Investment, Security and Portfolio Management
Investment, Security and Portfolio Management
Investment, Security and Portfolio Management
INVESTMENT ENVIRONMENT
INTRODUCTION TO SECURITIES
Investment Definition:
Investment refers to commitment of funds for future periods against a return which is
adequate to induce to part with money. This word is in a wide variety of contexts such as
investment in a 'house' or investment in a mutual funds or investment in securities. This
individually visualise a pay-off by putting their money in productive avenues.
It may be appropriate to define the term "investment" in a general sense. It means
postponed consumption. For example, an employee who contributes a part of his salary
to buy shares, his current consumption is curtailed and the return on shares/securities
realised in future time periods would be available for future consumption.
It is interesting to observe that all investment decisions arise from trade-off between
current and future consumption. For example, an individual has Rs. 50,000/- which he
can spend or invest @ 11% per annum. His current consumption (C0) could be zero (if he
invests the whole sum) to Rs. 50,000/- (if he does not invest even a single rupee).
Similarly his future consumption (C1), could be as high as Rs. 50,000/-(investment plus
interest) to as low as (if he consumes the whole amount in the beginning). Normally,
individuals do neither consume the whole nor invest the whole. Such a situation is called
a "trade off between current and future consumption. This is presented in fig (i), which
plots one of the several possibilities for our hypothetical individual on the tradeoff
function MN. Our investor is on point x' which suggests that he spends Rs. 30,000/today and invests Rs. 20,000/- (@ 11% interest per annum).
Here we should know a person postpones his current consumption to future. Individuals
are guided by "time preference theory". An investor would not invest his money if it does
not yield a positive rate of return. Thus to him "turn over off will offer larger quantity of
money.
Investment Decisions:
An individual invests or "postpones current consumption" only in response to a rate of
return which must be suitably adjusted for inflation and risk. This basic postulate, in
fact, unfolds the nature of investment decisions. Let us explain as follows:
Cash has an opportunity cost and when one decide to invest it he is deprived of this
opportunity to earn a return on that cash. Also, when the general price level raises the
purchasing power of cash declines, the larger the increase in inflation, the greater the
depletion in the buying power of cash. This explains the reason why individuals require
a "real rate of return" on their investments. Now, within the large number of investors,
some buy government securities or deposit their money in bank accounts that are
adequately secured. In contrast, some others prefer to buy, hold, and sell equity shares
even when they know that they get exposed to the risk of losing their money much more
than those investing in government securities. One will find that this latter group of
investors is working toward the goal of getting larger returns than the first group and, in
the process, does not mind assuming greater risk. Investors In general, want to earn as
large returns as possible subject, of course, to the level of risk they can possibly bear.
The risk factor gets fully manifested in the purchase and sale of financial assets,
especially equity shares. It is common knowledge that some investors lose even when
the securities markets boom. So there lies the risk.
One may understand risk as the probability that the actual return on an investment will
be different from its expected return. Using this definition of risk, one may classify
various investments into risk categories.
Thus, government securities would be seen as risk-free investments because the
probability of actual return diverging from expected return is zero. In the case of
debentures, say of a company like TELCO or GRASIM, again the probability of the
actual return being different from the expected return would be very little because the
chance of the company defaulting on stipulated interest and principal repayments is
quite low. One would obviously put equity shares in the category of "high risk"
investment for the simple reason that the actual return has a great chance of differing
from the expected return over the holding period of the investor which may range from
one day to a year or more.
Investment decisions are premised on an important assumption that investors are
rational and hence, prefer certainty to uncertainty. They are risk-averse which implies
that they would be unwilling to take risk just for the sake of risk. They would assume
risk only if an adequate compensation is forthcoming. And the dictum of "rationality"
combined with the attitude of "risk aversion" imparts to investments their basic nature.
The question to be answered is how best to enlarge returns with a given level of risk, or
how best to reduce risk for a given level of return? Obviously, there would be several
different levels of risk and different associated expectations of return. The basic
investment decision would be a trade-off between risk and return.
Figure depicts the risk-return trade-off available to rational investors. The line RfM
shows the risk-return function i.e., a trade-off between expected return and risk that
exists for all investors interested in financial assets. RfM line always slopes upward
because it is plotted against expected return which has to increase as risk rises. No
rational investor would assume additional risk unless there is extra compensation for it.
This is how his expectations are built. This is, however, not the same thing as the actual
return always rising in response to increasing risk. The risk-return trade-off is figured
on "expected or anticipated (i.e., ex-ante) return and not an "actual or realised (ex-post)
return".
Figure explains the relative positioning of different financial assets on the risk-return
map. The point RfM is the expected return on government securities where risk is zero.
As one moves on the RfM line, one finds successive points which show the increase in
expected return as risk increases. Thus, equity shares which carry lot of risk than
government securities and company debentures are plotted higher on the line. Company
debentures are less risky than equity shares because of the mortgages and assurances
made available to the investor but more risky than government securities. They are
placed between the two securities viz., government securities and equity shares.
Warrants, options and financial futures are the other specialised financial assets ranked
in order of rising risk.
An important point deserves attention while interpreting the "risk-return trade-off of
the type presented in Figure. One should underline the fact that the function is graphed
in a rational situation, i.e., it is valid only if investors are rational. Thus, if an investor is
not willing to assume any risk he will have to be satisfied with the risk-free rate, i.e.,
However, since rational investors like returns but dislike risk, any increase in risk
required to be borne by them must invariably be accompanied by an adequate rise in the
anticipated return. And one will find many different kinds of rational investors in the
market-some will assume less risk and some more. There will be a large number of riskreturn combinations since investors will determine for themselves the level of risk they
can bear at any given point of time.
What is fundamental to the risk-return trade-off is the objective of all rational investors
who attempt to maximise their utility or welfare, which in turn is assumed to be a
function of present and future wealth. It must be noted that wealth is a function of
current and future income which is discounted for the amount of risk involved. In effect,
therefore, investors maximise their welfare by working out optimum combinations of
risk and expected return on the risk-return trade-off function.
Investment Process:
After understanding the concept of investment decision, one might now like to know as
to how does an investor go about the task or business of investing, how much to invest at
any moment, and when to make the investment? These questions essentially relate to
the investment process. A typical investment decision undergoes a five-step procedure
which is as follows:
conservative individual may decide to invest, say 60 per cent of his cash in debentures
and the remaining 40 percent in equity shares. On the other hand, and individual who is
prepared to assume greater risk may like to put, say, 60 percent of his cash in equity
(note that this expectation may or may not materialise) and the balance 40 per cent in
debentures with a relatively assured returns. And within these broad groups of equity
shares and debentures, he may specifically select specific firms. This problem of specific
identification is known as the problem of selectivity. It is obvious that the issue of
selectivity will have to be based on micro-level forecasts of expected cash flows from
specific shares/debentures of different companies. The investor will use security
analysis approaches for this. Then, he must determine the timing of his investment and
for this he will have to observe the forecasted price movements of shares relative to
debentures at the macro level. Finally, he will make all possible efforts to minimise his
risk for a given expected level of average return of his potential portfolio. This he would
be able to achieve when the returns of shares and debentures which would comprise his
portfolio are not positively correlated to each other. The resultant portfolio would be
known as a "diversified" portfolio. Thus, portfolio construction would address itself to
three major problems viz., selectivity, timing, and diversification.
Portfolio Revision
As time passes, the investor would discover that new securities with promises of high
returns and relatively low risk. In view of such developments it would be necessary for
him to review the portfolio. He would liquidate the unattractive securities and acquire
the new stars from the market. In a way, he repeats the first three steps of the
investment process. He sets new investment policy, undertakes security analysis afresh,
and re-allocates his cash for the new portfolio.
Portfolio Performance Evaluation
A rational investor would constantly examine his chosen portfolio both for average
return and risk. Measures for doing so must be developed. Also the calculated riskreturn positions must be compared with certain yardsticks or norms. This step in the
investment process, thus, acquires considerable significance since the tasks involved are
quantitative measurement of actual risk and return and their evaluation against
objective norms.
Financial Investments:
Investment decisions to buy/sell securities token by individuals and institutions are
carried through a set of rules and regulations. There are markets-money and capital
which function subject to such rules and established procedures and are, in turn,
regulated by legally constituted authority. Then there are securities or financial
instruments which are the objects of purchase and scale. Finally, the mechanism which
expedites transfers from one owner to another comprises a host of intermediaries. All
these elements comprise the investment environment. Investors have to be fully aware
of this environment for making optimal investment decisions.
Decisions in the following paragraphs provide a brief overview of the three elements of
the investment environment viz., instruments, institutions, and markets.
Financial Instruments
Financial instruments can be classified in a variety of ways. Securities are classified into
creditorship and ownership securities on the basis of the nature of the buyer's
commitment. The description will then be split into public and private issues
differentiating the two major forms.
Creditorship Securities
Debt instruments furnish an evidence of indebtedness of the issuer to the buyer.
Periodic payments on such instruments are generally mandatory and all of them provide
for the eventual repayment at maturity of the principal amount. Securities may also be
sold a price below the eventual redemption price, the difference between the redemption
price and the sale price constituting the interest.
Debt instruments can be issued by public bodies and governments and also by private
business firms.
Public Debt Instruments
Governments issue debt instruments for long and short periods. They are rated the best
in terms of quality and are risk-free. A common term used to designate them is giltedged securities. The 182 day treasury bills issued by the Government of India are
examples of short-term instruments and 11.5 per cent Loan 2009 (V issue) of the
Government of India, an example of long-term instruments. State Governments and
local bodies also issue series of loans and bonds. Banks, insurance, pension and
provident funds, and several other organisations buy government debt in compliance
with their statutory obligations.
Private Debt Instruments
They are issued by private business firms which are incorporated as companies under
the Companies Act, 1956. Generally, these instruments are secured by a mortgage on the
fixed assets of a company. Unsecured or naked debentures are now of theoretical
importance. A very popular variety of such debentures is "convertible" whereby either
the whole or a part of the par value of a debenture is convertible (usually automatically)
on the expiry of a stipulated period after issue. Select Indian companies can raise shortterm funds by issuing a debt instrument known as Commercial Paper (CP). The Reserve
Bank of India has issued detailed guidelines in January 1990 in this regard. They are
contained in "Non-Banking Companies (Acceptance of Deposits through the
Commercial Paper) Directives, 1989". The eligibility for entering into the CP market is
based on transparent norm which companies themselves can readily access. These
conditions were relaxed in April, 1990.
Portfolio Investment:
Financial Intermediaries:
Financial intermediaries perform the intermediation function i.e., they bring the users
of fund and suppliers of funds together. Many of them issue financial claims against
themselves and use cash proceeds to purchase the financial assets of others. The Unit
Trust of India and Mutual funds, belong to this category.
Most financial institutions underwrite issues of capital by non-government public
limited companies in addition to directly subscribing to such capital either under a
public issue or under a private placement.
The following table presents the pattern of absorption of private capital issues and
focusses attention on the intermediation function of financial institutions.
Inflow of Foreign Investments:
The small investor is unfairly handicapped almost invariably. Moreover, the existing
recognised stock exchanges work only for limited hours and even if they organise odd lot
sessions their business, by and large, remains centred on the "market lots". The demand
for an over the counter market has been keenly felt and the Government of India
approved the creation of an OTC market in August, 1989. This would help in introducing
a multi-tiered market in the country.
The regulatory mechanism is also under a thorough overhaul. The Securities and
Exchange Board of India (SEBI) is now to take over the responsibilities of monitoring
and controlling the stock market operations, new capital issues, working of mutual
funds and merchant banking subsidiaries of banks. The capital market developments
may take it to a new era of self-discipline, unitary control, and progressive automation.
Investment Objectives and Risks involved:
An investor postpones his consumption today and invests money to earn large money
tomorrow. Thus the investor will work to his investment objective first and then evolve a
policy with the amount of investible wealth at his command. But the pursuit of earning
"large money" is wrong, since returns are not possible without "large losses". Hence, the
objectives of an investor must be defined in terms of risk and return. The desire to keep
risk under counted is an important factor in financial investing and the practices of
minimising risk probably constitute the main constituents on investors' profits. Thus
investing has two principal objectives, one profit maximisation and the other risk
minimisation at a given point of time.
Gamble vs. Speculation
People make investments with a future end date in mind. The length of time when fund
is blocked in an asset or security is called holding period. If the holding period is very
short, it may be simply a gamble or a speculation, and is not really an investment.
Gamble:
A gamble is usually a very short term in a game of chance. The holding period can be
measured in seconds. The results of these investments are quickly resolved by the turn
of a card.
Speculation:
They typically last longer than gambles but briefer than investments. A speculation
usually involves the purchase of a stable asset with a hope to make quick profit in few
weeks or months. The investors refer to this activity as speculation. There is no precise
dividing line with respect to the length of investment holding periods that could be used
to separate gambles from speculations and speculations from investments. Since the
Internal Revenue Services (IRS) charges lower income rates on what it calls "long term
capital gains". Long term capital gains are defined as increases in the value of assets
owned for more than one year. Using this, one can define and investment of the holding
period is in excess of one year.
It is impossible to know how far into the future an investors planning horizon should
extend. No investor can reasonably hope to see further than about one decade ahead
and, of course, many investors cannot forecast even two years ahead. For convenience,
10 years is considered as the maximum investor's planning horizon. Following figure
illustrates the various holding periods discussed.
RISK
A dictionary defines risk as the chance of loss. Thus it relates to variability of return. The
source of such disappointment is the failure of dividends (invest) and/or the security's
price to materialise as expected. Hence, forces that contribute to variations in returnprice or dividend (invest) constitute elements of risk.
Relationship between risk and return:
Investment decision cannot be taken without taking the riskiness or the attractiveness
into account. For example, notice the following alternatives.
Rs. 100/- 12% (Government Bonds)
Rs. 200/- 15% (Public Ltd. company non-convertible debentures)
Rs. 200/- 15% (Public Ltd. company non-convertible
Rs. 10/- 35% dividend (Equity share of a multinational company)
Government loan would have zero risk. Since, payments are assured. In the case of
public limited company in spite of protective coverage in the form of corporate assets,
there is chance of default. The equity share of multinational company is a risk born
alternative. Except in the case of the government loan, risk perceptions of investors will
keep changing the market prices.
Two elements in the concept of risk as applied to the world of investment and finance
deserve attention. One, risk in the investment sense is associated with return. A person
buys an equity share with expectations of a return. The investment decision would be
premised on an unexpected return which may or may not actually be realised. The
chance of an unexpected return would be the risk carried by an investment decision.
Risk Connotations
It may be of interest to know that this concept and its later refinements have evolved
over a time-period. In the early years of the present century analysts would use financial
statement data for evaluating the risk of securities of a company. The broad indicators
used by them were the amount of debt employed by the firm. Their rule was: "the higher
the amount of debt the greater the riskiness of securities". Graham Dodd and Cottle,
who are considered pioneers of "security analysis" are the view that security analysis
must calculate the "intrinsic value" of a security independent of is market price.
According to them, "intrinsic value of a security would be a security analyst's own
judgement based on its earning power and financial characteristics and without
reference to its market price. The difference between "intrinsic value" and "market
price" was called the "margin of safety" and the rule used for assessment of risk was:
"the higher the margin of safety, the lower the risk."
Graham and Dodd not only concentrated on the individual security but also recognised
the importance of its contribution to the risk of a well-diversified portfolio. It must,
however, be mentioned that what brought the concepts of risk for a portfolio and a
security under a clearer focus was the work of Markowitz and the later development of
the capital asset pricing model (CAPM).
Several measures, have been used to measure risk viz., range, semi variance, and mean
absolute deviation. But standard deviation has been accepted in general because its
knowledge permits probability statements for most types of distributions. William
Sharpe observes that: The standard deviation of a portfolio's return can be determined
from the standard deviations of the returns of its component securities, no matter what
the distributions. No other relationship of comparable simplicity exists for most other
variability measures." One may note that the risk of a portfolio is not just the
mathematical addition of the risk of each of the individual securities that comprise. One
may further note that where the portfolio is well-diversified, portfolio risk would be less
than this mathematical total.
Types of Risks
Securities produce cash income streams over future time periods. They are discounted
by the market to yield present values which influence prices of these securities. This is a
continuous market process and whenever the discount factor or the cash stream
changes, prices also change. Interest rate risk arises from variations in such rates which
cause changes in market prices. It can be seen that a rise in market interest rates causes
a decline in market prices of securities and vice versa.
The time period over which the cash income is received also affects market prices of
securities. Thus, given the total cash income, the longer the time span over which it is
received the lower the present value and the lower would be the market price. These
effects are illustrated below:
Illustration
Assume Rs.500 14% secured non-convertible debenture for five years. The market
interest rate (as against the 14% coupon rate) is 15% and rises to 20%. Show the effect
on present values if the period of interest payment is stretched away by one year,
ignoring repayment of principal.
Solution
The solution shows that the present value of the annuity of Rs.70 declines from Rs.
234.65 (at 15%) to Rs. 209.34 when the discount rate rises to 20%.
In order to assess the effect of stretching, notice the difference between two sets of
present values using discount rates of 15% and 20%. For five year period, difference
between the PV at 15% and that at 20% is Rs.234.65 - Rs.209.34 = Rs.25.31.
It can now be stated that the market prices (or present values) of securities would be
inversely related both to market interest rates (or yield to maturity). One will recognise
that the interest rate risk is the price fluctuation risk which the investor is likely to face
when interest rates change.
With a view to avoid the interest rate and duration risk, the investor, may like to invest
in short term securities. Rather than buying a 5 year debenture he may buy one year
security every time the earlier one year security matures. This strategy, though
successful in reducing the interest rate or the price fluctuation, would possibly expose
the investor to another risk. Even the coupon rates in successive short term securities
may vary and the range of variation may be wide too. What the investor would now
encounter is the coupon rate risk". It will be the constant endeavour of investor to
weigh between the interest rate risk and the coupon rate risk while keeping funds
invested over his holding period.
One would have noticed that interest payments on bonds and on debentures are
contractual payments and the company can be sued for default. Cumulative preference
dividends must also be paid to avoid trouble from preferences shareholders. Equity
dividends can always be skipped if the company is in deep financial troubles and a
dividend payment would hasten insolvency. In such a situation the cash dividend yield
will be much more risky than the coupon yield on debentures.
Interest rate risk varies in degree for different financial assets. Historical data reveals
that average dividend yields of equity and preference shares fluctuated together with the
average market interest rates of debentures over a period of years, even if there were
some differences. For example, equity shares will have the lowest average yield because
many companies do not pay high levels of dividends and investors obtain a large part of
their return in the form of capital gains. In contrast, preference shares have high
average yields because they are a bigger insolvency risk than debentures. The fact that
various yields fluctuate together in spite of these differences shows that all securities
have some common interest rate risk factor. It must, however, be noted that even if the
present value model remains relevant for all securities, prices of preference and equity
shares do change exactly together with debenture or bond prices because the former
face default and management risks more than bonds and debentures. Thus, the interest
rate risk is the maximum in bonds and debentures followed by the preference shares
and equity shares in that order.
Diversifiable vs. Non-diversifiable Interest Rate Risk
When all interest rates move together, they are correlated. This makes interest rate risk
systematic or non-diversifiable. It is necessary to point out that market forces bring
about this tendency of all market interest rates to get positively correlated. It may
happen, for example, that the demand for funds from first-grade bonds may increase at
a particular point of time relative to the supply of loanable funds by investors in such
bonds. This will push up interest rates and will attract suppliers of funds from, say, the
low-grade bonds market. But then the low-grade bonds market will get a position of disequilibrium and shortage of loanable funds due to withdrawal in favour of first-grade
bonds will push interest rates on low grade bonds. Many such actions by investors
produce systematic trends in markets and, barring some exceptions, will make all
market interest rates correlated positively.
In the midst of a stage of positive correlation between market rates of interest, may
stand a particular firm which, say, faces a deep financial crisis and needs funds
desperately to avoid closure. Bonds and debentures of such a firm would not be
purchased except at higher interest rates. This may go against the general trend of
interest rates to decline and will be known as a situation of unsystematic action.
Investors may purchase these bonds and debentures to diversify their portfolios which
otherwise comprise only normal bonds and securities.
Market Risk
Market risk arises because market prices in general move up or down consistently for
some time periods. These movements can be observed on a graph which plots daily,
weekly, or monthly shifts in a market index like the BSE sensitive Index.
Broadly two mutually opposite patterns in Index movements can be noticed and their
duration observed. One of the patterns is known as bull market. When a security index
rises fairly consistent from a low point called a trough and continues to rise for a
significant period of time, the bull market is said to have arrived. A bull market will end
when the index reaches a market peak and begins the downward trend till it reaches
another trough. This phase from the "peak" to next trough is called the bear market.
One may notice that the duration and coverage of both bull and bear markets are "on an
average". In actual practice, there may be days, weeks and months within a particular,
say, bear phase when the index rises Likewise, there may be some individual shares
which may oppose the particular phase i.e., their prices may rise in the midst of a bear
phase and fall when there is a bull phase.
Market risk is demonstrated by the increased variability of investor returns due to
alternating bouts of bull and bear phases. Efforts to minimise this component of total
investment risk requires a fair anticipation of a particular phase. This needs an
understanding of the basic cause for the two market phases.
It has been found that business cycles are a major determinant of the timing and extent
of the bull and bear market phases. This would suggest that the ups and downs in
securities markets would follow the cycle of expansion and recession in the national
economy,
A bear market triggers pessimism and price falls on an extensive scale. There is
empirical evidence which suggests that it is difficult for investors to avoid losing in bear
markets. The question of protection against market risk naturally arises. Investors can
protect their portfolios by withdrawing invested funds before the onset of the bear
market. A simple rule to follow would be: "buy just before the security prices rise in a
bull market and sell just before the onset of the bear market", that is, buy low and sell
high. This is called good investment timing.
Market risk as pointed out earlier is also classed as systematic and non-systematic.
When a combination of systematic forces cause the majority of shares to rise during a
bull market and fall during a bear market, a situation called systematic market risk. As
already noted, a minority of securities would be negatively correlated to the prevailing
market trend. These unsystematic securities face diversifiable market risk. For example,
firms granted a valuable patent of obtaining a profitable additional market share, by the
bankruptcy of a touch rival may find its share prices rising even when overall gloom
prevails in the market. Such unsystematic price fluctuations are diversifiable and the
securities facing them can be combined with some systematic shares so that the
resulting diversified portfolio offsets the systematic losses by gains from the
nonsystematic securities.
Inflation Risk
Inflation risk is the variability in the total purchasing power of an asset. It arises from
the rising general price level. The interest rate on bonds and debentures and dividend
rates on equity and preference shares are stated in money terms and if the general price
level rises during some future period the buying power of the cash interest/dividend
income is likely to be received for that period would decline. And if the rate of inflation
is equal to the money rate of return, the investor does not add anything to his existing
wealth since he obtains a zero rate of return.
Many investors believe that if the market prices of their financial assets increase they
are financially better off in spite of inflation. Their argument is: after all money is
increasing". A moment's contemplation would confirm that this is nothing but "money
illusion". Consider, for instance, a situation when the market price of a security that one
is holding doubles and the general price level increases four-fold. Would he say that he
is richer simply because his command over money doubles by selling the security? But
he can't dismiss the fact that his command over goods and services (which is the
eventual objective of all investment decisions) has declined due to a four-fold rise in
prices in general.
The money illusion is partly rectified by obtaining real rates of return (interest/dividend
cash income + capital gains) which are equivalent to the inflation adjusted monetary or
nominal rates of return. If the real rate of return is denoted by Rr, inflation rate by q,
and nominal rate of return by r, then
For example, a Rs. 500 debenture earns a coupon rate of 20% per annum. Inflation rate
expected in the coming one-year period is 12%. Then the real rate of return would be:
One may notice the drastic fall in the real rate of return to 7.14% from the coupon rate of
20% due to inflation rate of 12%.
Default Risk
The default risk arises from a deterioration of financial strength of the company.
If not handled properly, the default episodes of a firm may as well finally end up in
bankruptcy. This would, however, not be quite a swift process and one may notice
warning signals before the final disaster strikes. For example, a company may begin
stopping payment of its bills, accumulate arrears of cumulative preference dividends
and accrued interest on loans, default on debenture interest, incur persistent losses,
slash the equity dividend, and finally skip it, and so on. In more objective terms, adverse
movements in financial ratios like the current ratio, the acid test ratio, the cash to
operating expense ratio, the net-worth to total assets ratio and so on can be put on the
watch. The point is that bankruptcy will not be a bolt from the blue except when an act
of nature destroys all assets which are not insured.
When the first signs of a weakening financial health of a firm are noticed market prices
of its securities react and take a dip. The immediate target groups would be lenders and
creditors but ultimately even shareholders would suffer. In fact, if the worst happens,
losses of equity holders could be total and they may end up with share prices nearly
dropping to zero. Also, even at such abysmally low levels, there may not be any takers.
As with other risk factors, there may be diversifiable and non-diversifiable components
of default risk. Thus tight credit conditions created by the Reserve bank of India would
push up interest rates and financially weak companies may not be able to borrow.
Similarly, a recession may curtail orders and firms that are already weak may start
defaulting when their sales and income decline. These are examples of systematic forces
that affect all firms simultaneously, and systematically push them toward default. One
should note that these are extraordinary circumstances and would push up the normal
default rate of firms. Thus, a systematic default risk element is added to the normal
default risk which remains diversifiable. The former will affect even the most diversified
portfolios but the latter will nearly vanish in such portfolios.
The systematic element in default risk is more harmful to the investor than the
diversifiable element. The latter can be anticipated and managed.
Management Risk Factor
Management risk is that part of total variability of return which is caused by managerial
decisions.
Management faults are the main reasons which give rise to management risk
component of total investor risk. These errors are so numerous that it is difficult to
either list them or even to classify them. Some potential areas of management errors can
be highlighted. The one great blunder that management might commit is to ignore
product obsolescence. Another risk area is the dependence of a firm on a single large
customer. Management must adequately diversify customer groups. Yet one more area
of management errors could be the wrong handling of a correct decision when it is
subjected to unfair criticism and is even fought out in a court. One should note that
these cases are only illustrative and the list may go to an infinite number of factors.
Agency theory and Management Risk
A recent development in the area of explaining management risks is concerned with
research that seeks to explain the basic motivations of owners and managers. It has been
stated that owners work harder than managers. Moreover, non-owner managers have
strong incentives to consume non-pecuniary benefits since they are hired employees.
The emerging theory hypothesis is that owner-non-managers delegate all authority to
non-owner-managers, who then operate under a principal agent relationship. Since expost rewards and punishments are not perfect and just, hired executives may not make
much effort to generate profitable investment opportunities than they would if they own
the firm. Thus, there is a conflict of interest between owners and managers and the
latter may abuse the authority delegated to them much to the detriment of owners. In
consequence, investors who are rational individuals would pay a higher price for shares
of owner managed firms than for shares of employee managed firms. The difference
between the two sets of prices has been termed as agency cost" and the whole logic
presented in this para as "agency theory". It must be observed that the theory has not
gone without criticism but the view is getting increasingly accepted.
Evaluating Management
An investor and security analysts must attempt to evaluate the management team of a
company for its strengths and deficiencies. The task, though difficult and highly
subjective, must be done using some checkpoints which are briefly stated below:
1) Age, health, and experience profile of executives
2) Growth-orientation and aggressiveness of management
3) Product and customer diversification
Liquidity risk of securities results from the inability of a seller to dispose them off except
by offering price discounts and commissions. It is easy to rank assets according to
liquidity. The currency unit of a country is immediately saleable at par and no discount
etc. need be given. Government securities and blue chips shares are the next highly
liquid group of assets. Debt securities and equity shares of some small and less known
companies are less liquid or even illiquid.
The investor cannot recover his asked price while selling illiquid securities. He has to
face a bid price which is always the highest of the potential buyer but even so is always
less than the asked price. The difference between the asked price and the bid price is
known as the bid-asked spread'. This spread increases with illiquidity of assets Investors
must consider the liquidity risk factor while selecting securities.
The history of stock exchanges in foreign countries as well as India shows that the
development of joint stock enterprise would never have reached its present stage but for
the facilities that the stock exchanges provide for dealing in securities. Stock exchanges
have a very important function to fulfill in the country's economy. According to,
Supreme Court of India has enunciated the role of the stock exchanges in these words:
"A stock exchange fulfills a vital function in the economic development of a nation: its
main function is to liquify capital by enabling a person who has invested money in, say a
factory or a railway, to convert it into cash by disposing off his shares in the enterprise
to someone else. In modern days a company stands little chance of inducing the public
to subscribe to its capital, unless its shares are quoted in an approved stock exchange.
All public companies are anxious to obtain permission from reputed exchanges for
securing quotations of their shares and the management of a company is anxious to
inform the investing public that the shares of the company will be quoted on the stock
exchange.
The stock exchange is really an essential pillar of the corporate economy. It discharges
three essential functions in the process of capital formation and in raising resources for
the corporate sector".
First, the stock exchange provides a market place for purchase and sale of securities viz.,
shares, bonds, debentures etc. It, therefore, ensures the free transferability of securities
which is the essential basis for the joint stock enterprise system. The private sector
economy cannot function without the assurance provided by the stock exchange to the
owners of shares and bonds that they can be sold in the market at any time. At the same
time those who wish to invest their surplus funds in securities for long-term capital
appreciation or for speculative gain can also buy scripts of their choice in the market.
Secondly, the stock exchange provides the linkage between the savings in the household
sector and the investment in corporate economy. It mobilises savings, channelises them
as securities into those enterprises which are favoured by the investors on the basis of
such criteria as future growth prospects, good returns and appreciation of capital. The
importance of this function has remained undiminished in spite of the prevalence on the
Indian scene of such interventionist factors as industrial licensing, provision of credit to
private sector by public sector development banks, price controls and foreign exchange
regulations. The stock exchanges discharge this function by laying down a number of
regulations which have to be compiled with while making public issues e.g. offering at
least the prescribed percentage of capital to the public, keeping the subscription list
open for a minimum period of three days, making provisions for receiving applications
on a fair and unconditional basis with the weightage being given to the applications in
lower categories, particularly those applying for shares worth Rs. 500 or Rs. 1,000 etc.
Members of stock exchanges also assist in the flotation of new issues by acting as
managing brokers/official broker of new issue. In that capacity, they, try to sell these
issues to investors spread all over the country. They also act as underwriters to new
issues. In this way, the broker community provides an organic linkage between the
primary and secondary markets.
Thirdly, by providing a market quotation of the prices of securities stock exchange
serves the role of a barometer, not only of the state of health of individual companies,
but also of the nation's economy as a whole. It is often not realised that changes in the
share prices are brought about by a complex set of factors, all operating on the market
simultaneously.
These trends are influenced to some extent by periodical cycles of booms and
depressions in the free market economies. As against these long-term trends, the day to
day prices are influenced by another variety of factors notably, the buying or selling of
major operators, the buying and selling of shares by the investment financial
institutions such as the UTI or LIC. Speeches and pronouncements by ministers and
other government spokesmen, statements by company chairmen to annual general
meetings and reports of bonus issues or good dividends by companies etc. While these
factors, both long-term and short-term act as macro influences on the corporate sector
and the level of stock prices as a whole, there is also a set of micro influences relating to
prospects of individual companies such as the reputation of the management, the state
of industrial relations in the enterprises etc. which have a bearing on the level of prices.
In the complex interplay of all these forces, which leads to day to day quotation of prices
of all listed securities, speculation plays a crucial role. In the absence of speculative
operations, every purchase by an investor has to be matched by a sale of the same
security by an investor seller, and this may lead to sharp fluctuation in prices. With
speculative sale and purchases taking place continuously, actual sale and purchase by
investors on a large scale are absorbed by the market with small changes in prices. There
are always some professional operators who are hoping that the prices would rise. Both
these groups acting on their respective assumption buy or sell continuously in the
market. Their operation helps to bring about an orderly adjustment of prices. Without
these speculative operations, a stock exchange can become a very mechanical thing. The
regulatory authorities should always take necessary precautionary measures to prevent
and penalise excessive speculation and to discipline trading.
Another important function that the stock exchanges in India discharge is of providing a
market for gilt-edged securities i.e. securities issued by the Central Government, State
Government, Municipalities, Improvement Trusts and other public bodies. These
securities are automatically listed on the stock exchanges when they are issued and
transactions in these take place regularly on the stock exchanges.
In comparison to the developed markets abroad, the Indian market is less transparent.
While the day's opening, high, low, and closing prices are reported, no information is
made available to investors as to the volume of transactions executed at the highest and
lowest prices. Neither client orders to buy or sell nor trades executed on the floor of the
exchange are time stamped.
Dilatory settlement
Trades are settled by physical delivery of securities accompanied by transfer deeds. The
physical movement of securities from the seller to the seller's broker (through the
clearing house of the exchange, or directly) and from the buyer's broker to the buyer
makes the settlement dilatory. The problem is further accentuated because the buyer
has to lodge the securities with the company or its transfer agents for transfer. This
process of transfer may take two to three months.
Inadequate professionalism
While there are brokers who are highly competent and professional in their dealings,
many of them seem to lack high professional standards.
The institution where this buying and selling of shares essentially takes place is the
Stock Exchange. In the absence of stock exchanges, i.e. institutions where small chunks
of businesses could be traded, there would be no modern business in the form of
publicly held companies. Today, owing to the stock exchanges, one can be part owners
of one company today and another company tomorrow; one can be part owners in a
company hundreds or thousands of miles away; one can be all of these things; and none
of them, should we for whatever reason decide to convert all our ownership stake into
cash at short notice. Thus, by enabling the convertibility of ownership in the product
market into financial assets, namely shares, stock exchanges bring together buyers and
sellers (or their representatives) of fractional ownerships of companies, much as buyers
and sellers of vegetables come together in a vegetable market. And for that very reason,
activities relating to stock exchanges are also appropriately enough known as Stock
Market or Security Market. Also, just as a vegetable market is distinguished by specific
locality and characteristics of its own, mostly a stock exchange is also distinguished by a
physical location and characteristics of its own.
Meaning
Traditionally, a stock exchange has been an association of individual members called
member brokers formed for the purpose of regulating and facilitating the buying and
selling of securities by the public and institutions at large. A Stock Exchange in India
operates with due recognition from the government under the Securities & Contracts
(Regulations) Act, 1956. The member brokers are essentially the middlemen, who carry
out the desired transactions in securities on behalf of the public.
Governance
At present there are 21 stock exchanges in India, the largest among them being the
Bombay Stock Exchange (BSE) Typically, a stock exchange is governed by a board
consisting of directors largely elected by the member brokers, and a few nominated by
the government. Government nominees include representatives of the Ministry of
Finance, as well as some public representatives, to safeguard the public interest in the
functioning of the exchanges. The Board is headed by a President, who is an elected
member, usually nominated by the government from among the elected members. The
Executive Director is appointed by the stock exchange with government approval. His
duty is to ensure that the day to day operations of the stock exchange are carried out in
accordance with the various rules and regulations governing its functioning. Lately, a
Securities and Exchanges Board of India (SEBI) has been set up in Bombay by the
government to oversee the orderly development of stock exchanges in the country.
Listing
All companies wishing to raise capital from the public are required to list their securities
on at least one stock exchange. Thus, all ordinary shares, preference shares and
debentures of publicly held companies are listed in stock exchanges.
Brokers/sub-brokers Involvement
While in the developed countries, brokers have long since graduated to rendering a
whole range of consulting and advisory services to their clients based on their own
research and analysis, unfortunately, the profession of brokers in India has remained a
rather closed club, traditional and primitive. Their function has largely remained limited
to carrying out the transaction orders on behalf of their clients (and often at prices far
from satisfactory). In their role as sub-brokers and jobbers (those who specialise in
specific securities catering to the needs of other brokers), their activities are even less
organized and regulated.
Control is an important factor for a stock exchange to thrive. The salient points of the
Acts are discussed below:
The Stock Exchanges in India are regulated by the Securities Contracts (Regulation) Act
of February 20, 1957. It has the following features:
(a) Functioning of recognised stock exchanges.
(b) Control over the stock exchanges by Central Government.
(c) Regulatory measures in the working of stock exchange.
(d) Curbs on speculation.
(e) Setting up Directorate of Stock Exchanges for administration and control of stock
exchanges.
(a) Recognised Stock Exchanges:
Under the Act every stock exchange must apply for recognition to the Central
Government. A recognised Stock Exchange has to ensure:
(i) That it will follow the rules and bye-laws of statute.
(ii) That it will act in accordance with the conditions laid down by the Central
Government failing which the Central Government may withdraw recognition.
(b) Control by Central Government:
Under the Act the Central Government has the right to control the stock exchange in the
following ways:
(i) By requiring stock exchanges to furnish periodical returns about their affairs.
(ii) By requiring stock exchanges to provide any explanations and information.
(iii) By requiring the submission of the annual report.
(iv) By exerting its right the Central Government may make an enquiry into the working
of any recognised stock exchange.
(v) The Central Government may also order suspension of business and supersede
Governing Boards of Stock Exchanges if business is conducted in violation of rules.
(vi) The Central Government may appoint maximum three of its own nominees on any
stock exchange subject.
(vii) It may also compel companies to get themselves listed and also to comply with
listing arrangements.
(c) Regulatory Measures:
Central Government regulates the working of a stock exchange in the following manner:
(i) It frames bye-laws regarding time of trade and hours of work in a stock exchange.
(ii) Regulation or abolition or speculative trades like options, badla and blank transfers.
(iii) Maintenance of clearing houses.
(iv) Framing of arbitration rules to be followed during disputes.
(v) Fixation of brokerage fees and license.
(d) Curbs on Speculation:
The Act has made various curbs on speculation.
(i) Making option dealings illegal.
(ii) Making option dealings before the Act void.
(iii) Discouraging blank transfers.
(e) Directorate of Stock Exchanges:
A Directorate of Stock Exchanges was set up in 1959. It administers and implements the
bye-laws contained in the Securities Regulation Act. It is both in an advisory position as
well as in a position of implementing laws. It controls the activities of the stock
exchange and maintains a close watch over options and other illegal dealings. It also
gives licenses to dealers on unrecognised stock exchanges. It maintains a liaison
between Government and the Stock Markets in India.
(f) Securities Exchange Board of India:
In 1987 as a measure of legislative reform and bringing in confidence among the
investors, a Securities Exchange Board was set up. Every company issuing capital was to
register itself with the SEBI and co-operate in stream lining procedures regarding issue
and transfer of shares. It would bring about discipline among existing companies and
provide information to the investors about the working of these companies.
As an extension to the stock market activity an over the trading counter has been
formed. The primary objective of an 'OTC market is to help small or medium companies
with viable projects but with high risks. The capital base of the companies which would
be benefited would be between 50 lakhs and 3 crores. The OTC market would extend
their services to semi urban and rural areas. They would be decentralized and extend
their operations beyond the frontiers of the Stock Exchange.
Odd-lot Dealers
The purchase or sale of less than 100 shares of a stock is referred to as an odd-lot
transaction. Trades of 100 shares or multiples of 100 are referred to as round-lot
transactions. Odd- lot trades are executed through special odd-lot dealers. Odd-lot
dealers must buy in round-lots, deliver a portion of the round-lot to the odd-lot buyer,
and then be left holding the remainder of the round-lot they purchased in their
inventory. As compensation for performing this service, odd-lot dealers used to charge a
special fee.
Brokers
Traditionally, in the stock exchanges the world over, the members of the exchange
assemble on the floor of the stock exchange, for trading, during the trading hours. In
most stock exchanges, including Bombay, any member is free to announce a bid to buy
or an offer to sell a particular security or to remain silent. With a lot of members or their
representatives simultaneously shouting their bids and offers on behalf of their clients,
and using a wide variety of signals with their hands and fingers to reach out to another
dealer above the overcoming din, to a casual observer the scene frequently resembles a
bedlam. Surprisingly, however, to those in the ring the entire proceedings may appear
perfectly orderly and meaningful. This system of trading, with a large number of buyers
and sellers at one place is supposed to replicate a highly competitive system of market
making. Currently online trading is in force in BSE.
Budlawalas
They execute what is known as carry-over business. They are financiers. The job is
highly technical.
Arbitrageur
He specializes in buying and selling in different markets. The difference between the
buying price in one market and selling price in another market constitutes his profit.
However, he can transact such business only if a security is traded on more than one
stock exchange and if the exchanges are telephonically or fax-linked. In India
arbitraging has become a growing business with the prior approval of the Governing
Body in order to avoid the evil of joint account with members of other stock
exchanges and the consequence involvement of one exchange in the difficulties of
another.
Security Dealer
This dealer specialises in trading in government securities. He mainly acts as a jobber
and takes the risk inherent in ready purchase and sale of securities. The government
securities are traded over the counter and not on the floor. They maintain daily contact
with the Reserve Bank of India and commercial banks and other financial institutions.
As a result of their activities, government securities are quoted finely.
Members are permitted to deal only in listed securities. However, with the approval of
the Governing Body, they can deal in listed securities of other exchanges.
There are three types of contracts permitted by the stock exchanges. Members can
transact for Spot-delivery, i.e., for delivery as well as payment on the same day as the
date of contract or at the most the next day; for Hand Delivery, i.e., delivery and
payment within the time and date stipulated at the time of entering into bargain, (which
shall not exceed 14 days following the date of contract); for special delivery i.e., for
delivery of the share and payment for it within anytime exceeding 14 days from the date
of contract when entering into a bargain but permitted by the Governing Body or
President.
Dealings in government securities are transacted between 12 noon and 3 p.m., on the
Bombay Stock Exchange. The securities are largely transacted by institutional investors
and also brokers and dealers. The business is settled largely through banks. The
documents are delivered through banks against payment at the contract rate plus
interest rate accrued to the date of delivery.
The bargains are entered into by word of mouth but seldom any serious mistakes occur;
also bargains are scrupulously honoured.
