Module 2

Security Analysis and Portfolio Construction

Security analysis are of two kinds: Fundamental analysis and Technical analysis

Fundamental Analysis

Fundamental Analysis is the process of evaluating a security by examining economic,

industry and company factors affecting its value. Before buying a share, investors examine
the company's actual strength and future prospects. Therefore, Fundamental Analysis is the
study of economic, industry and company factors to estimate the intrinsic value of a security.

The investor asks:

"What is this company actually worth?"

If intrinsic value > market price

→ Stock is undervalued

→ Buy

If intrinsic value < market price

→ Stock is overvalued

→ Sell

Why is Fundamental Analysis Important?

Share prices fluctuate every day.

However, in the long run, prices tend to reflect Company profits, Economic growth and
Industry performance. Fundamental analysis helps investors identify good companies for
long-term investment.

Objective

To determine the intrinsic value of a share and identify whether it is Undervalued, Fairly
valued or Overvalued

Three Levels of Fundamental Analysis

Economy Analysis

Industry Analysis
 ↓

Company Analysis

A company cannot perform well if its industry is declining. An industry cannot perform well
if the economy is collapsing. Hence analysis begins from the top.

So the three levels of fundamental analysis are:

1. Economic Analysis

2. Industry Analysis

3. Company Analysis

1. Economic Analysis

Economic Analysis involves the study of overall economy.

Factors:

• GDP Growth: Higher GDP growth → Higher corporate profits → Rising stock
prices.

• Inflation: Moderate inflation is acceptable. However, high inflation: Increases

production costs, Reduces profits, Lowers stock prices

• Interest Rates: Increase in interest rates - Cost of borrowing rises, Corporate profits
fall, Stock market may decline

• Government Policies

Examples: GST, Industrial policy, Export-import policy.

o A reduction in corporate tax-----Profits rise----------- Stock market reacts

positively.
o Exchange rate: Since Infosys earns in US dollars, I f rupee depreciates,
Infosys receives more rupees---Profit increases----Stock becomes attractive.
 Business Cycle and Stock Market

Economies move through:

1. Expansion

2. Peak

3. Recession

4. Recovery

Expansion

 High employment
  Rising production

 Rising profits

Stock market usually rises.

Recession

 Falling production

 Falling profits

Stock market generally falls.

Cyclical Indicator Approach

Used to predict future economic activity.

Indicators are:

Leading Indicators

Change before economy changes.

Examples: Stock prices, Building permits

Coincident Indicators

Move along with economy.

Examples: GDP, Industrial production

Lagging Indicators

Change after economy changes.

Examples: Unemployment rate

2. Industry Analysis

Even in a growing economy, all industries do not perform equally. Different industries react
differently to economic conditions. For example, During Covid, Pharmaceutical companies
grew, Tourism companies suffered. Therefore industry matters.

Factors Affecting Industry Performance

Industry Growth Rate

Fast-growing industries attract investors.

Examples:

 Renewable energy
  Artificial Intelligence

 Electric vehicles

Competition

Too much competition reduces profits.

Government Regulation

Government policies may help or hurt industries.

Example:

PLI schemes support manufacturing.

Technological Change

New technology may create opportunities.

Example: Digital payments transformed banking.

Industry Life Cycle

Industries pass through four stages.

Introduction

New industry---High risk----Low profit.

Example: Early electric vehicles.

Growth

Demand rises rapidly----Profits increase.

Example: Indian fintech sector.

Maturity

Growth stabilizes----Competition increases.

Example: Telecommunications.

Decline

Demand falls---Profits fall.

Example: Traditional film cameras.

3. Company Analysis

Examines company-specific performance.

 Indicators:

• Earnings Per Share (EPS)

EPS = Profit after tax / Number of shares

• Price Earnings Ratio (P/E)

P/E = Market Price / EPS

• Dividend Yield

Dividend Yield = Dividend per share / Market Price ×100

• Book Value

Net asset value per share. Useful for comparing market price and actual asset value.

Eg(EPS): Suppose a company earns a profit of ₹100 crore and has 10 crore equity shares.

100
EPS= =₹ 10
10

This means the company earned ₹10 per share during the year.

• Relation of EPS with P/E Ratio

Market Price = ₹500

EPS = ₹25

500
P/E= =20
25

This means investors are willing to pay ₹20 for every ₹1 of earnings.

Technical Analysis

When we study profits, sales, assets, management and future prospects, we are doing
Fundamental Analysis. But when we do not study the company at all, but only study how the
share price is moving, then it is referred to as Technical Analysis. Technical analysis studies
price movements and trading volume to predict future prices. A technical analyst believes:
"The price itself tells a story."

