management, and reviews of
and options on individual
Equity index options embedded in bonds, caps and companies policy and performance. The annual reports of the companies and the unaudited quarterly and
-

futures options, options

Interest rates bond options, interest rate half-yearly results also provide an insight into the performance of the company. Software companies also
floors, etc. sell details regarding the financial performance of companies in compact discs.

INVESTMENT INFORMATION
Apart from these sources, several websites give detailed information on company-related factors such as
should have knowledge about investment
alternatives mergers, acquisitions, changes in the board of directors, issue of bonus and right shares. Some investment
have seen that the investor companies' websites give a detailed analysis of the performance of the company.
In the investment process, we and the company. For all these, he needs
able to analyse the economy, industry
and the markets. He must be information required.
of information varies with the type of
adequate flow of information. The source Stock market information All financial dailies and investment-related magazines publish stock market
news. Separate news bulletins are issued by the BSE, NSE and OTCEI, providing information regarding the
affect the national economy as
international events
International affairs With increasing globalization, changes that take place in the stock market. The SEBI newsletter provides infomation on changing rules
linked economicaly and politically with each other. The economic crisis of
countries the world over are
Mexico affects and regulations in the stock market. The Reserve Bank of India Bulletin also carries information about stock
one nation has a contagion
effect on the other. The depreciation of the value of the peso in markets. SEBI, BSE, NSE and RBI have their official websites:
which began in July 1997, had affected Asia, the United States
trade in Asia. The South-East Asian crisis, www.sebi.gov.in
slowdown in developing countries in many parts of the world. The
and Europe. It led to the economic www.bseindia.com
markets also reacted to the crisis and the Sensex fell for a brief period. The policies of the
Indian capital www.nseindia.com
and the orld Bank also affect the wlume of loan for development
International Monetary Fund (IMH www.rbi.org.in
economic events, political evenis and wars also affect the stock market. The US
purposes. Apart from
air raids on Iraq in 2003, 2006 and
2009
arteced ne indian economy and the capital market. All daily Stock exchanges' websites give details regarding trading in particular
stocks and the company-related
newspapers carry the
international news. Baron s Nanonal Business and Financial Weekly, Wall Street The SEBI website gives information about
details. Historical data also can be accessed on these websites. of the stock
ouR(a Us daily), International Business Week ortiune nemational,
the Financial Times of London
ond the Economist (a weekly from OK) provide inancial intormation, news of market developments and the rules and regulation regarding the stock market. Its
annual report gives an overall picture
available on their respective
NSE and RBI are
executives and the investors. market. Bulletins and other publications of SEBI, BSE,
to business
relevant statistics
websites.
 CHAPTER 2

INVESTMENT PLANNING AND

ALTERNATIVES

CHAPTER QUERY
Sukumar, 35, works in the infrastructure industry. His take-home pay is
T60,000, and he expects his salary to grow by 7-11 per cent annually. In addition to his salar
he eams 20,000 per month by offering consultancy services. He has two
dependents-a
wife and a son aged9. His cunrent monthly expenditure is R20,000, which includes car maintenance.
Besides that, he pays a housing loan equated monthly instalment (EM) of T22,000 and a car loan EMI
of 3,700, which is likely to be repaid in the next two years. After
meeting all monthly commitments
he has a surplus of T30,000.
He availed a home loan in December 2011, and the current outstanding is T30 lakh. He owns a flat
worth 65 lakh (less home loan) and 700 grams of gold. Of this, 500
grams are in the form of jewellery
and the rest in coins., He owns ancestral property of 2.5 acres of coffee plantations, the current market
value of which is 75 lakh. The plantation is expected to give a net lease income of 25,000 from 2015
for the next 40 years at current market prices. He also owns a house in a semi-urban area of 20 cents
(0.2 acres), the current market value of which is R50 lakh.
He invested1 lakh in the shares of mid- and small-cap companies in 2004, and their current market
value is only 60,000. He has fixed deposits worth 6 lakh.
He as a monthly premium of 2.000 in SBI Life Insurance Unit Linked Insurance Pblicy
(ULIP), T1,500 a month in Birla Sun Life ULIP, T32,000 annually in HDFC insurance and 5,000
annualpremium for an LIC endowment policy. His current provident fund balance is i1.25 lakh after
withdrawing for the purchase of the flat.
For his retirement, he contributes 3,000 per month towards the
employees' provident fund (EPF),
nd his employer contributes an equal amount. For his son's education at today's value he fels that he
may require 8 lakh and for his marriage, 2 lakh. For the next 10 years, he would like to spend around
2 lakh once every three years on travel abroad, provided he has enough surpluses after providing for
savings.
If his life expectancy is 80 years, should he change his investments? Are his investments sufficient?

CHAPTER OBJECTIVES
To understand financial planning and
To identify various financial assets
investment planning
To be aware of the investment avenues in non-financial assets
 Alternatives 23
and
Investment Planning
Portfoio Management
Analys:s and
22 Secunty
PLANNING timeframe
INVESTMENT
used nterchangeably, the re is Deciding the investment be clear about his investment
timeframe. In investment
are often
AND has decided to invest, he has to investor shouid
planning Once the investor investment one makes. The
PLANNING
'investment
role in deciding the kind of
FINANCIAL
and
planning, timeframe plays hiskey
"financial planning' the into three
the terms planning and m a n a e mment time period is divided
Although between them through proper of investment. Typically, the investment
of financial goals and any entity whio decide the time period
a difference the artainment frusts term, and the long termn.
the short term, the medium
Financial planning
is defined as
individuals but
also covers corporatons, a c t i o n s taken to achieve a categories, i.e.,
restnicted to just refers to a
series
of year, If the
investor is
of finances. i
is not Financial planning it enables the planner. r to
Funds invested for a time period of a few days to one
other planning, are
with m a t i e r s of
finances.
finances. Like any the short- and lono.
Short-term investment that has given good quarterly
for a short period, he should choose company
a
is concerned of his of the
wise management commiments. i
belps him to unaersand takes into account the
interested in investing money will lead to capital appreciation
person's life goals by quarterly results because this
Fimancial planning
results or is expected to give good
financial
his
to
and meaning of his life. book a profit.
The investor may sell the stock and
direction areas
give on other
impact of his
financial decisions
family. It helos particular stock.
term
as well as those of
the
with the
nvestor 's
limited resources.
Ips from one year to f+ve
needs of the individual, the benefits medium-term investment, the time period ranges
Medium-term investment In
maximize a
essential to
The dividend paying capacity
of
Investment planning is should be selected for investment.
years. Dividend paying companies investor confidence and the
to performance.
its Good corporate performance boosts
Provide financial securiy the company indicates
concerned.
Generate wealth in the long-term company stock price
of risk and returns
more than five years. Generally
combination
Amve at an optimal investment, funds are invested for
life's financial goals Long-term investment n a long-term with good track records
Acquire assets to achieve It involves returns over a long period. Companies
one's investment goals. financial and real assets give maximum
to accomplish
investment. Blue chip companies' stocks are
often a better choice than other company
planning refers to
a course
of actions taken is based on the individual-need-driven approach. must be selected for frame. If he has to plan for his
and goals decide the investment time
Investment II
return.
balance risk with the desired stocks. The investor's financial needs
the taking of steps to invest regularly.
retirement, he has to start early and
Features of Investment Planning
of investmeat planning
are as follows Risk profiling
The disinctive feaures investor may be either conservative.
The investors' attitudes and ability to
undertake risks vary greatly. An
Setting of investment goals
timeframe
or aggressive in undertaking
risk.
Deciding he investment moderate
Risk profiling risk and are risk averse by natture. They typically
invest in
Evaluating the markets
and the investment landscape Conservative investors They take only minimal
Designing an investment portíolio less risky. Their portfolios have less of an equity component
securities and fixed-income securities that are
and more of debt securities.
Setting of investment goals investment
does not indicate successful invesument; it is reaching the investment mainly consists of mutual funds, bonds.
Earning the highest possible returm Moderate investors They take moderate risk. Their
an individual. Investment goals guide the choice of investment.
successful invesument for etc. They try to balance their risk and return
more
goal that means
stages of life and the coTesponding investment goals.
shows the different
fundamentally strong companies equity shares,
Figure 2.1
judiciously than the other two types of investors.
retuns.
Family of two
Famly wih Preretirement Aggressive investors They take a high risk on investments in order to obtain high (above-average)
Single Retirement period shares and have less of a debt
chidren peniod They follow market movements. Their portfolios consist of speculative equity
component.
The ability to take risks largely depends on the following:
.Financial ASSet Investment
secunty ccumulaton and wealth
Investment in |Wealth Personal factors like age, education, and marital status
Initiabon of House, car, rebrementplans utlization
Requirement for income and knowledge about risk
investment
generation Provision for Provision for
insuranoe
Provision for
Provision for old age personal needs Past experiences with investing etc.
children's
family educaton and
and medical
Evaluating the markets
care forces of bull and be:ir
marmage The markets have to be constantly evaluated, as it always experiences alternating has
and exit strategies. The investor
Figure 2.1 Stages of life and phases. Trend reversals have to be carefully watched to formulate entry
investment goals
 Management
and Portfolio
24 Security Analysis
Investment Planning and Alternatives 25
financial securities. On he
the basis of
trends before
investing in
international market
to analyse national and the
course of stock market.
evaluation he can then predict the future The retirement corpus should include the possibility of increase in future expenses. With
this
the likely increase in future income the standard of living is likely to advance, which may
portfolio asset has a different
current living cost of 20,000 per month will be
combinas.

Designing an
investment
financial assets because
each financial and real
and resultin additional household The
expenses.
Portfoliois a mix of real and
of assets and
financial assets
determines

and tax benefits in the ca

the overall return per when
88,000 month MrSukumarturns 60. For this, it is ideal to create a corpus of 1.74 crore
for retirement, He has to save monthly 13,500 for the next 22 years to accumulate the corpus.
An appropriate mix return, liquidity, case of
of risks and rewards. should balance risk,
investment portfolio investment options.
exposure. The right the different
the features of ReshufTe his investments If his tax savings obligations are met, it is better to select top performing
a s s e s s m e n t . Table 2.
l shows
an income tax

risk of investment options mutual funds and invest through the Systematic Investment Plan (SIP) mode. Yet, the mutual fund
portfolio has to be restricted to four or five schemes. Some of the ULIPs can be discontinued.
Table 2.1 Profile of
Llquidilty Taxbenefits
Return on the Provided for infrastructure
Securities Risk Low to high volatilty Liquidity depends
equity
INVESTMENT AVENUES
Equity High perormance of the company
exchange traded
tunds Specifnc funds are given
Debt Stock
Low to high risk. Debt Low to high olatility. tax concessions
Mutual funds
fundHess volatile. Equity are more liquid than other Investmert Avenues
fundHow isk.
fund-more volaBile funds
Equty fundhigh risk Cannot withdraw for a
certain Not available
Sate Moderate
Government eriod Tax saving bonds are Insurance Real assels
securities
Medium
Low liquidity Securities Deposits Postal schemes
Bonds Low. Public sector bonds available

debentures
are less risky than
debentures
Short-term return Highty liquid
Not available Stocks Bank deposits Monthily Income Life insurance Real estate
Money market Less nsky Bonds/Debentures Non-banking Scheme (MIS) policies Precious metals
Not available G-securities financial com National ULIP Art and antiques
Securities Medium to high. Depends Liquid
Derivatives
Hedge against risk
Money market pany (NBFC) Savings
onthe undertying secumy Available instruments deposits Scheme (NSC)
Medium to low returns Low liquidity
Insurance
Hedge against risk
(Dependson the scheme) Derivatives .Vikas Patras
Available
Mutual funds Public Provident
Medium returns Low liquidity Fund (PPF)
Postal saving Safe (Depends on the scheme)
Available for house
Moderate risk High returns Low iquidity Figure 2.2 The different investment avenues
Real estate COnstruction

Securities
The main types of securities are discussed below.
Solution to Chapter Query
his investment shows two major lacunae. Lack of
If we take Mr Sukumar's case, an analysis of
and improper evaluation of equity class investment. In 2008 the Equity shares
investment in Mediclaim policies, an
In the early nineties, the stock market was the best and safest place
market did extremely wel, but he missed to book profit. If Mr Sukumar is not comfortable taking Equity shares attract the interest of many. the
The characteristic features of the equity share have been detailed in
from such investment. It is best to route his equity investments for the ordinary individual to invest.
risks, it is good for him to stay away common classifications are:
the following: previous chapter. The most
through mutual funds. He should look doing
at

than the home market capitalization. The market

Settle his house loan Since the post-tax return on the fixed deposits will be lower Large-cap, mid-cap, and smal-cap stocks Stocks are categorized by
of outstanding
loan interest, it is advisable to close the fixed deposits to prepay the home loan. Before repaying,
he
is calculated by multiplying the current price of the stock with the number
capitalization market capitalization, the small-cap ones
have
must set aside six months' expenses as an emergency fund. The large-cap stocks are shares of high
shares in the market. are also
fall in between these two. Stock market indices
a low market capitalization and
the mid-cap ones
Create more funds for education and retirement The present value of 8.4 lakh, if inflated at
7 per cent for the next 13 years, would mean that the corpus required to complete higher education built on the basis of market capitalization.
would be around 20 lakh. To reach the larget, he has to save monthly 5,400, and it should earn a
return of 12 per cent.
 Alternatives 27
Investment Planning and
and Portfolio Management
26 Security Analysis

consistent record track

exceedine
anga
are
doing
consist of blue c the trading of the company
The shares of companies
which have a
shares. Senser and Nity
The chances of a company not performing well always exist. In such a case,
Blue chip shares known as blue chip are market Jlead
stocks concerned becomes thin, resulting in low liquidity of the stocks.
other companies are on the indlCes. 1hey
well compared with an impact of lhdia (SBI), ICI the company goes bankrupt dissolved. The assets are sold and the money obtained
and gets
m o v e m e n t s of these
companies have State
5ank Sometimes
the assets is distributed among the stakeholders, debenture holders and preference
Reliance,
companies.
The price examples are
dervices Lud (TCS), Winr from liquidating
market. Some
and have the potential
to influence the Tata Consultancy ipro, shareholders in the order of priority. Only the remaining amount is given to the equity shareholders.
Corporation Lid (ONGC), Infosys,
and Natural Gas
HDFC, Ol and Jindal Steel. Fixed Income Securities
HLL, ITC, Tata Steel growth rate:are
in profitability
than
the industry
9 per cent in 2011 Fixed-income securities are categorized
as follows:
rate of growth over
Growth shares
Stocks that have a higher a negative reurn or
the Nifty had gien 2011. Another FMCC shares is given in Chapter 1. Preference shares are
as growth
shares. For example,
index with a
32 per gain
cent in Preference shares A detailed description of preference or investors prefer to subscribe
referred to the Nifty third biggest
gainer, with gains of over
er as inferior to equity capital. High-tax paying companies
Hindustan Unilever (HUL) outperformed was the no longer regarded instruments. The conversion
16 per cent. Ambuja Cement
preference shares and
investors with a low tax burden prefer to go in for debt
fim, IIC. gained nearly
to is the tax-exempt status
in preference shares also make it attractive. The biggest advantage
9.5 per cent in this year. options provided
and pay regular dividends. share's dividend.
have stable
operations of the preterence
companies that
to 400% dividend in the same
These stocks belong and HCL Info gave to investors who willing to sacrifice liquidity
Income shares 2012 option available are
of 2050% in March VST Industries, RCOM, ITC Debentures Corporate
debentures are an
dividend GE Shipping, of the capital market, the
the debentures are not actively traded in the debt segment
a
ONGC, Tata Group,
JB Chemicals gave
Industries, HDFC, for higher return. If were actively traded in the secondary
period. Infosys, Page instruments till maturity. If the instruments
dividend policies. investors have to hold the the yield ona
Wipro also have strong hands at a considerable premium, thereby lowering
and
market movements.
For example, a host of market, it would have perhaps changed rates on debentures.
unaffected by pharmaceutical industry current interest rate. These reasons contribute towards high coupon
shares Defensive stocks are
relatively
market slowdown. The par with the
Defensive of
even in the period The value
posted returns the downturn in
the economy.
to debentures. However, they are
issued by public sector undertakings.
pharmaceutical stocks by
affected
of its demand, is
not Bonds Bonds are similar The rate is the nominal
the inherent nature
market depends upon the interest rate and the maturity. coupon
of the bond in the
to of the
Owing downward movements
contractual as per the terms and
conditions of the
The upward and the bonds. The coupon rate is
cyclical shares.
cycie affects Such shares provide interest rate offered on
during the tenure of the instrument.
shares The
business and their stock prices. contractual, it cannot be changed
Cyclical of certain companies the automotive sector issuance of the debt security. Being rates are lowered, actually,
the
business cycle affect
the business prospects variable. For example, of the bank rates. When the bank
Investors are not affected by lowering
a
be highly IDBI and ICICI have
current yield.
The capital gain may interest rates above the bank rate, would appreciate.
low to moderate
business cycles.
value of the bonds, which carry these are deep discount bond,
education benefit
affected by the needs of investors. Some of
stocks are
referred to as speculative
issued various bonds to suit
index bond.
that have a lot of speculative
trading in them are of the traders. bond, retirement benefit bond, and
Shares attention
Speculative shares of share attracts the
of the market, this type central government, state governments
and quasi-
shares. During
the bull and bear phases switch over to another category
in another period. The securities issued by the
in one period may Government securities As a government
under one category shares. securities or gilt-edged securities.
Stocks which fall example, growth shares may be speculative are known as government
which guarantees the
should not be considered rigid.
For government agencies is a secure financial instrument,
The classification claim on the government, it
guaranteed security is a securities is relatively lower because of their high liquidity
of interest on these
income and capital. The rate
Investment in Equity Shares
shares offers the following advantages: and safety.
Investing in equity to other financial assets, if the company performs less than a year
the equity sharc are higher compared short-term maturity, say
T h e retuns of market securities have a
market securities Money of deposit.
well and earns profit5 Money bills, commercial paper and certificate
track record. instruments are treasury the
is high if the shares are of a company with a good Common money market short-term borrowing by
T h e scope for capital appreciation the transferability has bill is fundamentally an instrument of
trading and demat accounts, Treasury bills A treasury investors with financial
.It be transferred With the onset
easily. of online i) and
bill market provide
of India. To develop the treasury
can of
become much easier. Government cash management requirements
of the stock short-term maturities and to help the in April
raded in the stock exchanges and can be bought and sold easily. But liquidity instruments of varying maturities were introduced
They are
treasury bills of varying second half
the performance of the companry various segments of the economy, June 1997. In the
depends basis was introduced on 6
on
to
1997.A 14-daytreasury bill on a weekly basis. Further, it
was decided
introduced on an auction Since
of such investments are given below: bill of 28 days was bills are of 9l days.
The disadvantages of 1997-98, a treasury Generally, treasury
host of other factors like bills through auctions.
.Stock prices are more wolatile. Not only the company's performance but a reintroduce the 182-day treasury
bills are low,
individuals very rarely
invest in them.
economic melidown and political events also affect the prices of equity in the secondary market. on treasury
the interest rates offered
 28 Security Analysis and Portfolio Management Investment Planning and Alternatives 29

world. This offers the biggest

negotiable instrument with a fixed network in
the distribution channel in the The post office handles
ii) Commercial papers Commercial paper (CP) is a short-term avings bank accounts, recurring deposit accounts, and time deposits. Apart country.
from his, it provides investment
the company either directly or through
maturity period. It is an unsecured promissory note issued by was originally three (minimum) opportunities in
the following:
banks/merchant banks. The maturity period of a commercial paper
the maximum period National Savings Certificate (NSC)
to Six (maximum) months from the date of issue.
In October 1993, was
(KVP)
maturities between a minimum of 7 days .Kisan Vikas Patra
extended to one year. At present, CP can be issued for Monthly Income Scheme
the date of issue. The commercial papers
(April 2005) and a maximum of up to one year from the interest
.Senior Citizen Scheme
their face value. The discounted value implies Fund (PPF) Account
are sold at a discount and redeemed at Public Provident
are mostly favored by companies and
.

rate. The denomination of commercial paper is high. They

institutional investors. ional Savings Certificate National Savings Certificate (NSC) is issued by the Department of Post,
ernment of India, in denominations of <l00, R500, Ri,000, 75,000, and 10,000 for a maturity period
funds deposited in a
is a marketable receipt of six years. It is obtainabie at all post OTfice counters in the country. A T10,000 denomination certificate
ii) Certificate of deposit The certificate of deposit (CD) is a bearer document and readily negotiable.
bank for a fixed period at a specified rate of
interest. It
is mainly preferred by willincrease to R16,010 on completion of six years. It is long-term safe investment option for the investor.
a

interest rate on them are high. It The scheme has thespecial feaure of growth in capital with reductions in tax liability as per the provisions
The denominations of the CD and the
Minimum amount of a CD should Act, 1961.
more than by individuals. Tàx
nstiutional investorS and companies subscriber should not be of the Income
could be accepted from a single Tax benefits arefor
available
on
amounts invested in NSC under Section 88, and exemptioncan be claimed
be Ri lakh, i.e., the minimum deposit that issued by
of R1 akh thereafter. The maturity period of CDs under section 80L interest accrued
on the NSC.
Interest accrued for any year can be treated as fresh
less than1 lakh and in the multiples Fls issue CDs for a period
not more than one year. The
can
investment in NSC for that year tax benefits can be claimed under Section 88. But the liquidity of the
and
banks should be not less than 7 days and
from the date of issue. investment is low and premature withdrawal is allowed in certain situations like the death of the holder,
notless than 1 year and not exceeding 3 years
surrender by the nominee or on court orders.
Deposits resemble fixed-income securities, they
are
Kisan Vikas Patra (KVP) Certificates are available in denominations (face value) of100, 7500, R1,00,
fixed of retum. Even though bank deposits
rate
Deposits earn a

not negotiable
instruments. Some of the deposits are explained below 5.000, R10,000, and R50,000. In this,8.40the investment doubles at he end of the specified period. It offers
a fixed rate of interest, currently
at per cent per annum compounded half yearly that is subject to
investor. He has to open an account
and deposit after
investment avenue open to an variations according to the decisions. The
govermment's policy amount doubles
invested on maturity
Bank deposits It is an easy account and fixed deposit account.
Current The maximum limit for
eight years and seven months. It is suitable for those seeking guaranteed
returns.
the banks offer current account, savings
the money. Traditionally accounts is that the under the scheme. The deposits
interest. The drawback of having large amounts in savings purchase of the certificates is not fixed. No
income tax benefit is available
account does not offer any the Reserve Bank of India (RBI) at source (TDS) at the time of withdrawal. It is more liquid than NSC as the
The savings account interest rate regulated by
is are exempt from tax deduction
return is just 3.5 per cent. convenient
cost of servicing it. The savings account is more liquid and holder can withdraw the money at any time after two-and-a-half-years.
and kept low because of
the high fixed period. With
interest rate and the money is locked up for a
to handle. The fixed
account carries high account with the fixed
have bundled the plain savings interest amount is given on a monthly
among banks, the banks Post Office Monthly Income Scheme (POMIS) In this scheme the
increasing competition The deposits in the banks are considered to be safe because annum. For the investor looking for
account to cater tothe needs of the small savers. basis for the deposited amount. It offers an interest rate of 8 per cent per
deposits. limit is R1,500. The maximum
monthly income, POMIS is a much desirable scheme. The minimum deposit
investors prefer bank
of RBI regulations. Risk
averse
account. Deposits in all accounts
limit is 4.5 lakh in case of a single account and 9 lakh in case of a joint
there has been a significant increase in the importance of non-banking in single account and R9 lakh in a joint account. An investor
NBFC deposits In recent years, taken together should not exceed R4.5 lakh a

(NBFC) in the process of funancial ntermediation. The NBFC comes under the purview than one account subject to the maximum deposit limits at any post
office. Only one deposit
financial companies can have more
of the RBI ACt in January 1997 made registration compulsory for the NBFCs. the period of maturity of an account is six years.
of the RBI. The amendment canbe made in an account, and
with the NBFCS 1S lower than of the deposits with banks. To improve the liquidity fixed vide Section 80L of the Income
Security of the deposits Income tax relief is available on the interest earned as per limits
of NBFCS the percentage
of liquid assets required to be maintained by them has been enbanced by the RBI. time. It is highly liquid scheme as depositors can withdraw
from
ax Act, as amended from time to
a

The Company Law Board is

authornzed to aiect toe aerauung NBFCS to repay the deposits. In spite of the ne scheme at the end of one year from the date of investment. If he tenure of the scheme (six years) Is
and regulations laid down by KBl tne aetault rate 1s high in the case of NBFCs.
strict rules completed,a bonus of 10 cent on the investment amount is provided.
per
benefit
Postal Savings
scheme was introduced on 2 August 2004 for the
Daetal Savings are considered a reilabie1om o nvestment because they are backed by the Government of Citzen Scheme (SCS) savings
This new the
O invest. The maturity period of
r A one time, postal savings werc nmucu S0ugnt arer by the lower-middle class and the lower clasS, Senior citizens. Citizens of 60 years of age and above are eligible to investment is 1,000; additions
minimum
ncome and higher-income groups are COSidering
also
considering this
this avenue with the increase in the 1s another three
five years and extendable by
The years nterest of
hut now midd the efturn investmen i The deposit carries an
uncertainties in
r e u m of other financial
or other financial investments. The Indian POstal Departnment has the dde in multiples of T1,000 subject to a maximum of T15 lakh.
largestpostal
30 Security Analysis and Portfolio Management
Alternatves 31
Investment Planning and
is allowed arter
a of one
d of
period one year
year,
per cent per anmum, which is
taxable. Premature withdrawal subjec of life insurance follows:
to some deductions. The major advantages are as

of India in 1968 saver. The

the Govermment Protection Saving life
through guarantees full protection against risk of death of the
insurance
was introduced by
Pubie Provident Fund (PPF) This scheme
scheme iS proviaed
at the branches of the Am full assured sum is paid, whereas in other schemes, only the amount saved is paid.
Ciizen of lndia may make a contribution to
the scheme. ThisZS00 can be made per annum and any
there is
Easy payments Salary saving schemes areintroduced to the salaried people. Further,
or an easy
A minimum amount
office and of the State Bank of India. of <I00,000 per annum.
The duration of
Scheme can
deposit is 15beyears
madebut
in can of 5 subject
be extended
multiples for 1-5 to a maximum
years. The interest accrued from tihe PPF is wholly exe
exempt instalment method of payment through monthly, quarerly, half-yearly or yearly mode.
from income tax under Section 88 of the IT Act and any amount that is to be credited is also fully eveafter
Liquidity Loans can be raised on the security of the policy.
it untl seven years are completed, af
investor cannot withdraw
from wealth tax. The limitation is that the Tax relief Tax reliefs in
income tax
and
weaith tax are available for amounts paid by wey of premium for
be withdrawn, if needed.
tax rates in force.
which 50 per cent of the deposits life insurance subject the
can to
in Table 2.2.
A brief conparative analysis is provided
Factors to be Considered while Taking Insurance
similarities among different schemes and the amount taken often depend on
of the differences and Insurance needs differ from family to family. The insurance policy
Table 2.2 Analysis POMIS SCS PPE the following factors:
Features KVP 9% per annum 8o, Compounded One's persSonal income level
8, Compounded 840, cCompounded 8per annuUm
interest annually Tax planning
haf-yearty hayeanty
Monty payments Monthy payments No monthly/ The number of dependents
No morthlylyeary No mortly or yearly
Interest payment yeary payments The wealth, income, and expense levels of the dependents
paymerds payimerts 71.000 7500 (required Their significant foreseeable expenses
100 71 500
irumuT ivestment 7100 annualy) The inheritance and lifestyle to be provided for them

5 lakh 100,.000 Life Insurance Policies

Maximum ivestmert No im No imt 45lakh discussed below.
5 years 15 years common life insurance policies
Some of the are
6 yeers
8 years and7 morts 6years
Duraton of
NEStTen Interest taxabie Tax benefit under Endowment policy
Under Secion 80 C Not zvaiabe Exenled Income tax relief
the insurer. This policy is a combination of
An endowment policy covers the risk for a period specified by
Tx beret s avalabie on he beyond Section 80 C
from deducion
avaiabe
Maximum ims sourTe at tedempion nerest eamed a imt available. insurance and investment. A certain portion of the premium gets invested and generates a certain return

7I0.000 under Section B0L Maximum limit is

every year. This return is declared as a bonus. At the end of the specified period, the sum assured is paid
100,000 (limit of the with the bonus accumulated during the term of the policy.
back to the policyholder, along
to provide a living benefit
investment in PPF) Unlike whole life, an endowment life insurance policy is designed primarily
for life insurance protection. Therefore, it
during the lifetime of the individual and secondarily provide for an endowment life policy is higher than
mesmet Good medisHEm Good medunHerm Good regiar Interest income Good ong-term to
Type d nETet pton roome scherme higher than bank investment option The premium
is more of an investment than a whole life policy.
nesmet opn
endowment policies are as described below:
that for a whole life policy. The various types of

endowment policy. Under this, the insurance

LIFE INSURANCE Unit-linked endowment This is a popular form of the
fncurance is a highly lucraive aeue o heip savings. The core feature of insurance is protection. Life several units of a specified unitized insurance fund. Often, the insurance holder can
premium is invested in
insurance is a contract for paymet of a sanm d money to the
person assured (or to the person entitled select the funds in which he prefers to invest the premium.
toreceive the same) on the happening t he vem insuTed against. Usuaily, the contract
on t e caie provides for the The basic amount assured is equivalent
to the
navment of an
amouni matunity or a specified dates at regular intervals or if death occurs. Full endowment This is usually with-profits endowment. is higher than the
none other things. the
coniracis aso
provide
tor the payment of
premium periodically to the deah benefit from the beginning of the policy. Based on
the growth, the final payout
hw he policy holders
E a e Eimals
nSS. Tbus, insurance
corporation initial sum.
investneni and assurance emerges as a combination of both
investment to meet the target
a combination of a specific
Low-cost endowment A low-cost endowment is a minimum if any
Insurance =iavestnet entire amount is paid as
Assurance life insurance component. The target
amount and a declining
kind of physical illness or death occurs.
 Aiternaves 33
32 Securty Analyss and Portfolio Management Investment Planning and

is
whole Iite policy as the policyholder is alive.
The risk covered for,r the Jolnt life pollcy and offer maturity benefits to the policyholders, apart
remains in force a s long and th to
endowment policies
y p ciite whole lufe policy Hence, it is known as whole life policy. 1he waoe e pOlCy amount
a of Joint life policies are similar life
insurance policies. But joint life policies
are
categorized
the poliqholder. 1ne policyholder covering zisks,
the
Just as the other for a married
entre to the nominee of the bencficiary
upon dhe death
of
tne poueynOTde Survival benefi
from
two lives simultaneously.
These policies offer a unique advantage
bonus are payabie lifetime, 1.¬.. wunere no separately as they cover
in a business firm.
money during
his o r ber w n h o l e i t e policy with single or for partners
t o receive aoy
and couple
5 ot eniitiedwhoie life policy, whole life poligy with limited payment
endowment pony:
LIC
prowides fusion of whole life and
Chlldren's insurance pollcy
premum. LIC's Jeevan Anand' is a
those thatparents legal
or guardians provide as life insurance for their
Children's insurance policies includec o v e r c o m m e n c e s from the
birth. The risk
time the child attains the age
of 127 17/

away, the family js children from their a r e given in Table 2.4.

