Security Analysis and Portfolio Management

Unit-3: Stock Selection and Portfolio Construction

Meaning - Fundamental Analysis:
Fundamental analysis is a method of evaluating a security or asset by attempting to measure its
intrinsic value by examining related economic, financial and other qualitative and quantitative
factors.
FUNDAMENTAL ANALYSIS THUS INVOLVES 3STEPS/EIC FRAME WORK

1) ECONOMIC ANALYSIS
The performance of a company depends much on the performance of the economy if the
economy is in BOOM, the industries and companies in general said to be prosperous. On the
other hand, if the economy is in RECESSION, the performance of companies will be generally
poor.
Key economic variables that an investor must monitor as a part of the fundamental analysis
The analysis of macroeconomic environment is essential to understand the behavior of the
stock prices. The commonly analysed macro economic factors are as follows.
1. GNP/GDP Gross domestic product
GNP represents the aggregate value of goods and services produced in the economy. It reflects
the overall performance of the economy. The growth rate of GNP indicates the growth rate of
the economy the higher the rate of growth of GNP, the more favorable it is for the stock market
and vice versa.
2. Savings and investment
Stock market is a channel through which the savings of the investors are made available to the
corporate bodies. Savings are distributed over various assets like equity shares, deposits,
Mutual fund units, real estate and bullion. The saving and investment patterns of the public
affect the stock to a great extent.
3. Inflation
Inflation has considerate impact on the performance of companies. A higher rate of inflation
upset business plans and erodes purchasing power in the hands of consumers. This will result
in lower demand for products. Thus, high rates of inflation in an economy are likely to affect
the performance of companies adversely.

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4. Agriculture
Agriculture forms a major part of the Indian economy. Some companies are using agricultural
raw material as inputs and some others are supplying inputs to agriculture. Such companies are
directly affected by changes in agricultural production. Hence, the increase/ decrease in
agricultural production has a significant bearing on the industrial production and corporate
performance.
5. Interest rates
A low interest rate stimulates investment by making credit available easily and cheaply. As a
result cost of finance for companies decreases which assures higher profitability. On the other
hand, higher interest rates result in higher cost of production, which may lead to lower
profitability and lower demand. Hence an investor has to consider the interest rates prevailing
in the economy and evaluate their impact on the performance and profitability of the
companies.
6. Government Revenue, Expenditure and Deficit
Government is the largest investor in economy of any country thus revenue, expenditure and
deficit have significance impact on the performance of, industries and companies. Expenditure
stimulates demand and creates job. The excess of expenditure over revenue is deficit, (budget
deficit), most expenditure are spent on infrastructure, and deficit financing fuel inflation.
7. Infrastructure facilities
Development of an economy depends very much on the infrastructure available. Industry needs
electricity for its manufacturing activities road and railways to transport raw material and
finished good. Communication channels help supplier and customers. Good infrastructure is
symptoms of development. Bad infrastructure leads to inefficiencies, low productivity
wastages and delay. Investors should analysis the infrastructure of any economy.
8. Monsoon
The lndian economy is essentially an agrarian economy and agriculture forms a important
sector or the lndian economy. But the performance of agriculture to a very great extent depends
upon the monsoon. The adequacy of the monsoon ensures the success of the agricultural
activities in lndia and vice versa. Hence, the progress and adequacy of the monsoon becomes
a matter of great concern for an investor in India.
9. Political Stability
A stable political environment is necessary for steady and balanced growth. No industry or
company can grow and prosper in the midst of political turmoil. Such long term economic are
needed for industrial growth. Such stable policies can be framed only by stable political
systems.

