ANALYSIS OF VARIABLE INCOME SECURITIES :

FUNDAMENTAL ANALYSIS

VARIABLE INCOME SECURITIES

The term variable income security refers to investment that provides their owners with a rate of
return that is dynamic and determined by market forces. Variable income securities provide
investors with both greater risks as well as rewards.

Variable income securities, also known as variable rate securities, are typically valued by
investors looking for higher returns than those offered by fixed income securities Ex: Equity
shares, which offer investors virtually unlimited up-side growth as well as the complete loss of
principal. In exchange for this risk, investors in these securities demand higher returns than their
fixed income securities.

ANALYSIS OF VARIABLE INCOME SECURITIES (FUNDAMENTAL ANALYSIS)

Rational investment decisions are based on effective security analysis. While investing his
money, the investor has the primary purpose of some gains from that investment.

MEANING OF FUNDAMENTAL ANALYSIS:

Fundamental analysis is a logical and systematic approach to estimating the future dividends
and share price. It is based on the basic premises that the share price is determined by a number
of fundamental factors relating to the economy, industry and company

Intrinsic Value: Each share is assumed to have an economic worth based on its present and
future earning capacity. This is called its intrinsic value or fundamental value.

The purpose of fundamental analysis is to evaluate the present and future earning capacity of a
share based on the economy, industry and company fundamentals and there by assess the
intrinsic value of the share.

Fundamental Analysis is method of finding out the future price of a stock which an investor
wishes to buy. It relates to the examination of the intrinsic worth of a company to find out
whether the current market price is fair or not, whether it is overpriced or underpriced, in the
background of the company’s performance, industry and the general economic conditions.

OBJECTIVES OF FUNDAMENTAL ANALYSIS

The main objectives of fundamental analysis are as follows:

1. Fundamental analysis is an attempt to identify the underpriced and overpriced securities
in the market place so that the investment decisions- buying and selling can be made.
2. The fundamental analysis view investments as long term decisions. The end objective of
this analysis is not to make speculative profits, rather it is to avoid the risk of loss from
buying an overpriced stock and selling underpriced stock.
3. Another objective of fundamental analysis is to beat the market. Buying an underpriced
stock and earning some abnormal return on investment is known as beating the market.

As fundamental analysis is based on factors like economic climate and trends in financial
markets, it generally gives more realistic estimate of the value of the stock. The fundamental
analysis is helpful in establishing the basic standards, but cannot be totally relied upon
because of the uncertainties associated with economic and market factors.

FUNDAMENTAL ANALYSIS FRAMEWORK

The analysis of economy, industry and company fundamentals constitute the main activity in
the fundamental approach to security analysis.

Economy Analysis

Industry Analysis

Company Analysis

The logic of this three tier analysis is that the company performance depends not only on its
own efforts, but also on the general industry and economy factors. A company belongs to an
industry and the industry operates with in the economy.

ECONOMY ANALYSIS

The performance of a company depends on the performance of the economy. If the economy
is booming, income rises, demand for goods increases and hence the industries and
companies in general tend to be prosperous. On the other hand, if the economy is in
recession, the performance of companies will be generally bad.

Investors are concerned with those variables in the economy which affect the performance of
the company in which they intend to invest. A study of these economic variables would give
an idea about future corporate earnings and the payment of dividends and interest to
investors.

Some of the key economic variables that an investor must monitor as part of his fundamental
analysis:

1. Growth rates of National Income

2. Inflation
3. Interest rates
4. Government expenditure, Expenditure and Deficits
5. Exchange rates
6. Infrastructure
7. Monsoon
8. Economic and political stability

Growth Rates of National Income:

The rate of growth of the national economy is an important variable to be considered by an

investor. GNP (Gross National Product), NNP(Net National Product), GDP(Gross Domestic
Product) are the different measures of the total income or total economic output of the
country as a whole. The growth rates of these measures indicate the growth rates of the
economy.

An economy passes through different phases of economic or business cycle. The four stages
of an economic cycle are depression, recovery, boom and recession. The stage of the
economic cycle through which a country passes has a direct impact on the performance of
industries and companies.

Inflation:

Inflation prevailing in the economy has considerable impact on the performance of

companies. Higher rates of inflation upset business plans, lead to cost escalation and result in
decreased profit margins.