Term ife policy insurance. If the insured person passes 18/21 as per the policy
document. Some examples ofsuch policies
be the purest form of life covered
for that period
Term insurance is said to
is taken for a chosen period and the IS risk
certain amounm. The policy the premium required
larger In Table 2.4 Some examples of children's insiirance policies
protected by pay
to
initially unable
a
who are
A term plan meets the needs of people
be able to pay
o r a polic future, the near
Polcy
only. whole life or an
endowment assurance policy, but would because reserves are
not accumulated. If
Compa
for a Joan o r paid-up values are not granted under dhis policy without acquiring any paid-up value Aviva Lite Insurance3
AVIva ute Young AchiEver

Surrender, will lapse

is not paid within the grace period, the policy HDFC Standard Life Insurance
Lhe premium survive the term, but the risk
cover comes to an

life
end.assured but betore the expiry of HDFC Standard Life
Insurance

The policyholder may

lapsed policy may be
revived during the lifetime of the
Accident and/or disability benefits ICICI Prudential Life
Insurance
ICICI Pru Smart kid
However. a
the due date of the first unpaid premium. are listed in Table 2.3.
ING Vysya Creating Life
the period of rwo years from life policies
granted on policies under the
term plan. Some of the term
INGVysya Life Insurance SBI Life Scholar lI
shall not be
SBI Lfe Insurance
TATA AIG Assure Educare
Table 23 Exampes of term Ite policies TATA AIG Insurance Jeevan
LIC Jeevan Anurag, LIC Jeevan Kíshore, LIC Komal
Polg Life Insurance Corporation of India
Company Raksha
Tata AlG
SBI ShieldAnnual Premium
Group policy as employers, employees,
to various groups such
under grour policies is provided insurance coverage for people
SBI Le Term lite-Annual Premium Life insurance protection etc. It also provides
weaker sections of society, insurance coverage, it
ING Vysya professionals, co-operatives, premiums. Besides providing
Reliance Tem Plan at the lowest possible liabilities of
in certain approved occupations that allow the funding of the granuity
and the pension
Reliance e Level Tem Policy also offers group
schemes to employers
Max New York the employers.
Bharti AXA
Secure Confidet
Term Assuranoe Regular Premium Plan (ULIP) with savings at
market-
Unit Linked Insurance life insurance combined
HDFC Standard insurance plan. ULIPs provide with insurance plans.
With an
Suraksha Regdar Prenium This is a market-linked in the ULIP compared
is invested differently securities (G-secs)
Metife linked returns. Premium money risk-free securities like government
is mainly invested in gets invested
in equity
endowment plan, the premium But in ULIP premium money
securities with high credit rating.
and fixed income
Moneyprimariy.a
pa an dowment policy, as a portion of the sum assured is paid to the policyholder in the ULIPs can be classified
as:
and G-secs.
This is fized intervals, before malurity date. The risk with corporate bonds
the cover on life continues for shares along
premium plan
Single premium and regular
form aSSured even after
alte
payment of survival beneliis, and bonus is also calculated on the full sum
ll the end of he
the poliay
policy term, the survival benefits
s u r v i v e s ull h e
end of Guarantee plans
plans
and non-guarantee
assured. If the
policyholder would be deducted based
L i f e stage based and non-life stage
from the maturityva
feature f
of this is that in the event c
this policy is
policy n even o death at any time
within the policy term, the Child's education plans
An important ssured, without
deducion of any of the survival benefit amounts that
death claim comp aid money-back componenis.
compeS. Sim advantages:
Sunilariy, the bonus is also calculated ULIPs generally have the following
money-back
been paid as during
have already on the full be inereased
might flexible and transparent. Life insurance c o v e r
can
sum assured. They are to change the
life cover.

The ULIP holder has the option

on the needs
of the insured.
plan tenure depending
 Aliternatives 35
34 Security Analysis and Portfolio Management Investnent Planning and

to suit the insured's Dre

provides the option to raise
or lower premiums
after a certain
period
premiun ncome Tax Benefits
ULIP regular premium may he. from income for payment of life insurance premium under Section 80C
of the Income
paying capacity. the e paid Deductions allowable
contribution over and above
An additional are asgiven below:
op-up facility is provided. investment gans Tax Act
in order to give effect or to keep in force an insurance on the life
of the
There is extra
invest flexibility
money to by
optthe
forinsurer
a rider.to A rider is the
maximize an added benefit that can De availed along with
ability . Life insurance premium paid Undivided Family
to benefit rider, accident and disahi assessee or on the lite of the spouse or any child of assessee and, in the case of Hindu
excess of 20
critical illness the life of any member thereof, provided premium paid is not in
policy. Commonly offered riders
are
HUF, premium paid on

naln insurance
waiver of premium rider, etc. euher per cent
of capital sum assured.
for deferred
benefit rider,
fund option. He choose
can
Contribution to deferred annuity planshisin order or give child of suchkeep
to effect or to in force a contract a

to choose his contract

The unit holder has the opportunity balance in aeDt,
on his own life or the life
of spouse any individual, provided such a
invest 80-100 per cent equities,
in annuity,
ABgressiveULIPs (which
proOVision to exercise an option by the insured to receive a cash payment in lieu of the
cent in equities), or does not contain
a
Balanced ULIPs (invest around 40-60 per
Conservative ULIPs (invest up to 20 per cent in equities). across different plan. payment of the annuity.
allowed to switch ans Contribution to p sion/annuity plans.
unit holder is
ULIP plans is provided. The can switch from debt to
Switching among the unit holders
Based on the market performance After that, the fund chares Section 80 Ccc
from the same company.
debt. A certain number of free
switchovers are allowed.
Speclal feature of deposited by him from his taxable income in the
cquity or equity to individual
for an for any amount paid or
A deduction by the institution under the Pension
for each switchover. plans for receiving a pension (from the fund set up
above annuity
Scheme) is allowed.
ULIPs is ensured by:
Transparency The transparency of benefit illustration.
to ask for a sales
Giving customers the right MUTUAL FUNDS
the sale of units. The
brochures to follow the plan. to the investor when he investment trusts obtain funds from many investors through
Providing essential features of the plan Investment companies or the benefit of the investors.
document containing all the investors are placed under professional management for
Sending a key features funds collected from the
takes the insurance plan. classified into open-ended and close-ended schemes.
provides as of now. This is free-look
a
The mutual funds are broadly
feature that no other financial product
Incorporating a distinctive if the insured is not satisf+ed, he can close the
15 days. During this period
period that is provided for the charge borne by the company
in issuing the Open-ended schemes
continuously.
entire premium after deducting units continuous basis and accepts funds from investors
policy and get back the open-ended scheme offers
on a
The to withdraw money any their at
policy. daily basis to Repurchase is continuing basis, thus helping the investors
carried out on a
the companies' websites on a
and exit into the funds. The open-ended
scheme
asset values of different funds
on
Making aailable the net time. In other words, there
shall be an uninterrupted entry
investor can deal directly with the
track the performance of
the policy. and is not listed on the stock exchanges. An
has no maturity period fund provides liquidity to the investors
well as redemption. The open-ended
of them listed below. The websites of these mutual fund for investment as
value of the unit.
a wide variety of ULIPs. Some
are
is fixed by net asset
Several companies provide
details about their schemes.
since the repurchase facility is available. Repurchase price
companies provide
AEGON Religare Life Closed-ended funds
investments are made when the close-
fixed maturity period. The first-time
Insurance
Bajaj Allianz Life The close-ended funds have a Investors
B i r l a Sun Life
Insurance
for a limited period. Once closed, the units are listed on a stock exchange.
end scheme is kept open
Standard Life
Insurance
only. Demand and supply factors influence the prices
HDFC Ltd can buy and sell their units through stock exchanges not be the same
Insurance Company
DBI Fortis Life also affects the unit prices. The market price may
of India of the units. The investor's expectation
Life Insurance Corporation as the net asset value.
Reliance Life Insurance
Tata AIG Insurance
interval schemes and these
open-ended schemes are launched,
Aviva Life Insurance
Sometimes mutual funds with the features
of close-ended and
Bharti AXA Life Insurance for repurchase
can be listed on the stock exchange or may be available
Life Insurance are known as interval funds. They
DLF Pramerica Life Insurance at net asset value or related prices.
ICICI Prudential during specific periods
Old Mutual Life Insurance
Kotak Mahindra
Life
Max New York
Star Union Dai-ichi
Co. Ltd
Life Insurance
 Y Me
36 Security Analysis and Portfolio Management
investment Planning and Alternatives 37
Systematic Withd irawal Plan (SWP) SWP is a
existing portfolio either toplanreinvestprovides
Types of Mutual Funds that
the
the existing for future needs
systematicaly irom by withdrawing
Mutual funds are classified by their nature, objectives and other factors. The major categories are given
remain Money
idle. Money can earn better
returns
in
anotherportfolio or to meet amounts
below. no longer regular payments.
if
reinvested, instead of
expenses. Savings
acCOunt for
meeting
remaining idle in a savings
major portion of this type of fund's corpus is invested in equities. The proportion of
Equity fund Plan (STP) This plan allows the
fer Plan
Systematic Transter
certain amount from one schemeinvestor
nvestment in diferent equities may vary for different schemes, and it depends on the rund manager's to make
Outlook regarding different stocks. Equity funds bear the feature of high rate of risk and reun. Ihe equity
systematicaly transfer a
to another.
a
provision to
periodically and

funds may be: Basis forsSelecting Mutual Funds

Diversified equity funds may choose mutual funds on the basis of the
.Mid-cap funds . Net assets
following:
Sector specific funds Portfolio composition
Tax savings funds (ELSS) Income composition

Gross income
as a percentage of net assets
the medium to long term. Generally, these .

Growth fund This aims to provide capital appreciation over Expense ratio

funds invest their money in equities. Realized gains per unit

these funds Unrealized appreciation per unit
to its unit holders. By and large, deploy
Income fund This fund aims to provide a regular return
their funds in fixed-income securities. REAL ASSETS

The most popular

1orms or real assets are detailed below:
and debt instruments. These funds prcvide a
Balanced fund The copus of this fund is invested equities
in
combination of steady return as well as reasonable growth. Equity part of the fund is responsible for growth
Gold
and the debt part maintains stability in returns. Gold is the oldest form of investment in the world and is popular across continents and cultures. There is a
wide range of reasons for the investor to seek gold as a form of investment. These are:
market index. S&P 500 in the US, the BSE Sensex, the
Index fund Index funds replicate a specific stock Expectations of growth in demand for gold
NSE S&P CNX 50 in India, NASDAQ 100, Russel 2000, MCSI-EAFE, etc., are the popular stock indices Steady increase in the price of gold except for minor fluctuations
of securities that are found in the index, which
that form the basis of index funds. These funds invest in a set Ability to insure against uncertainty and instability
is used as a benchmark. .Uncertainties inthe intermational financial sector
Increase in demand for exchange-traded paper backedproducts
securities are issued by govermment
Debt fund The objective of this fund is to invest in debt securities. Debt Low to negative correlation with many otherassetclasses
most of the debt instruments have a
authorities, private companies, banks, and financial institutions. As Not linked to the performance ofthe economy, industry or companies
investors. Debt funds can
fixed rate of return, these funds have low risk and provide a stable income to the
Ability to diversify portfolio risks
be classified as follows:
take many forms, and some investors may choose to combine two or more forms
Gold investment can
securities.
Gil fund This fund mainly invests in government securities, popularly known as gilt-edged to appetites and investment time frames. There are many ways holding gold.
suit their risk
of The most
Zero default risk is the special feature of this fund. Yet, it is not free from interest rate risk. common ones are described below.

Liquid fund These funds are known as morey market funds. These funds provide liquidity and preserve
capital. The fund focuses its investment in short-term instruments like reasury bills, inter-bank call
Phy'sical gold sold
buy gold is bars. Gold bars are
and coins The long-established way of investing in gold
to
money market, CPs, and CDs. These funds are useful to corporations for short-term cash management. Gold bars another
dealers. Gold coins are
than the gold value at major banks and bullion
They have a low-risk profile. aa
Sgntly higher price investors. They are available in two forms, namely, gold bullhon

POpuar investment choice with small goldinvestors looking to invest purely gold
in should buy gold bulhon
Systematic Investment Plan (SIP) SIP is a method of investing a fixed sum on a regular basis in a
S and collectible gold coins. Gold that are more expensive they carry
as numismatic
mutual fund scheme. It is more or less like a recurring deposit. In SIP, one buys units on a given date of collectible gold coins (ancient gold coins) in
coins are available many
SLead and condition. Bullion
can implement a saving plan for oneself. SIP allows the investor to pay 10 PTices are fixed on the basis of their rarity, age, is small in
each month or quarter
and
periodic investments of i,000 each in place of a one-time investment of 10,000 in a mutual fund. being 2, 4, 8, 20,
investment
and 50 grams. Ifthe
Wegnts with the most common
38 Securty Analysis and Portolio Managemet

amounts tne investor Investment Planning and Alternatives

amount, it is good to buy gold bulion coins and hars. For large investment should 39

always consider the risk of counterfeit gold coins and bars and storage nisk
passion for
ln A
Gold ornaments Gold ormaments consistently form three-quarters gold
of demand inula.
world to purchase gold ornaments.
t
is custonmary t
the shining yellow metal motivates women around the
season the demand i0r gOd is very high
provide brides gifts in the form of jewellery. During the mariage of the
qualit
omaments because of the uncertainty
n India. However, it is not the hest way to invest in gold are made
tor impurniy and makinp
of gold used and hiçh additional making costs.
In resale, deductions
charges, which is a loss for the investor.
Gold securities
These can take the following forms:
Exchange traded fund (ETF)
Gold mining companies' stocks

Gold options and futures

Gold bullion secuntües (GBS)

related to renurns provided by the
rerurns closely
is to provide securikes as permitted by regulators
ETFs The investment objective of ETFs
Investmeat is made in pbysical
gold or other gold-based EKchange. Some of them are Gold
price of gold. are traded on
the NañonalStock

from üme to time. Most goid ETFs and UTI Gold ETE
Goid, Reliance Gold,
BeE Kotak Gold. Quantum
Investing in gold by holdino
traded in the stock exchanges.
Gold mining companies'
stocks These are
as such because
the price of the stocks
to investment in gold
is not cqual
shares of a gold mining company
on the performance of the company.
depends
investment, an investor may invest by buying gold
For short-term speculative investment offers leverage to the
Gold options and futures exchange. This kind of gold
derivative
options or futures in a commodiry a relatively small investment.

investor and helps to control a large

position in gold with
called gold
uraded fund products are
Gold Council-initiated exchange
Gold bullion securities The World selected stock exchanges in the London Stock
like equity shares in
bullion securities. They are traded one-tenth of an ounce of gold and
Exchange
IS
and Australian Stock Exchange. Each
of
Supported by physical bolding gold
share of GBS is equal to
in the custody of HSBC. It is a convenient form
of investment for
i
institutional investors as well as individuals. NYSE. It is also sponsored by
the
Street Tracks Gold Shares is another
ETF gold fund traded on the one-
Each share represents
State Street Global Markets.
World Gold Council and marketed by ETF provider Association.
tenth of an ounce of gold bullion as priced by
the London Bullion Market

Silver Ornaments and jewellery are

metal and used as a currency.
Histoncally, silver has been valued as a precious abundance and is the least expensive of all
also made of silver. Compared with other metals silver
is found in
will find many ways
time frames, and risk appetites
precious metals. Investors with varying investment sizes, or silver coins. But it is
difficult
silver as silver bars
to invest in silver. Just like gold, one can hold physical mutual
silver can be held as silver stocks,
to store physical silver and it involves storage cost. Non-physical
funds, ETFs, futures and options.
 40 Security Analysis and Portoio Management Investment Planning and Alternatrves 41

rOwth in technology. business

information

Platinum and Palladium

rarer than gold and is uscdd in
Created demand for office and corporate space outsourcing and
Cmergence of new companies has
Platinum is a white metal, found places of the
in few world. It is 30 times Entry ofthe 1ancial sector in the real estate business
gold' because of its wbust price movement and prosDe Dects vided by banks and housing finance has increased the demand for real estate.
Loans are provide
jewelery. It is popularly known as "high-octane India was 2.5 tonnes 201. Most
in t
ofthe other structures. companies to builders and individuals to construct
the jewellery sector in houses and
for a high rtturn. Purchase of platinum by cent of tne woria splatinum supnl of house gives
Africa and Rusia. Approximately per
80 Pply The possession
a an nvestor a
platinum is poduced in South
Palladirum is newcomer to the precious
metals market. te DGTchmark price
.
friends and relatives. psychologically secure feeling and a
standing among his
palladium marret. omnodity futures nf
Africa. a
comes from South funds are floated by mutual funds.
o platinum and palladrum are fixed in
the London platinum and EXchange, Mi ealestate
Real
New York Mercantile Exchange, Tokyo Commoaity
these metals are primanily traded in the is used in jewellen.

American Commodity Exchange, and

India's Multi Commodity
Exchange. Platinum Problems real estate investments
denisuiy equpnent, and catalyti oblems associated with real estate
electronics and scienific apparatus,
the
thermometers, petroleum refining,
Some of investments are as follows:
converters for automobiles, etc.
Need for large investment The value
Nrequires
alue of land has
soared in the recent
a sizeable amount of funds. Even a small past. Investment in real estate
inve apartment in a suburban area costs several lakhs.
Limitedted liquidity
of the investment The investment in real estate
Platinum as a form of investment lacks liquidity. If the investor wants to
form of investment are sell the property,
he cannot
not immediately realize the money. The
prices There is no proper marketplace for waiting
as a
The main points to be noted about platinum demand for this metal. Mining and extraction of platinum .Difficult to establish period may be months ths or years.
T h e r e is an imbalance in the supply of and per cent of annual gold land and
every year. II accounts for less
than
arive at the price. LOcation and accessibility influence the price of the property. Hence, it is difficult
yield about6 million ounces of platinum olissues The title of the property has to be verified clearly to find outproperty.
production The increase in demand for platium
num oht to sell it. The site should be Iree from encumbrance. Sale deed has towhether the seller has the
siows down the price of platinum.
Slowdown in industrial activity
mCreases the price of piatinum.
ts should be approved by the local authority because construction of a housebeis duly
plots
registered. The
not permitted on the
increase the price to twice the price of gold. unapproved layout.
Economac srength and stability may
.Restrictions on purchase The Land Ceiling Act restricts the purchase of agricultural land beyond a limit.
Exchange traded funds on platinum Subindex Total Return and the UBS E-TRACS
Dow Jones-UBS Platinum Art
The availabie funds are iPath of
Both of these funds are designed to track the performance a basket The size of the art market is growing rapidly. The auction market in Indian art was worth $5 million in 2003
CMCI Long Platinum Toral Retun. but their objective is to provide
funds do not physically hold platinum, and had grown to $85 million in 2010. The prices in the art market are rising and this rise is expected to
of platinum futures contracts. These London-based platinum exchange fund isa
a returm equivzlent to changes
in platinum prices. However, the contiue. Paintings are the most sought after form of art. The reasons for the increasing interest in art as a

physically backed platimum fund. form of investment are as follows:

. Price volatility of art pieces is minimum compared with other forms of investment. However, the price
Real Estate of contemporary Indian art compared with art in other Asian markets is still low
returns. Real estate refers to various fixed
Real estate as an asset class has rewarded investors with superior Indian art is recognized in the international market. Contemporary Indian art is displayed in art galleries
assets whuch can be classified into three caiegories. in New York and around the world. Famous auctioneers such as Sotheby's and Christie's have started
Residential property-fats, apartments, cotages and houses auctioning Indian art.
Commercial property-hotels, resorts, hospitals, educational instiutions, and commercial premises Indian auctioneers like the Mumbai-based Saffron Art hold multiple auctions every year with higher lots
Land-farmhouse plots, industrial plots, and agricultural and non-agricultural land in each.
Non-resident Indians show more interest in Indian art. According to Vadodara Art Gallery, Mumbai,
Residential and commercial properies provide rental yield to the investors apart from capital
appreciation. 20 per cent of their clients were NRIs.
The rental yield from commercial property is higher than the rental yield from residential property. The real
estate
Private banks have started offering art advisory services for investors interested in
art.
For example
industry is receiving much attention and has grown tremendously in the recent past. Bajaj Capital has set up an art house--Bajaj Capital Art House--to offer an art advisory service.
Kotak
shown
Mahindra is also offering art advisory services to high net worth individuals. Mutual funds have
Reasons for growth Crayon Capital and
The main reasons for the growing importance of real estate as an investment avenue are the following: nterest in investment in art. Art funds are available in the market. Osian's, Yatra, five
Indian Fine Art Fund are all close-ended art funds with lock-in periods of three to years.
High capital appreciation compared with gold or silver, particularly in urban areas.
Foreign direct investment (FD) is automatically allowed in townships, housing, to build up infrastructure, a psychological reward
of
joy
EVen though the purchase of a beautiful painting or reputedin art the gives
artwork
and in
construction-development projects. the status and of the investor, before investing investor should understand certan
The minimum
mandatory areá of FDI in real estate sector has been reduced from 100 to 25 acres. r DoOsts ego
facts about such investments.
The population growth and overcrowding in urban areas has created demand in the suburban areas.
 Investment Planning and Alternatives 43
Portfolio Management
42 Security Analysis and

sell sculptures or paintings and convert themn into cash. QUESTIONS

Investment in art lacks liquidity. It is difficult to investments.
are more liquid than art
Financial securities can be sold quickly and forms of investment alternatives? Give a detailed account of any five.
securities. the various
do not generate periodic income for the investor like financial What are
They
Extensive kmow-how about the artistic quality and authenticity
of the work is required. 1wehinguish between investment planning and financial planning and explain the factors that influence
2. Distinguishbetween
investments in art. investment planning.
There is no regulator such as SEBI or IRDA to protect
I t is difficult to understand the pricing process of an art piece. rentiate between capital and money market securities.
Differer
1ate Explain the commonly available money
market seCurities.

