INVESTMENT AND SECURITIES ANALYSIS

Investment & Securities Analysis

CREATED BY:M. Adnan Arshad Lecturer (GC University Faisalabad) Contact: 0301-7120098 E-mail: [email protected]

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INVESTMENT AND SECURITIES ANALYSIS

BRIEF CONTENTS

Topics

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Understanding Investment Indirect Investment Securities Markets How Securities Are Traded Risk & Return Fundamental Analysis Market Efficiency

3 7 12 18 21 26 33

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INVESTMENT AND SECURITIES ANALYSIS

Chapter# 1 INVESTMENT “The commitment of funds for the purpose of generating profit is called investment.” Or “A commitment of funds made in the expectation of some positive rate of return.” For example a person may purchase one kg of gold for the purpose of selling it when its price increases or a person may purchase any security for the purpose of generating profit. CHARACTERISTICS/FEATURES/PROCESS/FACTORS OF INVESTMENT There are four features of investment which are given below:

1. RETURN: “The extra amount received on your principal amount is called return.” Return may b received in the form of yield or capital gain. Return=yield + capital gain The difference between sale price and purchase price is capital gain. The dividend or interest received from investment is called yield. The return on investment depends on the nature of investment.

2. RISK “Uncertainty of fluctuating in return is called risk.” The risk may relate to loss of capital, delay in repayment of capital, nonpayment of interest or variability of returns. The risk of an investment depends on the following factors: 1. The longer the maturity period, the larger the risk. 2. The lower the credit worthiness of the borrower, the higher the risk. 3. The risk varies with the nature of investment. Investment in ownership securities like equity shares carry high risk compared to investment in debt instruments like debentures and bonds.

3. SAFETY Safety is also the feature which investor desires for his investments. The safety of an investment means that there is a certainty of return of capital without loss of money and time. Every investor wants to get back his capital without loss or without delay.

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4. Liquidity It means how quickly the securities are sold in the market without loss of money or time. For example, equity shares are easily saleable than debentures or bonds because there are no buyers in many cases.

INVESTMENT VERSES SPECULATION Investment and speculation are two terms which are closely related. Both involve purchase of assets like shares and securities. Investment is distinguished from speculation with respect to three factors: Risk: No investment is completely risk free. Higher return is associated with higher risk. An investor generally commits his funds to low risk investment, whereas speculator commits his funds to high risk investments. A speculator is prepared to take high risk in order to achieve high return. Simply the investment is less risky then speculation. Capital gain: The speculator’s motive is to achieve profits through price changes, i.e. he is interested in capital gains rather than the income from the investment. If purchase of securities is preceded by proper investigation and analysis to receive a stable return and capital appreciation over a period of time, it is investment. Thus the return or capital gain of investment is low as compared to speculation. Time period: Investment is long term in nature, whereas speculation is short term. An investor commits his funds for a longer period and waits for his return. But a speculator is interested in short term trade gains through buying and selling of investment instruments.

Investment verses Gambling Typical examples of gambling are horse races, card games, lotteries etc. Gambling consists of taking high risks as compared to investment. Gambling is unplanned and non scientific whereas investment is planned. Gambling is surrounded by uncertainty and is based on tips and rumors. The investment is a planned activity and the investor evaluate and allocate funds to various safety outlets which offer safety of principal and moderate and continuous return over a long period of time.

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Types of investors There are two types of investors: individual investors and institutions investors.

1. Individual investors Individual investors are large in numbers but their invest able resources are comparatively smaller. They generally lack the skill to carry out extensive evaluation and analysis before investing. Moreover they do not have a time and resources to engage in such analysis.

2. Institutional investors Institutional investors are the organizations with surplus funds who engage in investment activities. Mutual funds, investment companies, banking and non banking companies, insurance corporations, etc. These institutions are fewer in number but there invest able resources are much larger. These institutions are skilled enough to evaluate before investing. There investment activities are more rational and scientific as compared to individual investors.