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2. INDUSTRYANALYSIS
Industry Analysis- Meaning
Industry analysis refers to an evaluation of the relative strengths and weaknesses of partuculuar
industries. Industry analysis involves reviewing the economic, political and market factors that
influence the way the industry develops.
INDUSTRY LIFE CYCLE ANALYSIS
Many industrial economists believe that the development of almost every industry analyzed in
terms of following stages.
1. Pioneering stage: During this stage, the technology and product is relatively new. The
prospective demand for the product is promising in this industry. The demand for the product
attracts many producers to produce the particular product. This lead to severe competition only
fittest companies survive in this stage. The producers try to develop brand name, differentiate
the product and create a product image. This would lead to non-price competition too. The
severe competition often leads to change of position of the firms in terms of market share and
profit.
2. Rapid growth stage: This stage starts with the appearance of surviving firms from the
pioneering stage. The companies that beat the competition grow strongly in sales, marketshare
and financial performance. The improved technology of production leads to low cost and goo
quality of products. Companies with rapid growth in this stage, declare dividends during this
stage. It is always advisable to invest in these companies.
3. Maturity and stabilization stage: After enjoying above-average growth, the industry now
enters in maturity and stabilization stage. The symptoms of technology obsolescence may
appear. To keep going, technological innovation in the production process should be introduced
A close monitoring at industries events are necessary at this stage.
4. Decline stage: The industry enters the growth stage with satiation of demand encroachment
of new products, and change in consumer preferences. At this stage the earning period of the
industry are started declining. In this stage the growth of industry is low even in boom and
decline at a higher rate during recession. It is always advisable not to invest share of low growth
industry.
CLASSIFICATION OF INDUSTRY
Industry means a group of productive or profit making enterprises or organizations that have a
similar technically substitute goods, services or source of income.
These are classified as follows:
1. Growth Industries: "These industries have special features of high rate of earnings
and growth in expansion, independent of the business cycle. The expansion of the
industry mainly depends on the technological change or an innovative way of doing or
selling something.
2. Cyclical Industries: The growth and profitability of the industry move along with the
business cycle. These are those industries which are most likely to benefit from a period
of economic prosperity and most likely to suffer from a period of economic recession.

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 These especially include consumer goods and durables whose purchase can be
postponed until personal financial or general business conditions improve
3. Defensive Industries: Defensive industries are those, such as the food processing industry,
which hurt least in the period of economic downswing. For example- the industries selling
necessities of consumers withstands recession and depression.
4. Cyclical-growth Industries: These possess characteristics of both a cyclical industry and a
growth industry. For example, the automobile industry experiences period of stagnation,
decline but they grow tremendously.
PROFIT POTENTIAL OF INDUSTRIES: PORTER MODEL
Michael Porter has argued that the profit potential of an industry depends on the combine
strength of the following five components as explained below.
Following Figure depicts the forces that drive competition and determine industry profit
potential. These are
1. Threat of New Entrants: New entrants add capacity, inflate costs, push prices down and
reduce profitability. Hence, if an industry face threat of new entrants, its profit potential would
be limited. The threat from new entrants is low if the entry barriers confer an advantage on
existing firms and deter new entrants. Entry barriers are high when:
 The new entrants have to invest substantial resources to enter the industry.
 Economics of scale are enjoyed by the industry.
 The government policy limits or even prevents new entrants.
2. Rivalry among the Existing Firms: Firms in an industry compete on the basis of price,
quality, quality, promotion service, warranties etc. If the rivalry between the firms in an
industry is strong, competitive moves and countermoves dampen the average profitability of
the industry. The intensity of rivalry in an industry tends to be high when:
 The number of competitors in the industry is large.
 At least a few firms are relatively balanced and capable of engaging in a sustained
competitive battle.
 The industry growth is sluggish, prodding firms to strive for a higher market share.
3. Pressure from Substitute Products: All the firms in an industry face competition from
industries producing substitute products. The substitute goods may limit the profit potential of
the industry by imposing a ceiling on the prices that can be charged by the firms in the industry.
The threat from substitute products is high when:

 The price-performance trade off offered by the substitute products is attractive.

 The switching costs for prospective buyers are minimal.
 The substitute products are being produced by industries earning superior profits.
4. Bargaining Power of Buyers: Buyer is a competitive force. They can bargain for price cut,
ask for superior quality and better services and induce rivalry among competitors. If they are
powerful, they can depress the profitability of the supplier industry. The bargaining power of
a buyer group is high when:

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  Its purchases are large relative to the sales of the seller.
 Its switching costs are low.
 It poses a strong threat of backward integration.
5. Bargaining Power of Suppliers: Suppliers, like buyers, can exert a competitive force an
industry as they ca raise prices, lower quality and curtail the range of free services they provide.
Powerful suppliers can hurt the profitability of the buyer industry. Suppliers have strong
bargaining power when:

