22. Security Analysis and Portfolio Managemont PRIMARY MARKET/NEW ISSUES MARKET When a new company is floated, its shares are issued to the public in the primary market as an Initial Publie Offer (!PO). Whe company subsequently decides to include debt in its capital structure by issuing bonds of debentures, these also be floated in the primary market. Similarly, when a company decides to expand its activities using either equity finance or bond finance, the additional shares or bonds may be floated in the primary market. The primary market or new issues market (NIM) docs not have a physical structure or form. All the agent which provide the facilities and participate in the process of selling new issues to the investors constitute the NIM. The NIM has three functions to perform, They are: 4. Origination 2. Underwriting 3. Distribution. Origination Origination is the preliminary work in connection with the floatation of a new issue by a company . It deals with assessing the feasibility of the project, technical, economic and financial, as also making all arrangements for the actual floatation of the issue. As part of the origination work, decisions may have to be taken on the following issues: 1, Time of floating the issue 2. Type of issue 3, Price of the issue. Timing of the issue is crucial for its success. The floatation of the issue should coincide with the buoyant mocd in the investment market to ensure proper support and subscription to the issue. The type of issue whether equity, preference, debentures or convertible securities, has to be properly analysed at the time of origination work . Pricing of the issue is a sensitive matter, as the public support to a new issuc will depend on the price of the issue to a large extent. In the primary market, the price of the security is determined by the issuer and not by the mark et, New issues are made either at par or at premium. Well- established companies may be able to sell their shares at a premium at the time of a new issue, Further, the pricing of new issues is also regulated by the guid clines on capital issues issued hy SEBI. The origination function in the NIM is now being carried out by merchant bankers. In the 1980s, commercial bunk s in India created special divisions called merchant banking division s to perform the origination function for Noa tation of new issues, But now there ‘are separate institutions registered with SEB! as merchant bankers. Underwriting The second function performed by NIM is und erwriting which is the activity of prov nice to the issuer to ensure successful marketing of the issue. An underwrite individual or instiution which gives an und ertakin g to the stock issuing company to ase a specified number of shares of the company in the event of a shortfall in Scanned with CamScannerSocuritios Market 23 sue, The sto. 1g company can thus ensure Full subscription to the new issue through underwriting agreements wilh different underwriters, even if there is no proper response fo the new issue from the investors, Underwriting activity in the NIM is performed by large financial institutions such as LIC, UTI, IDBI. IFCI. general insurance companies, commerc_ial banks and also by brokers. The underwriters earn commission from the issuing company for this activity, subscription to the new Distribution The new issue market performs a third function besides the functions of origination und underwriting. This third function is that of distribution of shares, The distribution function is carried out by brokers, sub-brokers and agents. New issues have to be publicised by ing different mass media, such as newspapers, magazines, television, radio, Internet, etc. New issues are also publicised by mass mailing. It has become a general practice to distribute prospectus, application forms and other literature regarding new issues among the investing public. Methods of Floating New Issues The me! ods by which new issues of shares are floated in the primary market in India are: J. Public issue 2. Rights issue 3. Private placement. Public Issue Public issue involves sale of securities to members of the public, The issuing company makes an offer for sale to the public directly of a fixed number of shares at a specific price. The offer is made through a legal document called Prospectus, Thus « public issue is an invitation by a company to the public to subscribe to the securities offered through a Prospectus. Public issues are mostly underwritten by strong public financial institutions. This is the most popular method for floating securities in the new issue market, but it involves an elaborate process and consequently it is un expensive method. The company has to incur expenses on various etivities such as advertisements, printing of prospectus banks’ commissions, underwriting commissions, agents’ fees, legal charges, etc. Rights Issue The rights issue involves selling of securities to the existing shareholders in proportion to their current holding. As per section 81 of the Companies Act, 1956, when a company issues additional equity capital it has to be offered first to the existing shareholders on a Pro rata basis. However, the sharcholders may forfeit this special right by passing a special resolution and thereby enable the company (o issue additional capital to the public through a public issue. Rights issue is an inexpensive method of floatation of shares as the offer is made through a formal letter to the existing shareholders. Scanned with CamScanner24° Security Analysis and Portfolio Management Private Placement A private placement is a sale of securities privately by a company to a selected group of investors . The securities are normally placed, in a private placement. with the institutional investors, mutual funds or other financial institutions . The terms of the issue are negotiated between the company and the investors . A formal prospeetu s is not necessary in the case of private placement. Und enwri ting arrangements are also not required in private placement, as the sale is directly negotiated with the investors, This method is useful 10 small companies and closely held companies for issue of new securities, because such companies are unlikely to get good response from the investing public for their public issues. They can avoid the expenses of a public issue and also have their shares sold. Principal Steps in Floating a Public Issue In a public issue, investors are allowed to subscribe to the shares being issued by the company during a specified period ranging from a minimum of three days to a maximum of ten days. The issue remains open during this period for subscription by the public. This is the principal activity in the process of a public issue. Before the issue is opened for public subscription. several activities/Iegal formalities have to be completed. ‘These are the pre-issue steps or obligations. Similarly, after the issue is closed, several activities are to be carried out to complete the process of public issue. These activities may be designated 1s the post-issue tasks. Thus, we can identify three distinct stages in the successful completion of a public issue. Pre-issue tasks Opening