Investment Avenues It means in what kind of securities the investor invest his money. Some securities are marketable and liquid while others are non marketable. Some of them are highly risky while some others are almost risk less. The investor has to choose proper avenues from among them depending on his preferences, needs and ability to assume risk. The investment avenues can be broadly categorized under the following heads: 1. Corporate securities: Corporate securities are the securities issued by joint stock companies in the private sector. These include equity shares, preferences shares and debentures. Equity shares have variable dividend and hence belong to the high risk and high return category, while preference shares and debentures have fixed returns with lower risk. 2. Deposits: Among the non corporate investments, the most popular are deposits with banks such as savings accounts and fixed deposits. Savings deposits have low interest rates whereas fixed deposits have higher interest rates varying with the period of maturity. Interest is payable quarterly or half yearly. 3. Post office deposits and certificates: The investment avenues provide by post offices are generally non marketable. Moreover the major investments in post office enjoy tax concessions also. Post office accepts saving deposits as well as fixed deposits from

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the public. E.g. six year national savings certificates are issued by post offices to investors. 4. Life insurance policies: The life insurance corporation offers many investment schemes to investors. These schemes have the additional facility to life insurance cover. Some of the schemes of LIC are whole life policies, convertible whole life assurance policies, endowment assurance policies, money back plan and marriage endowment plan. 5. Provident fund schemes: Provident fund schemes are compulsory deposit schemes applicable to employees in the public and private sectors. There are three types of provident funds applicable to different sectors of employment, namely, statutory provident fund, recognized provident fund and unrecognized provident fund. 6. Government and semi government securities: The government and semi government bodies like the public sector undertakings borrow money from the public through the issue of government securities and public sector bonds. These are less risky avenues of investment because the credibility of the government and government undertakings.

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Chapter # 2 INDIRECT INVESTMENT The investor can invest in the securities in two ways.

1. Direct Investment “Purchasing of securities without involving any middleman directly from company is called Direct Investment.” OR “The investment did by the investor independently.” For example, Mobilink has done direct investment in Pakistan.

2. Indirect Investment “Purchasing of securities with the help of brokers is called Indirect Investment. In this case the commission is given to brokers.” OR “When the investor invests his money through brokers or investment companies then it is Indirect Investment.” For Example: The purchasing of house with the help of property dealer, or purchasing the securities through ARIF Habib group etc.

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INVESTMENT COMPANIES “The company who collect the money from different people and develop portfolio (investment in different securities) for the investor.”

Or “An investment company is a company that is engaged primarily in the business of investing in and managing a portfolio of securities.” By pooling funds of thousands of investors, a specifically selected portfolio of financial assets can be purchased and the investment company can offer its owners (shareholders) a variety of services in addition to diversification, including professional management and liquidity. Or Generally, an "investment company" is a company (corporation, business trust, partnership, or Limited Liability Company) that issues securities and is primarily engaged in the business of investing in securities. An investment company invests the money it receives from investors on a collective basis, and each investor shares in the profits and losses in proportion to the investor’s interest in the investment company. The performance of the investment company will be based on (but it won’t be identical to) the performance of the securities and other assets that the investment company owns.

Types of Investment Companies 1. 2. 3.

Open end Funds(legally known as open-end companies); Closed-end funds (legally known as closed-end companies); UITs (legally known as unit investment trusts).

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1) Open Ended Companies “An investment company whose capitalization constantly changes as new shares are sold and outstanding shares are redeemed.” There are some points relating to open end companies: 1. It offers redeemable securities (the securities purchase by investment companies from other companies for making portfolio but these securities can not be sold in the markets. These securities can be return back to the company if investor needs money. 2. There is no decision about time period. 3. Securities are sold at Net asset value (the value on which company take back its securities).

2) Close Ended companies “An investment company with a fixed capitalization whose shares trade on exchanges.” Some points relating to close ended companies: 1. It offers non redeemable securities (these securities cannot be sold to the company if investor needs money). 2. Securities are sold at Market price (the price on which the securities are sold and purchased in the market) 3. There is no restriction on time. 4. The price of closed-end fund shares that trade on a secondary market after their initial public offering is determined by the market and may be greater or less than the shares’ net asset value (NAV).

3) Unit Investment Trusts “An unmanaged form of Investment Company typically holds fixed income securities, offering investor diversification and minimum operating costs.” 1. 2. 3. 4.

It offers both redeemable and non redeemable securities. Redeemable securities are sold at NAV(net Asset Value) Non redeemable securities are sold at MP (market price). For example National Investment Trust.

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Mutual Funds “An open end investment company, selecting and managing a portfolio of securities.” The company collects money from different investors and invests that money in different securities.

Mutual fund categories Mutual funds fall into the following categories: money market funds, bonds funds, stocks funds, balanced funds, and asset allocation funds.

