MBA–H4010 SecurityAnalysisandPortfolioManagement INVESTMENT: UNIT - 1 Investment involves making ofa sacrifice in the present with the hope of deriving future benefits. Two most important features of an investment are current sacrifice and future benefit. Investment is the sacrifice ofcertain present values for the uncertain future reward. It involves numerous decision such as type, mix, amount, timing, grade etc, of investment the decision making has to be continues as well as investment may be defined as an activity that commits funds in any financial/physical form in the present with an expectation of receiving additional return in the future. The expectation brings with it a probabilitythat the quantumofreturn mayvaryfroma minimumto amaximum. This possibility of variation in the actual return is known as investment risk. Thus every investment involves a return and risk. Investment has many meaning and facets. However, investment can be interpreted broadly from three angles - - economic, - layman, - financial. Economic investment includes the commitment of the fund for net addition to the capital stock of the economy. The net additions to the capital stock means an increase in building equipments or inventories over the amount ofequivalent goodsthat existed, say, one year agoat the same time. The layman uses ofthe term investment as any commitment of funds for a future benefit not necessarily in terms ofreturn. For example a commitment of money to buy a new car is certainly an investment from an individual point of view. Financial investment is the commitment of funds for a future return, thus investment may be understood as an activity that commits funds in any 1 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license. MBA–H4010 SecurityAnalysisandPortfolioManagement financial or physical form in the presence of an expectation of receiving additional return in future. In the present context of portfolio management, the investment is considered to be financial investment, which imply employment of funds with the objective of realizing additional income or growth in value of investment at a future date. Investing encompasses veryconservative position as well as speculation the field of investment involves the study of investment process. Investment is concerned with the management of an investors’ wealth which is the sum of current income and the present value of all future incomes. In this text investment refers to financial assets. Financial investments are commitments of funds to derive income in form of interest, dividend premium, pension benefits or appreciation in the value of initial investment. Hence the purchase of shares, debentures post office savings certificates and insurance policies allare financialinvestments. Such investment generates financialassets. These activities are undertaken byanyone who desires a return, and is willing to accept the risk fromthe financial instruments. INVESTMENT VERSES SPECULATION: Often investment is understood as a synonym of speculation. Investment and speculation are some what different and yet similar because speculation requires an investment and investment are at lest some what speculative. Probablythe best wayto make a distinction between investment and speculation is by considering the role of expectation. Investments are usually made with the expectation that a certain stream of income or a certain price that has existed will not change in the future. Where as speculation are usually based on the expectationthat some change willoccur in future,there byresulting a return. Thus an expected change is the basis for speculation but not for investment. An investment also can be distinguished from speculation by the 2 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license. MBA–H4010 SecurityAnalysisandPortfolioManagement time horizon of the investor and often by the risk return characteristic of investment. A true investor is interested in a good and consistent rate of return for a long period of time. In contrast, the speculator seeks opportunities promising very large returnearned within a short period oftime due to changing environment. Speculation involves a higher level of risk and a more uncertain expectationofreturns, which is not necessarilythe case with investment. Basis Investment Speculation Type ofcontract Creditor Ownership Basis ofacquisition Usuallybyoutright purchase Often- on-margin Lengthofcommitment Comparativelylong term For a shorttime only Sourceofincome Earnings ofenterprise Change in market price Quantityofrisk Small Large Stabilityofincome Verystable Uncertainand erratic PsychologicalattitudeofParticipants Cautious and conservative Daring and careless Reasons for purchase Scientific analysis of intrinsic worthHunches, tips, “inside dope”, etc. The identification of these distinctions of these distinctions helps to define the role ofthe investor and the speculator in the market. The investor can be said to be interested in a good rate of return of a consistent basis over a relatively longer duration. For this purpose the investor computes the real worth of the security before investing in it. The speculator seeks very large returns from the market quickly. For a speculator, market expectations and price movements are the main factors influencing a buy or sell decision. Speculation, thus, is more riskythan investment. 