It involves maintenance cost. Art pieces have to be handled carefuly and maintained properly to
avoid forms of post office investments?
decay. What are the various of
features equity investment.
5. Discuss the and SIP.
on ULIP
a note
Antiques 6. Write
the tax sheltered
schemes available in the market.
In Western countries, investment in antiques is more common than in India. An antique is an object o . Examine
the advantages or
investing in life insurance schemes?
3 What funds offer the best form of investment. Discuss.
historical interest. It may be a coin, sculpture, manuscript or any other object of olden days. The owner of are
the
antique has to register himself with the Archaeological Society of India. The society after
examining te aMutual
invest in gold and silver?
authenticity of the antique issues a Cerificate of Registration. Any dealings, i.e., purchase and sale of antiques do investors
10. Why real estate in their portfolio?
should be informed to the society. The government has the right to buy the antique from the owner, if it 11. do investors add
Why
wants
to keep it in a museum. With this investment, the investor has to be careful about fakes.
Moreover, the rise in
the price of antiques is uncertain.

sUMMARY Nirmal's Dilemma

Case Study:
Financial planning is defined as the attainment
of finances.
of financial goals through proper planning and management Mr Nirmal is an employee in a public sector bank with a take home pay of R50,000 per
month
ater all deductions, including income tax. He is 50 years old and will retire after eight years
Investment planning refers to a course
to balance risk with the desired
of action taken to accomplish the investment goals. It takes steps His wife is a homemaker. He has two children, a girl and a boy.
His daughter got married and
return.
to pursue an engineering degree in electronics
The features of investment
planning are the setting of investment goals, deciding the investment time is settled. The boy is in high school and desires
he will get a
frame, risk profiling, evaluating the markets, and and communication. His son is an intelligent and industrious boy. Nirmal hopes
designing an investment portfolio. Nirmal's present monthly
Investment alternatives are mary in number. seat in college by merit, and he will have to pay only the hostel fees.
Equity offers high return with high risk. Bonds and 25,000
and fixed flow of income. Securitües issued the
by government are secured
provide a steady expenditure is between <25,000 and <30,000. He expects it to be berween R20,000
Treasury bills carry a very low rate of interest. investments. when he retires. Nirmal is against dowry and wants to save a moderate amount of R5 lakh
for a
favoured by companies and institutional Commercial paper has short-term
investors. Certificate of maturity and is simple wedding ceremony for his son.
readily negotiable. deposit's denomination is high and it is of
Bank deposits are a safe form of He has purchased a house worth F40 lakh with his money and house loan. The EMI
investment. The age-old post office 10,000 per month expires when he retires. It is included in the deductions. He has an endowment
The post office
monthly income scheme's annualized yield is higher. NBFCdeposits pay high interest rates.
interest. The risk associated with them is also deposits offer high rates of policy worth15 lakh, which manres when he turns 65. He has to pay a premium of R12,000 per
high. RBI has laid dowm several income
Life insurance provides a wide amum. He has parked 7 lakh in the equity market and 5 lakh in the 755 post office monthly
relief.
variety of life and accident cover. Deductions arerules to regulate them. His retirement benefits inclusive of granuity will be around lakh. He will receive a
allowed for income-tax SCDeme. a flat to receive a
Mutual funds collect funds from investors
and invest in equities or pEnsion of 33,000 per month. He wishes to use his retirement benefits to buybenefits in
by the schemes. money market instruments as
specified gular monthly rent. His wife insists that he invest at least 20 per cent of the preCiOus
Gold and silver are investments in and acvely parucipa
years.
real assets. The
appreciation of gold has been high in the s . His co-worker advises him to increase the investment in shares retirement days. Are other
past few market. Nimal is perplexed, and he wants to plan for his
Real estate is a lucrative form
of investment with
dee of investments are available, advise nim
high de avenues available for Nirmal? If other avenues
Knowledge about art and antiques is an essential capital appreciation.
prerequisite for investment in art and Tegarding them.
antiques.
 CHAPTER 7

RISK

CHAPTER QUERY
Mohan, a beginner in the stock market, is trying to trace the movements of the Sensex

M which crossed the 20,000 mark in October 2007. It took only 10 trading days to gain 1,000
points after the index crossed the 19,000-mark on 15 October. The major drivers Bank
heavyweight companies such as Larsen and Toubro, Reliance Industries, ICICI Bank,
HDFC
were

and SBI.
In the third week of January 2008, the Sensex experienced a big fall along
with other market
indices around the world. On 21 January 2008, the Sensex saw its biggest-ever loss 1,408 points
of at
after it tumbled to the day's low
the end of the trading session. It recovered and closed at 17,605.40
of 16,963.96.
On 21 January 2008, the BSE Sensex went into free fall. It hit the lower circuit breaker in barely
a minute after the markets opened at 10
a.m. Trading was suspended for an hour. On reopening at
10.55 a.m., the market saw its biggest intra-day fall, and hit a low of 15,332. It was down by
market recovered and
2,273 points. However, after a reassurance from the finance minister, the
the worst
closed at 16,730. Yet, it had lost 875 points. The Indian stock market found mention among
performers across the world in 201il and suffered a loss of 25 per
cent.
These facts are creating panic in Mohan and giving rise to many questions in his mind. Why
cannot the Sensex move smoothly? Why are there these ups and downs? What are the factors causing
these fluctuations? How can I assess the volatility? Have all stocks moved along with the index? Why
do some stocks not reward their investors even when the market seems to be doing reasonably wel1?

CHAPTER OBJECTIVES
To understand the concept of risk
To distinguish between systematic and unsystematic risk

To know how to measure risk

Mr Mohan should accept the fact that equity investment is the most risky investment in all financial
narkets. Any rational investor, before investing his or her investible wealth in a stock, analyses the risks

asociated with it. The actual return he receives from a stock may vary from his expectec return, and the
isk is expressed in terms of variability of return. The downside risk may be caused by several factors, either
common to all stocks or specific to a stock. Investors liketo analyse the risk factors because a thorough
knowledge of the risk helps them plan their portfolios to minimize risk.
 134 Securny Analysis and Portoio Management
DEANITON OF RISK
The dictionary meaning of risk is the possibility of loss or injury and the degree or probability of suchi
Risk is defined as variability in return or volatility in return. Risk is the chance of the actual returnbe
ess than the expected return. Thus, risk means any deviation from expected returns. More specificalv
probability that the returms from any asset will differ from the expected yields is the risk inherent in
asse. In risk assessment, the probable outcomes of all the possible events are listed. Once the events that
listed subjectively, the derived probabilities can be assigned to the entire possible events. For example. ate
investor can analyse and find out the possible range of returns from his investrments. He can assign son
the
subjective probability to his returns, such as 50 per cent of the time there is a likelihood of getting
share as dividend and S0 per cent of the time the possible dividend may be 3 per share. Often risk is uper
used
interchangeably with uncertainty. In uncertainty, the possible events and the probabilities of their occurrene
are no known. Hence. risk and uncertainty are different from each other. Risk consists of the followino
two components:
wing
Systematic risk Extermal factors cause unsystematic risk to a company. The company is not ableto
control this risk. Systematic risk affects the market as a whole.
Unsystematic risk Here, the factors are specific, unique and related to the industry or company.
SYSTEMATIC RISKx
Systematic risk affects the entire market. Often we read in the newspaper that the stock market is caught ina
hear hug or is in a bull grip. This indicates that the entire market is moving in a direction either downwards
or upwards. Economic conditions, the political situation or sociological changes affect the securities market.
A recession can affect the profit prospects of the industry and the stock market.
The recession experienced by developed and developing countries in 2008 affected stock markets all
over the worid. The economic crisis in the US affected the stock markets worldwide. These factors are
beyond the control of the corporation or the investor. They cannot be entirely avoided by the investor. This
means, systematic risk is unavoidable. Systematic risk is further sub-divided into the following:
Markt risk
Interest rate risk
Purchasing power risk
Market Risk
Jack Clark Francis has defined market risk as that portion of total variability of return that is caused bythe
alternating forces of the bull and bear phases. Both tangible and intangible events can affect the market
During the bull and bear phases more than 80 per cent of the securities' prices rise or fall along with the
stock market indices.
When the security index moves upward haltingly for a sigificant period, the market is known as abul
market. In a bull market, the index moves from a low level to its peak. A bull market tends to be associated
with rising investor confidence and expectations of further capital gains.
A bear market is just the reverse of a bull market; the index declines haltingly from the peak to a mark
low point called the trough for a significant period. A bear market is typified by falling stock prices, adver
economic news and iow investor confidence in the economy.
The forces that affect the stock market can be either tangible or intangible.
Tangible events Tangible events are real events such as earthquake, war, political uncertainty and fall in
value of curency. In 2007, the stock market Louched an all-time high on 21 December when the benchun
 Risk 125

ensex closed above the 20,000 mark. It was supported by foreign institutional investors (FII) investment in
Sen
2007: the inflow was 69,731.10 crore for the calendar year till 10 December. On 21 January 2008, the Sensex
Lost 1,408.35 points. The rising number of defaults in the US sub-prime market affected the US stock markets.
This led to the failure of many leading financial institutions, including the Lehman Brothers. These events
adversely afected the Indian markets. Sub-prime credit refers to high-interest, high-risk debt given to those
with poor credit records or ratings. FIs' investment and failure of financial institutions are tangible events.

Intangible events Intangible events are related to market psychology. Such psychology is affected by real
events. However, reactions to tangible events become over-reactions and push the market either upward or
downward.
Thus, any untoward political or economic event can lead to a fall in the price of the security which can be
further accentuated by the over-reactions and herd-like behaviour of investors. If some financial institutions
start disposing of their stocks, it can cause fear that spreads to investors. This will then result in a rush to
sell the stocks. The actions of the financial institutions would have a snowballing effect. This type of over-
reaction affects the market adversely, and the scrips' prices can fall below their intrinsic values. This is
beyond the control of the corporations.
Figure 7.1 illustrates some of the events that have created the bull and bear run in the Indian stock market.

25000
Infiow of Fl Investment Inflation, slowdown of GDP and
and high GDP growth global recession
20000

15000
Global financial crisis

Corrective measures and

ww
10000
recovery of the economy

2 A p0
2 Aug
r.7
0 .7 2 Dec0. 7 2 Apr
0 . 82 Aug
0 . 8 2 Dec0. 82 Ap0r.
9
2 A p1
r .0 2 Aug
1 . 0 2 D e c1
. 0 2 A p r
1 . 1
2 A u g1. 1
2 D e c1. 1

2 A u g
0 .

2
9

De0c .9

Figure 7.1 Movement ofthe BSE Sensex 2007-11

Interest Rate Risk

Interest rate risk is the variation in the return caused by fluctuations in the market interest rate. Most
commonly, interest rate risk affects the following:
Bond return
Cost of borrowing

Dond return Fluctuations in interest rates are caused by changes in the government's monetary policy and
aanges that occur in the interest rates of treasury bills and government bonds. These cause changes in the
price and its return, which in turn lead to changes in investment patterns. These are summarized here
126 Security Analysis and Portfolio Management

When interest rates rise, new issues will approach the market with higher interest rates es tha
than olde
Securities. Hence, the prices of the latter go down.
market with lower yields than older ser
When interest rates decline, new bond issues come to
more. Hence, their prices go up.
uriüies,
making those older, higher-yielding ones worth loan/bond with a higher
the budget, floats a new
If the government, to tide over the deficit in
from
inestments private-sector bonds to public-secto
interest, an investor would like to switch his like to shift their money to the bond
investors would
Likewise, if the stock market is depressed, 1996 when most of the initiole
assured rate of return. The best example
that of
is April
to have an
but IDBI and IFC bonds were oversubse
offerings of many companies remained
undersubscribed
to the bond market.
cribed,
investors from the stock market
The assured rate of return attracted
This affects stock tra
interest rate affects the cost of borrowing. traders
Cost of borrowing The rise or fall in
and corporate bodies in the following ways: The increase in the cost ofmari
.Most stock traders trade in the
stock market with borrowed funds.
traders who use borro
affects the profitability of the traders.
This dampens the spirit of the speculative
stock index.
securities leads to a fall in the value of the
funds. The fall in the demand for
traders but also corporate bodies that carry on their businesu
Interest rates not only affect the security
increases; a heavy outflow of profit takes place in the fom
with borrowed funds. The cost of borrowing share and a consequent
of interest on the capitalborrowed. This leads to a reduction in the earnings per
fall in the price of the share.

Purchasing Power Risk

of the currency. Purchasing power rist
Variations in returns are caused also by the loss of purchasing power
the returns to be received. Inflation is the reason behind
is the probable loss in the purchasing power of
increase in prices, is a serious risk for any
the loss of purchasing power. Inflation, defined as persistent
a
faster than the increase in capital value. The rise in
long-term investor. The level of inflation proceeds
rise in price is a risk to the investor. Broadly
price penalizes the returns to the investor, and every potential
inflation is classified as:
Demand-pull
Cost-push
the demand for goods and services ther
exceeds
Demand-pull inflation In the demand-pull inflation,
the would not be able to supply goou
supply. At full employment level of factors of production, economy The cannot be inereas
in the short run, and the demand for products pushes
the price upwards. supply
demanu
unless there is an expansion of labour force or machinery for production. The equilibrium between
and supply is attained at a higher price level.

the rise in prices cauSed

Cost-push inflation Cost-push inflation, as the name indicates, refers to
cost of raw material, labour and equipment makes the co
the increase in costs. The increase in the
level. The producer tries to pass the higher cost of producu
production high and results in high price in the co
workforce try to make the corporation share the increase
the consumer. The labourers or the
inflation has a spiralling effect on the price leve
living by demanding higher wages. Thus, cost-push dustrial

levels are measured by the consumer price index for inThe

Real rate of return The changes in the price of
used by industrial labourers in different parts Inue
workers. This index uses a basket of goods
 Risk 127

index also is used to measure inflation. The real return of any investment can be calculated
who
saleprice.
following way.
in the ifan
ar investor gets a return of 12 per cent on his investment and the inflation rate is 0.068,
example,
For
real value
would be
then the

=
1.0 + -1
of return
Real rate 1.0+IR

Where, IR =Inflation rate; r =

return

1.0+0.12
-

1 =1.0486 1 =
0.0486 =
4.86%
1.0+0.068

mis chews that his actual rate of return is only 4.86 per cent. The purchasing power has not increased byY
4 ercent aceording to his earnings. If he really wants to protect himself from inflation, and earn a 12 per
12 pe
cent real rate of return, then his rate of return should be 19.6 per cent.
1.0+r
RR =
1.0+IR
- 1
1+T
= 0.12 + 1 = 1040068 = 1.1961 -1 =0.196 =
19.6%
1.0 +0.068

his investment in stocks, even though it gives an illusion of

If the investor earns a 5 per cent return from
calculation explains it.
earning, his earning is actually negative. The following
1.0+r
RR =
1.0+IR
1.0 +0.05
1 = -0.0169 = -1.69%
1.068
The investor's income has increased by 5 per cent. However, his real rate of return has declined by
1.69 per cent. His investment has a negative real rate of return. Thus, the changes that occur in the purchasing
actual return. To tide over the purchasing power
power also cause variations in the expected return and the
of return is greater than the inflation rate
TISk, the investor should try to ensure that the nominal rate
affects returns from bonds, debentures, and stocks.
prevailing in the economy. Thus, purchasing power risk

UNSYSTEMATIC RISK If one's equity investment is in Tata Motors,

industry.firm or an
Tematic risk is unique and peculiar to a other stocks will
only impact investment in Infosys; all
,and Infosys, adverse news about Infosys willfinancial leverage, managerial inefficiency, technological
Cany impact. Unsystematic risk stems from material, changes in consumer preferences and labour
chan: tne production process, availability of raw
problems.
The r factors differ from industry to industry and company
to 1ure and magnitude of the above-mentioned for each industry and firm. Changes in consumer
Drefa These factors have to be analysed separately machines, refrigerators, etc., more than
theuES affect consumer products like television sets, washing
affect the information technology industry
CE the iron and steel industry. Technological changes
128 Security Anatysis and Portolio Management

more than the consumer product industry. Thus, the impact varies from industry to industry. Fint
leverage of the companies, i.e., the debt-equity portion of the companies, also varies. The nature andm
of raising finance and paying back the loans involve a risk element. All these factors constitute unsystem
risk and contribute to the total variability of the return. Broadly, unsystematic risk can be classified
as.
Business risk, which refers to the difference between revenue and earnings before interest and
(EBIT), and
taxes
Financial risk, which refers to the difference between EBIT and earnings before tax (EBT)

Business Risk
Business risk is that portion of unsystematic risk caused by the operating environment of the businesSS,
Variations in the expected operating income reflect business risks. Variations that occur in the opera
erating
environment are reflected in the operating incomes and expected dividends. Business risk is concerned ui
th
the difference between revenue and EBIT.
For example, consider two companies, Anu and Vinu. In Anu Company, operating income could grow
as much as 15 per cent and go as low as 7 per cent. In Vinu company, the operating income can be either
12 per cent or 9 per cent. When both the companies are compared, Anu Company's business risk is higher
because of its high variability in operating income compared to Vinu Company. Business risk arises from
the inability of a firm to maintain its competitive edge and the growth or stability of the earnings. Busines
risk can be divided into internal business risk and external business risk. The concept of business risk is
illustrated in Figure 7.2.

Business Risk

Internal bussiness risk Extenal business risk

Fluctuations in sales Social and regulatory factors

Research and development Political factors
Personnel management Business cycles
Fixed cost
Single product
Figure 7.2 Business risks

Internal business risk

Internal business risk is associated with the operational efficiency of the firm. This differs from compau
to company. The efficiency of operations is reflected in the company's achievement of its goals and
fulfilment of its promises to investors.

ners

Fluctuations in sales The sales level has to be maintained. It is common in business to lose custo
e
abruptly because of competition. Loss of customers will lead to a loss in operational income. Hence.
company has to build a wide customer base through various distribution channels. A diversified salesto
 Risk 129

. to tide over this problem. Big corporate bodies have a long chain of distribution channels. Smail
to tide
mayhelp lack this diversified
firmsoften
customer base.
Research
hand development (R&D) Sometimes the product may go out of style or become obsolete. It
is the management
that has to overcome the problem of obsolescence by concentrating on the in-house
R&D DrOgramme. For example, if Maruti has to survive the competition, it has to keep its R&D active
ner-oriented technological changes in the automobile sector. This is often carried out
introduce consumer

atroducing sleekness, Seating comfort, and brake efficiency in its automobiles. New products have to
rouced to replace the old ones. Shortsighted cutting of the R&D budget would reduce the operational
be produced

firm.
efficiency of any

Prsonnel management Personnel management in a compay also contributes to the operational efficiency
ofthe frm. Frequentstrikes and lockouts result in loss of production and high fixed capital costs. Labour
productivity can also sufter. The challenge of labour management exists in allfirms. Itisup to the company
Solve the problems at the negotiating table and provide adequate incentives to encourage the increase in
to.
labour productivity. Encouragement given to labourers at the floor level will boost the morale of the labour
force and lead to higher productivity, and less wastage of raw materials and time.

Fixed cost The cost component also generates internal risks, if fixed costs are high in the total cost. During
a recession or low demand for a product, the company cannot reduce the fixed costs. At the same time, in
a boom period, it cannotchange the fixed factors at a short notice. Thus, a high fixed cost component can
be a burden to the firm. The fixed cost component must always be kept at a reasonable level, so it does not
affect the profitability of a company.

Single product Internal business risks are higher for a firm producing a single product. The fall in the
demand for a single product can be fatal for the firm. Further, some products are more vulnerable to
business cycles while some products resist and can go against the tide. Hence, a company must diversify its
product base ifit has to face the competition and business cycles successfully. Take for instance, Hindustan
Lever Lad, which is producing a wide range of consumer cosmetics and is thriving in this business. Even
when a company diversifies its product base, it must guard against unknown and unrelated product to
minimize the risk factor. Poorly thought out diversification is as dangerous as producing a single good.

External business riskk

External risks arise from operating conditions imposed on the firm by circumstances beyond its control.
The external environments in which it operates exerts some pressure on the fim. These could be social
and regulatory factors, monetary and fiscal policies of government, business cycles or the general economic
environment in which a firm or an industry operates. A government policy that favours an industry will lead
o a rise in the stock prices of the particular industry. For instance, the Indian sugar and fertilizer industries
are very vulnerable to external factors.
Social and regulatory factors A harsh regulatory climate and legislation against environmental degradation
ay mpair the profitability of an industry. Price controls, volume controls, import/export controls and
Cnvironment controls reduce the profitability of a firm. This risk is high in industries related to public utility
OTS Such as telecom, banking and transportation. The government's tariff policy for the telecom sector
rect bearing on its earnings. Likewise, interest rates and norms for lending can affect the profitability
ns.The Calcutta Elecetric Supply Corporation has not been able to increase its power tariff owing
esistance from the West government. The Pollution Control Board has asked most of the
Bengal
TIeS in Tamil Nadu to close, and this has affected the leather industry.
130 Secunity Analysis and Porttolio Management

Political risk Political risk arises out of changes in governnent policy. With a change in the
was the finance minisier ne
Iiberalized the Ind
nuling
party. policies also change. When Dr Manmohan Singh efforts were made to augment fora
Indian
even though
economy. During the Bharathiya Janata Party government,
Political risks arise mainly in the case of fore
investment, stress was placed indigenous production.
on
regarding foreign investment For
foreign
investment. The host government may change its rules and regulations
their equity and share thejir oro
in 1977, the decided that multinationals must dilute Mh
example, governnent
their holdings in lndian companies
with Indian investors. This forced many multinationals to liquidate
fluctuations in the earnings of a company. A
Business cycle Fluctuations in business may lead to
cycle
of many industries. Steel and white consumer gond.
economic recession could lead to a drop in the output
a boom, there is much demand for stel
industries tend to move in tandem with the business cycle. During
in a recession, demand for such goods takes a hit. In rmore
products and white consumer goods. However,
has resisted business cycle, and moved counter cyclicall
recent times. the information technology industry
from one company to another. Sometimes, companjes
during a recession. The effects of business cycles vary
be forced to close down. In some other cases, there may be
with inadequate capital and consumer base may
external to the corporate bodies, and
a fall in profits, and the growth
rate may decline. This risk factor is

they may not be able to control it.

Financial Risk
because of the debt capital. Financial risk
This refers to the variability in income vis-a-vis the equity capital
structure consists of equity funds and borrowed
is associated with the capital structure of the company. This
funds. The presence of debt and preference capital results in a commitment of paying interest or a pre-fixed
to the equity holders. The interest payment affecs
rate of dividend. The residual income alone is available
increases the variability of the retuns
the payments that are due to the equity investors. Debt financing
to the common stockholders and affects their expectations regarding
the returm. The use of debt with own
funds to increase the return to shareholders is known as financial leveraging.
to the
Debt financing enables companies to have funds at a low cost and offer financial leverage
shareholders. As long as the earnings of a company are higher than the cost of borrowed funds, shareholdes
holders.
earnings go up. At the same time, when the earnings are low, it may lead to bankruptcy equity
for
This is illustrated in Table 7.1.

Table 7.1 Capital Structure and EPS

Years
20X6 20X7 20X8

CompanyA
20,00,000 20,00,000 20,00,000
Equity capital: 10 per share
Debt fund (10% interest) 10,00,000 10,00,000 10,00,000
3,00,000 40,00,00 20,00,00
Operating income
0.5
Earnings per share 1.5

Company B 10,00,000
Equity capital: 710 per share 10,00,000 10,00,000
20,00,000
Debt fund (10% interest) 20,00,000 20,00,000
2,00,000
Operating income 3,00,000 4,00,000
Nil
Earnings per share 1.0 2.0
 Risk 131

amole detailed in Table 7.1 deals with three different situations. In the year 20X6, both the
companies earmedned the same amount and earning per share were the same. In the year 20X7, there was
cent hike in the earnings of the two companies. In company A, a 33.33 per cent rise in operating
cent hil
3.33 per
resulted in
income resulted a 50 per cent increase in earnings per share. In company B, the effect of an increase in
was so considerable that the earnings per share increased by cent per cent, i.e., from 1
operating income was

son behin
reason behind this is that the bondholder receives only the pre-fixed interest amount, whether
to 2. The
-ampany fares well or not. The increase in earnings per share would cause a change in the capital
con
the
jation of the shares of
company B during a good year.
20X8,
n
the economic climate changed, and there was a fall in the operating profit by 33.33 per cent
or hoth the companies. This caused a s0 pe Cent fall in earnings per share for company A compared to
20X6. However, company B's earning per share fell to zero, affecting shareholders adversely. If we assume
nther situation of negative earnings, the situation would be worse in company B, and the shareholders
anot
will be further adversely affected. A few years of persistent negative earnings will erode the shareholders'
emity, Fixed return on borrowed capital either enhances or reduces the return to shareholders.
The financial risk considers the difference between EBIT and EBT. Business risks cause variations
hetween revenue and EBIT. The payment of interest affects the eventual earnings of the company stock.
Volatility in the rates of return on the stock is magnified by borrowed money. The variations in income
Caused by borrowed funds in highly leveraged firms are greater compared to companies with low leverage.
The financial leverage or financial risk is an avoidable risk because, the management decides the share of
equity and borrowed funds in the total capital.

MINIMIZING RISK EXPOSURE

Every investor wants to guard against risk. This can be done by understanding the nature of the risk and by
careful planning. The following paragraphs explain how investors can protect themselves from the different
types of risks.

Protection against Market Risk

An investor must study the price behaviour of the stock. Usually, history repeats itself even though it is not
in perfect form. The stock that shows a growth pattern may continue to do so for some more periods. The
Indian stock market expects the growth pattern to continue for some more time in information technology
stock and depressing conditions to continue in textile-related stocks. Some stocks may be cyclical stocks.It
isbetter to avoid such stocks.
The standard deviation and beta indicate the volatility of the stock. The standard deviation and beta are
avalable for thestocks included in the indices. The NSE news bulletin provides this information. By looking
a the beta values, the investor can gauge the risk factor and make decisions according to his risk tolerance.
Further, the inestor should be prepared to hold the stock for a minimum period to reap the benefits of
Tsing trends in the market. He should be careful about the timing of the purchase and sale of the stock. He
Should purchase it when it is low and should exit at a higher level.

Protection against Interest Rate Risk

Aninvestor can protect himself against interest rate risk by:
Holding the investment to maturity: If he sells it in the middle due to fall in the interest rate, the capital
invested will experience a heavy loss.
ying treasury bills and bonds of short maturity: After maturity, the invested money can be reinvested
to suit the
market interest rates.
Vsting in bonds with different maturity dates: When the bonds mature on different dates, reinvestment
132 Secty Analysis and Povthio
Managovnent
canbe done
acconding to the changes in the investment climate.
est esuts Maturity diveraifleation can vieta

Protection agalnst Intation

The folkwing
points should be noted:
The general
opinion is that the bonds or debentures with fixed returns cannot solve the
bond yield is 13 to 15
per cent with low risk factor, it can provide a problem te
Another way to avoid risk is to hedge against inflation.
have investment in short-term securitles and
the
invesments. A rising consumer to
index may wipe out the real ratc of interest in avoid lonu letm
price
Investment diversification can also solve this the long
his investment to include real problem to u certain extent. The investor has toterm
diverait,
estate. precious metals, arts and antiques, besides
ensure that such diversification will
necurities. One cat
provide a
perfect hedge against inflation, but it can
koss due to fall in purchasing power. minimize t
Protection against Business and Financlal Risk
Iavestors can protect themselves by:
Analysing the strength and weakness of the industry to which the company
much of government interference by way of rules and belongs.
If the weaknes
ofthe industry is too
avoid it. regulations, it is better
Analysing the profitability trend of the company. The calculation of standard deviation would
yicld the
variabilitry of return. If there is inconsistency in the earnings, it is better to avoid it. The investor
choose stock with a consistent track record.
a mut

Analysing the capital structure of the company. If the debt equity ratio is high, the investor should
exercise caution. Along with an analysis of the
capital structure, he should also take into account the
interest payments. In a boom, the investor can select a
during a recession.
highly leveraged company but should not do

RISK MEASUREMENT
Understanding the nature of the risk is not adequate unless the investor or analyst is capable of expressing t
in some quantitative terms. Expressing the risk of a stock in
quantitative terms makes possible comparixons
with other stocks. Measurements cannot be cent per cent accurate
because risk is caused by numerous
factors-social. political, economic, and managerial. Measurement provides an
of risk. approximate quantification

Expost Risk
Variance from the value
measures the ex-post risk using historical data. The statistical measure
mean
o
variance uses the returns of an asset to measure risk. For example, if one wants to measure risk associated
with a stock, one has to take the returns of the stock over a period. Then he has to calculate the variance of
stock return. The value of variance indicates the risk of that stock.