 Few suppliers dominate and the supplier group is more concentrated than the buyer
group.
 There are hardly any viable substitutes for the products supplied.
 The switching costs for the buyers are high.
3. COMPANY ANALYSIS
Company analysis deals with return and risk of individual share and security. The analyst tries
to forecast the future earnings which has direct effect on share price.
Company Analysis includes quantitative and qualitative aspects which are as follows:
1. Quantitative Aspects
Earnings of the Company
The earnings of a company decide its stock value in the market. The company pay dividend
from its earnings. In simple terms, earnings are the operating profits of a company. A company
may derive revenue from sources other than sales.
Financial Leverage
The degree of utilisation of borrowed money in a business is known as financial leverage. This
depends on financing decisions of the company. These decisions involve deciding the capital
structure.
Operating Leverage
If a firm’s fixed cost are a major portion of total costs, the firm is said to have a high degree of
operating leverage. 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 fixed costs and operating leverage.
Competitive Edge
Major industries in India are composed of hundreds of individual companies. The large
companies are successful in meeting the competition. Once companies attain a leadership
position in the market, they seldom lose it. Over time, they prove their ability to withstand the
competition and retain a sizeable share of the market.

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Production Efficiency
It means producing the maximum output at minimum cost per unit of output. Increasing
efficiency boosts the capacity of a business, without any change in the number of inputs
employed.
Financial analysis
It includes the financial statement analysis which studies company's financial statements from
various viewpoints. The statement gives the historical and current information about the
company's operation.
Tools of Financial Analysis
Financial parameters used in the Company analysis are:
 Balance sheet
 Profit and loss account
 Comparative financial statements
 Trend analysis
 Common size statements
 Fund flow analysis
 Cash flow analysis
 Ratio analysis
2. Qualitative Aspects
1. Business Model
The business model describes the company in which a company makes money. It provides a
description of the company's operations and mode of revenue generation, nature of expenses,
organisational structure and its sales & marketing efforts.
2. Management
Good and capable management teams generate profits for investors. The management of a firm
should efficiently plan, organise, actuate and control the activities of the company for the good
of the equity holders, the public and the employees
3. Corporate governance
It refers to the set of systems and practices put in place by a company to ensure accountability,
transparency and fairness in dealings to safeguard the interests of the stakeholders. A
stakeholder includes everyone from members of the board of directors, management and
shareholders to customers, employees and society
4. Foreign collaboration
Where a company has entered into technical collaboration with a foreign company, the investor
must find out more about the nature of the collaboration agreement.

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5.R&D
Progressive companies spent substantial sums of money on R & D to upgrade their existing
product.
6. Govt. regulations
The investor must assess the implications of governmental regulations such as licensing entry
barriers, patent registrations.
TECHNICAL ANALYSIS
What is Technical Analysis
Technical Analysis is a method of evaluating securities by analyzing statistics generated by
Market activity. It does not attempt to measure intrinsic value. Instead look for patterns and
indicators on charts to determine future performance.
ASSUMPTIONS OF TECHNICAL ANALYSIS
1. The market value of a security is solely determined by the interaction of demand and
supply factors operating in the market.
2. The demand and supply factors of a security are surrounded by numerous factors; these
factors are both rational as well as irrational.
3. The security prices move in trends or waves which can be both upward or downward
depending upon the sentiments, psychology and emotions of operators or traders.
4. The present trends are influenced by the past trends and the projection of future trends
is possible by an analysis of past price trends.
5. Except minor variations, stock prices tend to move in trends which continue to persist
for an appreciable length of time.
6. Changes in trends in stock prices are caused whenever there is a shift in the demand
and supply factors.
7. Shifts in demand and supply, no matter when and why they occur, can be detected
through charts prepared specially to show market action.
8. Some chart trends tend to repeat themselves. Patterns which are projected by charts
record price movements and these patterns are used by technical analysis for making
forecasts about the future patterns.
Techniques of technical Analysis
1. Bar and Line Charts
2. Moving Average Analysis
3. Relative Strength Analysis
4. The Dow Theory
1. Bar and Line Charts
The bar chart depicts the daily price change along with the closing price. A line chart shows