In the matter of delivery, trades are classified into two groups- Delivery orders and
Receive orders. For both groups there is now a computerised system of settlement.
These orders are issued to the first and last party respectively. Delivery in respect of the
first group passes through the Clearing House. In the case of the other group the
delivering member hands over directly to the receiving member named in the Receive
order, the share certificates together with duly executed transfer needs. Such deliveries
should be effected before 2 p.m. on the prescribed day which is generally Thursday.
All bargains except in Equity shares entered into from Thursday of any week up to the
following Wednesday are required to be settled by delivery and payment on Wednesday
in the week after. Many other procedures are involved for final settlement.
A Clearing House, established in Bombay in 1921, receives delivery and payment on
behalf of the customers. The Clearing House guarantees that whenever shares are
delivered payments would be duly made, or it returns the shares to the concerned bank
if a member defaults, and per contra when payment is made the shares would be duly
delivered, or return the money to the bank if a member defaults. Clearing operations
cost huge sums of money to the Bombay Stock Exchange. The services are tendered in
the interest of the investing public. The clearing operations introduced in Calcutta in
1944 and in Madras and Delhi in 1957.
In the process of trading in stock exchanges there is the basic need for a 'transaction
between an individual and broker. A transaction to buy or sell securities is also called
'trades'. This is to be done through of a broker.
1. Finding a Broker:
The selection of broker depends largely on the kind of services rendered by a particular
broker as well as upon the kind of transaction that a person wishes to undertake. An
individual usually prefers to select a broker who will render the following services:
(a) Average Information: A broker should be able to give information about the
available investments, in the form of capital structure of companies' earnings, dividend
policies, and prospects. These could also take the form of advice about taxes, portfolio
planning and investment management.
(b) Provide Investment Literature: Secondly, a broker should be able to supply financial
journals, prospectuses and reports. He should also prepare and analyse literature to
educate the investor.
(c) Hire Competent Representatives: Brokers should have competent representatives
who can assist customers with most of their problems.
The investor who is satisfied with the qualities of the broker will have to look next for a
specialised broker. The second process is to find a good reputed and established broker
in the kind of deal that the investor is interested. In India, the stock exchange rules, bylaws and regulations do not prescribe any functional distinction between the members.
However, brokers do establish themselves and are known for their specialisation. In
India, the following specialists can be contacted for trading in the 'Securities' market.
2. Selection of Broker:
Kinds of Brokers
(a) Commission Broker: All brokers buy and sell securities. From the investor's point of
view he is the most important member of the exchange because his main function and
responsibility is to buy and sell stock for his customers. He acts as an agent for his
customer and earns a commission for the service performed. He is an independent
dealer in securities. He purchases and sells securities in his own name. He is not allowed
to deal with non- members. He can either deal with a broker or another jobber.
(b) Jobber: A jobber is a professional speculator. He works for a profit called 'turn'.
(c) Floor Broker: The floor broker buys and sells shares for other brokers on the floor of
the exchange. He is an individual member, and receives commissions on the orders he
executes. He helps other brokers when they are busy and as compensation receives a
portion of the brokerage charged by the commission agent to his customer.
(d) Taraniwalla: The Taraniwalla is also called a jobber. He goes for auction in the
market in the stock he specialises. He is a localised dealer and often handles
transactions on a commission basis for other brokers who are acting for their customers.
He trades in the market even for small differences in prices and helps to maintain
liquidity in the stock exchange.
(e) Odd Lot Dealer: The standard trading unit for listed stocks is designated as a round
lot which is usually a hundred shares. Anything less than a round lot is called odd lot.
Only round lots are traded on the floor of the exchange. It is impossible to match buying
and selling orders in odd lots. The specialists handle odd lots. They buy and sell odd
lots. If dealers buy more than they sell or sell more than they buy they can clear their
position by engaging in round lot transactions. The price of the odd lot is determined by
the round lot transactions. The odd lot dealer earns his profit on the difference between
the price at which he buys and sells the securities.
(f) Financier: The financier in the stock exchange is also called to Budliwalla. For giving
credit facilities to the market, the budliwalla charges a fee called contango or
'backwardation' charge. Budliwalla gives a fully secured loan for a short period of two to
three weeks. This loan is governed by the interest prevailing in the market. The
budliwalla's technique of lending is to take up delivery on the due date at the end of the
clearing to those who wish to carry over their sales.
(g) Arbitrageur: An arbitrageur is a specialist in dealing with securities in different
center of stock exchange centres at the same time. He makes a profit by the difference in
the prices prevailing in different centres of market activity. He maintains an office with
a good communication system.
(h) Security Dealers: The purchase and sale of government securities are carried on by
the stock exchange by Security Dealers. Each transaction of purchase or sale has to be
separately negotiated. The dealer takes risk in ready purchase and sale of securities for
current requirements.
3. Opening an Account with Broker:
After a broker has been selected the investor has to place an 'order on the broker. The
broker will open an account in the name of the investor in his books. He will take from
the investor margin money as advance. In case, the investor wishes to sell his securities,
he will have to deposit with the broker, share certificates and discharged transfer deeds.
The broker satisfies himself that the prospective investor has a good credit rating. The
broker may ask for bank reference and two or three credit references from the investor.
Knowledge of type of securities the customer is seeking and the degree of market risk he
is willing to assume will help the broker in knowing the customer's requirements in the
stock market. When the broker is satisfied about the customer's intention to trade in the
market, the broker and the investor will come to an agreement. The broker then enrolls
the name of the customer in his books and opens an account.
4. Placing an Order:
Brokers receive different types of buying and selling orders from their customers.
Brokerage orders vary as to the price at which the order may be filled, the time for which
the order is valid, and contingencies which affect the order. The customer's
specifications are strictly followed. The broker is responsible for getting the best price
for his customer at the time the order is placed. The price is established independently
by brokers on an auction basis and not by officials of the exchange. The following
transactions take place on orders in the stock exchange.
Choice of Orders:
(a) Long: When an investor buys securities, he is said to be long in the issue, if he sells
securities, he eliminates his long position, and when he strongly believes that an issue is
overpriced and will in most likelihood fall short within the foreseeable future he may ask
his broker to sell 'short.
(b) Short: A short sale involves selling an issue that one does not own and must borrow
to settle the account, or does possess but does not wish to deliver. Financial institutions
are not allowed to sell short. In short sales the broker buys securities for his customer to
make delivery but expects the seller to buy back at a later date in order to repay the
borrowed share certificate. Short selling is legal and the most obvious reasons for buying
short is to cover stock in declining prices.
(c) Spot Delivery: Spot delivery means delivery and payment on the same day as the
date of the contract or on the next day.
(c) Hand Delivery: Hand delivery is the transaction involving delivery and payment
within the time of the contract or on the date stipulated when entering into the bargain
which is usually 14 days following the date of the contract.
(d) Special Delivery: Special Delivery is the delivery and payment exceeding 14 days
following the date of the contract as specified when entering into a bargain, with the
specific permission of the President or Governing Board. These transactions are
conducted at the time of executing an order.
The types of orders that can be made by the broker for his customer are described
below:
(i) Market Orders: Market orders are instructions to a broker to buy or sell at the
best price immediately available. Market orders are commonly used when trading
in active stocks or when a desire to buy or sell in urgent. With this order a broker
is to obtain the best price he can for his customer.
(ii) Limit Orders: Limit orders instruct a broker to buy or sell as a stated price 'or
better. When a buyer or seller of stock feels that he can purchase or sell a stock at
a slight advantage to himself within the next two or three days, he may place a
limited order to sell at a specified price. A limit order protects the customer
against paying more or selling for less than intended. A limit order, therefore,
specifies the maximum or minimum price the investor is willing to accept for his
trade. The only risk attached to a limit order is that the investor might lose the
desired purchase or sale altogether for a trifle margin.
(iii) Stop Loss Order: Another type of order that may be used to limit the amount
of losses or to protect the amount of capital gains is called the stop order. This
order is sometimes also called the "stop order". Stop loss orders are useful to both
speculators and investors. Stop loss orders to sell can be used to sell out holdings
automatically in case a major decline in the market occurs. Stop orders to buy can
be used to limit possible losses on a short position. It may also be used to buy if a
most frequently used as a basis for selling a stock once its price reaches a certain
point.
5. Choosing the trading activity with the broker:
Kinds of Trading Activities:
- Options:
An Option is a contract which involves the right to buy or sell securities at specified
prices within a stated time. There are various types of such contracts, of which puts and
calls are most important. A 'put' is a negotiable contract which gives the holder the
right to sell a certain number of shares at a specified price within a limited time. A 'call
is the right to buy under a negotiable contract.
(a) Establishing a Spread: A spread involves the simultaneous purchase and sale of
different options of the same security. A vertical spread is the purchase of two options
with the same expiry date but different striking prices. In a horizontal spread, the
striking price is the same but the expiry date differs.
(b) Buying a Call: Buyers of Call look for option profit from some probable advance in
the price of specified stock with a relatively small investment compared with buying the
stock outright. The maximum that can be lost is the cost of the option itself.
(c) Writing Options: A written option may be 'covered or 'uncovered. A covered option
is written against an owned stock position. An uncovered or naked option is written
without owning the security. A covered option is very conservative. The income derived
from the sale of a covered option offsets the decline in the value of the specified security.
(d) Wash Sales: A wash sale is a fictions transaction in which the speculator sells the
security and then buys it at a higher price through another broker. This gives a
misleading and incorrect position about the value of the security in the market. The
price of the security in the market rises in such a misleading situation and the broker
makes a profit by 'selling or 'unloading' his security to the public. This kind of trading is
considered undesirable by the stock exchange regulations and a penalty is charged for
such sales.
(e) Rigging the Market: This is a technique through which the market value of securities
is artificially forced up. The demands of the buyers force up the price. The brokers
holding large chunks of securities buy and sell to be able to widen and improve the
market and gradually unload their securities. This activity interferes with the normal
interplay of demand and supply functions in the market.
(f) Cornering: When brokers create a condition where the entire supply of particular
securities is purchased by a small group of individuals, those who have dealt with 'short
sales' will be 'squeezed' and will not be able to make their deliveries in time. The buyers,
therefore, assume superior position and dictate terms to short sellers. This is also an
unhealthy technique of trading in stock exchange.
(g) Blank Transfers: A blank transfer is one in which the transferor signs the form but
does not fill-in the name of the transferee while transferring shares. Such a transfer
facilitates speculation in securities. It involves temporary purchases and sales of
securities without regulation.
Blank transfers encourage (i) Non-payment of transfer fees of shares, (ii) Evasion of tax,
and (iii) Unhealthy trading
- Non-registration
Non-registration of transfer of shares gives rise to non- disclosure of the name of the
transferee in the books of the company. The 'transferor' or the seller of the shares
remains liable for the uncalled part if a partly paid share if the name is not transferred in
due course according to the procedure of the company. The stamp duty on transfer of
shares also remains unpaid unless proper transfer is executed.
Due to problems associated with blank transfers, the Companies Act of 1966 has made
certain changes and regulated blank transfers. Since 1st April, 1966, shares which have
to be transferred must be on a prescribed form and presented to the Registrar of
Companies, i.e., the prescribed authority before it is signed by the transferor for
endorsement thereon of the date of presentation. It must therefore, be delivered to the
company for registration of the transfer, in case of listed securities before the first
closure of Register of Members after the date of presentation and in the case of nonlisted securities within two months of presentation. These measures have been taken for
discouraging blank transfers.
- Arbitrage
Arbitrage is a technique of making a profit on stock exchange trading through difference
in price of two different markets. If advantage of price is taken between two markets in
the same country it is called 'domestic arbitrage. Sometimes arbitrage may also be
between one country and another. It is called foreign arbitrage. Such an advantage in
prices between two countries can be taken when the currencies of both the countries can
be easily converted.
Arbitrage usually equalizes the price of security in different places. When the security is
sold at a high price in a market, more of the supply of the security will tend to bring a
fall in the price, thus neutralizing the price and making it equal to the price in the
cheaper market.
On placing an order, the brokers get busy through different kinds of trading activities,
which may also include options and other speculations such as wash sales, rigging,
cornering, blank transfers or arbitrage. The speculators in the stock market are
generally represented by 'bull, 'bear', stag, and 'lame duck.
Bull: A bull is an investor on the stock exchange who expects a rise in the price of a
certain security. A bull is also called a tejiwala because of his expectation of price rise.
The usual technique followed by a bull is to buy security without taking actual delivery
to sell it in future when the price rises. The bull raises the price in the stock market of
those securities in which he deals. He is said to be on the long side of the market'.
If the price falls the bull pays the difference at a loss. The 'bull may thus close his deal if
the price continues to fall or carry forward the deal to the next settlement day by paying
an amount called 'contango charge. The bull may carry forward his deal as he expects a
price rise in the future which will cover the contango charge and also bring him profit.
Thus active bulls in a stock market can raise the price of the security. The increase in
prices is generated through bulk purchasing of securities.
Example of bull transaction
An investor asks his broker to buy for him 500 shares at Rs. 10 each for which there is
no immediate payment. Before he pays for the shares on the date of settlement, the price
of shares rises by Rs.5 per share. He would instruct his broker to sell the share on his
behalf. The transaction may not be real. Only the difference may be paid for on the date
of settlement. The Bull's profit is calculated below:
Bear: A bear is the opposite of a bull. He expects a fall in prices always. He is popularly
known as 'Mandiwalla'. He agrees to sell for delivery, securities on a fixed date. He may
or may not be in actual possession of these securities. On the due date he purchases
securities at a lower price and fulfills his premise at a higher price. In this way he makes
a profit on a transaction which may be 'real' or 'notional' with settlement of differences
only.
The bear makes a loss if the price rises on the date of delivery. In such a situation he will
have to buy at a higher price and sell at a lower rate in fulfillment of his agreement.
The share market usually shows a decline in prices when 'bears' operate and sell
securities not in their possession. On the date of settlement the bear has an option either
to close the deal or carry it forward by an amount called the 'backwardation charges. If
the bear is able to make a profit on the settlement date it is called 'cover' because the
bear buys the requisite number of shares and sells them at a specified price on the
delivery date.
Example
A person expects a fall in the price of shares of a company. He may agree to sell 500
shares at Rs. 25/- each on a specified date. If before the fixed date the price of the share
has fallen to Rs.22/- he makes a profit of Rs.3/- per share, as calculated below is total
profit on 500 shares.
Bullish and Bearish: When the price is rising and the 'bulls' are active in the market,
there is buoyancy and optimism in the share market. The market in this situation is
'bullish. When there is decline in prices, the market is said to go 'bearish'. This is
followed by pessimism and decline in share market activity.
Bull Campaign and Bear Raid: The bulls begin to spread rumours in the market
about rise in prices when there is an over- bought condition in the market, i.e., the
purchases made by the speculators exceeds sales made by them. This is called a 'bull
campaign'. Similarly, a 'bear raid' is a condition when speculative sales made by bear
speculators exceed the purchases made by them and they spread rumours to bring the
price down.
Lame Duck: A bear cannot always keep his commitments because the price does not
move the way lie wants the share to move. He is, therefore, said to be struggling like a
'lame duck.
Example: A bear may agree to sell 1500 shares for Rs. 25/- each on a specified date. On
the due date, he may not be able to settle his agreement for scarcity or non-availability
of security in the market. When the other party insists on delivery on that date itself, the
bear is said to be a 'lame duck'.
Stag: A stag is a cautious speculator. He does not buy or sell securities but applies for
shares in the new issue market just like a genuine investor on the expectation that the
price of the share will soon rise and be sold for a premium. The stag shares the same
approach as a bull, always expecting a rise in price. As soon as the stag shares receives
an allotment of his shares, he sells them. He is, therefore, taking advantage in the rise in
price of shares and is called 'premium hunter.
The stag does not always make a profit. Sometimes public response is not
extraordinarily good and he may have to acquire all the shares allotted to him and he
may have to sell at a. lower price than he purchased it for when the stag sells at a
discount he makes a loss. The market also suffers a decline. The stag is not looked upon
with favour.
Hedging: Hedging is a device through which a person protects himself against loss. A
bull' agreeing to purchase a security for someone may 'hedge or protect himself by
buying a 'put option' so that any loss that he may suffer in his transaction may be offset.
Similarly, a seller can hedge against loss through 'call'.
After the order has been placed on the broker and the various instructions have been
given to him so that he can execute the order in the market the broker asks his customer
for a 'margin'.
6. Giving margin money to broker:
Margin is the amount of money provided by customers to the brokers who have agreed
to trade their securities. It may also be called a provision to absorb any probable loss.
When a customer buys on margin the customer pays only part of the margin, the broker
lends the remainder. For example, if a customer purchases Rs. 1,00,000 worth market
value of stocks and bonds, the customer might provide 50% margin or Rs.50,000 and
the broker would lend the margin, the securities bought become collateral for the loan
and have to be left with the broker. The collateral in banks is carried in the broker's
name but is the purchaser's property. He is entitled to receive dividends and to vote in
the share holders' meeting. Therefore, margin may be expressed in the following
manner:
Example
X purchases 1000 shares @ Rs.100 per share or a total of Rs.1,00,000 worth of stock at
a margin of 70% (Rs.70,000) and he borrows Rs.30,000 from the broker. Assuming no
commission is paid.
Margin system
Margin system is the deposit which the members have to maintain with the clearing
house of the stock exchange. The deposit is a certain percentage of the value of the
security which is being traded by members. In India, the margin system is applied in
Bombay, Calcutta, Ahmedabad and Delhi Stock Exchanges. In these exchanges, if a
member buys or sells securities market for margin above the free limit, specified amount
per share has to be deposited with the clearing house.
7. Execution of Order in the Stock Exchange:
Making a Deal:
When the broker receives the margin money and is clear about the order, he puts the
details in the 'order book'. The broker in the beginning of his career makes the deals
himself. Once his business grows he employs clerks to transact his orders.
The stock exchange 'floor is divided into a number of markets according to the security
which is being dealt with. The authorised clerk goes to the particular part of the floor
called 'pit arid makes his quotation for the purchase or sale according to the order. The
dealer to whom the quotation is given quotes his own price, if it does not suit the clerk
he asks for a lower price to be quoted. When both the sides are satisfied the price is
settled and the 'bargain is made. Usually, these bargains are orally settled. There is no
written contract between the two parties. The clerk usually keeps a small note book
which records all purchases on the debit side and sales on the credit side. This is called a
'Kuchcha Hisaab' for noting down details.
8. Preparing Contract Note in the Stock Exchange:
Contract Note: The clerk takes the details of the day's transaction to the broker at the
end of working day. The broker scrutinises all transactions of the day and prepares a
contract note and signs it on a prescribed form. The contract note gives the details of the
contract for the purchase or sale of securities. It records the number of shares, rate and
date of purchase or sale. It also gives the 'brokerage' entitlement to the broker.
9. Settlement of Contracts:
Settlement: The last step is the settlement of the contract by the broker for his client.
The procedure for settlement is to be made (a) for ready delivery contracts, and (b) for
forward delivery contracts.
- Ready delivery contracts: A ready delivery contract is to be settled within 3 days in
Calcutta Stock Exchange and 7 days at the Bombay and Madras Stock Exchange. A ready
delivery contract is also called a spot contract. The settlement, under this contract can
be made on the same day or during the maximum period of 7 days and there can be no
extension, or postponement of the time of settlement. Ready delivery contracts can be
settled in two days
(i) by actual delivery: The securities may be purchased or sold and the price is paid or
received in full.
(ii) by paying the difference: The securities are not actually delivered but on the
settlement day the transaction is squared by paying the difference. For example may
contract to sell 500 shares at Rs. 110.On the settlement day if the price falls to Rs.105 in
the stock market, he receives Rs.5 on each share for his client, thus receiving a
difference only without actual delivery. The total gain is Rs. 2,500.
Clearing House:
Ready delivery contracts may be either for cleared securities or non-cleared securities.
The procedure or settlement of securities will depend on the group to which the
securities belong. Cleared securities must be delivered and paid for through a clearing
house. In house, these clearing houses exist in five stock exchanges - Bombay, Madras,
Calcutta, Ahmedabad and Delhi. A clearing house is useful for settling contracts
between buyers and sellers. The clearing house makes and receives total amounts on
transactions. The buyers and sellers have only to give or receive the dues. Those
securities which are active in the stock exchange are cleared through the clearing
houses. The share certificates and transfer deeds are also delivered to the clearing house
which maintains an account of the securities purchased and sold by each transacting
party. The broker sends a cheque for any balance due to him on the Wednesday
preceding the clearing day.
Non-Cleared Securities:
The 'non-cleared securities are settled by hand delivery. On the date of settlement, the
selling broker delivers the share certificate, signed by the transferor to the purchasing
brokers office. The actual settlement is done in tin: presence of an official of the
exchange on the 'Monday following the dale of the contract. Thus the non-cleared
securities are not delivered or paid for through a clearing house.
- Forward Delivery Contract: Forward dealings can be made in those Securities
which are placed on the forward list by an exchange. Forward delivery contracts are
done with the object of making profit. The intention of the parties involved is not to take
delivery or make payment on buying and selling securities. These forward delivery
contracts are settled on a fixed settlement day occurring at fortnightly intervals. These
contracts can be settled on agreement between the parties involved in the next
settlement period. Thus date of transaction can be 'carried over'.
On the date of settlement of forward delivery contract one of the following situations
may arise:
(a) delivery of securities is actually made, (b) transaction is reversed through a
neutralising purchase or sale, (c) transaction is 'carried over' to the next settlement day.
Generally the first situation rarely arises.
Forward contracts are settled over a period of six days.
(a) First day: The memorandum slips are compared by the buying and selling brokers.
(b) Second day (or Ticket Day): The clearance lists are submitted by the brokers to the
clearing houses. The members' lists indicate the balance of securities to be taken or to be
delivered and the net amount due in the clearing lists. This is called the Ticket Day.
(c) Third day: The day for actual delivery of shares-to clearing houses.
(d) Fourth day: The fourth day like the third day is also for the purpose of actual delivery
of shares to clearing houses.
(e) Fifth day (or Pay Day): The members submit their statements. Balance in statements
is debited or credited to the account of the person. This is also called the 'Pay Day' or
'Account Day'. A member unable to pay his balance before noon the next day after the
pay day is declared a 'defaulter. If the account of the member is squared up, it is scored
out.
(f) Sixth day: Sixth day is also known as 'Settlement Day' when members receive
payments from the clearing house.
Carry over or Budla
Carry Over or Budla is the facility of postponing a transaction till the next settlement
day. This facility is available only in forward delivery contracts. Postponement of a
transaction is effected by payment of an amount called 'Budla charge. Budla is
transacted in the following manner:
First, cancel existing contract by squaring it up. Cancellation is to be made at the price
determined by Stock Exchange authorities.
Second, prepare a new transaction through the original transaction for settlement on the
next settlement day.
Third, make payment of 'budla charge. When a bull speculator wishes to defer his
transaction, he pays a 'contango charge to the bear speculator for carrying over of his
purchase agreement to the next settlement.
When the sellers or the bearers deal with the bull buyers they have to pay the charge
called 'Backwardation.
Budla charges are a higher rate of interest.
Budla or Carry over transaction can be effected several times and it is important to
sustain speculation. Shares in the share market can be bought Cum-dividend or Exdividend.
Cum-dividend: It is the right acquired by the buyer of shares to receive dividend
declared by the buyer on shares but not paid by the company up to the time of
purchase of shares. The purchase price of cum-dividend shares usually includes
the value of the dividend and, therefore, the price of such shares is higher than
shares without this right. Under the Companies Act of 1956 only registered
shareholders have the right to receive dividend even if the dividend declared
relates to a period before acquiring shares. Therefore, the purchase price of
shares is treated in the investment account and the price paid for the dividend is
considered as a revenue expense.
Ex-Dividend: When shares are bought Ex-dividend. The purchase price paid for
the shares does not include any dividend in it. Usually, the person purchasing
shares buys them ex-dividend when the company closes its-share register and the
buyer cannot get his name registered in time for claiming the dividend, The buyer
does not acquire any right to claim on dividend on shares which he acquires Exdividend.
To sum up, trading on Stock Exchange as described in the various steps involves the
following order:
(1)
(2)
Selection of broker.
(3)
(4)
(5)
Exercising the right or choice of type of method or dealings in the stock
exchange.
(6)
(7)
(8)
(9)
Settlement of contracts.
STATUTORY REGULATIONS
Securities Contracts (Regulation) Act 1956 and the rules made there under, namely the
Securities Contracts (Regulation) Rules, 1957 are the main laws governing stock
exchange in India.
The preamble to the Securities Regulation Act states that it is "an act to prevent
undesirable transactions in securities by regulating the business of dealing therein, by
prohibiting options and by providing certain other matters connected therewith." This
Act provides for the direct and indirect control of virtually all aspects of securities
trading and the running of the stock exchanges. The act makes every transaction in
securities in any notified State or area illegal and punishable by fine and/or
imprisonment if it is not entered into between or with members of a recognised stock
exchange in the state or area. It also makes every such securities contract void.
The Act thus prohibits the existence of other than recognised stock exchanges and
provides the mechanism of recognising stock exchanges. Application to the Central
Government for recognition must include a copy of the rules relating in general to the
constitution of the stock exchange and in particular to, among other things, the
admission into the stock exchange of various classes of members, the exclusion,
suspension, expulsion and readmission of members, and the procedure for registration
of partnership as members.
In determining whether to grant recognition, the Central Government may make
whatever inquiry is necessary and impose in the rules and bye-laws of the stock
exchanges whatever conditions are required to ensure "fair dealing" and to "protect
investors". These conditions concern, inter alia, the qualifications for members, the
manner in which contracts are to be entered into and enforced, the representation of not
more than three Central Government nominees on the board of the stock exchange, and
the maintenance of books and record by members and their audit by chartered
accountants. The Central Government has the power to impose further conditions, other
than in the rules and bye-laws, such as limiting the number of members. Finally, the
Central Government has the power unilaterally to withdraw recognition.
After it recognises a stock exchange, the Central Government exerts regulatory control
over it. Periodic reports are furnished to the Central Government. Certain books and
records are maintained for a period of five years. The Central Government can make an
inquiry itself, or through an appointed third party, into the affairs of a stock exchange or
any of its members. All officers, directors, members, and others who have had dealings
in the matter under inquiry are required to produce requested documents, statements,
or information.
The Central Government retains control over the stock exchanges bye-laws and its rule
amendments. A stock exchange, subject to previous Central Government approval, has
the authority to make bye-laws for the regulation and control of contracts and the
regulation of trading. Similarly, no rule amendments have effect until they are approved
by the Central Government. The Central Government, furthermore, has the power to
direct stock exchange to amend its rules; and if it fails to do so, the Government may
directly amend such rules. The Securities Regulation Act grants the Central Government
power to supersede governing body of a recognized exchange. The suspension of
business may be complete or subject to' conditions. Suspensions may not last more than
seven days initially but may be extended from time to time. The Central Government
may supersede the governing body of any exchange by declaration and then appoint any
person or group of persons to exercise and perform all the power and duties of the
governing body.
Other powers granted to the Central Government include the ability to stop further
trading in specified securities for the purpose of preventing undesirable speculation, and
the power to compel a public company "in the interest of the trade or in the public
interest" to list its securities on any of the recognised exchanges.
In arriving at the net worth figure to be issued in the above ratio the following points
were kept in view:
- Intangible assets are not considered.
- Revaluation of fixed assets will ordinarily not be taken into account
- A reserve not created out of genuine profits or out of cash will not be
considered.
- Proper provision is made for gratuity and other terminal benefits to the
employees.
- Adequate provision is made for liabilities like arrears of preference dividends,
unclaimed dividends, and bad debts.
- The debit balance in profit and loss and the arrears of depreciation are
deducted.
- Contingent liabilities which are likely to impair the net worth are properly
considered.
- Deprecation is calculated as per a consistent basis.
In arriving at the average profit after tax in the above expression the following
considerations were taken into account:
Provisions for taxation should be made at the current statutory rate under the Income
Tax Act.
The profits shown in the audited accounts are adjusted so as to exclude non-recurring
miscellaneous income of an abnormal nature and write back of provisions.
Normally, the averaging of profits is done .or the latest three years. However, in
industries subject to cyclical ups and downs, it is advisable to consider the profits of the
latest five years.
If profit variation in the last three years is regarded as normal a simple arithmetic
average is calculated, in which the latest year is assigned a Weightage of three, the
middle year a weightage of two, and the first year a weightage of one. If profit shows a
tendency to decline then the profit of last year only is considered.
The capitalisation rate in the above expression is chosen as follows:
1. Fifteen per cent in the case of manufacturing companies,
2. Twenty per cent in the ease of trading companies, and
3. Seventeen and half per cent In the case of "Intermediate companies.
Step 3: Calculation of the "Market Value" (MV)
The MV which serves as a guiding factor for valuation where shares being valued are
listed on the stock exchanges is calculated as the average of:
the high and low of the preceding two years, and
the high and low of each month in the preceding 12 months
(in this calculation, appropriate adjustments are made for bonus issues and dividend
payments).
Step 4: Determination of the "Fair Value" (FV)
For determining FV, the starting point was the average of the NAV and PECV based on a
15 per cent capitalisation rate. If this average was less than the MV by about 20 per cent
only, it is regarded as the FV. If, however, the average of the NAV and PECV was less
than the MV by a margin of over 20 percent, the PECV must be reworked by lowering
the capitalisation rate. (In no case, however, can it be lower than eight percent.)
The FV was than determined as the average of the NAV and PECV (based on a lower
capitalisation rate.) For reasons of prudence, a further deduction equal to one year's
dividend per share may be made. It may be noted that the procedure employed for
determining the FV was not mechanistic and fully structured. It involved some exercise
of discretion and judgment based on assessment of the facts and circumstances of each
case.
Since 1992 the regulation of the new issue market has come under the Securities and
Exchange Board of India. In exercise of its power, under the SEB1 Act, the board has
issued Guidelines on Capital Issues or what are also known as Guidelines for Disclosure
and Investor Protection. The guidelines will be applied to all issues to be made after the
promulgation of the ordinance No. 9 of 1992 by which the capital Issues (Control) Act
has been repealed.
All those holding CCI consents prior to the promulgation of the ordinance may proceed
with the issues on the terms and conditions laid down therein, provided, however, that
these guidelines are also, followed where they are not inconsistent with the terms and
conditions of the CCI consent. It may be added here that since CCI consents are valid for
12 months, this transitory arrangement will be valid for 12 months from the date of the
promulgation of the Capital Issues (Repeal) Ordinance, 1992 i.e., May 29, 1992. SEBI
has issued a number of other guidelines which regulate the primary market in India.
These guidelines include:
a) Guidelines on issue of securities by development financial institutions.
b) Guidelines for merchant bankers
c) Code of conduct for merchant brokers
d) Guidelines regarding purchase of non-convertible part (Khokhas) of debentures from
the subscribers.
In addition to these and other guidelines and clarifications affecting the primary market,
SEBIs consultative paper on free market pricing of capital issues, which was issued on
March 3, 1992, has been a highly important contribution. Guidelines for Disclosure and
Investor Protection provided a simplified version of this paper in a tabular form which is
reproduced below:
SELF REGULATION
In the section, earlier regulatory framework applicable to primary and secondary
markets are discussed. In addition to legislative regulation, self-regulation is equally
important. Indeed, in developed securities markets like U.K. self-regulation plays an
important role. There exist a number of self- regulatory organisations (SROs) which
really complement legislative regulation.
The spirit of self-regulation had been prevalent in the Indian securities market as well. If
one looks at the powers given to recognised stock exchanges in India to make and
enforce bye-laws under the Securities Contracts (Regulation) Act, 1956, one tends to
conclude that Indian Stock exchanges have been envisaged as self-regulatory
organisations. Just to elaborate the point let us look at section 9 of the Securities
Contracts (Regulation) Act, 1956 which states as follows
Any recognised stock exchange may, subject to the previous approval of the Central
Government (till 1991) and Securities and Exchange Board of India (since 1992) make
bye-laws for the regulation and control of contracts.
In particular, without prejudice to the generality of the foregoing power, such bye-laws
may provide for:
a) the opening and closing of markets and the regulation of the hours of trade;
b) clearing house for the periodical settlement of contracts and difference there under,
the delivery of the payment for securities, the passing on of delivery orders and the
regulation and maintenance of such a clearing house:
c) the submission to the Central Government (till 1992) and Securities and Exchange
Board of India (since 1992) by the clearing houses as soon as may be after each
periodical settlement of all or any of the following particulars as the Central
Government (till 1991) and Securities and Exchange Board of India (since 1992) may,
from time to time, require namely:
i) the total number of each category of security carried over from one settlement
period to another
ii) the total number of each category of security contracts which have been
squared up during the course of each settlement period;
iii) the total number of each category of security actually delivered at each
clearing;
d) the publication by the clearing house of all of the submitted to the Central
Government Exchange Board of India (since 1992) under clause (c) subject to the
directions, if any, issued by the Central Government (till 1991) and securities and
Exchange Board of India (since 1992) in this behalf;
e) the regulation of prohibit of blank transfers;
f) the number and classes of contracts in respect of which settlements shall be made or
different paid through the clearing house;
g) the regulation, or prohibition of budlas or carry-over facilities;
h) the fixing altering or postponing of days for settlements;
i) the determination and declaration of market rates, including the opening, closing
highest and lowest rates for securities;
j) the terms, conditions and incidents of contracts, including the prescription of margin
requirements, if any, and conditions relating thereto and the forms of tracts in writing;
k) the regulation of the entering into, making, performance, recession and termination,
of contracts, including contracts between member or between a member and his
constituent or between a member and a person who is not a member, and the
consequences of default or insolvency on the part of a seller or buyer or intermediary,
the consequences of a breach by a seller or buyer, and the responsibility of members
who are not parties to such contracts;
l) the regulation of taravani business including the placing of limitations thereon;
m) the listing of securities on the stock exchange, the inclusion of any security for the
purpose of dealings and the suspension or withdrawal of any such securities, and the
suspension or prohibition of trading in any specified securities;
n) the method and procedure for the settlement of claims or disputes, including
settlement by arbitration;
o) the levy and recovery of fees, fines and penalties;
p) the regulation of the course of business between parties to contracts in any capacity;
q) the fixing of a scale of brokerage and other charges;
r) the making, comparing, settling and closing of bargains;
s) the emergencies in trade which may arise, whether as a result of pool or syndicated
operations or cornering or otherwise, and the exercise of powers in such emergencies
including the power to fix maximum and minimum prices for securities;
t) the regulation of dealings by members for their own account;
classified according to terms of issue as secured and unsecured bonds, redeemable and
irredeemable etc.
DISTINCTION BETWEEN SHARE AND STOCK
A share in a company is one of the units into which the total share capital of a company
is divided. It is a fractional part of the capital of the company which forms the basis of
ownership.
Sections 2(46) of the Indian Companies Act 1956 defines the term "share" as "share in
the capital of a company and includes stock, except where a distinction between stock
and share is expressed or implied".
Meaning of Stock: Stock is the aggregate of fully-paid up shares of a company
consolidated for the purpose of facilitating its division into fractions of any
denomination. A company with a share-capital, if authorised by its Articles of
Association, may convert some or all of its fully paid-up shares into stock. When so
converted, stock represents the consolidated amount of the capital of the company.
The share and the stock may be distinguished on the following grounds:
(1) Paid-up Amount: A share may be partly paid up or fully paid up but a stock is
always fully paid up. Fully paid up shares only can be converted into stock.
(2) Nominal Value: A share has a nominal value whereas a stock has no nominal
value.
(3) Transferability in Fractions: A share cannot be transferred in fractions whereas
a stock can be transferred to any fraction and sub-division.
(4) Distinct Numbers: All shares bear distinct numbers representing the units of
share capital while stocks disclose the consolidated value of the share capital. Fractions
of stock do not bear any number.
(5) Denomination: All shares are of equal denomination. Stock may be of unequal
amounts and may be transferred in different fragments.
(6) Offer to Public: Shares can be issued to the public directly in the first instance but
stocks cannot be offered directly to the public. Only fully paid up shares are converted
into stock.
(7) Registration: Shares are always registered and not transferable by delivery
whereas stocks may be registered or bearer. If they are registered, they are transferable
by transfer-deed and if unregistered, only by delivery.
Meaning of Share Capital and Share: Share capital is the capital raised by a
company through the issue of shares. Share capital constitutes the basis of the capital
structure of a company. Only companies limited by shares and registered with a share
capital can raise capital through the issue of shares. Share capital can be raised either at
the time of formation of the company for starting business operations or later on for
further expansion of the business.
Meaning of Share: The Capital of a company is divided into a number of indivisible
units of specified amount. Each of such units is called a share. According to section 2 of
the Indian Companies Act 1956 "Share means share in the share capital of company and
includes stock where a distinction between stock and shares is expressed or implied".
According to Lord Justice James Lindley, "A share is that proportionate part of capital
to which a member is entitled". Thus a share is a small unit of the capital of a company.
The total capital of the company is divided into a large number of shares just to facilitate
the public to subscribe the capital in smaller amount.
KINDS OF SHARES
According to the Indian Companies Act, 1956 there are two types of shares.
1. Equity Shares: According to the Indian Companies Act, 1956, the shares which are
not preference shares are equity shares. Equity means the ownership interest or the
interest of shareholders as measured by capital and reserves. Thus equity shares are
those ownership securities which do not carry any special or preferential rights in
respect of dividend or return of capital. Equity shareholders are the owners and riskbearers of the company. An equity share is distinguished by the following
characteristics:
(a) It does not bear any fixed rate of dividend. In any case, dividends in respect of equity
shares will be paid only after the preference shareholders have been paid the dividends
due to them.
(b) In the case of winding up of the company, an equity shareholder will be paid back his
capital only after all other debts.
(c) The equity shareholder is entitled to the right to vote at the annual general meetings
of the company and thus participate in the management and control of the company.
This right is not available to the preference shareholder, except in special circumstances.
2. Preference Shares: As the very name suggests, preference shares are those shares
which enjoy the preferential rights over other types of shares. According to Indian
Companies Act, 1956, "a preference share is a share which carries a preferential right
both as regards to a fixed dividend and as regards to the payment of capital in windingup".
Following are the features of preference shares.
(a) There is a fixed rate of dividend on them.
(b) In respect of payment of dividend, they get priority over equity shareholders.
(c) In the event of the company's liquidation, they are paid back their capital ahead of
equity shareholders.
(d) They do not have any voting rights except in some special circumstances.
The preference shares may be of following types according to the right attached to
them:
(i) Cumulative and Non-cumulative Preference Shares: The holders of
cumulative preference shares are entitled to arrears of dividend on their shares to be
paid out of the profits of subsequent years, if in any year the dividend on them cannot be
paid. Thus, they are sure to receive dividend on company. If in a particular year they are
not paid the dividend, they will be paid such arrear in the next year before any dividend
can be distributed among equity shareholders. But the dividends on non-cumulative
shares do not accumulate if dividend is not paid in any year.
(ii) Participating and Non-Participating Preference Shares: The holders of
participating preference shares are entitled to a share in the surplus profits if they
remain after paying dividend to preference shares and equity shares. Thus, participating
shareholders obtain return on their investment in two forms: fixed dividend, and share
in surplus profits. The preference shares which do not carry the right to share in the
surplus profits are known as non-participating preference shares.
(iii) Redeemable and Irredeemable Preference Shares: Redeemable preference
shares are those which in accordance with the terms of their issue, will be repaid on or
after a certain date. The preference shares which cannot be redeemed during the
lifetime of the company are known as Irredeemable preference shares.
(iv) Convertible and Non-convertible Preference Shares: If the preference
shareholders are given a right to convert their shares into equity shares, such shares are
known as convertible preference shares. The preference shares which cannot be
converted into equity shares are known as non-convertible preference shares.
(v) Guaranteed Preference shares: They are usually issued when a company is
converted from a private limited company or when one company is sold to another
company.
EQUITY SHARES
Equity shares are those shares which are not preference shares. Dividend on these
shares is not fixed and paid after the fixed rate of dividend on preference shares has
been paid off. They are residual claimant even on dissolution. They control the affairs of
the company.
Advantages of Equity Shares to Company:
Preference shares carry a preference both in respect of dividend and return of capital in
case of winding up. The rate of dividend is fixed and paid before the dividend on equity
shares is paid.
Advantages of Preference Shares for Company:
(1) Fixed Return: The dividend payable on preference share is fixed, usually lower
than that payable on equity shares. Thus they help the company in. maximising the
return to equity shareholders.
(2) No voting right: Preference shareholders have no voting right on matters not
directly affecting their rights; hence equity shareholders retain control over the affairs of
the company uninterrupted.
(3) Flexibility in capital structure: The Company can maintain flexibility in its
capital structure by issuing redeemable preference shares as they can be redeemed
under terms of issue.
(4) No burden on finances: Issue of preference shares does not prove to be a burden
on the finances of the company, as is the case with debentures or bonds. Dividends on
preference shares are paid only if profits are available for dividend. Thus it leaves the
company with a stronger balance sheet and hence, greater scope for future borrowings.
(5) No charge on assets: Non-payment of dividend on preference shares does not
create a charge on the assets of the company. Thus it enables the company to conserve
mortgageable assets.
Advantages of Preference Shares for Investors:
(1) Regular fixed income: Investors get a fixed rate of dividend on preference shares
regularly even if there is no profit. It is possible that the dividend for the years in which
company earned no profit or inadequate profits, would be paid in the years of profits.
(2) Preferential rights: Preference shares carry preferential rights as regard to
payment of dividend and repayment of capital in case of winding up of company.
(3) Voting right for safety of interest: Preference shareholders are given voting
rights in matters directly affecting their interest. It means that their interest is
safeguarded.
(4) Lesser capital losses: As the preference shareholders enjoy the preferential right
of repayment of their capital in case of winding up of .company, it saves them from
capital losses.