1. Stock funds As the name implies, stock mutual funds invest mainly in common stocks. There are four basic types of stock funds. Stock Fund Types 1. Large Cap: Primarily invests in "Blue-chip" companies - large, well-known industrials, utilities, technology, and financial services companies with large market capitalization. Large cap stocks are perceived to be less risky than smaller capitalized companies. 2. Mid Cap: Primarily invests in companies whose market capitalization is smaller than large caps but larger than small caps. Mid caps are generally considered more risky than large cap stocks but have a higher return expectation. 3. Small Cap: Primarily invests in emerging companies, thought to have potential for future growth and profit. Small caps are generally considered the riskiest stocks compared to larger capitalized firms but carry the expectation of higher returns. Small cap funds are subject to greater volatility than those in other asset categories. 4. International: Primarily invests in stocks traded on foreign exchanges International funds are subject to additional risks such as currency fluctuation, political instability and the potential for illiquid markets. 5. Sector: Primarily invests in specific industry sectors such as technology, financials, health, or energy. Since sector funds focus their investments on companies involved in a specific industry sector, the funds may involve a greater degree of risk that an investment in other mutual funds with greater diversification.

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2. Bond Funds Bond funds invest in various types of bonds - issued by corporations, municipalities, and the government. Bond Fund Types: 

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Government: Primarily invest in bonds issued by the U.S. Department of Treasury as well as various federal agencies. Government bonds are generally taxable. Municipal: Primarily invest in municipal bonds issued by state and local governments and their agencies to fund projects such as schools, streets, highways, hospitals, bridges, and airports. Municipal bonds can be insured or non-insured securities. Income generated from municipal bonds may be tax free at both the federal and state level (consult the funds prospectus). Corporate: Primarily invest in bonds issued by corporations to help fund business activities. Income from corporate bonds is taxable.

3. Money market funds Money market funds invest in short-term securities such as Treasury bills. Most money market funds offer a higher rate of interest than bank savings accounts, and some are free of federal or state taxes. Money market Fund types a. Treasury Bills (T-bills) These money market securities are issued to finance the federal budget deficit. These securities are issued by the Government of the country. The investment in T-bills is less risky because the guarantee is given by the Government. At maturity the face value of the T-bill. b. Commercial Paper: Commercial paper is type of short term promissory note issued by large corporation with strong credit worthiness. Commercial paper is unsecured. It means that issuing corporation does not provide any security that the lender can take instead of issuing corporation becomes solvent. c. Banker’s Acceptance: Banker’s acceptance is a short term debt instrument that is guaranteed for payment by commercial bank (the bank accepts the responsibility to pay). The bank gives the guarantee that if company cannot pay to the investor than the bank will pay them.

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Fund Management Style Actively managed funds: Mutual Fund managers are professionals. They are considered professionals because of their knowledge and experience. Managers are hired to actively manage mutual fund portfolios. Instead of seeking to track market performance, active fund management tries to beat it. To do this, fund managers "actively" buy and sell individual securities. For an actively managed fund, the corresponding index can be used as a performance benchmark. Is an active fund a better investment because it is trying to outperform the market? Not necessarily. While there is the potential for higher returns with active funds, they are more unpredictable and more risky.

Actively managed fund styles: Some active fund managers follow an investing "style" to try and maximize fund performance while meeting the investment objectives of the fund. Fund styles usually fall with in the following three categories. Fund Styles   

Value: The manager invests in stocks believed to be currently undervalued by the market. Growth: The manager selects stocks they believe have a strong potential for beating the market. Blend: The manager looks for a combination of both growth and value stocks.

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Chapter # 3

SECURITIES MARKET Financial Markets: The market where securities are sold and purchased for generating finance is called Financial Market. There are five further markets included in financial markets:

1. The Primary Market “The market for issues of new securities, typically involves investment bankers”. When a security is created and sold for the first time in the financial market place, this transaction takes place in the primary market. In this market the issuing business or entity sells its securities to investors (the investment bankers simply assist with this transaction). The company can issue its new securities in two ways in the primary market: i.

Direct Placement:

The company offered its security in the primary market without involvement of any middleman is called Direct Placement. Sale of new security→ IPO → Investor ii.

Indirect Placement

When the company offered its security in the primary market with involvement of middleman i.e. investment banks, brokers etc. then it is called Direct Placement. Sale of new securities→ IPO using →investment Banks IPO “The prices at which the securities are sold by the issuer for the first time are called Initial Public Offerings (IPO). Investment Bankers: Institutions called investment banking firms exist to help business and state and local governments to sell their securities to the public. Investment bankers arrange securities sales on either an underwriting basis or on best efforts basis: 13

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a) Underwriting refers to the process by which an investment banker purchases all the new securities from the issuing company and then resells them to the public. The bank purchases the securities on low price from the company and sells them on high prices in the market. The difference between these prices is the underwriting fee. In underwriting all the risk is faced by the bank. b) In best effort offering basis the bank cannot purchase the securities from the bank. It took the securities from the company and tries to sell them in the market. The unsold securities are return to the company. The bank charges fee for this service. In this service all the risk is faced by the company.