Instead of studying Balance Sheet, Profit and Loss Account and Annual Report, he studies
Price changes, Market trends, Trading volume and Investor behaviour.

Why Technical Analysis Developed

Before computers, investors found it difficult to analyse hundreds of annual reports. They
noticed Prices often move in patterns. They began studying charts. This became Technical
Analysis. Today, Traders, Brokers, Investment firms use technical analysis extensively.
Assumptions

(1) Market discounts everything: All information affecting a company is already reflected in
its share price. Information may include profit, loss, government policy, interest rate changes,
inflation, investor expectations, news everything gets incorporated into price.

Example: Suppose Infosys announces excellent profits, Investors immediately buy the stock,
Price rises. Thus the information is already reflected in the price.

A technical analyst says:

"I don't need to read the report. The price movement already reflects the information."

(2) Prices move in trends: Share prices do not move randomly every day. They generally
move in a particular direction for some time.

Example: Suppose Reliance share price moves:

₹1000---₹1050---₹1100---₹1150---₹1200

This is not random- A trend is visible.

Types of Trends

Uptrend

• Prices continuously rise.

• Higher highs.

• Higher lows.

• Example:

• 100 → 110 → 120 → 130

• Investors are optimistic-Demand exceeds supply.

Downtrend

• Prices continuously fall.

• Example:

• 200 → 190 → 180 → 170

• Investors are pessimistic.

• Supply exceeds demand.

Sideways Trend

• Prices fluctuate within a narrow range.

 • Example:

• 100 → 102 → 98 → 101 → 99

• Investors are uncertain.

Trend Lines: Line connecting price points----Used to identify trend direction.

(3) History repeats itself: Human behaviour does not change significantly. People react
similarly in similar situations.

Key Emotions

• Greed

• Fear

These emotions influence investment decisions.

Suppose a stock rises rapidly. Many investors think: "I might miss the opportunity. "They
start buying. Price rises further. This behaviour repeats repeatedly.

Example of Fear: Suppose negative news emerges, Investors panic. Everyone starts selling.
Price falls sharply. This pattern also repeats.

Technical Analyst's View: Because human behaviour repeats, chart patterns also repeat.
Therefore past patterns can help predict future movements.

COMPARISON

DOW THEORY
(Foundation of Technical Analysis)

Dow Theory states that stock prices reflect all available information, move in identifiable
trends and continue in those trends until a clear reversal occurs. Developed by Charles Dow,
the founder of the Dow Jones stock market index.
Main Principles

Principle 1: Market Discounts Everything All information gets reflected in price.

Principle 2: Prices Move in Trends Market movements are not completely random.

Principle 3: Trends Continue Until Reversed A rising market tends to continue rising until
evidence shows otherwise.

Types of Trends

Primary Trend - Long-term trend

Example: Indian stock market rising for several years.

Secondary Trend - Temporary correction.

Example: Market falls for 2 months during a long-term rise.

Minor Trend - Daily fluctuations.

VOLUME INDICATORS (Comes under Technical Analysis)

Volume = Number of shares traded.

Example:

• If 1 lakh shares of Infosys are traded today,

• Volume = 1 lakh.

• Volume shows the strength of investor interest.

Example: Price rises from ₹1000 to ₹1100 - Volume also rises significantly.

Interpretation: Many investors support the increase-Strong signal.

• Example : Price rises but volume is very low - weak support- trend may not continue.

• Simple Rule: Price ↑ + Volume ↑ Strong bullish signal

Price ↓ + Volume ↑ Strong bearish signal

MARKET SENTIMENT INDICATORS

• Measure the overall mood of investors.

"What happens when everyone expects gold prices to rise?"

People rush to buy.

The same happens in stock markets.

Stock markets are influenced by: Logic, Emotions

Two dominant emotions: Greed Leads to buying; Fear Leads to selling.

• Bull Market: Optimism - Investors expect prices to rise - Heavy buying.

• Bear Market: Pessimism-Investors expect prices to fall-Heavy selling.

Market sentiment indicators measure whether investors are optimistic or pessimistic.

CONFIDENCE INDICATORS

Confidence indicators measure investor trust in economic and market conditions.

Confidence: Strength of belief;

Sentiment: Mood

High Confidence: Investors willingly buy shares, Risk-taking increases

Low Confidence: Investors prefer: Bank deposits, Gold, Government securities

Example

• Suppose GDP growth is strong.

 • Inflation is moderate.

• Corporate profits are rising.

• Investor confidence increases

Points & Figure charting

A chart showing only price movements - Time is ignored.

