Investment Analysis & Portfolio Management
Chapter One
Introduction to Investment
1.1. Investment
Investment is an activity that is engaged in by people who have savings and investments
are made from savings. But all savers are not investors so investment is an activity which
is different from saving. If one person has advanced some money to another, he may consider
his loan as an investment. He expects to get back the money along with interest at a future
date. Another person may have purchased one kilogram of gold for the purchase of price
appreciation and may consider it as an investment. Yet another person may purchase an
insurance plan for the various benefit it promises in future. That is his investment.
Investment involves employment of funds with the aim of achieving additional income or
growth in values or the commitment of resources which have been saved in the hope that
some benefits will accrue in future. Thus, investment may be defined as, “a commitment of
funds made in the expectation of some positive rate of return”. In the financial sense,
investment is the commitment of a person’s funds to derive future income in the form of
interest, dividend, premiums, pension benefits or appreciation in the value of their capital.
Purchasing of shares, debentures, post office savings certificates, insurance policies are all
investments in the financial sense. Such investments generate financial assets. In the
economics sense, investment means the net additions to the economy’s capital stock which
consists of goods and services that are used in the production of other goods and services.
Investment in the sense implies the formation of new and productive capital in the form of
new constructions, plant and machinery, inventories etc. Such investments generate
physical assets. The money invested in financial investments are ultimately converted into
physical assets. Thus, all investments result in the acquisition of some assets either
financial or physical.
1.2. Characteristics of Investment
Return: Investments are made with the primary objective of deriving a return. The return
may be received in the form of capital appreciation plus yield. The difference between the
sales price and the purchase price is capital appreciation. The dividend or interest received
from the investment is the yield.
Risk: Risk may relate to loss of capital, delay in repayment of capital, nonpayment of
interest, or variability of returns. While some investments like government securities and
bank deposits are riskless, others are riskier.
The risk of an investment depends on the following factors:
1) The longer the maturity period, the larger is the risk.
2) The lower credit worthiness of the borrower, the higher is the risk.
3) Investments in ownership securities like equity shares carry higher risk compared to
investments in debt instruments like debentures and bonds. Risk and return of an
investment are related. Normally, the higher the risk, the higher is the return.
1
Investment Analysis & Portfolio Management
Safety: Safety is another feature which an investor desires for his investments. The safety
of an investment implies the certainty of return of capital without loss of money or time.
Every investor expects to get back his capital on maturity without loss and without delay.
Liquidity: An investment which is easily saleable or marketable without loss of money and
without loss of time is said to possess liquidity. Some investments like company deposits,
bank deposits, P.O. deposits, NSC, NSS etc are not marketable. Some investment
instruments like preference shares and debentures are marketable but there are no buyers
in many cases and hence their liquidity is negligible. Equity shares of companies listed on
stock exchanges are easily marketable through the stock exchanges.
An investor generally prefers liquidity for his investments, safety of his funds, a good return
with minimum risk or minimization of risk and maximization of return.
1.3. Objectives of Investment
The main objectives of investments are:
▪ Maximization of return
▪ Minimization of risk
Other subsidiary objectives are:
▪ Maintaining liquidity
▪ Hedging against inflation
▪ Increasing safety
▪ Saving tax
Maximization of return: The rate of return could be defined as the total income the
investor receives during the holding period, stated as a percentage price at the beginning of
the holding period.
Return = Capital Appreciation + Yield (Dividend, Interest)
Return = (End period value – Beginning period value) + Yield value
Beginning period value
If a particular share is bought in 2011 at $50 and sold in 2012 at $60 and the dividend yield
is $5, then what would be the return?
Minimizing the risk: The risk of holding securities is related to the probability of the
actual return becoming less than the expected return. If we consider the financial assets
available for investment, we can classify them into different risk categories. Government
securities would constitute the low risk category as they are practically risk free.
Debentures and preference shares of companies may be classified as medium risk assets.
Equity shares of companies would form the high-risk category of financial assets.
Maintaining Liquidity: Liquidity depends upon marketing and trading facilities. If a
portion of the investment could be converted into cash without much loss of time, it helps
the investor to meet emergencies. Stocks are liquid only if they command a good market by
providing adequate returns through dividends and capital appreciation.
2
Investment Analysis & Portfolio Management
Hedging against inflation: The rate of return should ensure a cover against inflation to
protect against a rise in prices and fall in the purchasing value of money. The rate of return
should be higher than the rate of inflation otherwise the investor will experience loss in real
terms.