Ex-ante Risk
The word ex-ante refers to future events. When risk is measured ex-ante, varíance is calculated with the eup
of probable returns. If the variable has a normal distribution, the theory of normal distribution canca
be applied to find out the probability of this deviation. Oherwise, subjective estimates of the probabiluy
have to be made.
turn
For example, say the changes in a stock price follow a normal distribution. One can take the meanret
 Risk 133

basedon t
Dast return of the stock. Then, using the standard normal probability distribution, one can tind
m on that stock
probability of return falling below that mean or
ut he
stock price i.is not normally distributed, subjective estimates expected return
of probabilities of returns are needed.
If the
an investor ocan find out the expected return of that stock. Then the
Using that calculation of variance gives
of the expected stock returm.
the risk other statistical tool often used to measure and used as a proxy for risk is the standard deviation.
The

dard deviation It is a measure of the values of the variable around its mean. In other words, it is the
o t of the sum of the squared deviations of variable values from the mean divided by the number of
squa
ervances. The monthly reurns of SBI stock for the financial year 2011-12 are given in Table 7.2 along
with the relevant calculations for the standard deviation.

Table 7.2 Monthly returns for SBI Stock in 2011-12

Monthly Return
x- -
3.17 4.71 22.1841
-14.63 13.09 171.3481
3.27 4.81 23.1361
3.27 1.73 2.9929
-15.77 14.23 202.4929
4.15 2.61 6.8121
2.36 -3.9 15.21
-7.33 5.82 33.8724
-10.98 9.44 89.1136
26.47 -28.01 784.5601
8.01 9.55 91.2025
5.62 4.08 16.6464

Average: A=154
N

EX-F
N-1
1459.71=1152
12-1
andard deviation Excel Open the Excel spread sheet; type the monthly return in Column A. Click the
menu and choose Standard Deviation. Select Column A and press Enter; automatically you will get the
standard deviation.
can
arithmetic mean of the returns may be same for two companies, the renuns may vary widely. This
be illustrated
with an example.
i e t us take two companies A and B to calculate the expected returns.
134 Securty Analysis and Porttolio Management

Company A Company B8
P) (PX
6 0.10 0.6 4 0.1 0.4
0.25 1.75 0.2 1.2
0.30 24 8 0.4 3.2
0.25 2.25 10 0.2 2.0
10 0.10 1.00 12 0.1 1.2

2E)=8.00 XEl)=8.00

In the exanmple given above the expected means are the same in both the companies. The A company's retuim
varies from 6% to 10% while the B company's return varies from 4% to 12%. To find out the variation, the
standard deviation technique is applied.

a-A-E
N
Variance (o)=An-Et)
i=l

Hence -/Variance (a*)

For Compamy A

-E) -E0OF P-E

0.10 2 4 0.4
7 0.25 0.25
8 0.30
0.25 +1 0.25
10 0.10 +2 4 0.40
1.30

2-E()

=130 =114
 Risk 135

For Company B

E) -EQF P-E(0
0.1 4 16 1.6
6 0.2 2 4 0.8
0.4
10 0.2 +2 4 0.8
12 0.1 16 1.6
4.8

G2A-E)
G=4.802.19
The expected returns are the same for A and B companies but the variations in expected returns are
different. Company A's expected return is stable compared to Company B's expected returm. The standard
deviation helps to measure the variability of return. The variability in return includes both systematic and
unsystematic risks.

Characteristic Regression Line (CRL)

The characteristic regression line or CRL is a simple linear regression model estimated for a particular
stock against the market index return to measure its diversifiable and undiversifiable risks. The model is

R =a,+ P, R+ e
R = Return of the ih stock

a Intercept
P Slope ofthe i stock
R = Return of the market index

e= The error term

The security return is

Today's price - Yesterday's price

Today's security return x 100
Yesterday's price
Today's index - Yesterday's index
Today's market return = x 100
Yesterday's index

AE daily returns, weekly returns can be calculated by using this week's and last week's prices instead of
toda sand yesterday's prices in the above-mentioned formula.
Monthly
returns also can be calculated.
136 Security Analysis and Portolio NManagement

Let us consider the daily prices of the Shaji Auto stock and the index for the period 5 October 200
16 Octoher 2012. The objoctive of this example is only toillustratethe computation of beta. Usul
2012 t
vabes have to he calculated from data ofa fairly long period to minimize the sampling error. beta

Index ( Shajl Auto ()

October 5 904.95 597.80

Octaber 6 845.75 570.80
October 7 874.25 582.95
October8 847.95 559.85

October 9 849.10 554.60

October 12 835.80 545.10
October 13 816.75 519.15
October 14 843.55 560.70
Octaber 15 835.55 560.95

October 16 839.50 597.40

To calculate the beta, the returns have to be calculated. Then using the formula below, the beta and alph
co-efficient can be calculated.

XY-(x)(Ey
X-(2x
a=-
The calculations are given below.

2
index Shaji Auto XY
Return X stook return Y

6.54 42.77 4.52 20.43 29.56

3.37 11.36 2.13 4.54 7.18
-3.01 9.06 -3.96 15.68 11.92
0.14 0.02 0.94 00.88 -0.13
-1.57 246 -1.71 2.92 2.68
2.28 5.20 4.76 22.66 10.85
3.28 10.76 8.00 64.00 26.24
0.95 0.90 0.04 0.00 -00.04
0.47 0.22 6.50 42.25 3.06
-7.09 82.7 0.78 173.36 91.32
 Risk 137

nEXY-(Ex)(Ey)
-(2
9x91.32-(-7.09)(0.78)
9x82.75-(-7.09)2
B 119

a =7-
F 0.78 0.086

FA0.79
0.086-(119x- 0.79)
a=102
The manual calculation seems to be laborious. At present beta can be calculated with the help of hand
calculators and computers very easily. When an investor has to calculate for a long period, a computer
would be of great use. Along with beta, other information also can be obtained. Given below is the computer
spreadsheet for the previous example, i.e., for Shaji Auto stock return on NSE index return.

R = a, +P, R, + e
a = 1.02 B, = 1.19 standard error is 0.0266

Standard deviation ofstock return :4.39

Variance of stock return 19.27
Standard deviation of index return :3
Variance of the index return 9
Correlation coefficient :0.795

Beta: Beta is the slope of the characteristic regression line. Beta describes the relationship between the
stock's return and the index returns. In the above example, beta indicates that one per cent change in NSE
index return would cause 1.19 per cent change in the Shaji Auto stock retun.

1) Beta = + 1.0
One per cent change in market index return causes exactly 1 per cent change in the stock return. It
indicates that the stock moves in tandem with the market.
2) Beta = +0.5
One per cent change in market index return causes 0.5 per cent change in the stock retum. The stock
1S less volatile compared to the market.
3) Beta =+2.0
One per cent change in market index return causes 2 per cent change in the stock return. The stock
return is more volatile. When there is a decline of 10 per cent in the market return, the stock with a
Deta of 2 would give a negative return of 20 per cent. The stocks with more than one beta value are
considered to be risky.
Negative beta value indicates that the stock return moves inthe opposite direction to the market return.
A Stock with a negative beta of -1 would provide a return of 10 per cent, if the market return declines
by 10 per cent and vice versa.
38 Security Analysis and Portfolio Management

Stocks with negative beta resist the decline in the market return, but stocks with negative returne
urns a
very rare.
Figure 7.3 (a), (d), (c) shows = 1. B> 1 and ß < 1 and the t.

-X
Market Return
market
Figure 7.3 (a) Systematic risk same as

Market Return Market Return

Figure 7.3 (b) High systematic risk Figure 7.3 (c) Low systematic risk

the characteristic regression line is alpha i.e.

the distance between the intersecton
Alpha The intercept of of the market return. A posiu
It indicates that the stock return is independent
and the horizontal axis. to
Positive alpha values would yield profitable return. According u
value of alpha is a healthy sign. of alpha of all stocks turns out
to be zerd
in a well-diversified portfolio, the average value
portfoliotheory, the
between
co-efficient measures the nature and the extent of relationship
Correlation The correlation
and the stock return in a particular period.
stock market index return
 Risk 139

nXY (XZYn
nEx-(2x* y»2?-(2Y?
9x91.32-(-7.09) (0.78)
9x82.75(7.09) 9x 173.36-(0.78)2
827.41
=0.79
1040.73

cmLare of the correlation co-efficient is the co-efficient of determination. It gives the percentage of
The squa
ion in the stock's return explained by the variation in the market's return. In our example,
amatid

P (0.79)¥ = 0.62

The interpretation is that 62 per cent of variations in stock's returm is explained by the variations in the
NSE index return.

Case: Is This the Right Stock...?

stocks in the banking sector, has selected the HDFC Bank stock.
Mr Mohan, after considering many
He has downloaded the stock price and the Sensex values from the BSE website www. bseindia.com
that HDFC Bank
and, as usual, he is concerned with market upswings and downswings. He knows
was able to withstand
the global financial crisis. Yet he wants to know how much market movements
can afect the HDFC stock price. What will happen to the stock return if there is downturm in the
a
market? Will the uptrend reward him more than the market return? He turns to you, an MBA student
with specialization in finance, for help. How will you help him? He has downloaded the price data
for HDFC stock and the Sensex value as given in Table 7.3 from the BSE website.

Table 7.3 Price of HDFC Bank stock and Sensex value

Date Sensex HDFCbank Date Sensex HDFC Bank

1/4/2012 17,583.97 514.15 16/4/2012 17,466.2 507.7

518.3 19/4/2012 17,273.37 498.65

2/4/2012 17,636.8
34/2012 17,636.99 518.9 20/4/2012 17,316.18 504.85

54/2012 511.3 21/4/2012 17,601.71 515.4

17,362.87
6/4/2012 507.6 22/4/2012 17,196.47 502.6
17,173.29
714/2012 515.3 23/4/2012 17,361.74 513.85
17,145.52
94/2012 522.85 26/4/2012 17,052.78 510.55
17,503.24
12/4/2012 519.85 27/4/2012 17,257.36 518.05
17,587.67
28/4/2012 17,121.62 513.3
13/4/2012 17,813.62 524.8
29/4/2012 17,058.61 510.7
14/4/2012 17,919.3 527.05
30/4/2012 17,404.2 520.05
15/4/2012 17,675.85 510.95
140 Security Analysis and Porttollo Management

Case anahysls
Estimation of B and r values can help Mr Mohan understand the market-related risk. Normaly, bets
alues are caleulated from data over a long period to minimize sampling error. To ease Mr Mohan
understanding, here it is calculated for a month.

XY-(2X)x2)
X-EX*
a=Y-

Return=
Today'sprice - Yesterday's price x 100
Yesterday's price
Usually, for research purposes only log values are used. In that case, all prices and index values are
converted into log values and the retum is calculated as follows.

InP- InP, x 100

nP log of today's price
=

inP= log of yesterday's price

Investors normally use the first one to assess the performance of a stock. In this calculation, the first
method is used. The calculated returns and other calculations are given below:

03 0.09 0.807 0.652 0.242

0.001 0 0.116 0.013
-1.55 2.403 465 2.145 2.27
-1.09 1.188 0.724 0.524 0.789
-0.16 0.026 1.517 2.301 -0.243
2.086 4.353 1.465 2.147 3.057
0.482 0.233 0.574 0.329 0.277
1.285 1.65 0.952 0.907 1.223
0.593 0.352 0.429 0.184 0254
-1.359 1.846 3.055 9.331 4.15
-1.186 1.407 -0.636 0.405 0.754
-1.104 1.219 -1.783 3.177 1.968
0.248 0.061 1.243 1.546 0.308
1.649 2.719 2.09 4.367 3.446
-2.302 5.3 -2.484 6.168 5.718
0.961 0.924 2.238 5.01 2.151
-1.78 3.167 -0.642 0.412 1.143
1.2 1.439 1.469 2.158 1.762
Contd..
 Risk 141

-0.787 0.619 0.917 0.841 0.721

0.368 0.135 -0.507 0.257 0.186

2.026 4.104 1.831 3.352 3.709

X-0.86 2-33.235 EY 1.37 Y 46225 XY=33.334

R2XY-(2)x(2Y)
nXnX-(2XR6NI31) 1006
21x33.234-(-086X137)
)-1006
21x33.235-(-086
a=Y-
1.37 0.065
21

-UB0041
21
a 0.065-(1.006x 0.041)-0106

This is written as an equation

R=a+BR+
R 0.0106 + 1.006 R

Excel application
Mr Mohan can use the Excel programme to find the beta valuc. Open the Excel spreadsheet. Enter
Sensex data in column A and HDFC Bank data in column B.

To obtain return cell C2, write = (A2-AlVA1" 00. Press Enter. Drag cursor to other cells.
In cell D2 write = (B2-B1)/B1* 00. Press Enter. Drag cursor to other cells.
Now click Data on the Excel menu and then click Data Analysis to view analysis tools.
Select Regression Analysis.
Select the input Y (dependent, HDFC Bank return).
Select the input X (independent, Sensex renurn).
Click OK. You will get the following results.

Summary output
Regression Staistics
Mutiple A 0.853143
R Square
0.727853
Observaions 21
142 Secunty Analysis and Portolio Management

Lower 95% Upper 95% Lower

Coeficients Standard t Stat P-value Upper
95.0% 95.0%
Error
0.599 0.556 -0.265 0.478 -0.265 0.478
Intercept (a) 0.106 0.178
7.128 8.89E-07 0.710 1.301 0.710 1.301
0.141
XVariable ( 1.005

Correlation

21x3334-(-0.86)137)
21x33235-(-086) -21x46.225-(137)2
698.96
=085
26.404x31113
= (0.85} =0.72

A beta value oft.006) indicates that one

unit change in Sensex will cause a 1.006 unit change in
the HDFC Bank stock move in unison. An upturn
HDFC return. This shows that the market and
return than market return. But a
in the market will reward Mr Mohan with a manginally higher
return. If a boom period is anticipated, it is a good
dowawards trend has a negative effect on the
investment proposal. The r2 indicates that 72 per
investment. Otherwise, he has to reconsider his
return. This
return is explained by variations in the Sensex
cent of the variation that occur in stock
shows the high relationship of the stock with the
market. Anyhow, Mr Mohan is advised to have data
at least for a year to confirm the results.

SUMMARY

Risk has two components, systematic and unsystemaue

Risk is measured by the variability of return.

risk.
crisis
Systematic risk affects the market as a whole. Tangible events such as war and global known as and
financial
intangible events like investor's psychology affect the entire stock market,
which are markc
risk.
Interest rate risk is the variation in returm caused by the changes in the market interest rate.
of returm earned from
Purchasing power risk is caused by inflation. Inflation reduces the real rate
securities.
business T
Unsystematic risk is unique to the particular industry or company. This is classified into
and financial risk. nal

Business risk is caused by the operating environment of the business. This may be caused by inte
factors like fluctuations in sales or personnel management or external factors like government po
rules and regulations.
. Financial risk emerges from the debt component of the capital structure. Isof
and diversification of the investment can moderate the etre
A careful analysis of the past, planning
the various risk factors.
Statistically, the standard deviation and beta estimation help to quantify the risk.
 CHAPTER 10

EUNDAMENTAL ANALYSIS: ECONOMIC ANND

FUNDAME

INDUSTRY ANALYSIS

CHAPTER QUERY
he Burozone crisis and the economic slowdown in the US economy have made Mr Jeevan
NOTried about his investment in the stock market. Will the foreign institutional investors
FIIs) keep their net investment low for a long period? Is the rupee value going to be under
prsure? Willthe government contain inflation? How will these factors impact the stock market?

CHAPTER OBJECTIVES
To understand the meaning of fundamental analysis
To know the impact of economic factors on stock value
To evaluate particular industries
To comprehend the different models used in forecasting

Mvan will find answers to his questions in the course of this chapter. Fundamental analysis is the
aisofcritical factors that affect the value of a stock. The intrinsic value of an equity share depends
d tiade of factors. The eanings of the company, the growth rate, and the risk exposure of the
a v e a direct bearing on the price of the share. These factors in turn rely on a host of other factors
COomic environment in which they operate, the industry they belong to, and companies' own
Dmance. The appraisal of the intrinsic value of shares in this school of thought is done through:
Economic analysis
Industry analysis
Compamy analysis
s ental analysis is a combination of economic, industry and company analyses to obtain a
s
current fair value and
a predict its future value. This is illustrated in Figure 10.1.
leTundamental analysis is also known as 'top-down approach' because the analysis starts from
alysis of the econo
nomy, moves to industry, and narrows down to the company. This is also called EIC
esonoTy dustry and company) analysis.
214 Secunity Analysis and Portfolio Management

Economy

Industry
Stock valse
Company

valuation analyses
Flgure 10.1 Stock

into an evaluation of a security's e

ECONOMIC ANALYSIS
economic factors that go
of the general
Economic analysis is a study level ofeconomic activity is low, stock nri
an integral part of
the economy. When the
The stock market is
is high, stock prices are high,
reflecting a boomingout
the level of economic activity is essential to undestnd
are low, and when macroeconomic environment derstand
sales and profits of firms. An analysis of the factors are as follows:
for the macroeconomic
The commonly analysed
the behaviour of stock prices.
Gross domestic product (GDP)
Savings and investment

Inflation
Interest rates
deficit
Budget and fiscal
Tax structure
Balance of payments
Foreign direct investment
institutional investors (FIls)
Investment by foreign
International economic conditions

Business cycles and investor psychology

Monsoon and agriculture
Infrastructure facilities
Demographic factors

Gross Domestic Product

services produced in the economy
value of the goods and
the aggregate monetary estimatesa
The GDP represents calculated on an annual basis, quarterly
Although GDP is usually
during a specified period.
common equation
for the calculation of GDP is:
also available. The

Investment + Exports -Imports

GDP Consumption +
industrial sector and the return investors cane
for the
out the prospects slowdown. A hign
The growh rate of GDP points potential economic
shares. A decline in
the GDP indicates a
in
from an investment market.
to the stock
growth rate is advantageous
 Fundamental Analysis: Economic and Industry Analysis 215

marked the initiation of the rise of the Indian GDP growth rate with the opening up of Indian
The1990s
A foforeign direct investments (FDI) and Flls. Real GDP growth at factor cost increased to 8.5 per
ma 2010-1 from 8 per cent in 2009-10. According to the RBI Annual Report (2010-11) the real GDP
cent in
increased for the second successive year after the global crisis induced a sharp slowdown in
growthrate
2008-09.

Savings and Investment

hvious that growth requires investment, which in turn, requires a considerable amount of domestic
t is Growth in savings naturally leads to more investments. High capital investment means possibility
savings.
more production, more demand and supply, better prices in the future and consequently, higher business
t s and a positive outlook for the stock market. Savings are distributed over different assets like equity
P deposits, mutual fund units, real 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
Table 10.1
orate savings
corp
have increased and, in turn, the gross domestic investment has also increased.
shows this.

Table 10.1 Savings andinvestment (as a percentage of GDP atcurrentmarketprices)

Years 05-06 06-07 08-09 09-10 10-11
Household 23.5 23.2 22.4 23.6 25.4 22.8
Private sector 31.0 31.0 31.8 31.1 38.6 30.6
Savings Public sector 2.4 3.6 5.0. 1.0 0.2 1.7

Gross domestic 33.4 34.6 36.8 32.0 33.8 32.3

Gross domestic investment 34.7 35.7 38.1 34.3 36.6 35.1

Source: CSO Report (tp/indiabudget.nic.in)

Inflation
A simple explanation of inflation is that it refers to a situation where too much money is chasing too few
with the growth of GDP, if the
goods. Inflation indicates a rise in the price of goods and services. Along stock markets have
inflation rate also increases, then the real rate of growth would be very low. Inflation and
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 eanings
and market return. f there is a mild level of
These factors have a negative impact on the stock price
ntlation, it is good for the stock market but high rates of inflation are harmful.

Interest Rates
base rate of banks affects the cost of borrowed funds.
nLerest rates have a direct impact on the economy. The banks lend to
anyone. It is the floor rate below which
ne base rate is the minimum rate of interest at which for scheduled commercial banks for March 2011
S Will not allow banks to lend. The base rate range
was as follows:
Public sector banks--8.25 to 9.50 per cent
216 Security Analysis and Portfolio Management

Private sector banks-8.20 to 10.0 per cent

Foreign banks--6.25 to 11.75 per cent
The base rate is influenced by RBI's bank rate, the repo rate, and the cash reserve ratio.
A decrease in the interest rate implies low cost of finance for firms and more profitability. More
is available at a low interest rate to brokers who do business with borrowed money. Availability of afford
funds encourages speculation and a rise in the price of shares.
An increase in lending rates affects negatively firms which depend on banks for their working
capital
and growth requirements.

Budget and Fiscal Deficit

revenues and expenditures. A deficit budett may
The budget draft provides a detailed account of government
n

lead to a high rate of inflation and adversely affect the cost of production. A surplus budget may result
to the stock market.
deflation. A balanced budget is highly favourable
Fiscal deficit is the difference between the governmene's total receipts (excluding borrowing) and total
follows:
expenditure. It can be expressed as
Fiscal deficit Total expenditure (revenue + capital) (Revenue
=
-

receipts capital receipts)

+ Non-debt
is high and a def+cit occurs, it is a healthy sign. Capital
If capital expenditure in total expenditure on infrastructure
of the economy. For example, spending
expenditures augment the productive capacity due to excessive revenue
investment in the economy. If a deficit
occurs
projects can stimulate private then the deficit is not conducive
and administrative expenses,
expenditure like interest payments, subsidies,
these expenditures are unproductive in
nature.
to economic growth because and totalrevenue
between the government's revenue expenditure
The revenue deficit is the difference
The Fiscal Responsibility and Budget
(that is, tax and non-tax revenues excluding borrowing).
receipts to eliminate the revenue deficit andto
Management (FRBM) Act, 2003, required the central government these fiscal and
March 2009. The revised estimates of
reduce the fiscal deficit to 3 per cent of GDP by from 200-01
4.57 and 3.42 for the year 2011-12. Figure 10.2 gives the fiscal deficit
revenue deficits are

to 2011-12.

Net fiscal deficit

GDP
5

Deficit as % 4
3

1
Revenue deficit
A
0 012
2005 2006 2007 2008 2009 2011
2002 20032 0 0 4
200

Fiscal and revenue deficits (2001-12)

Figure 10.2
 Fundamental Analysis: Economic and Industry Analysis 2i17

Tax Structure

w year in March, the business community eagerly awaits the statement from the government regarding
EEynlicy. Concessions and incentives given to a particular industry encourage investment n that
he finance minister introduced tax exemptions for stock market investments in the
rticular industry. The
aion Budget (2012-13) to attract retail investors to the stock market. The scheme, named the Rajiv Gandhi
ity Savings Scheme, willallow S0 per cent tax deductions for those whose annual income is below 10
D who invest up to 50,000 in stocks subject to a three-year lock in. The securities transaction tax
delivery
cash de transactions has also been reduced by 20 per cent from 0.125 to 0.1 er cent. These
(STT) on
may directly influence
stock market activities.
ax sops

Balance of Payments
The balance of payments is the record of a country's money receipts from abroad and payments to foreign
cOuntries. The diference 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 fvourable balance of payments has a positive effect on the stock market.

Foreign Direct Investment

Accordting to the International Monetary Fund (IMF), the definition of foreign direct investment (FDI) includes
diferent elements, namely, equity capital, reinvested earnings of foreign companies, inter-company debt
wansactions, 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. The "Asian Tiger economies
such as China, South Korea, Singapore and the Philippines benefited much from FDIs in their economy. The
cumulative amount of FDI flows (from April 2000 to January 2012) into India stood at US$159.97 bilion.
Under the FDI policy, FDI up to 100 per cent is allowed under the automatic route in most sectors/
activities, except a few, where sectoral equity/entry route restrictions apply. FDI, under the automatic route,
does not require any approval and only involves intimation to the Reserve Bank of India within 30 days of
inward remittances and/or issue of shares to non-residents.
The FDI policy rationalization and liberalization measures taken by the government have resulted in
ncTreased inflows of FDI over the years. FDI equity inflows in January 2012 stood at US $2 billion. The
anountof FDI inflows from April 2011 to January 2012 were recorded at US$26.19 billion.

vestmet by Foreign Institutional Investors (Flls)

Sre considered to be the main drivers of the stock market. Outflows of FIl investments affect the stock
bea v e l y According to a report in the Times of ndia 3 April 2012), net investments by Flls in
u ck market in 2011-12 were the lowest of the past three years, and stood at R47,935 crore. The stock
e t barometer Sensex lost 2,041 points or 10 per cent in fiscal 2011-12. The index finished at 17,404.20
points on 30 March.
Iering the importance of Fll investments, in January 2012, the government announced its decision
i e d foreign investors (QFIs) to invest directly in the Indian equiry market. In August 2011,
Sch
Schemes ofnent
allowed foreign investors to invest directly to the extent of US$ 13 billion in equity and debt
mutual funds.
218 Secunity Analysis and Portiolio Management

International Economic Conditions

Worldwide economies are not independent but
affects other countries and the stock market. For
interdependent. The boom or depression ino
example, the sub-prime crisis in the One
bankrm
US, counttyn
a 29 per centdrop in the Dow Jones and NASDAQ had an impact on the Indian
financial sectors, real estate, the automobile economy, IT
indus
industry, investment banking, and other industries fae
Tuptcies, an
losses. Further, the global recession resulted in the
pulling of Fl funds from the Indian stock maa
Sensex plunged and became
highly volatile in 2008. market. The
Business Cycles and Investor Psychology
The business &ycle contains four phases with distinct features, namely, boom,
recovery. Figure 10.3 illustrates a trade cycle. recession, depression.
3and
Boom
Boom

Recovery Recession

Depression Depression

Figure 10.3 Atypical trade cycle

During a boom, economic activity is at its peak, and the

Companies record high turnover and profits. They engage ingrowth
of industry and GDP are
prominent.
This leads to investor optimism. Retail expansion plans, mergers, and acquisitions.
investors, big and small, are enthusiastic about the market and are
willing to invest. The market reaches a new high.
Some of the companies may fail to fulfil the
trade cycle, a recession, sets in. Economic
goals and as their profit margins fall, the next phase of the
growth declines, and there is an economic slowdown. The stock
market reacts with a fall in the price and volume of stock.
Fear
depression. It results in additional fall in growth rates and increasegrips
the market. The recession slips mo
in unemployment. The investor becoms
pessimistic about the market. Panic prevails, and the stock market reaches a low 1level.
After a while the economy slowly begins to recover.
Some entrepreneurs begin to realize that
cannot get any worse and start investing in the business. The thng
changes to hope and caution. Once again, the cycle goes on. recovery
starts. In the stock market, the mow

Monsoon and Agriculture

In spite of technological advancements, Indian agriculture still depends heavily on the mons0ons.
a boon for
monsoons are agriculture. Agriculture is directly and indirectly linked to many industries.
example, the sugar, cotton, textile, and food-processing industries depend upon agriculture for raw
Farm equipment, fertilizer, and insecticide industries mate
supply the inputs used in agriculture. Afavou
monsoon leads to higher demand for these
inputs, a bumper crop, and more disposable income in rural areas

This leads to buoyancy in the stock market. When the monsoon

fails, agricultural and hyaro
power

generation decline. They cast a shadow on the share market. This phenomenon is production
explained in Figure
 runaamental Analysis: Economic and Industry Analysis 219

Favourable
Cilimatic condtion Failure of
monsoon
monsoon

High demand for hybrid seeds, Low demand for hybridseeds

fertlizers, farm equipment, etc. Stock market
fertilizers, farm equipment,etc.

