Security Analysis

and
Portfolio Management
Rahul Kumar
(Department of Business Administration-
M.J.P. Rohilkhand University, Bareilly)

1
 Outline
• Analysis for equity investment:
– Economy & industry Analysis
– Company Analysis
– Technical Analysis
• Introduction of Random walk Theory & EMT
• Forms of market efficiency

2
 Analysis for equity Investment
– Economy & Industry Analysis
– Company Analysis
– Technical Analysis
 Types of Stock Analysis
• Fundamental Analysis - using economic and
accounting information to predict stock
prices.
– If securities markets are semi strong form
efficient, then fundamental analysis is useless

• Technical Analysis - using prices and volume

information to predict future prices.
– If securities markets are weak form efficient, then
technical analysis is useless

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 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 analysts attempt to study everything that can

affect the security's value, including macroeconomic factors
(like the overall economy and industry conditions) and
individually specific factors.

❖The fundamental approach is based on an in-depth and

all-around study of the underlying forces of the economy,
conducted to provide data that can be used to forecast future
prices and market developments.
❖ A combination of the data is used to establish the true
current value of the underlying asset, to determine whether
they are over- or under-valued and to predict the future
value of the underlying asset based on this information.

❖ Fundamental analysis can be composed of many different

aspects: the analysis of the economy as the whole, the
analysis of an industry or that of an individual company.

❖ As far as short-term trading is concerned, fundamental

analysis cannot be used as a "tactical", short-term
decision-making method.
❖ It helps an investor obtain information about the overall state
of the market, attractiveness and state of a specific security as
compared to other securities, However, when and how to react
to the information, derived through fundamental analysis, is
determined using technical analysis.

❖ Though the basic approach is the same while doing

fundamental analysis, the various factors that affect the value
of the underlying asset keep changing depending upon the
class and nature of the asset under focus.

❖ Thus it is important for an analyst to identify the factors that

are likely to affect the value of the underlying asset and then
resort to the study of the said factors.
❖ Thus it is important for an analyst to identify the
factors that are likely to affect the value of the
underlying asset and then resort to the study of the
said factors.

❖ For example weather may not play a major factor

while analysing the value of the share of a company,
which is in the business of Information technology.
• Fundamental analysis seeks to identify the fundamental
economic and political factors that determine a
commodity’s price.
• It is basically an analysis of the (current and future) demand
and supply of a commodity to determine if
– a price change is imminent, and
– in which direction and by how much prices are expected
to change.
• This approach requires
– gathering substantial amounts of economic data and
political intelligence,
– assessing the expectations of market participants, and
– analyzing these information to predict futures price
movement
❖ The end goal of performing fundamental
analysis is to produce a value that an investor
can compare with the underlying assets current
price in hopes of figuring out what sort of
position to take with that security(under priced
= buy, overpriced = sell).
• Fundamental analysis focuses on cause and
effect — causes external to the trading markets
that are likely to affect prices in the market.
– These factors may include the weather, current inventory levels,
government policies, economic indicators, trade balances and even
how traders are likely to react to certain events.

• Fundamental analysis maintains that markets

may misprice a commodity in the short run but
that the "correct" price will eventually be
reached. Profits can be made by trading the
mispriced commodity and then waiting for the
market to recognize its "mistake" and correct it.
• Various Techniques of Fundamental
Analysis

– The Demand-Supply Framework

• Price Elasticity

– The Balance Table

• Stocks-to-Disappearance Ratio

– The Tabular and Graphic Approach

– The Regression Analysis
• Econometric Models

– Seasonal Price Index

• Market Demand: Market demand represents how much people are
willing to purchase at various prices. Thus, demand is a relationship
between price and quantity demanded, with all other factors
remaining constant.
The Balance Table summarizes the key
components of current-season supply and
disappearance, along with prior-season
comparisons.
 Fundamental Analysis:
Seasonal Price Index
March Sugar Contract: Average Monthly Prices

Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Avg.
1998 12.8 11.4 9.9 8.8 9.3 8.4 7.5 7.1 7.8 7.2 6.7 6.7 8.6
1999 8.5 9.3 11.5 12.5 12.1 12.5 11.2 10.8 9.6 8.7 7.7 6.9 10.1
2000 9.1 8.6 7.5 7.2 6.0 5.4 5.5 5.9 5.6 4.6 4.4 4.0 6.2
2001 5.5 5.0 4.2 3.8 4.0 5.0 5.8 5.6 6.1 6.1 5.6 5.8 5.2
2002 8.3 9.0 8.6 7.5 6.8 6.9 6.1 6.6 6.8 6.5 7.0 7.6 7.3
2003 8.3 7.6 7.7 7.4 7.0 6.7 6.9 7.4 7.7 8.6 9.8 8.5 7.8
2004 8.6 8.7 9.1 10.3 12.4 10.4 9.8 9.8 10.4 11.3 10.0 10.7 10.1
2005 11.3 11.7 11.6 12.0 13.0 12.9 13.5 14.0 14.8 13.5 14.5 14.7 13.1
2006 14.0 14.4 14.1 12.3 11.4 10.7 10.7 9.7 9.9 9.7 9.0 8.7 11.2
2007 8.5 8.3 7.8 8.3 8.7 8.4 8.8 8.8 8.6 8.9 8.4 8.1 8.5
2008 8.6 8.8 9.0 9.5 9.4 9.1 8.9 8.8 8.7 8.3 8.5 8.8 8.9
 Fundamental Analysis thus involves 3 steps
• Economic analysis
• Company analysis
• Industry analysis
 Economic Analysis
⚫ The performance of a company depends much on the
performance of the economy if the economy is 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.
⚫ Investors are interested in studying those economic
varieties, which affect the performance of the company
in which they proposed to invest. An analyzed of those
economic variable would give an idea about future
corporate earnings and the payment of dividends and
interest to investors.
Classes of Macro economic policies
• Fiscal policy – Government spending ,
stimulates the demand for goods.
• Monetary policy – Manipulation of money
supply in an economy.
 Techniques for Economic
(1) GNP forecasting
(2) SAVINGS AND INVESTMENT
(3) INFLATION
(4) AGRICULTURE
(5) RATES OF INTEREST
(6) GOVT. REVENUE, EXPENDITURE & DEFICITS
(7) INFRASTRUCTURE
(8) MONSOON
(9) POLITICAL STABILITY
 Diffusion Index
• An indicator of the extensiveness of an
expansion or contraction.
• Developed by NBER, USA.
Categories
Composite index- combines several index into
single measure.
Component Index – examines a particular series
for components.
D.I. = no. of members in the set in same
direction/ total no. of members in the set.
 Coincidental Indicators

• Index of industrial Production.

• Mfg. & sales.
• Personal income.
 Indian Approach
Lagging Indicators –
Duration of unemployment.
Ratio of mfg.
Commercial loans.

Leading Indicators –
Money supply.
Consumer expectations.
Orders for plant & machinery
 Anticipatory surveys
• Opinion of experts regarding the spending of
consumers, future plans of customers.
• Investors can also form their opinion for the
economy.
 GNP/ Geometric Model
GNP represents the aggregate value of goods
and services produced in the economy. It
reflects the over all 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 is it
for the stock market and vice versa
 Saving & investment
• Savings and investment denote that position
of GNP, which is saved and invested savings
increases in India since eighties now the rate
of savings is 25% from 21% in 80’s, which
indicates the growth of capital market. The
higher the level of savings interest, the more
favorable is it for the stock marketed vice
versa
 Inflation
Inflation has considerate impact on the performance
of companies. Higher rates of inflation upset
business plans and erode 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. However industries and
companies prosper during periods of low inflation.
Hence an investor has to evaluate the inflation
rates prevailing in the economy currently as well as
the trend of inflation likely to prevail in the future.
 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
 Rate of interest
The cost and availability of credit for companies are
determined by the rates of interest prevalent in an
economy. 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.
 GOVT. REVENUE, EXPENDITURE & DEFICITS