and closing of the issue Post-issue tasks. ype Pre-issue Tasks These are the preparatory obligations to be complied with before the actua I opening of the issue. Drafting and finalisation of the prospectus Prospectus is an essential document in a public issue. The Companies Act 1956 defines a prospectus as: "Any document described or issued as a prospectus and includes any notice, circular, advertisement or other document inviting deposits from the public or inviting offers from the public for the subscription or purchase of any shares in or debentur es of a body corporate”. It is the offer document which contains all the information pertaining to the company which will be useful to the investors to arrive at a proper decision regarding investing in the company. It is a communication from the issuer to the investor. ‘The prospectus contains detailed information about th e company, its activities, promoters, directors, group companies, capital structure, terms of th e present issue, details of proposed project, details regarding underwriting arrangements, etc. SEBI has issu ed guidelin es regarding the contents of the prospectus and these have to be complied with by the company. The draft prospectus has to be approved by the Board of Directors of the company. The draft prospectus has also to be filed with SEBI and the Registrar of companies, The final prospectus ha s to be prepared as per the su gestion s of SEBI and filed with SEBI and the Reaistrar af eamnanies Scanned with CamScannerSecurities Market 25 Selecting the intermediaries and entering into agreements with them Several intermediaries are involved in the process of a public issue. These intermediaries have to be registered with SEBI. Important categories of intermediaries are the following: 1, Merchant banker: Merchant banker is any person or institution which is engaged in the business of issue management cither as manager, consultant, adviser, or by rendering corporate advisory service in relation to such issue management. Merchant bankers play an important role in the process of managing 1 public issue, It is the duty of the merchant bankers to ensure correctness of the information furnished in the prospectus as well as to ensure compliance with SEBI mules, regulations and guidelines regarding public issue of securities. Merchant bankers are registered with SEBI in four categories, with different eligibility criteria for each category. Registrar to an issue: Registrar to an issue is any person or institution entrusted with the following functions in connection with a public issue: (a) Collecting applications from investors. (>) Keeping a record of applications and monies recei (©) Assisting the stock issting company in determining the bi of securities in consultation with the stock exchany (a) Finalising the list of persons entitled to allotment of securities. (©) Processing and despatching allotment letters, refund orders, certificates and other related documents, ed from investors is of allotment 3 Share transfer agent: Share transfer agent is a person or institution which maintains the records of holders of securities of a company on behalf of that company . The share transfer agent is authorised to effect the transfer of securities as well as the redemption of securities wherever applicable. 4. Banker to an issue: Banker to an issue is a scheduled bank entrusted with the following activities in connection with a public issue: (a) Acceptance of application and appli (b) Acceptance of allotment or call monies: (©) Refund of application monies {d) Payment of dividend or interest warrants. ‘The intermediaries are service providers possessing professional exper tise in the relevant areas of operation, The market regulator, SEBI, regulates the various intermediaries in the primary market through its regulations for these intermediaries. SEBI has defined the role of each category of intermediary, the eligibility criteria for granting registration, their functions and responsibilities, and the cade of conduet to which they are bo The stock issuing company has to select the intermediaries such as merch registrar to the issue, shure transfer agent, banker to the issue, underwriters. ete separate agreements with each of them to engage them for the publi issue. Attending to other formalities The prospeetus and application forms have to be printed and despatch ed to all intermediaries and brokers for wide circulation among the public, An initial listing application has to be filed with the stock exchange where the issue Scanned with CamScanner26 Security Analysis and Portfolio Management is proposed to be listed. An abridged version of the prospectus along with the issue opening and closing dates has to be published in newspapers. Opening and closing of the issue The public issue is open for subscription by the public on the pre-announced opening date. The application forms and application monies are received al the branches of the bankers to the issue and forwarded by these bankers to the Registrar to the issue. Two closing dates are prescribed for the closing of the public issue. The first of these is the ‘earliest closing date’ which should not be less than three days from the opening date. If sufficient applications are received by the company, the company may choose to close the issue on the earliest closing date itself. The other closing date is the final or latest closing date which shall not exceed ten days from the opening date. Pasteissue Tasks After closing of the publ process of public issue, several activities are to be carried out to complete the sue. They are: 4. All the application forms received have to be scrutinised. processed and tabulated. 2. When the issue isnot fully subscribed to, it becomes the liability of the tmderwriters to subscribe to the shortfall. The liability of each underwriter has to be determined. 3, When the issue is oversubscribed, the basis of allotment has to be decided in consultation with the stock exchange. 4. Allotment letters and share certificates have to be despatched to the Refund orders have to be despatched to the applicants whose applic rejected. 