Bumper crops
Failure of harvest

High ruraldisposable income Less rural disposable income;

High rural demand for consumer goods,
cars, etc. non-availability of raw materials
Raw materials at low prices to sugar, for agro -based industries
texlile, and food-procassing industries

Economic buoyancy Economic slowdown

Flgure 10.4 Monsoons and the stock market

Infrastructure Facilities
Good infrastructure facilities affect the stock market
favourably. Infrastructure facilities are essential for the
growth of the industrial and agricultural sectors. A wide communications network is a must for the
of the economy. Regular supply of growth
energy without any power cuts will enhance production. The banking and
financial sectors should also be strong enough to
provide adequate support to industry and agriculture. In
India, even though infrastructure facilities have been developed, they are not
liberalized its policy for the communication, transport, and
enough. The government has
power sectors. For example, the power sector
has been
opened up to foreign investors with assured rates of return.

Demographic Factors
Demographic data provide details about the population by age, occupation, literacy, and geographic location.
is is needed to forecast the demand for consumer goods. The population by age indicates the availability
0r a skilled workforce. The cheap labour force in India has
encouraged many multinationals to launch their
venures. 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
mate stock price changes, an analyst must look at the macroeconomic environment and the factors
nd the industry he is concerned with. Economic activities affect corporate profits, investor attitudes,
C
prices. A fall in the GDP or a slowdown in economic growth may lead to a fall in corporate
220 Security Analysis and Porttolio Management

profits and consequentdy stock prices. For the purpose of economic analysis, an
with forecasting techniques. He should know the advantages and disadvantages ofanalyst should be
the various
be familar deany

The common techn.

techniques used are an analysis of the key economic indicators, diffusion index, survo
cconometric model building. These
techniques help an investor to decide the right time to invest DI

type of security he should purchase, i.e., stocks or bonds or some

combination of stocks and
d
bonde the
Economic Indicators e

Any economic variable that predicts the future of financial or economic trends
is called an
indicator. The purpose of using indicators is to make an ecom
help to indentify the turning points of business cycles. Theearly diagnosis of cyclical movements. omie Eco

the They
economic indicators point out
status, progress, or slowdown of the
economy. Indicators are classified as leading, coincident present
They are capital investment, business profits, money and lao
supply,
unemployment rate, etc. The indicators are selected on basis ofgross
national product (GNP), interestgging,
la
the following criteria: rate, ner
Economic significance
Statistical adequacy e le
Timing T
Conformity det
nd
Leading indicators indicate what is going to happen in the economy. They s aftt
of the economy. help investors predict the path
Popular leading indicators are the fiscal policy, monetary policy, ormc
capital investment and the stock indices. The fiscal policy shows what the productivity, rainfal. stock
the fiscal deficit or surplus has an effect on the government aims to do and of the
economy. The tax policy of the government
an
encouragement or a deterrent to industry. The sops given to export-oriented industries may act as
the exports of the economy. Likewise, the may improve inme
cheap money or tight policy adopted by the monetary
authorities also affects the future of industry. The rise of the BSEmoney
Sensex and NSE Nifty shows that the
economy is heading for recovery. Sele
The
Coincidental indicators indicate the the v
state of the economy. The coincidental indicators are GNP, industrial of ste
production, interest rates, and reserve funds. GDP is the
aggregate amount of goods and services producd of de
in the national economy. The gap between the
budgeted GDP and the actual GDP indicates the current
situation. If there is a large gap between the actual
growth and potential growth, the economy is slowing Cat
down. Low corporate profits and industrial production show that the
economy is hit by recession. Vari
The changes occurring in the leading and coincidental indicators are
reflected in the indicatos.
Lagging indicators are usually the unemployment rate, consumer price index and flow of lagging
foreign funds. The EXOE
leading, coincidental, and lagging indicators provide an insight into the economy's current and furure position. exOE
COn
den
Diffusion and Composite Indices
The diffusion index indicates the current business cycle phase. It measures the breadth of a business oyce
pe
movement (expansion or contraction). It provides an overview of the economic activity of the county The
The diffusion index is a composite or consensus index. It consists of GD
leading,
coincidental, and 1aggus
indicators. This index has been constructed by the National Bureau of Economic Research in the US. T
diffusion index is complex in nature and difficult to calculate. Irregular movements that occur in individual
indicators cannot be completely eliminated.
DSite
The best of the leading, coincident, and lagging indicators are selected and combined into the compesie
index. This highlights the cyclical patterns in data and reduces the volatility of individual indicatob
Specifically, a composite index reveals common turning point patterns in a set of economic data u
 undamental Analysis: Economic and Industry Analysis 221

arly than any individual component. The OECD Development Centre of Asian Business Cycle Indicators
clearly

structs both ithe diffusion and the composite index.

Diffusion and composite ndices are based on the same set of data. Standardization procedure of variables
es. Sometimes, the indices move in different directions. The merit of composite index is, it differentiates
small and large overall movements in the component series. Diffusion index measures the occurrence
between small

nts. The difference is useful to confirm or predict the cyclical turning points.
general movements.
oftheg
Econometric Models
of economic factors provides directions for investment in the stock market. Economists have
An analysis
Neloped many econometric models to forecast endogenous variables. The variables whose values are
termined within the model are called endogenous variable. To make forecasts, the model depends on certain
determ
her variables known as exogenous variables. The variables whose values are given outside the model are
ROgenous variables. For example, the sales of cars may be related to gross national income, interest rates, and
he level of employment. The level of sales is the endogenous factor and the other factors are exogenous factors.
The model may be deterministic or stochastic. When an exact relationship is assumed in the model, it
is deterministic. In the consumption function, a deterministic relationship is assumed between consumption
and expenditure. Usually, it is difficult to establish an exact relationship because consumption expenditure
is affected by several other factors like age, educational level, occupation, etc. In the stochastic model, one
or more variable may be random. The values of random variables for different points may be different. The
stock return varies over a period and is considered to be a random variable. The probability of occurrence
of the values is included in the stochastic model.
The classical macroeconomic models involve several steps. Even now, the following steps are followed
in model building.

Selection of the variables

The objectives of the model decide the variables to be included in it. If the model is for the Indian economy,
the variables related to the economy are included. When the purpose of the model is to predict the volatility
of stock prices, factors like the flow of FIl investments, GDP, and interest rate are included. The availability
of data is the major constraint in model building.

Categorization of variables
Variables are categorized as endogenous and exogenous. Endogenous variables in one model may become
exogenous variables in another model. In an open economy, international factors are considered to be
exogenous. For example, in a model for predicting export of cotton textiles, international demand is
considered to be an exogenous variable. At the same time, if the model is built to estimate the world's
demand for cotton textiles, it becomes an endogenous factor.

Specification of the model

The variables related to the models are broken down into blocks of variables such as Sensex, Nifty movement,
GDP price indices, FDIs, and FIl investments. The causal relationship between the sectors is drawn. The
model may have single equation or multiple equations. Take the Keynesian consumption function

ya+ Bx
y= Consumption expenditure
X Income
222 Securiy Analysis and Portfolio Management

Another example that can be cited for the single equation model is the single Sharpe index modet
odel.
R= a+ BRm
R =Stock return
R= Market retum
In the above model, a deterministic or exact relationship is established. But the relationship between s
vari
is inexact. The stock retum is not decided by the market return alone. It is influenced by other ley
related factors and investor preferences. If the index returns on the horizontal axis and stock retiny
vertical axis are plotted for a period of one or two years, we would not expect all the observationsOn he
ns
exactly on the straight line because of the other influencing factors.
The modified equation for an inexact relationship between variables is given below:

R a + BR+5
, s known as the error term and is a random variable (stochastic), i.e., a variable with well-defue
probabilistic properties. The error term or disturbance term includes all the variables that affect the stosk
return but are not considered
ock
explicitly.
Macroeconomic modeling involves several sets of simultaneous equations with a multitude of
endogenou
and exogenous variables

Collection of data
Numerical data are essential for the estimation of the model. If the model is built by the
Planning Commission
to estimate the trend of economic variables like GDP, several sets of data
pertaining to employment,
industrial production, agricultural production, export, savings, investments, etc., are needed. Usually, the
data are obtained from secondary sources. In the social sciences, data are non-experimental, and there is a
possibility of observational errors, either of omission or commission. Even in an experiment type, the eror
arises due to approximations. In surveys, there is a problem of non-response.
Estimation of the parameters
The parameters have to be numerically expressed. A statistical technique, namely, regression analysis, is
commonly used to estimate the parameters. Sometimes, there may be a linear relationship between the
explanatory variables. This may distort the parameter values. For example, taking wealth as an exogenous
variable with income. Both wealth and income variables are correlated with each other. The simples
solution is to drop the factor that is correlated with other factors.
In a two-variable model, it is easy to make manual calculations. When the number of variables increas,
and the simultaneous equations to be solved are many, it is difficult to do this manually. Software package
such as Minitab, SPSS, SAS, SHAZAM, and E-VIEWS help solve them with ease.

Forecasting Once the parameters are estimated and tested for their significance, the future value or he
endogenous variable can be predicted with the help of the parameter values. Once the consumption tun
is estimated, the value of consumption can be estimated with the
given value of income. In the single dua
index model, the estimation of p helps to predict the stock return for a given index return.

Prediction Models
n and
The stock prices are predicted adopting several modes. Typically, the traditional time-series predicto
machine learning methods are used.
 zz3
Fundamental Analysis: Economic and Industry Analysis

series prediction model

to predict future values. The econometric models used in this are
T r a d i t o n a l

nethod, d. historical data are analysed most common

thsariate (simple regression) multivariate (mulivariate regression). These are the
or
eitherin econometrics to forecast the future value of variables based on past values.
toolsused function
models are used in forecasting. An autoregressive model gives the forecast as
Tessive a

values time series. In simple terms,

of
ofprevio

stock returm of n period

y.
Stock return of t-I period. It can be extended to any p order.

linear ARIMA model is a

Autoregressive integrated moving average (ARIMA) models are also used. The
ARIMA models do not
madel, which is capable of representing stationary and non-stationary time series. itself to generate forecasts.
nce independent variables, but they make use of the information in the series
Lagged variables are used to predict the variable concerned.

Mechine learning technique (MLT)

method used in prediction. The neural network has its foundation in biology.
Neural network is the common
assess information, the machines' (computers') highly
in the human brain process and
Just as neurons
in unison to solve specific problems. In MLT, computers develop
interconnected processing elements work
behaviours based on empirical data. Reasoning is automated, and with the
and design algorithms to assess
aims to use reasoning to find new and relevant information.
given background knowledge, this technique
of connected input and output units where each connection has a
In simple tems, neural network is a set
weight related to it. A neural network is characterised by the following properties:
Network type (the pattern of connections between the network layers)
Complexity (number of neurons in each layer)
Learming algorithms
Neuron activation functions
data makes them fit for
The ability of neural networks to find out the non-linear relationships in input
are developed to
predictions in the non-linear dynamic stock market. Various neural network configurations
predict the direcion of stock prices.

INDUSTRY ANALYSISS
An analysis of the performance, prospects, and problems of an industry of interest is known as industry
the direction of the and the stock market.
analysis. The economic analysis gives an indication aboutlevel of industries
economy
differ. The risk factors related to
unanustry analysis is required because the return and risk
the information technology industry. Consumer
utomobile industry are different from those related to than on the IT industry. The perfor1mance of an
ending has a greater impact on the automobile industry
ndustry reflects the performance of the companies it consists of.
of production and produce
ndustry is a group of firms that have a similar technological
structure
of industries is given in financial
rproducts. For the convenience of investors, a broad classification
and magazines. Companies are distinctly classified to give a clear picture about their manufacturing
dailies
classification given in Reserve Bank of India
R sand procucts. Table 10.2 gives the industry-wise
224 Security Analysis and Portfolio Management

Table 10.2 Industry groups

No. Industry Classification No. Industry Classification
Food products and beverages 12 Other non-metalic mineral products
Tobacco products 13 | Basic metals

3 Textiles 14 Fabricated metal products, Xcept machinery and

equipment
Clothing apparel; dressing and dyeing of fur
15 Machinery and equipment n.e.c
Luggage, handbags, sadlery, hamess and footwear,
tanning and dressing ofleather products 16 Office, accounts and computing machinery
6 Wood and wood products except furniture; articles of 17 Electrical machinery and apparatus n.e.c
straw andplatingmaterials 18 Radio, TV and communication equipment and
7 Paper and paper products apparatus
8 Publishing, printing and reproduction of recorded 19 Medical, precision and optical instruments, watches
media and clocks
9 Coke, refined petroleum products and nuclear fuel 20 Motor vehicles, trailers and semi-trailers
10 Chemicals and chemical products 21 Other transport equipment
11 Rubber and plastic products 22 Fumiture,manufacturingn.e.c
Source: RBI Bulletin, August 2012

Table 10.2 shows that every industry is different. The textile industry is entirely different from the stel
industry or the power industry in terms of its product and processes.

Kinds of Industries
to their reactions
Industries can be classified on the basis of the business cycle, i.e., classified according
to the different phases of the business cycle. They are classified as growth, cyclical, defensive, and cyclial

growth industries.

rate of earnings and growth in expansion,

Growth industry Growth industries have special features of high
independent of the business cycle. The expansion of the industrywas depends mainly on technological change
there a spurt in the growth of the alternaive
For instance, despite the recession in the global economy,
in each phase al
It defied the business cycle and continued to grow. Similarly,
energy industry in 2011-12. industries hat
colour televisions, pharmaceuticals and telecommunication
history, certain industries like
shown remarkable growth.

and profitability of an industry move in tandem with the business cy

Cyclical industry The growth suffer a setback. For example, wail
boom, industries enjoy growth and during a depression they
During a market in a boom, wnu
machine and kitchen range products command a good
goods like a fridge, washing a recession.
demand for them slackens during
2nd

cycle. For example, fooU

defensive industry defies the
movement ofthe business
The stocas
Defensive industry A withstands recessions and depressions.
needs. The food industry
shelter satisfy basic human and earmin
the investor for income earning purposes. They expand
defensive industries be held by
can nature.
counter-cyclical in
umbrella of protection, and are
the governmene's
in a depression too, under
 Fundamental Analysis: Economic and Industry Analysis 2

wth industry This is a new

type of industry that is
Cycnhe cyclical and at the same time growing. HOr
the automobile industry experiences periods of
automobilei
stagnation and decline but als0 grows
Changes in technology and introduction of new models can help the automobile industry tremendousiy.
example,
to resume 1S
growthpath.

Industry Life Cycle

jnotry life cycle theory is generally attributed to Julius Grodinsky, a professor at the Wharton School
1 , The life cycle of the industry is separated into four well defined stages
Pioneering stage
as given below:
Rapid growth stage
Maturity and stabilization stage

.Declining stage

oneering stage In this stage, the prospective demand for the

product is promising and the technology
he nroduct is low. The demand for the product encourages many producers to produce that particular
t There is severe competition and only the fittest companies survive this The producers try
develop the brand name, differentiate the product, and create a product image.stage. This leads to
moetition too. The severe competition often leads to the change of position of the fims in terms non-price
Compe
of market
chares and profits. In this situation it is difficult to select companies for investment because the survival
rate is unknown.

Rapid growth stage This stage starts with the appearance of surviving firms from the
pioneering stage.
The companies that have withstood the competition steadily improve their market share and financial
oerformance. The technology used in production improves resulting in low cost of productionand
quality products. The companies have stable growth rate in this stage and they declare dividend to good
their
shareholders. It is advisable to invest in the shares of these companies. The pharmaceutical industry has
improved its technology and the top companies in this sector are giving dividend to their shareholders. The
power and telecommunications industries can also be cited as examples of industries in this
In this stage the growth rate is more than the industry's average growth rate.
expansion stage.

Maturity and stabilization stage In the stabilization stage, the growth rate tends to moderate and the
rate of growth more or less
equals the industrial growth rate or the gross domestic product growth rate.
Symptoms of obsolescence may appear in technology. To keep going, technological innovations in the
production process and products have to be introduced. Investors must closely monitor the events that take
place in the maturity stage of the industry.

Declining stage In this stage, demand for the particular product and the earnings of the companies in the
UTy decline. Nowadays, very few consumers demand black and white television sets. Innovation and
i n consumer preferences lead to this stage. The specific feature ofthe declining stage is that even
m
aboom; the growth of the industry is low and declines at a higher rate during a recession. It is better to
nvesing in the shares of the low-growth industry even during a boom. Investment in the shares of
eypes of companies leads to erosion of capital.

Other Factors
industry life cycle analysis, an investor must also analyse factors such as those given below:
Growth of the industry
Cost structure and
profitability
226 Security Analysis and Portiolio Management
Fundamens
Nature of the product G O v e m m e n p
t o l l c y

Nature of the
competition ies affect the very nerve of the i
Government policy e m m e n t

tax e holidays are provide or

industry an

Labour govemPrOducteies
idiesand certain procu
the pricing ofcerta
Research and development SUcion and
sizeOlp r o d u c t
inconsie8of

by inconsistent govermment policies. Cor

a f i f e c t e d

indhuer
often In some cases,
Growth of the industry e ofthe
sugar
entry barrie
ofitability corporations are permit to operate only th=
The historical
wise growth is
performance of the industry in terms of growth and profitability should be ectonp, r i v a t e

policy regarding that particular industry should

published periodically by the Centre for analysed. Ind. g o v e r n i m e n tp o l i c y

in return and
growth in reaction to macroeconomic factorsMonitoring
Indian Economy. The
past ndustry. jeensinghave brou
rought immense threat to isting domestic

history may not repeat in the exact manner, by looking intoprovide an insight into the
the past growth
future. Even t variability
predict the future. The information technology industry has witnessed of the industry, an analy
of the labour scenario
tremendous growth in the
Labour

in a particular
the scrip prices
of the IT past as b ysistheir indust
industry. and thei
operating mode have an impact on labour-
known for its militant trade
Cost structure and industry is
ile unions
profitablity
The cost structure, that is the frequently, it will lead
he
to a fall in production. In an indust
proportions fixed and variable costs, affects the cost of i to losses. hen trade unions oppose the introc
profitability of the firm. In the case of the oil and natural gas industry, production an
and the iron and steel
mayle
fixed cost portion is high and the stand to lose owing to the high cost of produ
the greater is the sales volume
gestation period is also lengthy. The higher the fixed cost industry
componet
te Companymay
goodwill.
required to reach the firm's break-even o loss of customers"
reached and production is on track, point. Once the break-even point i Stiledlabour is needed for certain industries. In the -
profitability
maximum capacity is reached, capital must
can be increased by
utilizing the capacity to full.
Once the derindustries, a skilled and well-qualified labour is a
fixed costs, the easier it is to adjust to
again be invested in the fixed
equipment. Hence, the lower the RSOnS attracting multinationals to set up companies in
changing demand and to reach break-even point.
Nature of the product Research and development
The products produced by industries are r anry industry to survive the competition in the na
demanded by consumers and other industries. Demand for industrial
goods like pig iron, iron sheets, and coil, for example, comes from the construction production processes have to be technically competitive.
textile machine tools industry produces tools for the textile industry. Likewise, the or industry. Economies of scale and new markets can
health of the textile industry. Several such
industry and the entire demand depends
upon the apenditure on R&D should be studied diligently befom
examples can be cited. An investor must analyse the condition of
the feeder industry as well as the end-user
industry to assess the demand for industrial goods. Pollution standards
In the case of the consumer goods
industry, a change in consumer preference, technological innovations, Follution standards are very high and strict in the in-
and substitute products affect demand. A simple
example is the demand for ink pens, which has been demical and pharmaceutical industries that have
affected by the ball point pen as consumer preferences have sig
changed in favour of ease of use.
Nature of the competition ANALYTICAL TOOLS
Ihe strength of the industry and its
The nature of competition is an essential factor that determines the demand for a
particular product, 15 Force Model. competitiveness
profitability, and the price of the scrip concerned. The supply may arise from indigenous producers ad
multinationals. Take detergents produced by indigenous manufacturers and distributedlocally at competiie SWOT Analysis
prices. This poses a threat to the products made by a big company. Multinationals are also entering te The above
field with sophisticated product processes and better quality procducts. The company's ability to withstun SWOT) formentioned
the
factors themselves would bex
the competition locally and from the multinationals affects its earnings. If too many fims are present ake for industry. Hence, the investor shou
instance,
the organized sector, the competition will be severe. It will lead to a decline in the price of the prod
The investor, before investing in the scrip of a company, should analyse the market share of the particu
i
nmumerous playersincrea in the demand for an ind
in the market, i.e., competiud
ogress in the research
company's product and compare it with the top five companies. and development in that f
ae ionals in the industry and importso
aTanged and analyse cheap
ysed To make the industury a
and its SWOT
resul
sults presented in su
 Fundamental Analysis Economic and Industry Analysis 27

Gvemmentpollcy

nment
nolicies affect the very nerve of the
industry and the effects differ from industry to industry
T sidies and holidays
tax are provided for
export-oriented products, The
pricing of certain products. The sugar, fertilizer, and government regulates
the
dction and the prici
ected by inconsistent government policies. Control and decontrol ofpharmaceutical
industries
sugar prices affect the
t h e sugar industry. In some cases, entry barriers are placed by the government. In the airline
r a corporations are permitted to operate only the domestic flights. When selecting an industry,
ntnolicy regarding that particular industry should be carefully evaluated. Liberalization and de
AMT he brought immense threat to existing domestic industries in several sectors.
xersng.

bour
ssis of the labour scenario in a particular industry is of great importance. The number of trade
T ndtheir operating mode have an impact on labour productivity and modernization of the industry.
exile industry is known for its militant trade unions. If the trade unions are strong and strikes occur
ny it will lead to a fall in production. In an industry of high fixed costs, the stoppage of production
a d 1o losses. When trade unions oppose the introduction of automation, in the product market the
MTaTy may stand to lose owing to the high cost of production. An unhealthy labour relationship also leads
customers" goodwill.
o lass of
Galled labour is needed for certain industries. In the case of the Indian labour market, even in the IT and
her indhustries, a skilled and well-qualified labour is available at a cheaper rate. This is one of the many
rasons attracting multinationals to set up companies in India.

Research and development

For amy industry to survive the competition in the national and international markets, the product and
production processes have to be technically competitive. This depends on the R&D in the particular company
or industry. Economies of scale and new markets can be obtained only through R&D. The percentage of
cpenditure on R&D should be studied diligently before making an investment.

Pollution standards
Pollution standards very high and strict in the industrial sector. This is particularly
are in the
so leather,
chemical and pharmaceutical industries that have significant industrial effluents.

ANALYTICAL TOOLS
Te strength of the industry and its competitiveness can be analysed with help of SWOT and Porter's Five
Force Model

wOT Analysis
e above mentioned factors themselves would become strengths, weaknesses, opportunities, and threats
WOT) for the industry. Hence, the investor should carry out a SWOT analysis for the chosen industry.
aIe lor instance, increase in the demand for an industry's product becoming its strength, and the presence
AUNTOUS players in the market, i.e., competition becoming a threat to a company in the industry. The
uress in the research and development in that particular industry is an opportunity while the entry of
Onals in the industry and cheap imports of the product are a threat to it. This is the way the factors
dand analysed. To make the industry analysis more clear, the pharmaceutical industry has been
dysed and its SWOT result
presented in the subsequent section.
228 Security Analysis and Portfolio Management

Porter's Five Force Model

affects its profitability. The competitive structure differs
The competitive structure of an industry
Business School in 1979 came up with a modelfon
industry to industry. Michael E. Porter of Harvard lye
his opinion, five competitive forces decide the atrae
the competitive structure of an industry. In iveness and
profitability of an industry (Figure 10.5).
1. Entry of new compettors
2. Threat of substitutes
3. Bargaining power of suppliers
4. Bargaining power of buyers
5. Rivalry among the existing fimns

Threat of new
entry

Suppliers' Buyers'
bargaining power bargaining power

Degree of
Competition

Availability of Rivalry among the

substitutes existing firms

Figure 10.5 Porter's five forces that affect competitiveness

Entry of new competitors

The entry of new companies in the market increases the competition and reduces profitability. The bari
to entry decide the number of new entrants. Entry barriers are higher in industries like aircraft manl dustries
than in the car industry. The government rules and regulations for establishing a company in sucn e
as the steel industry may be more stringent than in others. The investment requirements to estaulisha
istance

the
company, economies of scale, switching costs, creation of distribution channels, and ress
customer
of existing players are the main barriers for an entrepreneur to start a company.
 Fundamental Analysis: Economic and Industry Analysis 229

T h r e a to fs u b s t i t u t e s

products reduces he sale of the industry's products and in turn,

ilability of substitut itute
yalan0Sd by substitutes depend on the following factors:
Thet h r e a t s p o s e c
the profitability.
Willingness ofthe buyers to utilize:substitute products
level of the substitute
The price
similarity and pertormance of the substitute
Thedegree
degree of of

The :ostincurred
switching over to substitutes
Suppliers' bargaining power

uPndustry requires raw materials for production. Suppliers may be individuals or companies that
t h e required raw materials to the firm. The cost of raw materials forms a significant portion of the
o t production.
1otalco
of If there are few suppliers, and
they are also organized as cartels, the suppliers
When there are many
bargaining power high.
is I
suppliers who are
fragmented, their bargaining power is
I . The bargaining power of the supplier is high when:
.Number of suppliers is low
There are many buyers
Products are similar and of high worth
There is the possibility of suppliers integrating forward into the industry
There is the probability of buyers integrating backwards into supply is lower
The product may be demanded by not just a single industry but by others also

Buyers'bargaining power
Here, customers of the industry's product are referred to as buyers. A strong customer can demand a higher
quality product or service for the same price. If they cannot get that, they may move over to other similar
products. Usually, the more the number of customers for the industry's product, the less their commercial
pover over it. If the mumber of producers is high, they can switch from one to the other. When the products
aTe similar and standardized, the possibility of a switch is high.

Rivalry among existing firms

h industry, all the firms try to improve their market share. If it is a fast-moving consumer
an goods industry
or the telecommunications industry, the players compete fiercely with each other to improve their market
share and keep their existing share intact. The intensity of competition depends on the
following factors
The structure of competition When there are more players, the competition is high. It is less when there
IS a market leader, and if there are cartels.

LOst structure of the industry In some industries, the fixed costs are high. To make use of unutilized
paCity, firms may cut the price of the end product. This may create a market for their products and create
problems for the other players. At the same time, if the variable costs are more than the fixed costs, the
problem of using the unutilized capacity may not arise.

