INTRODUCTION TO SECURITY ANALYSIS

What Does Security Mean?

An instrument representing ownership (stocks), a debt agreement (bonds) or the rights to ownership (derivatives).

A security is essentially a contract that can be assigned a value and traded. Examples of a security include a note, stock, preferred share, bond, debenture, option, future, swap, right, warrant, or virtually any other financial asset
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INDTRODUCTION
OVERVIEW

INVESTMENT ALTERNATIVES
SECURITIES MARKET

Investment is a sacrifice of current money or other resources for future benefits

OVERVIEW
Numerous avenues of investments are available today such as : 1. Deposit with banks 2. Government Bonds 3. Equity shares 4. Provident Fund

5. Stock options
6. Plot of land
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 The two key aspects of any investment are time and risk In some investments time (like Govt Bonds ) The time element is the dominant attribute . In other investments (Like stock options) the risk element is the dominant attribute. In yet other investments ( like equity shares) both time and risk are important

Investment V/S Speculation

Investment and speculation both involve the purchase of assets such as shares and securities, with an expectation of return. The capacity to bear risk distinguishes an investor from a speculator. An investor prefers low risk investments, whereas a speculator is prepared to take higher risks for higher returns. Speculation focuses more on returns than safety, thereby encouraging frequent trading without any intention of owning the investment.
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Investment V/S Speculation

Investor Speculator

Planning Horizon

longer planning horizon.

Short planning horizon

Risk deposition

Not willing to take more than moderate risk Modest rate of return commensurate with risk assumed Attaches greater significance to fundamental factors Uses own funds

Willing to assume high risk High rate of return

Return expectation

Basis for decisions

More on technical and hear say Resorts to borrowing

Leverage

Investment alternatives

Non marketable Financial Assets

Equity Shares

Bonds

Mutual fund Schemes

Real estate

Investment alternatives

Money market Instruments

Life insurance Policies

Precious Objects

Financial Derivatives

Bonds

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Non marketable Financial Assets

1. Bank Deposits
2. Post office deposits 3. Company deposits 4. Provident fund deposits

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EQUITY SHARES

Equity shares represent ownership capital.

The equity shareholders have residual claim on assets of the company BONDS Bonds or debentures represent long term debt instruments . Bonds may be classified into following catogories

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1. Government securities

2. Saving Bonds
3. PSU Bonds 4. Debentures or Bonds of private sector companies 5. Preference Shares *

* Preference shares are Hybrid securities which partake features of Bonds and equity shares

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Mutual Funds

Instead of directly buying equity shares and/ or fixed income instruments , you can participate in various schemes floated by mutual funds which in turn , invest in equity shares and fixed income securities . There are three broad types of mutual fund schemes :
1. Equity Schemes

2. Debt Schemes
3. Balanced Schemes
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Life Insurance

In a broad sense , life insurance may be viewed as an investment.

Insurance premiums represent the sacrifice and the assured sum , the benefit. The important types of insurance policies are : 1. Endowment assurance policies 2. Money back Policy 3. Whole life policy
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Real Estate

For bulk of the investors the most important assets in their portfolio is a residential house.
In addition to a residential house , the more affluent investors are likely to be interested in the following types of real estate : 1. Commercial Property 2. A second House 3. Agriculture Land / Resort Home
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Precious Objects :

Precious objects are items that are generally small in size but highly valuable in monetary terms
1. Gold and silver 2. Art objects 3. Precious stones

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Financial Derivatives

A financial derivative is an instrument whose value is derived from the value of an underlying assets. It may be viewed as a side bet on the asset.
The most important financial derivatives from the point of view of investors are : Options Futures
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Criteria for Evaluation

For evaluating an investment avenue , the following criteria are relevant Rate of return Risk Marketability Tax Shelter

Convenience

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Rate of return
The rate of return on an investment for a period ( which is usually a year ) is defined as follows

Rate of Return = Annual income + ( Ending price Beginning price) Beginning Price

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Example
Consider the following information about a certain equity share :

Price at the beginning of the year Rs 85

Dividend paid towards the end of the year Rs 4.00 Price at the end of the year Rs 98

The rate of return on this share is calculated as follows : 4.00 + ( 98- 85) 85

= 19/85 = 22.35%

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Risk
The rate of return from investments like equity shares , real estate silver and gold can vary rather widely. The risk of an investment refers to the variability of its rate of return. How much do individual outcomes deviate from the expected value ?

Measure used commonly in finance are as follows

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Variance : the is the mean of square deviations of individual returns around their average value Standard deviation : this is square root of variance

Beta : this is how volatile is the return from an investment relative to market swings.

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Marketability : An Investment is highly marketable or liquid if : (a) it can be transacted quickly (b) the transaction cost is low and (c ) the price change between two successive transaction is negligible

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Tax shelter
Some investments provide tax benefits ; others do not . Tax benefits are of the following the three kinds. Initial Tax benefit .

Continuing Tax benefit

Terminal Tax benefit

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Initial : tax relief enjoyed at the time making investment.for eg Provident fund / LIC benefit under section 80 C of IT Act. Continuing : Tax benefit associated with periodic returns ; for example Dividends on shares Terminal : tax benefit associated at the time of redemption ; for example Provident fund/LIC

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Convenience
Convenience broadly refers to the ease with which the investment can be made and looked after

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Financial Markets
Financial markets is market for creation and exchange of financial assets , if you buy or sell financial assets , you participate in financial markets in some way or other. Functions of the financial markets 1. Facilitate price discovery 2. Provide liquidity 3. Reduce cost of transacting

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Classification of financial markets

According to the period of maturity of the financial assets with which the markets are dealing, the markets can be classified as * Money Market. * Capital Market. These markets are again classified as primary markets and secondary markets.