Increasing safety: The selected investment avenue should be under the legal and
regulatory framework. If it is not under the legal framework, it will be difficult to represent
grievances. Approval of the law itself adds a flavor of safety. From the safety point of view,
investments can be ranked as follows: bank deposits, government bonds, UTI units,
nonconvertible debentures, convertible debentures, equity shares and deposits with non-
banking financial companies.
1.4. Investment Process
The investment process involves a series of activities leading to the purchase of securities
or other investment alternatives.
The process can be divided into five stages:
1. Framing of the investment policy
2. Investment analysis
3. Valuation
4. Portfolio construction
5. Portfolio evaluation.
1) Framing of the investment policy:
For systematic functioning, the government or investor, formulates the investment policy
before proceeding to invest. The essential ingredients of the policy are:
A. Investible funds: Funds may be generated through savings or from borrowings. If
the funds are borrowed, the investor has to be extra careful in the selection of
investment alternatives. He must make sure that the returns are higher than the
interest he pays.
B. Objectives: The objectives are framed on the premises of the required rate of return,
need for regular income, risk perception and the need for liquidity. The risk taker’s
objective is to earn a high rate of return in the form of capital appreciation whereas
the primary objective of the risk-averse is the safety of principal.
C. Knowledge: Knowledge about investment alternatives and markets plays a key role
in policy formulation. Investment alternatives range from security to real estate. The
risk and return associated with investment alternatives differ from each other.
D. The investor should be aware of the stock market structure and functions of the
brokers. The modes of operations are different in the BSE, NSE and OTCEI.
Brokerage charges are also different. Knowledge about stock exchanges enables an
investor to trade the stock intelligently.
3
Investment Analysis & Portfolio Management
2) Security Analysis:
Securities to be brought are scrutinized through market, industry and company analyses
after the formulation of investment policy.
A. Market analysis: The growth in Gross Domestic product and inflation is reflected
in stock prices. Recession in the economy results in a bear market. Stock prices may
fluctuate in the short run but in the long run, they move in trends. The investor can
fix his entry and exit points through technical analysis.
B. Industry analysis: An analysis of the performance, prospectus and problems of an
industry of interest is known as industry analysis. The risk factors related to the
automobile industry are different from those related to the information technology
industry. The performance of an industry reflects the performance of the companies
it consists of.
C. Company analysis: The purpose of company analysis is to help the investors make
better decisions. The company's earnings, profitability, operating analysis, capital
structure and management have to be screened. A company with a high product
market share is able to create wealth for investors in the form of capital appreciation.
3) Valuation: Valuation helps the investor determine the return and risk expected from an
investment in common stock.
Intrinsic value of the share is measured through the book value of the share and price
earnings ratio. Simple discounting models can be adopted to value the shares. Future
value of securities can be estimated by using a simple statistical technique like trend
analysis. The analysis of the historical behavioral of price enables the investor to predict
the future value.
4) Construction of a portfolio:
A portfolio is a combination of securities. By constructing a portfolio, investors attempt to
spread risk by not putting all their eggs into one basket and it also helps to meet their goals
and objectives.
A) Diversification: The main objective of diversification is the reduction of risk
in the form of loss of capital and income. A diversified portfolio is
comparatively less risky than holding a single portfolio. Several models are
available to diversify a portfolio.
i) Debt and equity diversification: Debt instruments provide
assured returns with limited capital appreciation. Common stock
provides income and capital gain but with a flavor of uncertainty.
ii) Industry diversification: Banking industry shares may provide
regular returns but with limited capital appreciation. Information
technology stocks yield higher returns and capital appreciation.
iii) Company diversification: Securities from different companies
are purchased to reduce the risk. Technical and fundamental
analysts suggest the investors to buy the securities.
B) Selection and allocation: Securities have to be selected based on the level of
diversification and funds are allocated for selected securities.
4
Investment Analysis & Portfolio Management
5) Portfolio Evaluation:
It is the process which is concerned with assessing the performance of the portfolio over a
selected period of time in terms of return and risk.
A. Appraisal: Developments in the economy, industry and relevant companies from
which stocks are bought have to be appraised. The appraisal warns of the loss and
steps can be taken to avoid such losses.
B. Revision: It depends on the results of the appraisal. Low-yielding securities with
high risk are replaced with high-yielding securities with low risk factor. The investor
periodically revises the components of the portfolio to keep the return at a level.
