INVESTMENT MANAGEMENT Security Analysis and Portfolio Management Preeti Singh Professor, Jagannath International Management School, New Delhi. NINETEENTH REVISED EDITION : 2015 MUMBAI (cid:122) NEW DELHI (cid:122) NAGPUR (cid:122) BENGALURU (cid:122) HYDERABAD (cid:122) CHENNAI (cid:122) PUNE (cid:122) LUCKNOW (cid:122) AHMEDABAD (cid:122) ERNAKULAM (cid:122) BHUBANESWAR (cid:122) INDORE (cid:122) KOLKATA (cid:122) GUWAHATI © Author No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the publishers. First Edition : 1988 Tenth Revised Edition : 2002 Second Revised Edition : 1990 Eleventh Revised Edition : 2003 Third Revised Edition : 1992 Twelfth Revised Edition : 2004 Fourth Revised Edition : 1994 Thirteenth Revised Edition : 2005 Fifth Revised Edition : 1996 Fourteenth Revised Edition : 2006 Sixth Revised Edition : 1997 Fifteenth Revised Edition : 2007 Seventh Revised Edition : 1998 Sixteenth Revised Edition : 2008 Eighth Revised Edition : 1999 Seventeenth Revised Edition : 2009 Ninth Revised Edition : 2000 Eighteenth Revised Edition : 2013 Nineteenth Revised Edition : 2015 Published by : Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd., “Ramdoot”, Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004. Phone: 022-23860170/23863863, Fax: 022-23877178 E-mail: [email protected]; Website: www.himpub.com Branch Offices : New Delhi : “Pooja Apartments”, 4-B, Murari Lal Street, Ansari Road, Darya Ganj, New Delhi - 110 002. 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PREFACE Investment Management is a science of combining different kinds of investments available in an individual’s portfolio. It requires both long term and short term planning. It comprises of high risk and low risk investments. Normally an investor is averse to risk and therefore he has to plan his portfolio and constantly review it to get an additional income in addition to his regular income. There are systematic and unsystematic kinds of risks present in the investment market and they affect the investor in different ways. Unsystematic risk can be reduced completely because it is unique and it affects a particular organization or industry. However, systematic risk is broad spectrum and cannot be reduced but it can be somewhat diversified which may help in reducing some risks but it cannot be completely elimated. The book explains the different kinds of risks that surround the investors and the techniques through which they can be minimized. This book provides some techniques through which different securities can be combined to get a high return. It explains different theories of portfolio management and guides an investor to take correct decisions in combining their securities. Investor should take their own decisions and through fundamental analysis. They should not follow a herd or group. This book analyzes the profile of the investor and his expectations to make investments. It discusses the network of financial markets and institutions and the manner in which they function in India. It has explained the online and the broker method of purchasing and selling securities and how the market regulator disciplines and regulates the intermediaries and transactions in the financial markets. The theories of Harry Markowitz and William Sharpe have been discussed for analyzing and diversifying the portfolio of an individual. Fundamental Analysis, Technical Analysis and Efficient Market Theory, Capital Asset Pricing Model and Arbitrage Theory are useful in investing funds. This is the 19th edition of the book and it gives an insight to the investor of the investment climate in India. It is useful for students of management, commerce, accounting and finance. It is comprehensive and completely revised to suit the latest developments in the Indian financial system. Certain chapters have been added, changed or deleted to make the book useful. I would like to acknowledge the co-operation of my publishers M/s Himalaya Publishing House Pvt. Ltd. and continuing support in publishing this book. Brajendra Kumar has provided prompt and efficient secretarial assistance in preparing the manuscript of this book. I would like to thank my colleagues from various colleges for giving me a feedback of my book and for making suggestions during the revision process. Finally I would like to thank all my students for continuously supporting me and giving me suggestions while revising the book. Dr. PREETI SINGH CONTENTS 1. INVESTMENT MANAGEMENT - AN INTRODUCTION 1–13 1.1 Introduction 1.2 What is Investment? 