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the line connecting successive closing prices. Technical analysts believe that certain formations
or patterns observed on the bar chart or line chart have predictive value. For example, a head
and shoulder pattern represents a bearish development.
2. Moving Average
An average is a sum of prices of a share over some weekly periods divided by the number of
weeks. Moving Average smoothens out the apparent erratic movement of share prices and
highlights the underlying trend.
3. Relative Strength Index
This index emphasizes market moves before they occur When the price of a stock advances,
the closing price is lighter than the closing price of the previous day. When the price of the
stock declines, the closing price is lower than the closing price of the previous day.
4. Dow Theory
Originally proposed in the late nineteenth century by Charles H Dow, the editor of Wall Street
Journal, the Dow theory is perhaps the oldest and best-known theory of technical analysis. Dow
developed this theory on the basis of certain hypothesis, which are as follows:
a. No single individual or buyer or buyer can influence the major trends in the market.
However, an individual investor can affect the daily price movement by buying or selling huge
quantum of particular scrip.
b. The market discounts everything. Even natural calamities such as earth quake, plague and
fire also get quickly discounted in the market. The world trade centre blast affected the share
market for a short while and then the market returned back to normalcy.
c. The theory is not infallible and it is not a tool to beat the market but provides a way to
understand the market.
Explanation of the Theory
Dow described stock prices as moving in trends analogous to the movement of water. He
postulated three types of price movements over time: (1) major trends that are ocean, (2)
intermediate trends that resemble waves, and (3) short run movements that are like ripples.
Followers of the Dow theory hope to detect the direction of the major price trend (tide) known
as primary trend

 Primary Trend :
The price trend may be either increasing or decreasing. When the market exhibits the increasing
trend, it is called bull market. The bull market shows three clear-cut peaks. Each Peak Is higher
than the previous peak and this price rise is accompanied by heavy trading volume. The reverse
trend is true with bear market. Here, the chances of prices moving back to the previous high
level seemed to be low. This would result in the sale of shares.

 Secondary Trend
The secondary trend moves against the main trends and leads to the correction. In the bull
market, the secondary trend would result in the fall of about 33-66 percent of the earlier rise.

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In the bear market, the secondary trend carries the price upward and corrects the main trend.
Compared to the time taken for the primary trend, secondary trend is swift and quicker.

 Minor Trends
Minor trends are just like the ripples in the market. They are simply the daily price fluctuations.
Minor trend tries to correct the secondary price movement. It is better for the investor to
concentrate on the primary or secondary trends than on the minor trends.
THE EFFICIENT MARKET HYPOTHESIS AND ITS IMPLICATIONS
The Efficient Market Hypothesis (EMH) is a controversial theory that states that security prices
reflect all available information, making it fruitless to pick stocks. The Efficient Market
Hypothesis states that at any given time, security prices fully reflect all available information.
The| implications of the efficient market hypothesis are truly profound. Most individuals that
buy and sell securities, do so under the assumption that the securities they are buying are worth
more than the price that they are paying, while securities that they are selling are worth less
than the selling price. But if markets are efficient and current prices fully reflect all information,
then buying and selling securities in an attempt to outperform the market will effectively be a
game of
There are three variations of the hypothesis - the weak, semi-strong, and strong forms
- which represent three different assumed levels of market efficiency.
1. Weak Form
The weak form of the EMH assumes that the prices of securities reflect all available public
market information but may not reflect new information that is not yet publicly available.
It additionally assumes that past information regarding price, volume, and returns is
independent of future prices.
2. Semi-strong Form
The semi-strong form of the theory dismisses the usefulness of both technical and fundamental
analysis. The semi-strong form of the EMH incorporates the weak form assumptions and
expands on this by assuming that prices adjust quickly to any new public infomation that
becomes available, therefore rendering fundamental analysis incapable of having any
predictive power about future price movements.
3. Strong Form
The strong form of the EMH holds that prices always reflect the entirety of both public and
private information. This includes all publicly available information, both historical and new,
or current, as well as insider information. Even information not publicly available to investors,
such as private information known only to a company's CEO, is assumed to be always already
factored into the company's current stock price.
So, according to the strong form of the EMH, not even insider knowledge can give investors a
predictive edge that will enable them to consistently generate returns that outperform the
overall market average.