Degreef differentiation Fimns in industries with similar products and specification typically face the
o
following
Comperition: Usually, coal and steel products are similar in nature.
ost of switching: If the cost of switching from one product to another is high, there will be less
mpetition. In consumer goods, the switching cost is less and hence the competition is high.
230 Security Analysis and Portiolio Management

Strutegies: The strategies followed by the competitors affect the level ot rivalry. lf they follow an
20e
growth strategy, the marketing strategy will be aggressive. This will affect the level of co
Exit barriers: When firms face
high exit barriers, the competition may be severe.
gressive
etition.
Case: To Pharma or not to Pharma
The fact that the
pharmaceutical sector outperformed the Sensex in 2010 and recorded a gain of ah
34 per cent,
making it an attractive destination for foreign direct
investment, nas about
attracted the notice
Mr Balasingh, a real estate
dealer, who is considering parking his profits in this sector. The informaice of
he has collected on this sector is
given below: mation
The Indianpharmaceutical industry was almost non-existent in 1970, but over time, it becam.
prominent provider of health care products, meeting almost all of the country's Ame a
at the beginning of the 21 pharnmaceutical ned
century. More than 60,000 formulations are produced, and they cover
nearly every therapeutic segment. Formulations are the processed medicines. The raw materials
for the
pharma industry are several organic chemicals. The chemical industry is competitive and
Companies like Orchid Chemicals and Sashun Chemicals were basically chemical companies fragmented
turned themselves into pharmaceutical that
companies. The contribution of the Indian pharma industry
accounts for 1.4 per cent of the
global pharma industry in terms of value and 10 per cent in terms of
volume. The volume of production ranks third in the world. The
year-on-year growth rate was 18 per
cent in 201.
The pharma industry is highly fragmented, with over 10,500
manufacturing units in India. The
top 10
companies contribute more than one-third of the market. The number of generic product manufacturers
is quite large. The number of foreign players investing and expanding their bases in India is increasing
tremendously. Further, India is fast becoming one of the biggest hubs for conducting global clinical
trials. The industry witnessed eight acquisitions and 17 collaborations or
partnerships in 2011
The Government of India has given permission for 100 per cent FDI in
drugs and the phama
sector to establish various pharma
Special Economic Zones across the country.
The implementation of product patents has provided a thrust to innovation and research to launch
new patented products. The expenditure incurred on R&D by the top five companies ranges between
5 and 10 per cent of revenues. The global R&D
expenditure on sales is 15-20 per cent. Even though,
English-speaking and skilled scientists are available for this sector, most of the companies have
witnessed high attrition rates. Along with employment costs, raw material costs have also increased.
According to a PricewaterhouseCoopers (PWC), the Indian pharmaceutical market is expected 0
touch US$ 74 billion in sales by 2020. The boom in sales is expected because of a large population,
increasing health care expenditure, growing urbanization, rising life expectancy, and active private secior
participation. Acconding to Mckinsey estimates, in 2025 the Indian middle class is expected to stand
at 580 million, representing an annual growth of 12 per cent. The change in lifestyles has resulted n
cardiovascular diseases, diabetes and depression. Drugs that address these complaints will continue to be
lucrative and fast growing.
Besides the domestic market, Indian pharma companies concentrate a lot on exports. The US 0 d
and Drug Administration (FDA) has stringent rules with respect to the inspection of manufacturug
plants. The market leaders have problems with regard to their plants satisfying FDA rules
evere.
Even though India is the largest supplier of generic drugs, the menace of fake drug is sev
are
Estimates show that the akes account for 15-20 per cent of the pharma industry. The fakes
common in cough syrups, vitamin supplements, painkillers, and the like.
 Fundamental Analysis Econornic and Industry Analysis 231

he aCeresive penetration of health insurance in nural and urban areas will benefit the pharma

ndustry.
It is ssaid that nearly 650 million people will have health insurance cover by 2020, and private
arnce coverage will grow by nearly 15 per cent annually until 2020.
TThe industry is controlled by a complex variety of laws and policies. The National Drug Policy, Drug
Pie Control Orders, and the Indian Patents Act, have a say on the industry. The new pharmaceutical
354 essential drugs under price control.
policyaims to bring
t h the given informmation can you analyse the industry with one or two analytical tools and help
make a decision?
Mr Balasingh

Case enalysis
The pharmaceutical industry is a fast-growing industry and considered to be one of the industries
nrpdacing essential products. The SWOT analysis is given below.
this industry are as given below:
The strengths of
.Volume of production ranks third in the world
The year-on-year growth rate was 18 per cent in 2011
More than 60,000 formulations are produced and they cover nearly every therapeutic segment
Foreign players areinvesting and expanding their bases in India
Growth in the mumber of global clinical trials in India
Large population, increasing health care expenditure
The following are the main weaknesses:
.Presence of a large number of players and a fragmented industry
Existence ofcomplex laws and policies
R&D expenditure on sales is lower in Indian companies compared to the global average
Employee cost and raw material cost have also increased
The opportunities this industry offers are as follows:
Aggressive penetration of health insurance in rural and urban areas
Growing urbanization, rising life expectancy, and active private sector participation
Increase in cardiovascular diseases, diabetes, and depression
Product patent regime
Proposal toestablish various pharma SEZs across the country
The threats this industry faces are as follows:
Existence of a fake drug industry
Stringent US FDA regulations
Proposal to bring more drugs under drug price control
According to the SWOT analysis the strength and opportunities outweigh the weaknesses and
threats. Hence, Mr Balasingh may invest a portion of his funds in the pharmaceutical industry.
Now let's adopt the Porter model and see what it throws up.

argaining power of the suppliers The raw materials for the pharma industry are several organic
emcals. The presence of heavy competition and fragmentation is common in the chemical industry.
e bargaining power of the suppliers is limited. Switching costs are low for the pharma companies.
Howeve
wEver, suppliers can plan forward integration and turn into a pharma company. For example,
 CHAPTER 11

FUNDAMENTAL ANALYSIS:
COMPANY ANALYSIS

CHAPTER QUERY
iss Arshi, a beginner in the stock market, is perplexed. As of December 2011, there are
Over 5,112 listed Indian companies on the BSE and if she narrows down her focus to
companies in the Sensex, this number is still 30. How can she select one or two companies
for investment? Even if she isolates the information technology stocks, the other companies are still
numerous. What factors should she analyse? Aseries of questions crops up in her mind

CHAPTER OBJECTIVES
To know what factors influence the value ofthe stock
To understand the importance of earmings in assessing a company
To become familiar with the various valuation techniques
To be able to analyse financial statements related to a company

In the case cited above, Arshi must evaluate the financial performance of the company before selecting its
stock. An industry consists of hundreds of companies that may be producing similar products, yet their
level of diversification, operational profits and efficiency may differ. Within an industry, companies' risk
and return profiles may vary. The difference may be marginal or wide. An investor must choose the best-
performing company from among the group for his investment. If he selects the information technology
industry, for instance, then he has to choose between companies such as Infosys, TCS, Wipro, Cognizant,
Hexaware, Mahindra, Satyam, Tech Mahindra, Oracle Fin, Rolta, Polaris, Mindtree, etc. For this, the
investor has to assimilate several bits of information related to the company and evaluate the present and
future value of the stock. The valuation process depends upon the investor's ability to look for the right
mtormation from the inter-relationships of the company variables.

COMPANY ANALYSIS
Yaluating the financial performance of a company on the basis of qualitative and quantitative factors is
Cd Compary analysis. Qualitative factors are non-quantifiable factors that represent certain aspects of
company's business. Integrating such information into evaluation of stock prices can be quite difficult.
e Same time, they cannot be ignored. The management factor is a qualitative factor. It is difficult to
e t exerts tremendous influence on the profitability, or even the existence of the company. Satyam
u c T S 1s an example of the collapse of a company because of the mismanagement of funds. Quantifiable
2% Secunty Analysis and Porttolio
Management
factors are measurable factors like
of the company. This is earnings, sales and cost of production, which directly affecs.
explained in Figure 1l1.1. ect the reene
Qualitative Factors
Quantitative Factors
Business model Earnings
Management .Competitive edge
Corporate govemance Financial leverage
.Corporate culture Operational leverage
Production efficiency
Value of the shares
Figure 11.1 Factors that affect the value of a
company's shares
QUALITATIVE FACTORS
The
qualitative factors that affect the value of a company's shares are discussed in
this section.
Business Model
The business model describes the in
way which a
company makes money. A business model may be simple
or very
complex. Even before making a financial
does. This is explained by the business model. analysis
an investor must know what
It provides a
exactly the compay
mode of revenue generation, nature of description of the company's operations a
expenses, organizational structure and its sales and marketing
A review of the business model
reveals the possible success level of the enon
Tata Motors is in the automobile sector company. For example, knowng
is not enough for an investor.
and cars. Further, Tata Motors produces truck,
they manufacture the world's cheapest car, namely, Tata Nano, which has a place
Guinness Book of World Records. Thus, it caters to the car needs of a model
ensures some large segment and the business
safety of returns.
Management
Good and capable
management teams generate
efficiently plan, organize, actuate, and control profits
for investors. The management
the activities of the The
oaiective d
management is to attain the stated objectives of the company. basie er,t
public, and the company for the good of the equi nroft
employees. If the
objectives of the company are achieved, investors will rece
management team that ignores profits does more harm to investors than one that over-empila
 237
Fundamental Analysis: Company Analysis

ublic
Every publiclimited company provides corporate information on its website. For example www.
com. under the heading Home>, gives the management profile of the ompany. On the other
com gives this information under the heading <Wipro leadership team>. Despite these
arnd. www.w

they both give a brief profile of each executive such as his employment history, educational
feachievements, and awards. All the positive aspects are detailed. For a more critical analysis the
for other sources.
to look
nestorhas

of M a n a g e m e n t Analysis
rces for management analyses such as the following:
Sources

sourc
are many
There

conference calls are hosted by the chief executive officer (CEO)

generally
.on e Calls Quarterly the call, the
ief financial officer (CFO) and sometimes involve other executives. In the first part of
aad ca
The next part consists of a question and answer session.
a s the financial results of the company. to the
imvestor. In this session, the analyst can ask direct questions
sesion is of importance to the for
This reveal facts regarding the company. The investor should listen carefully
neat. Answers may
m a n a g e m e n t .

indicate problem areas.

hfnness. Avoiding questions or giving evasive answers may
The company annual report begins with a section called Management
Mengoement discussion and analysis on the
icTiSsion andAnalysis (MD&A). In theory, it is assumed that MD&A is a frank commentaryetc. The
overview,
financial business overview,
It contains the overview,
urlook of the management. disputes.
business model, alliances, joint ventures, and judgments regarding
EView shows the company's and routine. For example,
and at other times it may be just standard
Sometimes the content revealing
is
states under the risk and concern heading
Fertilizer and Chemical Ltd in their MD&A (2010-11) fertilizer companies
Nacarjuna Now, this is common to all the
urea continues to be under the regulatory regime.
that
and does not reveal anything
new.
and accomplishments of the company. They can find out the
An investor can compare
the promises between net income
strategies. If any mention of a switch
the stated and implemented because this can
gaps berween the investor must read it carefully
made in the statement,
and gross income has been five years of MD&A can explain
the outlook of the
affect the amount of EPS. Analysing the previous
management.
it
team owns stock of the company,
of the equity stock If the management invested in the
Management ownership venture. It indicates that they
have
has confidence in their own
shows that the management shareholders' interests. It is said
with the
success. The team's
interests tend to coincide to perform
stock or more, the company likely
COmpany's future is
owns 10 per cent of the equity
if the management team
that
betier and more efficiently than its competitor.
team sells its stock,
unless it is being considered
when the managenent
he nvestor has to be cautious sale of shares by the management
Technical analysts show the purchase and towards
a sbort-selling opportunity. stock chart. Such activity reveals the attitude of the management
uwith the of flags in the
help
the company.

Corporate Governance and practices put in place by

a company to ensure

set of systems stakeholders. A

governance refers to the to safeguard the interests of the
fairness in dealings and shareholders to
Saebe , ransparency and members of the board of directors, management,
determined in the company
cludes everyone from
are defined and
CIs and practices
Enployees, and society. The system
238
Security Analysis and Portfolio
Management
charter and
by-laws, as well as in
corporate laws and regulations.
following reasons: Corporate governance iss ee.
To provide the
To
framework for the creation of
long-term trust between the
needed
for t
encourage induction of independent directors company te
To enable the with rich experience and and the ca
To facilitate a management to monitor and face risk
To ensue that
careful
decision-making process and reduce the liability
innovative ideas
akeholden
proper checks and balances are in of top management and
company management place to prevent non-ethical and illegal acti
Areas of corporate
governance
Corporate governance typically
Structure of the board of directors the following
covers areas:
Financial and information
Stakeholder rights transparency
Corporate culture
Structure of the board of directors
The board is the
highest governing authority in the management structure of
Before taking investment any public limited comna
decisions, Indian institutional investors and Flls
boards. The main
responsibility of the board of directors is to closely examine the qualitympany
of the
that their investments protect the shareholders'
yield reasonable returns. It is the board of directors which interests and ensim
dividend to be paid, recommends the stock decides the percentage t
split, monitors the buy-back offer provided by the
approves the financial statements and encourages or
discourages acquisitions and mergers. Further,companv
board selects, evaluates and te
(CEO) and other top-level executives. appropriate compensation for the compay's chief executive office
approves
Independent directors are the trustees of good corporate governance. Shareholders elect
directors, which consists of internal and external directors. the board d
Internal directors are individuals chosen from
within the company. They may be
shareholders, a CEO, CF0 or a manager. If the internal directors forma
part of the company's management team, they are known as executive directors.
not either directly or indirectly related to the Independent directors a
company and are chosen externally.
Realizing the importance of independent directors, SEBI has made it mandatory for listed entities
at least 50 per cent of their to hae
representation on the board of directors in case the chairman is an execute
member, or at least one-third in case thechairman is a non-executive member. The annual report of ue
company gives a clear overview of the independent directors.

Financial and information transparency

Financial transparency in the reports is vital for the investor as it enables him to assess the performan
of the company. Transparency enables the board of directors to evaluate the management's
pertorman
effectiveness. It helps them take early corrective action, when necessary, and prevent deteriorati are
the financial condition of a company. Consistent accounting standards and comparable pracue
ts and
necessary for an investor to take informed decisions. If the company has a diversified range of prou
subsidiary companies, the income earned from different sources should be clearly mentioned. wilh
three subsidiaries may be made good by another subsidiary. Investors should be able to find tnisa
ease while going through the reports of the company.
 Fundamental Analysis: Company Analysis 239

Stakeholderrights
nay with.
A company with a high-quality corporate governance ensures that its policies benefit stakeholder interests,
shareholder interests. If shareholders have apprehensions in company-rela matters such as
particularly

acquisition, they should be able to approach the board of directors. A company with strong
ergers or acqu
nance provides voting rights to shareholders to call meetings to discuss important issues with
corporate goverman

This helps estors to present their concerns over an issue.

che board

Corporate culture
orate culture refers to the collective beliefs, value systems and processes of a company. It gives a
Corporate culture

eerupany a unique entity. Every company has a set of values and goals that helps to define what the business
i all about. The basis of corporate culhure is usually expressed in terms of the policies and procedures
adoted in the company's functioning. A strong corporate culture that enables adaptation to a changing
market leads to strong financial results. A corporate culture that values employees, customers and owners
and encourages leadership from everyone in the company, is bound to perform well. If the customer needs
change, a fim's corporate culture changes its practices to meet these new needs. An example of the
coporate culture of Wipro as revealed in the Spirit of Wipro, taken from www.wipro.com, is given below.

Make customers successful Team, Innovate, Excel

This is the desire to stretch, to achieve that which seems beyond our grasp. This is aiming for
maximum. This is the ardor to do our best, the hunger to be the best. This is the devotion to
challenging Our limits, it is about realizing our pótential and about expanding our potential.
I t is not about winning at all costs. It is not about winning every time. It is not about winming at
the expense of others,
It is about working together to create synergy. It is realizing that I win when my team wins; my
team wins when Wipro wins; and Wipro wins when its customers win, when its stakeholders
win.
I t is about innovating all the time. It is a continuous endeavour to do better than last time.
Iis the Spirit of fortitude, the Spirit of never letting go... ever

dn QUANTITATIVE FACTORS
What follows is a discussion of the quantitative factors that influence stock values.

Earnings of the Company

The earnings of a company decide its stock value in the market. The company pays dividends from its
carnings. Growing earnings result in high valuation of the stock. Sometimes, the prices of a stock may be
hugh but nor the earnings. This is because the market anticipates a future rise in the earnings ofthe company
n simple terms, earnings are the operating profits of a company. The income for a company is generated
atrugh operating sources and non-operating sources. The sources of operating income vary from industry
o ndustry. For the service industry no tangible product is involved and income is generated through the sale
ervices. Take the case of commercial bank; its income is the interest on loans and investments. Interest
come is referred to as the operating income. But in the case of industries producing tangible go0ds,
earnings arise from the sale of goods.
240
Security Analysis and Portfolio Management

Company may derive revenue from sources other than sales. The non-operating income
generated from interest from bonds, rentals from lease, dividends from securities, ands ma
sale of assets.
nvestor should analyse the income source diligently to know whether it 1s from the sale of assets or
vestments, Sometimes, earning per share may seem to be atractive in a particular year but ina frorm
the revenue
generated through sales may be comparatively lower than n the previous year. Theea actual
nignt have been generated through the sale of assets. An investor should be aware that the
income
company may vary due to the following reasons:
Change in sales
Change in costs
Depreciation method adopted
Depletion of resources in the case of oil, mining, forest products, gas, etc.
Inventory accounting method
Replacement cost of inventories
Wages, salaries and fringe benefits
Income tax and other taxes

Measurement of Earnings
A company's earnings are measured as follows:

Gross Profit = Sales - cost of goods sold

EBITDA (Earning before interest, taxes, depreciation and amortization)
=
Gross profit operating expenses
EBIT (Earnings before interest and tax) = EBITDA - (depreciation and amortization)
EAT (Earnings after tax) = EBIT - tax

Net income decides the cash flow and is of primary concern to an investor because it shows the heæ
of a company.

Earnings per share

Earnings give an overall picture of the financial performance of a company. Yet for a comparative analy
it may be misleading. Take for instance, the earnings of Omega and Vega companies. Omega has
million and Vega has {150 million in eamings, employing the same amount of capital. Omega's earmi
are greater than that of Vega. Should we conclude that Omega is doing better than Vega? This is incon
from the point of view of the investor, because the number of outstanding shares may be different for
two companies. If the number of outstanding shares is 100 million for Omega and 60 million for Vega
Vega shares reward the investor more than the Omega shares (Omega EPS = 200/100 = 2; Vega EPs

150/60=2.5).
Earnings per share (EPS) are calculated as the earnings after tax divided by the number of comu
shares outstanding.

Net Incomne Dividends on Preferred Stocks

EPS=
Average Outstanding Share
standi

For accuracy, the average outstanding shares is used. It is a weighted average number of shares ou1
riod.
over the reporting period. The number of shares may change in any part of the accounting P
 Fundamental Analysis: Company Analysis 241

ay issue new shares or coersion ofwarranty or debenture into equity may happen. Sometimes,
hares may be reduced through buyback. Factors that affect the number of outstanding shares are
equity

listed below.

Stock options
Conversion of warrants
Convertible preferred stock
Secondary equity offerings
Bonus and right issue to existing shareholders
Share split
(consolidation of shares)
Reverse share split

Thic requires additional calculation. For example, Omega Company has 10 lakh outstanding common
haresfor eight months and has 12 lakh outstanding shares for the remaining four months due to afollow
The weight for 10,00,00 shares would be 8/12(0.77) and the weight for 12,00,000 shares would
onoffer.
be 4/12(0.33).
The weighted average of outstanding shares for Omega
= (0.77 x 10) + (0.33 x 12) = 7.7 + 3.96 = 11.66 lakh

Diluted earnings per share

Ifa company issues convertible bonds,
An investor must consider diluted EPS when evaluating companies.
in the number of equity shares. This will result
debentures or stock options, there is a chance of an increase
is the EPS of a company after the
in a low EPS for existing shareholders. A diluted earnings per share
shareholder's
conversion of all convertible securities into shares. This provides clear picture to the equity
a

earnings when he invests in a company.

In
Example Omega earns a net profit of 200 million, and it has 100 million common shares outstanding.
addition, there are R100 million convertible bonds that have a 9 per cent interest rate. The bonds potentially
10 million of Omega's common shares. Omega's tax rate is 40 per cent. Table 1.1 shows the
convert to
compilation of its diluted earnings per share.
Table 11.1 Diluted EPS for Omega (in millions)
Net profit T200
+Interest saved on T10 m bond at 9 per cent 79.0
3.6
-Reduced tax savings on foregone interest expense
Adjusted net eanings 205.4
100.0
Common shares outstanding

+Potential converted shares 10.0

110.0
Adjusted shares outstanding
Diluted earnings per share 1.87
F205.4 /110)
e t the conversion of bonds into share, the EPS is 1.87. Previously, EPS was 2.
 242 Security Analysis and Portolio Management

Growth in earnings
The growth in earnings influences the value ofstock. This depends on the earnings retained
in the firm. and
.The rate of return on equity also influences the growth rate. This analysis is known as D Kemvese
because it was popularized by DuPont company. Ont analy
Growth rate = RR x
Sales Total assets (TA) Net income (NI)
X
Total assets (TA) Equity (EQ Sales

Crowth rate Retention rate x Return on equity

The same can be rewritten as follows:
=
RR x ROE

Sales
Growth rate = RR X X TA NI
TA EQ Sales
RR =
Retained eamings/Net income =
RE/NI
Substituting and rearranging we get
Growth rate = RE NI Sales TA RE
X
NI Sales TA EQ EQ
Lerner and Carleton model
Lerner and Carleton have given a model for the EPS.
(1-T) [R + (R - 1) L/ EJE
EPS
Number of common shares outstanding

EPS Earnings per share

T -

Effective tax rate (Tax exposure/EBT)

R -

Before tax return on assets (EBIT/A)

I Effective interest rate (interest
L - Total liabilities expense/liabilities)
E - Equity

The model gives a

comprehensive outlook of the earnings per share. According to the model the earnu
per share are affected by the following factors:
Utilization of assets in the company
Margin on sales
Effective cost of the borrowed funds
Debt-equity ratio
Equity base of the company
Effective tax rate paid by the company

Price earnings multiples

One of the most common financial
parameters used in the stock market is the
the price-earnings
relates the share price to the
earnings per share. Most newspapers give the P/E price-earnings ratio
rau (P/E).
ratio along wu
 Fundamental Analysls: Company Analysis 243
n The P/E ratio is the multiplying factor that
p i cq
eu o t a t i o
the market is willing to offer the company
earning. Ifthe earnings per share of company A is 6 and
to
A n u r e .
its price 50, then:

Market price per share

Price-carnings ratio =

Earnings per share

750
-= 8.33 times
R6

niE value of 8.33 means that an investor is

prepared to pay 8.33
for every rupee of future earnings.
famance is the base for the estimate. A
high P/E ratio
indicates high expectation of the market
ing the growth of the company's future
earnings. The P/E
ratio is linked to other financial
dividend payout, dividend growth rate and the cost of the company's funds. Large dividendparameters
hich dividend growth rates and low cost of funds will result in high P/E ratios. payouts,
Investors generally compare the PiE ratio of the company with that of the industry and the market. When
he P/E ratio value is lower than that for the
industry; it means the stock is underpriced. Investors should be
earefil in comparing scrip's
a P/E with the
industry's P/E because sometimes the industry P/E be high
hecause of an overheated market. In Such a situation, the industry's P/E should be moderated tomay
levels, The investor can also forecast the future PIE ratio and compare it with the current P/E to acceptable
assess the
ertent of underpricing of the particular share. The forecasting can be done by studying fundamental factors
and applying statistical techniques using past P/E data. The comparison of the estimated P/E ratio with the
actual P/E ratio would lead to one of three conclusions as given below:
If the current P/E ratio is bigger than the expected (P/E) ratio, the stock is overpriced. It is better to sell
the shares before the fall in price.
If the current P/E ratio is smaller than the expected (P/E) ratio, the stock is underpriced and it could be
best buy with the expectation of a rise in prices.
a
If the current P/E ratio equals the expected (P/E) ratio, the stock is correctly priced. No significant
changes in prices are likely to occur.

Intrinslc value
The true economic worth of a share is its intrinsic value. Analysts can determine the intrinsic value of a
share by using the following formula:
Intrinsic
value of a share Normalized EPS x Expected P/E ratio
=

The expected P/E ratio can be calculated as

Cash dividend/ E (EPS)_ D/E (EPS)

E (PIE) =
Discount rate growth rate K-8
The numerator is:
ayout ratio Cash dividend per share/Expected earnings per share = D/E (EPS)
0 Torecast the P/E, the analyst should have the following details:
Stock's risk-adjusted discount rate (K)
Growth rate (g)
Cash dividend per share
(D)
44 Secuity Analysis and Portolio Managemet

Eamings per share (EPS)

Payut ratio (D/E)

ASimple technique adopted by analysts is as follows:

Intrinsic value= Average P/E ratio over the years X Present earnings per share
Average P/BV ratio over the years X Present book value per share

This calculation is hased on the following assumptions

The trend in profitability of the immediate past and the present will continue in future
The average P/E, P/BV, and average earnings-to-equity ratio will remain constant overa
time

Financial Leverag
The degree of utilization of borrowed money in a business is known as financial leverage. This derend
pends
the financing decisions of the company. These decisions involve the selection of the appropriate fim
mix and deciding the capital structure or leverage. Capital structure refers to the proportion of lon inancn
debt capital and equity capital in the company. The long-term debt capital includes bonds, debentir
and preference share capital. A fixed rate ofinterest has to be paid for long-term debt capital and pamet
obligatory. Ahigh degree of financial leverage (high usage of debt capital) results in high interestperae
This will affect the bottom-line earnings per share negatively. As a company increases debt and prefere
cquities, interest payments increase. This reduces the EPS and increases the risk of stock retums
The leverage effect of debt is highly advantageous to equity holders during a boom because the posite
side ofthe leverage effect increases the eamings of shareholders. At the same time, during arecesiaa
leverage effect induces insability in eamings per share and can lead to bankruptcy. Hence, it s inpur
to
limit the
debt component of the capital and keep it to a reasonable level. The limit depends ontheimi
earning capacity and its fixed assets.

Earmings limit of debt

The earnings determine whether the debt is excessive or not. The earnings indicate the probabiliy d
insolvency. The ratio used to find the limit of the debt is the interest coverage ratio, i.e., the raioofm
income taxestointerest paid on debt. The ratio shows the firm's ability to pay the interest charges a
after
the number of times interest is covered by earnings.

Asset limit to debt

This asset limit is found out bylookingatthe fixed assets to debt ratio. The financing of fixed assets ty
should be within a reasonable limit. For industrial units, the recommended ratio is below 0.5.

Degree of financlal leverage

According to Brigham in 1995, the degree of financial leverage (DFL) is the percentage changein aearnng
per share (EPs) that results from a given percentage change in earnings before interest and taxes(

Percentage change in EPS

DFL=
Percentage change in EBIT
 245
Fundamental Analysis: Cornpany Analysis

calculated with the following formula.

can
be
o rii

EBIT

DFL= EBIT Interest

means that a 100 per cent increase in EBIT will result in a 158 per cent increase in
is 8, it n
theDFL
carmingsp e rShare.

Ameoa's Curent production of personal care products is worth 785 million annually. The company's
poampeafsales are 45 per cent of sales, and its fixed costs are R28 million. The company's annual interest
a r i a b l ec o s t

million annually. If we increase Omega's EBIT by 20 per cent, how much will the company's
erpenseisS
E P Si n c r e a s e ?

company's DFL is calculated as follows:

ution The
Soluti

EBIT
DFL EBIT Interest

85-(38.25 + 28)
.= 1.36
DFL 85-(38.5 + 28 + 5)

have the DFL. Using the DFL value, one can find the percentage increase in the EPS.
Now, we

Percentage change in EPS

DFL
Percentage change in EBIT

Percentage change in EPS 27.2%

1.36
20

Given the company's 20 per cent increase in EBIT, the DFL indicates EPS will increase 27.2 per cent.