5. Shares have to be listed in the stock exchange for trading. For this purpose. the issuing company has to ener into a listing agreement with the stock exchange. Book Building Companies may raise capita I in the primary market by way of public issue, rights issue or private placement . A public issue is the selling of securities to the public in the primary market. The ustal procedure of a public issue is through the fixed price method where securities are offered for subscription to the public at a fixed price. An alternative method is now available which is known as the book building process, Although book building has been a common practice in most of the developed countries, the concept is relatively new in India, SEB! announced guidelines for the book building process, for the first time, in October 1995. Under the book building process, the issue price is not fixed in advance. It is determined by the offer of potential investors about the price which they are willing to pay for the issue . The price of the security is determined as the weighted avera ge at which the majority of investors are willing to buy the security. Thus. under the book building process. the issue price of a security is determined by the demand and supply forces in the capital market. SEBI guidelines define book building as: "A process undenaken by which a demand for the securities proposed to be issu ed by a bod y corporate is elicited and built up and the price for such securities is assessed for the determination of the qu ntum of such Scanned with CamScanner‘Securities Market 27 securities tobe issued by means of a notice, circular, advertisement, document or information memoranda or offer document". Book buildin g is a process of price discovery . It puts in place a pricing mechanism whereby new securities are valued on the basis of the demand feedback following a period of marketing. It is an alternative to the existing system of fixed pricing. A public issue of securities may be made through the fixed price method, the book buildin g method, or a combination of both, In case the issuin ¢ company chooses to issue securities through the book building rout e, then as per SEBI guid elines the issuer compan y can select any of the following methods: 1. 100 per cent of the offer to the public through the book building process. 2. Seventy-five per cent of the offer to the public through the book buildin g process and twenty -five per cent throu gh the fixed price method at the price determined through book building. 3. Ninety per cent of the offer to the public through the book building process ten per cent through the fixed price method . ad The issue of the fixed price portion is conducted like a normal public issue ufler the book built portion is issued. ‘The steps involved in the process of book building may be listed out as follows 1. The issuer appoints a merchant bank er as the lead manager and book runner to the issue. 2. The book runner forms a syndicate of underwriters. The syndicate consists of book runner, Jead man ager, joint lead managers, advisors, co-managers. and underwritin g members, 3. A drafl prospectus is submitt ed to SEBI without a price or price hand, The draft prospectus is then circulated amon g eligible investors with a price hand arrived at by the hook runner in consultation with the issuer. Such a prospectus is known as a Red Herring prospect 4. The book runner conducts awareness campaigns, which include advertising, road shows and conferences . 5, Investors pluce their orders w ith syndicate member s. These members callec t orders from their clients on the amount of securities required by them as well ay the price they are willing to pay. 6, The book runner builds up a record known as Book after receiving orders from members of the syndicate, He ma inta ins detail ed records in this regard. The book iy thus built wp to the size of the portion to be raised throu gh the book buildin g process. When the book runner rece ives substantial number of orders, he announces closure of the book. A book should remain open for a minimum of thr ee wark ing days, The maximum period for which the bidding process may be allowed iy seven working days. 7. On the basis af the offers recei determines the price at which the securities shall be sold. 8. The book nunner finalisey the allocation to syndicate members. Procurement agreements ure signed between issuer and the syndicate members for the subscription to be procured by them. ed, the book runner and the ssuer company then Scanned with CamScanner28 Security Analysis and Portfolio Management 9. The final prospectus along with the procurement agreements is then filed with the Registrar of companies within two days of the determination of the offer price. 10. The book runner collects from the institutional buyers and the underwriters the Application forms along with the application monies to the extent of the securities proposed to be allotted to them/subscribed by them. Book building is a process wherein the issuer of securities asks investors to bid for their securities at different prices. These bids should be within an indicative price band decided by the issuer. Here investors bid for different quantity of shares ai different prices. Considering these bids, issuer determines the price al which the securities are to be allotted. Thus, the issuer gets the best possible price for his securities as perceived by the market or investors. Scanned with CamScannerStock Exchanges 37 LISTING OF SECURITIES For the securities of a company to be traded on a stock exchange, they have to be listed in that stock exchange . Listing is the process of including the securities of a company in the official list of the stock exchange for the purpose of trading. At the time of issue of securities, a company has to apply for listing the securities in a recognised stock exchange. The Securities Contracts Regulation Act and mules, SEBT guidelines, and the rules and regulations of the exchange prescribe the statuiory requirements to be fulfilled by a company for getting its shares listed in a stock exchange. Important documents such as memorandum of association, articles of association, prospectus, directors’ report, annual accounts, agreement with underwriters, etc. and detailed information about the company’s activities, its capital structure, distribution of shares, dividends and bonus shares issued, etc. have to be submitted to the stock exchange along with the application for listing. The stock exchange examines whether the company satisfies the criteria prescribed for listing. When the stock exchange finds that a company is eligible for listing its securities at the exchange, the company would be required to execute a listing agreement with the stock exchange . This listing agreement contains the obligations and restrictions imposed on the company as a result of listing. The company is also required to pay the annual listing fees every year. The purpose of the listing agreement is to compel the company to keep the shareholders and investors informed about the various activities which are likely to affect the share prices of the company. A company whose securities are listed in a stock exchange is obliged to keep the stock exchange fully informed about all matters affecting the company. Moreover, the company has {o forward copies of its audited annual accounts to the stock exchange as soon as they are issued, The secut of companies listed on a stock exchange may be classified into different groups. For instance, the securities listed on the Bombay Stock Exchange (BSE) have been Classified into A, BI, B2, F, G and Z groups. The equity shares listed in the exchange have been grouped under three groups, namely A, BI and B2, based on certain qualitative and quantitative parameters which include number of trades, value traded, etc. The F group represents the fixed income securities. The G group includes Government securities for retail investors. The Z group includes companies which have failed to comply with the listing requirements of the exchange or have failed to resolve investor complaints or have not made arrangements with the depositories for dematerialisation of their