2. Secondary Market: Once a security has been issued, it may be traded from one investor to another. The secondary market is where previously issued securities or used securities are traded among investors. Suppose you called you stockbroker to request that she buy 100 shares of stock for you. The shares would usually be purchased from another investor in the secondary market. Secondary market transactions occur thousand of times daily as investors trade securities among themselves. OR “A market where issued securities are sold and purchased is called secondary market” 3.

The Money Market

Short term securities ( a maturity of one year or less) are traded in the money market. “The market where securities whose maturities are less than or equal to one year are sold or purchased is called money market.” Securities in the Money Market Governments, corporations and financial institutions that want to raise money for a short time issue money market securities. The following securities are available in the money market: a)

Treasury bills: These money market securities are issued to finance the federal budget deficit. These securities are issued by the government of the country. The investment in the T-bills in less risky because the guarantee is given by the Government. At maturity, the government pays the face value of the T-bill. b) Commercial Paper: Commercial paper is type of short term promissory note issued by large corporation with strong credit worthiness. Commercial paper is unsecured. It means the issuing corporation does not provide any security that the lender (the one

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who buys the commercial paper) can take instead of a payment if the issuing corporation becomes solvent. Banker’s Acceptance: Banker’s acceptance is a short term debt instrument that is guaranteed for payment by a commercial bank (the bank accepts the responsibility to pay). The bank give the guarantee if the company cannot pay to the investors then the bank will pay them. c)

4. The Capital Market Long term securities (maturities over one year) trade in the capital market. Federal, state and local governments as well as large corporations, raise long term funds in the capital market. The market where securities whose maturities are more then one year are sold and purchased Securities in the Capital Market: When government, corporations and financial institutions want to raise money for a long period of time, they issue capital market securities. In contrast to money market securities, capital market securities may not be very liquid or safe. They are not generally suitable of short term investments. The following securities are available in the capital market.

a) Bonds: Bonds are the securities that promise to pay their owner a certain amount of money on some specified date in the future and in most cases the company pay interest amount at regular intervals until maturity. Two types of bonds are available in the market. I. Secure bonds: The bonds against which the companies pledge its real assets are called secure bonds. These bonds are issued by the new companies or those companies which are not publicly well known. II. Unsecured bonds: The bonds against which the companies cannot pledge its real assets are called secure bonds. These bonds are issued by those companies who had larger credit worthiness in the market.

b) Corporate Stock or Shares: Rather than borrowing money by issuing bonds, a corporation may choose to raise money by selling shares of ownership interest in the company. Those shares of ownership are stock. Investors who buy stock are called stockholders. Two types of stock are available in the market.

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Preferred shares

Common shares

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Fix dividend

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No fix dividend

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No claim on assets

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Claim on assets: It means in case of solvency of the business the first payment is given to preferred shareholders. No voting right.

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Voting right

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Less risky

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More risky

5. Over the Counter Market(OTC) The over the counter market has no fixed location or more correctly it is everywhere. The OTC is a network of dealers around the world who maintain inventories of securities for sale. Suppose you want to buy a security that is traded in OTC. You would call your broker, who would locate among competing dealers who have the security in the inventory. After locating the dealer with the best price, your broker would buy the security on your behalf. The securities are sold and purchased through telephone and internet.

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Stock Market Indexes: “Index is the number that shows the selling and purchasing behavior of the securities on a particular day.” When index increases then it means people invest more in the common stock and when it decreases it means people withdraw money or sell securities. Index shoes the price movement of securities in the market. The stock market index of country plays an important role to attract the international investors. Stock market indexes generally understate the total returns to investors from owing common stock.

Types of Stock Market Indexes: The types of indexes are given below:

1. The Dow Jones Averages(DJAI): “A price weighted series of 30 leading industrial stocks, used as a measure of stock market activity.” The best known average in the United States is the Dow Jones Industrial Average (DJIA), probably because it has always been affiliated with Dow Jones & company, publishers of The Wall Street Journal, and it is reported daily on virtually all major newscasts. It is the oldest market measure originating in 1896 and modified over the years. This average is composed of blue chip stocks, meaning large, well established and well known companies. DJIA is a price weighted series, which is unusual. Because it gives equal weight to equal dollar changes, high priced stock carry more weight than low priced stock.

2. Standard & Poor’s stock price indexes: “It is the market value index of stock market activity covering 500 stocks.” This index is carried in the popular press such as The Wall Street Journal. It is a good measure of what the overall market is doing for the investors. The S & P 500 is typically the measure of the market preferred by institutional investors when comparing their performance to that of market. S & P 500 is a market value index or capitalization weighted index.