Operating Leverage the firm is said to have a high degree of operating

a firm's fixed costs are a major portion of total costs,
with little force. A high degree of
eage. Leverage means the use of a lever to raise a heavy object in a
a relatively small change in sales results
rating leverage implies that, other factors being constant,
with the help of the following example.
"nange in return on equity. This can be explainedsmall amount of fixed charges, say, 40,000. It also
US take firms A and B. Firm A has a relatively and maintenance costs are low. The variable
D have much automated equipment, so its depreciation automated equipment.
entage is higher than it would be if the firm used more
n Here the firm uses automated equipment
other case, firm B has high fixed costs of 120,000. extent. The break-even
so one
operator can turn out many units for the sanme labour cost) to a much larger is variable cost
B. The selling price (P) R4; the
u n i t s in firm A and at 60,000 units in firm
for firm A andoccurs
The break-even 2 for when
firm the
B return
unit.on equity (ROE) = 0, and hence, when EBIT = 0.
per
246 Security Analysis and Portfolio Management

EBIT =0 = PQ - VQ - F

Here, P is the average sales price per unit of output, Q is units of output, V is the
variable cost
st n
Fis the fixed operating costs. The break-even per unit
quantity is ara

P-V
For Firms A and B this is:

A
40,000 = 40,000 units
4 3
B
B
1,20,000
4 2
60,000 units

To a large extent, operating

leverage is determined by technology. For example, telephone companies
iron and steel companies, and electric utilities have
heavy investments in fixed assets leading to high fue
costs and operating leverage. On the other hand, cosmetic
companies and consumer goods companies ma
need significantly lower fixed costs, and hence lower
operating leverage.
The investor should understand the
operating leverage of the firm because the firm with high operatig
leverage is affected significantly by the cyclical decline. The operating efficiency of the firm
profit expectations of the company. determines th

Competitive Edge
Major industries in India are composed of hundreds of individual companies. In the information technolog
industry, even though the number of companies is large, a few companies like TCS, Infosys and Wipro(),
control the major market share. Likewise in other industries, where some
eminence and dominance. The large companies are successful in
companies rise to a posihon a
meeting the competition. Once compans
attain a leadership position in the market, they seldom lose it. Over
time, they prove their ability
withstand the competition and retain a sizeable share of the market. The competitiveness of a company u
be assessed by looking at the following aspects:
Market share
Growth of annual sales
Stability of annual sales

Market share
in
The market share of annual sales helps determine a company's relative competitive position witm
industry. If the market share is high, the company would be able to meet the competition sucessfuly
information technology industry, the top 10 companies had over 95 per cent ofthe market share oIndian
s
IT services industry (excluding hardware) in 201. Among them, TCS had accounted for 25 per cenl
18 per cent, Wipro 15 per cent and Cognizant 13 per cent. While analysing the market share,the si
company should also be considered because smaller companies may find it difficult to survive inu
leading companies of today's market will continue to lead, at least in the near future. Acompariso
be made of companies with similar product groups or the results could be misleading. A software
should be compared with other software companies when selecting the best in that industry.
 247
Fundamental Analysis: Company Analysis

Growthof
sales

Wn be a leading one, but if the growth in sales is comparatively lower than that of anotner

dicate an erosion of the company's lead. A company with rapid growth in sales is better for
A onmpany

c a a n p a n y I
, ti n d i c a t e ;

rate. Investors the a

shareholderst h a n o n e
one with a stagnant growth prefer a large company because bigger
heter its
its ability to withstand business cycles. At the same time, shareholders will not be keen
beter
the
companympaay with inadequate sales growth. Growth in sales is usually followed by growth in profits
Com
latter is
naath in sales of a company 1S analysed both in rupee terms and in physical terms. The
1 Pnt because it shows growth in real terms. Sales growth in rupee terms is affected by intlaton.
diversified sales are compared in rupee terms and in terms of percentage of growth over
with
e r y
i m p o r t a t

Companies

Stabilityofsales
constant, will have more stable earnings. Wide variations
i t h stable sales revenue, other things being All financial newspapers
A ead to variations in capacity utilization, financial planning, and dividends.in an The fall in
periodically provide iinformation about the market share of different companies
n sales industry.
trend for the company, even if the sales are stable in absolute terms.
et shares indicate a declining market shares.
of sales should be compared with market shares as also the competitors'
the stability
Hence

Sales forecast
a Superior poSition commanding more sales
both in monetary and physical terms
may be in
ACompany furure. For this purpose, he needs to
hut the investor
should have an idea of whether this will continue in
can be done in the following ways:
forecast sales. This
either linear or non-linear, whichever is suitable.
By fitting a trend line, sales to industry sales. Even simple least square technique
By analysing historical percentages ofcompany sales.
f(ls), where Cs company sales, and Is industry
=
=
function Cs
could be used to determine the
=

macroeconomic variables like gross domestic product, per capita

By comparing sales growth with
income, and population growth. demand may arise
of demand for the company's product since
By analysing the different components demand may come from consumers as well
as from industry.
from different sources. For some products, industries.
demanded by consumers and
for example, steel and petroleum products are
the least square techniques.
and the competitors' product, using
'By analysing demand for the substitutes
Production Efficiency at minimum cost per unit of output. This
UCiOn efficiency producing the maximum output means
is performing. Increasing efficiency
or transformation process
CIEDcy measures how well the production All businesses
without any change in the number of inputs employed.
sthe capacity of a business, important fora growing
business. To withstand
y to operate efficiently. However, this is particularly to survive successfully in the
as its main competitors
business be at least as efficient
petinion, a must
a lower cost than competitors
the firm to produce goods at
Eificient production efficiency enables An expanding company that maintains high operating
ecienency withore profit possibly at lower prices. with a high break-even point. This
more than the company
a low break-even point earns
an increase in production
mately benefits the form of high earnings per share. Thus,
eficiecets the investor in
ticiency results in the following
Increase in profitability
Low operational costs
Opt use of
company resources
250 Security Analysis and Portfolio Management
Its shortcomings are as follows:
I t is time consuming.
Accrual distortions related to depreciation and amortization affect the measurement.
I t is applicable only to the period for which it is calculated.
I t does not predict the future.
Hybrid Valuation Models
There are three broad approaches to estimate the value of the company-the income
approach, the
basedapproach,and the market approach. Income approach makes use of capitalization and the di
cash flows models. Variables used in this approach are earnings or scouned
cash flows because
they indicaa
expectations of the shareholders.
The asset-based approach is mainly about the determination of company's assets value in
total. Valhee d
both assets and liabilities are restated to their current values to arrive at a net asset value.
The restatemeu
may be made either for individual components of the asset or collectively. It is difficult to value
a variev
assets such as real estate, machinery and
equipment, and inventory. Valuation specialists are emploved m
value them. The hybrid model is a derivative of the other
of the other two approaches. In the income and asset-based
two approaches. The hybrid model is a derivatiw
approaches, each has its own
advantages and weaknesses, the hybrid model that utilizes a combination of income and comparatie
may be superior as a valuation model. The hybrid model uses the
asset-based dan
the P/E and book values of similar
regression technique for analysis. It tuks
companies in the industry and regress it against the market value of the
companies. The estimated coefficients are used for the calculation of the valuation of the
company.
Relative Valuation Models
The relative valuation method is asimple way for investors to discover low-priced companies with strong
fundamentals. The concept behind relative valuation is
similar companies' market values. Ratios such as the analysing
the market value ofa company in relation to
before interest, depreciation and amortization
price earnings ratio (P/E), enterpris value to earning
find the relative worth and (EV/EBITDA) and price-to-book ratio are computed n
performance of companies. This
opportunities. The steps involved in this method are as follows: helps investor to identify buy-and-el|
the
Preparation of a list of comparable companies, often industry peers with their market values.
Conversion of market values into trading
multiples such as P/E, price-to-book, enterprise value af
company to sales and enterprise value to earnings before
interest,multiples
Comparison of a company's multiples with similar companies' depreciation and amortization.
to assess the valuation or u
company. This reveals whether the company is undervalued or
overvalued.
FINANCIAL ANALYSIS
The best source of financial information
about a company is its own financial
source of information for statements. This is a pr imary
evaluating the investment prospects in a company's stock. Financial
ement
analysis is the study of a company's financial statement from various viewpoints. The statement
stac
historical and current information about the ghelps 0
predict the future. The current information aidscompany's operations. Historical financial statement
in analysing the man
statements used in the analysis are: present status of the company. 1
Balance sheet
Profit and loss account
 251
Fundamental Analysis: Company Analysis

B a l a n c eS h e e t

cheet shows all of a company's sources of funds (liabilities and stockholders' equity) and usSes
The balane
given point in time. The balance sheet can either be in the horizontal or vertical form. Tables
at a given
f fun .5
show the
the balance
Show balance sheet of sky Company in horizontal and vertical forms.
and
1.4
Table 11.4 Balance Sheet of Sky Ltd as on 31 March 2012
horizontal form (in lakh rupees)

Llabilities
2012 2011 Assets 2012 2011

Sharecapital:
Fixed assets less
10,000 20,000 Depreciation 1,20,000 1,10,000
Equity 20,000 10,000 Current assets:
Prelerence

Reserves and surplus 30,000 30,000 Inventories 44,000 40,000

Profit Loss account 49,825 40,000 Sundry debtors 33,025 30,000
Loan tunds: Marketable securities 10,800 15,000
12% Debentures 38,000 40,000
19,000 20,000 Cash 8,000 5,000
Term loans
Curent liabilties

Bls payable 9,000 8,000

Sundry creditors 15,000 12,000
Other current liabilities 25,000 20,000

2,15,825 2,00,000 2,15,825 2,00,000

Table 11.5 Balance Sheet of Sky Ltd as on 31 March 2012

vertical form (in lakh rupees)
I.Sources of funds
(1) Shareholders' funds:
(a) Equity capital 20,000
(b) Preference capital 10,000
(c) Reserves& surplus 30,000
(d) P/L account 49,825 1,09,825
(2) Loan funds:
(a) 12% Debentures 38,000
(6) Term loans 19,000 57,000
Total 1,66,825
IL Application of funds
(1) Fixed assets 1,20,000
(2) Current assets
a Inventories 44,000
(6) Sundry debtors 33,025
c) Securities 10,800
(d) Cash 8,000 95825
(3) Less: Curent liabilities
(a) Bills payable 9,000
(6) Sundry creditors 15,000
(c) Other current liabilities 25,000 49,000
(d) Net Working capital 46,825
Total 1,66,825
252
Security Analysis and Portfolio
Management
The balance sheet
outstanding provides an account of the capital structure
long-term
of cost and market debt are known from
the balance sheet.
of the
company. The
acceptability. The use of debt The debt has certain net un
shareholders depending on the size creates financial
leverage beneficial oradvantaoand
amount of debt can be and stability of
carried and it is beneficial to earnings. If revenues are stable detrimtem
should be low in the the shareholder. If and certoto
better for the investorcapital structure, so that the
to avoida of
the
earnings
payment interest is not detrimental fluctat la
the balance
sheet, the company with an excessive debt to sharekhle
de
assets and current liquidity position of the company can
component
also be assessed with in its capital struch
liabilities. The overall the
ability to pay its short-term
obligations information o HE
Profit and Loss can be found O
Account out.
Analysis of the financial condition of the
statement reports the flow of company
funds from business requires report on the flow of funds
a
lists the items of operations that take place between two too. The:income
income and
profit or loss expenditure.
for the period. It is The difference between the income and points of i
also called income
Sky Ltd is given in Table 11.5. The and expenditure renTe
expenditure statement. Profit
These are listed below: investor should be aware of the limitations of and loss ar
The financial the financial statem
statements contain historical
should be concerned more information.
about the present and future. This information is useful; but an
Financial statements are investor
investor should know them.prepared on the basis of certain
accounting concepts and
The statements contain
only
conventions, AnAa
information
incurred by a firm due to flood or that can be measured in monetary units.
fire is included because it For example,
the loss incurred
by the can be
expressed in
the los
company due to the loss of monetary tems. B
cannot be measured in
monetary units. reputation is not given in the statement
Sometimes, management may resort to because i
Charging depreciation manipulation of data and window
dressing in the following wayg
Valuation of inventory
Revaluation of fixed assets
Changing of the accounting year
An investor should scrutinize
the financial statements to
report and notes to the balance sheet find out the
give vital clues to the investor inmanipulations, if any. The auditos
statements should be undertaken this regard. Analysis of financia
only after nullifying the effects of such
any manipulation.
Analysis of Financial Statements
The analysis of financial statements
reveals the nature of the
and the sources and
application of funds. The investor relationship between income and expendinurs
of the company determines the financial position and the
through analysis. The investor is interested in the progre
about the profitability and the yield and safety of his capital. He cap
management's policy regarding dividends. Towards this end, he can u
the
following simple analysis:
Comparative financial statements
Trend analysis
Common size statements
Fund flow analysis
Cash flow analysis
Ratio analysis
 253
Fundamental Analysis Company Analysis

arative financíal statement

arative
statement pvides balance sheet figures for more than one year. The statement proNdes
spective ato the balance sheet figures. The annual data are compared with similar data of previous
T h ec o m p a r a

a t i n ep e
absolute terms or in percentages.
ther in
ears,

r e n da n a y s i s

are
Iculated
calcu with a base year. This provides insight into the growth or decline of the
percentages
Here. years. Sometimes, sales may be increasing continuousily, and the inventories may also
o v e r the yea
or profit
aeofThis would indicate the loss of market share of the particular company's product. Likewise, sales
e rising.This
trend but profts may remain the same. Here, the investor has to look into the cost
increasing
anagement
efficiency of the company
and

Common size statement

size balance sheet shows the percentage of each asset item to the total assets and each liability
Con thetotal liabilities. Similarly, a common size income statement shows each item of expense as a
two different size
ercentage ofnet:Sales. With common size statements comparisons can be made between
item

over
c helonging to the same industry. A common size statement can be prepared for the
same company
s
11.8 gives the common size statement for Sky Ltd.
Table 11.8
e years.
Fund fiow analysis
the
The balance sheet gives picture
a static of the company's position on a particular date. It does not reveal
occurred in the financial poSition of the unit over a period of time. The investor should
changes that have
know the following:
How are the profits utilized
Financial source of dividends
Source of finance for capital expenditures
Source of finance for repayment of debt
Destiny ofthe sale proceeds of the fixed assets
Use of the proceeds of the share or debenture issue or fixed deposits raised from the public

This information is provided in the funds flow statement. It is a statement of the sources and applications
of funds. It highlights the changes in the financial condition of a business enterprise between two balance
sheet dates. The investor can clearly see the amount of funds generated or lost in operations. He can see how
these funds have been divided into three significant uses such as taxes, dividends and reserves. Moreover,
the application of long-term funds towards the acquisition of current assets can be found out. This will reveal
the real picture of the financial position of the company.

Cash flow analysis

ne investor is interested in knowing the cash inflow and outflow of the enterprise. The cash flow statement
It can
some additional information.
prepared with the help of the balance sheet, the income statement andflows
prepared either in the vertical form or in the horizontal form. Cash related to operations and other
are calculated. The statement shows the causes of changes in cash balance between two
balance
dons
Dect dates. With the help of this statement the investor can review the cash movements over an operating
le. 1actors responsible for the reduction of cash balances in spite of increase in profits or vice
versa
an Annual Report
out. An example of Tata Consultancy Service's cash flow statement from its
2000
0is given in Table 11.6. This clearly shows the flow of cash from various activities.
254 Security Analysis and Porttolio Management

2010
Table 11.6 Cash flow statement of TCS, 31 March
Schedule 2010
Kin crores 2009
n crores
CASH FLOWS FROM OPERATING ACTIVITIES
Profit belore tares 6370.38
5139 6
Adjustment for
Depreciation 469.35
Provision for doubthul advances 2.52 411745
Provision tor doubtful debts 152.94 615
Diminion in value of long-tem investments
40.3
(4.50
Interest expense 9.54
Loss/ (Proft) on sale offixed assets (net)
7.44
2.81 (8.27
Profit from sale of long term investment (1.15)
Unrealized exchange loss / (gain) 2.59
Exchange diference on translation of foreign curency cash and cash equivalents (11.72
(14.18) (1821)
Dividend income
(15.99) (127.85
Interest income
(196.69) 82.24)
Profit on sale of mutual funds and other current investments (net)
Operating Proft before working capltal changes
(148.41) (489)
6629.21 5313.80
hventories 10.17 024
Unbilled revenues
164.15 53.12
Sundry debtors
169.79 68.08
Loans and advances
Curent liabilibes and provisions
(144.51) (198.73)
Cash generated from operations
608.33 476.39
7437.14 5712.90
Taxes paid
Net cash provided by operating activities (172.40) (79.-42)
2. CASH FLOWS FROM INVESTING ACTIvIMES 6264.74 4913.48

Purchase of fixed assets (Reter note 28 to Schedule Q.

page 170) (822.15) (1001.70)
Proceeds from sale of fued assets
Adjustment of purchase consideration 5.88 45.45
Purchase of trade investments 45.67
Proceeds from sale / transfer of trade investments (1200.00) (2451.98
Purchase of mutual fund and other investments 4.80
Sale of mutual funds and other (53197.89) (28973.50
investments
Loans given to subsidiaries 52633.26 30047.15
(75.36)
Loans repaid by subsidiarles (33.88)
123.28 46.08
Inter-corporate deposits placed
(170.00
Inter-corporate deposits refunded (224.00)
Fixed deposit with banks 90.0
(net) having original maturity over three months 39.00
Dividends received from subsidiarles (935.00
(2037.81) 8.52
Dividends received from other investments 11.62 119.3
Interest receed 4.37
65.06
Net cash used in
investing activities 01.21 3185.34

4556.64
 Fundamontal Analysis: Company Analysis 255

Table 11.6 Contd..

Schedule 2010 2009
incrores In crores

CASH
FLOWS FROM FINANCING ACTIVITIES
5.88
Borowings(net) (5.30)
dlvidend tax (1602.88)
Dhidendpald, including (1954.57)
Interestpaid (9.78) (7.-49)
used in financing activities (1969.65) (1604.49)
Nat cash
Increase in cash and cash
equivalents (261.55) 123.65
Net decrease/
at baginning of the year 540.65 398.79
Cash and cash equivalents
nslation of foreign currency cash and cash equivalents 18.21
Exchange diferen 14.18
at end of the year 293.28 540.65
Cash and cash equivalents
over three months 3097.97 1060.16
Deposits with original maturity
Restricled cash 4.91 4.45
Cash and bankbalance at the end ofthe year as per
schedule 3396.16 1605.26

and the profit and loss account of Sky Ltd are given in Table 11.7.
Example The balance sheet (Table 11.4)
As an investor in the company's scrips,
you can prepare the following for analysis:
Common size balance sheet
Funds flowstatement
Cash flow statement

Table 11.7 Profit and loss account of Sky Ltd as on 31 March 2012 (R in lakh)

2, 40,000
Net sales
Less: Cost of goods sold 1, 40,000
35,000
Selling expenses
Administrative expenses 25,000
8,350 2.08.350
Interest
31,650
Prolit before tax
15.825
LessIncome tax50% 15,825
Profit ater tax
1.000
Preference dividend 14,825
Net profit available to equity shareholders
S.000
Les: Dvidend to equity shareholders
9.825
Retained earnings
d goods includes preciation amount: 10,000
256 Security Analysis and Portfolio Management
Table 11.8 Common size balance sheet of Sky Ltd as on 31 March 2012 ( in lakh
Particulars As on 31.03.2012 As on 31.03.2011
Amount Per cent total Amount Per cent total
Capital and Reserves:
Share capital 20,000 9.3 10,000 5.0
Preterence capital 10,000 4.6 20,000 10.0
Reserves 30,000 13.9 30,000 15.0
PL account 49,825 23.1 40,000 20.0
1,09,825 50.9 50.0
Long-term debt
12% debentures 38,000 17.6 40,000 20.0
Tem loans 19,000 8.8 20,000 10.0
57,000 26.4 60,000 30.0
Curent liabilies:
Bils payable 9,000 41 8,000 4.0
Sundry creditors 15,000 7.0 12,000 6.0
Other curent liabilities 25,000 11.6 20,000 10.0
49,000 22.7 40,000 20.0
Total 2,15,825 100% 100,000 100%
Assets
Current assets:
Cash 8,000 3.7 5,000 2.5
Investment 10,800 5.0 15,000 7.5
Debtors 33,025 15.3 30,000 15.0
Inventory 44,000 20.4 40,000 20.0
Total current assets 95,825 44.4 90,000 45.0
Fixed Assets:
Gross fixed assets 2,40,000 2,20,000
Less: Accumulated depreciation 120,000 1,10,000
1,20,000 55.6 1,10,000 55.0
Total 2,15,825 100% 2,00,000 100%
Table 11.9 Statement of changes in working capital (WC)
Particulars 2011 2012 Change In WC
Increase Decrease
Current assets:
Cash 5,000 8,000 3,000
Investments (short-term) 15,000 10,800 4,200
Debtors 30,000 33,025 3,025
Inventory 40, 4,000 4,000
 Fundamental Analysis: Company Analysis 257
Table 11.9 Contd..
Rarticulars 2011 2012 Change in Wc
Increase Decrease
Total curent
&ssets (CA) 90,000 95,825
Cument liabilities:
Bls payable 8,000 9,000 1,000
Sundry creditors 12,000 15,000 3,000
Other curent liabilities 20.000 25,000 5,000
Total current
liabilities (CL) 40,000 49,000
CA-CL 50,000 46,825 3,175
13,200 13,200
Table 11.10 Fund flow statement ( in lakh)
Sources Uses
Funds from operations 41,650 Purchase of fixed assets 20,000
Decrease in working capital 3,175 Redemption of 12 per cent
Debentures 2,000
Repayment of term loans 1,000
Payment of tax 15,825
Payment of preference dividend 1,000
Payment of equity dividend 5,000
44,825 44,825
Dr. Funds from Operations P&L App. a/c (T in lakh)
To Depreciation 10,000 By balance b/d 40,000
To Income tax 15,825 (Opening balance)
To Preference dividend 1,000 By funds from operations 41,650
To equity dividend 5,000
To Balance c/d 49,825
(Closing balance) 81,650 (Balancing figure) 1,650
258 Security Analysis and Portfolio Management
Table 11.11 Cash flow statement ( in lakh)
Sources Uses
Opening balance of cash 5,000 Increase in sundry debtors
Increase in inventory
3,025
Add:
4,000
Purchase of fixed assets
Cash from operations 20,000
41,650 Redemption of 12%
Decrease in investments 4,200 Debentures
Increase in bils payable 2,000
1,000 Repayment of term loans
Increase in sundry creditors 1,000
3,000 Payment of income tax 15,825
Increase in other current liabilities 5,000 Payment of preference dividend 1,000
Payment of equity dividend 5,000
51,850
Closing balance of cash 8,000
59,850 59,850
Table 11.12 Cash from operations ( in lakh)
Retained earnings
9,825
Add:
Non-cashNon-operating expenditures
Depreciation 10,000
Income tax 15,825
Preference dividend 1,000
Equity dividend 5.000 31.825
Less:
41,650
Non-cash/Non-operating incomes Nil
Cash from profit
41,650
(a) The change in the capital conmponents causes fluctuations in profits. The common size heel
balance n
reveals that there is a reduction in long-term loans, while the current liabilities have increased. The
assets have also increased.
b) The fund flow statement shows that the majority of the fund is obtained from business operations The
funds are applied for uses like acquisition of fixed assets and and
redemption of debentures. Pro
working capital are sufficient to pay dividend and taxes.
(c) The cash flow statement indicates that the company is following a policy of sales on credit basis De ecause
the inventory and the sundry debtors have increased.
Ratio analysis
des
Ratio
is a relationship between figures expressed mathematically. A financial ratio
two
numerical relationship berweentworelevant financial data. Financial ratios are calculated from the nd
prowi
quouent
sheet and profit and loss account. The relationship can be expressed either as a per cent or as a
 259
Fundamental Analysis: Company Analysis

rize the data for easy understanding, comparison, and interpretation. Financial ratios may e
t i o s
s u m m a r i z e

ups. They are listed below:

Katios.
groups

into six
six
id
dvided
Liquidity ratios
into

Turnover ratios

Leverage ratios
Profit marginratios

investment ratios
on
Return
Valuation ratios

Liquidityratio

Ri means the ability of the firm to meet its short-term obligations. Current ratio and acid test ratio
the means
a
Liquidity
Lemostpopular ratios used to analyse liquidity. The liquidity ratio gives a rough indication of liquidiry
ihemostpopular
adequacy of working pital. The ratios for Sky Ltd are discussed below
andthe
Current assets
Current ratio =

Current liabilities

95825
= 1.96:1
49000
Current assets - Inventories

Acid test ratio=

Current liabilities

51825
= 1.06:1
49000

For the current ratio, the minimum value set is 1.33. The liquidity position of Sky Ltd is favourable
wien compared to this. The acid test ratio value of 1.06 shows that the company is able to meet current
labilies. Yet, the company has to work out plans to reduce the inventory level to slightly below the current
level.

Turnover ratio
The turnover ratios show how well the assets are used and the extent of excess inventory. if any. These
ratios are sales
aIOS are also known as activity ratios or asset management ratios. Commonlyandcalculatedtotal to turnover.
CuTEnt assets, sales to fixed assets, sales to inventory, receivable sales,
to assets
ach ratio has a specifñic application. Sales to current asset ratio shows the utilization of the current assets,
e sales to fixed asset ratio indicates the fixed asset utilization. The sales-to-inventory ratio reflects the
Inven management. The receivable to sales ratio gives a view of the receivables management. The value
te
calculated ratios for Sky Ltd are given below.
Net sales 2,40,000
lnventory turnover ratio =5.45 times
Inventory 44,000
Net sales 2,40,000
Receivables turnover ratio = 7.27 times
Receivables 33,025
260 Secunity Analysis and Portfolio Management

Fixed asset turnover ratio = Net sales 2,40,000

= 2.1 times
Fixed asset 1,20,000

Total assets turnover ratio Net sales 2,40,000

= = 1.1 times
Total assets 2,15,825

Leverage ratio
Investors are
usually interested in finding out the debt portion of the capital. The debt
payment because of the outflow of affects the d

return aspects of
profits in the form of interest. The financial leverage affects the ri
holding the shares. The total debt to total assets ratio indicates the
funds in the firm's assets. percentage of hor

Debt to asset ratio - Total debt

Total assets
1,06,000
x 100 49.9%
2,15,825

It shows that 49 per cent of the

assets owned by Sky Ltd are financed with borrowed
to-equity ratio compares the creditors' funds with owners' funds. money. The dehe

Debt to equity ratio = Total debt

Net worth

1,06,000
.=0.97:1
1,09,825
It indicates that creditors have also
placed the same amount of money
of the debt fund consists of interest-free trade as the equity holders. A
credit. pou
Hence, the long-term debt should be compared w
the net worth.
The long-term debt-to-equity ratio specifically indicates the proportion of
long-term borrowings.
Interest term debt to equity =. Long-term debt
Net worth
57,000
=0.52:1
1,09,825
Thelong-term debl portion is comparatively lower than the whichmea
operations depend more on the owners' equity than on borrowed net worth for Sky Ltd, wn
funds.
 251
Fundamental Analysis Company Analysis

Interestcoerage ratio

how many times

es the operaling income covers the interest payment.
shows

7his
EBIT
coverage
ratio =

Interest
Interest
40,000 = 4.79 times

8,350
Sky earnings before interest and tax are sufficient to service the debt to the extent of 4.79 times

rofitability ratio

tablity ratios relate the irm s profit with factors that generate the profits. Any investor would want to
w the net profit to sales,
know.
net profit to total assets and net profit to equity ratios. The profitability ratios
Overall efticiency of the firm
measure the

ratio
Netprofit margin
the net profit per rupee of sales revenue.
This ratio indicates

Profit after tax

(PAT)
Net profit margin
Sales
15,825 x 100 = 7%

2,40,000

The net profit margin of the Sky Ltd is 7 paise for a rupee sold.

