SECURITY ANALYSIS & PORTFOLIO

MANAGEMENT
 SECURITY :- Investments in capital markets is in various
financial instruments, which are all claims on money. These
instruments may be of various categories with different
characteristics. These are called ‘Securities’ in market place.
Securities Contracts Regulation Act, 1956 has defined the
security as inclusive of shares, scrips, stocks, bonds, debenture
stock or any other markatable instruments of a like nature in or of
any debentures of a company or body corporate, the government
and semi-government body etc. It includes all rights & interests in
them including warrants and loyalty coupons etc., issued by any
of the bodies, organisations or the government. The derivatives of
securities and Security Index are also included as securities.
 SECURITY ANALYSIS :- Security Analysis involves the
projection of future dividend or earnings flows, forecast of the
share price in the future and estimating the intrinsic value of a
security based on forecast of earnings or dividends.
Modern Security Analysis relies on the fundamental analysis of
the security, leading to it’s intrinsic worth and also risk-return
analysis depending on the variability of the returns, covariance,
safety of funds and the projections of the future returns.
•PORTFOLIO :- A combination of securities with different risk-
return profile will constitute the portfolio of the investor. Thus
portfolio is a combination of assets and/or instruments of
investments.
The combination may have different features of risk & return,
separate from those of components.
 PORTFOLIO MANAGEMENT :- Security Analysis is only a tool
for efficient portfolio management.
Traditional Portfolio theory aims at the selection of such
securities that would fit in well with the asset preferences,
needs and choices of the investor.
Modern Portfolio theory postulates that maximisation of return
and/or minimisation of risk will yield optimal returns and the
choice and attitudes of investors are only a starting point for
investment decision and that vigrous risk return analysis is
necessary for optimisation of returns.
 INVESTMENT SCENARIO
 Investment activity involves the use of funds or savings for
acquisition of assets & further creation of assets.
 INVESTMENT VS. SPECULATION

 An investment is a commitment of funds made in the

expectation of some positive rate of return commensurate
with the risk profile of the investment. The true investor is
interested in a good rate of return, earned on a consistent
basis for relatively long period of time.
 The speculator seeks opportunities promising very large
returns, earned quickly. Speculator is less interested in
consistent performance than is the investor & is more
interested in the abnormal, extremely high rate of return
than the normal moderate rate. Furthermore, the speculator
wants to get these returns in a short span of time &
switchover to other opportunities.
 Speculator adds to the market’s liquidity as he is frequently
turning over his portfolio. Thus, the presence of speculator
provides a market for securities, the much required depth &
breadth for expansion of capital markets.
 INVESTMENT CATEGORIES
 Investments generally involve –
A) Real Assets (Physical Assets) :- They are tangible, material
things such as buildings, automobiles, plant and machinery etc.
B) Financial Assets :- These are pieces of paper representing an
indirect claim to real assets held by someone else.
One of the distinguishing features of Real Assets & Financial Assets
is the degree of liquidity. Liquidity refers to the ease of
converting an asset into money quickly, conveniently and at little
exchange cost. Real Assets are less liquid than financial assets,
largely because real assets are more heterogeneous, often
peculiarly adapted to a specific use, and yield benefits only in co-
operation with other productive factors. In addition to it the
returns of real assets are frequently more difficult to measure
accurately, owing to absence of broad, ready, and active
markets.
 FINANCIAL ASSETS
 Financial Assets can be categorised according to their source of
issuance (public or private) and the nature of the buyer’s commitment
(creditor or owner). Accordingly different financial assets are –
DEBT INSTRUMENTS
These are issued by government, corporations and individuals &
represent money loaned rather than ownership to the investor. They
call for fixed periodic payments, called interest and eventual
repayment of the amount borrowed, called the principal. The interest
payment stated as a percentage of the face value or maturity value is
referred to as the nominal or coupon rate.
 Institutional Deposits & Contracts:- Demand & Time deposits,
Certificate of Deposits, Life Insurance policies, Contributions to
Pension Funds. Title can’t be transferred to a third party.
 Government Debt Securities :- These are the safest and most liquid
securities. The short-term securities have maturities of one year or
less and include Treasury Bills with maturities of 91 days to one year.
 Long term securities include Treasury Notes (one to ten year
maturity) and Treasury Bonds (maturities of ten to thirty
years), which bear interest.