(5) Fair security: Preference shares are fair securities for the shareholders during
depression periods when the profits of the company are going down or when the rate of
interest in the market is continuously falling down.
(8) Other Advantages: i) There is no face value, hence Directors have every right to
adjust the value of capital to correct the over-capitalisation; (ii) It induces investor to
study the financial position of the company carefully because real value of shares
depends very much on the earning capacity of the company.
Disadvantages of No-Par Stock:
(1) No Standard: No-par shares have no standard on the basis of which valuation of
assets may be compared with capitalization. Ignorant investors may be deceived because
the price level is detective. Investors cannot make valuation of their stock and cannot
judge the fairness of return in absence of par value.
(2) Manipulation: It offers enough scope to management to manipulate the sale
proceeds of shares and may pay dividend out of capital. In the absence of any standard,
management splits the sale proceeds of stock into two or more parts i.e., a nominal
amount may be credited to the stated paid up capital account and the balance to the
capital surplus which may later on be utilised for dividend.
(3) No Capital Planning: There cannot be any planning for the financial need of the
concern. It may lead the concern to over-capitalisation or under-capitalization.
(4) Under-payments for Promoters: The flexibility of capital account facilitates
the promoters to pay themselves unduly high remuneration for their services and for
good will. It may also help in concealing the losses.
(5) No additional Security to Creditors: The uncalled share capital provides an
additional security to creditors because uncalled capital may be realised whenever
necessary in case of par value shares. On par value shares provide no such security to
creditors because the whole of the amount is called to one sum.
(6) Difficult to Understand: No par value shares render the balance sheet of the
company unduly complex and difficult to be understood by investors, creditors and tax
authorities.
(7) Tax evasion: Taxation becomes complicated and tax-evasion is facilitated, if no
par shares are issued. More over the fee for the registration of companies is charged on
the amount of Authorised capital on par-value shares in almost all the countries of the
world but it is very difficult to calculate registration fee on companies issuing no parvalue shares.
The above limitations of the no par value shares have created certain doubts in the
utility of the issue of no-par shares. Even in the U.S.A., no-par shares have not lost their
popularity.
RIGHTS ISSUE
Whenever an existing company wants to issue new series of equity shares, it is required
to offer to these shares to the existing shareholders at a specified price during a
particular period. It is called a 'right or 'pre-emptive-right. It may simply be defined as
an option to buy a security at the specified price. Generally at par or at premium is but
much below the market price. The shares offered are called Right Shares.
Section 81 of the Companies Act provides that at any time after the expiry of two years
after the first allotment of shares or capital in that company, whichever is earlier, a
company can increase its capital further by issue of new shares. The new shares must
first be offered to the existing equity shareholders of the company in proportion, to
those shares at the time of offer.
Procedure of Rights Issue:
The procedure of right issue as given in the Companies Act may be followed as follows To company sends a letter of offer to the existing equity shareholders whose names are
on the Register of members mentioning therein the number of shares to which they are
entitled in proportion to their old shareholdings and the time within which the offer
must be accepted. Such period shall not be less than 15 days from the date of offer,
however, it may be more than 15 days keeping in mind that shareholders must have
sufficient time to make up their mind judiciously. The offer must also state that they
have the right to renounce all or any of the shares offered to them in favour of their
nominee(s).
Shareholders shall inform the company within stipulated period of their acceptance of
right or the name of the nominee to whom they want to renounce his right.
An existing shareholder may also apply for the additional shares but a shareholder who
has renounced his right in favour of any person is not entitled to apply for additional
shares.
If the right shares are not fully taken up, the balance left over shall be distributed
equally among the applicants for additional shares with reference to the shares held by
them in the company. Subject to this requirement, preference shall be allowed to the
small holders in concurrence with the stock exchange on which the company's shares
are listed. Any balance left after making allotment of additional shares, the company
may deal in any manner it likes.
Advantages of Right Issue:
The following are the main advantages of right issue:
(1) Right issue gives the existing shareholders an opportunity to maintain their pro-rata
share in the earning and surplus of the company and the voting power as before,
(2) The goodwill of the company increases in the eyes of existing shareholders.
Rs.25 crores (implying 2.5 Crore shares of Rs. 10 each), so that the reserves go down
accordingly by Rs. 5 crores. This has been shown in the partial balance sheet of a
hypothetical company in the box below:
Thus, the shareholder of the firm who previously held 4 shares is now in possession of 5
shares, i.e., one extra share. Henceforth, the shareholders would begin to receive
dividends on 5 shares, for every 4 shares held by them earlier.
The bonus issue enthusiasts may argue that fall in market price is likely to be much less
than 20%, so that the ex-bonus value of the three shares would be greater than the cumbonus value of the two shares, implying an increase in the wealth position of the
shareholder as a consequence of the bonus issue. If this were indeed so, in bonus issue is
nothing but just that! In a logical world, there is no reason to believe that the
shareholders would not have achieved the same increase in wealth if the company had
decided to merely enhance the dividend per share rather than issue a bonus. Thus,
strictly speaking, bonus issue implies absolutely no change in the fortunes of either the
issuing company or its shareholders.
SEBI Guidelines on Bonus Shares:
Subject to the provision under section J(a) above, the company shall, ensure the
following:
(a) the bonus issue is made out of free reserves build out of the genuine profits or shares
premium collected in cash only;
(b) reserves created by revaluation of fixed assets are not capitalised;
(c) the development rebate reserve or the investment allowance reserve is considered as
free reserve for the purpose of calculation of residual reserves test only;
(d) all contingent liabilities disclosed in the audited accounts which have bearing on the
net profits, shall be taken into account in the calculation of the residual reserve;
(e) the residual reserves after the proposed capitalisation shall be at least 40 percent of
the increased paid-up capital;
(f) 30 percent of the average profits before tax of the company for the previous three
years should yield a rate of dividend on the expanded capital issue base of the company
at 10 percent;
(g) the capital reserves appearing in the balance sheet of the company as a result of
revaluation of assets or without accrual of cash resources are neither capitalised nor
taken into account in the computation of the residual reserves of 40 percent for the
purpose of bonus issues;
(h) the declaration of bonus issues, in lieu of dividend, is not made;
(i) the bonus issue is not made unless the partly paid shares, if any existing, are made
fully paid-up;
(j) the company: (1) has not defaulted in payment of interest or principal in respect of
fixed deposits and interest on existing debentures or principal in respect of fixed
deposits and interest on existing debentures or principal on redemption thereof; and (2)
has sufficient reason to believe that it has not defaulted in respect of the payment of
statutory dues of the employees such as contribution to provident fund, gratuity, bonus,
etc.;
(k) a company which announces its bonus issue after the approval for the Board of
Directors must implement the proposals within a period of six months from the date of
such approval and shall not have the Option of changing the decision;
(l) there should be provision in the articles of association of the company for
capitalisation of reserves, etc. and if not, the company shall pass a provision in the
Articles of Association for capitalisation;
(m) consequent to the issue of bonus shares if the subscribed and paid-up capital exceed
the authorised share capital, a resolution regarding the immediately after the bonus
issue should be indications;
(n) the company shall get a resolution passed at its general body meeting for bonus
Issue. In the said resolution the managements intention regarding the rate of dividend
to be declared in the year immediately after the bonus issue should be indicated;
(o) no bonus shall be made which will dilute the value or rights of the holders of
debentures convertible fully or partly.
TRANSFER OF SHARES
Almost all the securities issued are registered securities, meaning that a register of
holders is maintained by or on behalf of the issuing body. The register shows the name
and address of the holder, the amount of stock or number of shares held and any
instructions which the holder may have given in connection with the payment of interest
or dividends. When stocks or shares pass from one holder to another the register must
be amended, and this is usually effected by the completion of a stock transfer form.
When the change of ownership arises as a result of a transaction on the Stock Exchange,
the procedure differs from that used in respect of a gift, a private sale or the distribution
of an estate.
If a holder of shares in a company agrees to sell them to another person without the deal
going through a broker, all the vendor needs to do is to fill in and sign a stock transfer
form and hand it, with his stock certificate, to the purchaser against payment of the
agreed proceeds. The purchaser then completes his own name and address on the form
and pays the transfer stamp duty. The study paid is shown by means of impressed
steams on the form. He then lodges the certificate, and stock transfer form with the
register of the company concerned and in due course receives a new certificate in his
own name.
This type of transaction, usually, takes place in shares that are not quoted on the Stock
Exchange. Where the transfer arises from a gift, the stamp office usually requires
evaluation in support of the amount of duty and valorem stamp duty tendered. Where
the transaction is one which is exempt from and valorem stamp duty a certificate on the
back of the form must be completed by both parties to the transaction or by some
acceptable agent, such as a blank to solicitors, having knowledge of the circumstances of
the transaction, before the Stamp Office will stamp the transfer form with the nominal
duty.
As a stock transfer does not have to be signed by a purchaser, and fully paid stocks and
shares can be transferred into any ones name without their knowledge, as the transferor
can pay any stamp duty himself and lodge the form with registrar.
RULES FOR LISTING OF SECURITIES
Statutory rules have been laid down for the listing of securities under the Securities
Contracts (Regulation) Act. A company requiring a quotation for its shares (i.e., desiring
its securities to be listed) must apply in the prescribed form supported by the
documentary evidence given below:
Documents to be attached:
(i) Copies of Memorandum and Articles of Association, Prospectus or Statement in lieu
of Prospectus, Director's Reports, Balance Sheets, and Agreements with Underwriters
etc.
(ii) Specimen copies of Share and Debenture Certificates, Letters of Allotment,
Acceptance, Renunciation etc.
(iii) Particulars regarding its capital structure.
The basic purpose behind making these provisions in the listing agreement is to keep
the shareholders and investors informed about the various activities which are likely to
affect the share prices of such companies so that equal opportunity is provided to all
concerned for buying or selling of the securities. On the basis of these details, the
existing as well as the prospective investors are able to make investment decisions based
on correct information.
The stock exchange enlisting the securities of a company for the purposes of trade
insists that all applicants for shares will be treated with equal fairness in the matter of
allotment. In fact, in the event of over-subscription, the stock exchange will advise the
company regarding the basis for allotment of shares. It will try to ensure that applicants
for large blocks of shares are not given undue preference over others.
A company whose securities are listed with a stock exchange must keep the stock
exchange fully informed about matters affecting the company, e.g.,
(i) to notify the stock exchange promptly of the date of the Board Meeting at which
dividend will be declared;
(ii) to forward immediately to the stock exchange copies of its annual audited accounts
after they are issued;
(iii) to notify the stock exchange of any material change in the general nature or
character of the company's business;
(iv) to notify the stock exchange of any change in the company's capital;
(v) to notify the stock exchange (even before shareholders) of the issue of any new
shares (right shares or otherwise) as the issue of any privileges or bonus to members.
The company must also undertake:
(a) not to commit a breach of any condition on the basis of which listing has been
obtained;
(b) to notify the exchange of any occasion, which will result in the redemption,
cancellation or retirement of any listed securities;
(c) avoid as far as possible the establishment of a false market for the company's shares;
(d) to intimate the stock exchange of any other information necessary to enable the
shareholders to appraise the company's position.
According to Section 73 of the Companies Act, 1976, if a company indicates in its
prospectus that an application has been made or will be made to a recognised stock
exchange for admitting the company's shares or debentures to dealings therein, such
permission must be applied for within a stipulated period of time.
If a recognised exchange refuses to list the securities of a company, the company can file
an appeal against such a decision with the government. The Act empowers the
government to set aside or change the decision after giving proper opportunity to both
the parties to explain their position in this regard.
Guidelines for Listing Securities:
To ensure the effective working of the recognised stock in the public interest,
Government framed securities contracts (Regulation) Rules, 1957. In November, 1982,
certain administrative guidelines governing the listening of securities on recognised
stock exchanges, in relaxation of Rule-19 (2) (b) of these rules were issued. These
guidelines broadly cover the following:
Establishment of Non-FERA companies
According to the Act, Non-FERA companies mean (1) those companies which are
incorporated in India at least ten years prior to the date of applying for the listing
regulation; or companies which have a profit earning record for a continuous period of
at least five year prior to the date of the listing application; and (2) in which foreign
equity does not exceed 40 per cent.
The rule provided that in relation to these non-FERA companies. But in certain cases,
where there is already a consideration public shareholding in the company, a further
reduction in the public offer may also be considered if the following conditions are
satisfied:
(i) The shares are held by persons not connected with the management, their associates
and associate companies.
(ii) The shares have remained widely distributed, without undue concentrations of large
holdings in the hands of the shareholders on record (or their predecessors in title) for a
period of at least 3 years prior to the date of the listing applications.
(iii) The number of such shareholders is at least 20 for every Rs. 1 lakh of capital held by
them.
Other Established or New Non-FERA companies
(a) Other established Non-FERA companies that is, companies incorporated in India
within ten years of the date of the listing application and in which foreign equity does
not exceed 40 per cent and
(b) New companies without any foreign equity participation, the provisions of Rules 19
(2) (b) of the securities contracts (Regulation) Rules will apply. In other words, the
public offer should be at least 60 per cent of the issued capital of the company in such
cases.
Notice that, subscription by the Central Government. State Governments and their
agencies and public financial institution will be counted as a part of the issued capital of
the company.
Existing FERA companies
In respect of existing companies having more than 40 per cent foreign equity and
undergoing the process of Indianisation under the foreign Exchange (Regulation) Act,
1973, the public offer should be balance of the issued capital after deduction of the
permissible level of foreign equity and the holdings of existing Indian shareholders.
However, in no case should the public offer be less than 20 per cent of the issued capital
of the company.
New Companies with Foreign Equity Participation
In respect of new companies with approved foreign equity participation, the public offer
should be the balance of the issued capital after deduction of the capital subscribed by
the foreign participants and the Indian promoters. The following conditions should,
however, be fulfilled.
(i) The public offer should in no case be less than 331/2 percent of the issued capital of
the company.
(ii) The share of the Indian promoters should not be more than 40 per cent of the capital
of the company.
New companies with Non-Resident Indian Equity Participation
Where non-residents of Indian nationality or origin of overseas companies, partnership
firms, trusts, societies and other corporate bodies owned predominantly by non-resident
individuals of Indian nationality or origin (the criterion for determining such
predominant ownership of this in title should be with non-residents of Indian
nationality or origin) are themselves the promoters of the company, the public oiler
should be the balance of the issued capital of the company after deduction of the capital
subscribed by them. However, public offer in such a case should not be less than 26% of
the issued capital of the company.
If the non-resident Indian equity is 74 per cent, the public offer should be 26 per cent of
the issued capital of the company.
If the non-resident Indian equity is 40 per cent the public offer should be 60 per cent of
the issued capital of the company, (there is no relaxation or Rule 19 (2) (b) in this case).
Joint Sector companies
In a joint sector company, the principal promoter will be a state Government and/or its
agencies and the co-promoter will be a private party. The shareholding of the State
Government and/or its agencies will not ordinarily be less than that of the co-promoter.
In such case, the public offer should be the balance of the issued capital of the company
after deduction of the capital subscribed by the promoters and the co-promoters subject
to the condition that the public offer should not normally be less than 33-1/3 per cent of
the issued capital of the company. To illustrate, if the state Government and/or Its
agencies take up 26 per cent and the co-promoter takes up 25 per cent of the issued
capital of the company, the balance of 49 per cent should be offered to the public.
Offer for the Sale of Existing Issues Capital:
Companies can have their shares listed on a recognised stock exchange by arranging for
an offer for sale of their existing issued capital. Such an offer for sale can be combined
with a fresh issue of capital also. The extent of public in these cases should be in
conformity with the provisions detailed above.
In addition, the following conditions should also be fulfilled:
(i) To net worth, (i.e., existing paid up equity capital plus free reserves, excluding
reserves created out of fixed assets) of the company should not be less than its existing
paid up capital and the company should not have incurred a loss in each of the three
years preceding the listing application.
(ii) The offer should result in a wide distribution of shares among the general public
without undue concentration of large holdings, and the number of public shareholders
should be at least 20 for every Rs. 1 lakh of the public offer.
(iii) If the share is offered at a price above its par value, the price should have been
approved by the Central Government.
(iv) The offer should set out all material particulars relating to the company and the
shares offered to the public. It must be in a form approved by the Stock Exchange
concerned and must comply with all conditions pertaining to public advertisement,
opening and closing of subscription lists, payment of application money, disposal of
applications, basis of allotment, etc., as are applicable to a company offering fresh
shares for public subscription in accordance with the listing regulations and instructions
issued by the government from time to time.
Advantages of Listing on Stock Exchange:
(a) Detailed information about the company is available.
(b) Information increases the activity of purchase and sale of the security of that
organisation.
(c) Continuous dealing raises the value of security.
(d) Convenience of sale of security lending liquidity to the shares.
is paid by the firm's directors out of the retained earnings of the firm. Stock dividends
are paid in the following circumstances:
(a)
If the company does not find sufficient amount to pay cash dividend to its
shareholders.
(b)
(c)
(d)
(e)
It has psychological effect in the minds of the shareholders that the firm is
competitive and is profitable to them.
The investor while accepting the fact that the firm has issued stock dividend should
know that stock dividend is a permanent method of capitalisation of earnings. Normally,
it should not be used as a method of distribution of corporate earnings because it divides
the amount of existing equity into a larger number of parts of shares. Through this
method there is no increase in wealth and shareholders also do not receive any
distribution in the form of cash. Stock dividend also has no effect on the assets of the
firm immediately. It only represents a typical example of capital account. The existing
shareholder's equity shares are not affected. In fact, the shareholders receive a larger
number of shares than he had before. A substitute of cash form of distribution of
dividend or supplementary to the cash dividend, stock dividend has some evils also:
(a) It may lead to over- capitalisation if a firm is not careful or efficient and does not
increase its rate of earnings proportionately.
(b) It also raises certain questions about the shareholder's position. A stock dividend
raises his expectation about the company's profitability and efficiency and his
expectation about the future profits becomes high. The company may not be able to
satisfy the shareholders.
(c) The issue of stock dividend cannot be a continuous process. It may be issued only
sometimes when the firm has surplus. Also, it can be paid only if the firm expects a
higher profit in the future. Sometimes the company cannot maintain even its present
rate of dividend after issuing a stock dividend.
3. Stock Splits
Stock split is only an increase in the number of shares that are outstanding. The change
does not affect the stated value of a stock or its surplus. It also does not affect the
shareholders equity. It is only the reformation of a shareholder's equity in smaller units
with the objective of providing:
(i) Reduction of the Market Price: A stock split helps in the stock exchange to make a
round lot. By reducing the stock price the firm is able to help the small investors to
purchase and sell stock with easy continuity.
(ii) Further Growth: Stock split indicated or is in other ways information to the stock
market of the continued growth of firms.
(iii) Reverse Split: When a firm reduces its number it is called a reverse split which has
the effect of reducing the outstanding shares. The reverse split is effected by a firm
sometimes when the stock price falls far below the required level of the firm. The
reversal split is an indication of financial problems faced by the firm.
(iv) Re-purchase of Stock: Sometimes the firm repurchases its own common stock of
outstanding shares. This does when it would be to control another firm and it is able to
do so only by promising the other firm its own equity shares for the equity stock of the
other firm which it wants to control. This becomes a fair exchange of stock and allows
the firm to acquire another firm without any dilution of earnings of the firm. It is also
re- purchased when the firm under contractual obligations has to retire some part of its
stock. Re-purchase of stock is also resorted to fulfill certain options without in any way
changing the total number of outstanding shares (i.e. without increasing its own
common stock).
4. Scrip Dividend
Scrip dividend is a promise to a shareholder to pay a dividend at a future date. The scrip
is in the form of a promissory note with interest and it is useful as a security to bank for
loans.
5. Property Dividend
Under unusual exceptional circumstances a firm sometimes pays property dividends to
a shareholder. These are non-recurring in nature and may be once in the life time of the
firm. The directors would usually not like to issue such a dividend. Distribution as
property dividend is only made when the price of the company stock falls to the extent
that if the dividend is not given in this form its value will be nil.
6. Bond Dividend
In the place of cash dividends, bond dividends are declared by a firm in order to
conserve their cash and to include the preference shareholders in the payment of cash
dividends.
7. Special Dividend
When cash dividend cannot be declared because the company is making efforts to
retrench its operations then it gives a special dividend as a return of capital to the
shareholders in a gradual manner.
8. Optional Dividend
Optional dividend is a method of payment of dividend either through cash or through
stock. If a cash dividend is not possible to be given because the firm has gone into
expansion, it may arrive at the policy of giving of stock dividend.
9. Depreciation Dividend
When companies reduce their capital they give a small amount to the shareholders as
dividend. In some form the company wipes out its deposit and is able to create a surplus
for the continuation of the payment of its dividend. Depreciation dividends are not a
good policy by a company.
10. Dividends from Capital Surplus
Cash dividend from the current sources of income is the best method of paying for the
investment in a company. But sometimes the company also makes its payments of
dividend out of capital.
11. Dividend from Appreciation
Sometimes assets are sold by the firm and the price received by the firm is higher than
the book value. The company may have to pay dividends out of the appreciation.
12. Liquidation Dividend
When a company is dissolved then at the time of liquidation, if some distribution is
made out of assets it is the distribution of dividend from liquidation. This liquidation
dividend is first paid to the bond holders, debenture holders and preference
shareholders. When claims of creditors are satisfied, the equity shareholders may also
be given an amount of such dividend.
13. Interim Dividend
Interim dividend is the income of the previous year in which the amount of such
dividend is unconditionally made available by the company to a shareholder.
Dividends can be declared by the Board of Directors only on fulfilling certain conditions.
The dividend that is declared should be out of a surplus. If the firm makes a deposit then
dividend should only be declared after the deposit has been absorbed. The directors
should also be careful that dividend impairs the capital strength of a firm which they are
managing by declaring dividends. Sometimes directors declare dividends at the time
when the firm is insolvent due to the bad conditions of business. Dividends should be
avoided in such circumstances. Before declaring dividends there should be a provision
for depreciation also.
In all circumstances the rights of the creditors should be protected by granting dividend
to the shareholders. The dividend which is given to the shareholders is a profit which is
distributed out of the profits of the firm. A dividend policy should, therefore, be carefully
prepared by the management of the firm and guidelines issued for strict adherence to
dividend programme.
Dividend is defined by the Income Tax Act as:
(1) Accumulated profits including the development rebate but not the reservations
provided for depreciation. Dividend also refers to the book profits and not the
accumulated profits which have been declared by the income tax authorities. 'Bonus
issues are not a part of dividend and they do not also relate to any asset of the firm.
(2) Any distribution of debentures, stock, deposit certificates and bonus to preference
shareholders.
(3) Distribution on liquidation of company.
(4) Distribution on reduction of capital.
(5) Any payments by way of loans or advances by a closely held company to
shareholders holding substantial interests provided the loan should not have been made
in the ordinary course of business and money lending should not be a substantial part of
the company's business.
On the basis of different decisions the following conclusions are drawn with respect be
accumulated profit:
(a) Accumulated profits do not include current profits.
(b) They are computed on the basis of commercial profits and not on assessed incomes.
(c) Balancing charge does not form of accumulated profits as it is not commercial profit
but it is considered to be withdrawal of depreciation after the asset is sold for a price
which is higher than the writer down value.
(d) Accumulated profits include all tax-free incomes; that is, for example, the
agricultural income; but the receipts of capital nature are included in the accumulated
profits if they are chargeable to Capital Gains Tax by the receiving company.
(e) Accumulated profit also includes general reserve.
(f) Provision for taxation and dividends are not considered to be a part of accumulated
reserve.
(g) Accumulated reserve should also not include the development rebate reserve
development allowance reserve and investment allowance reserve.
Normally dividend is declared at the annual general meeting and is considered to be the
income of the previous year in which it is declared.
Deemed dividend is treated as income of the previous years when it is distributed or
paid but it is notional dividend under section 2(22).
Dividend Policies:
Dividend policy is a method by the management of the firm towards some constant
payment to the shareholders out of the profits of the company. Dividend decisions may
be for a short-term purpose or made for a longer term period. A dividend policy should
be made by the management with certain consideration in mind. It the economic
environment and type of industry in which it operates. It should also take into
consideration the market and other consideration the needs of the shareholders in the
present position of the market and other considerations with regard to capital gain,
capital increase and maintenance of levels once achieved. Apart from this, the
consideration of tax should also be thought of. Dividend policy should also for future
expansion, business cycle operating in the industry and the nature of business thorough
which the firm operates.
The determinants of a dividend policy should be towards regularly of income stability of
income, and safety during the period of contingencies. The legal constraints should also
be looked upon by the directors. The determinants of the dividend policy should project
the following factors:
(a) Regular Dividend Payments:
A regular dividend establishes the company's position in the stock market. It also
provides a firm policy for taking decisions about the future of the firm with regard to its
expansion programmes. It also infuses strength and confidence in the minds of creditors
and it makes it easier for the firm to take loans from creditors on the strength of its
regularity of dividends.
Firms who pay a regular dividend should be careful to maintain it at a rate that they are
able to achieve every year. If too high a dividend is declared the firm may not be able to
achieve the same rate in the forthcoming years. If a company maintains a regular
balance in paying dividends it will be established and the investor can also plan to make
his investments for a fairly long time.
(b) Stability of Dividends:
In addition to dividends being paid regularly to shareholders, stability of income
through dividends also plays a major role for the satisfaction of the shareholders for the
following reasons:
(i) Information: When a shareholder receives stable dividend the information about
their shares are continuously received by the stock exchange. This gives the investor a
chance to know about the future of the company. It also is able to influence a larger
number of investors to continue to keep their funds in that particular firm.
(ii) Current Income: Investors believe that income received currently from the company
in which they invest is a supplement to their income received from salary and other
sources. This also helps in making decisions for them so that they part with some of
their savings for current consumption for the purpose of another investment which
would give them income annually.
(iii) Legal Aspect: Legally a dividend has many advantages. It gives to the institutional
investors like financial institutions chance to quality for investment in their corporate
organisations. One of the considerations of the investment policy of the large number of
financial institutions existing in India is that income should be stable over the previous
years. If the firm satisfies these conditions, the financial institutions like Life Insurance
Corporation of India and Unit Trust of India would prefer such a company to make their
investments.
(c) Regular and Extra Dividend:
A company should have a policy of giving both regular dividend to its shareholders plus
extra dividends whenever the firm is able to do well. The interim dividend is not an
expectation of the investor and when he receives it he is rather optimistic about the
future of the company without expecting more than the stable regular income. Extra
income need not be declared annually but only when the company makes extra
earnings. This gives the advantage to the investor to share in the growth of the company
without making it a legal restraint for continuous annual payments.
(d) Liquidity:
The company should be careful while declaring dividend not to jeopardize the liquidity
of the firm. Liquidity is an important criterion for the working of the firm. It is an
important to declare dividend only after maintaining liquidity position of the firm. The
company should not have too much liquidity because this means that it is not profitably
investing its funds for shareholders. Proper liquidity relationship in a firm will also help
to safeguard the funds of the shareholders.
(e) Target Pay-Out Ratio:
When declaring dividends, such amount should be paid to the shareholders, which can
be maintained by the company. If the earning position of the firm goes down and it
cannot pay the dividends in a particular year then its position in the stock market will
also go down. The payout ratio is rate of dividends to earnings. Although the amount
will fluctuate in direct proportion to earnings the shareholders will be satisfied because
if a company adopts 30% pay-out ratio for every year then although the percentage will
continue to be the same the rupee earned will be higher.
There are a variety of sources of financial information in India. These sources can be
grouped into variety three main categories:
1. Daily newspapers
2. Magazines in the field of Finance and Banking
3. Other information like (a) financial services, and (b) company and supplementary
data
1. Daily newspapers
Almost all daily newspapers publish important financial news, market reports,
quotations etc., but the coverage of financial news in these newspapers are usually quite
limited. The two dailies - The Economic Times and The Financial Express - publish
detailed daily reports of financial information, quotations and news. The information
published in these publish detailed information on the transactions on various stock
exchanges, and commodity markets, statistics and news on various economic and
business matters, feature articles on the trend and development of business, company
earnings, reports, dividend news, final accounts etc. Most of the news reports and
analysis of business conditions are reported in the above two newspapers in the form of
tables or articles. The quotations of various securities, in various stock exchanges in
India are dealt giving separately the opening, the closing, fluctuations during the day
and the paid-up value of each security.
The two newspapers present weekly comments on the trends and developments of
various markets with the help of averages and indexes. The movement of the averages
and indexes are widely watched and used by analysts, investors and financial managers
alike in analysing the weaknesses and strengths of various markets and securities. This
is particularly helpful at the time of flotation of new issues to raise capital for the
company. Other daily newspapers are Business Standard and Asian Wall Street Journal.
The newspapers also cover following information:
(i) Summaries of trading and commodity markets.
(ii) Foreign exchange rates.
(iii) Other business and economic indicators other than daily news and reports.
2. Magazines
A number of magazines and journals are published in India, containing various aspects
of the Indian economy in general and companies in particular. These contain
information regarding money, credits, personnel, law and financial matters and articles
of general interest. These magazines are as under:
(A) Weeklies
(1) Business Week
(2) Capital
(3) Commerce
(4) Indian Finance
(5) Economic and Political Weekly
(6) Business environment
(7) Eastern Economist
(8) Southern Economist
(B) Fortnightly Journals
(1) Bank of Indian Bulletin
(2) Company Law Journal
(3) Financial Analysis Journal (U.S.)
(4) Harvard Business Review (U.S.)
(5) Journal of the Institute of Bankers
(6) Company News and Notes
(C) Monthlies
(1) Chartered Accountant
(2) Chartered Secretary
Others sources of information are (i) company's annual reports including chairman's
speeches, (ii) company's announcements, and (iii) publications of prospectus in the
newspapers and magazines at the time of floating new shares or debentures. These
publications bring out a great deal of information about the company's history, its
working, its controllers, products, facilities etc. Besides, the company's sources, there
are other publications which carry the individual company's bio data and make them
up-to-date. These sources are
(I) Moody's Manual and Surveys
Published yearly in five separate volumes i.e., industrials; Banks; Insurance, Real Estate,
Investment Trusts; Public Utilities, Railroads; and Government and Municipals. These
manuals provide information and statistics for a wide range of corporations. Semiweekly supplements also published to keep the manuals up-to-date.
(II) Standard and Poor's Manuals and Surveys
Standard Corporation Record contains loose leaf current financial information about a
wide variety of companies which is kept up-to-date by daily supplements. The various
services the standard and Poor's are (i) Its industry surveys; (ii) weekly forecasts of the
security markets security statistics and several information services on the bond
markets; and (iii) a Monthly Earnings and Stock Rating Guide.
(III) The Stock Exchange Official Directory, Bombay
This directory is a publication of Bombay Stock Exchange, started in 1966 and contains
an analytical review of almost all the companies listed on other stock exchanges in India
representing in aggregate about 85 per cent of the total paid up capital of nongovernment public companies Incorporated in India. It covers important unlisted
companies as well as government companies and statutory corporations. The Directory
provides, interalia, the following information:
(i) Comparative and common size financial statement for ten years;
(ii) Trend percentages of selected years;
(iii) Ratio analysis of items selected from financial statements;
(iv) Equity share data for ten years;
(v) Graphs and charts of equity prices, net sales, net profits equity dividend, etc.;
(vi) Supplementary background material compiled from the annual reports.
(vii) Tabular history of the capital structure of each company in most cases from its
inception.
The official directory thus fills up a gap that existed for having systematically analysed
operating results, financial positions and progress of Indian companies.
The Economic Times and The Financial Express the two dailies also publish indexes of
ordinary share prices, based on quotations of some sensitive scripts from forward and
cash lists. The analysis is made industry-wise. The E.T. index covers only 51 scripts
while Financial Express index covers 100 scripts. The Reserve Bank of India also
publishes index numbers (1971-71 = 100) of security prices of 606 scripts which were
quoted on March 31, 1971 under the four categories viz.
(a) Government and Semi Government securities; (b) Debentures of joint stock
companies; (c) Preference shares; and (d) Equity shares.
The financial controllers and managers may go through the relevant publications
containing the required information before taking any decision considering the
company's financial position and the expected developments in the general economy
into account. They should, therefore, be well-versed of the various sources of relevant
information.
FINANCE PAGE OF THE NEWSPAPERS
Information on stock market activity is reported in various media. It is covered by
newspapers, business periodicals, other publications, radio, and even television. For
most of the investors, the coverage in the Economic Times or Financial Express is
reasonably adequate. For investors seeking greater detail, the most comprehensive
source of information is perhaps the Daily Official Quotations List of the Bombay Stock
Exchange. Investors are interested in knowing what is happening to individual securities
and what is happening to the market as a whole.
The manner in which daily newspapers provide information on individual securities
may be illustrated with the help of The Economic Times.
(100) Baroda Rayon (867.5), 852.5, 860.0, 857.5
The number in the brackets to the left of the company's name represents the paid-up
value per share. In this case, it means that the paid-up value per share of Baroda Rayon
is Rs 100. If no number is specified to the left of the company, it implies that the share
has paid up value of Rs. 10 (which is the standard denomination now). The number in
the brackets to the right of company's name, which in the case of Baroda Rayon is 867.5,
represents the previous closing quotation. The first un-bracketed quotation after this
represents the opening price of the issue. Subsequent numbers represent other prices at
which Baroda Rayon was traded during the day with the last number representing the
closing price of Baroda Rayon for the day.
While reading stock exchange quotations, we come across various abbreviations. The
important ones are shown below:
con
convertible
xd
ex (excluding) dividend
cd
xr
ex (excluding) rights
si
small lot
investors index with perhaps a stronger tilt towards FERA and ex-FERA companies.
The composition of the index is given in Table.
Investors often ask the question, 'How is the market doing?' This interest in the broad
market movement stems from the general observation that prices of most of the stocks
tend to move together a fact that has a fairly strong empirical underpinning. The general
movement of the market is typically measured by indices representing the entire market
or important segments thereof. Most of the stock market indices used, in practice, are of
two types:
* Type A: An index reflecting the simple arithmetic average of the price relatives of the
shares in a certain year (or month or week or on a particular day) with reference to a
base year.
* Type B: An index reflecting the aggregate market capitalization of the sample shares in
a certain year (or month or week or on a particular day) in relation to the same in the
base year.
To illustrate the nature of these two types of indices, consider the data for a sample of
five shares for two years, the base year and year t, given in table.
The index reflecting the simple arithmetic average of the price relatives of the sample
shares will be 183 (915/5) and the index reflecting the aggregate market capitalization of
the sample shares will be 160 (4550/2850 multiplied by 100).
Having described how the stock market indices are constructed, let us look at the nature
of the following stock market indices in India, which appear to be the more popular
ones: The Economic Times Index of Ordinary Share Prices, Financial Express Equity
Index, Bombay Stock Exchange Sensitive Index, Bombay Stock Exchange National
Index, and Reserve Bank of India Index number of Ordinary Shares. Table summarizes
the salient features of these indices.
Issues in Application:
Investors often ask the following questions with respect to the stock market indices: Are
indices based on samples reliable? Should we use a value weighted index like the BSE
National Index, or an equal weighted index like the ET Index of Ordinary Share Prices?
Reliability
Indices based on samples (even when samples are small) are fairly reliable because of
the tendency of all stocks to move together. When the purpose of an index is to
represent the changes in the value of stocks, one can have great confidence in a small
sample of large companies because relatively few companies account for a large
proportion of the value of all companies.
Choice
If the objective is to indicate changes in the aggregate value of all stocks a value
weighted index is used. On the other hand, if the purpose of the index is to reflect price
movements of typical or average stocks, an equal-weighted index is more appropriate.
Table - Data for Constructing Stock Market Indices
Parliament on 3rd March, 1992 and was passed by both houses of Parliament on 1st
April, 1992. The Bill became an Act on 4th April, 1992 the date on which it received the
President's asset. However, as provided for in section 1(3), this Act is to be deemed to
have come into force on 30th January, 1992, i.e. the date on which the SEBI Ordinance
was promulgated.
Functions
Under Section 11 of the SEBI Act it is provided that subject to the provisions of this Act,
it shall be the duty of the Board to protect the interests of investors in securities and to
promote the development of and to regulate the securities market, by such measures as
it thinks fit. It is further provided that without prejudice to the generality of the
foregoing provisions, the measures referred to therein may provide for:
a) regulating the business in stock exchanges and any other securities markets;
b) registering and regulating the working of stock brokers, sub-brokers, share transfer
agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant
bankers, underwriters, portfolio managers, investment advisers and such other
intermediaries who may be associated with securities market in any manner;
c) registering and regulating the working of collective investment schemes, including
mutual funds;
d) promoting and regulating self-regulatory organisations;
e) prohibiting fraudulent and unfair trade practice relating to securities markets;
f) promoting investors education and training of intermediaries of securities markets;
g) prohibiting insider trading in securities;
h) regulating substantial acquisition of shares and take-over of companies;
i) calling for information from, undertaking inspection, conducting inquiries and audit
of the stock exchanges and intermediaries and self-regulatory organisations in the
securities market;
j) performing such functions and exercising such powers under the provisions of the
Capital Issue (Control) Act, 1947 (29 of 1947) and the Securities Contracts (Regulation )
Act, 1956 (42 of 1956), as may be delegated to it by the Central Government;
k) levying fees or other charges for carrying out the purpose of this section;
I) conducting research for the above purpose;
m) performing such other functions as may be prescribed.
In sum and substance, Securities and Exchange Board of India has been constituted to
promote orderly and healthy development of the securities market and to provide
adequate investor protection. It aims to remove the unhealthy practices prevalent in the
Indian capital market and create an environment to facilitate mobilisation of resources
through the securities market. Thus the board plays a dual role by adopting regulatory
functions as well as playing an important developmental role. Its functions include:
1) to deal with all matters relating to development and regulations of the securities
market.
2) to administer various legislation affecting securities market.
3) regulation of the market intermediaries viz. stock exchanges, stock brokers, merchant
bankers, mutual funds etc.
4) to provide adequate investors protection.
Organisation
The management of SEBI vests in the board which consists of the following members
namely:
a) a chairman;
b) two members from amongst the officials of the Ministries of the Central Government
dealing with Finance and Law;
c) one member from amongst the officials of the Reserve Bank of India;
d) two other members to be appointed by the Central Government.
The general superintendence, direction and management of the affairs of the SEBI vests
in a Board of members, which may exercise all powers and do all acts and things which
may be exercised or done by the Board. The chairman shall also have powers of general
superintendence and direction of the affairs of the Board and may also exercise all
powers and do all acts and things which may be exercised or done by the board.
The chairman and members referred to at (a) and (d) above shall be appointed by the
Central Government and the members referred to at (b) and (c) above shall be
nominated by the Central Government and the Reserve Bank of India respectively.
For day to day functions the activities of SEBI have been divided into five operational
departments viz.
Consider the 25 large securities brokerages in the United States, listed in the table.
These firms underwrite new issues act as brokers in the stock bond, and commodity
markets; and provide a wide range of customer services. Using the table answer the
questions below:
1) Do you think it is wise to rank the brokerage in terms of their capital rather than in
terms of their number of employees, number of offices, number of salespeople (that is,
registered representatives), or another criteria? Explain.
Case 1: The Largest Securities Brokerages
2) Do you think that Salomon Brothers was large enough to be number two in 1982
why?
3) How did Salomon Brothers jump from fourth in 1981 to second in 1982? How did
Goldman, Sachs & Co. jump from fifth to seventh?
4) If you could get a job as a securities broker at any of these brokerage firms, which
firm would you pick? Why?
Case 2: Merrill Lynch Pierce Fenner & Smith, Inc.
Peggy McKitty had recently been hired by a large regional brokerage firm as an account
executive and was participating along with other new brokers in a company instituted
training program. The objectives of the training program were to familiarize the
participants with the procedures of the brokerage house, develop selling skills, prepare
for the New York Stock Exchange registration examination, and provide an introduction
to investment analysis and management.
Before joining the firm Peggy had been successful in sales with a manufacturer of
industrial chemicals. She was a psychology major-in college and had taken no business
courses. Because of her lack of background, Peggy, was particularly interested in the
investment, the session leader dealt with the importance of diversification. He felt that
account executives spent entirely too much time selling individual securities.
Peggy-had been able to grasp the general points brought out in the initial session but felt
she had missed much of the detail. The session leader had used terms unfamiliar to her,
such as beta, systematic and unsystematic risk, and the coefficient of determination. At
the end of the lecture, Peggy asked the instructor if he would provide her with some
additional materials so that she could get a better feel for the terminology. The
instructor provided Peggy some additional reading material as well as a short exercise
and examples to help familiarize her with risk-return concepts.
Later that week the instructor provided some selected readings from the Financial
Analyst Journal dealing with portfolio management. He also gave her some monthly
prices for the common stock of the Merrill Lynch Corp. and the Standard and Poor's
Composite average of 500 stocks (see Exhibit 1). He suggested that it was possible to
examine Merrill Lynch (ML) stock in terms of its volatility both absolutely and relative
to the market (S&P 500). In the latter case, one could also calculate an expected return
for ML stock given a conditional return for the market. This expected return could
further be predicted with a certain degree of confidence in a statistical sense.
During the training sessions the participants examined historical risk/return
Information and interrelationships between assets available in the world capital
markets, Including equities, bonds, cash equivalents, real estate, and metals. These
groups were loosely aggregated in referring to the "world capital market".
Data provided in Exhibit 2 and 3 that depict risk and return. Exhibit 2 shows return
(simple arithmetic and compound) and risk (standard deviation of returns) for asset
categories for the period 1960-1984. Exhibit 3 is a correlation matrix. It can be
interpreted as follows: For example, the correlation (r) between total U.S. real estate and
Asia equities is -0.033 (see number within the box). This suggests that the returns of
these two series move in opposite directions. Correlation coefficients have a range of +
1.0 to -1.0. The correlation between total U.S. corporate bonds and U.S. Treasury bonds
is 0.902 (see number within box). This suggests returns on these two assets move very
much in unison.