Government is the largest investor and spender

of money. So the trends in government
revenue expenditure deficits have a significant
impact on the performance of industries and
companies. So the investor has to evaluate
these carefully to assess their impact on his
investments.
 Infrastructure
• The development of an economy very much
on the availability of infrastructure. It includes
electricity, roads and railways, communication
channels etc. The availability of infrastructural
facilities affects the performance of
companies. Bas infrastructure leads to
inefficiencies, lower productivity, wastage and
delays and vice versa. Thus an investor should
assess the status of infrastructural facilities
available in the economy before finalizing his
 Monsoon
• The Indian economy is essentially an agrarian
economy and agriculture forms a very
important sector of the Indian 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 India and vice
versa. Hence the progress and adequacy of
the monsoon becomes a matter of great
concern for an investor in India.
 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
policies are needed for industrial growth. Such
stable policies can be framed only by stable
political systems.
 Industry Analysis
Industry analysis indicates to an investor whether the
industry is a growth industry or not. It gives an
investor a choice of the industry in which the
investments should be made.
Industry analysis refers to an evaluation of the
relative strength and weakness of particular
industries which can be divided in to three parts,
viz.,
1. Life cycle of an industry
2. Characteristics of an industry
3. Profit potential of an industry
 Life Cycle
a) Pioneering Stage: Technology and product are newly introduced.

(b) Expansion stage: Those companies which reached first stage

grow
further and becomes stronger.

(c) Stagnation Stage: In this stage the growth of the industries

Stabilizes. Sales increases at slower rate.

(d) Decay stage: The industry becomes obsolete and gradually

ceases to exist.
 Characterstics of an industry
Relationship between Demand & supply: Excess supply reduces the profitability of the industry and
insufficient supply tends to improve the profitability. Thus an investor should estimate the demand
and supply gap in an industry.

(b) Period of life: Life of the industry depends on the products and the technology used by the
industry. Technological changes leads to product obsolete. No investment should be made in such
industries.

(c) State of labour: When there is labour revolution, industries cannot become bright.

(d) Governments attitude: The Government may encourage the growth and development of certain
industries by giving much assistance to such industries.

(e) Availability of Raw Material: An industry may depend on internal / external country for raw
material. Sometimes they depend on import of raw material.

(f) Cost structure: It refers to the proportion of fixed costs to variable costs. (Discuss about Marginal
Cost)
 Profit potential of industry
(i) Threat new entrants: New entrants inflate cost, push down the prices and reduce
profitability. An industry which is well protected from the entry of new firms would be
ideal for investment.