3 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license. MBA–H4010 SecurityAnalysisandPortfolioManagement In any stock exchange, there are two main categories of speculators called the bulls and bears. A bull buys shares in the expectation of selling them at a higher price. When there is a bullish tendency in the market, share prices tend to go up since the demand for the shares is high. A bear sells shares in the expectation of a fall in price with the intention of buying the shares at a lower price at a future date. These bearish tendencies result in a fall in the price of shares. A share market needs both investment and speculative activities. Speculative activity adds to the market liquidity. A wider distribution of shareholders makes it necessaryfor a market to exist. INVESTMENT PROCESS An organized view of the investment process involves analyzing the basic nature of investment decisions and organizing the activities in the decision process. Investment process is governed by the two important facets of investment they are risk and return. Therefore, we first consider these two basic parameters that are of critical importance to all investors and the trade off that exists betweenexpected returnand risk. Given the foundation for making investment decisions the trade off between expected return and risk- we next consider the decision process in investments as it is typically practiced today. Although numerous separate decisions must be made, for organizational purposes, this decision process has traditionally beendivided into a two step process: securityanalysis and portfolio management. Security analysis involves the valuation of securities, whereas 4 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license. MBA–H4010 SecurityAnalysisandPortfolioManagement portfolio management involves the management of an investor’s investment selections as a portfolio (package ofassets), with its ownunique characteristics. Security Analysis Traditional investment analysis, when applied to securities, emphasizes the projection of prices and dividends. That is, the potential price of a firm’s common stock and the future dividend stream are forecasted, then discounted back to the present. This intrinsic value is then compared with the security’s current market price. If the current market price is below the intrinsic value, a purchase is recommended, and if vice versa is the case sale is recommended. Although modern security analysis is deeply rooted in the fundamental concepts just outlined, the emphasis has shifted. The more modern approach to common stock analysis emphasizes return and risk estimates rather than mere price and dividend estimates. Portfolio Management Portfolios are combinations of assets. In this text, portfolios consist of collections of securities. Traditional portfolio planning emphasizes on the character and the risk bearing capacity of the investor. For example, a young, aggressive, single adult would be advised to buy stocks in newer, dynamic, rapidlygrowing firms. Aretired widow would be advised to purchase stocks and bonds inold-line, established, stable firms, suchas utilities. Modern portfolio theory suggests that the traditional approach to portfolio analysis, selection, and management may yield less than optimum results. Hence a more scientific approach is needed, based on estimates of risk 5 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license. MBA–H4010 SecurityAnalysisandPortfolioManagement and return of the portfolio and the attitudes of the investor toward a risk-return trade-offstemming fromthe analysis ofthe individualsecurities. Characteristics ofInvestment The characteristics ofinvestment canbe understood interms ofas - return, - risk, - safety, - liquidityetc. Return: All investments are characterized bythe expectationofa return. Infact, investments are made with the primary objective of deriving return. The expectation of a return may be from income (yield) as well as through capital appreciation. Capital appreciation is the difference between the sale price and the purchase price. The expectation of return from an investment depends upon the natureofinvestment,maturityperiod, market demand and so on. Risk: Risk is inherent in any investment. Risk may relate to loss of capital, delay in repayment of capital, nonpayment of return or variability of returns. The risk of an investment is determined by the investments, maturity period, repayment capacity, natureofreturncommitment and so on. Risk and expected return of an investment are related. Theoretically, the higher the risk, higher is the expected returned. The higher return is a compensationexpected byinvestors fortheir willingness to bearthe higher risk. Safety: The safety of investment is identified with the certainty of return of capital without loss of time or money. Safety is another feature that an investor 6 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license. MBA–H4010 SecurityAnalysisandPortfolioManagement desires from investments. Every investor expects to get back the initial capital onmaturitywithout loss and without delay. Liquidity:An investment that is easily saleable without loss ofmoneyortime is said to be liquid. A well developed secondary market for security increase the liquidity of the investment. An investor tends to prefer maximization of expected return, minimization of risk, safety of funds and liquidity of investment. Investment categories: Investment generallyinvolves commitment offunds intwo types ofassets: -Realassets - Financialassets Real assets: Real assets are tangible material things like building, automobiles, land, gold