securities. Permitted Securities ‘The securities of companies which have signed listing agreement with an exchan ge are traded at the exchange as listed securities, A stock exchange som es permits trading in cenain securities which are not listed at the exchange but are actively trad ed in other stock exchanges. Such securities are known as permitted securities. Thi to help market panicipants to trade in certain actively traded securities even though they are not formally listed at the exchan ge, Thus, a stock exch ange ay have certain listed securities and certain permitted securities, and trad in g may take place in these securities reg ularly. Scanned with CamScannerTypes of Orders An investor can have his buy or sell orders executed either at the best price prevailing on the exchange or at a price that he determines, Accordingly, an investor may place two types of orders, namely, market order or limit order. Marhet Orders In a market order, the broker is instructed by the investor to buy or sell a stated number of shares immediately at the best prevailing price in the market. In the case of a buy order, the best price is the lowest price obtainable; in the case of a sell order, it is the highest price obtainable. When placing a market order, the investor can be fairly certain that the order will be executed, but he will be uncertain of the price until after the order is executed, Limit’ Orders While placing a limit order, the investor specifies in advance the limit price at which he wants the transaction to be carried out. In the case of a limit order to buy, the investor specifies the maximum price th at he will pay for the share; the order has to be exeeu ted only at the limit price or a lower price. In the case of a limit order to sell shares, the Scanned with CamScannerTrading System in Stock Exchanges 43 investor specifies the minimum price he will accept for the share and hence, the order has to be executed only at the limit price or a price higher to it. Thus for limit orders to purchase shares the investor specifies a ceiling on the price, and for limit orders to sell shares the investor specifies a floor price. Limit orders are generally placed “away from the market" which means that the limit price is somewhat removed from the prevailing market price. In the case of a limit order to buy, the limit price would be below the prevailing price and in the case of a limit order to sell, the limit price would be above the prevailing market price. The investor placing limit orders believes that his limit price will be reached and the order executed within a reasonable period of time. But the limit order may remain unexecuted. There are certain special types of orders which may be used by investors to protect their profits or limit their losses, Two such special kinds of orders are stop orders (also known as step loss orders) and stop limit orders. Stop Orders A stop arder may be used by an investor to protect 1 profit or limit a loss. For a stop order, the investor must specify what is Known as a stop price, If it is a sell order, the stop price must be below the market price prevailing at the time the order is placed . If it is a buy order, the stop price must be above the market price prevailing at the time of placing the order . IC subsequen tly, the market price reaches or passes the stop price, the stop order will be execu ted al the best available price. Thus, a stop order can be viewed as a conditional market order, because it becomes a market order when the market price reaches or passes the stop price. amples will help to clarify the working of stop orders. Suppose an investor has 100 shares of a company which were purchased at Rs. 35 per sh are, The current market price of the share is Rs. 75. The investor thus has earned a profit of Rs. 40 per share on his share holdings. He would very much like 10 protect this profit wi thout foregoing the opportunity of caring more profit “if the price moves still upwards . This con he achieved by placing a stop sell order at a price below the current market price of Rs, 75, for example at Rs. 70, Now, if the price subsequently falls to Rs . 70 or below, the stop sell order becomes a market order and it will be executed at the best price prevailing in the market. Thus, the investor will be able to protect the profit of around Rs. 35 per shure. On the contrary, if the market price of the share moves upwards, the stop sell order will not be executed and the investor retains the opportunity of curuing higher profits on his holding. Stop orders can also he used 10 minimise loss in trading, Suppose that a share is currently selling for Rs. 12Sand an investor expects 1 full in the price of the share. He may place an order for sale of the shure at the current market price of Rs. 125 hoping to cover up his position by purchasing the share ala lower price and thus make a profit on the deal, This type of a tra tion is known a short sale. If price of the share falls as anticipaled by the investor, he would make a profit, There is a possibility that the price may move upwards and in that case the investor has to purchase the share at a higher price to cover up his position and meet his sales commitment. This will result in a loss to the investor. This loss can he minimised by placing a stop buy order at a price above the current price of Rs. 125, for example at Rs. 130, Now, if the price of the share rises to Scanned with CamScanner44 Security Analysis and Portfolio Management Rs. 130 or abave, the stap buy order will become a market order and will be executed at - the best price available in the market, Suppose that the stop buy order was executed at Rs. 131, then the loss of the investor is limited to Rs. 6 per share, that is, the difference between the selling price of Rs. 125 and the buying price of Rs. 131 per share. One disadvantage of the stop orders is that the actual price at which the order is executed is uncertain and may be some distance away from the stop price. Stop Limit Orders The stop limit order is a special type of order designed to overcome the uncertainty of the execution price associated with a stop order. The stop limit order gives the investor the opportunity of specifying a limit price for executing the stop orders: the maximum price for a stop buy order and the minimum price for a stop sell order. With a stop limit order, the investor specifies two prices, a stop price and a limit price. When the market price reaches or passes the stop price, the stop limit order becomes a limit order to be executed within the limit price. Hence, a stop limit order can be viewed as a conditional limit order. Let us consider two examples. Consider a share that is currently selling at Rs. 60. An investor who holds the share may place a stop limit order to sell with stop price of Rs. 55 and limit price of Rs. 52. If the market price declines to Rs.55 or lower, a limit order to sell the share at the limit price of Rs. 52 or higher would be activated. Here the order will be executed only if the share is available at Rs. 52 or above. Thus a stop limit order may remain unexecuted . Consider an investor who desires to make a short sale of a particular share at its current market price of Rs. 85. That is, he intends to sell the share without owning it but hoping to buy it later from the market at a lower price. He may also place a stop limit order to buy the share to minimise his loss in case the share price moves upwards contrary to his expectations . He may specify a stop price of Rs. 90 and a limit price of Rs. 93 for his stop limit order to buy. If the price moves up to Rs. 90 or above, then a limit order to buy the share with limit price of Rs . 