(ii) Competitions among existing firms: The firm competes with each other on the basis
of price, quality, promotion, service, warranties and so on. If the rivalry between the
firms in an industry is strong average profitability of the industry may be discouraged.
The rivalry in an industry is high when the following conditions prevail in the market:
(a) There is a sustained competitive battle
(b) The industry growth is dull
(c) The level of fixed cost is high
(d) There is over capacity in the industry continuing for a long time.
(e) The industry product is considered as a commodity, which
stimulates strong competition.
(f) The industry struggles much to withstand.
Pressure from substitute products: Each firm in an
industry face competition from other firms in the same
industry producing substitute products. Substitute
products may affect the profit potential of the industry
badly. The pressure from the substitute products is
found to be high under the following circumstances:
(a) When the price of the products is attractive
(b) When the cost for the prospective buyers to switch
over to a substitute product is minimum.
(c) When the substitute products are earning greater
profits.
Bargaining power of buyers: Buyers can bargain
for price reduction asks for better quality and
better service. The bargaining power of a
buyer group is said to be high under the
following conditions:
(a) If its capacity to buy is more than the
capacity of the seller to sell.
(b) If the cost of the switch over to a
substitute product is low.
(c) If it poses a threat of backward integration
strongly.
Bargaining power of sellers: Sellers also can exert a
competitive force in an industry and bargain for rise in
prices, lower quality, curtail some of the free services they
offer etc. Powerful suppliers can affect the profitability of
the buyer industry badly. Suppliers are said to be powerful
under the following circumstances.
(a) Few suppliers dominate the entire market.
(b) There is no viable substitute for the products supplied.
(c) The switching poses a strong threat of forward
integration.
(d) Suppliers also pose a strong threat of forward
integration.
 Company Analysis
It involves a close investigative scrutiny of the
companies financial and non financial aspects
with a view to identifying its strength,
weaknesses and future business prospects.
The financial and non financial aspects are as
follows:
Marketing success
Accounting Policies
Profitability
 Mktg. Success
• The success of the market of the firm depends
on (a) The share of the company in the
industry (b) Growth of its sales and stability of
sales (c) Sales.
 Accounting Policies
A. Inventory Pricing
⚫ Cost/market value method
⚫ FIFO
⚫ LIFO
B. Depreciation methods
⚫ Straight line method
⚫ Sum of the years digit method
C. Non operating income
⚫ Dividend
⚫ Interest
D. Tax Carry over
⚫ Provision for taxation
 Profitability
A.(a) Gross profit Margin
(b) Net profit Margin
(c) Earning power
(d) Return on equity
(e) Earning per share
(f) Cash EPS
B. Financial Statement Analysis
Trading, P& L A/C Analysis
Balance Sheet Analysis
C. Ratio Analysis
⚫ Liquidity Ratios
⚫ Leverage Ratios
⚫ Profitability Ratios
⚫ Activity / Efficiency Ratio
 Technical Analysis
• Technical analysis differs significantly from
fundamental analysis.
• Technical analysis is a controversial set of
techniques for predicting market direction based on
– Historical price and volume behavior
– Investor sentiment
• Technical analysts essentially search for bullish
(positive) and bearish (negative) signals about stock
prices or market direction.

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 Dow Theory
• The theory is so called because it was formulated by
Charles H. Dow who was the editor of the Wall Street
Journal in USA. In fact, the theory was presented in a series
of editorials in the Wall Street Journal During 1900-1902.
• Charles Dow formulated a hypothesis that the stock market
does not move on a random basis but is influenced by three
distinct cyclical trends that guide its direction. Primary
movements, secondary reactions and minor movements.

• The Dow theory is a method that attempts to interpret and

signal changes in the stock market direction.
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• The primary movement is the long range cycle
that carries the entire market up or down.
• The secondary reactions act as a restraining
force on the primary movement. These are in
the opposite direction to the primary movement
and last only for a short while.
• The third movement in the market is the minor
movements which are the day-to=day
fluctuations in the market.
– The three movements of the market have been
compared to the tides, the waves and the ripples in
the ocean.
 Dow Theory

The primary direction is either bullish or bearish,

and reflects the long-run direction of the market.

Secondary
trends,
temporary Corrections,
departures reversions to the
primary direction

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Bullish Trend(Three Phases)

se 3
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se 2
P h a
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Speculation
and inflation
Revival of
confidence
Bearish Trend(Three Phases)

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P h a
se 2
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2) Price Carts
3) Line Chart
4) Bar Chart
 5) Japanese candlestick chart

• A hi-lo-close chart is a bar chart showing, for

each day, the high price, low price, and closing
price.
• A candlestick chart is an extended version of
the hi-lo-close chart. It plots the high, low,
open, and closing prices, and also shows
whether the closing price was above or below
the opening price.
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 Candlestick Making, Basics

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 Candlestick “Formations”

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 Point and Figure Charts, I.
• Point-and-figure charts attempt to show only major price
moves and their direction.
– The point and figure chart maker decides what price move is major.
– That is, it could be $2, $5, or any other level.