etc. Financial assets: Financial assets are piece of paper representing an indirect claim to real assets held by some one else. These pieces of paper represent debt or equity commitment in the form of IOUs or stock certificates. Investments in financialassets consist of– - Securitiesed (i.e. securityforms of) investment -Non-securities investment The term‘securities’ used in the broadest sense, consists of those papers which are quoted and are transferable. Under section 2 (h) of the Securities Contract (Regulation) Act, 1956(SCRA) ‘securities’ include: 7 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license. MBA–H4010 SecurityAnalysisandPortfolioManagement i) Shares., scrip’s, stocks, bonds, debentures, debenture stock or other marketable securities ofa like nature inor ofany incorporated companyor other bodycorporate. ii) Government securities. iii) Suchother instruments as maybe declared bythe central Government as securities, and, iv) Rights ofinterests insecurities. Therefore, in the above context, security forms of investments include Equity shares, preference shares, debentures, government bonds, Units of UTI and other Mutual Funds, and equity shares and bonds of Public Sector Undertakings (PSUs). Non-security forms of investments include all those investments, which are not quoted in any stock market and are not freely marketable. viz., bank deposits, corporate deposits, post office deposits, National Savings and other small savings certificates and schemes, provident funds, and insurance policies. Another popular investment in physical assets such as Gold, Silver, Diamonds, Real estate, Antiques etc. Indian investors have always considered the physical assets to be very attractive investments. There are a large number of investment avenues for savers in India. Some of them 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 specific need, risk preference, and return expectation. Investment avenues can be broadly categorized under the following heads: - 1.Corporate securities . Equityshares .Preference shares . Debentures/Bonds . GDRs /ADRs . Warrants . Derivatives 8 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license. MBA–H4010 SecurityAnalysisandPortfolioManagement 2.Deposits inbanks and non banking companies 3.Postoffice deposits and certificates 4.Life insurance policies 5.Provident fund schemes 6.Government and semigovernment securities 7.Mutualfund schemes 8.Realassets CORPORATE SECURITIES Joint stock companies in the private sector issue corporate securities. These include equity shares, preference shares, and debentures. Equity shares have variable dividend and hence belong to the high risk high return category; preference shares and debentures have fixed returns with lower risk. The classification of corporate securities that can be chosen as investment avenues can be depicted as shown below. Equity Shares-: By investing in shares, investors basically buy the ownership right to that company. When the company makes profits, shareholders receive their share of the profits in the form of dividends. In addition, when a company performs well and the future expectation from the company is very high, the price ofthe company’s shares goes up inthe market.This allows shareholders to sell shares at profit, leading to capitalgains. Investors can invest in shares either through primary market offerings or in the secondary market. Equity shares can be classified in different ways but we will be using the terminologyofInvestors. It should be noted that the line of demarcation between the classes are not clear and suchclassificationare not mutuallyexclusive. 9 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license. MBA–H4010 SecurityAnalysisandPortfolioManagement Blue Chips (also called Stalwarts) : These are stocks of high quality, financially strong companies which are usually the leaders in their industry. They are stable and matured companies. They pay good dividends regularly and the market price of the shares does not fluctuate widely. Examples are stocks of Colgate, Pond’s HindustanLever, TELCO,MafatlalIndustries etc. Growth Stocks: Growth stocks are companies whose earnings per share is grows faster than the economy and at a rate higher than that of an average firm in the same industry. Often, the earnings are ploughed back with a view to use them for financing growth. They invest in research and development and diversify with an aggressive marketing policy. They are evidenced by high and strong EPS. Examples are ITC, Dr. Reddy’s Bajaj Auto, Sathyam Computers and Infosys Technologies ect.. The high growth stocks are often called “GLAMOURSTOCK’ or HIGHFLYERS’. Income Stocks: A company that pays a large dividend relative to the market price is called an income stock. They are also called defensive stocks. Drug, food and public utility industry shares are regarded as income stocks. Prices of income stocks are not as volatile as growthstocks. Cyclical Stocks: Cyclical stocks are companies whose earnings fluctuate with the business cycle. Cyclical stocks generally belong to infrastructure or capital goods industries such as general engineering, auto, cement, paper, construction etc.Their share prices also rise and fallin tandemwiththe trade cycles. Discount Stocks: Discount stocks are those that are quoted or valued below their face values. These are the shares ofsick units. 10 AcroPDF - A Quality PDF Writer and PDF Converter to create PDF files. To remove the line, buy a license.