1.5. Investment Avenues
1) Negotiable investments
2) Non-negotiable investments
Negotiable investments
a) Variable income securities
b) Fixed income securities
Variable income securities - Equity shares
Equity shares are commonly referred as common stock or ordinary shares. The most
common classification under this share are:
A. Large-cap, mid-cap and small-cap stocks: The large-cap stocks are shares of high
market capitalization, the small cap ones have a low market capitalization and the
mid-cap ones fall in between these two.
B. Blue chip shares: The shares of companies which have a consistent track record
and are doing exceedingly well compared with other companies are known as blue
chip shares.
C. Growth shares: Stocks that have a higher rate of growth in profitability than the
industry growth rate is referred to as growth shares.
D. Income shares: These stocks belong to companies that have stable operations and
pay regular dividends.
E. Defensive shares: Defensive stocks are relatively unaffected by market movements.
Ex: a host of pharmaceutical stocks posted returns even in the period of market
slowdown.
F. Cyclical shares: The upward and downward movements of the business cycle affect
the business prospects of certain companies and their stock prices. Such shares
provide low to moderate current yield. Ex: automobile sector stocks are affected by
business cycle.
G. Speculative shares: Shares that have a lot of speculative trading in them are
referred to as speculative shares.
5
Investment Analysis & Portfolio Management
Fixed Income Securities
Fixed income shares are categorized as follows:
A. Preference shares: The biggest advantage is the tax-exempt status of the
preference share’s dividend.
B. Debentures / Bonds: Debentures are generally issued by the private sector
companies as a long-term promissory note for raising loan capital. The company
promises to pay interest and principal as stipulated whereas bond is a long-term debt
instrument that promises to pay a fixed annual sum as interest for a specified period
of time. Public sector companies and financial institutions issue bonds.
C. Government Securities: The securities issued by the central government, state
government and quasi government agencies are known as government securities or
gilt-edged securities. It is a secure financial instrument, which guarantees the income
and capital.
D. Money market securities: These have a short-term maturity, say less than a year.
Common money market instruments are treasury bills, commercial paper and
certificate of deposit.
I. Treasury bills: It is fundamentally an instrument of short-term borrowing by the
government to help the cash management requirements of various segments of the
economy. Generally, treasury bills are of 91 days. Since the interest rates offered on
treasury bills are low, individuals very invest in them.
II. Commercial Papers: It is a short-term negotiable instrument with a fixed maturity
period. It is an unsecured promissory note issued by the company either directly or
through Banks.
III. Certificate of deposit: It is a marketable receipt of funds deposited in a bank for a
fixed period at a specified rate of interest.
II) Non-negotiable instruments:
Deposits:
a) Bank deposits: The banks offer current account, savings account and fixed deposit
account with a fixed rate of return.
b) Non-Banking Financial Companies (NBFC): It is one of the financial intermediate
company which comes under the purview of RBI. Security of the deposits with the NBFCs
is lower than of the deposits with banks.
Postal Savings: Postal savings like National Savings Certificate (NSC), Kisan Vikas Patra
(KVP), Monthly income scheme, Senior citizen scheme, PPF are considered as reliable form
of investment because they are backed by the Government of India under Indian Postal
department. Postal savings schemes offered to lower-middle class and lower-class investors
but now middle income and higher-income groups are also considering this avenue with the
increase in the uncertainties.
Life Insurance: It is contract for payment of a sum of money to the person assured on the
happening of the event insured against. The core feature of the is protection and elimination
6
Investment Analysis & Portfolio Management
of risks. Insurance emerge as a combination of both investment and assurance. The major
advantages it includes are: protection, easy payment, liquidity and tax relief.
Unit Linked Insurance Plan (ULIP): This is a market-linked insurance plan. It provide
life insurance combined with savings at market-linked returns. The premiums is mainly
invested in risk free securities like government securities and fixed income securities.
Real Assets: includes Gold, Silver, Real estate which refers to various fixed assets which
can be classified into three categories: Residential Property, Commercial property, Land. It
also includes Art and Antiques
1.5. Capital Market
Capital market deals with medium term and long-term funds. It refers to all facilities and
the institutional arrangements for borrowing and lending term funds (medium term and
long term). The demand for long term funds comes from private business corporations,
public corporations and the government. The supply of funds comes largely from individual
and institutional investors, banks and special industrial financial institutions and
Government. It is the market segment where securities with maturities of more than one
year are bought and sold. Equity shares, preference shares, debentures and bonds are the
long-term securities traded in the capital market.
Capital market is classified in two ways:
1) Primary Market (New Issue Market)
2) Secondary Market (Stock Market)
Primary Market:
• Primary market is the new issue market of shares, preference shares and
debentures.
