Module 3

Stock Selection and Portfolio Construction

 Fundamental Analysis

Fundamental analysis is a method of evaluating securities by

attempting to measure their intrinsic value.

It involves examining various qualitative and quantitative factors

related to a company's business operations, financial health,
management quality, industry trends, and economic indicators to
determine whether a stock is undervalued, overvalued, or fairly
valued.
 KEY COMPONENTS OF FUNDAMENTAL ANALYSIS

1.Financial Statements Analysis

2.Revenue and Earnings Growth Assessment
3.Profitability Ratios Evaluation
4.Financial Health Examination
5.Valuation Metrics Analysis (PE, PB Ratio)
6.Industry and Market Analysis
7.Management Quality Assessment
8.Consideration of Macro-Economic Factors
9.Evaluation of Qualitative Factors
10.Risk Assessment
 Economic Analysis
3.
2. Employment
& Labor
1. GDP Inflation Market
Rate

6.
Government 4. 5. Business
Policy &
Fiscal Consumer Investment
Stimulus Spending

9. 8. 7. International
Geopolitical Commodity Trade & Exchange
Risks Prices Rates
 Sector Analysis

1. Screen 5. Consider
Regulatory
Industries Environment

4.
3. Assess
Competitive
Evaluate
Dynamics Financial
Metrics
2.
Analyze
Industry 6. Assess
Trends Industry
Risks
Company Analysis & Valuation
Financial Statement Analysis (IS, BS & CFS)

Revenue and Growth Drivers (Source, Sustainability, Growth, Compt. Adv)

Profitability Analysis (GPM, NPM, ROA, ROCE, ROE

Financial Health & Risk Assessment (Solvency, int.c.ratio, & liq. position, Corp. Gov)

Valuation Analysis (DCF, P/E, P/B Ratio, U/O Value?)

Industry & Competitive Analysis (Trend, Compt Adv, PP, MS, Entry Barriers)
 Technical Analysis
Dow Theory is one of the foundational theories of technical analysis. It was formulated by Charles
Dow, the founder of Dow Jones & Company and co-founder of The Wall Street Journal, and refined by
his successors William Hamilton and Robert Rhea. The theory is based on the analysis of market price
action and volume and is primarily used to identify the primary trends in the stock market.
 Key Principles of Dow Theory
The Market Discounts Everything
Market Trends Have Three Phases
Volume Should Confirm the Trend
Primary Trends Are Confirmed by Averages
Trends Persist Until Reversal Is Confirmed
 KEY CONCEPTS & TOOLS
Charts
Support & Resistance Levels
Trend Lines
Moving Averages
Relative Strength Index (RSI)
MACD (Moving Average Convergence Divergence)
Chart Patterns
Line, Bar & Candle Stick Charts
Support & Resistance Levels
 Trend Lines

https://howtotradeblog.com/what-are-support-and-resistance/
Moving Averages
Relative Strength Index (RSI)
 MACD
(Moving Average Convergence Divergence)
Chart Patterns
 Efficient Market Hypothesis
An efficient market is one where prices adjust quickly and accurately to new
information, making it difficult for investors to consistently outperform the market.

The Efficient Market Hypothesis (EMH) is a theory in finance that suggests financial
markets quickly and accurately incorporate all available information into asset prices.

In simpler terms, it means that the prices of stocks, bonds, and other assets reflect all
known information at any given time, making it nearly impossible for investors to
consistently outperform the market.

Weak Form Efficiency

Semi-Strong Form Efficiency
Strong Form Efficiency
 Weak Form Efficiency

In a weak form efficient market, all past market prices and data are
already reflected in current prices. This means that studying past prices
or trading volume won't help you predict future price movements.

In simple term, Past price patterns or trends have no predictive power for
future prices, the market is considered weak-form efficient.
 Semi-Strong Form Efficiency

In a semi-strong form efficient market, all publicly available

information is already reflected in asset prices.