Questions: Consider data in Exhibits 1 though 4
1. Calculate the ingredients of the characteristic line (alpha and beta) for Merrill Lynch
stock for the period 1988-1989. Interpret the meaning of these ingredients individually
and in combination.
2. How would you characterize the behavior of this stock during the period 1988-89
(e.g., aggressive, neutral, defensive, etc.) relative to the market? State why in terms of
(a) underlying statistical relationships and (b) company basics (e.g., products, services,
operations, financing).
3. Calculate total risk (variance in rate of return) for Merrill Lynch stock for the period
1988-89. Divide the total risk of the Merrill Lynch stock into systematic and
unsystematic components. Calculate each component as a percentage of total risk.
4. Suppose the S&P 500 stock index was expected to move up 15% in 1990. How much
of a return would you expect from Merrill Lynch stock? How confident would you be in
this prediction? State this in quantitative terms, given what you know about risk in this
stock relative to the market.
5. Refer to Exhibit 2 which investment would you classify as the superior performer over
the period in question? Which category was clearly inferior? What were the reasons
behind your selections?
6. Refer to Exhibit 3:
a) Does it seem to help much to invest in all three stock markets (i.e., NYSE, AMEX, and
OTC)? Explain.
b) Suppose you had a position in U.S. equities and wanted to diversify your risk. What
are three key sectors you might consider adding to your portfolio (e.g., Treasury notes,
etc.)? Why?
c) Are there apparent gains achieved by investing in long-term corporate, U.S.
government and U.S. agency bonds as a package? Why?
d) Why do you suppose that gold is negatively correlated with U.S. equities?
e) What other cogent observations can be gleaned from the data in Exhibit 3?
Exhibit 4
MERILL LYNCH CORPORATION SELECTED FINANCIAL DATA
Year
EPS
DPS
1988
1987
1986
1985
1984
1983
1982
$4.29
3.58
4.44
2.26
1.03
2.68
3.80
$1.00
0.95
0.80
0.80
0.80
0.78
0.66
Average annual
Stock Price
Price Earnings
(close)
Ratio
30
6.0
22
9.0
40
8.5
35
13.5
28
28.0
32
15.5
32
6.0
DPS / EPS
0.23
0.26
0.18
0.35
0.78
0.29
0.17
External appraisers suggested that the company would have a liquidation value of about
$600,000. Management concluded that as an alternative, a reorganization was possible
with additional investment of $300,000. Management was confident that the firm could
undertake the manufacture of new smoking products, such as long, slim cigars for
women, cigarette papers of varying colors for the growing roll-your-own market.
Turkish water pipes and stylish small pipes for customers who wish to smoke less than
the normal full bowl. Outside consultants concluded that this broadened product line
could be produced and marketed readily through Apex's existing marketing channels
and that new investment of $300,000 was needed. However these consultants also
forecasted that the additional investment would restore earnings to $125,000 a year
after taxes and before fixed charges. Apexs common stock sells at about eight times its
earnings per share. Management is negotiating with a local investment group to obtain
the additional investment of $300,000. If the funds are obtained, the holders of the
long-term debt would be given one-half of the common stock in the reorganized firm in
place of their present claims. Should the creditors agree to the reorganization, or should
therefore liquidation of the firm?
Case 3: Handling Interest-Rate Risk
1. Assume that you and your twin each have $100,000 in cash. You are both very
conservative, and you don't want to lose any of that money.
Assume that you both invest your funds in U.S. Treasury notes due in two years at a
price that yields 4 per cent. Your twin then becomes concerned that a general increase in
the level of interest rates will reduce the present value of the bond portfolio. What will
you say to allay your twin's fears?
2. Assume you manage an investment counseling firm. One of your clients has read
something about interest-rate risk and is worried that if market interest rates decline
her coupon interest income will likewise decline. Her bond investments have maturities
ranging from 15 to 30 years ahead. What can you tell this client to allay her fears?
QUESTIONS:
1. Define Investment?
2. Describe the steps involved in the investment process.
3. State and explain the effect of changes in investment environment on investment
decisions
4. Distinguish Speculation and Investment.
5. Distinguish between Financial and Business Risk, diversifiable risk and nondiversifiable risk.
6. What is meant by the Riskiness of a company?
7. How does one classify Risk?
8. a. What do you mean by stock market and explain its functions?
b. What do you mean by stock exchange?
9. a. Write brief note on management of stock exchanges in India
b. What are the characteristics of stock exchanges in India?
10. What are the principal weaknesses of Indian stock exchanges?
11. What are the membership rules in a Stock Exchange?
12. Give details of legal control of stock exchanges in India.
13. What are different categories of players operating in stock markets?
14. How do brokers function in the stock exchanges?
15. Distinguish between self-regulation and legislative regulation. Which is more
relevant for India? Why?
16. Describe the different kinds of transactions that take place in a stock exchange.
17. What different forms of securities can a public limited company issue under the
Companies Act, 1956?
18. What do you mean by Share Capital and distinguish share and stock?
19. Examine the relative suitability of preference shares and equity shares for an
industrial concern.
20. What do you understand by no-par stock? Examine its advantages and
disadvantages.
21. What is right issue? What is the procedure of Rights Issue? Explain its advantages.
22. What is a bonus issue? What are the benefits / advantages to shareholders?
23. Why does a company issue bonus shares?
24. Write about history and role of SEBI.
25. Explain 'transfer of shares'.
26. Elaborate requirements for listing securities on Stock Exchanges.
27. Demonstrate the advantages of listing.
28. Why is dividend important and what are different decisions on dividends taken by a
company?
29. Write a brief note on the regulation of OTCEI
30. Elaborate the initiatives adopted by SEBI in recent times.
31. Elaborate SEBI guidelines on capital issues.
FUNDAMENTAL ANALYSIS
quickly if not instantaneously. Earning abnormal profits is not the only and final goal for
most of the investors, rather, it has been observed that earning the normal returns, (i.e.,
the return commensurate with risk prevalent in the market) is a worthwhile objective to
pursue which most of the investors are not even able to achieve. In a nutshell, security
analysis has an important role to play for investment decision made in an efficient set
up.
A Framework of Economy-Industry-Company Analysis:
The analyst should take into account all the three constituents which form different but
crucial steps in making investment decision. These can be looked at as different stages
in the investment decision making process and are depicted graphically with three
concentric circles as shown in Fig. below.
Operationally, to base the investment decision on various fundamentals, all the three
stages must be taken into account.
ECONOMY ANALYSIS
In actual practice, investment decisions are made in the economic set up of a particular
country. It becomes essential, to understand the state of the economy at macro level.
The analysis at macro level incorporates how the economy has performed and is
expected to perform in the future. One should know how various sectors of the economy
are going to grow in the future and which of its sectors are showing signs of stagnation
and degradation in the economy. One can begin by analysing historical performance of
various sectors of the economy in the past, present and then forming expectations about
its performance in the future. It is through this systematic process, one would be able to
identify various relevant investment opportunities whenever these arise. Sectorial
analysis, therefore, is very essential along with overall economy analysis as the rate of
growth in overall economy often differs from the rates of growth in various
segments/sectors.
The above analysis depends on economic considerations too. The people in general earn
their income and the way they spend these earnings would in ultimate analysis decide
which industry or company would grow in the future. Their spending affects corporate
profits, dividends and prices of the shares at the market place. According to him on an
average, over half the variations in stock returns are attributed to a market influence
that affect all the market indices. Over and above this, industry specific factors account
for approximately 13 percent of the variation of stock returns. Thus, taken together twothird of the variation of stock prices/returns are attributed to market and industry
related factors. King's study, despite the limitations in terms of its importance of
economic and industry analyses in making investment decisions. To neglect this analysis
while deciding where to invest would be at one's peril.
It must be clear by this now that analysis of historical performance of the economy is a
starting point; overall economy along with its various segments is most relevant to the
direction of the economy so that the decision to invest or to disinvest the securities can
be made effectively.
Researchers have found that stock price changes can be attributed to the following
factors:
G
:
Government expenditure on goods and services (excluding transfer and
payments)
E-M :
imports)
Net export of goods and services (E stands for export and M stands for
The average rate of GNP growth in India during the last 20 years or so has been between
4 and 5 per cent in real terms. It is expected that this may rise to 6 per cent or so in the
decade to come.
The bigger the rate of growth of GNP, other things being equal, the more favourable is it
for the stock market.
Savings and Investment
This is the portion of GNP that is saved and invested. The rate of savings in India has
risen appreciably over what it was in the fifties, sixties, and even early seventies. During
the decade of eighties, the rate of savings in India has hovered around 21 per cent. This
rate compares favourably with the savings rate in most of the other countries in the
world, given a reasonably high level of savings rate in India.
The higher the level of savings and investment, other things being equal, the more
favourable is it for the stock market.
Price Level and Inflation
The effect of inflation on the corporate sector tends to be uneven. While certain
industries may benefit, others tend to suffer. Industries that enjoy a strong market for
their products and which do not come under the purview of price control may benefit.
On the other hand, industries that have a weak market and which come under the
purview of price control tend to lose.
On the whole, it appears that a mild level of inflation is good for the stock market.
Agriculture
Agriculture accounts for a major share of the Indian economy and has important
linkages, with industry. Hence, the increase or decrease or agricultural production has a
significant bearing on industrial production and corporate performance. Companies
using agricultural raw materials as inputs or supplying inputs to agriculture are directly
affected by the changes in agricultural production. Other companies also tend to be
affected due to indirect linkages.
Monsoons
As is well-known, agricultural production in India is considerably dependent on the
monsoons. If the monsoon is good, agricultural output increases; in addition, the
generation of hydel power improves. If the monsoon is bad, agricultural output suffers;
further, the generation of hydel power declines.
Unfavourable
A budget with a high surplus or high deficit
A level of debt (both external and internal)
which is difficult to service
An unsatisfactory balance of payments
A satisfactory balance of payments situation
situation
A tax structure which provides incentives for A tax structure which discourages savings
savings and investments
and investments
A rate of increase in money supply which
A rate of increase in money supply which
ensures inflation is within controlled limits fuels a high level of inflation
A volatile and inequitable interest rate
A stable and equitable interest rate structure
structure
A credit policy which accommodates
A credit policy which is unresponsive to
reasonable business demands
reasonable business demands
The fiscal and monetary variables impinge on industrial performance and the stock
market in unpredictable ways. Hence, the observations made above are indicative and
not definitive.
Infrastructural Facilities and Arrangements
Industrial performance is influenced by infrastructural facilities. The following are
important:
ECONOMIC FORECASTING
Economic forecasting is a must for making investment decision. As it has been
mentioned earlier too, the fortunes of specific industry and the firm depends upon how
the economic outlooks looks like in the future-short term and long term Accordingly,
forecasting techniques can also be divided into two categories: Short term and long term
forecasting techniques. Time horizon in investment decision is a critical variable that
plays a crucial role. Short term refers to a period up to three years. Sometimes, it can
also refer to much shorter period, such as a quarter or a few quarters. Intermediate
period refers to a period of three to five years period. Long term forecast refers to the
forecast made for more than five years. This may mean a period of ten years or more.
We shall discuss some short term forecasting techniques in the following:
The central theme of economic forecasting is to forecast national income. This is
because it summarizes the receipts and expenditures of all segments of the economy, be
the government, business or house hold. These macro economic accounts describe the
level of economic activities over a period of time.
GNP is an important indicator of the level and the rate of growth in economic activities
and is of central concern to analysts for forecasting overall as well as various
components during a certain period. Following are some of the techniques of short term
economic forecasting:
Anticipatory Surveys
This is method through which investors can form their opinions with respect to the
future of the economy. As is generally understood, this is the survey of expert opinions
of those who are prominent in the government, business, trade and industry.
Anticipatory surveys can also incorporate the opinion or future plan of consumers with
regard to their spending. So long as people plan and budget their expenditures and
implement their plans accordingly, such surveys should provide valuable as a starting
point.
Despite the valuable inputs provided by this method, precautions are needed because:
(1) Survey results cannot be regarded as forecasts per se. A consensus of opinion may be
used by the investor in forming his own forecasts.
(2) There is no guarantee that the intentions surveyed would certainly materialise. To
this extent, the investors cannot rely solely on these.
Surveys are very popular in practice and used for short term forecasting which, of
course, requires continuous monitoring.
Coincidental Indicators:
Lagging Indicators:
Consumption expenditure
Gross private domestic investment
Government purchases of wood and services
Net exports
(3) After forecasting the individual components of GNP the analyst then adds them up
and gets a figure of the forecasted GNP.
(4) The analyst compares the total of GNP so arrived with an independently arrived
GNP and test, the overall forecast for internal consistency. This is done to ensure that
both his total forecast and subcomponents forecast make scene and fit together in a
reasonable manner.
The opportunistic model building involves all the details described above with a vast
amount of judgement and inequity.
Diffusion Indexes
The diffusion index is a method which combines the different indicators into one total
measure. The diffusion index is also called a census or a composite index. The method
adopted in this economic reading of the future, is to take the leading, the coincidental
and the lagging factors together, so to summarise them and then draw out infer a
particular composite answer. Usually, both the micro aspect of the data and the macro
aspect are combined. This is a complex statistical method and the combination of
various factors in tills technique makes it extremely difficult to draw out of proper
understanding of the forecasting methods.
Opportunistic Model Building
This method is the widely used economic forecasting method. This method uses the
national accounting data to be able to forecast for a short term period. The method of
forecasting is to find out the total income and the total demand for the forecast period.
To this are added the environment conditions of political stability, economic and fiscal
policies of the government, policies relating to tax and interest rates. This must be
added to Gross domestic investment, government purchases of goods in services,
consumption expenses and net exports. The forecast has to be broken down first by an
estimate of the government sector which is to be divided again into State Government
and Central Government expenses. The gross private domestic investment is to be
calculated by adding the business expenses for plan, construction and equipment
changes in the level of business. The third sector which is to be taken is the consumption
sector relating to the personal consumption factor. This sector is usually divided into
components of durable goods, non-durable goods and services. When data has been
taken from all these sectors, these are added up to get the forecast for the Gross National
Product. They are then tested for consistency. This may also be used in the form of a
matrix to find out of the flow of savings as well as the flow of investments. This method
of is very reliable and it is often used for forecasting the economic conditions of an
economy.
Table below gives sources and uses of information.
The industry has been defined as a homogeneous group of people doing a similar kind of
activity or similar work. Industry would include all the factors of production,
transportation, trading activity and public utilities. The broad classification of industry,
however, would not be relevant for an investor who would like to ensure that he does
not lose from the investment that he makes. It is, therefore, essential to qualify the
industry into some characteristic homogeneous group. The industry is classified in
process and in stages. It may also be classified according to work group that it identifies
to. Sometimes, it is classified as manufacturing, transportation public utility etc. In
India, the broad classification of industry is made according to stock exchange list which
is published. The same list is also published in Economic Times and Financial Express
daily. This gives a distinct classification to industry in different forms such as (a)
engineering, (b) electricity generation, (c) textiles, (d) cement, (e) steel mills and alloys,
(f) cable and electricals, (g) plantation, (h) chemicals and pharmaceuticals, (i) paper, (j)
sugar, (k) rubber, (1) automobiles, cycle and accessories, (m) miscellaneous. This
classification broadly gives the investor some kind of headway and he may then analyse
the industry and find out whether it is profitable to make an investment or not.
The industrial growth begins with technology. Technology keeps on changing. These
technological changes should be carefully viewed by the investor. A product with
frequent technological changes may be useful for the investor to notice as product
obsolescence may ride his investment.
The second factor is to enquire about the competitive pressure that an industry faces in
the country. A study of representative sample may give a picture of the kind of
competition that an industry faces. For example, in India the garments industry had a
sudden boost and large number of small companies have entered into the industry
which has a lesser number of firms competing with each other. Profits are expected to be
more in a company which is under pressures of competition.
The third factor is of economic environment and prevailing in a country. Poverty in a
country would have an economic climate where cheaper products would be sold and
demand for these products will be higher than quality and long lasting products.
Economically advanced country will have customer activity in higher price and better
quality products.
Some of the more useful bases for classifying industries from the investment point of
view are as follows:
Growth industry: This is the industry which grows persistently and its growth is likely
to exceed the average growth of the economy.
Cyclical industry: In this category of the industry, the firms included are those that
move closely with the rate of industrial growth of the economy and fluctuate cyclically as
the economy fluctuates.
Defensive industry: It is a grouping that includes firms which move steadily with the
economy and decline less than the average decline of the economy in a cyclical
downturn.
Declining industry: This is that category of firms which grow less than the average
growth of the economy.
INDUSTRY LIFE CYCLE
Another useful criterion to classify industries is the various stages of their development.
Industries with different stages of their life cycle development show different
characteristics. In fact, each development stage is quite unique. Grouping firms with
similar characteristics of development helps investors to properly find different
investment opportunities in the companies. Based on the stage in the life cycle,
industries may be classified as follows:
Initial Stage: This is the first stage in the life cycle of a new industry. Being the first
stage, the technology and its products are relatively new and have not reached a stage of
perfection. Experimentation is the order both in product and technology. However,
there is a demand for its product in the market, thereby, the opportunities are in plenty.
At this stage the risk of many firms being out of the industry is also more; hence,
mortality rate is very high in the industry, with the result that if an industry withstands
the risk of being out of the market, the investors would reap the rewards. A very
pertinent example of this stage of industry in India is aquaculture industry which was
trying to come-up during nineties. There was a mushroom growth of companies in this
period. Hundreds of companies came into existence. Viral attack slashed the industry it
became difficult for a number of companies to survive. This period saw many companies
that could not survive the onslaught. Only those which could tolerate this onslaught
could remain in the industry. Aquaculture industry today In India is much pruned
compared to mid-eighties.
Growing Stage: This is the second stage when the chaotic competition and growth that
were the hallmark of the first stage is over. Firms that could not survive onslaught have
already died down. The surviving large firms now dominate the industry. The demand of
its product still grows faster in the market leading to increasing amount of profits
companies could reap. This is stage where companies grow orderly and rapidly. These
companies provide a good investment opportunity to the investors. In fact, as the firms
during this stage of developments grow faster, they sometimes break the records in
various areas like payments of dividends etc., thus becoming more and more attractive
for investment.
Maturity Stage: The third stage where industries grow roughly at the rate of the
economy and are fully developed reach a stage of stabilisation. Looked at differently,
this is a stage where the ability of the industry to grow appears to have more or less lost.
As compared to the competitive industries, rate of growth in the industry is slower. Sales
may still be rising, but at a lower rate. Investors have to be very cautious to examine and
interpret these signs before it is too late.
Declining Stage: The fourth stage of life cycle development is the decline stage.
Industry at this stage has grown old. New products, new technologies have come in the
market. Customers have changed their habits, styles, etc. Its products are not much in
demand as was in the earlier stages. Still, the industry can continue to exist for some
more time. Consequently, the industry would grow less than the average growth of the
economy during the best of the times of the economy. But as is expected, the industry
would decline much faster than the decline of the economy in the worst of times.
STRUCTURE AND KEY CHARACTERISTICS OF AN INDUSTRY ANALYSIS
Since each industry is unique, a systematic study of its specific features and
characteristics must be the basis for the investment decision process. Industry analysis
should focus on the following:
I. Structure of the industry and nature of competition
The number of firms in the industry and the market share of the top few (four to
five) firms in the industry
Licensing policy of the government
Entry barriers,
Pricing policies of the firm
Degree of homogeneity or differentiation among products Competition from
foreign firms
Comparison of the products of the industry with substitutes in terms of quality,
price, appeal, and functional performance.
III. Profitability
Proportions of the key cost elements, namely, raw materials, labour, utilities, and
fuel
Productivity of labour
Turnover of inventory, receivables, and fixed assets Control over prices of outputs
and inputs
Behaviour of prices of inputs and outputs in response to inflationary pressure
Gross profit, operating profit, and net profit margins Return on assets, earning
power, and return on equity.
On the basis of the above model, the following inferences can be drawn:
(1) Higher the EPS, higher would be the value of the share.
(2) Higher the b (retention rate), higher would be the value of share.
(3) Higher the k (discount rate), lower would be the value of the equity.
(4) Higher the g (growth rate), higher would be the value of the equity.
One has to be careful about using the discount rate, k. A higher value of discount rate
would unnecessarily reduce the value of equity while a lower value would unreasonably
increase it, which will have implications to invest/disinvest the shares. A discount rate is
based on the risk free rate and risk premium. That is,
Discount rate = risk free rate + risk premium
K = rf + rp
where rf = risk free rate of return
rp = risk premium
Thus, higher the risk free interest rate, lower the value of the equity. In the same way,
higher the risk premium, lower the value of the equity. Like discount rate, growth rate is
equally critical variable in this method of share valuation. Growth from internal sources
depends on the amount of earnings retained and returns on equity. Thus, higher the
retention rate, higher would be the value of the firm. Higher return on equity would lead
to higher value of equity.
Price-Earnings Ratio Approach:
The future price of equity is calculated by multiplying the P/E ratio by the EPS. Thus,
P = EPS x P/E ratio
This approach seems quite straight and simple. There are, however, important problems
with respect to the calculation of both P/E ratio and EPS. Pertinent questions often
asked are:
How to calculate the P/E ratio?
What is the normal P/E ratio?
What determines P/E ratio?
How to relate company P/E ratio to market P/E ratio?
The problems often confronted in calculating this ratio are: which of the earnings-past,
present or future are to be taken into account in the denominator of this ratio? Likewise,
which price should be put in the numerator of this ratio? These questions need to be
answered while using this method.
Indeed, both these methods are inter-related. In fact, if we divide the equation of
dividend discounted method under constant growth assumption by E0 (Earnings per
shares), we get
17) Does the board of directors have access to information it needs to properly oversee
and direct the firm?
18) Does management satisfactorily respond to vigorous questioning by the board at
regular intervals?
19) Does the firm have management depth?
20) Is the firm run by someone whose ego won't permit other competent managers to
develop, or does the firm have an established chain of command?
21) Are authority and responsibility delegated or decentralized?
22) Does the firm have a good team of middle managers being groomed to take over
some day?
23) Are junior executives being developed properly?
24) Is management dynamic and flexible?
25) Do the firm's managers have the foresight and self-confidence needed to make the
decisions essential to earnings high rates of profit?
26) Is the company profitable?
27) Is each product fine profitable or at least potentially profitable?
28) Is each of the firm subsidiaries making its fair contribution to the parent
corporation?
29) How high are the firm's profits margins compared with those of its competitors?
30) How does the firm's rate of return on equity compare with the returns available in
equally risky industries?
31) Does the firm maintain or even arguments its cash dividend payouts?
32) Is the firm keeping up with business development?
33) Are computers being used as they should be within the firm?
34) Is the company cleaning up its own messes or might the Environment Protection
Agency sue the firm in order to force compliance with the pollution laws?
35) Does the firm hire fairly from among groups that have suffered the effects of
discrimination?
the dimensions relevant for establishing the price-earnings multiple may be done on a
rating chart of the kind shown in Exhibit.
an intrinsic value range of, say, Rs. 110 to Rs. 140. Given this value range, decision rule
may be as follows:
Market price
Decision
Buy
Hold
Sell
foreign funds and stockbrokers investing in India want to know more about Indian
business and depend on Indian researchers, who are more familiar with the local
environment". Indeed, currently equity research is a bottom area.
Equity research seems to be characterized by the following shortcomings.
Lack of clarity: Equity researchers are fumbling, still groping around; the market is
trying to get a clearer idea about how one could get going.
Inadequate specialization: Most equity researchers in India presently cover several
industries and a large number of firms. It is impossible to achieve meaningful depth
with such extensive coverage.
Emphasis on numbers: In many equity research reports, the emphasis is on
financial numbers and ratios. Historical financial data and indicative trends are often
passed on as research with meager attention to analytical forecasting.
Short term orientation: Till recently, most equity researchers of took a short term
view. Their horizon was typically six months, sometimes extending to one year.
Fortunately this is changing.
Equity researchers who succeed in overcoming the above shortcomings have bright
prospects. The future belongs to those who will:
* Have a clear understanding of what their research is supposed to do and how they
should go about doing it.
* Have their capabilities for conducting in depth, original analysis.
* Concentrate their efforts on one or two industries and increase the depth of their
analysis.
* Learn to interpret financial numbers and assess qualitative factors which may not be
immediately reflected in numbers.
* Develop a medium-term or long-term perspective based on an incisive understanding
of the dynamics of the companies analysed.
INTERNAL INFORMATION
The basic financial statements which are required as tools of the fundamental analyst
are the income statement, the balance sheet, and the statement of changes in financial
position. These statements are useful for investors, creditors management of a firm. On
the basis of these and statements the future course of action may be taken by the
investors of the firm. While evaluating a company, its statement must be carefully
judged to find out that they are (a) correct, (b) complete, (c) consistent, and (d)
comparable.
The income statement gives the past records of the firm and this becomes a base for
making predictions for the future. Its importance as a statement of analysis has come
out since the seventies and its significance is to assess the earnings of a firm. When the
income statement is being analysed there are certain items which require particular
attention:
i. Inventory Cost Methods:
There are many methods for evaluation of inventory out of which the last-in-first-out
(LIFO) is the most popular. In the first-in-first-out method the items of inventory which
are first brought in the organisation are consumed first. Alternatively, in the last-infirst-out (LIFO) method the inventory which is purchased last is first consumed.
The LIFO method is an attempt to provide an element of conservatism. The effect of this
method when prices rise is to show a profit at a lower rate by creating a low carrying
value for inventory. The effect is opposite at the time of falling prices.
The FIFO method shows greater earnings during time of inflation and rising prices.
Thus it is important to find out the kind of inventory method that a film operates upon
while analysing the income statement to m make adjustments in the value of stock.
ii. Depreciation:
Depreciation method should also be uniform from year to year to find out the exact
effect on a firm. Depreciation is a means of reducing the life of an asset every year till
depletion. The problem regarding depreciation arises at the time of comparability of one
firm and another because there are a large number of depreciation methods.
Depreciation is dependent on three factors. These are the original cost of an asset, its
estimated life and the estimated residual value at the end of its life. Usually,
depreciation methods are on the basis of time or on the basis of use. The straight line
method of depreciation is usually used to write off an asset uniformly till it reaches the
end of its useful life. When depreciation is based on the accelerated method, then the
asset depreciation is regulated. The effect of depreciation is that if a large amount of
depreciation is written off in the beginning of the life of the asset it reduces the taxable
income of the firm and also the taxes which it pays. On the other hand, during the later
years of the life of the asset if the depreciation charges are small then the taxable income
becomes high The tax rate usually does not change under both the methods of
depreciation but accelerated depreciation methods take into consideration the time
value of money which the straight line method does not consider.
Every firm uses the method of depreciation which is stable and useful or its own official
purpose. This creates a complication for an investor while estimating the earnings
through the financial statement.
EXTERNAL INFORMATION
External sources are prepared by investment services and brokerage firms. Three of the
major services, to which even the novice investor will often turn for valuable
information, are Standard & Poor's, Moody's and The Value Line.
Standard & Poor's Stock Report concerns a firm on the New York Stock Exchange, but
S&P also publishes similar reports on all American Stock Exchange firms and selected
over-the-counter securities. These reports contain a report on the firm's operation and
recent developments, information on the firm's financing, and pertinent share-price
data, as well as other financial data. New reports are issued for this loose-leaf service at
frequent intervals.
Moody's Handbook of Common Stocks, published quarterly, contains approximately the
same type of information as the S&P Stock Reports.
The Value Line Investment Survey, in conjunction with the Industry Reports, lists
excellent one-page summary sheets of member firms. These reports are abundant in
LIABILITIES
Liabilities defined very broadly represent what the business entity owes others
(including shareholders). According to the companies Act liabilities are as follows.
Share Capital
They are two types: Equity capital and preference capital. The first represents the
contributions of equity shareholders, who are the owners of the firm. Equity capital,
being risk capital, carries no fixed rate of dividend. Preference capital represents the
contribution of preference shareholders and the dividend rate payable on it.
Reserves and surplus
Profits retained represent reserves and surplus. Reserves may be classified into two
broad types: revenue reserves and capital reserves. Revenue reserves represent
accumulated retained earnings from the profits of normal business operations. Capital
reserves arise out of gains which are not related to normal business operations.
Secured loans
Borrowings from the firm against which collateral is provided are referred to as secured
loans, such as loans from financial institutions, debentures, and loans from commercial
banks.
Unsecured loans
Borrowings of the firm against which no specific security has been provided are referred
to as unsecured loans. The major components of unsecured loans are: fixed deposits,
loans and advances from promoters, inter corporate borrowings and unsecured loans
from banks.
Current liabilities and provisions
Current liabilities and provisions consist of the following: amounts due to the suppliers
of goods and services bought on credit; advance payments received; accrued expenses;
provisions for taxes, dividends, gratuity, pensions, etc.
ASSETS
Assets represent what the firm owns'. Assets are classified as follows:
Fixed Assets
Acquired for long periods of time, fixed assets are ordinarily not meant for resale, such
as land, buildings, plant, machinery, patents, and copyrights.
Marketable Securities
These are financial securities owned by the firm. Some investments are made for longterm purposes, others are meant for short-term purposes.
Current assets
This category consists of such as components cash, debtors, inventories, pre-paid
expenses, loans and advances. Cash denotes bank balance and currency. Debtors
represent the amounts owed by its customers. Debtors are shown in the balance sheet at
the amount owed, less a provision for bad debts. Inventories consist of raw materials,
work-in-process, finished goods, and stores and spares. They are reported at the cost or
market value. Pre-paid expenses are incurred for services to be rendered in the future.
These are shown at the cost of unexpired service. Loans and advances are the amounts
given to employees, and suppliers and contractors, and deposits made with
governmental and other agencies. They are shown at the actual amount.
Miscellaneous expenditures and losses
Miscellaneous expenditures are such as preliminary expenses and pre-operative
expenses that have not been written off. As per company law requirements, the share
capital cannot be reduced when a loss occurs. So, the share capital is kept intact on the
left-hand side of the balance sheet and losses are shown on the right-side of the balance
sheet.
FINANCIAL ANALYSIS
The financial statements are of interest to different groups of persons, who are
interested in the financial position a firm. According to Myres, "Financial statement
analysis is largely a study of relationship among the various financial factors in a
business as disclosed by a single set of statements and a study of the trend of these
factors as shown in services of statements". According to Kennedy and Memullez, "The
analysis of financial statements are an attempt to determine the significance and
meaning of the financial statements data so that a forecast may be made of the prospects
for future earning capacity, ability to pay interest and debt maturities and probability of
a sound dividend policy". It is identifying strengths and weaknesses of financial
position.
The technique of financial analysis is typically devoted to evaluate the past, current and
projected performance of a business firm. The term is applied to enquire into financial
data. For all this, they have to study the relationship among various financial variables
in a business as disclosed in various financial statements.
Object of Financial Analysis:
The following are the main objectives of the analysis:
1. To estimate the earning capacity of the firm.
2. To gauge the financial position and financial performance of the firm.
3. To determine the long term liquidity of the funds as well as solvency.
4. To determine the debt capacity of the firm.
5. To decide about the future prospects of the firm.
Procedure of Financial Analysis:
Steps in financial analysis are -
(i) Deciding upon the Extent of Analysis: First of all the depth, object and extent of
analysis will be determined by the analyst. The determination of these basic facts
determines the scope of analysis, tool of analysis and the amount and quality of financial
data to be required.
(ii) Collection of necessary information: All other necessary and useful information will
be collected from the management which has not been revalued in the published
financial statements.
(iii) Going through the statements: Before analysing and composing financial ratios, it is
necessary for the analyst to go through the various financial statements of the firm.
(iv) Rearrangement of Data: Before making actual analysis and interpretation the
analyst must rearrange the data provided by these statements in a useful manner. The
appropriation of figures, reclassification, and consolidation of items may be done as
preliminary step to actual analysis.
(v) Final Analysis: Now the actual analysis is made. For this purpose any of the above
techniques may be adopted.
(vi) Interpretation and Presentation: After analysing the statements the interpretation is
made and the inferences drawn from the analysis are presented in the shape of reports
to the management etc.
Uses of Financial Statement Analysis:
Analysis of financial statements is an attempt to measure the enterprise liquidity,
profitability, solvency and other indicators to assess its efficiency and performance.
Analysis of financial statements is linked with the objective and interest of the
individual/agency involved. Such as shareholders bankers, lenders, suppliers,
customers, employees, management and tax authorities, stock exchanges, company law
board, etc. who have diverse and conflicting interests.
(1) Shareholders: A shareholder is interested in the profitability and safety of his
investment and would like to know whether the business is profitable, has growth
potential and is progressing on sound lines in the long run.
(2) Creditors: creditors interested in servicing of their loans by the enterprise, i.e.,
regular payment of interest and repayment of principal amount on schedule dates.
Bankers and lenders would also like to know the safety of their investment and
reliability of returns.
(3) Suppliers: Dealing with the enterprise are interested in receiving payments as and
when fall due and would like to know its ability to honour its short term commitments.
(ii) Vertical Analysis: Analysis of financial data based on relationship among items in a
single period of financial statement is called vertical analysis. For example, various
assets can be expressed as percentage of statements. The common size profit and loss
account is more useful in analysing operating results and costs during the year. It shows
each element of cost as a percentage of sales. Similarly Common Size Balance Sheet
shows fixed assets as a percentage to total assets or building or plant is expressed as
percentage of total assets.
Tools for Financial Analyst:
Following are the various tools available to the financial analyst:
A. Comparative statements.
B. Trend analysis.
C. Average analysis.
D. Statement of change in working capital.
E. Fund-flow analysis.
F. Cash-flow analysis.
G. Ratio-analysis.
A. Comparative Statements: The comparative statements are prepared in a form
that reflects the financial position for two or more periods. Comparative statements are
important tools of horizontal financial analysis. Financial data become more meaningful
and logical when compared with similar data for a number of years.
Comparative statements are made to show:
1. Absolute data (money values or rupee amounts)
2. Increases and decreases in absolute data in terms of money values.
3. Increases or decreases in absolute data in terms of percentages.
4. Comparisons expressed in ratios.
5. Percentage of totals.
Advantages
They indicate the duration of the movement with respect to the financial position
and operating returns.
Financial data become more meaningful when compared with similar data for
previous periods.
It is helpful in measuring the effects of the conduct of a business during the
period under consideration.
The comparative profit and loss accounts will present a review of operating
activities of the business.
The comparative balance sheet shows the change in the financial position during
the period under consideration.
Limitations
Comparisons lose their significance and are misleading if the data do not reflect
the consistent.
In the preparation of comparative financial statements, uniformity is essential.
Care must be taken to see that all account heads or groups of these like
'administrative expenses', fixed assets', 'current assets', 'long term funds', 'short
term funds etc. have the same connotation. Otherwise, comparison will be
vitiated.
paper also in the shape of curves. In this form the analysis and comparison becomes
more comprehensive and impressive.
D. Statement of Changes in Working Capital: To know an increase or decrease
in working capital over a period of time the preparation of a statement of changes in
working capital is very useful. The statement gives an accurate summary of the events
that affected the amount of working capital.
E. Funds Flow Analysis: Funds flow analysis is an important method to evaluate the
uses of funds by the firm and to determine how these uses were financed. It is very
helpful for financial executives in planning the intermediate and long term financing of
the firm.
F. Cash Flow Analysis: A cash flow statement provides information for planning for
short range cash needs of the firm. It highlights the changes in financial structure of
enterprise as change in various sources of cash, debt and equity.
G. Ratio-Analysis: It is the most popular tool of financial analysis. It develops
meaningful relationship between individual items in the Balance Sheet or Profit and
Loss Account. Ratio analysis highlights the liquidity, solvency, profitability, capital
gearing etc.
FINANCIAL RATIOS AND THEIR IMPORTANCE
Ratio analysis is based on ratios. A ratio is a numerical relationship between two items.
Ratio analysis of financial statements stands for presenting the relationship of items and
group of items in the statements. Each major item in the balance sheet and income
statement has a relationship with one or more items in either or both statements which
can be expressed in ratio.
Ratio analysis involves three steps which are as follows:
(i) The financial manager selects from the statements those sets of data which are
relevant to his objective of analysis and calculates appropriate ratios from them.
(ii) The second step is the comparison either with the industry standards or with the
ratio of the same firm relating to the past.
(iii) After comparison, the conclusions may be drawn and presented in the shape of
reports.
Objects of Ratio-Analysis:
1) To facilitate the comparison of financial statements and evaluation of various aspects
such as financial health, profitability and operational efficiency.
2) To help in providing a comparative study of various business organisations.
3) To help the management in evaluating its policies and taking remedial measures if
any.
4) To help in planning and control.
5) To facilitate the investors in investment decisions.
Role of Ratio-Analysis
Ratio analysis is useful for financial analysis. It simplifies, summarizes and systematises
a long array of accountancy figures. It explains the inter relationship between various
segments of business. It is an instrument for diagnosis of the financial health of an
enterprise.
Liquidity, solvency, profitability, and capital gearing ratios enable to draw conclusions
regarding the financial requirements and the capabilities of business units. Ratios
indicate the trend of the firm. It helps the financial management in evaluating the
financial position and performance of the firm. The use of ratio analysis is not confined
to the financial manager only, but the credit supplier, bank, lending institutions and
experienced investor all use ratio analysis as their initial tool in evaluating the firm as a
desirable borrower or as potential investment outlet. The following are important
managerial uses of ratio analysis.
(i) Financial Forecasting: Ratio analysis is helpful in forecasting. Ratios relating to past
sales, profits and financial position are based for future trends.
(ii) Aid in Comparison: Ratios can be composed and they can be used for comparison of
a particular firm's progress and performance with other firms.
(iii) Cost control: Ratios are useful for measuring the performance and in cost control.
(iv) Communication value: Different financial ratios communicate the strength and
financial standing of the firm to the internal and external parties.
(v) Other uses: Financial ratios are very helpful in the diagnosis of financial health of a
firm. They highlight the liquidity, solvency, profitability and capital gearing etc., of the
firm. They are useful tool of analysing financial performance.
Utility of Ratio Analysis to the Management
The ratio analysis is of immense use to the management in the discharge of its basic
functions of forecasting, planning, coordination, communication and control. It helps in
predicting and projecting the future. It assists in communication by conveying
purposeful information. It promotes coordination and paves the way of effective control
of business operations. Ratio analysis is an integral part of budgetary control system.
1. Liquidity ratios
These measure the ability of a company to meet its current obligations, and indicate the
short term financial stability of the company. The parties interested in the liquid ratio
would be employees, bankers and short term creditors.
2. Profitability ratios
These measure the overall effectiveness in terms of returns generated, with profits being
related to sales and adequacy of such profits as to sales or investment. The profitability
ratios are important to internal management, to bankers, to investors and to the owners.
3. Leverage ratios
These measure the extent to which the company has been financed through borrowing
(debt financing whether short or long term). Those interested would be bankers, owners
and investors.
4. Activity ratios
These measure how effectively the company is using its resources, and is useful
primarily to internal management as also perhaps to bankers who are investing their
funds in the company.
5. Solvency ratios
These ratios would give a picture of the company so that an early forewarning is
available for remedial action in time.
6. Financial ratios
These enable quick sporting of over or undercapitalization of a business, so that a
proper balance is achieved between owner's funds, borrowed funds and shareholders
funds.
Table given below, would indicate the objectives of analysis of the appropriate ratios.
The definitions and utility of these ratios are given in more detail below:
Liquidity ratios
By liquidity of a company it means its ability to pay current obligations. To express it in
absolute terms or amount, this is known as the working capital and, when expressed in
relative figures, is known as liquidity ratio. The working capital of a company is defined
as:
Net working capital = Current Assets - Current Liabilities
Current Assets and Liabilities include:
The net working capital, if it is positive, indicates that the company has a margin of
safety, and will be able to meet its short-term liabilities in time. However, too high a net
working capital may indicate that funds are lying idle in the organization which could be
put to a better use.
Basically, there are two ratios which are used to assess liquidity of the company. These
are:
(a) Current Ratio, and (b) Quick Ratio or Acid Test Ratio,
(a) Current ratio
Current Ratio = Current Assets / Current Liabilities
This ratio indicates the company's ability to meet current obligations. As a rule of
thumb, the current ratio should at least be 2:1 by which is meant that even if half of the
current assets could not be quickly converted into cash, there would still be left enough
to pay off short-term obligations. However, for interpreting current ratio the quality and
liquidity of each current asset and current liability must be considered as also the nature
of the business as it may well be that various types of business may require less liability.
(b) Quick Ration or Acid Test ratio
Quick Ratio or Acid Test ratio = (Cash+Bills receivables+Debtors+Temporary (saleable)
investment)/Current liabilities
The Acid-test ratio ignores less liquid assets like inventory, or prepaid and deferred
charges, and takes into account only the most readily available cash and other assets
which can be applied for meeting short-term obligations at short notice. As a rule of
thumb, a quick ratio of 1:1 is indicative of a company having a good short-term liquidity.
Profitability Ratios
Every organisation, in order to survive and grow, should earn profits and, therefore,
there is need to know, whether it is making adequate profits or not. Ratios for assessing
profitability are described below:
(a) Gross Profit Margin
Gross Profit Margin = (Gross Profit / Net Profit) x 100 %
The gross profit margin shows the proportion of sales after meeting the direct cost of
goods sold. The gross profit margin should be high 65-70% (say) enough to cover other
operating, administrative and distribution expenses as otherwise the line of activity
would not be profitable for the company.
(b) Return on Owners' Equity:
Return on Owners' Equity = Net profit after tax / Equity capital reserves
This indicates to the shareholders what is the return on their investment in the
company; whether in the shape of share capital or in the shape of retained profits not
distributed (through dividends), and whether their continued investment in the
company is worthwhile or not.
The ratio is also called "Return on Net Worth".