 Private Issues:- Private debt issues are offered by corporations

engaged in mining, manufacturing, merchandising and service
activities. The most common short-term privately issued debt
securities are Commercial Paper. CP is unsecured promissory
note from 30 to 270 days maturity. These securities are issued to
suppliment bank credit and are sold by companies of prime
credit standing. Banker’s acceptances are issued in international
trade. They are of high quality having maturities from ninety
days to one year.
The long-term debt contracts cosist of two basic promises-
i) To pay regular interest
ii) To redeem the principal at maturity.
The long-term debts are in the form of bonds, Debentures,
Convertible bonds, Mortgage Bonds, Collateral Trust Bonds.
International Bonds-International domestic bonds are sold by an
issuer within the country of issue in that country’s currency- e.g.
Sony Corp selling yen-denominated bonds in Tokyo.
 Foreign bonds are issued in the currency of the country
where they are sold but sold by a borrower of different
nationality. E.g. A dollar denominated bond sold in Newyork
by Sony Corp is called Yankee bond. Yen denominate bond
sold by IBM in Tokyo is called Samurai bond.
 Company Deposits – Large corporate time deposits in commercial banks are
often of certain minimum amounts for a specified time period. Unlike time
deposits of individuals, these CDs are negotiable; i.e. They can be sold to &
redeemed by third parties.

EQUITY INSTRUMENTS
These instruments are divided into two categories – one representing
indirect equity investment through institutions and the other
representing direct equity investment through the capital markets.
Investment Through Institutions :- These investments involve a
commitment of funds to an institution of some sort that in return
manages the investment for the investor.
Direct Equity Investments :- Equity investments are either in common
stock or preferred stock. The holders of common stock are the
owners of the firm, have the voting power, can elect the BOD and
carry right to the earnings of the firm after all expenses &
obligations have been paid and also carry a risk of losing earnings in
case of losses.
 Common stock holders receive a return based on two
sources- Dividends & Capital Gains.
Preferred stock is called a ‘hybrid security’ because it has
features of both common stock & bonds.
In the event of liquidation, preferred stockholders get their stated
dividends before common stockholders.
International Equities :- Foreign Stocks offer diversification possibilities
because correlation with domestic stocks is much lower in case of
foreign stocks than any other domestic stock. These could be acquired
directly at foreign stock exchanges by purchase of depository receipts
( ADRs, GDRs ). International equities face the same currency risks as
in foreign bonds.
OPTIONS & FUTURES
These instruments of investment derive their value from an underlying
security (stock, bond or basket of securities). Thus they are so called
as derivatives.
An option agreement is a contract in which the writer of the option grants
the buyer of the option the right to purchase from or sell
 to the writer a designated instrument at a specified price
(or receive a cash settlement) within a specified period of
time. Call options are options to buy & put options are
options to sell.

Financial futures represent a firm legal commitment between a buyer

and seller, where they agree to exchange something at a specified
price at the end of a designated period of time. The buyer agrees to
take delivery and the seller agrees to make delivery. Futures are
available either on stocks (stock futures) or basket of stocks (index
futures). Futures on fixed-income securities (e.g. Treasury Bonds) are
called interest-rate futures.
REAL ESTATE
Investments in real estate can be direct one as a owner or indirect as a
creditor. Debt participation is also offered by direct acquisition of
mortgages or the indirect purchase of mortgage backed securities.
Real estate pools that are similar to mutual funds are called Real
Estate Investment Trusts (REITs). They are available for diversified
debt & equity ownership in pools of property of various types.
 RISK & RETURN

 Risk in holding securities is generally associated with the possibility

that realised returns will be less than that were expected. Some risks
are external to the firm & can’t be controlled, thus affect large number
of securities (Systematic Risk). Other influences are internal to the
firm & are controllable to a large degree (Unsystematic Risk).
 Systematic Risk refers to that portion of total variability in return
caused by factors affecting the prices of all securities. Economic,
Political and sociological changes are the sources of systematic risk.
 Unsystematic Risk is the portion of total risk that is unique to a firm or
industry. E.g. Factors such as management capability, consumer
preferences, labour strikes etc.
SYSTEMATIC RISK
Market Risk:- This risk is caused due to changes in the attitudes of
investors toward equities in general, or toward certain types or groups
of securities in particular. Market risk is caused by investor reaction to
tangible as well as intangible events. The tangible events include
political, social and economic environment.
 Intangible events are related to market psychology. Market
risk is usually touched off by a reaction to real events
leading to emotional instability of investors.

 Interest-Rate Risk :- It refers to the uncertainty of future market

values and of the size of future income, caused by fluctuations in
the general level of interest rates.
The root cause of interest rate risk is fluctuating yield on government
securities.
 Purchasing-Power Risk :- Purchasing power risk refers to the

impact of inflation or deflation on an investment. Rising prices of

goods & services are associated with inflation & that falling with
deflation
UNSYSTEMATIC RISK
Unsystematic risk is that portion of total risk that is unique or
peculiar to a firm or industry. Factors such as management
capability, consumer preferences and labour strikes can cause
unsystematic variability of returns for a company’s stock.
 Business Risk :- This risk is a function of the operating
conditions faced by a firm and the variability these
conditions inject into the operating income and expected
dividends. Business risk can be divided into two broad
categories- external & internal.