This includes not only historical data but also news, earnings
announcements (Financial Statement), and any other information that's
available to the public.

In simple term, If prices adjust rapidly to new public information, the

market is considered semi-strong form efficient.
 Strong Form Efficiency
In a strong form efficient market, all information, including public and
private information, is already reflected in asset prices. This means that
even insider information, which is not available to the public, is quickly
incorporated into prices

If even investors with access to non-public information cannot

consistently earn abnormal returns, the market is considered strong-
form efficient.
 Portfolio Construction
Portfolio construction refers to the process of selecting and combining
various assets (such as stocks, bonds, real estate, commodities, etc.) into
a single investment portfolio. The goal of portfolio construction is to
achieve a balance between risk and return that aligns with the investor's
objectives, risk tolerance, and time horizon.
Q. Calculate expected return of portfolio from the following information

Risk-Free Rate (Rf​): 3%

Expected Return of the Market E(Rm​): 8%
Betas:
• Stock A (βA​): 1.2
• Stock B (βB​): 0.8
• Stock C (βC​): 1.0
• Stock D (βD​): 1.1
• Stock E (βE​): 0.9

Calculate Portfolio Return, if

i) Equal weightage for all the stock
ii) Weightage for A:35%, B: 30%, C:20%, D:10% and E: 5%
iii) Weightage for A:5%, B: 10%, C:20%, D:30% and E: 35%
Calculation of Return of Share Price

Stock Return = x 100

Market Return = x 100

Beta (β) is a measure of a stock's volatility or systematic risk relative to the
overall market. It indicates how sensitive a stock's returns are to changes in
the market.

Beta (β)

Covariance= Variance (MR)=

Q1. Mr. Arjun has decided to purchase securities of MK Ltd. He is required to earn 17% in next year. Beta
value of company is 2.2. Rf is 8% and market return is 15%. Suggest what should be his decision about
purchase.

Q2. Mr. Kishore purchased stock at Rs. 7,000. The same share has a net worth of Rs. 10,000 at the end of
the year. Shareholder receives a dividend of Rs. 500. Calculate the total return earned by Mr. Kishore.
Q3. Mr. Ashoka,28-year-old is manager in a restaurant. He has saved an amount of Rs. 20,000. He is thinking
about how to invest his savings. He has approached you to get advice. Now as a financial planner advise him on
which security he must invest and what are the benefits that he would get from the investment
 Markowitz's Theory of Portfolio
Construction
Harry Markowitz is a Nobel Prize-winning economist known for his pioneering work on
portfolio theory.
Markowitz's theory of portfolio construction provides a systematic approach to
building investment portfolios that aim to maximize returns while minimizing risk
through diversification and optimization

Risk and Return

Diversification
Efficient Frontier
Portfolio Optimization
Modern Portfolio Theory
 Risk and Return
Markowitz's theory begins with the idea that investors are rational and seek to
maximize returns while minimizing risk.

Diversification
Markowitz argued that spreading investments across different asset classes can
reduce risk without sacrificing returns. This is because different assets often move
in opposite directions in response to various economic factors.
 Efficient Frontier
This is a graph that illustrates the optimal risk-return combinations for a given set of
assets. Portfolios that lie on the efficient frontier offer the highest expected return
for a given level of risk, or the lowest risk for a given level of return.
 Portfolio Optimization
Markowitz developed mathematical models to help investors construct portfolios
that maximize returns for a given level of risk or minimize risk for a given level of
return. This involves analyzing the expected returns, volatilities, and correlations of
different assets to find the optimal portfolio allocation.

Modern Portfolio Theory (MPT)

Markowitz's work laid the foundation for Modern Portfolio Theory, which is widely
used in finance today. MPT provides a framework for evaluating investment
decisions based on risk and return and has greatly influenced portfolio management
practices
 Decomposition of Risk
It refers to the process of breaking down overall risk into its constituent
parts or components to better understand and manage it. This approach
allows for a more detailed analysis of the various factors contributing to
risk and enables risk managers to develop strategies to mitigate each
component individually.
 Identifying Risk Factors
Factors such as interest rates, market volatility, credit quality, and liquidity
may all contribute to the overall risk of a portfolio.