Interest rates:

Interest rates determine the cost and availability of credit for companies operating in an
economy. A low interest rate stimulates investment by making credit available easily and
cheaply. Moreover it implies lower cost of finance for companies and thereby assures higher
profitability. On the contrary, higher interest rates results in higher cost of production which
leads to lower profitability and lower demand.

Government revenue, Expenditure and Deficits:

As the government is the largest investor and spender of money, the trends in government
revenue, expenditure and deficits have a significant impact on the performance of industries
and companies. Expenditure by the government stimulates the economy by creating jobs and
generating demand. However, when government expenditure exceeds its revenue, there
occurs a deficit. Budget deficit is an important determinant of inflation.

Exchange rates:

The performance and profitability of industries and companies that are major importers or
exporters are considerably affected by the exchange rates of the rupee against major
currencies of the world. A depreciation of the rupee improves the competitive position of
Indian products in foreign markets, thereby stimulating exports. But it would also make
imports more expensive. A company depending heavily on imports may find devaluation of
the rupee affecting its profitability adversely.

Infrastructure:

The development of an economy depends on very much on the infrastructure available.

Industry needs electricity for its manufacturing activities, roads and railways to transport raw
materials and finished goods, communication channels to keep in touch with suppliers and
customers.

The availability of infrastructure facilities such as power, transportation and communication

systems affects the performance of companies. Bad infrastructure leads to inefficiencies,
lower productivity, wastage and delays.

Monsoon:

Performance of agriculture to a very great extent depends on the monsoon. The adequacy of
the monsoon determines the success of failure of the agricultural activities in India. Hence,
the progress and adequacy of the monsoon becomes a matter of great concern for an investor
in the Indian context.

Economic and 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. Stable long term economic
policies are what are needed for industrial growth. A stable government with clear cut long
term economic policies will be conductive to good performance of the economy.

ECONOMIC FORECASTING

Investment is a future oriented activity, the investor is more interested in the expected future
performance of the overall economy and its various segments. For this, forecasting the future
direction of the economy becomes necessary. Economic forecasting involves the estimation
of the future trends of the economy.

ECONOMIC FORECASTING TECHNIQUES

Economic forecasting may be carried out for short term periods(up to three years),
intermediate term periods(three to five years) and long term periods (more than five years).
An investor is more concerned with the short term economic forecasts for periods ranging
from a quarter to three years. Some of the techniques of forecasting are as follows:

Survey method: Anticipatory surveys are the surveys to intentions of the people in
government, business, trade and industry regarding their construction activities, plant and
machinery expenditures, level of inventory etc., such surveys may also include the future
plans of consumers with regard to their spending on durables and non-durables. Based on the
results of these surveys, the analyst can form his own forecast of the future state of the
economy.

Barometric or Indicator approach: In this approach to economic forecasting, various

types of indicators are studied to find out how the economy is likely to perform in the future.
These indicators are times series data of certain economic variables. The indicators are
classified as Leading, Coincidental and Lagging indicators.

Leading indicators are the hints that an analyst can get before the incident occurs in the
economy. Ex; number of new business firms starting, contracts and orders for plant and
machinery, money supply etc

Coincidental indicators are the indicators which move along with the economic
performance. Ex: GDP, personal incomes, extent of production etc.,

Lagging indicators reach their turning points after the economy has already reached its own
turning points. Ex: unemployment, ratio of production and stock level, loans outstanding in
the banks etc.,

Econometric model building: This is the most precise and scientific of the different
forecasting techniques. This technique makes use of Econometric, which is a discipline that
applies mathematical and statistical techniques to economic theory.
In the economic field we find complex interrelationships between economic variables. The
precise relationships between the dependent and independent variables are specified in a
formal mathematical manner in the form of equation. The system of equations is then solved
to yield a forecast that is quite precise.

Opportunistic model building: This is one of the most widely used forecasting techniques.
It is also known as GNP model building or sectoral analysis. In this method, the analyst
estimates the total demand in the economy and based on this he estimates the total income or
GNP for the forecast period. This estimation will take into consideration the prevailing tax
rates, interest rates, inflation rates and other economic and fiscal policies of the government.

INDUSTRY ANALYSIS

An investor ultimately invests in a company, which belongs to an industry. The performance

of the companies would, therefore, be influenced by the fortunes of the industry to which it
belongs. For this reason an analyst has to undertake an industry analysis so as to study the
fundamental factors affecting the performance of different industries.