Points & Figure (P&F) charting is a time-independent technical analysis method.

It plots price action using columns of X's (rising prices) and O's (falling prices).

By completely ignoring time and volume, P&F charts filter out market noise to clearly
reveal supply/demand dynamics and define entry/exit points.

Symbols

X - Price rising

O - Price falling

Box Size: This is the minimum price increment required to draw a new X or O.

Reversal Amount: This determines how far the price needs to move in the opposite
direction to start a new column. (For instance, an asset might need to drop by an amount
equal to 3 boxes before a new column of "O"s is started).

Advantage

Removes unnecessary daily fluctuations.

Highlights major trends.

Point and Figure Charts focus on significant price movements and ignore time intervals.
Bar Charting

Each single bar represents a chosen timeframe (e.g., 5 minutes, 1 day, or 1 week) and
contains specific elements:

Top of the bar: The High price reached during that period.

Bottom of the bar: The Low price reached.

Left horizontal dash: The Open price.

Right horizontal dash: The Close price.

Shows OHLC

• Opening Price

• Highest Price

• Lowest Price

• Closing Price

Helps investors study daily market behaviour.

Bar chart provides more information than a simple line chart.

Example:

Opening Price = ₹1500

Highest Price = ₹1540

Lowest Price = ₹1480

Closing Price = ₹1525

These four values appear in one bar.

Why Traders Use Bar Charts

 Clear Price Action: They strip away visual noise so traders can solely focus on price
behaviour and structure.

Trend Identification: The relationship between the open and close helps traders see if the
overall session was bullish (up) or bearish (down).

Volatility Measurement: The total height of the bar (High minus Low) shows how
volatile the market was during that period.

MOVING AVERAGES

A Moving Average (MA) is a widely used financial indicator that smooths out daily stock
price data to create a single, flowing line.

How Moving Averages Work

Instead of focusing on chaotic, day-to-day price spikes (or "noise"), a moving average
calculates the average closing price of a stock over a specific number of days. As each
trading day passes, the oldest data point is dropped and the newest one is added, allowing
the average to "move" along with the price.

Types of Moving Averages

Simple Moving Average (SMA): Gives an equal weight to every price point in the chosen
timeframe.

Exponential Moving Average (EMA): Places a higher weight and significance on the
most recent prices. This makes the EMA react much faster to recent market changes.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a popular technical analysis tool used by traders to
measure the momentum of a price movement of a stock or asset. It evaluates the speed
and magnitude of recent price changes, displayed on a scale from 0 to 100. Developed by
J. Welles Wilder Jr. and introduced in 1978, the RSI is typically plotted as a line graph
beneath a standard price chart. While it’s highly useful for identifying potential entry and
exit points, traders often use it in combination with other tools (like moving averages or
volume trends) to avoid false signals.

How the RSI Works

Overbought (Above 70): If an asset's RSI hits or exceeds 70, it is traditionally considered
overbought. This means the price may have risen too quickly and could be due for a
pullback or reversal.
 Oversold (Below 30): An RSI reading at or below 30 is typically considered oversold.
This suggests the asset's price has dropped sharply and could be primed for a rebound.

Neutral (Around 50): A reading of 50 signals a neutral balance between buyers and sellers

Chart Patterns

Chart patterns are visual formations created by the price movements of an asset over time.
They are the foundation of technical analysis, used by traders to identify historical price
trends and anticipate future market movements based on recurring shapes and market
psychology.

Chart patterns come in a few main categories:

Reversal Patterns: Signal that an ongoing trend (either rising or falling) is about to change
direction.

Continuation Patterns: Indicate that the current trend is taking a brief "pause" or
consolidating before resuming in the same direction.

Bilateral Patterns: Signal that the price could break out in either direction.

These patterns can be applied to any chart type (like candlesticks, bar charts, or line charts)
and across any timeframe, from 1-minute intervals to monthly charts.

A. Head and Shoulders Pattern

This is the most important pattern.

Peak

/\

/ \

/\ / \ /\

/ \ / \

Looks like:

Left shoulder

Head

Right shoulder

Meaning
Uptrend is ending.

Possible fall ahead.

B. Double Top

/\ /\
/ \__/ \

Two peaks.

Price fails to rise further.

Meaning

• Bearish signal.

• Price may decline.

C. Double Bottom

\__/ \__/

Two troughs. Price fails to fall further.

Meaning

Bullish signal. Price may rise.

D. Triangle Pattern

Price movement narrows. Looks like a triangle.

Meaning

Market is waiting.

Eventually price breaks out.