Quantifying Risk Components

This may involve statistical analysis, scenario modeling, or other
quantitative techniques to assess the relationship between the risk factors
and the outcome of interest.

Understanding Interactions
Risk factors are often interconnected, and changes in one factor can affect
others. Eg. portfolio of financial assets, changes in interest rates may
impact both market risk and credit risk simultaneously.
 Managing Individual Components
By breaking down overall risk into its individual components, risk
managers can develop targeted strategies to manage each component
more effectively. (Hedging, Adjusting portfolio allocations, Diversifying
exposures)

Portfolio Optimization
By understanding the relative importance of each component and its
contribution to overall portfolio risk, investors can construct portfolios
that achieve their risk-return objectives more effectively.
Sharpe’s Single Index model & the
Capital Asset Pricing Model (CAPM)
Both models are used to calculate the expected return of an asset or a
portfolio based on its risk relative to the market.
 Assumptions
The CAPM makes more restrictive assumptions than the single index
model.

CAPM assumptions: Investors have homogeneous expectations, no

taxes or transaction costs, unlimited lending/borrowing at the risk-free
rate, and that all investors hold the same efficient portfolio (the market
portfolio).

The single index model does not make such strict assumptions about
market perfections and investor homogeneity.
ARBITRAGE PRICING THEORY (APT)

It is a financial theory that seeks to explain the relationship between the

expected return on an asset and its risk. It suggests that the price of an
asset should reflect its expected return relative to other assets, taking
into account the various factors that influence its risk
 Basic Concept
• APT assumes that the expected return of an asset is influenced by
multiple factors or sources of risk, rather than just one factor like the
Capital Asset Pricing Model (CAPM).

• These factors could be anything that affects the return of the asset,
such as changes in interest rates, inflation, economic growth, or
industry-specific factors
 Arbitrage

• Arbitrage is the practice of buying and selling assets simultaneously in

different markets to take advantage of price differences. In the context
of APT, if an asset is incorrectly priced relative to its expected return
and risk, investors can exploit this mispricing through arbitrage.

• For example, if two assets with similar risk profiles have different
expected returns, investors could buy the undervalued asset and sell
the overvalued one to make a risk-free profit.
Consider two assets, Asset A and Asset B, with similar risk profiles.
Suppose both assets have the following characteristics:
Risk-free rate (Rf​): 3%
Market return (Rm​): 10%
Beta (β) for both assets: 1.2
Now, let's say Asset A is currently priced to provide an expected return
of 11%, while Asset B is priced to provide an expected return of 9%.

Since Asset A is priced lower than its expected return according to CAPM, and Asset B is priced
higher, there is an arbitrage opportunity. An investor could buy Asset A, expecting a return of 11%,
and sell Asset B, which is priced at 9%. This would result in a risk-free profit of 2%.
 Factors

• APT identifies several factors that affect asset returns. These factors
are not explicitly defined but are derived from statistical analysis of
asset returns.

• For instance, in a simplified APT model for stock returns, factors

could include changes in interest rates, GDP growth, inflation rates,
and industry-specific variables like oil prices for energy stocks.
Sharpe’s Single Index Model
Mr Ram wants to invest in stocks and will do so only after assessing the systematic
and unsystematic risk of his investment. His friend, a stock broker suggested A, B
and C Co. stocks for investment. He provides the following information about the
stocks to him.
Company α β Ei ²
A 0.07 1.52 0.19
B 0.09 0.81 0.06
C -0.02 1.41 0.15

a. If the market index is expected to have a return of 0.20 and a variance of 0.20,
which single stock would Ram prefer to own from the risk and return point of
view?
b. If he invests equally in all the 3 stocks, what will be his risk and return
portfolio?