Leverage Ratios
Leverage ratios are analytical for long-term creditors. Such long-term creditors are
primarily interested in whether the company has the ability to regularly pay interest due
to them and to repay the principal at the date of maturity. The principal ratios used for
calculating the leverage ratios are the following:
(a) Times interest covered;
(b) Debt equity ratio;
(c) Shareholders equity to total capital; and
(d) Debt ratio.
These are explained below;
(a) Times Interest covered:
Times Interest covered = Profit before interest and tax / Investors obligation
This ratio is computed for each accounting year and over the time period of the (longterm) credit made available.
(b) Debt Equity ratio:
Debt Equity ratio = Total debt / Equity
Where, total debt is sum of long term loans, short term loans, debentures and interest
bearing deposits
This ratio indicates the proportion of fixed interest bearing capital taken by the
company, as compared with the shareholders' capital. A high ratio would indicate that
the company is relying on capital bearing fixed-charges rather than on equity capital.
Often companies resort to such loans in order to avoid dilution in control. Shareholders
should be vigilant particularly against too high a debt equity ratio.
(c) Shareholders' Equity to Total Capital:
Shareholders' Equity to Total Capital = Owned capital / Total capital
where, owned capital is the sum of equity capital and reserves
Total capital is the sum of Fixed assets, Working total capital, and Loan capital
This is also called Equity Ratio or the Proprietary Ratio. The last named two terms
being defined as:
Equity ratio = Proprietary ratio = Net Worth / Total Assets
This is an important ratio for determining the long-term solvency of a company. In
general, the higher the share of proprietors' capital in the total capital of the company,
the less is the likelihood of insolvency.
(d) Debt Ratio:
Debt Ratio = Total Liabilities / Total Assets
This ratio compares the total liabilities to total assets.
A useful ratio which is used by long-term lending institutions is the Debt Service
Coverage Ratio which is defined as under:
Debt Service Coverage Ratio = Profit before interest and depreciation / Interest
payments and principal installments falling due during the year
This indicates at a glance whether the borrowing company has adequate funds for
servicing both interest payments falling due and the principal re-payments falling due in
installments for the loan taken. Depreciation is added back to the net profits, as also the
interest, in order to calculate this ratio.
Activity Ratios
There are six ratios which can assess the liquidity of a firm
(a) Turnover of current assets,
(b) Turnover of inventory,
(c) Turnover of raw materials,
(d) Turnover of work in process,
(e) Turnover of finished goods stock,
(f) Credit collection period
(a) Turnover of current assets:
Turnover of current assets = Net Sales / Current Assets
The higher the turnover of current assets ratio, the greater is the liquidity of the firm,
and the lesser is the amount blocked in current assets.
(b) Turnover of Inventory ratio:
Turnover of Inventory ratio = (Net sales Operating Profit) / Inventory
This ratio gives the turnover of inventory and indicates how funds invested in
inventories are being turned over. The higher the turnover of inventory ratio, the
smaller is the amount blocked in inventory and, therefore, the less need is there for
working capital for financing the inventory.
This ratio can also be used to find out the period for which inventory stock is held.
Inventory stock = Days in a year / Inventory turnover
= 360 + (Sale during the year / Average inventory during the year)
where, average inventory during the year is the inventory at the beginning of the year
minus inventory at the end of the year.
If the inventory stock is worked out from the turnover of inventory ratio for each type of
inventory / stock held, it will show up the slow moving items, the type of inventory, and
the funds blocked therein.
The logic for fundamental analysis becomes crystal clear once we understand the
chemistry of earning and the macro and micro factors influencing the earning.
SOURCE: Security analysis and portfolio management, Block 3 MS- 44, p.8 IGNOU,
NEW DELHI.
One would notice from the table that distributable earnings is the difference between
sales revenue and the costs of goods, interest, depreciation, taxes and preference
dividend, and expense which are influenced by company specific, industry level and
macro-economic factors.
VALUATION OF SHARES
The study of investments is concerned with the purchase and sale of financial assets and
the attempt of the investor to make logical decisions about the various alternatives in
order to earn returns on them. The returns are further dependent on the degree of risk
involved. A functional definition as defined by Ambling is "Investment may be defined
as the purchase by an individual or institutional investor of a financial or real asset that
produces a return proportional to the risk assumed over some future investment
period". Fischer and Jordan describe it as "An investment is a commitment of funds
made in the expectation of some positive rate of return. If the investment is properly
undertaken, the return will be commensurate with the risk the investor assumes".
than rupee received later. The principle which works in time value of money is 'interest.
The techniques used to find out of the time value of money are:
(i) Compounding, and
(ii) Discounting.
Compounding:
An initial investment or input will grow over a period of time. The terminal value can be
seen as:
FV
FV (1 + i)n
FV = Future value
i = Interest rate
n = Number of years
PV = Present value
Thus, for example, Rs. 100/- placed in the savings account of a bank at 10% interest will
grow to Rs. 110 at the end of one year, since:
FV = P (1 + i)n
FV = Rs.100 (1 + 0.10)1 = Rs.110.00
At the end of two years, we will have:
FV = Rs.100 (1+ 0.10)2 = Rs.121.00
At the end of three years, we will have:
FV = Rs.100 (1+ 0.10)3 = Rs.133.10
This procedure will continue for a number of years. If these calculations are for longer
periods of time the problem of calculation arises. The compounded value of Re. 1 is
given in table and the compound value can be calculated easily with the help of this
table. For example, if it is required to find out the value of Rs.100 after 25 years at 10%
interest, the table will show immediately at a glance that the amount will be
accumulated to Rs.862.30.
Compounding Periods within One Year
In the above example, it is assumed annual compounding of interest or that interest was
only once a year but interest can be received every six months or quarterly. For
compounding within one year one should simply divide the interest rate by the number
of compounding within a year and multiply the annual periods by the same factor. For
instance, in the first equation:
Annual compounding: FV = PV (1 + i)n
The first equation would not change and the new equation will be:
Semi-Annual Compounding: FV = PV (1 + i/m)mn
where m is introduced for number of compoundings during the period. Suppose one
wishes to know how much Rs. 100 would accumulate at the end of 5 years at 6%
interest, the answer from the table and equation is:
FV = PV (1 + i)n
FV = 100 (1 + 0.006)5
FV = 133.8
Let us apply semi-annual compounding. The equation would be as follows:
FV = PV (1 + i/m)nm
FV = 100 (1 + 0.06/2)5 x 2
= 100 (1 + 0.06/2)10
= 100 (1+ 0.03)10
The semi-annual compounding of Rs. 100 at 6% interest for a two-year period is
illustrated in the following table:
Since m is the number of times per year when compounding is made, for semi-annual
compounding 'm' would be 2, while for quarterly compounding it would be 4 and if
interest is compounded monthly, weekly and daily m' would equal 12, 52, 365
respectively.
Future Value of a Series of Payments:
So far it is considered only the future value of single payment made at time 0.
Sometimes, one may have to find out the future values of a series of payments made at
different time periods. For example, if the following amounts are invested each year Rs.500, Rs.1000, Rs.2000 and Rs.2,500 in a saving bank for 5 years. If the rate of
interest is 10% what would be the total value of the deposit at the end of 5 years?
The future value of the entire stream of payment is 8,578.00. Rs.500 put in at the end of
first year compounds for 4 years and has a future value of Rs.732. Similarly, Rs. 1,000
deposited at the end of 2nd year compounds for 3 years and amounts to Rs. 1,331.
Rs.2,500 comes at the end of the 5th year and, therefore, the future value remains at
Rs.2,500.
Compound Sum of Annuities:
An annuity is a stream of equal annual cash flows. To find the sum of the annuity the
annual amounts must be multiplied by the sum of appropriate compound interest
factor. Such calculations are available in table which gives the compound value of an
annuity of Rs. 1 for N periods. Re.1 when deposited every year for five years at 10% will
give a value of 15.937 at the end of ten years. An example may be cited of an amount of
Rs.2,000 deposited at the end of every year for 5 years at 5% interest compounded
annually. The sum at the end of 5 years will be Rs. 12,000 x 51.660 = 6,19,82,000.
Present Values:
Present values can be thought of as the reverse of compounding or future values.
Present value can be found out in the following way:
Step 1 - Equation FV = PV(1 + i)n
Step 2 - PV = FV (1 + i)n
For example, how much should we deposit in the bank today at 24% interest in order to
have Rs.2200 after one year.
PV = 2000 / (1 + i)1
= 2000 x 0.806 = 1612
The Present Value tables are given in table for reference. Present values can not only be
considered as a single receipt but a series of receipts received by a firm at different time
periods. In this case present value of each future payment is required to be determined
and then aggregated to find the total present value of the stream of cash flows:
P = Sum of individual present values of the separate cash flows C1 , C2 , C3, Cn refers to
cash flows in time periods 1, 2, 3, ...n. Thus if IF1, IF2, IF3, IFn represent relevant
present value factors in different time periods 1, 2, 3 .. n, the formula can be more
practical oriented. Thus,
P = C1 (IF1) + C2 (IF2) + C3 (IF3) + + Cn (IFn)
= Ct (IF t)
Example: Now if the time value of money is 10% the following series of yearly
payments will be as calculated in table.
Thus, the Present Value can also be calculated with the help of the Present Values tables.
Thus, sum of annuity of Rs.100 at 10% discount = 3.791 in the annuity tables for the
value of Re. 1 multiplying it with the annuity amount 100 it is 379.1
Thus P = 100 (3.791) = 379.1
At any time the interest factor for the present value of an annuity is always less than the
number of years the annuity runs. In the case of compounding the relevant factor is
larger than the number of years the annuity runs.
Basic Valuation Models:
After considering the rudiments for taking the future or present value of a single lump
sum payment or annuities, there is now a need to develop a valuation model for the
bonds and shares of firms. The fundamental basis of value is the amount of returns.
Therefore, the value of the firm will depend on the expected returns measured in terms
of net cash inflows generated by the firm's assets.
Bonds with a Maturity Period:
When a bond or debenture has a maturity date, the value of a bond will be calculated by
considering the annual interest payments plus its terminal value using the present value
concept, the discounted value of these flows will be calculated.
By comparing the present value of a bond with its current market value it can be
determined whether the bond is overvalued or undervalued.
If V = Value of bond
I = Annual Interest (Rs.)
i = Required rate of interest (%)
P = Principal value at maturity
N = Number of years to maturity
While bonds carry a promise to maintain constant Re interest payment to maturity, I,
and pay a fixed Principal at maturity, P, the number of years to maturity, N, and the
required rate of interest, i, can vary.
The value of the bond can be determined in the following way:
Example:
If X purchases a 5 year Rs. 100 par value bond bearing nominal rate of interest at 6%
what should be willing to pay now to get a required rate of 8% to purchase the bond if on
maturity he will receive the bond value at par:
The value of the bond is Rs. 259.58 + 681.00 = Rs. 940.58. This implies that Rs. 1,000
bond is worth Rs. 960.51 today if the required rate of return is 8%. The investor should
not be willing to pay more than Rs.960.51 for the purchase of the bond today. Rs.960.51
is a composite of the present value of interest payments Rs.279.51 and the present value
of the maturity value Rs.681.00.
Bonds in Perpetuity:
In a perpetual bond there is no maturity or terminal value. The formula for calculation
of value of such bonds is:
V = Value of bond,
I = Annual Interest
i = required rate of return.
The value of the perpetual bond is the discounted sum of the infinite series. The
discount rate depends upon the riskiness of the bond. It is commonly the going rate or
yield on bonds of similar kinds of risk.
Example:
If a bond pays Rs.80 interest annually on a perpetual bond, the current yield is 9%?
The value of the bond is determined as follows:
V = I / i = 80 / 0.90 = 888.89
If the rate of interest currently is 8% the value of the bond is Rs. 1,000 and if it is 9% it is
888.89 and if it is 10% the value is 800. The value of the bond will decrease as the
interest rate starts increasing.
In the example both perpetual and short-term bonds are at Rs. 1000. When the rate
rises to 10% perpetual bond falls to 800, i.e., V = I/i = 80/10 = 800. The graph shows
how the long term bond and short term bond are sensitive and react to change with the
required rate of interest.
while the term bond will fall to 924.20. This difference between long and short term
bonds is true in all situations, even if the risk of default is known to be similar on two
bonds.
Yield on Bond:
The discount rate or capitalization rate to be applied for bond valuation is generally the
current market yield. While finding out the value of the bond previously we assumed
that the discount rate is given.
If the coupon rate of interest on a Rs. 1000 par value perpetual bond is 8%. The bond's
market price is Rs.700. The current yield is calculated as 80 / 800 = 10%
Value of Preference Shares:
Preference shares give a fixed rate of dividend without a maturity date.
The value of preference shares as a perpetuity is calculated thus V = D / i
V = Value of Preference share.
D = Annual Dividend per Preference share
i = Discount Rate on Preference shares
Example:
A company sold its preference shares @ Rs. 50 last year. The discount rate at that time
was 8%. The company pays an annual dividend of Rs.4. This type of Preference Share is
currently yielding 6%. The value of the company's Preference share is calculated as V =
(4 x 100) / 6 = 66.67%
Yield on Preference Shares:
The yield on Preference share is calculated in the following manner:
i=D/V
Example:
If current price of a preference share is Rs 60 and annual dividend is Rs. 4 The yield on
Preference Shares is calculated as follows:
i = D / V = 4/60 = 6.67%
Common Stock Valuation:
Bonds represent constant and regular income flows with a finite measurable life and
preference stocks have constant return on their shares. The valuation of common stocks
is comparatively more difficult. The difficulty arises because of two factors:
(1) The amount of dividend and timing of cash flows expected by investors are certain.
(2) The earnings and dividends on common shares are generally expected to grow.
Present Value Approach:
The value of a common stock at any moment in time can be thought of as the discounted
value of a series of uncertain future dividends that may grow or decline at varying rates
overtime
The Basic Valuation Model
One Year Holding Period:
Common Stock Valuation is easy to start with when the expected holding period is one
year. In such case the rewards from a common stock consist of dividend plus market
value of stock at the end of one year.
Example
An investor buys a share at the beginning of the year for Rs. 100. He holds the stock for
one year. Rs. 5 in dividends is collected and the share is sold for Rs.130. The rate of
return achieved is the composite of dividend yield and change in price (capital gains).
The price at the end of the fourth year and all future prices are determined in a similar
manner. The formula for determining the value of the share today can be written as
follows:
It is obvious from the equation that the today's value of the share is equal to the
capitalised value of an infinite stream of dividends plus future market price of the share
at nth year.
Constant Growth:
If the dividends remain constant over a period of time, the equation will be
P0 = D / r
Example:
A company pays a dividend of Rs.6 annually if the capitalisation rate is 15%., price of
share today, using the above model:
(2)
The present value of the share is equal to initial dividend D1 divided by the difference of
the capitalisation rate and the growth rate (r g), a perpetual growth model is based on
the following assumptions:
(1) Relationship between r and g will be constant.
(2) The capitalisation rate must be greater than zero.
Share Valuation:
The following steps will indicate the value of a common stock of a firm:
Step 1: The present value of the share
A firm X has a cash dividend of Rs. 10 per share and an average growth rate of 2% per
annum in cash dividends. The required rate of return of an investor who wishes to
purchase stock is 10% per year. The Present Value of the share will be as follows:
The present value of share thus falls from Rs. 125 to Rs.72.70 when the required rate of
return is increased, i.e., more risk less value of the stock.
Evaluation of stock under changing growth conditions:
Assume that the growth rate is increasing at a rate of 9% instead of 2%.
(a) If P/E ratio is larger than V/E ratio the stock is overpriced. Investor should sellbefore price falls.
(b) If P/E ratio is smaller than V/E ratio, the stock is underpriced. Investor can hold.
(c) If P/E ratio is equal to V/E ratio the stock price is correctly valued. Prices are not
expected to change significantly.
Note: P/E ratio is also called 'Earnings Multiplier.
A company is expected to pay a dividend of Rs. 5 per share; the dividends are expected
to grow perpetually on a growth rate of 10%. The market capitalizes dividend at 12%.
The price of the share will be:
CASE: 1
BEST BUY
Three months after learning of the death of his uncle, Mahesh got letter from Digpaul &
Associates, Attorneys at Law, that reads in part as:
and therefore, you will receive from your uncle's estate the following securities:
These securities may be picked up by you or your representative at our office at any time
after December 31, 1992.
Mahesh was very pleased to be remembered in his uncle's will but was less than pleased
with a portfolio consisting of fixed income securities.
Being a young man with family responsibilities, Mahesh decided that he was more
interested in capital growth than fixed income. He called Lal & Co., his broker, and
asked for some advice. In response he received the following letter:
I am delighted to hear of your good fortune and of your desire to invest in high quality
securities. May I suggest that you investigate Maharashtra Cement and Hind Petro, two
fine companies with excellent prospects for their common stocks? I enclose our recent
write-ups on each company. If you decide to invest in common stock, let me know and I
would be pleased to liquidate your fixed income holdings.
After looking over the prospects for the two companies, Mahesh has decided that either
company would suit his needs, provided it offered 24 percent before tax return on his
investment in the common stock. He has decided to liquidate his current portfolio and
invest in the firm whose stock is most realistically priced, if the stock also offers a return
of at least 24 percent.
Required
1. What is the current value of Mahesh's portfolio?
2. What are the intrinsic values of the common stock of Maharashtra and Hind?
9. Define industry analysis and bring out its relevance for selecting equity share for
investment?
10. How might one classify industries with in a business cycle frame-work?
11. What is cyclical industry?
12. What is the use of industry life cycle approach to an industry analyst?
13. Which stage of industry life cycle is most attractive from an investment?
14. What is the relationship between industry analysis and company analysis?
15. Chemistry of earnings provides readymade logic for Financial Analysis;
Comment.
16. In what way is ratio analysis an indicator of a company's health?
In stock market parlance, it is customary; to classify equity shares into the following
broad categories, blue-chip shares, growth shares, income shares, cyclical shares,
defensive shares, and speculative shares.
III. 1.CLASSIFICATION STRATEGY
Blue-chip shares
Shares of large, well-established, and financially strong companies, with an impressive
record of earnings and dividends are generally referred to as blue-chip shares. For
example, equity shares of ponds India Limited may be regarded as blue-chip shares.
Generally, blue-chip shares provide low to moderate current yield and moderate to high
capital, gains yield. Further, the price volatility of such shares tends to be moderate.
Growth Shares
Shares of companies that have a fairly entrenched position in a growing market and
which enjoy an above average rate of growth as well as profitability are characterized as
growth shares. For example, Reliance Industries Limited and Hindustan Aluminium
Limited may be regarded as growth shares. It may be noted that often growth shares are
also blue-chip shares. Growth shares generally provide a very low current yield and a
very high capital gains yield. Further, such shares tend to be fairly volatile.
Income shares
Shares of companies that have fairly stable operations with relatively limited growth
opportunities may be characterized as income shares. The equity shares of power supply
companies and tea companies for a long time were regarded as income shares. Such
shares typically provide a very high current yield and a very low capital gains yield.
Cyclical shares
Shares of companies that have a pronounced cyclicality in their operations are referred
to as cyclical shares. Shares of shipping companies for example, are regarded as cyclical
shares. Such shares provide a low to moderate current yield and a highly variable capital
gain yield. Obviously such shares tend to be highly volatile.
Defensive shares
Shares of companies that are relatively unaffected by the ups and downs in general
business conditions are referred to as defensive shares of food and beverage companies,
for example, maybe regarded a defensive shares. Such shares generally provide
moderate current yield and moderate capital gains yield. Further, they are relatively
stable.
Speculative shares
Shares that tend to fluctuate because there is a speculative trading in them may be
characterized as speculative shares. These shares periodically catch the fancy of bull and
bear operators who may resort to frenzied speculative trading in them.
Two points need to be stressed about the classification attempted above:
(a) It is an indicative classification. Hence, it should not be regarded as very rigid
and straitjacketed.
(b) It is not meant to pigeonhole every share exclusively into one of the six
categories delineated above. In fact, many shares may fall into two (and a few even
into three) categories.
Peter Lynch's Classification:
There are different ways of classifying stocks. Here is Peter Lynch's classification of
companies (and by derivation stock).
Slow growers: Large and ageing companies that are expected to grow slightly faster
than the gross national product.
Stalwarts: Giant companies that are faster than slow growers but are not agile
climbers.
Fast growers: Small, aggressive new enterprises that grow at 20 to 25 per cent a year.
Cyclicals: Companies, whose sales and profits rise and fall in a regular, though not
completely predictable, fashion.
Turnarounds: Companies which are steeped in accumulated losses but which show
signs of recovery. Turnaround companies have the potential to make up lost ground
quickly.
Asset plays: Companies that have valuable assets which have been somewhat
overlooked by the stock market.
There are two major categories of equity investment strategy: active and passive. Active
strategies involve attempts at picking undervalued stocks and by implication Placing
bets against the market consensus. Passive strategy is basically a buy and hold approach
to stocks.
Active Strategy:
In this, one reviews briefly a number of currently used active equity selection
techniques. The approach used by the analyst will vary depending upon the
methodology he favors. However, in this section and in the sections to follow, all the
techniques involve active involvement in the selection of the individual stocks for his
portfolio. After this brief review of a number of approaches one will, devote time to two
very widely used active equity selection techniques.
I. Growth-Stock Approach
The basic premise of the growth-stock approach is that those companies who have above
average earnings over a period of time will tend to produce stock values that will lead to
above average returns for the investor. Therefore, it is necessary for the analyst to select
those stocks that have historically had the highest above average earnings growth and
that he feels will also continue to have above average earnings growth. He must also be
careful to avoid selecting those stocks whose price already adequately reflects the high
historic or projected growth rates in the earnings of the firm. The stocks selected can be
small, medium-sized, or large companies. The size of the company alone is not
indicative of the historic or projected growth rates in earnings of the-company. Stocks
selected on the basis of high growth rates of high anticipated growth rates in earnings
tend to have high amounts of both systematic and unsystematic risk.
II. Undervalued Stock Approach
Managers seeking high yield, tend to look for companies that have either high dividend
yields, low market to book value ratios, or low price earnings ratios. In times of
economic uncertainity there tends to be an Increasing emphasis on seeking such high
yield investments. This stems from the desire to achieve high current income. This can
be accomplished through the holding of stocks that pay high current dividends. A
variation of this approach is often used by some analysts. This alternate approach is
called purchasing out of favor stocks.
Out of favor stocks tend to be stocks that have low P/E ratios. At various times in the
economic cycle certain stock groups - that is, stocks whose basic businesses are in
certain sectors of the economy - tend to be out of favor. For example, at a given point in
the cycle, may be automobile stocks or steel industry stocks are not popular. This means
investors shy away from owing these stocks because they feel the economic environment
is not conducive to solid business in these industries.
When this occurs and there are very few buyers around and may be lots of sellers, the
prices of these securities tend to drop; sometimes they drop way out of line with the
earnings of these companies. This then causes deterioration in their P/E ratios, and
when their P/E ratios become very low, these analysts jump in to buy the out of favor
stocks.
III. Small Capitalization Approach
In recent years, there has been a growing attraction of securities in smaller companies.
Traditionally, institutional investors have primarily sought the largest companies and
have shied away from the smaller companies and in the over-the- counter market.
However, in the 1970s and 1980s, many of these smaller-capitalization companies have
performed extremely well; thus a "new" approach is to seek investment in smaller
companies that have potential to, grow rapidly.
IV. Market Timer Approach
The portfolio manager who is a market-timer varies the proportion of certain types of
stocks in his portfolio depending on where he views the stock market to be at particular
time. He may vary the proportion of his portfolio in stocks versus bonds versus cash. He
may vary the proportion of stocks he holds in specific industries-for example, durable
goods sector stocks or consumer goods stocks. At certain times in the market he will
favour one of these sectors versus the other. Such a market-timer approach can then
either rotate the number of stocks in a portfolio or specific groups of stocks in a
portfolio.
These approaches can be called as active equity management strategies, because in each
case the analyst or portfolio manager is making affirmative decisions regarding the
securities selected based on his philosophy of investment
Passive Strategy
A passive approach to investing in stocks normally manifests itself in an attempt to buy
the market" - that is, acquire a representative cross section of the market for stocks.
The most popular way to achieve this has been by owning a representative sample. It is
not necessary to own all stocks. There are a number of mutual fund groups that offer
index based schemes which mechanically invest in a representative cross-section of
stocks underlying an index.
Index based funds have two main advantages. First, they provide investors with a
broadly diversified way to participate in the stock market Second, investment can be
done at less cost-lower brokerage and management costs-because stocks in index funds
are not actively traded. Computers do most of the work.
Index based funds have their limitations. Because passive implies that they are virtually
unmanaged, their performance will mirror the moods and swings of the stock market.
They look good in strong bull markets, but investors must be prepared for a scary- and
expensive-downhill seldom when the overall market slumps.
BOND TRADING STRATEGIES
Bond trading strategies of buy and sell presented below are based on the present value
concept. Present value theorem can be used as the basis of bond trading strategy.
Present Value Theorem One
The present value I or more future cash flows varies inversely with the interest (or
discount) rate used to calculate the present value:
Present value theorem I means that when market interest rates change bond prices react
by moving inversely. These price fluctuations are part of interest rate risk.
The key to putting present theorem I to profitable use is to be able to forecast the
movements of market interest rates. An aggressive bond trader who can forecast the rise
and fall of market interest rates can profit handsomely by buying when bond prices are
low (that is, when market interest rates are high) and selling when bond prices are high
(that is, when market interest rates are low). This chapter discusses tools that aid in
forecasting market interest rates. However, before examining these tools, one should
review present value theorem II, which can be used profitably along with present value
theorem I.
Present value theorem II can also be adapted to suggest a profitable refinement in the
buy-low-and-sell-high trading strategy.
Present Value Theorem Two
The interest-rate risk of an investment increases with the futurity of the investment's
cash flows. Stated differently, the present value of a bond varies inversely with the
interest-rate over a wider range as the length of time until the bond matures increases.
Present value theorem II means, essentially, that trading profits will be larger (or if the
interest rate forecast is erroneous, the losses will be larger) from trading in bonds with
long terms until maturity than they would be if short-term bonds were traded in the
same way. Thus, a bond trader who can correctly anticipate changes in market interest
rates can earn larger profits by trading long-term bonds than could be earned by making
the same trades using short-term bonds.
So far it is discussed only individual securities, but an investor cannot hope to achieve
all his objectives by investing in a single security. Hence, he has to manage a diversified
portfolio of securities.
Identifying Industries with Growth Potential:
An investor can identify the growth potential of an industry by the following analysis:
Statistical Analysis of Past performance
An Investor studies the relative change in the price index of an industry a compared
with the change in the average price index of all industries. (RBI publishes an index
number of share prices on a monthly basis. For this publication, RBI has divided the
industries into 24 main categories. So an investor can compare the change in the price
index of a particular industry to changes in the price indexes of all other industries. This
would pinpoint those industries that have been growing. However, an industry cannot
always remain a growth industry.
Assessment of the intrinsic value of an Industry
The Investor identifies the factors peculiar to the growth of a particular Industry.
Broadly, these factors are the inherent strength and weakness of the industry. Based on
such an analysis, the investor should consider the importance and impact of each factor
peculiar to a particular industry in the light of changing national and international
economies some such key factors are as follows:
For this, an investor has to consider the past record of the earnings of the company, the
share market price, dividend distribution issue of bonus shares, etc. Labour relations are
also a reflection on the management
On the basis of such analysis, an investor identifies the industries having a growth
potential. However, the next step is to identify one or two companies within the
industry, where investment should be made to meet his objectives. For company
analysis, an investor should study the size and ranking, growth record, profitability,
management expertise, etc. of each company i.e. its fundamental data and compare the
findings. If a particular company possesses a distinct advantage over other companies in
the industry, then that company may be more profitable than other companies in the
same industry. To illustrate, if a company's plant is located in a union territory in an "A"
Category backward area, then the company enjoys 15 years' sales tax exemption and
other backward area benefits. A plant may be located near the sources of raw material if
the cost of transportation would otherwise be very high.
A growth industry, therefore, is affected by changes in government policy, management,
national or international economies, etc. Therefore, an investor should always review
and analyze the changes taking place and estimate their effect on its profits.
- End Of Chapter -
LESSON - 10
SPECULATION IN SHARES
share, the price is bound to fall sharply, since the supply of the share increases in
relation to its demand.
Curbing speculation
The Stock exchange authorities have a variety of measures in their arsenal to choose
from, whenever they perceive the price movements are high in the market indicating
excessive speculation, with possibly high default risk.
Daily Margins
To begin with, they may impose a daily margin on the settlement trading of the
concerned security. The margin may be a percentage of the share price, or simply an
absolute amount on each share. It may be levied on the bulls as well as bears, i.e. on
both buy and sell transactions. Imposition of daily margin requires the buyer or the
seller, as the case may be, to deposit the margin money with the stock exchange
authorities (through the broker) on the basis of the extent of transaction being done by
him every day. For example, if the daily margin on a particular security is 20% on the
price of that security, a buyer of that security in the carry-forward market has to pay the
margin amount to his broker in order to have his order executed. The higher the degree
of speculation, the higher the margin. The margin acts as a cushion against possible
default of the speculators.
Carry over Margin
There may also be a carry-over margin, which is levied only if a transaction is carried
forward to the next settlement period. The purpose of the carry-over margin is to
discourage indiscriminate carrying forward of transactions and induce the speculators
to settle at least some of their transactions through actual deliveries. Daily margins and
carry over margins may also be levied simultaneously. Clearly, the requirement of
margin discourages the speculators who may be speculators beyond their means.
Regulating the settlement price
The stock exchange authorities may also influence the settlement price so as to reduce
the default risk. For example, let us assume that a particular high-priced security has
risen steeply during a settlement period, say from Rs. 1000 to Rs. 2000 and a large
volume say 10,000 of this share has been sold by one party to another during a
settlement period. Now, the seller will be called to pay the price difference of Rs. 1.00
crore. Since such a transaction being carried forward may in all likelihood be
speculative, the Executive Director of the exchange may decide to keep the settlement
price lower, say Rs. 1,500 rather than Rs. 2,000 thereby reducing the immediate liability
of the seller on account of the price difference to Rs.50 lakh, and thus reduce the
possibility of default by the seller against such a large payment. Needless to say, such a
move, while welcome to the seller, will be most unpalatable to the buyer.
The move may be regarded as an indirect way of levying a carry- over margin on the
buyers in a bullish market.
Transfer of Specified share to the cash category
Often, a share may be transformed from the specified list to the cash list, so that the
transactions on the share can no longer be carried forward. This implies that the buyer
has to pay 100% of the purchase price at the time of settlement. The security may be
restored to the specified list only after the speculative tendencies have subsided. A share
may also be reverted to spot trading, so that the buyer has to make full payment for his
purchase within 48 hours. Evidently, apart from reducing the risk of default, these
measures are intended to reduce the volume of trading so that the prices are brought
within a reasonable band.
Price bonds
The Stock exchange authorities may also resort to fixing of price-bonds outside which a
share cannot be traded.
Restriction on Trading Volume
The authorities may also levy a ceiling on the volume of the transactions which can be
carried forward on certain specific securities.
Restrictions on Carry-Forward Duration
There may also be a restriction on the length of time for which transactions can be
forwarded.
Restrictions of Forwardation and Backwardation Charges
The authorities may also intervene as and when necessary to regulate the forwardation
and backwardation charges, etc.
Suspension of Trading
In more serious cases, the very trading in a security may be suspended till such time the
crisis is resolved.
Other Exceptional Measures
Exceptionally, settlement trading itself may be suspended altogether or the very stock
exchanges closed to cool of the heat in the market.
Understanding the implications of such measures by the stock exchanges enables an
investor to tread with greater care in a market place where every twist and turn may
have surprises in store. The very anticipation of such measures in the market can
influence the share prices and knowledge of such possibilities prepares an investor to
brace himself up better for the jolts.
Distinction between Investor and speculator
It is difficult to draw the line of distinction between investment and speculation;
however, it is possible to broadly distinguish the characteristics of an investor from
those of a speculator as follows:
III.6. TIMING
The secret of success in investment is when to buy and sell rather than what to buy and
sell, as nearly all shares tend to move upwards in price during a "bull" market and
downwards in a "bear" market. All investors would like to buy at the bottom of a bear
market and sell, or "go liquid" at the top of a bull market.
For the personal investor the difficulty lies in knowing when the top or bottom has been
reached. Although bull and bear markets regularly follow each other their duration and
amplitude; are not consistent enough to discern a regular pattern.
Selection, timing and price constitute the core of the investment process. Of the three,
selection is perhaps the earliest. Almost all the information and advice in the investment
business heavily oriented towards helping one makes his purchase decisions. As a result
one will find it easier to select a suitable share, evaluate its investment worth and fix a
price on it, but one will find it very difficult to forecast short-term favourable and
unfavourable price movements. This is because day to day, week to week price
fluctuations reflect psychology and reflex reactions to 'spot' news rather than reason,
logic or basic economic trends. Therefore, investment timing is a more difficult task
than investment selection.
There are no hard and fast rules which can help the right decisions on when to buy and
when to sell. Good investment timing is an art which involves an understanding of
individual and mass psychology and an ability to outguess the day to day twists and
turns of market behaviour. It cannot be picked up overnight. It can only be acquired
over a period of time through experience and actual involvement in regular stock market
operations.
This is why, unless one has an intuitive flair for predicting short-term price fluctuations,
one would be better off if he base his investment strategy on selection rather than on
timing. Automatic trading systems and mechanical investment formulas are designed to
do precisely this-they shift the emphasis from timing to selection. Buy and hold
strategies and other long-term investment strategies also rely heavily on selection rather
than timing. Almost all of them advocate a blend combining judgment based selection
decisions with an unthinking application of mechanical rules and techniques for
handling timing decisions.
Though investment timing is as important as investments selection, the negative impact
of bad timing decisions sometimes can be more than made up through superior
investment selections. But this does not mean that one can ignore investment timing
altogether. No investor can afford to do this because to get really superior results he will
have to learn to combine good selection with good timing.
Some useful tips for timing one's buy.
1.
i.
ii.
iii.
iv.
One should never buy a share at a price that is equal to or higher than the share's
peak price in the previous year.
Under normal conditions (when the stock markets are neither rising nor falling
rapidly) investor should try to buy the share at a time when its price is hovering
between the previous year's lowest and average price.
In a rapidly rising market, one can safely buy the share at a price which is equal
to, or a little higher than, its previous year's average price.
Investor should not buy a share at a price that is more than 10 per cent higher
than the share's average price in the previous year.
2. Investor should not buy shares in a falling market. Wait for the fall to be
completed, and share prices to stabilize at their lower levels, before buying.
3. One should not buy a share at a time when everybody is recommending it or
when it is in the limelight. Chances are that he will be buying an overpriced share.
Wait for the publicity to die out, and share prices to fall before buying it. The
other appropriate time to buy the share would be in the early stages, when the
publicity on the company is building up and the company is not fully exposed to
the glare of publicity.
4. One should not buy a share immediately after a steep rise in its price. A steep rise
is usually followed by a steep fall; the steeper the rise, the greater the subsequent
fall. When share prices fall, they usually retrace about one- third to two- thirds of
the price range covered by the early rice. Thus if the price of a share rises from
Ks.30 to Rs. 45, then the subsequent fall its price will probably drop to about
Rs.35 to Rs.40 per share. This is the appropriate time and price range for buying
the share.
5. A sharp fall in prices offers opportunity for buying, provided investor is confident
that the fall in prices is purely temporary and that the future outlook of the
company is promising enough to ensure that the subsequent rise in price will go
far beyond the level from which it earlier fall.
6. If one has a promising growth share in mind, and only looking for an opportune
moment and price for buying it, then the best time to do so would be around the
middle of its accounting year.
7. Share prices usually record a sharp rise just before an expansion project of a
company goes into commercial production. One should do buying a month or so
before this happens. On the other hand, if one is a seller one should sell a couple
of months after the plant goes into commercial production so that one can take
full advantage of that price rise.
8. Companies often issue press-releases about their expansion plans, diversification
plans, plans to issue better-selling new products, rising order book position and
proposals to issue bonus shares, rights shares, rights convertible debentures etc.
News of this nature has a bullish effect on share prices. Therefore, if one wants to
buy shares in such a company should not delay placing a buys order with broker.
Ideally it would be best if he buy the shares on the same day as the news item first
appeared in the newspapers. The same rule should be followed when companies
release their half-yearly working results to the press, indicating improved
performance.
9. Buying a share immediately on receiving a favourable news item is a good timing
decision. It works most of the time. But it is even better, if one can buy in
anticipation of a favourable news item or in anticipation of a favourable market
development.
Time to Sell
When to sell is always a more difficult decision than when to buy there are basically two
reasons for this. First, the best time to sell usually coincides with a stock market boom.
This is also the time when there is great reluctance to sell for share prices are rising fast,
emotions run high and there is a general widespread feeling of optimism and cheer. In
such circumstances it is very difficult for an investor to take a cool, calculated and
objective 'sell' decision. Secondly, there is far greater emotional involvement in a 'sell'
decision than in a buy decision. It is therefore very difficult for an investor to stand apart
and take a cool, calculated selling decision. What are these emotional Involvements? If
one knows them one will be able to take a more logical and rational attitude to selling
decisions.
(i) They develop strong emotional attachments to their shares; they are attached to
their houses, land, furniture, jewellery, car etc. Some shares, particularly those
belonging to high- growth," well managed, blue-chip companies, are often treated
as valuable family heirlooms to be passed on from generation to generation. The
ideal of selling such shares normally meets with strong family disapproval and
resistance.
(ii) When the investor makes a mistake in his initial choice of the share, they do
not want to admit, that they have made a mistake. Hence, they avoid taking a
selling decision. This reluctance to sell is more pronounced in those cases where
the investor has openly advocated the merits of the share to his friends. In fact,
most people make mistakes most of the time-yet they all make money this is
because stock markets provide big margins for errors According to Bernard
Baruch, 'if the speculator is correct half the time, he is hitting a good average.
(iii) The desire to break even prevents an investor from selling a share on which he
has incurred losses. Break even can be very expensive because the price of the
share may take a long time to recover. In fact, in some cases the desire to break
even may involve a long wait. Meanwhile, his funds are tied up in a virtually dead
investment. A share is either worth selling, or worth holding at a given price. The
subjective desire to break even should have nothing to do with the decision to
either sell or hold a particular share, which should be taken coolly on an objective,
unemotional analysis of the facts of the case. Breaking even can only give
emotional satisfaction and a sense of relief, not hard money.
(iv) Sometimes an investor's reluctance to sell can be directly attributed to a
reluctance to pay capital gains tax. Barring a few exceptions, tax considerations
should never be considered to influence basic selling decisions. If the time has
come to sell a particular share, then one should sell it, pay one's capital gain tax,
and re-invest the residual amount in more promising scrip.
III.7. Active Shares
Shares in which there are frequent and day-to-day dealings are called active shares.
Most shares of leading companies would be active, particularly those which are
influenced by economic and political events and are, therefore, subject to sudden price
movements. Some market analysts would define active shares as those which are bought
and sold at least three times a week. Easy to buy or sell.
III.6. Reasons for fluctuations in prices
Sometimes the market price of a share may fluctuate widely because of unrelated
factors. This is because the everyday price of an equity share is subject to a host of
factors. When the share market is sensitive, a slight change in any of these factors will
affect the market sentiment. Such factors which together go to determine the price of a
particular equity share may list as follows.
A. Vls-a-vis the company
The strength and weaknesses of the industry to which the company belongs.
The opportunities for, and the threats against the industry to which the company
belongs.
Takeover Bid
The price of a share may rise when there is a takeover bid resulting in large quantities of
that share being bought in the market. Once the knowledge of such takeover bid
becomes public, a whole lot of other investors join the spree, so that the price of the
share is pushed up further.
Insider Trading
There may be unusual buying or selling activity in the share of a company on account of
inside information, such as a Company's plan to enter into a profitable collaboration
with another company. This fact is bound to be known to some senior members of the
company's management much ahead of the general public. Thus, based on this inside
information, such members may indulge in heavy speculative buying of their company's
shares, hoping to sell the shares when the information about the collaboration becomes
public and the price of the company's shares rises. Presently, SEBI is engaged in
developing suitable laws to check insider trading in India.
- End Of Chapter -
LESSON - 11
BARGAIN HUNTING
Many neophytes buy stocks which are expected to rise. Speculators use the technique of
short selling to capitalize the downward' movement in stock prices. The broker/dealer
demands cash deposit from customer to meet debt balances in their margin accounts.
Meaning: Short selling is the sale of a security that is not owned at the time of the
transaction.
People sell short to make profit. They hope their purchase will be lower than their sale
proceeds, thus the difference is their profit. Sometimes expenses will be more than
precede thus the difference represents the loss. Investors involved in short selling and
creating artificial supply.
Short-sale transactions are ever mindful of protecting the lender's rights and privileges.
First, the lender is entitled to cash collateral equivalent at all times to the market value
of the shares loaned. For example, suppose that 200 shares of a stock were sold short
Rs.100. The lender is entitled to receive the Rs.20000/-, in proceeds as collateral for the
loan. Moreover, as the price of the shares rises or falls subsequent to the short sale, this
collateral must be adjusted. Should the shares rises from Rs.200 to Rs.210 say it is
necessary for the borrower to advance an additional Rs.2000 to the account of the
lender? Similarly, if the stock falls from Rs.100 to Rs.90, the lender must remit Rs.2000
to the borrower. This process is referred to as marking-to-the-market". The lender
always has a 100 percent collateralized loan.
Change:
Should the lender decide to sell his shares, another lender must be found if the short
seller intends to maintain his short position. This is frequently a simple book keeping
transfer. Thus, shares can be borrowed with no time limit. The lenders simply change,
Privileges:
The lender is entitled to all the privileges of ownership even though physical possession
of certificates has been surrendered. The short seller is ultimately responsible also for
protection of the lender's interest in the receipt of interest or dividend payments as well
as voting rights. The borrower must send the lender a check in the amount of any
interest or dividends paid by the issuing corporation since such payments are now being
made directly to a new holder of record (the part buying the shares from the short
seller).