3. KSE-100 index ( Karachi Stock Exchange): In this index the top, middle, low level companies are taken to check buying and selling behavior of Pakistan. It is local index.

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4. KSE 30 index: In this index the top 30 company’s stock behavior are checked. If index increases than it is a good sign for country, because international investors attracted towards Pakistan.

Regional Exchanges Every country has its own central stock exchange. The stock exchanges expect then central stock exchange in the country is called regional exchanges. For example in Pakistan KSE(Karachi stock exchange) is the central exchange and Lahore stock exchange and Islamabad stock exchanges are the regional exchanges

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Chapter # 4 HOW SECURITIES ARE TRADED Broker: “Broker is a person who works on the behalf of owner.” Brokers are hired for selling and purchasing of securities.

Types of Brokers: There are two types of brokers:

1. Full Service Brokers: “A broker offering a full range of services, including information and advice.” These brokers execute there customer’s orders, provide advice and recommendations to investors and send them publications about individual stocks, industries, bonds and so forth. In today’s investing world, full service brokers seek to meet all client’s needs, whether it be retirement planning, estate planning, taxes, financing children’s education and thinly traded foreign stocks.

2. Discount Brokers: “A broker offering execution services at prices typically significantly less than full service brokers.” These brokers provide only selling and purchasing services to investors. These brokers charge low commission than full service brokers. Discount brokers will provide virtually all of the same services except they may or may not offer advice and publications and will charge less for the execution of trades. Discount brokers also provide online services to investors.

Brokerage Accounts Broker can receive money from investors through following accounts:

1. Cash Account: The most common type of brokerage account is cash account in which all the transactions of selling and purchasing of securities is take place on cash. The customer makes only cash transactions with broker. The customer or investor provides money to broker and broker purchase securities.

2. Marginal Account or Margin Borrowing: In this account the customer or investor borrow money from broker to finance a securities transaction and broker charge interest on the loan taken by investor. Thus some payment of securities is made by investor and some by broker. Four terms are included in marginal account:

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1. Initial Margin: The amount of transaction paid by the investor to the broker is called initial margin.

2. Mark to market: The calculation of profit and loss on securities on daily basis is called mark to market.

3. Marginal Call: The additional amount required by the broker when the prices of securities are decreased. The broker call the investor to let him know that prices of securities are decreased so there is a need to give more money.

4. Maintenance Margin: The amount provided by the investor on marginal call is treated as maintenance margin.

Orders in the Stock Market “The way of selling and purchasing the securities in the market is called order.” The market dealers match the supply and demand, with each market maker making a market in certain securities. They do this by standing ready to buy a particular security from a seller or to sell it to a buyer. Types of Orders: Investors use three basic types of orders: 1. Market order. 2. Limit order. 3. Stop order.

1. Market Order: “An order to buy or sell at the best price when the order reaches the trading floor.” A market order ensures that the order will be executed upon receipt, but the exact price at which the transaction occurs is not guaranteed.

2. Limit Order: “An order to buy or sell at a specified or better price.” A limit order ensures that the price specified by the investor will be met or bettered, but execution of the order may be delayed or may not occur. In limit order the prices of securities are decided today but the transaction may take place in the future. But the limit order is effective for only one day

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.

3. Stop Order: “An order specifying a certain price at which a market order takes effect.” A stop order directs that when a stock reaches a specified price a market order takes effect, but the exact transaction price is not assured. Stop orders are used to buy or sell after a stock reaches a certain price level. A buy stop order is placed above the current market price, while a sell stop order is placed below the current price.

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Chapter # 5 Risk & Return Definition of Risk: “Risk is the potential for variability in returns”. Definition of Return: “The extra amount received on your principal amount” or “The return is that an investor expects to get from his investment”. The return may be in the form of yield or capital gain. Return= yield + capital gain An investment whose returns are stable is considered to be low risky, whereas an investment whose returns are likely to fluctuate are considered as risky investment.

Elements of Risk: The essence of risk in an investment is the variation in its returns. This variation in returns is caused by a number of factors. These factors which produce variations in the returns from an investment are called the elements of risk. The total risk is composed of systematic risk and unsystematic risk. Total Risk= systematic risk + unsystematic risk These two types of risk are explained below:

1. Systematic Risk: “The factors that is external to the company and effect on the return of investment”. These factors are uncontrollable by the company. External factors include economic, social or political instability. These changes affect the performance of the company or industry and their stock prices.