1.3 Financial and Economic Meaning of Investment 1.4 Investment and Speculation 1.5 Investment and Gambling 1.6 Investment and Arbitrage 1.7 Real and Financial Assets 1.8 Why is Investment Important? 1.9 Factors Favourable for Investment 1.10 Investment Media 1.11 Features of an Investment Program 1.12 The Investment Process 2. FINANCIAL INSTITUTIONS AND MARKETS IN INDIA 14–53 2.1 Background of the Financial System 2.2 Financial System: An Introduction 2.3 Legislative Measures 2.4 Structure of the Financial Markets 2.5 Important Stock Markets in India 2.6 Financial Institutions – Commercial Banks – Development Banks 2.7 A Critique of the Indian Financial System 3. INDIAN SECURITIES MARKET 54–91 3.1 Indian Securities Market 3.2 Participants in the Securities Market 3.3 Financial Instruments 3.4 Financial Engineering Instruments 3.5 Security Market Indices 3.6 Sources of Financial Information 3.7 The Relationship of the New Issue Market and Stock Exchange 3.8 Structure of the Indian Capital Market with Participants 3.9 Intermediaries/Participants in the New Issue Market 3.10 Issue of Capital in New Issue Market 3.11 Functions of the New Issue / Primary Market 3.12 Secondary / Stock Markets 3.13 Listing of Securities 3.14 Depository System or Paperless Trading 3.15 Broker System of Trading of Securities 3.16 Control of Indian Capital Market : SEBI 3.17 Developments in the Stock Market – Insider Trading – Circuit breakers – Free Pricing of Issue/Stock Splits – Screen Based Trading – Regulation of Foreign Institutional Investors (FIIs) – Regulation of Mutual Funds – Options and Derivatives – Regulation of Stock Brokers – Surveillance on Price Manipulation – Buyback of shares – Stock lending. 4. SECURITIES EXCHANGE BOARD OF INDIA 92–99 4.1 Establishment of Securities and Exchange Board of India (SEBI) 4.2 Objectives of SEBI 4.3 Investor Protection 4.4 Listed Companies and Model Code of Conduct 4.5 Investor Grievances 4.6 Departments of SEBI 4.7 OMBUDSMAN 2003 4.8 National Stock Exchange and Arbitration Facilities 4.9 Investor Education 4.10 Prohibition of Insider Trading 4.11 MAPIN 4.12 Investors’ Protection Fund 5. RISK 100–126 5.1 Background of Risk and Return 5.2 Risk 5.3 Systematic Risk 5.4 Unsystematic Risk 5.5 Quantitative Analysis of Risk 5.6 Investor’s attitude towards Risk and Return 6. RETURNS 127–140 6.1 Measurement of Returns 6.2 Traditional Technique 6.3 Modern Technique 6.4 Holding Period Yield: Influence on Bonds and Stocks 6.5 Returns and Probability Distributions 6.6 Taxes and Investment 6.7 Inflation and Investment 6.8 Return: Statistical Techniques 7. THE INVESTMENT ALTERNATIVES 141–163 (Bonds, Preference Shares and Equity Shares) 7.1 Investor Classification 7.2 Corporate Bonds 7.3 Convertible Bonds 7.4 Preference Shares 7.5 Equity Shares 8. DERIVATIVES 164–182 8.1 Derivatives 8.2 Financial Derivatives 8.3 Options 8.4 Black Scholes Model 8.5 Forwards 8.6 Futures 8.7 Swaps 8.8 Derivatives Market in India 9. SECURITY VALUATION 183–228 9.1 Background 9.2 Approaches to Investment 9.3 Historical Developments of Investment Management 9.4 Basic Valuation Models – Fundamental Approach 9.5 Valuation of Bonds or Debentures 9.6 Valuation of Preference Shares 9.7 Valuation of Equity Shares 9.8 Valuation of Equity Shares – Dividend Concept 9.9 Valuation of Equity Shares – Earnings Concept 9.10 Capital Asset Pricing Model (CAPM Model): Share Valuation 10. ALTERNATIVE FORMS OF INVESTMENT 229–253 10.1 Introduction 10.2 Government Securities 10.3 Life Insurance 10.4 Private Insurance Companies 10.5 Unit Trust of India 10.6 Commercial Banks 10.7 Provident Fund 10.8 Post Office Schemes 10.9 Fixed Deposit Schemes in Companies 10.10 New Instruments 10.11 Financial Engineering Securities 10.12 ADRs, GDRs & IDRs 10.13 Non-Bank Finance Companies 10.14 Mutual Funds 10.15 Land and House Property 10.16 Gold 10.17 Silver 10.18 Coins and Stamps Collection 10.19 Diamonds 10.20 Antiques 11. DIVIDEND POLICIES AND THE INVESTOR 254–283 11.1 Types of Dividend 11.2 Stock Splits 11.3 Procedure for Payment of Dividends 11.4 Dividend Policy 11.5 Dividend Decisions 11.6 Factors Affecting Dividend Decisions of Firms 11.7 Limitation on Dividend Payments 11.8 Walter’s Model 11.9 Gordon’s Model 11.10 M.M. Hypothesis 12. INVESTOR AND INTEREST RATES 284–292 12.1 What is Interest? 