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Portfolios Construction Theories
Meaning: Portfolio
Portfolio is a combination of securities such as stocks, bonds and money market instruments.
The process of blending together the broad asset classes so as to obtain optimum return with
minimum risk is called portfolio construction.
Approaches in Portfolio Construction
Commonly, there are two approaches in the construction of the portfolio of securities viz.
traditional approach and Markowitz efficient frontier approach (modern approach). In the
traditional approach, investor's needs in terms of income and capital appreciation are evaluated
and appropriate securities are selected to meet the needs of the investor
 Traditional Approach
The traditional approach basically deals with two major decisions. They are:
(a) Determining the objectives of the portfolio.
(b) Selection of securities to be included in the portfolio.
Normally, this is carried out in four to six steps. Before formulating the objectives, the
constraints of the investor should be analysed. Within the given framework of constraints, the
objectives are formulated. Then based on the objectives, securities are selected. After that, the
risk and return of the securities should be studied. The investor has to assess the major risk
categories that he or she is trying to minimise. Compromise on risk and non-risk factors has to
be carried out. Finally relative portfolio weights are assigned to securities like bonds, stocks
and debentures and then diversification is carried out. The flow chart below shows the steps in
traditional approach.

 Modern Approach
We have seen that the traditional approach is a comprehensive financial plan for the individual.
Markowitz Model (HM Model)
Harry Markowitz put forward this model in 1952.It assists in the selection of the most efficient
by analysing various possible portfolios of the given securities.
1. Harry Markowitz made the following assumptions while developing the HM model
2. Risk of a portfolio is based on the variability of returns from the said portfolio.

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 3. An investor is risk averse.
4. An investor prefers to increase consumption.
5. The investor's utility function is concave and increasing, due to his risk aversion and
consumption preference.
6. Analysis is based on single period model of investment.
7. An investor either maximizes his portfolio return for a given level of risk or maximizes
his return for the minimum risk.
8. An investor is rational in nature.
To choose the best portfolio from a number of possible portfolios, each with different return
and risk, two separate decisions are to be made:
1. Determination of a set of efficient portfolios.
2. Selection of the best portfolio out of the efficient set.
Determining the Efficient Set
A portfolio that gives maximum return for a given risk, or minimum risk for given return is an
efficient portfolio. Thus, portfolios are selected as follows:
1. From the portfolios that have the same return, the investor will prefer the portfolio with
lower risk, and
2. From the portfolios that have the same risk level, an investor will prefer the portfolio
with higher rate of return.
Demerits of the Markowitz Model
1. Unless positivity constraints are assigned, the Markowitz solution can easily find highly
leveraged portfolios (large long positions in a subset of investable assets financed by large short
positions in another subset of assets), but given their leveraged nature the returns from such a
portfolio are extremely sensitive to small changes in the returns of the constituent assets and
can therefore be extremely "dangerous'.
2 Practically more vexing, small changes in inputs can give rise to large changes in the
portfolio. Mean-variance optimization has been dubbed an 'error maximization' device an
algorithm that takes point estimates (of returns and covariances) as inputs an treats them as if
they were known with certainty will react to tiny return differences that are well within
measurement error'.
3. The amount of information (the covariance matrix, specifically, or a complete joint
probability distribution among assets in the market portfolio) needed to compute a
mean-variance optimal portfolio is often intractable and certainly has no room for
subjective.
Sharpe's Single Index Model
This simplified model proposes that the relationship between each pair of securities can
indirectly measured by comparing each security to a common factor 'market performance index
that is shared amongst all the securities. As a result, the model can reduce the burden of large
input requirements and difficult calculations in Markowitz's mean variance settings (Sharpe,
1963). This model requires only (3n+2) data inputs i.e. estimates of alpha and beta for each

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security, estimate of unsystematic risk for each security, estimates for expected return on
market index and estimates of variance of return on ).
Assumptions Made
The Sharpe's Single Index Model is based on the following assumptions:
1. All investors have homogeneous expectations.
2. A uniform holding period is used in estimating risk and return for each security.
3. The price movements of a security in relation to another do not depend primarily upon the
nature of those two securities alone. They could reflect a greater influence that might have
cropped up as a result of general business and economic conditions.
4. The relation between securities occurs only through their individual influences along with
some indices of business and economic activities.
5. The indices, to which the returns of each security are correlated, are likely to be some
securities' market proxy.
Sharpe’s Optimal Portfolio
Ri – Rf
β
The selection of any stock is directly related to its excess return to beta ratio:
Where, Ri = the expected return on stock
Rf = the return on a risk less asset
bi= Systematic risk
The Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) was introduced by Jack Treynor (1961) while parallel
work was also performed by William Sharp (1964) and Lintner (1965).
The Capital Asset Pricing Model is an economic model which is used for valuing the securities,
stocks and assets by relating risk and expected rate of return.
Assumptions of Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) is valid within a special set of assumption.
These assumptions are
1. All investors have homogenous expectations about the assets.
2. Investor may borrow and lend unlimited amount of risk free asset.
3. The risk free borrowing and lending rates are equal.
4. The quantity of assets is fixed
5. Perfectly efficient capital markets.
6. No market imperfections such like taxes and regulation and no change in the level of
interest rate exists.