• A major up-move is marked with an “X”

• A major down-move is marked with an “O”

• Start a new column when there is a direction change.

– Buy and sell signals are generated when new highs or new lows are
reached.
– Congestion area, the area between buy and sell signals—a time of
market indecision concerning its trend.

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 Point and Figure Charts, II.

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 Point and Figure Charts, III.

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 Chart Formations
• Once a chart is drawn, technical analysts
examine it for various formations or pattern
types in an attempt to predict stock price or
market direction.

• One example is the head-and-shoulders

formation.
– When the stock price “pierces the neckline” after
the right shoulder is finished, it is time to sell.

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 Chart Formations, The Head and
Shoulders

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 Other Technical Indicators
• The “odd-lot” indicator looks at whether odd-lot
purchases are up or down.

• Followers of the “hemline” indicator claim that

hemlines tend to rise in good times.

• The Super Bowl indicator forecasts the direction of

the market based on who wins the game.
– Two Conference representatives play in the Super Bowl:
one from the National Football Conference and one from
the American Football Conference.
– A win by the National Football Conference (or one of the
original members of the National Football League) is
8-61 bullish.
 Active or Passive Management
• Active Management
– Security analysis
– Timing
• Passive Management
– Buy and Hold
– Index Funds

8-62
 Returns Over Time

-t 0 +t

Announcement
Date
8-63
 The Performance of
Professional Money Managers
• From 1963 to 1998, the S&P 500 index outperformed
general equity mutual funds 22 times (out of 36).
• Why can’t the pros beat the averages? (You can hold a
market average very easily—SPDRs)

8-64
 Other Anomalies
• Neglected Firm
– Neglected firms are typically small firms for which there is
little analyst coverage. Tend to have higher returns – may
be due to lack of liquidity. Suggests this a risk premium in
addition to beta
• Market to Book Ratios
– market to book ratios seem to explain returns better than
beta
• Post-Earnings Announcement Drift
– ( see Figure 12.7). The reaction to earnings announcement
continues after the announcement date.
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 Strong Form Efficiency Tests
• Tests of insider trading suggests that insiders can
usually beat the market suggest that markets are
relatively efficient, up to semi strong form. Trying to
mimic insiders does not seem to be of value, after
their trades are reported.

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 Explanations of Anomalies
• May be risk premiums (but not beta)
• Behavioral Explanations
– What if people don’t act rationally? Does that
mean prices are irrational? Some irrational
decisions will create profit opportunities for
arbitrageurs, so there will be limits to the degree
of irrationality.

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 Information Processing
• Forecasting Errors – people put too much weight on
recent evidence (one good exam grade does not
necessarily mean you will ace the course or one good
quarter does not means the firms prospects are
forever better)
• Overconfidence – people tend to be over confident in
their beliefs. Those who trade a lot (confident in
their beliefs) do worse than others.
• Conservatism – some people under react
• Sample Size Neglect and Representativeness –
anecdotal evidence move people more than large
statistical samples
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 Behavioral Biases
• Framing – On the risk tolerance quiz, the same
question mathematically, often reversed the
answer, when asked a different way
• Mental Accounting – we budget in our mind
for certain things. People are more likely to
make risky gambles with the “house” money
than with their own.
• Regret Avoidance – certain losses cause more
pain than others, even if the dollar amount is
the same.
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 Limits to Arbitrage
• Fundamental Risk – if prices wander too long, those
trying to gain, may in the short term lose (E.g.
Priceline short seller)
• Implementation Costs - transactions costs may limit
arbitrage.
• Model Risk – what if your arbitrage model is wrong?
• Result: Prices could be wrong (do not reflect
fundamentals) but its hard to profit from the
apparent opportunities. In other words, absence of
profit potential does not imply EMH
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 Mutual Fund Performance
• Some evidence of persistent positive and
negative performance.
• Potential measurement error for benchmark
returns.
– Style changes: When Elton et. Al. compared
results to 3 potential index funds (large stocks,
small stocks, bonds), mutual funds showed
negative (but mostly not significant) alphas.
– May be risk premiums