93 would be activated. The order would be executed at a price of Rs. 93 or lower, if such price is available in the market. The disadvantage of a stop limit order is that it may remain uncxecuted. The stop order results in certain execution at an uncertain price, while a stop limit order results in uncertain execution within a specified price limit. Trading in stock exchanges takes place continuously during the official trading hours . Stock exchanges are open five days a week, from Monday throu gh Friday. An investor may place orders for trade through his broker at any time during the official trading hour s, but he needs to specify the time limit for the validity of the order. The time limit on an order is essentially an instruction to the broker about the time within which he should attempt to execute the order. Day Orders A day order is an order that is valid only for the trading day on which the order is placed. If the order is not executed by the end of the day, it is treated us cancelled. All orders are ordinarily treated as day orders unless specified as other types of orders. Scanned with CamScannerTrading System In Stock Exchanges 45 Week Orders These are orders that are valid till the end of the weck during which the orders are placed . They expire at the close of the trading session on Friday of the week, unless they are executed by then. Month Orders These are orders that are valid till the end of the month during which the orders are placed . Month orders expire at the close of the trading session on the last working day of the month. Open Orders Open orders are orders that remain valid till they are executed by the brokers or specifically cancelled by the investor. They are also known as good till cancelled orders or GTC orders. However, brokers generally seek periodic confirmation of open orders from the investors. Fill or Kill: Orders These orders are also known as Fok orders. These orders are meant to be executed immediately. If not executed immediately, they are to be treated as cancelled. Scanned with CamScannerQUALITIES FOR SUCCESSFUL INVESTING ‘The game of investment, asany other game, requires certain qualities and virtues on the part of the investors, to be successful in the long run. What are these qualities? While the lists prescribed by various commentators tend to vary the following qualities are found in most of the lists © Contrary thinking, ® Patience ® Composure Overview 119 © Flexibility and openness © Decisiveness Before we dwell on these qualities, one point needs to be emphasised. Cultivat these qualities distinctly improves the odds of superior performance but does not ‘guarantee it Traits of the Great Masters In a fascinating book, John Train studied the strategies employed by nine great ‘masters. Based on his analysis, he prepared a list of traits common among them: 1. He is realistic 2. He is intelligent to the point of genius. 3. Heis utterly dedicated to his craft. 4. He is disciplined and patient. 5. Heisa loner. Source: John Train, The Money Masters, New York: Harper & Row Publishers, Inc., 1981 Contrary Thinking Investors tend to have a herd mentality and follow the crowd. Two factors explain this behaviour. First, there isa natural desire on the part of human beings to be part of a group. Second, in a complex field like investment, most people do not have enough confidence in their own judgment. This impels them to substitute others’ opinion for their own. Following the crowd behaviour, however, often produces poor investment results. Why? If everyone fancies a certain share, it soon becomes overpriced. Thanks to bandwagon psychology, it is likely to remain bullish for a period longer than what is rationally justifiable. However, this cannot persist indefinitely because sooner or later the market corrects itself. And when that happens the market price falls, sometimes very abruptly and sharply causing widespread losses. Given the risk of imitating others and joining the crowd, you must cultivate the habit of contrary thinking. This may be difficult to do because it is so tempting and convenient to fallin line with others, Perhaps the best way to resist sucha tendency is to recognise that investment requires different mode of thinking than what is appropriate to everyday living. As James Gipson said: “Being a joiner is fine when it comes to team sports, fashionable clothes, and trendy restaurants. When it comes to investing, however, the investor must remain aloof and suppress social tendencies. When it comes to making money and keeping it, the majority is always wrong.” ‘The suggestion to cultivate ‘contrary thinking’ should not, of course, be interpreted to mean that you should always go against the prevailing market se If you doso, you will miss many opportunities presented by the market swings. A more sensible interpretation of the contrarian philosophy is this: go with the market during 7 James Gipson, Winning the Investment Game, New York: McGraw-Hill Book Company, 1986 Scanned with CamScanner1.20 Investment Analysis and Portfolio Management incipient and intermediate phases of bullishness and bearishness but go against the market when it moves towards the extremes. Here are some suggestions to cultivate the contrary approach to investment: ® Avoid stocks which have a high price-earnings ratio. A high relative price-earnings ratio reflects that the stock is very popular with investors. = Recognise that in the world of investment, many people have the temptation to play the wrong game. ® Sell to the optimists and buy from the pessimists. While the former hope that the future will be marvellous, the latter fear that it will be awful. Reality often lies somewhere in between. So it is a good investment policy to bet against the two extremes, More specifically, remember the following rules which are helpful in implementing the contrary approach: = Discipline your buying and selling by specifying the target prices at which you will buy and sell. Don’t try overzealously to buy when the market is at its nadir or sell when the market is at its peak (these can often be known only with the wisdom of hindsight). Remember the advice of Baron Rothschild when he said that he would leave the 20 percent gains at the top as well as at the bottom for others as his interest was only on the 60 percent profit in the middle. ® Never look back after a sale or purchase to ask whether you should have waited. It is pointless to wonder whether you could have bought a share for Rs.10 less or sold it for Rs.20 more. What is important is that you buy at a price which will ensure profit and sell at a price where you realise your expected