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 7. There are no arbitrage opportunities.
8. There is a separation of production and financial stocks.
9. Returns (assets) are distributed by normal distribution.
Using the Beta concept the Capital Asset Pricing Model will help to define the required turn
on a security. Normally the higher is the risk we take, the higher should be the return as
otherwise we avoid risk. So, the higher the β, the higher should be the return. The equation for
CAPM is
Ri = Rf+ βi(Rm-Rf)
Ri is the required return
Rf is the risk free return
Rm is the average market return
βi is the measure of systematic risk which is non-diversifiable.
Presently, the risk free return is 6% as the Treasury Bill rate and market return is expected to
vary with the ß chosen. Let us take ß as 1.2 and expected market return is 18%, then the return
on the stocki is as follows:
Ri=6%+ 1.2 (18-6)
=0.06+1.2 (0.12)
= 0.06+.144
=20.4%
If the investor is risk taker and chooses a Beta of 1.8, then the expected return will be higher
as shown below.
Ri =6+18 (18-12)
=.06+1.8(.12) 140 944 9l
=.06+ .216=.276 =27.6%.
CAPM has the following limitations:
 It is based on unrealistic assumptions.
 It is difficult to test the validity of CAPM.
 Betas do not remain stable over time.
Meaning of Beta (β)
Beta is a measure of the volatility or systematic risk, of a security or a portfolio in comparison
to the market as a whole.
How is the Beta coefficient Interpreted?
The beta of the market portfolio is ALWAYS =1.0
The beta of a security compares the volatility of its returns to the volatility of the market returns:

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β =1.0 - the security has the same volatility as the market as a whole.
β >1.0- aggressive investment with volatility of returns greater than the market.
β <1.0 - defensive investment with volatility of returns less than the market.
β <0 - an investment with returns that are negatively correlated with the returns of the market.
Security Market Line
The SML shows the relationship between risk measured by beta and expected return. The
model states that the stock's expected return is equal to the risk-free rate plus a risk premium
obtained by the price of the risk multiplied by the quantity of the risk.
Capital Market Line-CML
A line used in the capital asset pricing model to illustrate the rates of return for efficient
portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for
a particular portfolio.
Arbitrage Pricing Theory (APT)
In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that hold that
expected return of a financial asset can be modeled as a linear function of various factors or
theoretical market indices, where sensitivity to changes in each in factor is represented by a
factor-specific beta coefficient. The theory was proposed by the economist Stephen Ross in
1976.
The arbitrage pricing theory (APT) describes the price where a mispriced asset is expected to
be. It is often viewed as an alternative to the capital asset pricing model (CAPM), since the
APT has more flexible assumption requirements. Whereas the CAPM formula requires the
market's expected return, APT uses the risky asset's expected return and the risk premium of a
number of macro-economic factors. Arbitrageurs use the APT model to profit by taking
advantage of mispriced securities. A mispriced security will have a price that differs from the
theoretical price predicted by the model. By going short an over priced security, while
concurrently going long the portfolio the APT calculations were based on, the arbitrageur is in
a position to make a theoretically risk-free profit.
The APT formula is:
E(rj)=rf+bj1RP1+bj2RP2+ bj3RP3+ bj4RP4+ ... + bjnRPn
where:
E(rj)= the asset's expected rate of return
rf =the the risk-free rate
bj = the sensitivity of the asset's return to the particular factor
RP= the risk premium associated with the particular factor