Return on assets
The return on asset measures the overall efficiency of capital invested in business.

Net incomne
Return on assets=
Total assets

15,825
x100 7.33%
2,15,825
or every rupee invested in assets, the yield is 7.33 per cent.

Heturn on equity
Here, the net profitis related to the firm's capital.

Net incomne
Return on assets
Total assets
15,825 14.4%
x 100 =

1,09,825
 CHAPTER 14

EFFICIENT MARKET THEORY

CHAPTERQUERY

nica Company is expected to issue bonus shares in the ratio of 1:2. Funds can be parked
for two to three years, a newspaper report says. Mr Karan, who owns stock of Baj company,
has these questions: Should he dispose of his Baj stock and buy Arnica's stock? Will such a
switch yield extraordinary rewards?

CHAPTER OBJECTIVES
To understand the concept of market efficiency
To recognize the different forms of market efficiency
To apply empirical tests to ascertain market efficiency
To know market inefficiencies
Buying Amica stock based on the newspaper report may not yield extraordinary gains for Mr Karan.
Once the information is available in the public domain, the market will react to it. Expectation of returns
ao has an impact on the psychology of other investors. The price of Arnica stock may have increased.
Efficient market theory states that share price fluctuations are random and do not follow any regular
Pauem. Meanwhile, technical analysts see meaningful patterns in their charts. This raises these questions:
Des the intrinsic value of stock have any meaning? Is it related to the stock price? The following section
aplains how security prices are determined.

BASIC CONCEPTS
UOhstould know the meaning of phrases such as market efficiency, liquidity traders and information
,Delore trying to understand the random walk theory.

Market
The Eficiencystors regarding future cash flows are translated into or reflected in share prices.
ectations of investo
Market translates the expectation into prices.
There ae ywo 1s the accuracy and speed with which the market
types of market efficiencies:
Operational efficiency
lnformational efficiency
46 Security Analysis and Portoliho
Management

Operational efficiency
actors like the time taken to execute
the order and the number of bad
eficiency of a stock deliveries
The
exchange. Operational efficiency of the market is a matter of measure tho
efticient market hypothesis (EMH) does not take into concern for thlin
account this efficiency.

Informational
lt is measure of
a
efficiency
swiftness with which the market reacts to new
information. The market
new information in the form of economic reports, frequentlv
new industrial company analysis, political statements and notifieaTeceves
policy. How does it react to this?
Security prices adjust themselves rapidly and
They never take a long time to adjust to new information. accir
issue of bonus shares can lead to a For instance, a
company's
rise in the price of the stock. Likewise, stock announcementcCurately
significant changes in the policy decisions of the government. index movements of the
relec
r

Liquidity Traders
These traders' investments and resale of shares
sell their shares to pay their bills. depend upon their personal fortune. Liquidity traders r
They
do not analyse
before they invest. may

Information traders
Information traders base their buy or sell strategy on
shares. They enter the market on the basis of the deviation ofanalyses. They estimate the intrinsic value of
proper
the market value of shares from the
value. They sell if the market value is intrinsic
higher than the intrinsic value and vice versa. The buying and selling
of shares triggered by demand and
supply forces brings the market price back to its intrinsic value.
Arbitrage
The concept of arbitrage provides the basis for the efficient market
hypothesis. The this chapter. absorb
the potential excess return opportunities in the market. Take the case quoted earlier in arbitrageurs Armica
stock is expected to yield 15 per cent return per annum. If the current
price is lower than the expecied
price, making the return high, there is an unexpected opportunity for exceptional gain. The arbitrageurs buy
heavily, which leads to a rise in Armica's stock price. Thus, the equilibrium return and the expected reun
become equal. This eliminates the possibility of earning an abnormal return.
Likewise, if the optimal forecast of return is negative, say minus 2 per cent, and the equilibrium reu
is 15 per cent, this investment is not worth it. The arbitrageurs may sell the stock leading to a drop in pric.
This makes the optimal forecast price equal to the equilibrium price.

THE RANDOM-WALK THEORY

tions
In 1900, French mathematician Louis Bachelier wrote an article suggesting that security price flucu
were random. In 1953, British statistician Maurice Kendall reported that the stock price series is a wan
one. Each change is independent of the previous one. In 1970, American economist Eugene Fama sad
T e l e t

that efficient markets fully reflect the available infornmation. If markets are efficient, security pr
normal returns for their level of risk. Fama suggested that the efficient market hypothesis can b e e
into three calegories. They are the 'weak form', the 'semi-strong form' and the "strong form. 1
of information considered in the market is the basis for this segregation. Figure 14.1 illustralcs u

efficiency.
 Efficient Market Theory 327

Strongly efficient market

All information is reflected
on prices

Semi strong efficient market

All public information is
reflected on security prices

Weekly efficient market

All historical information is
reflected on security prices

Figure 14.1 Levels of information and the markets

WEAK FORM OF EFFICIENT MARKET HYPOTHESIS

form the ibasis of information used in the weak form of efficient market hypothesis
torical prices (EMH).
i n to it, current prices reflect all the information found in past prices and traded volumes. Future
Canot be predicted by analysing past prices. Everyone has access to past prices, even though some
ople can get these more easily than others. Liquidity traders may sell their stocks without considering the
rinsic value of the shares and cause price fluctuations. Buying and selling activities of the information
aders lcad the market price to align itself with the intrinsic value. Figure 14.2 shows a weakly efficient
market.

C
E

A Price
-Value

1+1
Time

Figure 14.2 A weakly efficient market

328 Security Analysis and Portfoiio Management

The dotted line in Figure 14.2 represents the intrinsic value. The intrinsic value changes at
times
t+1. In the weak form of market, the price of the stock and its intrinsic value diverge significan
to move towards the equilibri e
Supply and demand for the stock or any other asset has a tendency
Supply and demand match each other in the equilibrium return. Thus,
E(R) = Eq (R)
equilibrium
is the return.
where, E(R) is the expected return and Eq (R)
The expected return is equal to the optimal forecast of return, which is FR).

Then
F(R) Eq (R)
This indicates that the current price will be equal to the optimal forecast of a stock's return, which ia
turn is equal to the equilibrium return. The optimal forecast uses all the available information in the marke
Hence, EMH states that a security's price reflects all the available information.
In the weak form of eficient market, short-term traders may earn a positive return. On average, shor.
term traders will not outperform the blindfolded investor picking the stock with a dart. That is, traders
may earn by the naive buy-and-hold strategy and while some may incura loss, the average buy-and-hold
strategist cannot be beaten by the chartist. Many studies by market analysts have proven the weakform of
EMH. Empirical tests of the weak form are presented here.

Filter rule Investors use technical trading strategies based on historical prices to eam returns. Filer rule
is one such strategy. According to it, if the price of a security rises by X per cent, an investor should buy
and hold the stock until its price declines by at least X per cent from a subsequent high. Short sellers can
use the filter to earn profits by liquidating their holdings when the price decreases from a peak level by X
per cent. They can take up short position as the price declines till the price reaches a new low and the
increases by X per cent. Different traders use different filter rules. It ranges from as low as 0.5 percentto
as high as 50 per cent.
The filter rule can be explained with the help of an example. Take a hypothetical company XYand
assume the filter to be 10 per cent. The price fluctuates between 20 and 30. Assume the starting point
20. When there is an increase in the price of the share to T22, i.e., a 10 per cent rise, one buys it. The rauy
may continue up to 30 and decline. A fall in the price gives a sell signal at 27, i.e., 10 per cent oft
and the trader can take up a short position till it reaches its low level. When there is an increase in pne.
the same exercise is followed.
Several studies have found that after commissions the average gains produced by the filter rules are
below the gains of a naive buy-and-hold strategy adopted by the investor.
isan
Runs test A runs test finds out whether the series of price movements occurs by chance. A ru
uninterrupted sequence of the same observation. Tossing a coin gives the following sequence ofoccute
HHTTTHHHTHH
Here, occurrence of H H is a run and TT is another run. When the sequence of observations cuu
it is counted as a run.

RunstestZ=R-X

R number of runs

n+n2
 Efflcient Markot Theory 329

2 , (27, n - n )
(n+n) (n, +n2 -1)
mber of observations in cach category
gstandard deviation
variate
standard normal
7
, fallawing example explains the calculation of runs test, Table 14.1 gives the Real company stockK
The
with their runs.
prices along
Table 14.1 Real company stock prlces
Date
Prlce Runs Date Price Auns

oph.20
43.05 Oct. 19 54.70
43.40 +1 20 58.95 +11
41.76 -2 21 60.30
42.65 +3 25 59.65
43.60 26 58.65
43.05 27 56.80
43.40 28 53.50 -12

Sopl. 1 46.80 29 51.50

46.60 -6 Nov. 1 48.40

47.50 +7 2 52.30 +13
47.40 -8 56.05

52.15 55.15 -14

52.50 +9 56.40
53.45 57.15
12 57.55 57.25 +15
13 57.45 10 57.55
14
55.90 -10 11 56.75 -16
15 54.15

Rnstes ZR-X
R number of runs

2 241

219x15 |=17.76
34
 and Portolo Managonmont
390 Secuty Analysis
4;)
2, n, (2n,
-1)
( +n)(n +n
219x15|(2x 19x15)-19-151RO
(19+15)(19+15-1)
a 283
16-17.6
-0565
2.83
run and the decline would be counted ae
be counted as a poSitive
The consecutive rise in prices would
a negative run.
cent of the area under
the normal curve lies within +1%
According to the probability theory, 95 per is less than minus 1.96, the rune
Since thecalculated value of minus 0.565
standard deviation of the mean.
have occurred by chance. runs in the price series of stocks are not
using runs test suggest that
Published results of the studies
in the series of random numbers.
significantly different from the
runs
tests the independence of successive price changes
Serial correlation The serial correlation technique
Serial correlation or autocorrelation measures
the correlation co-cfficient in a series of numbers with the
+ 1 (or t + any number) are correlated with
lagging values of the same series. Price changes periodt
in
Scatter diagrams be used to find out the correlation. If
can
the price changes of the preceding period. will form a
there is a correlation between the price of t andt+ 1 period,
in the
the points graph straight
increase (or fall) in period t + 1, then the
line. If the price rise (or fall) in period t is followed by price
have failed to
correlation co-efficient will be +1. Many studies conducted on the security price changes
show any significant correlations. Fama computed serial correlations for 30 stocks for the period
1958-62
with varying t periods from t + 1 to t + 10. The values of the auto-correlations are usually insignificant
with multiple values faling within the range of 0.10 to minus 0.10. If there is little correlation between stock
prices over time, chart analyses cannot be of much use in predicting the future.
A STUDY PREDICTABILITY OF STOCK RETURNS
The National Stock Exchange has carried out research on the functioning of the market. The research deal
with the serial correlation factor in index returns.
This study looks at whether the Indian stock market is predictable by using returns of S&P CNA
NiRty index. Serial correlation with lag one is calculated. If markets are informational efficient, the senu
correlation will not be statistically significant.
Table 14.2 shows the monthly serial correlation for three years 1995-96, 1996-97, and 1997-98
Logarithmic returns are used to check serial correlation at lag one. Table 14.2 also gives the t-statisues
which help to determine if the calculated correlation parameter is different from zero in the statisticai se
 Efficient Market Theory 331

Table 14.2 Predictability of stock returns

1995-96
1996-97 1997-98
Correlation T Statistic Correlation T Statistic Correlation T Statistic
Montn
0.68 2.65 -0.12 -0.52 -0.31 -1.31

ADY
0.30 1.28 0.05 0.22 0.38 1.75

0.33 1.53 0.21 0.94 0.23 1.04

2.18 0.02 0.11 0.17 0.81
0.49
0.24 -0.99 0.31 1.41 0.26 1.15

1.31 -0.03 -0.16 0.42 1.99

0.29
0.64 0.21 0.98 -0.35 -1.46
0.15
0.42 0.05 0.23 -0.21 -0.92
0.09
0.04 0.17 -0.33 -1.45 0.11 0.51
Dec 1.54
0.41 1.94 0.04 0.20 0.34
1.02 0.38 1.75 0.25 1.10
0.23
0.57 0.14 0.60 -0.17 -3.17
0.13
Mar

whole, out of the 36 months analysed, the correlation

coefficients were statistically different
On the
S&P CNX Nifty is an efficient index, and
En 72r0 in only four months. The results thus indicate that the are
ht the information assimilation and price adjustment processes quick.
SEMI-STRONG FORM
available
of the EMH states that the security price adjusts quickly to all publicly
The semi-strong form information.
efficient markets, security prices fully reflect all publicly available
information. In semi-strong
but also the available information regarding the earnings of the
The prices not only reflect past prices,
acquisitions, and so on. In the semi-strong efficient
corporation, dividend, bonus issue, right issue, mergers, who adopt the naive
on short-run price changes rather than investors
market, a few insiders can earn a profit
buy-and-hold policy. at the
In the of a competitive market, supply and demand forces
case
determine the
price. price The
of the market. The intrinsic value
equilibrium level of supply and demand represents
the consensus opinion
information arrives on the market,
of the stock and the equilibrium price are the same. Whenever
new

processes the new information quickly,

market a new
Supply and the demand factors react to it. If the
and accurate dissemination
price will come out of it. To be semi-strongly efficient, a market needs timely
df information and assimilation of news. Only then can the market reflect all relevant information quickly.
Snudies show that stock markets in the US strongly support the semi-strong hypothesis because the prices

adjust rapidly to new information.

semi-strong
forerunners in
assessing the
mpirical evidence Fama, Fisher, Jensen and Roll (1969) were the Their
study was noteworthy because
um o EMH. They analysed the impact of stock split on share prices.
of the
following reasons:
t provided evidence of a semi-strong form of the market.
l analysed if stock splits increase the wealth of the shareholders.
helped researchers develop a design to test market efficiency.
332 Security Analysis and Portolio Management

The authors
developed a method to compute abnormal retums by using the sinple
Regressing the security return against the retum of the stock market index regression
following equation shows it. gives the normal technicq
eturn
,a,+8,+
Where.
=
realised return for the i the stock in the period t
=
realised return for index in period t
a B, regression coefficients
error term, or residual for the period t

The normal retum for any

period is as follows:
Normal returm a, +B, T
=

Here, e indicates the abnormal return.

For any period, AR
- ( a , + 8, )
This method of estimating the abnormal return is called the residual
represents normal return and e, represents abnormal return.
analysis. The regression equation
The average abnormal return (AAR) can be obtained
by adding the abnomal returns over time
dividing it by n. The AAR can be measured around a date of event or the announcement date of stock ad split
or bonus issue

AR,-AR
CAAR =
EAAR.
Adding the AAR, for each period gives the cumulative average abnormal renun
(CAAR). Period of study begins severalofweeks before the event takes place and ends several weeks after tht
event. The CAAR provides a snapshot average price behaviour of securities over time. If the markes
efficient, the CAAR should be close to zero.
The authors reviewed hundreds of cases of efficient corporations and heterogeneous sample periods a
study the effect of stock splits. They examined 940 stock splits from 1927 to 1959 in the New York St
Exchange. The price behaviour was analysed 29 months before and after the date of the stock splt. u
found the CAAR for all 940 observations. They found the level of CAAR to be insignificant and ua
essentially fell from the date of announcement of the split. According to them, the simple strategy ot u

shares after a stock split did not appear to generate abnormal returns. The study results provide evs
for the semi-strong form of EMH.
Thei
Ball and Brown analysed the market's ability to integrate the reported annual earnings persnate nd
study showed that the actual good price earnings were higher than the predicted good priceearw
at the same time, the low price earnings were lower than the ptedicted low price earnings. Ball n
found that even before the announcement of a good report, the respective shares experienced an n
price. Likewise, even before the announcement of the negative earnings report, the share pricese g sem

Both the groups generated only normal returns after the announcement providing support lo
strong form.
 Efficient Market Theory 333

found
his study found that the market is also
efficient
secondary offerings. Usually, price tends to infallidentifying
fying the seller. He analysed the
Scholes.
reeitecis
of

information effect and not due to selling pressures. If

the info
before the secondary offering. This s
e to
u i n yd u e .

nbers and officers, the prices tend to fall heavy selling is associated with the
at a faster rate. If it is sold by
o r a t i o n ' sm e m

in price is small. groups other tnan

ahe decrease
S T R O N GF O R M

fom AH states that security prices fully reflect all

EMH

sron information. It represents an extreme

The
strong
most observers do not believe to be
literally true. This hypothesis maintains that not oniy
esil 2Vailable information useless to the investor or
sthe
publicly

whether public or inside, cannot be used

analyst, but that all information is useless.
normaum This implies that security analysts andconsistently
to earn superior investor returns in
thes t r o n g portfolio managers, who have access to more
than ordinary inv
investors, are not able to use it to earn more
inbrmation
profits.
Pvidence Many of the tests of the
strong form of EMH deal with
pnalvsts have studied the risk-adjusted rates of return from hundreds mutual fund performances.
upirical.
of mutual funds and found
rofessionally managed funds are not able to outperform the naive -buy-hold strategists. Jensen
gudiedll5funds over a decade. He concluded that even though the analysts have a wide
range of
niations in both the business and financial committees, they are unable to predict returns
contacts
accurately
andassoe

enough recover the research and transaction costs. He holds this as a striking piece of evidence for the
to
GTong form
of he efficient market hypothesis.

ESSENCE OF THE THEORY

Ararding to the theory, successive price changes or changes in return are independent, and these successive
rice changes have a random distribution. The random walk model argues that stock prices fully reflect all
mhlicly available information and further that the stock prices instantaneously adjust to the available new
abrmation. The theory mainly deals with successive changes ather than the price or return levels.
Acording to the theory, the market may have imperfections like transaction costs and delays in
seminating relevant information to all market investors, but these sources of inefficiency may not result
h acessreturns above the normal or equilibrium returns. The equilibrium return is the return earned by
the naive buy-and-hold strategy.
Investors should note that the random theory says nothing about the relative price changes that are
Curing across the securities. Some securities may outperform others. Again, it does not say anything
2ut the decomposing of price into market, industry or firm factors. All these factors consider relative
pics but not with the absolute price changes. The random vwalk hypothesis deals with the absolute price
Changes and not with the relative prices.
he prices may change at random, but this does not imply that there would not be any upward or
MWard trend in the price. The random walk hypothesis is entirely consistent with the upward and
OwTward movements of stock
prices.
MARKET INEFFICIENCIES
Hdes have proven the prevalence of market efficiency. At the same time, several studies also
wnradict the
concept of market efficiency.
Overre
e nsof the market Recent studies have shown that the market overreacts to corporate news. If
oporation announces a reduction in the earnings or closure of a unit, the market overreacts. The price
334 Security Analysis and Portfolio
Management
of the
stock may decline. After the initial
decline, it may take several weeks for the stock
normal level. During this price to
period, the investor may buy the stock 'when the
price is low and sell it eachthe
normal level is reached. This
strategy helps him to earn an abnormal return, which goes on t
tonce
market hypothesis. against the ef
Forexample, take the studies conducted Joy, Litzenberger and McEnally ficien
1963-68, which gave different results. The authors examined the (JLM) over the
quarterly earnings of the
earnings of one quarter were compared with the earnings of the same quarter of the stock price . The
period
current year's earnings were 40 previous vear te
per cent or higher than the earnings for the same quarter in
the previn
the
year, the earnings were classified as better than
anticipated. the current quarter's earnings were belo
If
per cent of the previous year's earnings, they were classified as worse than
previous
Then the abnormal returns were calculated from 13 weeks before theexpected.
26 weeks after the announcement. The announcement of earnings
stocks whose earnings were significantly greater than anticipated
gave positive abnormal returns. The stocks whose earnings were below the
negative abnormal returns. anticipated earnings generate
The authors' main claim is that after the announcement of the
earnings, stocks that reported
substantially higher than that of the previous year continued to generate positive abnormal returns. earnines
to their study, investors could have earned Accordine
positive abnormal returns of around 6.5 per cent over the net
26 weeks simply by buying stocks that reported
earnings 40 per cent above the last quarterly earnings all
Meanwhile, for those stocks with earnings substantially below that of the previous year, the cumulative
average abnormal return remained relatively stable. This shows evidence against the semi-strong market
hypothesis because it states that when the information is made public, the analyst could not earn abnormal
profits. A study by CP Jones and R S Rendleman for the period 1971-80 also gave results similar to those
of JLM. BIery

Reversal to mean return Some studies have found that stock returns have a tendency to return to their in

average level. Stocks that currently yield low returns tend to yield high returns in future. Likewise, the MUDLicl
stocks that perform well at present may not yield high returns in future. The returns may go back to the CLLCTUS
average level. This gives an opportunity to predict the future price, which is contrary to the random walk
theory. wth ac
estor
Delayed albsorption of new information Usually, stock prices react quickly to information. Research has
proved that stock prices tend to increase continuously for some time after the announcement of good prothis. UEKA
Likewise, they continue to decline for some time after the reporting of low profits.
AMMre S
Low P/E effect Many studies have provided evidence that stocks with low price-earnings ratios (PES)Ye epla
higher returns than stocks with higher P/Es. This is known as the low PE effect. A study by Basu in 19 Poye
looked at risk adjusted return and even after the adjustment there was excess return in the low price-earning
estions
stocks. If historical information of P/E ratios can help investor to obtain superior stock returms, t e
the validity of the semi-strong form of market hypothesis. Basu stated that low P/E portfolio experien
superior returns relative to the market, and high P/E portfolio performed in an inferior manner relanve
the overall market. Since his result directly contradicts the semi-strong form of efficient market hypouno
it is noteworthy.
wilh

Small firm effect The theory of the small firm effect maintains that investing in small firms (hos
low capitalization) provides superior risk adjusted returns. Banz found the size of the firm to De i d
tncP
correlated with returns. Banz examined historical monthly returns of NYSE common stocks for
 335
Efficient Market Theory

yet-3,
Hehomied.
ed portfolios consisting of the 10 smallest firms and the 10 largest firms and computed the
esmall
The
r these portfolios. a
firm portfolio outperformed the large firm portfolio.
e r a lodnes
r tudies
tics have confirmed the existence of a small firm effect. The size effect raised doubts
iated with small firms. The risks associated with them are underestimated, and they do
nly as the large firms. The correct measurement of risk and return of small porttolos
as

elinuinae
least 50 per cent ofthe small firm effect.

o
nb o t French examined the returns generated by the S&P index for each day of the week.
ise all week, reaching a peak on Fridays. Usually, stocks trade on Monday at low
e k e n d .

rise
tend to
begin the week's price increase. Buying on Monday and selling on Friday from 1953
es

annual return of 13.4 per cent while a

ld have generated average
g197wOuldhave simple buy-and-hold would
5 . 5per cent ent annual reurn. If the transaction costs are taken into account, the naive buy-and-
uld have provided higher returns. The weekend effect knowledge is of value to investors.
would

n n e d on Thursday or Friday can be delayed until Monday, while sales planned for Monday can
end of the week. The weekend effect is a small but significant deviation from perfeculy
mvements and violates the weekly efficient market hypothesis.
andmprice
Research Bureau stated that the Bombay Stock Exchange reveals a clear pattern.
of the BL R
katesh
liualyMondaysees trading blues, and Friday, frenzied activity. The Friday rush is related to speculators
If the short sellers fail to cover their position within this period, their open
their open position.
Nering
in the auction where prices are dear.
results
sitions

eueIENT MARKETS AND THE INVESTORR

EFFI
is aimed
is aimed at the benefit of the investor. A technical analysis helps the investor to formulate
Eerytheory
and exit strategy. The efficient market hypothesis also has its message. But all the investment
entry
his
estment advice or technical analysis cannot guarantee an investor will earn abnormal profits. The
e aaiable information too cannot help the investor to outperform the market. All this leads to the
rson that predictions about the market are inadequate. The constant buying and selling of stocks will
alt in payment of commission to brokers. Instead, the investor should pursue a buy-and-hold strategy
ih acareful selection of stocks. Yet, the anomalies of an efficient market hypothesis suggest that a prudent
inestor can earn higher with predictions than by following a buy-and-hold strategy.

BEMAVIOURAL FINANCE
The anomalies of the efficient market hypothesis led to the evolution of behavioural finance. According to
Aadre Sheifer, it borrows concepts from the social sciences such anthropology sociology, and psychology
erplain the behaviours of security price.
Psypchologists opine that investors are unhappy when loss occurs and happy with the profit. This leads
othe conclusion that investors are risk averse. The arbitrageurs who make smart money reduce the profit
oportunities. They borrow stocks from the brokers and sell them. They hope to obtain the sold stock at
ilw price, and give it back to the brokers. The drawback of this process is that stock prices may go up.
Men stock prices rise, investors incur a loss. From the point of view of psychologists, the investors are
S aese. Hence, this psyehology limits the short selling activity in the stock market. This leads to an
ONErvaluation of stocks.
ologists also observe that investors are overconfident in their own judgments. They act according
beiefs. While one investor may feel that *' stock price is going to fall and it is better to get rid of
a y judge it to be a good investment at the prevailing price. Hence, the trading volume in the
stock m
may be high. The efficient market hypothesis has no explanation for it.
336 Security Analysis and Portfolio Management

Behaviour finance explains that the stock market bubbles are due to the social contagion
effect and
overconfidence of the investor. The media and word-of-mouth enthusiasm create stock markCt
Once the stock prices go up, the investor feels it will rally in future. This leads to a positi b
speculative bubble without the backino ba
loop, and stock prices continue to move up. This
creates a

fundamentals. This results in a stock market crash.

strong

SUMMARY
Market efficiency refers to the accuracy and the quickness with which prices reflect market rel.
related
information.
I n the weak form of the market, current prices reflect all the information found in past prices and ded
volumes. The filter rule, runs test and serial correlation are adopted to find out market efficiency
available information.
I n the semi-strong form of the market, security prices reflect all publicly
reflect all information.
I n the strong form of the market, stock prices fully
weekend effect are some of the inefficiencies of market.
The low P/E effect, small firm effect, and

QUESTIONS

What do they have in common?

1. Define the various forms of market efficiency.
the weak form of market efficiency?
2. What is the empirical evidence of
numbers. Examine.
3. "Stock prices are like random
4. What is residual analysis? efficient market hypothesis
that support the semi-strong form of
5. Discuss the results of the studies
(EMH).
with empirical evidence.
6. Explain the strong form of EMH
7. State the anomalies of EMH. information related to the
the pricing of securities? How is
new
8. How does new information affect
efficient market theory?
What are the evidences in support of
EMH?

10. What are the arguments against EMH? Explain.

State their implications.
11. What are the three forms of market efficiency?
12. How does EMH differ from technical analysis?
and EMH.
13. Discuss the relationship between fundamental analysis
random walk theory.
14. State the cempirical evidence against the
15. The Indian stock market is efficient. Discuss.