profit, Counterintuitive Trading Successful investors usually trade in a counterintuitive manner: they increase turno- ver when they are doing well, but patiently endure disappointments. This behaviour is at variance with human nature and the culture of most investment committees. If investments have fared well, it is human nature to complacently adhere to the strat- egy that has served well. Yet, investments that have performed well in the recent past, may no longer be attractively priced to generate good returns. Conversely, if investments have performed badly, human instincts prompt us to fix the problem by changing the portfolio. Yet, the portfolio may now be attractively priced to generate better returns. Patience Asa virtue, patience is strangely distributed among investors. Young investors, with all the time in the world to reap the benefits of patient and diligent investing, seem to be the most impatient. They look for instantaneous results and often check prices on a daily basis. Old investors, on the other hand, display a high degree of patience even though they have little chance of enjoying the fruits of patience. Whatever may be the temperamental basis for the young to be impatient, in the Scanned with CamScannerOverview 1.21 field of investment there are compelling reasons for cultivating patience. The game of investment requires patience and diligence. In the short run, the factor of luck may be important because of randomness in stock price behaviour, which may be likened to the Brownian motion in physics. In the long run, however, investor performance depends mainly on patience and diligence, because the random movements tend to even out. Composure Rudyard Kipling believed that an important virtue for becoming a mature adultis to keep your head when all around you are losing theirs. The ability to maintain composure is also a virtue required to be a successful investor. Conscious of this, as an investor you should try to (a) understand your own impulses and instincts towards greed and fear; (b) surmount these emotions that can warp your judgment; and (c) capitalise on the greed and fear of other investors. While the above advice sounds simple, it is difficult to practice. Greed and fear are far more powerful forces than reason in influencing investment decisions. Rarely do you come across an investor who is immune to these emotions that are so pervasive in the market place. Greed and fear tend to be insidiously contagious. In your attempt to overcome them, you may find the following suggestions helpful. = Maintain a certain distance from the market place. Your vulnerability to the contagious influences of greed and fear diminishes, if your contact with others caught in the whirlpool of market psychology decreases. = Rely more on hard numbers and less on judgment (which is more prone to be influenced by the emotions of greed and fear). Thisis the advice given by Benjamin Graham, widely regarded as the father of security analysis. Flexibility and Openness Nothing is more certain than change in the world of investments. Macroeconomic conditions change, new technologies and industries emerge, consumer tastes and preferences shift, investment habits alter, and so on. All these developments have a bearing on industry and company prospects on the one hand and investor expectations on the other. Despite the inexorability of change, most of us adjust to it poorly. We often base our expectations assuming that the status qua will continue. As J.M. Keynes said: “The facts of the existing situation enter, in a sense disproportionately into the formation of our long-term expectations; our usual practice being to take the existing situation and project it into a future modified only to the extent that we have more or less definite reasons for expecting a change.”* We tend to compound the problem further by being over-protective of our judgment, mainly due to psychological reasons. This leads to a failure to absorb and interpret new formation with an open mind. This inability to consider new evidence blinds us to the flaws in our operating premises. As Arthur Zeikel said: “We tend to develop a ‘defensive’ interpretation of new developments, and this cripples our capacity to make good judgments about the future.”” 5J.M. Keynes, The General Theory of Employment, Interest, and Money, New York: Harcourt, Brace & Co, 1935. ° Arthur Zeikel, “On the Threat of Change,” Financial Analysts Journal, vol.31 No.6, Nov-Dec. 1975. Scanned with CamScanner1,22 Javestment Analysis and Portfolio Management Since an open mind, not blocked by prejudices and biases, is crucial for success in investing, conscious and deliberate efforts should be made to re-examine old premises, assimilate new information, and cultivate mental flexibility. Barton M. Briggs put it this way: “Flexibility of thinking and willingness to change is required for the successful investor. In the stock market, in investing, there is nothing permanent except change. The investment manager should try to cultivate a mix of healthy skepticism, open- mindedness, and willingness to listen.”” Decisiveness An investor often has to act in the face of imperfect information and ambiguous signals. Investment decisions generally call for reaching conclusions on the basis of inadequate premises. To succeed in the investment game, the investor should be decisive. If he procrastinates, he may miss valuable opportunities; if he dillydallies, he may have to forego gains. Decisiveness does not mean rashness. Rather, it refers to an ability to quickly weigh and balance a variety of factors (some well understood and some not-so-well understood), form a basic judgment, and act promptly. It reflects the ability to take decisions, after doing the necessary homework of course, without being overwhelmed by uncertainties characterising the investment situation. The most successful investors tend to be those who are willing to make bold positions consistent with their convictions. Vacillation and half-hearted commitments often produce lacklustre investment results. Scanned with CamScanner3.8 = SEBI AND FUTURE CHALLENGES Before the establishment of the Securitiesand Exchange Board of India (SEB)), the principal legislations governing the securities market in India were the Capital Issues Control Act, 1956 (governing the primary market) and the Securities Contracts (Regulations) Act, 1956 (governing the secondary market). The regulatory powers were vested with the Controller of Capital Issues (for the primary market) and the Stock Exchange Division (for the secondary market) in the Ministry of Finance, Government of India. In 1989, SEBI was created by an administrative fiat of the Ministry of Finance. Since then, SEBI has gradually been granted more and more powers. With the repeal of the Capital Issues Control Act and the enactment of the SEBI Act in 1992, the regulation of the primary market has become the preserve of SEBI. Further, the Ministry of Finance, Government of India, has transferred most of the powers under the Securities Contracts (Regulations) Act, 1956 to SEBI. SEBI's principal tasks are to: = Regulate the business in stock exchanges