 Internal Business Risk :- This risk is largely associated with the

efficiency with which a firm conducts it’s operations within the
broader operating environment imposed upon it.
 External Business Risk :- It is the result of operating conditions
imposed upon the firm by circumstances beyond it’s control.
Govt. policies with regard to monetary & fiscal matters can
affect revenues thro’ the effect on the cost & availability of
funds.
Financial Risk :- This risk is associated with the way in which a
company finances it’s activities. The substantial debt funds,
preference shares in the capital structure of the firm creates
high fixed-cost commitments for it. This causes the amount of
residual earnings available for common-stock dividends more
stressed.
 RETURN
Investors want to maximise expected returns subject to
their tolerance for risk. It is the motivating force and the
principal reward in the investment process.

 Realised Return :- It is the return which is actually earned.

 Expected Return :- It is the return from an asset that investors anticipate
they will earn over some future period.
Return in a typical investment consists of two components. The basic
component is the periodic cash receipt on the investment, either in the
form of interest or dividends. The second component is the change in the
price of the asset – commonly called capital gains or loss. This element of
return is the difference between the purchase price and the price at which
the asset can be sold.
Total Return = Income + Price Change
= Cash payments received + Price change over the period
Purchase price of asset
Total return can be either positive or negative.
 BETA
Beta is a measure of non-diversifiable risk. It shows how
the price of a security responds to market forces. In effect,
the more responsive the price of a security is to changes in
the market, the higher will be it’s beta.

 It is calculated by relating the returns on a security with the

returns for the market. Market return is measured by the
average return of a large sample of stocks, such as stock index.
The beta for overall market is equal to 1.00 and other betas are
viewed in relation to this value.
 Measure of beta is helpful in assessing systematic risk and
understanding the impact market movements can have on the
return expected from a share of stock. Decreases in the market
returns are translated into decreasing security returns. Stocks
having beta more than one will be more responsive & that less
than one will be less responsive to the market movements.
 Measure of Beta = % Price change of a scrip return
% Price change of the Market
Index Return
 CAPITAL ASSET PRICING MODEL

 CAPM uses the concept of Beta to link risk with return. Using
CAPM, investors can assess the risk- return trade-off in any
investment decision.
Beta is a measure of non-diversifiable risk ( Systematic Risk). It
shows how the price of a security responds to changes in
market prices. The equation for calculation of beta is,
RL= a + β Rm
RL= Estimated return on i stock
a = expected return when market risk is zero
β = Measure of stock’s sensitivity to the market index
Rm = Return on market index
The equation for CAPM is,
Ri = Rf + βi (Rm – Rf)
Ri is the required return
Rf is risk-free return

Rm is the average market return

βi is the measure of systematic risk which is non-
diversifiable
 SECURITY MARKET LINE (SML)

When CAPM is drawn graphically, we

Y
get SML. If the investor wants to
decide on an investment with an
expected return he would know the
level of risk, he has preferred to take,
he would know the expected return
from this chart. The investor has to
%nr ut e R

Risk Less Return assess whether it is worth taking a

level of risk, if he has a target return
0 X which involves that risk, as he is
0.5 1.0 1.5
assumed to be generally risk averse.
RISK Thus, CAPM & SML help the investor in
(BETA) evaluating risk for a return, in making
any investment decision. The principle
of higher the risk, higher the return is
embodied in this model.
 ALPHA

 Alpha is an indicator of expected return when market return is

zero. It suggests an estimate of return if the market is flat i.e.
neither going up nor going down. Combining the alpha & the
beta we can predict the return on security if the market
moves up or down.
 FUNDAMENTAL ANALYSIS : INDUSTRY ANALYSIS
 At any stage in the economy, there are some industries which are
growing while others are declining. The performance of companies will
depend among other things upon the state of the industry as a whole
and the economy. If the industry is prosperous, the companies, within
the industries may also be prosperous although a few may be in a bad
shape. The performance of a company is thus a function not only of the
industry and of the economy, but more importantly, on it’s own
performance. The share price of the company is empirically found to
depend up to 50% on the performance of the industry and the
economy. The economic and political situation in the country has thus
a bearing on the prospects of the company. Following factors are
considered in the industry analysis.
 Product Line & stage in the life cycle
 Raw Material and Inputs, utilities
 Capacity Installed & utilised
 Industry Characteristics
 Demand & Market
Pricing & government controls on prices, distribution
Control on Imports & exports
Government Policy with regard to Industry
Taxation Policy & incentives offered
Labour & other Industrial problems.
Prospects of growth
Protection or Tariff preferences
Quality of Management
Levels of R&D.
IMPORTANCE OF INDUSTRY ANALYSIS
 The performance of the companies will depend upon the state

of the industry as a whole.

 Through industry analysis future projections of growth will get

highlighted.