Votes
Short selling cannot create more votes than actually exist. If the lender insists on casting
a proxy, the seller's broker merely allows the use of another, more disinterested
customer's right.
Risky
Short selling is risky. It should be noted that the most that can be lost (ignoring taxes
and commissions) on a buy (going long) is the sum paid. The loss is limited to 100
percent of the investment. However, there is no such finite limit on the loss that can be
sustained on a short sale, for theoretically, the stocks price can continue to rise
indefinitely. As a practical matter, an investor can prevent this occurrence by the
judicious use of stop orders. This also points out the very speculative nature of this form
of short-sell order, and why it is recommended for use only by more sophisticated
investors.
Against the box
There are several uses of sell-short orders that have come to be called short sales
against the box. These are situations in which the investor going short already has a
long position in the same stock. The "box" in the expression refers to the fact that the
stock certificate is so to speak, in hi safe deposit box.
Tax management
Shorting against the box can be used for tax purposes for hedging or insurance
purposes, and for convenience in delivery of the actual shares. In the first instance, the
investor may want to avoid earning any more capital gains in a given tax year. By
shorting against the box, he can guarantee a certain profit and postpone taxes for a year.
For example assume that one owns 100 shares of XYZ with a December market price
Rs.30 per share. Whose cost was Rs.20 per share; thus his profit is Rs. 1, 000. However,
one would rather earn the Rs.1,000 and be taxed on it, in the following year. So he goes
short XYZ at Rs.30 in December. The following year, perhaps in January, one delivers
the XYZ shares he owns long and closes out the short position. Thus both positions
(short and long) are closed, the Rs. 1,000 profit is retained, and the taxes are deferred to
the next year.
Suppose that one has a Rs. 1,000 profit from a long position in 100 shares of ABC
however, it is December, and for tax reasons he does not wish to take profit in this
calendar year. Assume that ABC is now trading at 60. He can short 100 ABC against the
box. If ABC rises to 70 next year, he will profit an additional Rs.1,000 on the long
position. Conversely, if ABC drops to 50, his Rs. 1,000 profit on the short position will
be offset by a loss of the same amount in the original long position (again ignoring
transaction costs). The merit of this technique is simply that his Rs.1,000 profits has
remained intact and yet has been transferred into a more favourable tax year. This
technique does not allow one to extend a short-term gain into a long-term gain.
Hedging purpose
This technique also is used to hedge or ensure a position about which the investor is
unsure and insecure. Suppose that one owns ABC but feel it may decline from its current
level. On the other hand, for some reason he does not want to sell out his position. One
way of handling this dilemma is to short the security against the box. If the stock's price
declines, as was thought possible, the profit on the short position will exactly offset the
loss on the long position (ignoring commission and taxes). Thus one ensures against the
decline.
Conversely, if the stock's price rises, the gain on the long position will be offset exactly
by the loss on the short (again ignoring commission and taxes). Obviously, if one knows
what was going to happen and had no qualms about closing out his position, this
technique would not be necessary, for in both cases profits would have been greater
without the short. In the former case, an outright sale followed by a new long position at
a lower price would have increased profits, and in the latter case, merely maintaining
the long position would have increased profits.
Delivery of Securities
Finally, shorting against the box can be used to facilitate delivery of securities. For
example, investor is out of town on a business trip or vacation and wishes to dispose of
his holdings, but he will be unable to get the stock certificate to his broker within the
allotted time. He can call his broker, sell the stock against the box at the current price,
thus ensuring the desired sale price, and deliver his stock (held long in safe deposit box)
upon return from his trip.
Shares which are more stable than others, and tend to fall less in a bear market,
providing a safe return of the, investor's money are called defensive shares, BLUE
CHIPS fall in this class.
Characteristics of defensive shares
The volatility of a share is expressed in terms of its beta co efficiency. The rate of return
on a share (dividend income plus capital gains expressed as a percentage of the opening
market value ) for successive periods is plotted on one axis of a graph, and the return on
a share index representing the average performance of a large number of shares on the
other axis (see fig.). The slope of the line, defined as the beta coefficient, measures the
volatility, or riskiness, of the share relative; to market as a Whole. Fig. makes it clear
that company A's share price is much less volatile than that of Company C. A is said to
be a defensive share and C an aggressive share. The volatility depends on both business
and financial risk. It is not only important how much the share price moves up and
down, but also what extent it does go together with, or independently of the stock
market as a whole. The greater the degree of independence the better as far as risk
Fixed--income investments
Gilt-edged securities
Company loan stocks
Variable--income investments
Ordinary shares
Unit trusts
Preference shares
There are such important differences between the securities within these groups,
however, that such a division is sometimes a hindrance to understanding. Preference
shares, for example, generally produce a fixed income but the security itself
fundamentally has more in common with ordinary shares since preference shares are
part of the share capital and are not a loan. Many trusts consist of holdings of ordinary
shares but because there is a spread of investment with the intention of eliminating
severe fluctuations in prices - unit trust income tends to be more stable than the typical
ordinary share.
Selection of Fixed Income Securities
One should carefully evaluate the following factors in selecting fixed income avenues.
Yield to maturity
The yield to maturity for a fixed income avenue represents the rate of return earned by
the investor if he invests in the fixed income avenue and holds it till its maturity.
Risk of default
To assess the risk of default on a bond, one may look at the credit rating of the bond. If
no credit rating is available, examine relevant financial ratios (like debt-to-equity ratio,
times interest earned ratio, and earning power) of the firm and assess the general
prospects of the industry to which the firm belongs.
Liquidity
If the fixed income avenue can be converted wholly or substantially into cash at a fairly
short notice, it possesses liquidity of a high order.
GUIDELINES FOR INVESTMENT IN FIXED INCOME SECURITIES
The important guidelines for investments in fixed income avenues are as follows:
1.
2.
3.
4.
5.
The rate of return, consisting of rental income (or rental saving) and capital
appreciation, is very high (capital appreciation, of course, dominates the rental
income).
The risk exposure is virtually negligible. Property values in India have been
moving upwards. Hence, investment in a residential house does not have any
downside risk associated with it.
As residential house provides significant tax shelter in the long run. For wealth
tax purposes, the value of a residential house is reckoned as its historical cost and
not the current market value.
Loans are available from various quarters for buying/constructing a residential
house. Further, interest on loans taken for buying/constructing a residential
house is tax-deductible within certain limits.
Even though there may be initial hassles when a residential house is
bought/constructed, in the long run it requires very little monitoring.
Ownership of a residential house provides psychic satisfaction which other forms
of investment may not offer.
(a) The higher the wealth position, the smaller should the assured sum be. In the
extreme, if one has enough wealth to take care of his family, he better to avoid life
insurance.
(b) The greater the earning capacity of his family members, the smaller should the
assured sum be.
(c) The greater the preference for current consumption over future consumption,
the smaller should the assured sum be.
Tax Shelters
The important tax shelters available in India are as follows.
1. Under Section 88 of the Income Tax Act, there is a tax rebate of 20 per cent in
respect of life insurance premium payments, contributions to recognized
provident fund and public provident fund schemes, etc.
2. Under Section 80L of the Income Tax Act, income up to Rs. 13,000 in the
following forms is tax exempt: interest on bank and post office deposits, equity
dividend, dividend on units/shares of mutual fund schemes, interest on public
sector bonds, and so on.
One must plan to avail of these tax- shelters fully. If due to inadequacy of income and/or
savings are cannot fully exploit these tax shelters, one must focus his attention
selectively on those tax shelters which are more relevant to his needs and circumstances.
Some suggestions in this regard are as follow:
If one wants to augment one's tax-exempt current income he should put greater
emphasis on (a) public sector bonds; (b) units of Unit Trust of India; (c) units of various
other mutual funds which enjoy Section 80L benefit; and (d) equity shares, which
provide a higher current yield.
If one wishes to reduce one's tax liability be should deposit or invest in (a) a recognized
provident fund scheme and/or the public provident fund scheme; (b) the tax savings
schemes of mutual funds floated by financial institutions; (c) the 6-year National
Savings Certificate VIII Issue; (d) recurring investment schemes (like ULIP), (e) life
insurance policy, and (f) the National Savings Scheme.
While in the short and intermediate term one may focus selectively on some aspects of
tax shelters relevant to one's needs and circumstances, one's long-term objective should
be to avail of all the tax shelters fully.
(a) Enjoy a tax-exempt current income of Rs 13,000 from one's investments under
section 80L;
(b) Reduce ones tax burden by Rs 12,000 under Section 88.
Judicious choice
The most popular forms of fixed income avenues in India are:
1.
2.
3.
4.
5.
6.
7.
8.
9.
While the above matrix provides broad guidance, here are some specific suggestions:
1. If investor is seeking to reduce his tax liability in the long run, he should deposit
in a recognized provident fund scheme and/or public provident fund scheme.
Investment in provident fund schemes offers several advantages: (a) initial tax
advantage; (b) continuing tax advantage; (c) facility for partial withdrawals; (d)
attractive rate of return; and (e) immunity from attachment of a court decree.
Given these advantages, it is a boon to the bulk of the investors. Hardly any other
form of investment offers such attraction. Hence, it should be accorded a very
high priority in one's scheme of investments.
2. Give preference to income-oriented units and public sector bonds if he is looking
for a tax-sheltered current income. They offer attractive rates of return compared
to other fixed income avenues carrying 80L benefits.
3. Invest in good convertible debentures. Due to some peculiar reasons, convertible
debentures, in general, sell for a price lower than the market value of the
underlying equity. Yet, till the conversion takes place, the interest income on
them is higher than the dividend income provided by the underlying equity.
Given this anomaly of the Indian stock market, it makes sense to buy convertible
debentures.
4. Consider investment in nonconvertible debentures, Indira Vikas Patras, and
corporate fixed deposit schemes under two broad circumstances.
a. when one's taxable income is less than Rs 40,000; and
b. When investor exhausted the limits for various tax sheltered investments.
5. While evaluating non-convertible debentures consider the following factors:
a.
b.
c.
d.
Yield to maturity
Credit-rating
Maturity period
Buy-back facility
6. One should look at the following factors before making a fixed one should
deposit with a company.
a.
b.
c.
d.
2. The prices of gold and silver rarely decline (or decline only marginally) though
the appreciation may be somewhat erratic.
3. There appears to be an inverse correlation between the returns from gold and
silver and the returns from equities. Hence, a modest commitment to gold and
silver will help him in reducing the overall risk of one's portfolio.
4. It is fairly convenient to buy and hold gold and silver bars. (It must be
emphasized that investment in gold and silver ornaments, should be avoided).
FIXED INCOME SECURITIES IN CORPORATE SECTOR PREFERENCE
SHARES
Preference shares represent a hybrid security that par-takes some characteristics of
equity shares and some of debentures. The salient features of preference shares are as
follows:
1. Preference shares carry a fixed rate of dividend. The maximum rate of dividend
payable on preference shares was 14 per cent per annum. This has now been
relaxed.
2. Preference dividend is payable only out of distributable profits. When there is an
inadequate profit, the question of paying preference dividend does not arise.
3. Since dividend on preference shares is cumulative, dividend skipped in one year
has to be made up subsequent year.
4. Preference shares are redeemable - the redemption period is around 12 years.
Cumulative Convertible Preference Shares
'Cumulative Convertible Preference' (CCP) shares were introduced in 1985. This
instrument is issued as preference share carrying a dividend rate of 10 per cent. The
preference shares are compulsorily convertible into equity shares between three years
and five years from the date of issue.
The salient features of CCP shares are: (i) Only public limited companies are entitled to
issue CCP shares, (ii) The CCP shares must be listed on one or more recognized stock
exchanges in the country. (iii) The funds raised from CCP shares should be applied
towards setting new projects, expansion or diversification of existing projects, normal
capital expenditure for modernization, and working capital requirement.
This instrument, however, has proved to be a non-starter so far on account of certain
limitations (i) it does not provide any benefit under the Income Tax Act. (ii) It
represents an expensive source of finance for the company.
CONVERTIBLE BONDS (DEBENTURES)
A convertible bond is that may be compulsorily or optionally converted into equity
shares in future. The general features of a convertible bond include the conversion ratio,
conversion price, conversion timing, and conversion value.
Conversion Ratio
It is the ratio in which a convertible bond can be exchanged for equity shares. For
example, XYZ Company has an outstanding convertible bond with Rs 500 par value that
is convertible into 50 shares. Hence, the conversion ratio is 50.
Conversion price
It reflects the per share price effectively paid for equity shares as a sequel to conversion.
It can be obtained by dividing the par value (not the market value) of the convertible
bond with the conversion ratio. For example, the conversion price for the convertible
bond of XYZ Company is Rs 10 (500/50). Implicit in the conversion price is the
conversion premium. It is simply the conversion price, less the par value. Thus, the
conversion premium for the convertible bond of XYZ Limited is (Rs 10-Rs 10).
Conversion timing
The convertible bonds are often convertible only during a specified period which is
referred to as the conversion timing. For example, the conversion may be effected after
24 months and before 27 months from the date of issue.
Conversion value
The conversion value is the value of a convertible bond as represented by the market
value of the equity shares into which it can be converted. It is obtained simply by
multiplying the conversion ratio by prevailing market price of the firm's equity.
With the enactment of SEBI Act in 1992, the rules of the game applicable to convertible
bonds have changed. As per SEBI guidelines:
The conversion premium and the conversion timing shall be predetermined and
stated in the prospectus.
Any conversion, partial or full, will be optional at the hands of the bond holder, if
the conversion takes place at or after 18 months but before 36 months will from
the date of allotment.
A conversion period of more than 36 months will not be permitted unless
conversion is made optional with put and call options.
Compulsory credit rating will be required if the conversion period for fully
convertible bonds exceeds 18 months.
SAVINGS CERTIFICATES
Issued by the post offices, savings certificates are a part of the small saving schemes. The
important savings certificates are:
3. Premature encashment of KVPs is permitted after two and a half years of issue,
according to a certain schedule. If KVPs are en-cashed prematurely, the effective
interest is lower.
GOVERNMENT SECURITIES
Securities issued by the central government, state governments, and quasigovernmental agencies are referred to as government securities or gilt-edged securities.
Three types of instruments are issued:
A promissory note, issued to the original holder, which contains a promise by the
President of India (or the Governor of a State) to pay as per a given schedule. It
can be transferred to a buyer by an endorsement by the seller. The current holder
has to present the note to the Government Treasury (or a designated authorised
agency) to receive interest and other payments.
A bearer security, where the interest and other payments are made to the holder
of the security.
Government securities have maturities ranging from 3-20 years and these carry interest
rates that usually vary between 9 and 13.5 per cent. Even though these securities carry
some tax advantages, they have hardly my appeal to individual investors because of low
rates of interest and long maturities. They are typically held by banks, financial
institutions, insurance companies, and provident funds mainly because of the statutory
compulsions.
MONEY MARKET SECURITIES
A money market security is a debt instrument that has a very short maturity. The
common money market securities in India are: treasury bills, commercial paper, and
certificates of deposit.
Treasury bills
A treasury bill is a short-term money market instrument issued by the central
government. Typically, it has a maturity period of six months. It is issued at a discount
and is repayable at par. Due to a very low rate of return, it has virtually no appeal for
individual investors.
Commercial paper
CASE: 2
CONSIDER THE FOLLOWING TWO INVESTMENTS
A U.S. Treasury bond that matures in 25 years and has a face value of Rs. 1000, a
coupon rate of 3.5 per cent, a current market price of Rs.770, and a yield-tomaturity of 5.15 percent
A share of common stock in a major steel corporation that pays Rs.1.7 annual
cash dividend and that can be purchased at Rs.38.50 per share
If you had Rs.770 to invest, would you rather buy the Treasury bond or 20 shares of the
common stock? What are the advantages and disadvantages of each investment?
Consider such factors as the different types of risks involved, the possible rates of
return, and the voice you would have in management. Write a management report,
assuming a current financial position, future financial forecast, emotional temperament,
and income needs. In light of the position assumed, defend your investment decision.
CASE 3
THE ARCHER CORPORATION
For the Archer Corporation 10 percent is an appropriate discount rate to use in valuing
shares. Archer's normalized earnings of 2 per share are all paid out in cash dividends.
Per-share cash dividends have been growing at 3 percent per annum for some time, and
the current market price of 28.60 reflects this growth. However, because of a
technological breakthrough, Archer's earning is expected to grow at a rate of 6 percent
per year in the foreseeable future. What effect do you think this technological innovation
will have on Archer's market price per share when the news becomes public? Explain.
QUESTIONS
1. Elaborate Investment strategies relating to corporate Securities.
2. What alternative stock-selection techniques being offered for successful portfolio
management?
3. Explain present value theorems in Bond trading activities.
4. What are the Prime characteristics of Growth Shares?
5. Suggest measures to identify growth potential.
6. Distinguish speculation, Investment and Gambling
7. Suggest steps to detect speculation.
8. What are the peculiar qualities of Investor?
9. What factors affect market price of shares? Explain
10. Highlight the importance of Timing in stock market operation and suggest
measures with time relevance to sell and buy shares.
11. What are defensive shares? And explain their characteristics.
12. Suggest method of selecting fixed income securities.
13. Give guidelines to invest in fixed income securities.
References:
Kuhn, R.L. (1990) (ed); Corporate and Municipal Securities, Vol. III of the Library of
Investment Banking, Homewood, III., Dow Jones - Irwin.
Bernstein, P.L. (1977) (ed), Theory and Practice of Bond Portfolio Management, New
York, Institutional Investor Books.
Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing Industries and
Competitors, New York, the Free Press.
S.K. Barua, et.al., Tata McGraw-Hill Publishing Company Limited,New Delhi, 1992.
Homer, Sidney, and Martin L. Leibowitz, inside the Yield Book: New Tools for Bond
Market Strategy (Englewood Cliffs, N.J.; Prentice-Hall; New-York: New York Institute
of Finance, 1972).
Cootner, Paul, ed., The Random Character of Stock Prices (Cambridge, Mass.: M.I.T.,
1964).
Kishore Shah, Pinki Shah, Atul Doshi, "How to Invest well", Tata Mc Graw-Mill
Publishing company Limited, New Delhi, 1990.
R.G. Winfield, S.T. Curry, Success in' Investment, John Murray (publishers) Ltd.,
London WIx4BD, 1981.
Rowlatt, J.: Guide to Savings and Investment. Pan (London, 1979).
Smith, A.: The Money Game, Pan (london, 1970).
Duthy, R.: Alternative Investment, Michael Joseph (London, 1978).
Ellis, Charles D. "Ben Graham: Ideas as Mementos". Financial Analysts Journal (JulyAugust, 1982), p.41.
Fabozzi, F.J., and T.D. Fabozzi, Bond Markets, Analysis and Strategies. Englewood
Cliffs, N.J.: Prentice Hall, 1989.
Amiling, F. 1984, Investment - An Introduction to Analysis and management, 5th ed.,
PHI, New Delhi.
Graham, Dodd, Cottle: Security Analysis, Mc Graw Hill (fourth edition) USA. 1962.
5. Shifts in demand and supply can be detected with the help of charts of market
action.
6. Analysis of past market data can be used to predict future price behaviour.
Job of Technical Analysis
Price action of stock incorporates all the insider information. This includes
manipulations within a company, the performance of the management, the hopes and
the fears of the investor, the policies of the Government, the economic conditions, etc.
Technical Analysis makes meaningful studies of this price action.
It brings order into a seemingly disorderly movement of prices. It highlights the hidden
features in the price movements and lay bare the way the market is behaving and might
behave in future. One will see from the description given later on, that the technical
indicators used in technical analysis are based on many different components of the
price movement.
This analysis of internal structure unfolds the insider action and brings to the fore the
true picture. The cobwebs of rumours, differing opinions, and interested comments of
the press are swept away. The investors are steered away from the crowd and are
directed towards that strategy they should follow to win.
Thus that technical analysis may be useful in timing a buy or sell order while
fundamental analysis may help in identifying undervalued or overvalued stocks. It is
perhaps for this reason that technical analysis is frequently used as a supplement to
fundamental analysis rather than as a substitute for it. The two approaches, however,
differ in terms of their data bases and of focus analysis. While fundamental analysis
focuses on macro and micro and qualitative and quantitative analysis, technical analysis
is focused on market and individual stocks and uses quantitative analysis.
The technician views price changes and their patterns mainly through price and volume
statistics, His bag of tools comprise charts and other indicators.
Fundamentalist, on the other hand, uses detailed economy, industry and company data
and information and makes use of accounting and statistical techniques.
Price determination
Technical analysis has an important bearing on the study of price behaviour in
predicting and significant price behaviour.
The technical school of thought has developed its own theory for determining the
behaviour of stock prices. The fundamental school of thought gave great weight-age to
the intrinsic value of the share. Intrinsic value is different for each investor and to find
out the intrinsic value the fundamental analysts undertakes financial statement analysis.
This gives them an insight into the performance of the company and helps to identify its
efficiency and profitability. Further, analysts have to evaluate it with other companies in
the same industry. The technical school of thought believes that it is a waste of time to
look into the intricacies of the internal management of a firm. According to them, prices
are determined in the following manner.
a. Prices of securities are determined by the demand and supply of securities in the
market. Demand and supply of securities are considered to be the essence of the
changes in security prices.
b. Technical analysis is a method of presenting financial data of the past behaviour
and to find out the history of price movements and depict these on a chart.
c. The charts have a method of predictions of significant price movements, project
meaningful patterns and the practical applications of these patterns help in
determining future prices.
d. Typical charts are made for making prediction about a single security.
e. Charts are used to find out the total spectrum of the market.
f. Charts determine the individual security prices and show the total market index.
Assumptions of Technical Analysis
The technical school of thought has the following certain assumptions.
1. The market value of a security is related to demand and supply factors operating
in the market.
2. There are both rational and irrational factors which surround the supply and
demand factor of a security.
3. Security prices behave in a manner that their movement is continuous in a
particular direction for some time.
4. The movement of security prices if going upward will continue to do so for a
while barring certain minor fluctuations in stock prices.
5. Whenever there are shifts in demand and supply, they can be detected through
charts prepared.
6. Recorded patterns are used by analysts to make forecasts about the movement of
prices in future.
Technical Analysis vs. Fundamental Analysis
Even though the fundamentals do not change much the prices of many stocks keep on
varying and fundamental indicate the price horizon of the shares of a company, but are
not able to say what would the price at what point of time. Hence, Technical Analysis
incorporates techniques to decide when equity is overbought or over sold at which point
of time the shares may be sold/bought at a high/low price. The fundamentalists believe
in intrinsic value of a share. Technical analysts forecast the demand and supply factors
operating in a market. They do not believe in the firm's risk and carrying growth. Also
fundamentalists do not depict the true intrinsic value of a share. They further say that
the prices of stock fluctuate around the true intrinsic value of a share. Therefore,
Technical Analysis is a simple and useful method to find out price fluctuations.
The technical analysts advise the most appropriate time to buy a share and the most
appropriate time to sell the share.
Basic Tenets of Dow Theory
1. The average discounts everything:
The theory states that every possible factor affecting supply and demand and thus, the
market prices, must be reflected in the averages. Even natural calamities are considered
though these cannot be anticipated. Thus, when they occur, they are quickly discounted.
2. Market Trends:
According to Dow, an uptrend exists so long as each successive rally high and each
successive rally low is higher than the one before. In other words, an uptrend has to
have a pattern of rising peaks and troughs. A downtrend would just be the reverse with
successively lower peaks and troughs. This definition of downtrend and uptrend is still
the basis of all trend analysis.
Trends are divided into three heads: they are primary, secondary and minor. The most
significant are the primary or major trends, which, usually, last for more than a year.
Primary trends reflect the basic mood of the market. The secondary or intermediate
trend usually lasts from three weeks to three months and represents corrections in the
primary trends.
Dow compared the three trends of his theory to the tide, waves and ripples of the sea.
3. Major trends
Dow categorized major trends into three distinct phases. The first phase is called the
accumulation phase and takes place when investors begin to buy securities discounting
the adverse economic news. Then the second phase begins, when keen followers of
trends notice the bullish trend and begin to participate in the buying. The third and final
phase is characterized by active public participation when the news of increased market
activity gets around. During the last phase, the statute investors who had initiated the
first phase begin to "disload" as the market is in a boom.
4. The averages must conform to each other
The theory had been concerned only with the industrial averages. Dow felt that bull or
bear signals could not take place unless both the averages gave the same signal. The
signals not need occur simultaneously, but the closer they get the better.
5. Volume must confirm the trend:
Volume should expand in the direction of the major trend. For the uptrend, volume
should increase as the prices rise higher and diminish as prices dip. It would be the
other way for the downtrend, where volume would increase when prices drop and
decrease when they rise.
6. A trend is assumed to be In effect until it gives definite signals that it has
reversed:
The Dow tenets evoked a lot of criticism by when correctly understood; all it does is
warm against changing one's market position. It does not imply that one should delay
action once a signal of change of trend has appeared, but it only asks the investor to be
sure before he attempts. Bull markets do not climb forever and bear markets always
reach a bottom sooner or later.
The Dow Theory
This is the oldest and famous technical theory. It is based on the principles enunciated
in late nineteenth century by Charles Dow, the founder of the Dow Jones and Co. Dow
observed that most stocks move in consonance with the market, going up when the
market goes up and coming down when the market comes down. Hence, one should first
understand the behaviour of the market as a whole. To do that, he constructed two
indices, calling them the Industrial Average and the Rail Average which are now known
as the Dow Jones Industrial Average (DJIA). He then postulated that the averages
would show three kinds of trends, the primary trend, the secondary reactions, and the
minor trends, likening them to the tides, the waves and the ripples in the ocean.
MECHANICS OF THE THEORY
Dow proposed that the primary uptrend would have three moves the first one being
caused by accumulation of shares by the far- sighted, knowledgeable investors, the
second move would be caused by the reports of good earnings by corporations. Last
move up would be caused by wide spread report of financial well-being of corporations.
The third stage would rampant speculation in the market. Influence the far-sighted
investors, realizing that the high earnings would not sustain would start selling,
resulting the first move down of a downtrend and as the non-sustainability of high
earnings is confirmed, the second move down would be initiated and then the third
move down would result from distress selling in the market. A trend remains effective
until a reversal is indicated and confirmed by the behaviour of both the averages. The
start of a bullish trend is signaled when both the averages cross the high achieved in the
previous secondary reaction to the basic downtrend, while a bearish trend begins when
both averages drop below the previous low reached during the secondary reaction to a
basic uptrend.
According to Dows Theory', the market always has three movements and the
movements are simultaneous in nature. These movements may be described as (i) the
narrow movement which occurs from day to day, (ii) the short swing which usually
moves for short time like two weeks and extends upto a month; this movement can be
called a short term movement, and (iii) the third movement is also the main movement
and it covers four years In its duration. According to the type of movements, they have
been given special names. The narrow movement is called fluctuations, the short swing
is better known as secondary movements and the main movement is also called the
primary trends.
Narrow movements or the fluctuations are called "random wiggles".
Secondary movements are those which last only for a short while and they are also
known as "corrections".
Primary trends are, therefore, the main movement in the stock market. It is also called
Bears and Bulls market.
According to the Dow Theory, the price movements in a market can be identified by
means of a line chart. In this chart the technical analysis over day plot the price of the
shares. This would help in identifying the movements. Figure shows upward, downward,
primary trends, abortive recovery, secondary movements, tops and bottoms and closing
prices per trading days. The description on the Figures show primary upward trend on
period T to time of peak price before T+X of trading day. T+X and abortive recovery' is
noticed showing a change in the direction of the market's primary trend. Abortive
recovery means secondary movement does not rise above the preceding top and after
the abortive recovery the tops descend till they find their place at T+Z. When secondary
movement falls to reach a new bottom it signals the beginning of bull market. The
majority of the Dow theorists feel that a new primary trend will emerge only after
ascending and descending top occurs simultaneously in industrial and transportation
averages.
The application of Dow Theory
The application of the Dow Theory in practice is to determine the points of buy, and
sell. The crux is to be able to distinguish between a normal secondary correction in an
existing trend and the first of a new trend in the opposite direction. Technicians differ in
their opinion of the exact points of buy and sell. The following figures illustrate the
determination of these points. The reversal pattern is referred to as failure swing.
Figures 5 and 6 refer to bull market conditions changing over to bearish conditions and
hence the question of 'when to sell' arises.
In Fig. 5 peak C fails to overcome the previous peak A and the through D also falls below
B. So the signal to sell is constituted at S. In Fig.6 peak E exceeds A before falling below
B. Technicians differ in their opinion as to whether the signal to sell is constituted at S1
or S2.
Figures 7 and 8 refer to bear market conditions changing to bullish and hence the
question is 'when to buy?
Fig. 7 the trough at C fails to fall below A and peak at D is also higher than B. so the 'buy'
signal is constituted at Bl.
In Fig. 8 peak D is higher than the previous peak B and the successive through E is
higher than B, indicating a reversal in the bearish trend. 'Buy' signals are constituted at
B1 and B2.
Though the Dow Theory has worked well in indentifying major bull and bear markets it
is not beyond criticism. One of the charges levied against it is that its signals are too
late. To answer this, one can only say that at the time of formulation of the theory, it
was not intended that the Dow chart would indicate buy and sell points. It was
intended to indicate bull and bear markets only.
Thus, Dow Theory has stood the test of time for over a century now and is still
considered to be a very good technique for using the stock market average as an
economic indicator. A diagrammatic representation of the Dow Theory is given below.
The Trend Line
A price trend can be established when the price of the particular share under study
begins to move in a specific direction and this movement persists for a period of time. If
the movement is in an upward direction, it is called an uptrend or a bull phase, but if it
is in the downward direction, it marks a downtrend or a bear phase. If it moves evenly, it
established a horizontal trend. These trends may be so illustrated:
The secondary movements which temporarily reverse the direction of an uptrend are
called reactions and movements that reverse the direction of a downtrend are called
rallies.
If the price movement continues in a particular direction for a sufficiently long period of
time, a channel (as illustrated below) is established. When an uptrend channel breaks in
the downward direction or when a downtrend channel breaks upwards, it usually
indicates a reversal of the trend. When share prices move within a narrow range, the
upper and lower limits of the range are called the resistant levels and the support price
level respectively. A large number of share transactions usually take place at these two
levels. This is diagrammatically explained graph. Thus after some time, the share price
may either break through the resistance level (as above) to form another set of support
and resistance lines or it any cross the support line. Using these concepts, various
patterns of share price movements can be observed. They are illustrated and explained
as follows.
Such a pattern is formed when there are three successive rallies and reactions with the
second one reaching the highest point in the head and shoulders-top pattern and the
lowest point in the 'head and shoulders-bottom' pattern. After each reaction in the head
and shoulders-top pattern, and alter each rally in the 'head and shoulders-bottom'
pattern, the price touches the neckline before moving in the opposite direction. When
the price movement breaks through the neckline, a secondary return move is normally
observed before the price again moves strongly in the opposite direction.
These are frequently observed patterns of share price movements and usually represent
turning points from previous directions.
Advantages of Technical Analysis
The advantages of the technical analysis are as follows:
1. Unless one has a very sophisticated and accurate forecasting model it is difficult
to reverse the trend. By the time one receives the information; most other
investors have also received it and have reacted accordingly, pushing the price up
or down. In other words, the fundamental information is almost invariably
already reflected in the market.
2. There are so many contradictory fundamentals impacting the market at any one
time and so many "structural changes" in how these fundamental factors interact
that it is often impossible to know how to weigh them. Again, this process of
evaluation is all done by the market place itself and reflected in the price.
3. In addition, the computer can readily zero in on technical analysis and make
good and unbiased judgments; whereas fundamental information would
normally require much more extensive interpretation on the part of an investor.
When one thinks about this, it will become clear. One can't possibly know more about
the value of a company's stock than its directors. In the commodity markets too, one will
never know more about crop conditions or the supply and demand factors at work on a
certain commodity than the actual professionals involved in work in that industry.
Limitations of Technical Analysis
The Dow's theory serves only as a starter and review each of the basic tenets of Dow
Theory, reflects that;
THE AVERAGES DISCOUNT EVERYTHING
The most popular depictions of averages are simple moving average (average of close,
high or low price of a given period) and exponential moving averages (which extend the
average over the entire record). Moving averages of 30 days or 5 weeks depict short term
trend and moving averages of 200 days or 14 to 40 weeks depict long term trend. The
crossovers of two averages indicate that the trend is changing direction. For instance, if
the 5-weeks moving average crosses the 14-week moving average from below to above, it
indicates beginning of bullish phase, and may define buying opportunities. The reverse
is true if crossing it from above to below.
THE MARKET HAS THREE MOVEMENTS:
Elliot Wave Theory is the most popular depiction of this principle. It states that the
market moves up in five waves up or down, e.g., three moves up and two down, while it
moves down in three to five waves. These waves are primary, secondary and tertiary
superposed on each other and it takes experience to separate the three movements. For
instance, an upward movement of a primary wave comprises five secondary waves, and
so on. This applies well to stocks in U.S.A. where the market movement is free from all
constraints, and the public takes part freely in investment as well as options trading.
However, in India the market suffers frequent upheavals because of the frequent
changes in the government policy, as well as speculative activity indulged in by brokers,
and it is not unusual to see the market gain by 25% post-budget, and the individual
stocks may jump up or down by 50% within a few weeks due to speculation. Hence, in
India this theory does not apply, though some analysts persist in trying to fit the market
movements to this theory.
PRICE BAR CHARTS INDICATE MOVEMENT:
Moving averages do not reveal the daily fluctuations.
PRICE/VOLUM RELATIONSHIPS PROVIDE BACKGROUND:
The volume data of specified group shares, where in forward trading is allowed by the
exchanges, is published after few weeks. Since forward trading is no indicator of the
actual market activity, these relationships are of little value in India.
THE AVERAGES MUST CONFIRM:
This is based on the premise that if one group of activity, say manufacturing, does not
trend in the direction of another group, say transportation, it indicates an oncoming
change of trend of the market. In U.S.A. data about different industries is regularly
published, for instance, utilities average and transportation average. In India, we only
get data for all activities grouped together in the published indices, e.g. BSE Sensitive
Index, BSE National Index, DSE Index, etc. Hence, such a comparison is not possible.
Further, in India the Stock Exchange Foundations create inaccuracies while publishing
daily price movements. Indian stock exchanges brokers indulge in huge trading on their
own account, using the customers money, and there by pocket profits to themselves.
The Futures trading is not at all unregulated, and the Badla charges are frequently
extended for no apparent reason.
Multi-dimensional Function:
Thus, limiting the power of the brokers. The function of technical analyst, investment
advisor, financial adviser, portfolio manager, stock broker and stock exchange
management are all vested with the stock brokers in India. In reality no one can do more
than one job listed above at one time.
LIMITED BROKERS:
The stock brokers are grossly inadequate in number compared to the transactions
involved and thus a seller's market has involved where in the public has to jostle in
order to get their orders executed. This gives the brokers a hand to cheat the public. This
shortage of brokers required to conduct the business of the day is compounded by the
shortest trading hours in the world (12.00AM to 2.30PM), Coupled with rely frequent
shut down of the Stock Exchanges. In U.S.A., the Stock Exchanges work from 9.00Am to
4.00 PM.
INSIDER TRADING:
Insider manipulations are rampant in the Indian Stock Market. In the India Stock
Market, the price of a share gets doubled in one day, and fell back to its original value a
few days later. All these malpractices leave their mark on the prices of stocks. The
Technical Analysis do not represent the true balance of the demand and the supply
forces, as in NYSE, Hence, some of the technical analysis techniques suitable for NYSE
(New York Stock Exchange) are not found suitable in India.
Market Indicators
Technical indicators help not only to predict individual stock price behaviour but also
the trend of the market. Some important Price, Volume and other indicators of the
market are highlighted below:
Price Fluctuations:
By comparing number of shares which advanced and those declined during a certain
period of time, one may know what the market is really doing. The difference between
the advances and declines is called breadth of the market. The Technician is generally
more interested in change in breadth than in absolute level. Further, breadth may be
compared with a stock-market index. Normally, breadth and the stock market index will
move in unision. However, when they diverge, a key signal occurs. During a bull market
if breadth declines to new lows while the stock market index makes new highs a peak in
the average is suggested. The peak will be followed by major downturn in stock prices
generally.
High-low Differential:
Can be used as supplementary measure to breadth of the market to pre-sit market. A
raising market will, generally, be accompanied by an expanding number of stocks
attaining new highs and a dwindling number of new lows. The reverse will hold true for
a bearish market.
The volume of short selling:
Will refers to selling shares that are not owned, be a useful indicator of the market.
Short selling is also called "short interest" also, can be related to average daily volume.
The short interest for a period say a month, divided by average daily gives a ratio. This
ratio indicates number of days of trading it would take to use up total short interest. In
general when the ratio is less than 1.0, the market is considered and the said to be
market is followed by overbought a decline sooner or later. The zone between 1.0 and 1.5
is considered a neutral indicator. Values above 1.5 indicate bullish territory with 2.0 and
above highly favourable. This market is said to be Oversold. And an 'oversold' state will
lead to buying pressure to cover short position in the market.
ODD-LOT TRADING: Can be measured by constructing and odd-lot index by relating
odd-lot purchases to odd-lot sales(Purchase + Sales),can indicate the direction of the
market, Rising index indicates rising market and falling index indicates falling market.
Mutual-funds Cash as a Percentage of Net Assets:
It is a popular market indicator. The theory is that low cash ratio would indicate
reasonably invested position leaving negligible buying power. This indicates the market
is due for climb down. High cash ratio indicates possibilities of market climb up.
Two Confidence indicators have been quite popular with market analysts. One is
Barron's ratio of higher-to lower grade bond yield. And the second is standard and
poor's low priced and high grade common stocks. A rise in Barron's ratio indicates the
rising markets. A fall in the ratio would indicate declining markets.
The S & P confidence indicator relates low-priced (Speculative) stocks to the high-grade
(quality) stocks. A rise in the ratio flow (low -price/high grade) indicates rising market,
while a fall in the ratio is indicative of declining market.
The number of indicators which the technicians use to predict the changes in the
direction of the market is limitless.
Channel: A series of uniformly changing tops and bottoms gives rise to a channel
formation. This pattern is realized when the rates at which the support and the
resistance levels change are identical and are constant over time. A downward sloping
channel would indicate declining prices and an upward sloping channel would imply
rising price. When the price breaks through the channel boundaries, then a definite
change in the market sentiment is indicated. The price could then either start rising or
falling depending on whether the upper boundary or the lower boundary is breached.
Wedge: A Wedge is formed when tops are decreasing then the bottoms are increasing.
Therefore, a wedge is nothing but a channel whose top and bottom boundaries are
converging (fig.). The slope of the wedge indicates the general direction of movement of
prices. A breach of the boundaries is indicative of a definite direction in the market
sentiment.
Triangle: This is an extreme form of wedge where the top and the bottom boundaries
intersect to form a triangle (Fig.). Triangle is an indication of which way the prices are
expected to move. A plausible A triangle may be formed at the arrival of some
information favourable or unfavourable about the scrip in the market; at the beginning,
when the information has just reached the market, and there is a great uncertainty
about the impact of the information on the performance of the company, and therefore
there are wide fluctuations in prices. The convergence of the top and the bottom
boundaries indicates a continuous reduction in the uncertainty, with the intersection
indicating a resolution of the uncertainty about the impact of the information on the
firm. A breakout indicates that the market has agreed on favourable or unfavorable
impact of the information on the performance of the firm.
Flag: A steep rise in price, followed by wide, uniform fluctuations around an average
price, lead to formation of a flag (Fig.). A breakout subsequently sets the trend of price
movement. Some news about the scrip triggers the initial rise in price. Subsequently, the
market goes through a process of verification and assimilation of the news. The
fluctuating prices indicate a great disagreement about the magnitude of the impact on
the share prices. A breakout indicates a resolution of uncertainty, leading to a definite
direction in the price movement. A series of flags in a rising market are a sign that the
market may not come down during its upward climb. Similarly, a series of flags in a
falling market would indicate that the prices may not rise quickly.
Gap: A gap is the difference between the opening price on a trading day and the closing
price of the previous trading day. The wider the gap, the stronger the signal, for a
continuation of the observed trend. On a rising market, if the opening price is
considerably higher than the previous closing price, it indicates that investors, after
careful thought overnight, are willing to pay a much higher price to acquire the scrip. A
gap in a falling market is an indicator of extreme selling pressure. It is clear from the
definition itself that gaps can be shown in the bar chart.
Lines Charts
Charts are used by fundamental to predict the future price of stocks. They are
prepared in a method that it connects the successive days and closing prices. These
charts are also called line charts.
Bar Chart:
Bar charts are prepared in vertical lines and made to show the closing price of each
day and the closing price movements.
POINT AND FIGURE CHART: (PFCs) are more complex than line or bar charts. PFCs
are used not only to detect reversals in trends, but also to make price forecasts, called
price targets.
Construction:
The construction of PFCs differs from the construction of line and bar charts in
several respects. First, the construction of the chart varies with the price level of the
stock being charted. Only "significant" price changes are noted on a PFC. Thus, for
high-priced securities only three- or five-point (that is, dollar) price changes are
posted. For low-priced securities only half- or one-point changes are noted. Thus,
there are half-point PFCs one-point PFCs, three-point PFCs and five-point PFCs.
A second unusual feature of PFCs is their lack of time dimension. On line and, bar
charts, each vertical column represents a trading day, but on a PFC, determining the
date is sometimes impossible because each Column represents a "significant reversal"
instead of a trading day.