Types of Systematic Risk: Systematic risk is further sub divided into three types: 1. Interest rate risk. 2. Market risk. 3. Purchasing power risk. These types of systematic risk are explained below:

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1) Interest Rate Risk: Interest rate risk is a type of systematic risk that particularly affects debt securities like bonds and debentures. A bond or debenture normally has a fixed coupon rate of interest. The issuing company pays interest to the bond holder at this coupon rate. A bond is normally issued with a coupon rate which is equal to the interest rate prevailing in the market at the time of issue. Thus the market interest rate moves up in relation to the coupon interest rate, the market price of the bonds decline and vice versa. This variation in bond prices caused due to the variations in interest rates in known as interest rate risk. Or the risk faced by the investor due to the fluctuations in interest rates is known an interest rate risk.

2) Market Risk: Market risk is a type of systematic risk that effects share. Market prices of shares move up and down consistently for some time periods. A general rise in share prices is referred to as bullish trend, whereas general fall in share prices is referred to as bearish trend. The risk faced by the investor due to alternating movements of share prices is known as market risk. The stock market is seen to be volatile. This volatility leads to variations in the return of investors in shares. The variation in returns caused by the volatility of stock market is referred to as market risk.

3) Purchasing Power Risk: It refers to the variation in investor returns caused by inflation. Inflation results in lowering the purchasing power of money. Whereas inflation is defined as the “increase in the prices of goods or services or when too much money chases too few goods.” Due to the increase in prices of goods or services the purchasing power of people lowers. Thus inflation causes a variation in the purchasing power of the returns in from an investment. This is known as purchasing power risk and its effect is on all securities in the market.

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2. Unsystematic Risk: “The factors which are internal to the company and effect on return of investment”. These are controllable to a great extent. These internal factors include raw material, scarcity, labor strike, management inefficiency. When variability of return is due to such internal factors is known as unsystematic risk or unique risk. Types of Unsystematic risk: There are two types of unsystematic risk: 1. 2.

Business risk. Financial risk.

These two types of unsystematic risk are explained below:

1. Business Risk: “Business risk is the variability in operating income caused by operating conditions of the company”. Every company operates within a particular operating environment. This operating environment contains both internal environment inside the firm and external environment outside the firm. The impact of these operating conditions is reflected in the operating costs of the company. The operating cost consists of fixed cost and variable cost. The greater fixed cost is disadvantage to a company. Such a firm is said to face a larger business risk. 2. Financial Risk: Financial risk is a function of financial leverage which is use of debt in the capital structure. The presence of debt in the capital structure creates fixed payments in the form of interest which is compulsory make payment whether the company faces losses or profit. This fixed interest payment creates more variability in the earnings per share (EPS) available to equity share holders. The increase or decrease in EPS in response to changes in operating profit would me much wider in the case of a levered firm (a company having debt in its capital structure) than in the case of un levered firm. The variability in EPS due to presence of debt in the capital structure of a company is referred to as financial risk. Or the risk faced by the company due to the use of more debts in its business is known as financial risk.

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Other risks:

Liquidity Risk: “The risk faced by the investor when the securities are not easily sold in the market”. If the investor invests his money in the new company’s security the liquidity risk is more and vice verse. How quickly the securities are sold in the market as liquidity. Exchange Rate Risk: It is the risk faced by the company due to the fluctuations in the currency exchange rate.

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Chapter # 6 FUNDAMENTAL ANALYSIS “The evaluation and analysis of the past performance and expected future performance of companies, industries and the economy before taking the investment decision is called Fundamental Analysis.” OR “The evaluation and analysis before investment for rational investment decision making is called Fundamental Analysis.” In this type of analysis the investor collect the information about the fundamental factors if the company or industry i.e. market share, credit position, financial statement, relation with other business etc.

Fundamental Analysis Process: Fundamental analysis consists on three stages: 1. Economy analysis. 2. Industry analysis. 3. Company analysis. These analyses can be shown by following diagram:

Company Analysis Industry Analysis Economy Analysis

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I. Economy Analysis The performance of company depends on the performance of the economy. Investor has to analyze those factors of the economy in which he want to invest. These factors are:

a) Growth rates of National income: The rate of growth of the national economy is an important factor or variable to be considered by the investor. GNP (gross national product), NNP (net national product) and GDP (gross domestic product) are the different measures of total income or total economic output of the country as a whole. The growth rate of these measures indicates the growth rate of the economy.

b) Stages of business cycle: The stage of the economic cycle through which a country passes has a direct impact on the performance of industries and companies. The four stages of economic cycle are: I. Depression Depression is the worst of the four stages. During a depression demand is low and declining. Inflation is often high and interest rates also high. Companies are forced to reduction, shut down plant and lay off workers. II. Recovery During recovery stage the economy begins to revive after a depression. Demand picks up leading to more investments in the economy. Production, employment and profits are on increase. III. Boom The boom phase of economic cycle is characterized by high demand. Investments and production are maintained are at high level to satisfy the demand. Companies generally earn high profits. IV. Recession The boom phase gradually slows down. The economy slowly begins to experience a downturn or decrease in demand, production, employment, etc. The profits of company also start to decline. This is the recession stage of the business or economy cycle.