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 So, are markets efficient?
• There’s the story of the finance professor walking
with a graduate student who spies a $20 bill on the
sidewalk. The professor says there is no point picking
up the $20 bill as if there really was a $20 bill on the
sidewalk someone else would have picked it up
already
• Superstar phenomenon:
– Who are the best investors of all time? Peter Lynch,
Warren Buffet, John Templeton, Jeff Neff. Why are there
so few in the club?

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 Random Walk Theory
• Stock price behaviour is explained by the theory. Its based
on the hypothesis that the stock market are efficient.
• Changes in stock prices show independent behaviour and
are dependent on the new pieces of information that are
received but within themselves are independent of each
other.
• The basic premise in random walk theory is that the
information on changes in the economy, industry and
company performance is immediately and fully spread so
that all investors have full knowledge of the information.
• Its presupposes that the stock market are so efficient and
competitive that there is immediate price adjustment.
• This theory later come to be known as the efficient market
hypothesis(EMH).
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 Random Walk with Positive Trend
Securit
y
Prices

Time

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 Random Price Changes
Why are price changes random?
• Prices react to information
• Flow of information is random
• Therefore, price changes are random

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 Efficient Market Hypothesis (EMH)
• Are security markets efficient relative to the
information available for valuing securities?
• Do security prices reflect relevant information quickly
and accurately?
• Why look at market efficiency?
– Implications for business and corporate finance
– Implications for investment
• Market efficiency research examines the relationship
between stock prices and available information.
– The important research question: Is it possible for investors
to “beat the market?”
– Prediction of the EMH theory: If a market is efficient, it is not
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possible to “beat the market” (except by luck).
 The Efficient Market Hypothesis
• This hypothesis states that the capital market
is efficient in processing information .
– An efficient capital market is one in which security
prices equal their intrinsic value at all times, and
where most securities are correctly priced.
• The concept of an efficient capital market has
been one of the dominant themes in academic
literature since the 1960s.
• Concerned with the speed with which
information is incorporated into security
prices.
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 Some Definition
• Elton and Gruber, “When someone refers to
efficient capital markets, they mean that
security prices fully reflect all available
information.”
• Eugene Fama, “In an efficient market, prices
fully reflect all available information. The
prices of securities observed at any time are
based on correct evaluation of all information
available at that time.”
 Forms of Market Efficiency,
(i.e., What Information is Used?)
• A Weak-form Efficient Market is one in which past prices
and volume figures are of no use in beating the market.
– If so, then technical analysis is of little use.

• A Semistrong-form Efficient Market is one in which publicly

available information is of no use in beating the market.
– If so, then fundamental analysis is of little use.
• A Strong-form Efficient Market is one in which information
of any kind, public or private, is of no use in beating the
market.
– If so, then “inside information” is of little use.
– Securities law regulates insider trading, so the law believe
markets are not strong form efficient.
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 Why Would a Market be Efficient?
• The driving force toward market efficiency is
simply competition and the profit motive.

• Even a relatively small performance

enhancement can be worth a tremendous
amount of money (when multiplied by the dollar
amount involved).

• This creates incentives to unearth relevant

information and use it.
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 Are Financial Markets Efficient?
• Nevertheless, three generalities about market
efficiency can be made:

– Short-term stock price and market movements appear to

be difficult to predict with any accuracy.

– The market reacts quickly and sharply to new information,

and various studies find little or no evidence that such
reactions can be profitably exploited.

– If the stock market can be beaten, the way to do so is not

obvious.

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 Some Implications if Markets are
Efficient
• Security selection becomes less important, because
securities will be fairly priced.

• There will be a small role for professional money

managers.

• It makes little sense to time the market.

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Thank You.....