12.2 Different Kinds of Interest Rates 12.3 Approaches to Interest Rates — Static Form, Dynamic Form and Eclectic Approach 12.4 Yield Curve 12.5 Liquidity Premium Hypothesis 12.6 Market Segmentation Hypothesis 12.7 Unbiased Expectations Theory 12.8 Expected Interest Rates and Term Structure of Interest Rates 12.9 Eclectic Theory and Investors 12.10 Financial Intermediaries and Term Structure 12.11 Interest Rates in India 13. FUNDAMENTAL ANALYSIS 293–320 13.1 What is Fundamental Analysis? 13.2 Economic Analysis 13.3 Industry Analysis 13.4 Company Analysis 13.5 Ratios Relevant for Equity Shareholders 13.6 Economic Value Added (EVA) 13.7 Sources of Financial Information 14. TECHNICAL ANALYSIS 321–332 14.1 Introduction 14.2 Dow’s Technical School of Thought 14.3 Assumptions of the Theory 14.4 Market Movements 14.5 Charts 14.6 Construction of Charts 14.7 Analysis of Charts 14.8 Short Sales 14.9 Confidence Index 14.10 Breadth of the Market 14.11 Relative Strength 14.12 Trading Volume 14.13 Moving Average Analysis 15. EFFICIENT MARKET THEORY 333–343 15.1 Background 15.2 Concept of Efficient Market Theory 15.3 Efficient Market Hypothesis 15.4 Empirical Analysis 15.5 The Random Walk Model Comparison with other Theories 15.6 Random Walk – Conclusions 16. PORTFOLIO ANALYSIS 344–379 16.1 Traditional Versus Modern Portfolio Analysis 16.2 Modern Portfolio Theories 16.3 Investor Attitude towards Risk and Return 16.4 The Rationale of Diversification of Investments 16.5 Markowitz Theory 16.6 Capital Market Line (CML) 16.7 Limitations of Markowitz Model 16.8 Sharpe’s Single Index Model 16.9 Sharpe’s Optimal Portfolio 17. PORTFOLIO SELECTION AND INTERNATIONAL DIVERSIFICATION 380–401 17.1 Introduction 17.2 Importance of Beta 17.3 Capital Market Theory — Capital Asset Pricing Model 17.4 Security Market Line 17.5 Limitations of CAPM Model 17.6 Distinction between Capital Market Line and Security Market Line 17.7 Validity of CAPM Model 17.8 Arbitrage Pricing Theory 18. TECHNIQUES OF PORTFOLIO REVISION 402–411 18.1 Formula Plans 18.2 Rules for Formula Plans 18.3 Constant Rupee Value Plan 18.4 Constant Ratio Plan 18.5 Variable Ratio Plan 18.6 Modifications of Formula Plans 18.7 Rupee Cost Average 19. PERFORMANCE MEASUREMENTS OF MANAGED PORTFOLIOS 412–428 19.1 Introduction 19.2 Structure of Mutual Fund 19.3 Features of Mutual Funds 19.4 Classification of Mutual Funds 19.5 Net Asset Value 19.6 Costs in Mutual Fund Investments 19.7 Return from Mutual Fund 19.8 SEBI and Mutual Fund Regulations 19.9 Management Performance Evaluation – Sharpe’s Performance Measure – Treyner’s Performance Measure – Jensen’s Model 19.10 Mutual Funds as Investments GLOSSARY 429–436 APPENDICES 437–448 Table A1 Table A2 Table A3 Table A4 INDEX 449–451 Chapter 1 INVESTMENT MANAGEMENT — AN INTRODUCTION Chapter Plan 1.1 Introduction 1.2 What is Investment? 1.3 Financial and Economic Meaning of Investment 1.4 Investment and Speculation 1.5 Investment and Gambling 1.6 Investment and Arbitrage 1.7 Real and Financial Assets 1.8 Why is Investment Important? 1.9 Factors Favourable for Investment 1.10 Investment Media 1.11 Features of an Investment Program 1.12 The Investment Process 1.1 INTRODUCTION This chapter is an introduction to the investment environment. It discusses the basic concepts of investment. It distinguishes between financial and economic meaning of investment and investment and speculation. It outlines the direct and indirect investments available to individuals. It also discusses the major types of investment media available to individuals and institutions. 1