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Money market deals with instruments having a period of maturity of one year or less like treasury bills, bills of exchange etc. Capital market deals with all instruments having a period of maturity of above one year like corporate debentures, government bonds, equity and preference shares etc.

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Money Market
Money market deals in short-term debt, and channel the savings into short-term productive investments like working capital, call money, treasury bills etc. In India, money market is classified into the organized segment and unorganized segment . The organized segment is characterized by fairly rigid and complex rules and is dominated by commercial banks and major financial institutions like UTI.
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This segment is subjected to tight control by the Reserve Bank of India.

Unorganized segment is characterized by informal procedures; flexible terms and attractive rates of interest both depositors and borrowers. The unorganized sector is dominated by money lenders.

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The Discount and Finance House of India (DFHI) is a finance house established as a company under the Companies Act, 1956. It is providing liquidity to money market instruments by creating a secondary market and offering buying / selling quotes for various instruments. RBI actually operates in the money market through the DFHI

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The position of money market in the Indian system has become important with recent liberalization of monetary policies, such as deregulation of lending rates, permitting mutual funds and banks subsidiaries to enter into money market operations. Money market ensures efficient functioning of the financial system and provides greater flexibility in banks operations

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Capital market is the market for financial assets having a period of maturity of more than one year or of an indefinite period. Thus, capital market provides long-term resources needed by medium and large scale industries.

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The Indian capital market which had been lying dormant in the seventies up to mid eighties has witnessed an unprecedented boom and undergone sea change with a number of financial services and banking companies, merchant bankers, more stock exchanges, ventures capital funds, private sector mutual funds, foreign institutional investors, over-the-counter exchange, national stock exchange, credit rating services, custodial services, portfolio management services, non-resident investment, new regulations etc. emerging on the Indian capital scene. 36

Before repeal of Capital Issues Control Act 1947, the entire working of the new issue market in India was governed by the Controller of Capital issues Control Act, 1947. The timing of the new issues by private sector companies, the composition of securities to be issued, interest (dividend) rates which can be offered on debentures and preference shares, the premium to be charged on securities were all subject to the regulation of the CCI.

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The repeal of Capital Issues Control Act, 1947 and the establishment of Securities Exchange board of India (SEBI) has been a milestone in the history of capital market in India. There is complete metamorphosis of the market system, policies and regulation with the birth of SEBI like allowing companies to fix the price of instruments, making guidelines for various issues involved in primary market and framing guidelines for various intermediaries of both primary and secondary market. The role of SEBI has changed from controlling to regulatory with investor protection as the primary motive. 38

Summary Evaluation of various Investments

Return Current yield Equity Shares Low Debentures High Return Capital appreciation High Negligible Nil Moderate Moderate Moderate Moderate High Avera ge Negli nil nil negli avera ge High Average High average average low high High Nil Low Sec 80 C Sec 80 high nill High High High high high fair avera ge
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Risk

Liquidity Tax shelter

Conv

Bank deposits Moderate PPF Nil

Life insurance Nil polices Residential house Gold and silver Moderate nil

Portfolio management process

1. Identifying the investors objectives and constraints 2. Choice of the Asset Mix 3. Formulation of Portfolio Strategy 4. Selection of Securities 5. Portfolio Execution

6. Portfolio revision
7. Performance Evaluation
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Identifying the investors objectives and constraints

The typical objectives sought by investors are current income, capital appreciation , and safety of principal. The relative importance of these objectives should be specified further , the constraints arising from liquidity , time horizon , tax and special circumstances must be identified.

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Choice of the Asset Mix

The most important decision in the portfolio management is the asset mix decision. Very broadly this is concerned with proportions of stock ( equity shares and units / shares of equity-oriented mutual funds) and bonds ( fixed income investments vehicles in general) in the portfolio. The appropriate stock-bond mix depends mainly on the risk tolerance and investment horizon of the investor.
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Formulation of portfolio strategy

Once a certain asset mix is chosen , an appropriate portfolio strategy has to be hammered out. Two broad choices are available :

1. Active portfolio strategy

2. Passive portfolio strategy Active portfolio strategy strives to earn superior risk- adjusted returns by resorting to market timing , or sector rotation , security selection
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Or some combination of these.

A passive strategy , on the other hand , involves holding broadly diversified portfolio and maintaining pre -determined level of risk exposure

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Selection of Securities

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 The portfolio management process broadly consists of three steps: Planning, Execution and Feedback. The planning step begins with identifying the investors objectives and constraints. Once these are established, an investment policy statement can be written to act as a guideline for future investment decisions. Long-term expectations for the capital markets will then be used to create a strategic asset allocation suitable to the objectives and constraints outlined. The execution step puts the plan into action. Specific assets can be selected, and decisions can be made on how best to implement the strategic plan. The portfolio can be optimized using quantitative tools and at times it may be deemed appropriate to make tactical alterations to the long-term strategic asset allocation. The feedback step consists of ongoing monitoring of the portfolio and rebalancing to the strategic asset allocation when needed. It also entails an evaluation of the performance not only how well the portfolio performed but what factors contributed to the performance.

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