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The general idea behind APT is that two things can explain the expected return on financial
asset:
(1) macroeconomic/security-specific influences and
(2) the asset's sensitivity to those influences. This relationship takes the form of the linear
regression formula above.
There are an infinite number of security-specific influences for any given security including
inflation, production measures, investor confidence, exchange rates, market indices or changes
in interest rates. It is up to the analyst to decide which influences are relevant to the asset being
analyzed.
Once the analyst derives the asset's expected rate of return from the APT model, he or she can
determine what the "correct" price of the asset should be by plugging the rate into a discounted
cashflow model
STOCK SELECTTON
Stock selection is an investment strategy that involves buying stocks and placing them in of
portfolio according to the perceived strengths of the individual stocks
STOCK SELECTION PROCESS
A. Fundamental Analysis
Fundamental analysis uses different factors such as the current economic environment and
finances of the company to estimate its stock value.
1. Top-Down Approach of Stock Selection
The Top Down approach for fundamental analysis means beginning the analysis to Global
Macroeconomic level right from the start, moving to consecutive narrower economic levels
until it reach the individual business. The factors to be focused while doing top down approach
of fundamental analysis are:
a. Economy: Analyzing the local economy like fluctuations in currencies, employment
rate, government taxation structure and stimulus for various sectors can affect the stock
performance.
b. Sector Level: After taking a look and narrowing down to a local economy that is doing
well, an investor need to analyse and take a look at how specific sectors may be doing
c. Industry Level: Taking one step further, once a sector is targeted, the next step the
investor need to follow is to take a look at the sector to which industry may be doing
better than others and their outlook
d. specific Company Level: Once an investor have narrowed down to a possible Industry,
he need to look at potential individual businesses within that industry.
The financial information about the company can be analyzed by reading annual report of a
company. An investor or his analysts should be able to read and understand the following
financial statements
i. Income Statement: It is a statement of estimation of the income of a specific time determining
Net Sales and each kind of investment or expenditures

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ii. Balance Sheet: A balance sheet provide information about business's financial situation by
clearly disclosing what the business has as assets and where its debts come from.
iii. Statement of Cash Flow: A cash flow statement is equally important as an income
statement in a list of financial statements, plainly describing stock production and its
application classified under distinctive actions. Its format doesn't involve distinctive figures
involved in financial planning. It only incorporates three types of activities:
1. Operating Activities: These are business operations that cover manufacturing and the
company's scalability events. This section only focuses on income boosting segments and
doesn't discuss debts or liabilities.
2. Investing Activities: The secondary division on the cash flow report shows the profits and
losses made because of speculation in fixed assets, including property, plant, or equipment
(PPE) hence indicating a complete transformation in the capital state for a business.
3. Financing Activities: The last segment on the cash flow report shows the cash flow within
the business, its proprietors and lenders. Economic actions involve activities including liability,
investment and interests. In these events, generated capital is listed when the property is grown
and outgoing stock is registered when shares are given.
Iv Statement of Change in Equity: It describes linking between a business income statement
and balance. sheet. Further, it combines the activities not included in these two economic
declaration including dividend cash, investment removal, financial strategies modification
changes of previous time-lapses, etc.
Iv Statement of Shareholder's Equity: Statement of shareholders" equity describes the
variations in the rate of shareholders' ownership or tenancy investment in a business from the
opening of a financial time to its termination.
2. Bottom-Up Approach of Stock Selection
Under this method of analysis the investors focus on micro economic factors initially and later
they look at the individual company's or industry performance and economy related factors
effecting that business.
a. Specific Company Level: The investor chooses the company or firm that is consistently
given good returns to investors. These companies usually will be top companies in any
particular sector.
b. Industry Level: The investors need to analyse micro or macro environmental factors
effecting the industry to which the firm belong to.
c. Sector Level: After analyzing the industry the next step is to analyze the specific sector which
the company belong to. The various factors like taxation policy, industrial policy etc, will affect
stock performance in different sectors.
d. Economy: Analyzing the local economy like fluctuations in currencies, employment rate
government taxation structure and stimulus for various sectors can affect the stock
performance.

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B. Technical Analysis
The technical analysis method involves examining data generated through market activities,
such as volume and prices.
The field of technical analysis is based on three assumptions:
a) The Market Discounts Everything: A major criticism about technical analysis is that it
only considers price movement, ignoring the fundamental factors of the company. However,
technical analysis assumes that, at any given time, a stock's price reflects everything that has
or could affect the company including fundamental factors.
b) Price Moves in Trends: In technical analysis, price movements are believed to follow
trends. This means that after a trend has been established, the future price movement is more
likely to be in the same direction as the trend than to be against it. Most technical trading
strategies are based on this assumption.
c) History Tends To Repeat Itself: The repetitive nature of price movements is attributed to
market psychology; in other words, market participants tend to provide a consistent reaction to
similar market stimuli over time.

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