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c) Inflation: Inflation prevailing in the economy has considerable impact on the performance of companies. Higher rates of inflation upset business plans and results in the squeeze of profit margins. On the other hands inflation leads to decrease in the purchasing power of the consumers which lead to decrease in the demand of products.

d) Interest Rates: Interest rates determine the cost and availability of credit for companies operating in an economy. Low interest rates stimulate investment by making credit available easily and cheaply. Higher interest rates result in higher cost of production which may lead to lower profitability and lower demand.

e) Government Revenues & Expenditures: When government expenditure exceeds its revenue there occurs a deficit. This deficit is known as Budget Deficit. Budget deficit is an important determinant of inflation, as budget deficit leads to financing deficit which fuels inflation.

f) Exchange Rates: The performance of business is also affected by the exchange rate of the rupees against major currencies of the world. It would also make imports more expensive. The exchange rate of the rupee is influenced by balance of trade deficit, the balance of payments deficit and also the foreign exchange reserves of the country.

g) Infrastructure: The development of the economy depends very much in the infrastructure available. Industry needs electricity for its manufacturing activities, roads and railways to transport raw material and finished goods, communication channels to keep in touch with suppliers and customers. The availability of infrastructure affects the performance of companies. Bad infrastructure leads to inefficiencies, lower productivity, wastage and delays.

h) Political Instability: A stable political environment is necessary for steady and balanced growth. No industry or company can grow due to political instability. Stable long term economic policies are necessary for industrial growth.

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2. Industry Analysis Industry is the collection of homogenous companies. An investor ultimately invests his money in the securities of one or more specific companies. Each company can be characterized as belonging to an industry. The performance of company is influenced by the fortunes of the industry to which it belongs. At any stage in the economy, there are some industries which are fast growing while others are stagnating or declining. If an industry is growing, the companies with in the industry may also be prosperous. Thus industry analysis refers to an evaluation of the relative strengths and weaknesses of particular industries. Following are some factors to be analyzed before investment:

a. Industry Life Cycle Industry life cycle consists of four stages which are 1. 2. 3. 4.

Pioneering stage or introduction stage. Expansion or growth stage. Stagnation or maturity stage. Decay or decline stage.

1. Pioneering stage: This is the first stage in the industrial life cycle of a new industry where the technology as well as the product is relatively new. This stage is characterized by rapid growth in demand for the output of industry. As a result there is a great opportunity for profit. Many companies compete with each other vigorously. As large number of companies attempt to capture their share of market, there arises high business mortality rates. Weak firms are eliminated and a lesser number of firms survive in this stage. Investment in companies in an industry that is in the pioneering stage is highly risky. Industries in the pioneering stage are called sunrise industries.

2. Expansion Stage: Once the industry has established itself it enters the second stage of expansion or growth. The industry now includes the companies that survive in the pioneer stage. These companies continue to become stronger. Each company finds a market for itself and develops its own strategies to sell and maintain its position in the market. The competition among the surviving companies brings about improved products at lower price. Companies in the expansion stage are quite attractive for investment purposes because demand exceeds the supply at this stage. Companies will earn an increasing amount of profits and pay attractive dividends.

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3. Stagnation Stage: This is the third stage in the industry life cycle. In this stage the growth of industry stabilizes. The ability of an industry to grow appears to be lost. Sales may increasing but at a lower rate. The industry begins to stagnate. The transition of the industry from the expansion stage to the stagnation stage is often very low. Two reasons for this transition are change in social habits and development if improved technology. Investment is risky because the after this stage the industry enters to the decline stage.

4. Decay Stage: From the stagnation stage the industry passes to the decay stage. This occurs when the products of the industry are no longer in demand. New products and new technologies have come to the market. Customers have changed their habits, style, and liking. These changes are the causes of decay of industry. The investment at this stage is very risky.

b) Demand Supply Gap: The investor has to check the demand and supply gap of the industry before investing. The industry may experience under supply and over supply. It is good to invest in the industry that experience the under supply because the supply is less as compared to the demand due to which the profitability is high and vice verse.

c) Competitive conditions The level of competition among various companies in an industry is determined by certain competitive forces. These competitive forces are: threat of competitive rivalry, threat of potential entrants, threat of substitutes, threat of buyers growing bargaining power and threat of suppliers growing bargaining power. It is risky to invest if there are large number of competitors in the market, there is no barriers for new entrants, there are substitute product in the market and if buyers or suppliers have strong bargaining power.

d) Permanence: The degree of permanence of an industry is an important consideration in industry analysis. Permanence is a phenomenon related to the products and the technology used by the industry. If an analyst feels that need for a particular industry will vanish in a short time or the technology will changes rapidly than it is risky to invest.

e) Labor Conditions: The investor should also analyze the labor conditions of the industry. If the labor in a particular industry is inclined to resort to strikes frequently, the future of that industry is not bright.