• Stocks available for the first time are offered through the new issue market. The
issuer may be the new company or the exit company.
• The issuing houses, investment bankers and brokers act as the channels of
distribution for a new issue. They take responsibility for selling the stocks to the
public.
• The issuer can be considered as manufacturer.
Types of Issues:
• Public Issue which is a method of raising a funds through the issue of shares to
investors in the primary market by companies.
• Preferential issue means when listed companies issue securities to a selected
group of persons. It may be financial institutions, mutual funds or high net worth
individuals.
• Rights issues means an issue of capital offered by a company to its existing
shareholders through a letter of offer. In other words, a listed company issue fresh
securities only to its existing shareholders.
7
Investment Analysis & Portfolio Management
Parties involved in the new issue:
1) Managers to the issue:
• Drafting the prospectus
• Preparing a budget expenses related to the issue.
• Suggesting the appropriate timing of the public issue
• Assisting in marketing the public issue successfully.
• Advising the company in the appointment of parties involved in it.
• Directing the various agencies
2) Registrar to the issue: The registrar to the issue is appointed in consultation with the
lead managers. They receive the share applications from various collections centers. They
arrange for the dispatch of the share certificates. They hand over the details of the share
allocation and related documents to the company.
3) Underwriters: Underwriting is a contract in which an underwriter gives an assurance
to the issuer that the he will subscribe to the securities offered in the event of non-
subscription by the persons to whom they are offered. Ex: financial institutions, banks,
brokers and approved investment companies.
4) Bankers to the issue: Bankers to the issue are responsible for collecting the application
money along with the application form. They charge commission as brokerage.
5) Advertising Agents: Advertising plays key role in promoting a public issue. The
advertising agencies take responsibility for giving publicity to the issue through appropriate
platforms.
Secondary Market: Secondary market deals with securities which have already been
issued and are owned by investors. The buying and selling of securities already issued and
outstanding take place in stock exchanges. Hence, stock exchanges constitute the secondary
market in securities.
Stock Exchange: The stock exchanges were once physical market places where the agents
of buyers and sellers operated through the auction process. These are being replaced with
electronic exchanges where buyers and sellers are connected only by computers over a
telecommunication network. Auction trading is giving way to “screen-based” trading
where bid prices and offer prices are displayed on the computer screen. Bid price refers to
the price at which an investor is willing to buy the security and offer price refers to the
price at which an investor is willing to sell the security.
A stock exchange may be defined in different ways. In simple terms, stock exchange is “
A centralized market for buying and selling stocks where the price is determined through
supply-demand mechanisms”. According to the Securities Contracts Act, 1956, “ Stock
exchange means anybody of individuals, whether incorporated or not, constituted for the
purpose of assisting, regulating or controlling the business of buying, selling or dealing in
securities”.
8
Investment Analysis & Portfolio Management
Functions of Stock Exchange
i) Maintains Active Trading: Shares are traded on the stock exchanges, enabling
the investors to buy and sell securities. The prices may vary from transaction to
transaction. A continuous trading increases the liquidity or marketability of the
shares traded on the stock exchanges.
ii) Fixation of Prices: Price is determined by the transactions that flow from
investors’ demand and supplier’s preferences. Usually the traded prices are made
known to the public. This helps the investors to make better decisions.
iii) Ensures Safe and Fair Dealing: The rules, regulations and by-laws of the stock
exchanges provide a measure of safety to the investors. Transactions are
conducted under competitive conditions enabling the investors to get a fair deal.
iv) Aids in Financing the Industry: A continuous market for shares provides a
favorable climate for raising capital. The negotiability of the securities helps the
companies to raise long-term funds. When it is easy to trade the securities,
investors are willing to subscribe to the initial public offerings. This stimulates
the capital formation.
v) Dissemination of Information: Stock exchanges provide information through
their various publications. They publish the share prices traded on daily basis
along with the volume traded. Directory of Corporate information is useful for the
investors’ assessment regarding the corporate. Handouts, handbooks and
pamphlets provide information regarding the functioning of the stock exchanges.
vi) Performance Inducer: The prices of stock reflect the performance of the traded
companies. This makes the corporate more concerned with its public image and
tries to maintain good performance.
vii) Self-regulating Organization: The stock exchanges monitor the integrity of the
members, brokers, listed companies and clients. Continuous internal audit
safeguards the investors against unfair trade practices. It settles the disputes
between member brokers, investors and brokers.