Key elements of Industry Analysis:

In an industry analysis, there are a number of key characteristics that should be considered
by the analyst. These features broadly relate to the operational and structural aspects of the
industry. Some of the characteristics are given below:

Demand Supply gap: The demand for a product tends to change at a steady rate, whereas
change in supply depends on installation of new plant and recruitment of labourers. As a
result, industry is likely to experience under or over supply at different times. This under or
over supply will have its impact on the price. As part of industry analysis, an investor should
estimate the demand supply gap in the industry.

Competitive condition in the industry: The level of competition among various companies
in an industry is determined by certain competitive forces. These competitive forces are
barrier to entry, number of competitors, bargaining power of suppliers, availability of
substitutes, bargaining power of consumers etc., each of these factors after the price and
output of the industry.

Succession of permanence of the industry: It is related to the products and level of

technology used in the industry. If the products are obsolete and particular industry is going
to vanish and the level of technology is low, then it is not advisable to invest in such industry
shares.

Labour conditions: The availability of labour, the attitude of the labour unions in the
particular industry etc., determine the health of an industry.
 Attitude of government: The attitude of the government towards an industry has a significant
impact on its prospects. The government may encourage the growth of certain industries and
can assist such industries and can assist such industries through favourable legislation. On
the contrary some industries may not enjoy the encouragement from the government. So as a
prospective investor it is wise to invest in the industry which enjoys government
encouragement.

Supply of raw materials: the availability of raw materials is an important factor determining
the profitability of an industry. The shortage of the raw material can affect the profitability
and prices of the industry.

Cost structure: the proportion of fixed and variable cost also matters to the profitability of
the industry. Higher fixed costs affect the Break Even Points. An analyst would consider the
industry which has lower break even point.

INDUSTRY LIFE CYCLE

An industry life cycle depicts the various stages where businesses operate, progress, prospect
and slump within an industry. An industry life cycle typically consists of five stages —
startup, growth, shakeout, maturity and decline. These stages can last for different amounts
of time, some can be months or years.

Startup / Birth Stage

At the startup stage, customer demand is limited due to unfamiliarity with the new product’s
features and performance. Distribution channels are still underdeveloped, so there are very few
product supply and promotional activities. There are also lack of complementary products
which add value to the customers, limiting the profitability of the new product.

Companies at the startup stage are likely to generate zero or very low revenue and experience
negative cash flows and profits due to large amount of capital initially invested in technology,
equipment and other fixed costs.
Growth Stage

As the product slowly attracts attention from a bigger market segment, the industry moves on to
the growth stage where profitability starts to rise. Improvement in product features leads to
easiness to use, thus increasing value to customers. Complementary products also start to
become available in the market so people have greater benefits purchasing the product and its
complements. As demand increases, product price goes down which further increase customer
demand.

At the growth stage, revenue continues to rise and companies start generating positive cash
flows and profits as product revenue and costs break-even.

Shakeout Stage

Shakeout usually refers to the consolidation of an industry. Some businesses are naturally
eliminated because they are unable to grow along with the industry or are still generating
negative cash flows. Some companies merged with competitors or are acquired by those which
were able to obtain bigger market shares at the growth stage.

At the shakeout stage, growth of revenue, cash flows and profit start slowing down as industry
approaches maturity.

Maturity Stage

At the maturity stage, majority of the companies in the industry are well-established and the
industry reaches it saturation point. These companies collectively attempt to moderate the
intensity of industry competition to protect themselves and maintain profitability by adopting
strategies to deter entry of new competitors into the industry. They also develop strategies to
become a dominant player and reduce rivalry.

At this stage, companies realize maximum revenue, profits and cash flows because customer
demand is fairly high and consistent. Products become more common and popular among the
general public, and the prices are fairly reasonable compared to new products.

Decline Stage

Decline stage is the last stage of an industry life cycle. The intensity of competition in a
declining industry depends on several factors: sped of decline, height of exit barriers and level
of fixed costs. To deal with decline, some companies might choose to focus on their most
profitable product lines or services in order to maximize profits and stay in the industry. Some
larger companies will attempt to acquire smaller or failing competitors to become the dominant
player. For those who are facing huge losses and do not believe there are opportunities to
survive, divestment will be their optimal choice.
Michel Porter’s five forces model
It is an analysis tool that uses five industry forces to determine the intensity of competition in an
industry and its profitability level.