Interpretation:
To find the price target a stock is expected to attain, PFC chartists begin by finding
congestion areas. A congestion area is a horizontal band of Xs and Os created by a
series of reversals around a given price level. Congestion areas are supposed to result
when supply and demand are equal
A breakout is said to have occurred when a column of Xs raised price rise. Penetration of
the bottom of a congestion area by a column of Os is a bearish breakout signal to sell (fig
16A).
PITFALLS:
Limitations of Display Technology: One to understand a little bit about the computer
screen is made up of thousands of dots (known as pixels). These dots are selectively lit
up to form characters and other impressions on the screen for the user. While the
number of dots varies with the kind of monitor used, we shall discuss the situation
where the screen has 640 x 480 dots (that is, there are 640 columns and 480 rows of
dots). Assuming that about 20% of these dots are used up in drawing and naming the
axes and in naming the chart, etc., we would have roughly a space of 500 x 380 dots for
actual plotting. That is, the chart can plot 500 distinct periods and 380 distinct prices at
one time on the screen. This physical dimension can pose difficulties in several
situations.
Let us say we want to plot the price of TELCO shares for the last three years on the
screen. The total number of observations may be about 650. How do we compress 650
observations into 500 columns available for plotting? We could use two approaches:
plot every alternate point or plot the average price of every pair of successive
observations, in both cases the number of observations would be brought down to
manageable level of 325. But either of the two procedures could lead to serious
distortions in the picture presented to us on the screen. And one cannot even know that
such a distortion has taken place.
Another limitation of charting that an intelligent user must be aware of is the optical
illusion that is often created by the method of drawing the graphs. A simple example to
drive home the point: examine the two graphs on Sales below and very quickly answer
as to which case has the growth in Sales been higher? Our answer is likely to be: Case 2.
Now let us look at the charts more closely; in fact, the growth in Sales in higher in Case
1. It is the choice of scale that conveyed the wrong impression.
In sum, charting may appear simple and yet is full of details which when ignored would
lead to erroneous conclusions.
FORMATION & ANALYSIS OF CHARTS
TRENDS AND TRENDLINES
One can earn profit in both an uptrend or down trend by buying or selling. When one he
buys it is said "going long" and one long. When one sells short, the expressions used are
a major uptrend is an opportunity to profit by being bullish. The key trend analysis is to
determine when the pattern will change so that one can shift in time from bearish to
bullish or vice-versa.
Trends which are very brief are called minor trends, those lasting a few weeks are known
as intermediates trends and trends lasting for a period of months are major trends.
Trends help to determine what trend is in force if a market is moving up, one draws a
line connecting each successively higher bottom. As long as the market remains on an
above this line, the uptrend is in force. Conversely, in a downtrend, one would draw a
line connecting each successively lower top. As long as prices remain on or below this
line, the downtrend is in force.
TRENDLINES:
Trendlines will help you determine what trend is in force. If a market is moving up, you
draw a line connecting each successively higher bottom. As long as the market remains
on or above this line, the uptrend is in force. Conversely, in a downtrend, you would
draw a line connecting each successively lower top. As long as prices remain on or below
this line, the downtrend is in force.
Trendline theory states that once a trendline is penetrated, the trend which was
previously in force is reversed. Thus, if an uptrend line is penetrated, it is a signal to sell
and if a downtrend line is penetrated, it is a signal to buy. But there is still more to know
about trendlines.
Let's say the downtrend line has just been decisively broken and you now believe we are
starting a new uptrend. One cannot draw a new uptrend line yet because he only has in
bottom. One must wait until prices move higher for about a week, and then react
downward for a couple of days, and later start moving higher again.
If prices, after moving higher, react downward and form a third bottom on the trendline,
the trendline then becomes more valid. One can say that prices tested the trendline and
it held. The longer this trendline remains intact, the more authority it will have.
One will find that very steep trendlines are not very authoritative in that they will often
be broken by a brief sideways movement or consolidation, after which prices shoot up
again. It is the trendlines with the gentler slope either upward or downward that usually
offer more technical significance.
In sum, factors to consider in weighing the validity of a trendline include: (a) number of
bottoms (or tops) that have formed on or near the trendline, (b) the overall duration of
the trendline and (c) the steepness of the angle.
Getting back to the example, what if the market accelerates and a third bottom is formed
way above the trendline? Now where is the real trend?
One may have to wait until the forth bottom forms before one knows for sure. Until
then, it would be a good idea to draw in two trendlines, A and B.
FAN LINES:
When a market drops sharply, one will have a steep downtrend line. Often this trendline
will be broken by a sharp rally, at which point a new trendline must be drawn. At a later
date, this second trendline might be
broken by a rally and a third trendline would need to be drawn. Such lines are known as
"fan lines".
The rule is that when the third fan line has been broken, the trend has changed to the
upside. In rising markets, this rule can also be applied in reverse.
VALID PENETRATIONS:
I, usually, recommend selling half of your positions on the trendline break and the other
half on the pullback.
TREND CHANNELS:
In an uptrend, one can construct a trend channel by drawing a line parallel to the
uptrend line using as one's starting point an intermediate top made between two
successively higher bottoms.
RETURN LINE:
This second line is often called the "return line" since it marks the area where reaction
against the prevailing trend originates. The area between the basic trendline and the
return line is the "trend channel".
This return line is less reliable than the basic trendline but is valuable enough to be
considered in one's trading strategy. One short term trading strategy applied by
professionals in an up market is to buy on or near the basic trendline and take profits on
or near the return line. Another variation on this technique is to draw a parallel line
equidistant between the basic trendline and return line. No one will have an upper
channel or "sell zone," and a lower channel or "buy zone" or sell zone and a lower
channel or buy zone.
A return line can also be used to forward of an impending change in trend. Any time
prices fail to move up to the area of the return line, one can consider the market is
weakening. Use this as a warning and be on the alert for a break of the trendline the next
time prices approach it.
The main problem with trendline analysis that it is too easy and, as a result, many an
investor and trader can follow it, pushing prices up or down prematurely, making it
difficult to make one's trade in time to catch the move. Therefore, we develop deeper
into chart analysis to find ways of predicting a break in a trend before it becomes
obvious to the average investor. But first lets examine one more critical factor-volume.
REVERSAL PATTERNS
THE HEAD AND SHOULDERS TOP:
Formation is one of the most common and also one of the most reliable of all the major
reversal patterns.
It consists of a left shoulder, a head and a right shoulder. The left shoulder is the usually
at formed end of an extensive advance during which volume is quite heavy. At the end of
the left shoulder, there is usually a small dip or recession which typically occurs on low
volume.
The head then forms with heavy volume on the upside and with lesser volume
accompanying the subsequent reaction. At this point, in order to conform to proper
form, prices must come down somewhere near the low of the left shoulder somewhat
lower perhaps or somewhat higher but, in any case, below the top of the left shoulder.
The right shoulder is then formed by a rally on usually less volume, than any previous
rallies in this formation.
A neckline can now be drawn across the bottom of the left shoulder, the head and right
shoulder. A breaking of this neckline on a decline from the right shoulder is the final
confirmation and completes the Head and Shoulders Top formation. This is, therefore,
one's signal to sell short.
A word of caution. Very often, after moving lower, prices will pull back to the neckline
before continuing their descent. One may wait for this pullback to sell or use it as a point
to add to your original short positions.
Most Head and Shoulders are not perfectly symmetrical. One shoulder may appear to
drop. Also, the time involved in the development of each shoulder may vary, causing the
structure to lose symmetry. The neckline, rather than being horizontal, may be sloping
up or down. The only qualification on an up-sloping neckline is that the lowest point on
the right shoulder must be appreciably lower than that of the top of the left shoulder.
A Head and Shoulders formation can also be extremely useful in estimating the
probable extent of the move once the neckline has been penetrated.
HEAD AND SHOULDERS BOTTOM:
Formation is simply the inverse of a Head and Shoulders Top, and often indicates a
trend reversal from down to up. The typical Head and Shoulders Bottom formation is
illustrated in figure 28.
The volume pattern is somewhat different in a Head and Shoulders Bottom and should
be watched carefully. Volume should pick up as prices rally from the bottom of the head
and then increase even more dramatically on the rally from the right shoulder. If the
breaking of the neckline is done on low volume one must suspect of this formation. The
breakout could be false, only to be followed by a retest of the lows. A high volume
breakout, on the other hand, would give good reason to believe the Head and Shoulders
Bottom formation is genuine.
The only other noticeable difference in the Head and Shoulders Bottom formation is
that it may sometimes appear flatter than the Head and Shoulder Top. Often the turns
are more rounded. Otherwise, all the rules and measuring objectives can be applied
equally well.
DOUBLE TOP FORMATIONS:
They appear as 'M' as in figure. They are very "popular". But watch out! Many analysts
often mislabel and misinterpret. Double Top and Bottom formations in any uptrend,
after a reaction, each new wave up will appear to be "marking" a Double Top.
`
But in truth, at this point there is absolutely no evidence pointing to a Double Top. Nine
times out ten, the trend will remain in force and prices will simply go on to make new
light. So, one need not be fooled. One has no confirmation whatsoever of a Double Top
until the valley has been broken as in figures.
Volume, again can offer a clue in the formation of this pattern. If the volume on the rise
of the second peak is less than on the first peak, one will have an initial indication that
prices may fail to go above the previous high, turn around and go on to confirm the
double Top. High volume accompanying the second rise would minimize that
possibility.
Another factor to use in determining the validity of a Double Top formation is the time
element. If two tops appear at the same level but quite close together in time, the
chances are good that they are merely part of a consolidation area. If, on the other hand,
the peaks are separated by a deep and long reaction, this is more likely a true Double
Top
As with the Head and Shoulders formation, a pullback to the valley areas is very
possible. If one wishes to measure the objective from the breakout point, one you can
simply take the distance from peak to valley and subtract from the valley to the "M" as in
figures.
DOUBLE BOTTOMS:
They are the inverse of Double Tops and appear on the charts as a W formation.
All of the rules associated with Double top formation, also apply to Double Bottoms. The
volume patterns, of course, are different. A valid Double Bottom should show a market
increase in volume on the rally up from the second bottom.
Triple Tops:
They are rarer than Double Tops. They appear on a chart similar to the pattern shown in
figure.
Volume is usually less on the second advance, and still less on the third. The highs need
not be spaced as far apart as those which constitute a Double Top, and they need not be
equally spaced. Also, the intervening valleys need out bottom out at exactly the same
level; either the first or the second may be deeper. But take triple top is not confirmed
until prices have broken through both valleys.
There are several different trading strategies that can be employed to take advantage of
the Triple Top formation. After a Double Top has been confirmed, if prices are rallying
again but on light volume, it is a good place to sell short with a stop (exit point) above
the highest peak of the Double Top.
If, however, prices continue to rally up to the level of the three previous peaks, they
usually go higher; and if prices descend to the same level a fourth time, they usually go
lower. It is very rare to see four tops or bottoms at equal levels.
Triple Bottoms:
They are simply Triple Tops turned upside down and all the rules can be applied in
reverse. (Figure 37). The accompanying volume pattern is different. The third low
should be on light volume and the ensuring rally from that bottom should show a
considerable pickup in activity.
The chart in figure 38 shows a gradual change in the trend direction, produced by a step
by step shift in the balance of power between buying and selling. As one begins a
Rounded Bottom, one will notice volume decreasing as selling pressure eases. The trend
then becomes neutral with very little trading activity occurring. As prices start up,
volume increases as well. Finally, price and volume continue to accelerate, with prices
often literally blasting out of this pattern.
BROADENING FORMATIONS:
They usually have bearish implications. They appear much more frequently at tops than
at bottoms and, for that reason; one will limit his discussion to Broadening Tops. The
theory is that five minor reversals are followed by a substantial decline.
The Broadening Top formation usually suggests a market that is lacking support from
the "smart money" and is out of control. Quite often, well informed selling is completed
during the early stages of the formation; and in the later stages, the participation is from
the less informed, more excitable public. Volume is often very irregular and offers no
clue as to the direction of the subsequent breakout. The price swings themselves are very
unpredictable so it is difficult to tell where each swing will end.
Broadening Tops are a difficult formation to trade. However, one can usually be quite
sure the trend has turned down after a break of the lower of the two valleys.
WEDGE FORMATIONS:
The Wedges, usually, only reverse a minor trend and, as a general rule of thumb, should
typically take 3 weeks or so to complete. It is a chart formation in which price
fluctuations are confined within converging straight lines. These form a pattern which
itself may have a rising or falling slant.
RISING WEDGE
In it both boundary lines slant up from left to right but the lower line rises at a steeper
angle than the upper line. After breaking the lower line boundary, prices usually decline
in earnest.
Generally, each new price advance, or wave up, is feebler than the last, indicating that
investment demand is weakening at the higher price levels. Rising Wedges are usually
more reliable when found in a Bear Market. In a Bull Market, what appears to be a
Rising Wedge any actually is a continuation pattern known as a Flag or pennant. This is
more likely to be rue if the Wedge is less than three weeks in length.
FALLING WEDGE:
In it both boundary lines slant down from right to left but the upper line descends at a
steeper angle than the lower line. Differing from the Rising wedge, once, price move out
of a Falling Wedge, they are more ATP to drift sidewise and saucer out before beginning
to rise. (Figure 41)
Island Reversals are quite rare, but are an extremely good indicator a reversal in the
trend. Their appearance indicates that an extreme change in sentiment has occurred.
CONSOLIDATION MATTERS:
But at other times, a trend may be interrupted, resulting in sideways movement for a
time, before continuing on in its previous direction. Such sideways movements may
even result in a break of the trendline. These formations are known as consolidations.
The ability to differentiate between reversal patterns and continuation patterns is vital.
TRIANGLES:
Have occasionally been known to reverse a trend. But usually they act as period of
consolidation from which prices continue on in the same direction. Triangles form as a
result of in decision on the part of both buyers and sellers. During this time, market
participants tend to withdraw to the sidelines, resulting in narrower market fluctuations
and diminishing volume. A breakout of the triangle usually occurs as the result of some
news affecting the market. And this breakout, if legitimate, is accompanied by a sharp
increase in volume.
SYMMETRICAL TRIANGLE:
Sometimes known as a coil, is the most common type. It is formed by succession of price
fluctuations, each of which is smaller than its predecessor, resulting in a pattern
bounded by a down slanting line and an up slanting line.
Symmetrical Triangles are not as reliable as the Head and Shoulders formations, and
really work out only about two thirds of the time because they are subject to false
breakouts called, END RUNS.
There is no way to avoid getting caught in such false moves unless one recognizes their
characteristic volume patterns. A breakout to the upside should be on high volume. If
volume is light, be suspect of a possible false move and, END RUN.
Downside breakouts are a different matter. Prices often break out on low volume with a
pickup in volume not occurring for a few days. Oddly enough, a high volume breakout
on the downside is often the signal of a "Shakeout".
RIGHT-ANGLE TRIANGLES:
Both Ascending and Descending are better predictions of the future direction of prices
than Symmetrical Triangles. In theory, prices will break toward the flat side upward in
an Ascending Triangle and downward in a Descending Triangle.
THE ASCENDING RIGHT-ANGLE TRIANGLE:
Is characterized by a top-line boundary, that is horizontal and a bottom-line that is
sloping upward. (Figure 44).
This formation occurs when demand is growing yet continues to meet supply at a fixed
price. If demand continues, the supply being distributed at that price will eventually be
entirely absorbed by new buyers, and prices will than advance rapidly.
THE DESCENDING RIGHT-ANGLE TRIANGLE:
Will exhibit a horizontal lower boundary and a down sloping upper boundary:
This formation occurs when is a certain amount of demand at a fixed price yet supply
continues to come into the market. Eventually, the demand is exhausted and prices
break out of the triangle on the downside.
THE RECTANGLE:
Formation, sometimes known as a "line," forms as a result of a battle between two
groups of approximately equal strength. Although offering little forecasting ability as to
which direction the breakout should occur, once prices begin to move out of the
formation, it can be very useful in setting objectives. (Figure 46).
Volume characteristics are similar to triangles in that volume tends to diminish as the
Rectangle lengthens. Breakouts have less tendency to be false than with the Symmetrical
Triangles. However, breakouts are more likely to be followed by a pullback.
All in all, there is a somewhat greater tendency for Rectangles to be consolidation rather
than reversal patterns. When a Rectangle is a reversal pattern, it is much more likely to
occur at a major or intermediate bottom rather than at a top.
A minimum measuring objective can be derived from adding the width of the Rectangle
of the point of breakout. Normally, wide-swinging Rectangles will offer more dynamic
moves than the narrower ones. A move out of a narrow Rectangle will often hesitate at
its minimum objective before moving on.
FLAGS AND PENNANTS:
Flags and Pennants are true consolidation patterns and are very reliable indicators both
in terms of direction and measuring. In an up market, flags usually from after a
dynamic, nearly straight move up on heavy volume. Prices react on lower volume and a
series of minor fluctuations eventually form a downward-sloping, compact
parallelogram. (Figure 47).
The pennant is very similar to the flag except that it is bounded by converging rather
than parallel lines:
Flags and pennants, in order to be considered valid should conform to three rules
Gaps can be valuable in spotting the beginning of a move, measuring the extent of a
move or confirming the end of a move. There are four different types of gaps: "Common
gaps," "break way gaps," "measuring gaps," and "exhaustion gaps." Since each has its
own distinctive implications, it is important to be able to distinguish between them.
COMMON GAPS
Common gaps also known as 'temporary gaps' tend to occur in a sideways trading range
or price congestion area. Usually, the price moves back up or down subsequently as the
market returns to the gap area in order to "fill the gap." If this does occur, the gap offers
little in the way of forecasting significance.
It may be noted, that common gaps are more apt to develop in consolidation rather than
in reversal formations. In other words, the appearance of many gaps within
consolidation patterns (such as a Rectangle or Symmetrical Triangle) is a signal that the
breakout should be in the same direction as that of the preceding trend. (Figure 50).
BREAKING GAP:
It occurs as prices break away from an area of congestion. Typically, prices will break
away from a Ascending or Descending Triangle with a gap.
This gap implies that the change in sentiment has been strong and that the ensuing
move will be powerful. Often the market does not return to "fill the gap", particularly if
volume is heavy after the gap has formed. If volume is not heavy, there is a reasonable
chance the gap will be filled before prices resume their trend. (Figure 50).
MEASURING GAP:
Typically occurs in the middle of a price move and can be used to measure how much
further a move will go. Rather than being associated with a congestion area, it is more
likely to occur in the "course of a rapid, straight-line advance or decline, usually, pat
approximately the halfway point, (figure 50).
EXHAUSTION GAP:
It signals the end of a move. Exhaustion gaps are associated with rapid, extensive
advances or declines. The problem is how does one know whether it's a Measuring gap
or an Exhaustion gap? One clue may be found in the volume. An exhaustion gap is often
accompanied by particularly high volume. Another method for detecting an Exhaustion
Gap is with a Reversal Day. (Figure 50).
There are many technical analysts who put great weight on these charts and formations,
but there are many others who do not. The modern technical analysis deals with
indicators, such as moving average, exponential moving averages, weighted moving
averages; moving averages cross over, various types of bands around the moving
averages like the bands in terms of standard deviations, Bollinger bands, etc., and take
rate of change, etc. Several oscillators are also used, like stochastic, relative Strength
index (RSI), strength relative to a market index, moving average conversance divergence
(MACD) technique.
In synergized trading systems, the trend following indicators and oscillators
complement and confirm each other. The recent researchers have found good results by
combining the results of the indicators and the oscillators. For example, combining the
moving averages with MACD or combining RSI with rate of change (ROC) can give
useful signals.
The assumption of the theory of contrary opinion are (a) the common man cannot make
predictions of price movements, (b) techniques should be adopted in such a manner that
the forecast of prices are made in exactly an opposite direction to what the common man
feels.
This would give a correct indication of prices and ultimately give confidence and
profitability to the investor. The odd lot theory is explained in the following manner:
Odd-Lot Theory:
The Odd-Lot Theory is a prediction of tops in the bull market price direction and the
price reversals of each security. Odd- lot is a method of trading shares in groups which
are less than 100 shares. These become round-lots if they are traded in groups of 100
shares, 200 shares, 300 shares or more. The odd-lot theory suggests that it is important
to find out information about groups of less than 100 because such investments are
usually not made by professional investors. This would, therefore, reflect the view of the
common man daily. The method of finding out the daily record of odd-lot is by
gathering information of the number of shares which are purchased each day, those
which are sold in the market and also of those shares which are sold short. (Example
XIII.6) The theory suggests that by charting out the ratio of odd purchases to of odd
sales then it indicates that there is a positive purchase; on the other hand, there can be a
negative purchase also. The odd purchases minus the sales are shown in the chart
against a market index. The net purchase by the odd-lot according to the technical
school is that a fall in the market prices is reflected if net purchases made by the
common man are positive. If the net purchases are negative then it reflects that the bear
markets are at a close.
The theory of odd-lot had been tried by the Dow Jones Industrial Average some time
during the years 1969-70 when there was a presence of a bear market. The chart showed
just the opposite of analysts analysis. It showed that the common man or the person
interested in odd-lots was purchasing net when the charts showed a low point. The
theory has been opposed by the odd-letters because they buy low and sell high and make
profits and this is contrary to the odd-lot theory.
Short sales is a method of covering up speculators short position in the market by
buying securities at a lower price than the price at which the seller would sell them.
Short sales are a means of covering up by the individual after finding out relevant
information about the security in which the position is likely to be covered up. The buyer
and the seller both analyze the situation of the short positions to indicate the demand
for the securities and thus try to cover their short positions which are outstanding. But
when the demand increases then the outstanding short positions also increase and these
are indications of future rise in price. These indications have also been tested on Dow
Jones Industrial Averages. These indications cannot be exactly correct and are only a
general indicator. The technical analysts thus believe that short sales is a sophisticated
technique and it is difficult for an average investor to understand its technique.
According to them, those who follow the short sales theory are not clear because when
they expect a price decline it does not decline immediately and follows slowly. This
technique can only broadly give certain indications.
Confidence Index:
The technical analysts analyze the market through a calculation of the confidence index.
This index shows the ration of yields between the types of bonds. These hands are the
high grade bonds and the low grade bonds and the confidence index shows the
willingness of the investors to invest in the market. This technique shows that the
purchase and sale of investment from high grade to low grade bonds depends on the
kind of confidence that the investor gains about the stock market price movements.
When the investor is confident that the economy is stable and the stock market is
reflecting boom, gain and peak period, then they would like to take a risk in the market
and try to gain high yields in the purchase of bonds. The investors would make again by
shifting their investments in such a manner that they are high yielding. This they are
able to do by shifting their investments which they are already holding in high grade
bonds to low grade bonds. High grade bonds are higher in equity but do not yield high
returns. Low grade bonds whole risky will offer a higher yield. When the price rises, the
yield also fall and because the price of the low grade bond has increased this given a
boost to the investor and that becomes more confident of the low grade bond.
Usually, large institutional investors make portfolio choice in the bond market but it is
the influence of the small investor and the change in his prices which is marketed by the
technical chartists to find out the confidence index.
The confidence index is limited to points to upper limit being limited by one. When the
confidence index is rising it indicates optimism and the technical analysts predict that
the money market is showing a chance for making speculative profit. At this time most
of the investors do not mind taking heavy risks and buying even low grade bonds. The
assumption is that the yields which are received on a high quality bond will be lower
than the yield on low quality bond at all times. The technical analyst analyses the
indicator of the confidence index to measure in a time period from two months to a
maximum of eleven months.
But the confidence index also indicates a fall in the stock prices and shows that the low
grade yields rise faster and fall slower than the high grade yields. A depression in the
movement causes the investors to become risk average and short time speculators do
not take advantage of shift in prices from high grade to low grade bonds. This is so
because they expect a downward trend in the economy to follow. Research has shown
that confidence index is not always positively correlated with the stock market. Although
this gives some indications and signals about the stock market trend because it is called
a leading indicator yet the signals which are formed by it show errors. According to the
technical analysts, signals will always show some errors in them and complete accuracy
can never be predicted.
Breadth of the Market:
This indicator measures the strength of declines or advances in the stock market. The
techniques and tools measure whether the stocks are yielding high profits and in finding
out how often the stock prices are changing their movements. The breadth of the market
is calculated by subtracting the number of issues whose prices have increased or
advances that is by measuring the volatility by stock prices. This is also referred to as
plurality. This measures the breadth of the market. If the breadth becomes negative the
technical analyst feels that the speculator should not think that this is a negative
direction. The measurement of the breadth of a market depends only on the direction
which is taken or shown by the breadth. Line charts are used to show the breadth of the
market. The indication that is shown, by the breadth in a downward period is that the /
prices of known shares and risky shares are falling but the price of growth/ and income
shares called blue-chips are stable or even rising but downward trend shows that the
market is weak and there is a signal that the prices in the market are falling. The breadth
of the market moves in the same direction as the market is falling. The breadth of the
market moves in the same direction as the market average. The market advance line
would show optimism in the market.
Trading Volume:
Another indicator according to the technical analysts, to find out the behaviour of stock
prices in the market is by checking the daily list of stock exchange quotations. This index
is generally on market condition and measures the intensify with which the investors
purchase or sell the security. The volume according to the technical analyst who
measures the volume of trading of stocks is careful in watching the demand and supply
of securities whenever there is a change in equilibrium. When the prices move up and
fall this reflects and also shows an upward trend then it is a signal that the market is
operated by bulls. A high trading volume in the share market when prices are falling
indicates that the volume of trading shows a bears signal. The technical analysts believe
that when the volume of purchase and sale is high but the prices are falling then bullish
market can be considered to have come to an end and the market operating for bear is
close and clears the market. It shows that the market for the bears is at an end and the
trends are for a rise in the market.
Technical analysts also mark that the bull markets is at an end through a speculative
blow off. When the volume of purchases is maximum and the price is also very high then
the bullish speculators come to an end and pave the way for the bears to walk into the
market. This is called the speculative blow off that in the death of the bull market with a
loud sound and change towards bear market as the bull market is completely exhausted.
MOVING AVERAGE:
An average is take sum of price of a share over some weekly periods divided by the
number of weeks. This point is market on the latest date for which a price bar has been
plotted. This process is repeated for the previous dates. The points thus obtained are
connected together to give the Moving Average line.
However, the rise of fall of a market is not smooth. During the rising phase, the price
falls several times, while during the falling phase, the price rises several times.
Relative Strength Index tells us whether the net difference between the closing prices is
increasing or decreasing. The concept of Relative Strength in illustrated, [fig. 53]
During the rising phase of the market, the prices move up fast, and the differences
between the recent close and the previous close are large. When the market reaches the
top, these differences reduce. When the market decline, the difference again become
large.
The formula for 14-week Cutler's Relative Strength Index (RSI) is given below.
RSI = 100 - [100/ (1 + RS)]
This is an indicator and pinpoints buying and selling opportunities ahead of the market.
It ranges in value from to 0 to 100. Values above 70 are considered to denote
overbought conditions, and values below 30 are considered to denote oversold
conditions.
If the RSI has crossed the 30 lines from below to above and is rising, a buying
opportunity is indicated. If it has crossed the 70 lines from above to below indicates a
selling opportunity.
Sell signal
If the Efficient Market Hypothesis is to decide when as what to buy and sell. Dollar Cost
Averaging abandons any attempt at optional timing. It involves investing the same
money sum per period, irrespective of the state of the market. Consequently more
shares or units are bought when share prices are low and fewer when they are high. The
average price paid is less than the mean price over the same periods; a fact often used a
recommendation for unit-linked savings schemes.
The advantage of dollar cost averaging over investing in the same number of shares or
units per month, or year, results from the difference between the harmonic mean and
the arithmetic mean. The harmonic mean is the reciprocal of the average of the
reciprocals of a series of numbers. For example, the harmonic mean of 2 and 4 is the
reciprocal of the arithmetic average of 1/2 and 1/4, which is 2.67. The arithmetic mean
is, of course, 3.
If $240 is invested at each of two dates in shares costing $4 on the first date and $2 on
the second, 60 shares are acquired the first time, 120 the second, and therefore 180 in
total. The average price paid is thus $2.67 ($480 / 180), the harmonic mean. If the same
$480 had been spent at the arithmetic mean price of $3, only 160 shares could have
been acquired. The greatest advantage is obtained when share prices are volatile,
assuming that there is no persistent downward trend; is such a trend was predictable it
would be preferable to stay out of the market altogether.
This is a technique which is specifically studied for those investors who do not have a
sum of investment but who would require to build a fund and invest some money for a
future date. Under this technique the investor should continuously invest a constant
sum of $ in specified stock of specified portfolio at periodic differences.
A $ average can be made by an investor by making a study of a complete school of stock
prices. He would be advised to buy when the securities are selling at a low rate than
when the prices are reaching high. It also helps in reducing the cost of transaction and
the cost of commission. Through this technique, the intervals of purchasing stocks can
be large and may be dependent in the prices of stocks. A short interval for conducting
the purchases and sale of stock is considered ideal but if it is not possible to buy the best
at short intervals the investor can wait for longer intervals thus bringing in flexibility in
time through variations in length of time between investments. The methodology in a $
'averaging plan is to be successful at a lower average cost per share when the fund is
small. The accumulation of the fund at different prices is made and an average is found
out on purchases to find out the average cost per share. Such an investor can shift to
other formula plans after accumulating his fund because his average cost per share is
very low.
The $ averaging plans like other formula plans does not help the investor in making a
selection of securities on his portfolio. It only helps him to combine his portfolio in a
manner to draw out the best results. This technique is useful when it is implemented for
long periods of time. Grater fluctuations in prices lead to high profit in a full cycle. Such
a programme is not useful for short intervals as it can lead the investor to losses. The
most important factor in this programme is the selection, the right quality of stocks and
the timing which is main for liquidating the stocks. The investor should have knowledge
of the economic industry company framework of investments when he is investing
under this plan.
EFFICIENT MARKET THEORY
INTRODUCTION:
Fundamental analysis, analyses fundamental factors such as economic influences,
industry factors and company-specific variables viz. Product demand, earnings,
dividend and management, in order to estimate the intrinsic value of stock and to make
buy/sell decision. The technician, found the fundamental analysis a futile exercise her.
Instead he concentrated on analyzing historical movements of price and volume of
trading, the final outcome of the price action triggered by fundamental analysis, to
predict future price of stock. Efficient market hypothesis (EMH) took the same logic a
bit further. It said one cant outperform the market for the simple reason that there are
numerous knowledgeable analysis and investors who would not allow the market price
to deviate from the intrinsic value due to their active buying and selling. The current
market price, therefore, reflects the intrinsic value at all time and there is, therefore, no
need for fundamental analysis or technical analysis.
EFFICIENT MARKET THEORY:
In 1953, Mauurice Kendall, a distinguished statistician, presented a paper before the
Royal Statistical Society in London. Kendall examined the behaviour of stock and
commodity prices in search of regular cycles. Instead of discovering any regular price
cycle, he found that prices appeared to follow a random walk, implying that successive
price changes are independent of one another. In 1959, two highly original and
interesting papers supporting the random walk hypothesis were published. Harry
Roberts showed that a series obtained by cumulating random numbers bore
resemblance to a time series of stock prices. In the second paper, Osborne, an eminent
physicist, examined whether stock price behaviour was similar to the movements of very
small particles suspended in a liquid medium.
Inspired by the work of Kendall, Roberts, and Osborne, a number or researchers
employed ingenious methods to test the randomness of stock price behaviour. By and
large, these tests have vindicated the random walk Hypothesis. Indeed, in terms of
empirical evidence, very few economic ideas can rival the random walk hypothesis.
KEY LINKS:
The empirical evidence concluded that the randomness of stock prices was the result of
an efficient market. Broadly, the key links in the argument are as follows.
1. Information is freely and instantaneously available to all the market
participants.
2. Keen competition among market participants more or less ensures that market
prices will reflect intrinsic values. This means that they will fully impound all
available information.
3. Prices change only in response to new information (otherwise it will not be new
information) and, therefore, unpredictable.
4. Since new information cannot be predicted in advance, price changes too
cannot be forecast. Hence, prices behave like a random walk.
MISCONCEPTIONS:
The efficient market theory has often been misunderstood. The common
misconceptions about the efficient market theory are stated below along with answers
meant to dispel them.
The oscillator is only a secondary indicator in the sense that it must be subordinated to
basic trend analysis. They are plotted along the bottom of the daily price chart and
resemble a flat horizontal band. The oscillator band is basically flat while prices may be
trading up, down, or sideways. However, the peaks and trough the oscillator coincide
with the peaks and troughs on the price chart. Some oscillators have a midpoint value
that divides the horizontal range into two halves, an upper and a lower. Depending on
the formula used, this midpoint line is usually a zero line.
As a general rule, when the oscillator reaches an extreme value in either the upper or
lower end of the band, it suggests that the current price move may have gone too far, too
fast and is due for a correction or consolidation of some type. As another general rule,
the trader should be buying when the oscillator line is in the lower end of the band and
selling in the upper end of the range. The crossing of the zero line is often used to
generate 'buy' and 'sell' signals. There are three situations when the oscillator is most
useful. These three situations are common to most types of oscillators that are used.
The oscillator is most useful when its value reaches an extreme reading near the
upper lower end of its boundaries. The market is said to be overbought when it is
near the upper extreme and oversold when it is near the lower extreme. This
warns that the price trend is overextended and vulnerable.
A divergence between the oscillator and the price action when the oscillator is in
an extreme position is usually an important warning.
The crossing of the zero line can give important trading signals in the direction of
the price trend.
Measuring momentum
The concept of momentum is the most basic application of oscillator analysis.
Momentum measures the rate of change of prices as opposed to the actual price levels
themselves. Market momentum is measured by continually taking price differences for a
fixed time interval. To construct a 10-day momentum line, simply subtract the closing
price ten days ago from the last closing price. The positive or negative value is then
plotted around a zero line. The formula for momentum is
M = V ~ Vx
Where V is the least closing price and Vx is the closing price 4xf days ago.
If the latest closing price is greater than that of ten days ago (in other words, prices have
moved higher), then a positive value would be plotted above the zero line. If the latest
close is below the close ten days earlier (prices have declined), then a negative value is
plotted below the zero line.
Any time period can be employed. A shorter time period (such as five days) produces a
more sensitive line with more pronounces oscillations. A longer number of days (such as
20 days) results in a much smoother line in which the oscillator swings are less volatile.
In the figure 54, a 10-day momentum line compare to a bar chart of a currency. The
momentum line oscillates around a zero line. Extremes in either direction warn of
oversold and overbought conditions. Signals are given by a crossing above or below the
zero line in the direction of the price trend.
RANDOM WALK THEORY
The random walk theory postulates that prices fluctuate randomly about their intrinsic
value and there can be no explanatory trend for the movement. The price changes are
independent and price history is not any indicator of the future price direction.
The Random Walk Hypothesis is contrary to the technical analysts view of behaviour of
stock prices. It does not believe that the past historical prices have any indication to the
future of stock prices. According to the technical analyst, history repeats itself and by
studying the past behaviour of stock prices, future prices can be predicated. The random
walk hypothesis is opposite to the technical school of thought.
The Random Walk Hypothesis is to some extent believes in fundamental analysis. It
argues that a change in information helps the superior analyst. This is possible because
of some super analytical power like financial statement analysis or knowledge about
inside factors which the public do not know. Therefore, random walk theory in its semistrong form supports the fundamental school of thought. The random walk theory states
that fundamental analysis which is superior in nature will definitely lead to superior
profits.
The random walk theory does not discuss the long-term trends. It discusses only the
short run change in prices and the independence of successive price changes. The
random walk theory, therefore, suggests that analysts should be able to look in for
superior analysis of the firm by making the following considerations:
a. by finding out the risk and return characteristics of each security;
b. by trying to combine the risk return characteristics of securities into and
adequate portfolio;
c. by holding a portfolio for a reasonable length of time and making a continuous
evaluation of the securities held by him;
d. By planning a well diversified portfolio and by revising it, if need be, after
consistent evaluation.
CONCERN OF EMH (EFFICIENT MARKET HYPOTHESIS)
1. A perfectly competitive market operates in an efficient manner in order to bring
about the actual stock prices with its present discounted value.
2. It further states that the participants in the market have free access to the same
information so that the market price which is prevailing reflects the stocks
present value.
3. If there is any deviation from this equilibrium theory it is quickly corrected and
the stock finds its way back to the equilibrium price.
4. This theory also states that a price change Occurs because of certain changes
which affect the company.
5. The change in prices alters the stock prices immediately and the stock moves to a
new equilibrium level.
6. This shift to a new equilibrium level occurs whenever information is received in
the Random Walk Theory.
7. The instant adjustment is recognition of the fact that all information which is
known as truly reflected in the price of stock.
8. Further change in the price of stock will be only due to some other new piece of
information which is entirely available earlier different from earlier.
9. According to this theory, the changes in prices of stock show independent
behaviour and are dependent on the new pieces of information.
FORMS OF MARKET EFFICIENCY
Eugence Fama gave three flavours to market efficiency and subsequently all empirical
testing has proceeded on these lines. The three forms are:
WEAK FORM
The weak form means that the current prices of stock fully reflect all the information
that is contained in the historical sequence of prices. Hence, abnormal profits cannot be
earned by studying the past behaviour of share prices.
SEMI-STRONG FORM
Tests of semi-strong deal with the speed at which market participants react to public
information. Empirical evidence generally supports that the public reacts quickly to
information; to which the market does not always digest new information correctly.
STRONG FORM:
Under the strong form the security prices reflect all information, including public and
private (monopolistic) information.
TESTS OF EFFICIENT MARKET HYPOTHESIS (EMH)
In order to enable market efficiency certain empirical tests have been devised. Let us
discuss these tests in the following:
TESTS OF WEAK-FORM
There have been empirical tests of weak-form market efficiently for equities, bonds and
futures contracts.
Weak Form
SERIAL INDEPENDENCE
Randomness and stock price movements can be tested by calculating the correlation
between price changes in one period and changes for the same stock in another period.
If the autocorrelations are close to zero, the price changes are said to be serially
independent.
Semi-Strong form contends that all public information is fully reflected in security
prices. Public information includes company financial statements, earnings and
dividends, bonus announcements etc.
Fama, Fisher, Jensen and Roll have tested the speed of the markets reaction to a
company's announcements of a stock split and with respect to a change in dividend
policy. They estimated the abnormal returns using "residual analysis".
Security returns were regressed against the returns on a market index and the error in
them the following linear equation represented the residual or abnormal return.
rit = ai + Bi rmt + eit
where
rit = realized return on security i in time period t
rmt = realized return for marked index in time period t
ai, Bi = regression co-efficients
eit = error term, or residual for time period t
eit = rit - (ai + Bi rmt)
i.e. realized return - normal return
They have examined 940 Stock Splits on the New York Stock Exchange, from 1927 to
1959. Price of the Stocks was examined for a period of 29 months before the date of the
split and 29 months .after the split. The actual act of splitting did not have any impact,
on the wealth of shareholders.
These studies have empirically documented the following inefficiencies and anomalies.
Stock prices adjust gradually, not rapidly, to announcements of unanticipated changes
in quarterly earnings.
Small-firm portfolios seem to outperform than to large-firm portfolios.
Low P/E multiple stocks tend to outperform than to large P/E multiple stocks.
Monday returns are lower than the returns for other days of the week.
TEST OF STRONG-FORM
Strong form contents that all information is fully reflected in security prices. Top
managements have access to corporate and financing strategies. Specialists have access
to the book limit orders for a share. Knowledge of the price and quantities of the limit
order represent private information. Professional portfolio managers who have large
research database and access to top management may have private information not
disclosed to the public. Merchant banking firms, for example, may have private
information on a new company which has not been disclosed to the public.
The strong form EMH is of two types:
a. Super-strong form which includes insiders and specialists b. Near-strong form
which includes private estimates developed by portfolio managers, etc.
The Securities and Exchange Board of India has released a draft on insider trading
which defines an insider as a person who, during the preceding eight months is
connected with a company. And have an access to unpublished price sensitive
information in respect of securities of that company. Who has an access to such
unpublished price sensitive information, such as declaration of dividends issue of shares
by way of public, rights or bonus, any major expansion or execution of new projects,
amalgamation, mergers and take-overs, taxation charges, extra- ordinary events like
strikes, etc.
Further the regulation say that a person guilty of insider trading based on reports
submitted by the inspector of SEBI is liable to be punished with a civic penalty not
exceeding three times of the profit gained or loss avoided as a result of dealing, subject
to minimum of Rs.5, 00,000 or punishable with rigorous imprisonment not exceeding
two years, or a fine not exceeding Rs. 5 lakhs or both as the court may decide.
With the implementation of the regulation to curb insider trading, it is hoped that stock
market would become more efficient and devoid of malpractices.
Joy, Litzenberger and McEnally tested the impact of quarterly earnings announcement
on stock prices. They found that favourable information published in quarterly reports
are not instantaneously reflected in stock prices.
S. Basu is a well researched article tested for the informational content earnings
multiple. His study inquired into whether low price earnings multiple tended to
outperform stocks with high P/E ratios. His study indicates that low P/E portfolio
experienced superior returns relative to the market. Over 20 different studies of market
reaction to earnings announcements reported post-announcement excess returns.
One of the studies found that the size of the firm is highly correlated with stock returns.
Larger the market value of the company, lower the rate of return and vice versa. Small
firm portfolios outperforms than large firm portfolio.
Another interesting study by French examined the returns generated by the standard
and poor 500 index for each day of the week, over the time period 1953-1977. Monday
returns were not only less than other days of the week but actually negative. This came
to be known as the Weekend
Effect. By purchasing on Monday and selling on Friday, one could earn abnormal
return.
CHALLENGES TO EFFICIENT MARKET THEORY
Opposing camp to the efficient market theory which argues that the stock market is
neither competitive nor efficient. According to evities, the following factors cast their
shadow over the efficiency of the stock market.
INFORMATION INADEQUACY:
Information is neither freely available nor rapidly transmitted to all the participants in
the stock market.
