Investment & Securities Analysis - WordPress.com...Investment & Securities Analysis CREATED BY:- M. Adnan Arshad Lecturer (GC University Faisalabad) Contact: 0301-7120098 E-mail: [email protected]

INVESTMENT AND SECURITIES ANALYSIS

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Investment & Securities Analysis

CREATED BY:-

M. Adnan Arshad

Lecturer (GC University Faisalabad)

Contact: 0301-7120098

E-mail: [email protected]


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BRIEF CONTENTS

Topics

Page No

Understanding Investment 3

Indirect Investment 7

Securities Markets 12

How Securities Are Traded 18

Risk & Return 21

Fundamental Analysis 26

Market Efficiency 33


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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. Open end Funds(legally known as open-end companies);

2. Closed-end funds (legally known as closed-end companies);

3. UITs (legally known as unit investment trusts).

http://www.sec.gov/answers/mfclose.htm

http://www.sec.gov/answers/uit.htm


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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. It offers both redeemable and non redeemable securities.

2. Redeemable securities are sold at NAV(net Asset Value)

3. Non redeemable securities are sold at MP (market price).

4. For example National Investment Trust.

http://www.sec.gov/answers/nav.htm


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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:

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:


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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.

c) 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.

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

Fix dividend

No fix dividend

Claim on assets: It means in

case of solvency of the

business the first payment is

given to preferred

shareholders.

No claim on assets

No voting right. Voting right

Less risky 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. Business risk.

2. 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:

Economy

Analysis

Industry Analysis

Company

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. Pioneering stage or introduction stage.

2. Expansion or growth stage.

3. Stagnation or maturity stage.

4. 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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Investment & Securities Analysis - WordPress.com...Investment & Securities Analysis CREATED BY:- M. Adnan Arshad Lecturer (GC University Faisalabad) Contact: 0301-7120098 E-mail: [email protected]