and any other securities markets. = Register and regulate the working of capital market intermediaries (brokers, merchant bankers, portfolio managers, and so on). = Register and regulate the working of mutual funds. = Promote and regulate self-regulatory organisations. Scanned with CamScanner3.30 Investment Analysis and Portfolio Management © Prohibit fraudulent and unfair trade practices in securities markets. = Promote investors’ education and training of intermediaries of securities markets. ® Prohibit insider trading in securities. = Regulate substantial acquisition of shares and takeovers of companies. = Perform such other functions as may be prescribed. * Initiatives SEBI has taken a number of steps in the last few years to reform the Indian capital market, It has cov gamut of capital market activities through nearly 30 legislations. The important initiatives are mentioned below. Freedom in Designing and Pricing Instruments Companies now enjoy substantial freedom in designing the instruments of financing as long, as they fully disclose the character of the same. More important, they enjoy considerable latitude in pricing the same. Ban on Badla The financial irregularities of 1992 highlighted the deficiencies of the ‘badla’ system which permitted excessive leveraging. To rectify the defects in trading practices, the ‘badla’ system has been banned. Screen-basedTrading Thanks to the competition posed by the National Stock Exchange and the insistence or prodding done by SEBI, all the exchanges have switched to screen- based trading. Electronic Transfer The traditional method of transfer by endorsement on security and registration by issuer has been supplanted by electronic transfer in book entry form by depositories. Risk Management A comprehensive risk management system has been put in place. Inter alia, it covers capital adequacy, limits on exposure and turnover, margins based on VAR (Value at risk), client level gross margins, online monitoring of positions, stringent KYC (know your customers) norms, market-wide circuit breakers, and scrip-wise price bands. Rolling Settlement The trading cycle, which was previously one week, has been reduced to one day and the system of rolling settlement has been introduced. Corporate Governance Code A new code of corporate governance, based on the recommendations of the Kumaramangalam Birla Committee report, has been defined. It has been operationalised by inserting a new clause (clause 49) in the Listing Agreement— the agreement that a listed company enters into with the stock exchange where its securities are listed. Change in Management Structure Stock exchanges earlier were broker dominated. SEBI now requires 50 percent non-broker directors. Further, ithas mandated that a non- broker professional be appointed as the Executive Director. Scanned with CamScannerSecurities Market 3.31 Registration and Regulation of Intermediaries Capital market intermediaries such as merchant bankers, underwriters, bankers to the issue, registrars and transfer agents, brokers, and sub-brokers are required to be registered with SEBI. Regulations for these intermediaries have been prescribed. Redressal of Investor Grievances Investor grievances have been on the rise. Thanks to the steps taken by SEBI the redressal ratio (the ratio of complaints resolved to complaints received) has improved. Regulation of Mutual Funds Mutual funds have been brought under the purview of SEBI and SEBI has issued the regulatory guidelines for this purpose. Regulation of Foreign Portfolio Investment The government welcomes foreign portfolio investment in the Indian capital market. SEBI has formulated guidelines to permit this investment through broad-based funds (such as mutual funds, pension funds, and country funds) referred to as foreign institutional investors. Development of a Code for Takeover Takeovers are gaining importance in India, SEBI has developed a code for regulating them. Introduction of Equity Derivatives SEBI has allowed the introduction of equity derivatives like stock index futures, stock index options, individual stock options, and individual stock futures. Thrust of SEBI’s Regulation Primary Market Access Restricted Instruments Multiplied Pricing Relaxed Disclosure norms Tightened Responsibility of merchant bankers Enhanced Method Book building Secondary Market Trading Computerised Settlement mode Electronic Transaction costs Lowered Transparency Enhanced Markets : Integrated Globalisation Encouraged Risk management Strengthened Exchange management Improved Settlement period Shortened Scanned with CamScanner3.32 Investment Analysis and Portfolio Management Integrated Market Surveillance System —SEBI has launched an IMSS from December 2006. IMSS integrates data from stock exchanges, depositories, and clearing corporations/ houses and comes up with alerts, based on certain pre-specified parameters. Such integration of data has been done for the first time in any market in the world. Thanks. to IMSS, officials of SEBI can detect capital market offences like market domination and control, artificial rigging, and creation of false market. IMSS is meant to curb wash sales, matched orders, synchronised trading, front running, cornering of free float, pumping and dumping (inflating share prices and then unloading the same on unsuspecting investors), and other forms of demand and supply manipulation. * Future Challenges While SEBI has done a great deal, it has a long way to go in accomplishing its mission. It has to address several challenges such as the followin; Preponderance of Speculative Trading and Skewed Distribution of Turnover There is a preponderance of speculative trading where the primary motive is to derive benefit from short-term fluctuations. Only a small fraction of trades results in delivery. Earlier when the account period was one week and the facility of badla was allowed, nearly 90 percent of the trades were squared up within the account period or carried forward. After the introduction of rolling settlement, intra-day squaring has become common. After the ban of badla, individual stock futures, which are cash-settled, have become very popular. An allied problem is that the distribution of trading is highly skewed. About 10 scrips account for nearly 80 percent of the turnover on the stock market. Thanks to such skewed distribution of trading, most shares are traded infrequently and, hence, lack liquidity. L.C. Gupta’ argues that the over-speculative character of the Indian market is evident from the following: (i) There is an extremely high concentration of trading in a small number of shares to the neglect of the remaining shares. (ii) The trading velocity is absurdly high for ‘speculative counters’—the trading velocity of a share is defined as: total trading volume in the share during a year divided by its market capitalisation. (iii) Hardly 10 to 15 percent of the transactions are genuine investment transactions, the balance being speculative transactions. To mitigate excessive speculation in the cash market and promote liquidity across the board, the following steps may be taken: = Introduce margin trading wherein investors put up a