These forces determine an industry structure and the level of competition in that industry. The
stronger competitive forces in the industry are the less profitable it is. An industry with low
barriers to enter, having few buyers and suppliers but many substitute products and competitors
will be seen as very competitive and thus, not so attractive due to its low profitability.

It is every strategist’s job to evaluate company’s competitive position in the industry and to
identify what strengths or weakness can be exploited to strengthen that position. The tool is
very useful in formulating firm’s strategy as it reveals how powerful each of the five key forces
is in a particular industry.

Threat of new entrants. This force determines how easy (or not) it is to enter a particular
industry. If an industry is profitable and there are few barriers to enter, rivalry soon intensifies.
When more organizations compete for the same market share, profits start to fall. It is essential
for existing organizations to create high barriers to enter to deter new entrants. Threat of new
entrants is high when:

 Low amount of capital is required to enter a market;

 Existing companies can do little to retaliate;
 Existing firms do not possess patents, trademarks or do not have established brand
reputation;
 There is no government regulation;
 Customer switching costs are low (it doesn’t cost a lot of money for a firm to switch to
other industries);
 There is low customer loyalty;
 Products are nearly identical;
  Economies of scale can be easily achieved.

Bargaining power of suppliers. Strong bargaining power allows suppliers to sell higher priced
or low quality raw materials to their buyers. This directly affects the buying firms’ profits
because it has to pay more for materials. Suppliers have strong bargaining power when:

 There are few suppliers but many buyers;

 Suppliers are large and threaten to forward integrate;
 Few substitute raw materials exist;
 Suppliers hold scarce resources;
 Cost of switching raw materials is especially high.

Bargaining power of buyers. Buyers have the power to demand lower price or higher product
quality from industry producers when their bargaining power is strong. Lower price means
lower revenues for the producer, while higher quality products usually raise production costs.
Both scenarios result in lower profits for producers. Buyers exert strong bargaining power
when:

 Buying in large quantities or control many access points to the final customer;
 Only few buyers exist;
 Switching costs to other supplier are low;
 They threaten to backward integrate;
 There are many substitutes;
 Buyers are price sensitive.

Threat of substitutes. This force is especially threatening when buyers can easily find
substitute products with attractive prices or better quality and when buyers can switch from one
product or service to another with little cost. For example, to switch from coffee to tea doesn’t
cost anything, unlike switching from car to bicycle.

Rivalry among existing competitors. This force is the major determinant on how competitive
and profitable an industry is. In competitive industry, firms have to compete aggressively for a
market share, which results in low profits. Rivalry among competitors is intense when:

 There are many competitors;

 Exit barriers are high;
 Industry of growth is slow or negative;
 Products are not differentiated and can be easily substituted;
 Competitors are of equal size;
 Low customer loyalty.

Although, Porter originally introduced five forces affecting an industry, scholars have suggested
including the sixth force: complements. Complements increase the demand of the primary
product with which they are used, thus, increasing firm’s and industry’s profit potential. For
example, iTunes was created to complement iPod and added value for both products. As a
result, both iTunes and iPod sales increased, increasing Apple’s profits.

COMPANY ANALYSIS
Company Analysis is the final stage of fundamental analysis. Company Analysis deals with the
estimation return and risk of individual shares. Many pieces of information are needed to make
the analysis of the company. The information can be financial or non-financial.

Financial Analysis:

This includes the detailed analysis of the financial statements. The financial reports include
Profit & Loss A/c and Balance Sheet. The financial ratios are calculated on the data included in
the financial reports and provide a basis for comparison of the various aspects of performance.

Ratios include:

 Profitability Ratios
 Liquidity Ratios
 Activity or Turnover Ratios
 Leverage Ratios

Non-Financial aspects of Company Analysis:

In addition to the financial parameters, the investor has to analyse some non-financial indicators
also:

1. Business of the company

2. Management strength and weakness of the company
3. Market share of the company
4. Product range of the company
5. Diversification
6. Expansion policy of the company
7. Distribution policy
8. Extent of foreign collaboration
9. Extent of research and development etc.,

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