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f) Attitude of Government: The attitude of government towards industry has impact on the future of industry. The government may place different kinds of legal restrictions on its development. The investor should analyze whether the role of government is the industry is favorable or unfavorable.

g) Supply of Raw Material: if there is a shortage of raw material in the industry than it is risky to invest. Some industries may have their own raw material while some will import from other countries. The investor should also analyze the availability of raw material and its impact on the prospects of industry.

H) Cost Structure: Another factor to analyze is the cost structure of the industry, viz. the proportion of fixed cost to variable costs. The higher the fixed cost component, higher is the sales volume necessary to achieve breakeven point. The lower the fixed cost the lower is the sales volume as well as breakeven point. The lower breakeven point has higher margin of safety.

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3. Company Analysis Company analysis is the final stage of fundamental analysis. The economy analysis provides the investor a broad outline of the prospects of growth in the economy. The industry analysis helps the investor to select the industry in which investment would be rewarding. Now investor had to decide the company in which he wants to invest. Company analysis deals with the estimation of return and risk of individual shares. Information regarding companies is classified into two groups: internal and external. Internal information consists of data and events made by public concerning their operations. The internal information sources include annual reports to shareholders, public and private statements of officers of the company, the company’s financial statement etc. external sources of information are those generated independently outside the company. These are prepared by investment services and financial press. In company analysis the analyst tries to forecast the future earnings of the company because earnings have a direct and powerful impact on share prices. Financial Statements: The financial statements published by the company periodically help us to asses the profitability and financial; health of the company. The company provides two types of financial statements: balance sheet and profit and loss account (income statement). Analysis of Financial statements: The financial statements of the company can be used to evaluate the financial performance of the company. Ratio analysis helps the investor to determine the strength and weakness of the company. Different ratios are given below: I. Liquidity Ratio: “The measure of the company’s ability to fulfill its short term obligations and reflect its short term financial strength or liquidity”. The commonly used liquidity ratios are:

a. current ratio= current assets current liabilities b. acid test ratio/quick ratio= current assets-inventory-prepaid exp. Current liabilities

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II. leverage Ratios: These ratios are also known as capital structure ratios. They measure the company’s ability to meet long term debt obligations. The commonly used leverage ratios are: a. debt equity ratio= long term debt Shareholder’s equity b. total debt ratio= total debt Total assets c. proprietary ratio= shareholder’s equity Total assets d. interest coverage ratio= Earnings before interest and taxes (EBIT) Interest

II. Profitability Ratio: The profitability of the company is measured by the profitability ratios. These ratios can be calculated by relating the profits either to sales or to investment or to equity shares.

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Chapter # 7 Market Efficiency Market efficiency that prices on traded assets (e.g., stocks, bonds, or property) already reflect all available information, and instantly change to reflect new information Stages of market efficiency There are three stages of market efficiency Weak form efficiency One of the most historical types of information used in assessing security values in market data, which refers to all past price information. If security price are determined in market that is weak form efficient, historical price and volume data should already be reflected in current price should be of no value in predicting future price changes .t Test of usefulness of price data are called weak form tests of EMH (efficient market hypotheses). If the weak form of EMH is true past price changes should be unrelated to future price change. Semi strong efficiency A more comprehensive level of market efficiency involves not only known and publicly available market data, but all publicly known and available data such as earning, dividend, and stock split announcements, new product developments, financing difficulties and accounting changes. A market that quickly incorporates all such information into prices is said to show semi strong efficiency Strong form of market efficiency The most stringent form of market efficiency is strong form which asserts that stock prices fully reflect all information, public and non public . If market is strong form efficient no group of investors should be able to earn, over reasonable period of time. Abnormal rates of return by using publicly available information in a superior manner

Efficient Market Hypothesis (EMH) Fama also created the Efficient Market Hypothesis (EMH) theory, which states that in any given time, the prices on the market already reflect all known information, and also change fast to reflect new information. Therefore, no one could outperform the market by using the same information that is already available to all investors, except through luck.

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