certain amount for purchase of securities, the balance being lent by brokerage firms. = Encourage market making by jobbers = Provide lines of credit to brokerage firms. "LC. Gupta, Stock Exchanges in India: Agenda for Reform, New Delhi: Society for Capital Market Research & Development, 1992. Scanned with CamScannerSecurities Market 3.33 Market Abuses Insider trading, market manipulation, and price rigging continue to impair the quality of the market. Insiders, who are privy to price-sensitive information, may use such information to their advantage. Often, companies issuing securiti the domestic market or international capital market artificially rig up prices. Cart powerful brokers tend to play manipulative games on the market. Improved Disclosure Standards Disclosure standards in India have improved significantly in the last decade or so. The standards for what, when, and where of disclosure have been specified in the Companies Act, Issue of Capital and Disclosure Requirements (ICDR), listing agreement, takeover code, regulations relating to insider trading, and so on. Disclosures relate to financial performance, shareholding pattern, insider trad- ing, acquisitions, related party transactions, audit qualifications, share buybacks, corporate governance, director remuneration, risk management, utilisation of is- sue proceeds, and so on. Disclosures are made through various documents like prospectuses, quarterly statements, annual reports, and so on, and are disseminated through various me- dia, company websites, exchange websites, and EDIFAR (Electronic Data Informa- tion Filing and Retrieval) System maintained by SEBI. Thanks to these improvements, disclosure standards in India are world class. In their article ‘What Works in Securities Laws,’ La Porta et. al give India 100 percent marks on disclosure. It is virtually impossible to eliminate market abuses because the ingenuity of manipulators manifests itself in unanticipated ways. Nevertheless a vigilant regulatory body, well-managed exchanges, and severe penaities can go a long way in mitigating market abuses. Though some progress has been made in that direction, a lot more has to be done. Scanned with CamScannerSecurities Market 3.11 © The National Stock Exchange Inaugurated in 1994, the National Stock Exchange seeks to (a) establish a nation-wide trading facility for equities, debt, and hybrids, (b) facilitate equal access to investors across the country, (c) impart faimess, efficiency, and transparency to transactions in securities, (d) shorten settlement cycle, and (e) meet international securities market standards. The distinctive features of NSE, as it functions currently, are as follows: = The NSE is ringless, national, computerised exchange. = The NSE has two segments: the Capital Market segment and the Wholesale Debt Market segment. The Capital Market segment covers equities, convertible debentures, and retail trade in non-convertible debentures. The Wholesale Debt Market segment is a market for high value transactions in government securities, PSU bonds, commercial papers, and other debt instruments. . The trading members in the Capital Market segment are connected to a central computer in Mumbai through a satellite link-up, using VSATs (Very Small Aperture Terminals). Incidentally, NSE is the first exchange in the world to employ the satellite technology. This enabled NSE to achieve a nation-wide reach. The trading members in the Wholesale Debt Market segment are linked through dedicated high speed lines to the central computer at Mumbai. The NSE has opted for an order-driven system. When an order is placed by a trading member, the computer automatically generates a unique order number and the member can take a print of order confirmation slip containing this number. When a trade takes place, a trade confirmation slip is printed at the trading member’s work station. It gives details like quantity, price, code number of counterparty, and so on. The identity ofa trading member isnot revealed to others when he places an order or when his pending orders are displayed. Hence, large orders can be placed on the NSE. = Members are required to deliver securities and cash by a certain day. The payout day is the following day. ® All trades on NSE are guaranteed by the National Securities Clearing Corporation (NSC). This means that when A buys from B, NSCC becomes the counterparty to both legs of the transaction. In effect, NSCC becomes the seller to A and the buyer from B, This eliminates counterparty risk. 2 2 * The Bombay Stock Exchange Established in 1875, the Bombay Stock Exchange (BSE) is one of the oldest organised exchanges in the world with a long, colourful, and chequered history. Its distinctive features are as follows: = The BSE switched from an open outcry system to a screen-based system in 1995, which is called BOLT (which isan acronym for BSE On Line Trading). Itaccelerated Scanned with CamScanner3.12 Investment Analysis and Portfolio Management ils computerisation programme in response to the threat from the NSE. = To begin with, BOLT was a ‘quote-driven’ as well as an ‘order-driven’ system, with jobbers (specialists) feeding two-way quotes and brokers feeding buy or sell orders This hybrid system reflected the historical practice of BSE where jobbers played an important role. A jobber is a broker who trades on his own account and hence offers a two-way quote or a bid-ask quote. The bid price reflects the price at which the jobber is willing to buy and the ask price represents the price at which the jobber is willing to sell. From August 13, 2001, however, BSE, like NSE, became a completely order-driven market. ® In October 1996, SEBI permitted BSE to extend its BOLT network outside Mumbai. A number of various, subsidiary companies of regional exchanges became members of BSE and through them members of regional exchanges now serve as sub-brokers of BSE. This has expanded the reach of BSE considerably. Demutualis: n Keen competition among stock exchanges all over the world has been reshap- ing their organisation. Till early 1990s almost all stock exchanges were mutual ventures, owned cooperatively by members who enjoyed trading privileges. In general, the owners (members) did not have much incentive to modernise the exchanges, as more efficient trading could diminish their profits, From 1993 onwards, however, a number of smaller exchanges resorted to demutualisation. They transformed themselves into profit-making companies, and issued shares to outsiders. With shareholders expecting profits, the stock exchanges have a stronger incentive to offer new products and services, increase trading volumes, and reduce costs. The idea of demutualisation was gradually accepted by bigger exchanges like the London Stock Exchange, NASDAQ, Tokyo Stock Exchange, and the New York Stock Exchange. The phenomenal success of the National Stock Exchange, which was started ab initio as a profit-oriented company promoted by institutional investors, provided the stimulus for demutualisation of stock exchanges in India. Indeed, SEB! has now mandated that all the stock exchanges in India should be demutualised. Scanned with CamScanner