LIMITED INFORMATION PROCESSING CAPABILITIES:
Human information processing capabilities are limited. As Nobel Laureate Herbert
Simon observed: "Every human organism lives in an environment which generates
millions of new bits of information every second, but the bottleneck of the perceptual
apparatus does not admit more than a thousand bits per second and possibly much
less".
Taking a dig the experts who claim to have superior information processing abilities,
David Dreman said: "Under conditions of anxiety and uncertainty, with a vast
interacting information grid the market can become a giant Rorschach test, allowing the
investor to see any pattern he wishes experts can not only analyze information
incorrectly, they can also fine relationships that are not their a phenomenon called
illusory correlation".
SIMILAR ERROR:
Investors make mistakes in valuation, their errors are independent on an average, these
errors tend to be mutually offsetting and the market valuation remains correct and
unbiased.
MONOPOLISTIC INFLUENCE:
The market is regarded as highly competitive. Single buyer or seller cannot have undue
influence over prices. In practice, powerful institution; and big operators wield great
influence over the market. The monopolists power enjoyed by them diminishes the
competitiveness of the market.
INVESTMENT IMPLICATIONS:
We have examined the development of the efficient market theory, the results of
empirical work, and the challenge posed by the critics of the efficient market theory. It is
time now to hammer out the investment implications of what we have learnt so far.
Before doing that let us briefly recapitulate the main points:
1. The logical development of the efficient market theory, giver certain assumptions
are virtually unassailable. However, the theory a rests on assumptions those are
somewhat fragile.
2. The empirical evidence regarding the randomness of stock price behaviour seems
to .be overwhelming.
3. The market often adjusts rapidly to public information. Yet on many occasions it
assimilates information rather slowly. (This appears to be truer of relatively less
developed markets like the Indian capital market).
4. The market is rational and orderly in many ways. However, it has its own quirks
and flaws: it displays certain anomalies which have not been properly understood
and behaves waywardly when psychological influences are strong.
Let us now look at the investment implications of the observations which are indeed of a
mixed nature made above.
1. The substantial evidence in favour of the randomness of stock price behaviour
suggests that technical analysis (which is based on the premise that stock prices
follow certain patterns) represents useless market folklore. Burton Milkiel says:
"Being somewhat incautious, I will climb out on a limb and argue that no technical
scheme whatever would work for any length of time".
Technical analysts, of course, vehemently dispute such an assertion and argue that the
tests employed by the advocates of random walk theory are too naive to reveal the kinds
of patterns and dependencies technical analysts perceive. Though there may be some
merit in this rebuttal, the overwhelming evidence on randomness certainly suggests that
technical analysis is of dubious value.
2. Routine and conventional fundamental analysis is not of much help in identifying
profitable courses of action, more so when you are looking at actively traded
securities. We have a curious paradox here. The efficiency of the market place
depends on the presence of numerous investors who make competent efforts to
analyze information and take appropriate actions based on their, analysis. If they
abandon their work, the efficiency of the market would decline. Yet, the efficiency
of the market place renders their efforts worthless. Though striking, this paradox
is not different from the paradox of all efficient, competitive markets.
3. The key levers for earning superior rates of return are:
PURPOSE OF PORTFOLIOS
Securities carry some degrees of risk. Risk defined as the standard deviation around
the expected return.
Securities carry different degrees of invest in risk as such investors more than one
security at a time, to spread risks by not putting all their money in one. Diversification
of one's holdings is intended to reduce risk in an economy in which every asset's
returns are subject to some degree of uncertainty. Even the value of cash suffers from
the inroads of inflation. Most investors hope that if they hold several securities, even if
one goes bad, the others will provide some protection from an extreme loss.
GOALS OF PORTFOLIO MANAGEMENT
The first step in the portfolio management process is to specify one's investment goals.
The commonly stated investment goals are:
* Income
:
To provide a steady stream of income through regular
interest/dividend payment.
* Growth
:
appreciation.
* Stability
Traditional security analysis recognizes the importance of risk and return to the
investor. However, direct recognition of risk and return in portfolio analysis seems very
much a "seat-of the - pants". Process in the traditional approaches, which rely heavily
upon intuition and insight, the results of these rather subjective approaches to portfolio
analysis have, no doubt, been highly successful in many instances. The problem is that
the methods employed do not readily lend themselves to analyze by others.
Most traditional methods recognize return as some dividend receipt and price
appreciation over a forward period. But the return for individual securities is not always
over the same common holding period, nor are the rates of return necessarily timeadjusted. An analyst may well estimate future earnings and a P/E to derive future price.
He will surely estimate the dividend. But he may not discount the values to determine
the acceptability of the return in relation to the investor's requirements.
In any case, given an estimate of return, the analyst is likely to think of and express risk
as the probable downside price expectation (either by itself or relative to upside
appreciation possibilities). Each security ends up with some rough measure of likely
return and potential downside risk for the future.
Portfolios, or combinations of securities, are thought of as helping to spread risk over
many securities. This is good. However, the interrelationship between securities may be
specified only broadly or nebulously. Auto stocks sire, for example, recognized as riskinterrelated with rubber stocks; utility stocks display defensive price movement relative
to the market and cyclical stocks like steel; and so on.
SELECTION OF ASSET MIX
Asset mix decision is concerned mainly with financial assets which may be divided into
two broad categories, viz., stock and bonds.
'Stocks' include equity shares 'Bonds', consist of non-convertible debentures of private
sector companies, public sector bonds, gilt-edged securities, units/shares of debtoriented schemes of mutual funds, National Savings Certificates, Indira Vikas Patras,
bank deposits, post office savings deposits, fixed deposits with companies, deposits in
provident fund and public provident fund schemes, deposits in the National Savings
Scheme, and so on. The basic characteristic of these investments is that they earn a fixed
or near-fixed return.
Would stock-bond mix be 50: 50 or 75: 25 or 25: 75 or any other? In resolving this issue,
which is perhaps the most important issue in portfolio management, one should bear in
mind two basic propositions.
PROPOSITION 1
In general 'stocks' earn a higher return compared with 'bonds'. This is because 'stocks'
have a higher degree of risk exposure compared with 'bonds'. Figure 56 portrays the
risk-return relationship for various types of stock' and bond' investments. James H.
Loric summed up 'The most enduring relation in all finance perhaps is the relationship
between returns on equities and returns on bonds. In all times of American history,
British history, French history, and German history, equities (stocks) have provided
higher returns than bonds".
PROPOSITION 2
Though expected return from 'stocks' is not very sensitive to the length of investment
period, the risk from stocks diminishes as the investment period lengthens. Figure 57
shows that the average return and range of
return from stocks for various investment periods over the period 1950-1980 in the U.S.
capital market. One can reasonably expect a similar pattern in other capital markets too.
This happens because of the benefit of 'time diversification' which is distinct from
'portfolio diversification. As the investment period lengthens, the average yearly return
over the period is subject to lesser volatility because low returns in some years may be
offset with high returns in other years and vice versa.
Hence, one can identify two key factors that have a bearing on the asset mix decision.
RISK TOLERANCE
Investors differ in their risk tolerance. Some do not like to be exposed to risk because of
their strong aversion to risk and some are willing to assume risk as they have gambling
instincts. Some lie in between investors who are willing to assume moderate levels of
risk.
INVESTMENT HORIZON
Investors have varying investment horizons ranging from 5 months to 5 years and
beyond.
Exhibit shows how the appropriate percentage allocation to the stock' component of the
portfolio is influenced by the two basic factors, viz., risk tolerance and investment
horizon. To obtain the corresponding percentage allocation to the 'bond' component of
the portfolio, simply subtract the number given in the exhibit from 100. One will find
this matrix helpful in resolving ones asset mix decision.
In applying this matrix, the zero per cent, given for the cell low risk tolerance/ short
time horizon, may be raised to 10 per cent or so. In a similar manner, the hundred
percent given for the cell high risk tolerance /long time horizon may be lowered to 90
per cent. These modifications will help the investor in realizing the benefit of
diversification across 'stocks' and 'bonds'.
For the same of simplicity, have it is assumed that there is a single investment horizon.
In reality, an investor may have multiple investment horizons corresponding to varied
needs. For example, the investment horizons corresponding to various goals sought by
an investor may be as follows:
Investment goal
Investment horizon
Buying a car
Two years
Constructing a house
Ten years
Twenty years
Thirty years
Obviously, the appropriate asset mix corresponding to these investment goals would be
different.
9.71 percent
XYZ Ltd.,
6.01 percent
The Economic
Times Share
Price Index
4.48 percent
Using the standard deviation of the market (the Economic Times Share Price Index may
be regarded as a proxy for the market for our purposes) as the basic unit of measure, we
may express the standard deviation of the percentage price changes in the stocks of ABC
Ltd., and XYZ Ltd., in terms of this basic unit, as shown in the last column of Exhibit,
this represent the total risk of a share.
Financial research has developed a useful framework which divides the total risk of a
security into two components:
The systematic risk or market risk is attributable to the fluctuations in the market as a
whole. If the stock market declines due to some unfavourable news, most stocks decline
with it. Likewise, the stock market rallies in the wake of favourable news and most
stocks move up with it irrespective of individual merits.
The systematic risk of a security is measured by its beta. Figure 58 shows how beta or
systematic risk is determined. In the exhibit given, the percentage change in The
Economic Times Share Price Index (which is used as a proxy for the market), referred to
hereafter as X, and the percentage change in the price of the equity share of XYZ Ltd.,
referred to hereafter as Y, have been plotted on the horizontal and vertical axis
respectively. Each point of this exhibit reflects what happened to The Economic Times
Share Price Index and the equity share price of XYZ ltd., at the end of a certain fortnight
during the period July 1,1988 through February 17, 1989 say The regression relationship
between X and Y is represented by the diagonal line shown in the exhibit. Representing
the best fitting line through the data points plotted in exhibit, the diagonal line shows
how the market influences, on an average, the price of the equity share of XYZ Ltd.,
The equation of the diagonal line (regression line), estimated with the help of the
method of least squares, and is:
According to the least squares method, the regressing line is chosen in such a manner
that the sum of the squares of deviations of actual observations from their estimated
value as per the regression line is minimized.
Y = 0.12 + 0.93 X
This means that the intercept of this line is 0.91 per cent and the slope is 0.93. A slope
(or beta) of 0.93 implies that if the market rises by 1 per cent, the equity share price of
XYZ Ltd., moves up by 0.93 per cent. By the same token, if the market falls by 1 per cent,
the equity share price of XYZ Ltd. falls, by about 0.93 percent.
UNIQUE RISK
The unique risk of a security is independent of the general market movement. It arises
from firm's specific factors such as technology change lock out, etc. Events of this nature
primarily affect a specific firm and not all firms in the industry or economy.
To understand the nature of unique risk, refer back to Exhibit. Looking at the data
points barring a few, they are scattered around the diagonal line. This means that while
the market changes explain a portion of the risk of the equity share of XYZ Ltd., they do
not explain the whole of it. The standard deviation of data points around the regression
line, scaled down by the standard deviation of the Economic Times Share Price Index,
reflects the unsystematic risk of the share of XYZ Ltd.
RISK RIGHT ANGLED TRIANGLE
The total risk and its two components, viz systematic risk and unsystematic risk, can be
much represented in the form of a "risk triangle" as shown in Figure 59.
Investors, generally own not just one security. They hold a portfolio consisting of several
securities. In such a context, the relevant questions are: What is the portfolio risk? How
does the portfolio risk behave if the number of securities increases?
Portfolio risk, like the risk of a single security, consists of two components, viz. market
risk and unique risk. The market risk of a portfolio is simply weighted arithmetic
average of the market risk of the individual Shares in the portfolio. For example, if a
certain amount is invested in three shares (A, B and C) in the proportions 0.4, 0.4, and
0.2and the market risks (beta factors) of these shares are 1.5, 0.5, and 0.8 the market of
the portfolio will be:
0.45(1.5) +0.4(0.5) +0.2(0.8) =0.96
The unique risk of a portfolio, however, behaves very differently. It typically tends to
decline as the portfolio becomes more diversified. This is because in a diversified
portfolio, the unique risks of different securities
tend to offset each other. The relationship between portfolio risk (consisting of market
risk and unique risk) and diversification is shown graphically in Figure 60. From this
exhibit, it is clear that the bulk of the benefit from diversification, in the form of
reduction of unique risk, can be achieved by forming a portfolio of 10 to 12 securities.
Thereafter, the gains of diversification tend to be negligible and even negative.
The risk of a security can be broken down into two components, viz. market risk and
unique risk. Diversification helps an investor in eliminating unique risk. Investors
would have to eliminate unique risk only through diversification.
Securities do carry some degree of risk. Risk defined as the standard deviation around
the expected return. A security's risk is equated with the variability of its return. More
the variability about a security's expected returns more risk it is. Securities carry
differing degrees of risk as such investors hold more than one security at a time, to
spread risks by not putting all their money into one scrip. Diversification of one's
holdings is intended to reduce risk. Even the value of cash suffers from the inroads of
inflation if kept idle. Investors hope that if they hold securities, even if one goes bad, the
others will provide various protections from an extreme loss.
DIVERSIFICATION
Efforts to minimize risk take the form of diversification. The more traditional forms of
diversification have concentrated upon holding a number of securities across industry
lines such as utility, mining, manufacturing groups. The reasons are related to inherent
differences in bond and equity contracts, coupled with the notion that an investment in
firms in dissimilar industries would most likely do better than in firms within the same
industry. Holding one stock each from mining, utility, and manufacturing groups is
superior to holding three mining stocks. Say this approach leads to that the best
diversification comes through holding large numbers of securities scattered across
industries. People would agree that a portfolio consisting of two stocks is less risky than
holding either stock alone. Feel that holding fifty such scattered stocks is five times more
diversified than holding ten scattered stocks.
RATIONALE OF DIVERSIFICATION
A portfolio consisting of securities of a large number will always bring a superior return
than a portfolio consisting of few securities. The simple diversification would be able to
reduce unsystematic or diversifiable risk. In securities both diversifiable and undiversifiable risks are present. An investor can expect 75% risk to be diversifiable and
25% to be un-diversifiable. Simple diversification at random would be able to bring
down the diversifiable risk if about 5 to 10 securities are held. Unsystematic risk was
supposed to be independent in the case of each security. Many research experts have
viewed that diversification at random does not bring the expected return Diversification
should, therefore, be related to industries which are not related to each other. Many
industries are correlated with each other in such a way that if the stock of 'X' increases
in price the stock of Y also increases and vice-versa. By looking at the trends industries
should be selected in such a way that they are unrelated to each other. Research studies
have shown that an investor should spread his investments that it leads to "superfluous
diversification". When an investor has too many assets on his portfolio he will have
many problems. It is very difficult for the investor to measure the return on each of the
investments. Consequently, he will find that the return he expects on the investments
will not be up to his expectations by over-diversifying. The investor will also find it
impossible to manage the assets, it requires knowledge of the liquidity of each
investment, return, and the tax liability and this will become impossible without
specialized knowledge.
ASSUMPTIONS UNDER MARKOWITZ THEORY FOR OPTIMUM
DIVERSIFICATION
Markowitz theory is based on the modern portfolio theory under several assumptions.
The assumptions are:
1. The market is efficient and all investors have in their knowledge all the facts
about the stock market and so on. No investor can continuously make superior
returns either by predicting past behaviour of stocks through technical analysis.
Thus all investors are in equal category.
2. All investors are risk averse.
3. All investors would like to earn the maximum rate of return.
4. The investors base their decision on the expected rate of an investment.
5. Markowitz brought out the theory by combining the assets in such a way that
they give the lowest risk maximum returns could be brought out by the investor.
6. Every investor assumes that while making an investment he will combine the
investments in such a way that he gets a maximum return and exposed minimum
risk.
7. The investor assumes that greater the return that he achieves higher the risk
factor that surrounds him.
8. The investor can reduce his risk by diversification of his portfolio.
9. An investor should be able to get higher return for each level of risk "by
determining the optimum set of securities".
MARCOWITZ THEORY
Marcowitz approach determines for the investor the efficient set of portfolio through
three important variables that is return, standard deviation and coefficient of
correlation. Marcowitz model is called the Full Covariance Model". Through this method
the investor can, with the use of computer, find out the efficient set of portfolio by
finding out the tradeoff between risk and return, between the limits of zero and infinity.
According to this theory, the effect of one security purchase over the effects of the other
security purchase is taken into consideration and then the results are evaluated.
THE EFFECTS OF COMBINING TWO SECURITIES
It is believed that holding two securities is less risky than having only one investment in
a persons portfolio. When two stocks are taken on a portfolio and if they have negative
correlation then risk can be completely reduced because the gain on one can offset by
the loss on the other. The effect of two securities can also be studied when one security
is more risky when compared to the other security. A combination of A and B will
produce superior results to an investor rather than if he has to purchase only Stock-A. If
an Investor constructs his portfolio in such a way that of his stock consists of Stock-A
and of stock consists of Stock-B, the average return of the portfolio is weighted average
return of each security in the portfolio.
Simple Situation
When there are two securities in a portfolio:
Security Nos.
Expected Return
Proportion
Rl%
X1%
15
40
25
60
It is clear that although X and Y have the same expected return, 9 percent; Y is riskier
than X (standard deviation of 4 versus 2). Suppose that when Xs return is high, Ys
return is low, and vice versa. In other words, when the return on X is 11 percent, the
return on Y is 13 percent. Question: Is a portfolio of some X and some Y in any way
superior to an exclusive holding of X alone (has it less risk)?
Let us construct a portfolio consisting of two-thirds stock X and one-third stock Y. The
average return of this portfolio can be thought of as the weighted average return of each
security in the portfolio; that is;
Where:
Rp=expected return to portfolio
xi = proportion of total portfolio invested in security i
Ri= expected return to security i
N = total number of securities in portfolio
Therefore,
Rp = (2/3)(9) + (l/3)(9) = 9
But what will be the range of fluctuation of the portfolio? In periods when X is better as
an investment, we have Rp = (2/3) (l1) + (l/3) (5) = 9; and similarly, when Y turns out to
be more remunerative, Rp = (2/3) (7) + 1/3) (13) + 9. Thus, by putting part of the money
into the riskier stock, Y, it is possible to reduce risk considerably from what it would
have been if one had confined purchases to the less risky stock, X. If held only stock X,
one's expected return would be 9 percent, which could in reality be as low as 7 percent in
bad periods or as much as 11 percent in good periods. The standard deviation is equal to
2 percent. Holding a mixture of two-thirds X and one-third Y, the expected return will
always be 9 percent, with a standard deviation of zero.
The reduction of risk of a portfolio by blending into it a security whose risk is greater
than that of any of the securities held initially suggests that it is not possible to deduce
the riskiness of a portfolio simply by knowing the riskiness of individual securities. It is
vital that one should know the interactive risk between securities!
The crucial point of how to achieve the proper proportions of X and Y in reducing the
risk to zero will be taken up later. However, the general notion is clear. The risk of the
portfolio is reduced by playing off one set of variations against another. Finding two
securities each of which tends to perform well whenever the other does poorly makes
more certain a reasonable return for the portfolio as a whole, even if one of its
components happens to be quite risky.
This sort of hedging is possible whenever one can find two securities whose behavior is
inversely related in the way stocks X and Y were in the illustration. Now we need to take
a closer look at the matter of how securities may be correlated in terms of rate of return.
COVARIANCE METHOD
The risk involved in individual securities can be measured by standard deviation or
variance. When two securities are combined, one should consider their interactive risk,
or covariance. If the rates of return of two securities move together, their interactive risk
or covariance is positive. If rates of return are Independent, covariance is zero. Inverse
movement results in covariance that is negative. Mathematically, covariance is defined
as
COVxy = 1/N [Rx - Rx ] [Ry - Ry]
Where the probabilities are equal and
COVxy = covariance between x and y
Rx = return on security x
Ry = return on security y
Rx = expected return to security x
Ry = expected return to security y
N = number of observations N = T
Instead of squaring the deviations of a single variable from its mean, one should take
two corresponding observations of the two stocks in question at the same point in time,
determine the variation of each from its expected value, and multiply the two deviations
together. If whenever x is below its average, so is y, then for those periods each deviation
will be negative and their product consequently will be positive. Hence, one will end up
with a covariance made up of an average of positive values, and its value will be large.
Similarly, if one of the variables is relatively large whenever the other is small, one of the
deviations will be positive and the other negative and the covariance will be negative.
This is true in the example above.
The coefficient of correlation is another measure designed to indicate the similarity or
dissimilarity in the behaviour of two variables, one defines
Where:
rxy= coefficient of correlation of x and y COVxy = covariance between x and y
x = standard deviation of x
y = standard deviation of y
The coefficient of correlation is, essentially, the covariance taken not as an absolute
value but relative to the standard deviations of the individual securities (variables). It
indicates, in effect, how much x and y vary together as a proportion of their combined
individual variations, measured by x y in this example, the coefficient of correlation is
where:
p = portfolio standard deviation
Xx = percentage of total portfolio value in stock X
X y = percentage of total portfolio value in stock Y
x = standard deviation of stock X
y = standard deviation of stock Y
rxy correlation coefficient of X and Y
Note: rxy xy y = covxy
(1) The proportions of funds devoted to each stock. (2) The standard deviation of each
stock, and (3) the covariance between the two stocks. If the stocks are independent of
each other, the correlation coefficient is zero (rxy = 0). In this case, the last term in the
above equation is zero. Second, if rxy> 0, the standard deviation of the portfolio is greater
than if rxy =0. Third, if rxy is less than zero, the covariance term is negative, and portfolio
standard deviation is less than it would be if rxy were greater than or equal to zero. Risk
can be totally eliminated only if the third term is equal to the sum of the first two terms.
This occurs only if (1) rxy = -1.0, and (2) the percentage of the portfolio in stock X is set
equal to Xx = y / x + y
To clarify these general statements, let us return to this earlier example of stocks X and
Y. In this example, remember that
The covariance between the two stocks and found it to be -8. The coefficient of
correlation was -1.0. The two securities were perfectly negatively correlated.
What happens to portfolio risk as we change the total portfolio value invested in X and
Y? Using the above equation:
Notice that portfolio risk can be brought down to zero by the skillful balancing of the
proportions of the portfolio to each security. The preconditions were rxy = -1.0
and Xx = y/( X + y ), ie 4/(2 + 4) = 666.
What effect would there be using X= 2/3 and Y=l/3 if the correlation coefficient between
stocks X and Y had been other than -1.0? Using the above Equation and various values
for rxy, we have
If no diversification effect had occurred, then the total risk of the two securities would
have been the weighted sum of their individual standard deviations:
Total undiversified risk = (.666) (2) + (.334) (4) = 2.668 since the undiversified risk is
equal to the portfolio risk of perfectly positively correlated securities (rxy = + 1.0), one
can see that favorable portfolio effects occur only when securities are not perfectly
positively correlated. The risk in a portfolio is less than the sum of the risks of the
individual securities taken separately whenever the returns of the individual securities
are not perfectly positively correlated; also, the smaller the correlation between the
securities, the greater the benefits of diversification. A negative correlation would be
even better.
In general, some combination of two stocks (portfolios) will provide a smaller standard
deviation of return than either security taken alone, so long as the correlation coefficient
is less than the ratio of the smaller standard deviation to the larger standard deviation:
rxy < x / y
Using the two stocks in our example:
-1.00 < 2/4
-1.00 < +0.50
If the two stocks had the same standard deviations as before but a coefficient of
correlation, for example, +0.70, there would have been not portfolio effect, since +0.70
is not less than 0.50.
The various cases where the correlation between two securities ranges from -1.0 to +1.0
are shown in Figure 60A. Return is shown on the vertical axis and risk is measured on
the horizontal axis.
A and B represent pure holdings (100 percent) or securities A and B. The intermediate
points along the line segment AB represent portfolios containing various combinations
of hte two securities. The line segment identified as rab = +1.0 is a straight line. The line
shows the inability of a portfolio of perfectly positively correlated securities to serve as a
means to reduce variability or risk. Point A along this line segment has no points to its
left. That is, there is no portfolio composed of a mix of perfectly correlated securities A
and B that has a lower standard deviation than the standard deviation of A. Neither A
nor B can help offset the risk of the other. The wise investor who wished to minimize
risk would put all his eggs into the safer basket, stock A.
The segment labeled rab is a hyperbola. Its leftmost point will not reach the vertical axis.
There is no portfolio where p = 0. There is, however, an inflection just above point A
that is explains in a moment.
The line segment labeled rab -1.0 is compatible with the numerical example it has been
used. This line shows that with perfect inverse correlation, it is possible to reduce
portfolio risk to zero. Notice points L and M along the line segment AGB, or rab = -1.0.
Point M provides a higher return than point L, while both have equal risk. Portfolio L is
clearly inferior to portfolio M. All portfolios that are superior to those along segment
PNA. Markowitz would say that all portfolios along all line segments are "feasible," but
some are more "efficient" than others.
EFFICIENT FRONTIER:
Markowitz theory is when these are more than three securities. His programme is a
conclusion of the least portfolio risk at a particular level of return. According to the
graphical representation of the securities which stand on the efficient line are called the
portfolios on the efficient frontier. Markowitz shows the efficient frontier by calculating
the risk and return of all individual assets and by plotting them by means of data on a
graph. Only portfolios which lie on the efficient frontier should be taken by an individual
because this will give the effect of diversification and will help in bringing down the risk
on different assets. The efficient frontier will show a bulge towards the vertical axis. This
is depicted in following figures 61, 62.
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
The reason for this is that the correlation coefficient lies between zero and one. Only
those assets which are perfectly positively correlated will generate an efficient frontier
which is represented by means of a straight line. It is difficult to find negatively
correlated assets. Therefore, the efficient frontier will very rarely occur in a curve over
the vertical axis.
All portfolios will not lay an efficient frontier which is represented by a straight line.
Some portfolios will dominate other portfolios. Selected through Markowitz
diversification pattern will be planned and scientifically oriented. This will lie in a
manner that they dominate portfolios which are simply diversified. Marcowitz model is
useful but difficult to use as it requires a lot of information.
The Marcowitz model is very tedious because when the number of investments increase
then the help of a computer is required because it is an arduous task to find out the
securities which lie on the efficient frontier.
To summarize the above discussion, Markowitz model showed the ideal combination of
securities through the efficient frontier. It was also called the Full Covariance Model.
The problem faced by the model was that as observations increased it became
cumbersome.
SHAPE'S MODEL
William Sharpe tried to simplify the Markowitz method of diversification of portfolios.
Shape's Index Model simplifies the process of Markowitz model by reducing the data in
a substantive manner. He assumed that the securities not only have individual
relationship but they are related to each other through some indexes represented by
business activity. Sharpe has improved the method of Markowitz but in addition he has
also put in some additional inputs. He made estimates of the expected return and
variance of indexes which may be one or more and are related to economic activity.
Sharpe's index showed that the return of each security is correlated by some securities
markets in the U.S.A. It is generally the Dow Jones Industrial Average or the Standard
and Poor's 500 stock indexes. In India it is Dalai Street Index which may be applied.
Sharpe's index takes into consideration 3N+2 kinds of information which is different to
the Markowitz assumption of N (N+3)/2. According to Markowitz, a portfolio of 100
securities would require the following bits of information: 100(100+3)/2=5150, and
Markowitz covariance shows that 100 securities would require ( N2 - N )/2 = (1002 - 100
)/2 = 9900/2) or 4950 covariance. Sharpe first made a single index model. This was
compared to multiple index models for conducting reliability test in finding out the full
variance efficient frontier of Markowitz. Many researchers have taken into consideration
the Sharpe Index Models. They have preferred the stock price index to the economic
indexes in finding out the full covariance frontier of Markowitz for the sake of simplicity.
The multiple index models are extremely cumbersome if they are related to the
economic indexes. The following table shows the difference in calculations between
Markowitz covariance model and Sharpe Index Co-efficient as observations increase.
According to Sharpe, it is important to simplify the index formulae by taking away from
the formula the covariance of the securities with other securities and instead to give the
information of each security and find its relationship with the market. According to
Sharpe's index, the formula is:
Ri = I + I + ei
Ri = expected return on security i.
I = intercept of a straight line or co-efficient.
= slope of straight line or Beta Co-efficient.
I = level of market ei = error
The regression coefficient comprises of the value of alpha through the equation y= +.
(Alpha) is the value of y when X in the equation is 0. Thus in a hypothetical case if the
return on the stock index is 0 (zero) X will be represented by o and the expected return
would be 9.0% y=9.0 - .05 (0). The beta coefficient helps in measuring the stocks return
with the changes in the market's returns. When beta is + 1.0 it means that 1% return on
the market index moves with a 1% return on the stock. A 5% return on the index shows a
greater responsiveness to change (i.e. 2.5 times 5%) or 12%. If the value of alpha and
beta are known, Sharpes Index takes into consideration the regression analysis through
beta coefficient and alpha analysis. Alpha + Beta are utilized by the Sharpe's Index to
find out systematic and unsystematic risk. The Sharpe's model generated series of
"corner portfolios" along the efficient frontier. The corner portfolios can be calculated
either when a security enters or leaves portfolio. The number of stocks increases until it
reaches the corner portfolio. The corner portfolio provides the minimum risk of the
lowest return, figure 63 shows the regression equation and figure 64 depicts the efficient
frontier connecting the corner portfolio.
- End Of Chapter -
LESSON - 20
PORTFOLIO STRATEGY
After choosing an asset mix one has to formulate an appropriate portfolio strategy. Two
broad choices are available in this respect, an active portfolio strategy and a passive
portfolio strategy.
ACTIVE PORTFOLIO STRATEGY
An active portfolio strategy is followed to earn superior returns, after adjustment for
risk. The four principal vectors of an active strategy are:
Market timing
Sector rotation
Security selection
Use of a special concept
MARKET TIMING:
This involves departing from the normal asset mix to reflect one's assessment of the
prospects of various assets in the near future. Suppose one's investible resources for
financial assets are 100 and ones stock-bond mix is 50:50. If one expect stocks to
outperform bonds, on a risk-adjusted basis, in near future one may perhaps step up the
stock component of one's portfolio to say 60 or 70 percent. Such an action would raise
the beta of portfolio. On the other hand, if bonds outperform stocks, on a risk-adjusted
basis. This will lower the beta of portfolio.
Anyone who reviews the fluctuations in the market may be tempted to play the game of
market timing. Yet very few seem to succeed in this game. A careful study on market
timing argues that an investment manager must forecast the market correctly 75 percent
of the time just to break-even, after taking into account the costs of errors and the costs
of transactions. As Fischer Black says, The market does just as well on average, when
the investor is out of the market as it does when he is in. So he loses money, relative to a
simple buy-and -hold strategy, by being out of the market part of the time."
GROUP ROTATION:
Group rotation may apply to the stock components of the portfolio, where it essentially
involves shifting the weightings for various industrial sectors based on their assessed
outlook. For example, if one believes that fertilizers and hotel sectors would do well
compared with other sectors in the forthcoming period one may overweight these
sectors, relative to their position in the portfolio. Put differently, stock portfolio will be
tilted more towards these sectors in comparison to the market portfolio.
SECURITY SELECTION:
The most commonly used vector by those who follow an active portfolio strategy,
security selection involves a search for under-priced securities. If one resort to active
stock selection, one may employ fundamental and/or technical analysis to identify
stocks which seem to propose superior returns and concentrate the stock component of
ones portfolio on them. Likewise, stocks which are perceived to be unattractive will be
underweighted relative to their position in the market portfolio.
SPECIALISED INVESTMENT CONCEPT:
A fourth possible approach to achieve superior returns is to employ a specialized
concept particularly with respect to investment in stocks. One possible way to enhance
returns is to develop a profound and valid insight into the forces that drive a particular
sector of the market or a particular group of companies or industries and systematically
exploit that investment insight or concept. Some of the concepts that have been
exploited successfully by investment practitioners are:
Growth Stocks
Neglected or 'out of favour' stocks
Asset-rich stocks
Technology stocks
Cyclical stocks
The advantage of cultivating a specialized investment concept is that it will help to: (a)
focus one's efforts on a certain kind of investment that reflects ones abilities and
talents,(b) avoid the distractions of pursuing other alternatives, and (c) master an
approach or style through sustained practice and continual self-critique. As against
these merits, the great disadvantage of focusing exclusively on a specialized concept or
philosophy is that it may become obsolete. The changes in market place may cast a
shadow over the validity of the basic premise underlying the investment philosophy.
Given ones profound conviction and long-term commitment to ones specialized
investment concept one may not detect the need for change till it becomes rather late.
PASSIVE STRATEGY:
The passive strategy, on the other hand, rests on the tenet that the capital market is
fairly efficient with respect to the available information. Hence, the search for superior
returns through an active strategy is considered futile.
Basically it involves adhering to the following two guidelines.
1. Create a well-diversified portfolio at a pre-determined level of risk.
2. Hold the portfolio relatively unchanged over time, unless it becomes inadequately
diversified or inconsistent with the investor's risk-return preferences.
PORTFOLIO MATRIX
Keith Ambachsteer has developed a matrix shown in Exhibit which pulls together the
elements of timing and selectivity. It can be a useful for developing ones portfolio
strategy.
SELECTION OF SECURITIES
Selection of Bonds (Fixed Income Avenues)
One should carefully evaluate the following factors in selecting fixed income avenues.
of the firm and assess the general prospects of the industry to which the firm
belongs.
Tax Shield In yesteryears, several fixed income avenues offered tax shield; now
very few do so.
Liquidity If the fixed income avenue can be converted wholly or substantially into
cash at a fairly short notice, it possesses liquidity of a high order.
OPTIONAL PORTFOLIO
All investors prefer those securities which have a high return but with low risk. At the
time of combining the securities an investor is faced with the same questions of risk and
return. There are three kinds of investors. An investor, who wishes to take more return
and sow risk, more return with comparatively higher risk and high return with a high
risk, these are depicted as desirable conditions for an investor through the use of utility
curves called indifferent curves. Indifference curves are usually parallel and liner. When
it is drawn on a graph it shows that the higher the investor goes on the growth the
greater is his satisfaction. In figures 65 - 69 these utility graphs are drawn. These are
positively sloped for a hypothetical investor X and the indifference curves are from 1 to
6. The investor 'X' is faced with the problem of finding out the indifference curve of
portfolio tangent which will give him the highest return. In illustration it shows that
there is a combination of securities on the indifferent curves and the efficient frontier at
point A is the best portfolio in terms of (a) efficiency, and (b) that it represents tangent
to the indifferent line.
It has been seen earlier that most of the investors are happy when they get a higher
return even though they have to take some additional risk with it. All indifferent curves
which are given higher satisfaction and higher return will show positively sloped lines,
illustration The higher the curve the greater the satisfaction of investor X (positively
sloped), higher return for greater risk, depicts(a) the positive sloping curves for a risk
fear investor X
1. A' portfolio is efficient
2. The efficient frontier is tangent to the indifference curve (Line).
The investor 'X has positive sloping curves from U. 1 to U.6 and his satisfaction shows
that slopes are positive and the higher he goes the greater the satisfaction. In the same
illustration (b) depicts the indifferent curves of a risk lover. An investor of this type will
have negative sloping curves with lines convex to the origin. Curves from U.l to U.4
show the investment preference of a risk lover. Investor Z is showing that he is less risk
fearing and U.1 to U.5 show his indifferent curves and his investment preferences. An
investor who is a risk averter is happy when his 0p is low in his portfolio but an investor
who enjoys taking a risk is happier when the 0p is higher. The slope of the growth that is
the degree with which the indifferent curves are associated show the kind of risk that an
investor has in mind. Figure 70 shows three are different curves of three different kinds
of slopes. There are three graphs curve X, curve Y curve and curve Z. Each of these
graphs represents a particular meaning in the graph. Curve X' shows that the investor is
a risk lover and his marginal utility is increasing. Curve Z represents a risk adverse
According to this method, the optimal portfolio will be selected by finding out the 'cutoff rate. The cut-off rate consists of various subjects which have been constructed. The
following subjects help in finding out the cut-off rate:
finding out stocks of different return risk ratios,
Ranking securities from higher excess return to B to less return to B.
Selecting of high rank securities above the cut-off-rate.
Making a comparison of (Ri - Rv) i with C and investor in all stocks in which (Ri
- Rv) i achieve the cut- off point C.
e. Find cut-off rate C. A portfolio of i stocks Ci is calculated
a.
b.
c.
d.
f. After finding out the securities differences included in optimal portfolio calculate
the percentage invested in each security.
This is calculated according to the following formula:
The first equation gives the rate of each security on adding the total sum should be equal
to i to ensure full investment. The second equation gives the relative investment in each
security.
The residual variance determines the amount to be invested in each security. The
desirability or satisfaction of an investor of any stock will always be the excess return to
beta ratio.
BETA SIGNIFICANCE:
Diversification and the holding of a sufficient number of securities can reduce the
unsystematic component of portfolio risk to zero by averaging out the unsystematic risk
of individual stocks. Systematic risk, which, is determined by the market (index), cannot
be eliminated through portfolio balancing. Thus the Sharpe attaches considerable
significance to systematic risk.
Beta is a measure which has been used for reducing risk of determining the risk and
return for stocks and portfolios. A number of research studies have been made to give
indications of beta co-efficient for selection of stock. When beta is used significantly for
stock selection it is to be compared with the market. The investor can construct his
portfolio by drawing the relationship of beta co-efficient with the prices prevailing in the
market. When there is buoyancy in the market then beta co-efficient which are large can
be selected. These betas would also carry with them a high risk but during the boom
period high risk is expected to give a maximum of return. If the market is bear market
and the prices are falling then it is possible to sell stocks which have high positive beta
co-efficient. The stocks which have a negative beta would withstand the fall in the prices
in the market. For example, when the beta is +1.0 the volatility which is relative to the
market would indicate an average stock. But when the beta changes to +2.0 it is
excluding the value which is provided by alpha, the stock would be estimated to show a
return of 20% when the market return is forecasted at 10%. This is in the case of a rising
market. But when the prices show a decline and the future is expected to provide a
decline of 10% then a beta which shows +2.0 would show that it is providing a negative
return of 29% if the stock is held by the investor for very long.
PREDICTION OF BETA
In general terms, a security's beta is determined by:
1. The proportional contributions of various categories of economic events to
market variance.
2. The relative response of security returns to these same events the relative
response coefficients.
More specifically, the beta for any security is the weighted average of its relative
response coefficients, each weighted by the proportion of total variance in market
returns due to those events.
SECURITY'S BETA WILL CHANGE WHEN:
1. The variance contributed by the various categories of economic events changes.
2. The response coefficients change. An accurate prediction of beta is the most,
important element in predicting the future behavior of a portfolio that is, in the
portfolio context, the relevant risk of a security lies in its impact on the risk of a
portfolio. Further, the risk of a well-diversified portfolio is almost exclusively
linked to the sensitivity of its component securities of future market moves. For
this purpose, backward-looking betas are inappropriate.
It is necessary to (1) consider the sources of such future moves, (2) project the security's
reaction to such sources, and (3) again probabilities to the likelihood of each possible
occurrence. This process, in turn, requires a thorough understanding of (1) the
economics of the relevant industry, (2) both operating leverage and financial leverage of
the company, and (3) other fundamental factors with meaningful relative response
coefficients.
Rosenberg's fundamentally derived beta has been shown to be more accurate than
historically derived estimates. Six risk indexes are based on current fundamental
characteristics of each company and are measures of the following: (1) market
variability, (2) earnings variability, (3) low valuation and unsuccessful, (4) immaturity
and smallness, (5) growth orientation, and (6) financial risk. Rosenberg has found that,
in the past, stock returns have tended to be related to these factors, and forecast of beta
are improved by adjusting them through appropriate weightings of these factors. To
calculate fundamentally based predictions of beta and residual risk, Rosenberg uses the
following six indexes of risk:
1. Market variability. Measures the impact of certain factors on the relationship
between the market variability of returns and security returns.
2. Earnings variability. Measures the variability of earnings. Earnings variability
contributes to risk.
3. Low valuation and "un-success". Designed to measure the variability of returns
(risk) inherent in consistently low-market-valuation stocks with dismal operating
records.
4. Immaturity and smallness. Differentiates between the lower and larger firms
which have accumulated substantial fixed assets and have a more secure
economic position and a lower degree of risk and the small, younger, and riskier
firms.
5. Growth orientation. Measures the risk associated with the so called high-multiple
(P/E) stocks.
6. Financial structure. Measures financial risk by incorporating leverage (long-term
debt and equity as a percentage of book value), coverage of fixed charges, the
ratio of debt to total assets, liquidity and net monetary debt. In general, the more
highly leveraged a financial structure, the greater is the risk to the common
stockholders.
Establishing efficient portfolios (minimum risk for a given expected return) comprising
broad classes of assets (e.g., stocks, bonds, real estate) lends itself to the mean-variance
methodology suggested by Marcowitz.
SIMPLE MARCOWITZ PORTFOLIO OPTIMIZATION
It is possible to develop a fairly simple decision rule for selecting an optional portfolio
for an investor that can take both risk and return into account. This is called a riskadjusted return. For simplicity, it can be termed the utility of the portfolio for the
investor in question. Unity is the expected return of the portfolio minus a risk penalty.
This risk penalty depends on portfolio risk and the Investors risk tolerance.
The more risk one must bear; undesirable is an additional unit of risk. Theoretically, and
as a computational convenience, it can be assumed that twice the risk is four times as
undesirable. The risk penalty is as follows:
Risk squared is the variance of return of the portfolio. Risk tolerance is a number from
zero through 100. The size of the risk tolerance number reflects the investors
willingness to bear more risk for more return. Low (high) tolerance indicates low (high)
willingness. Risk penalty is less as tolerance is increased.
For example, if a portfolios expected return is 15 percent, variance of return (risk
squared) is 200 percent, and the investors risk tolerance is 30, the risk penalty is 4.5
percent:
Challenge is not simply making better decisions than the average investor, but those of
the professionals from the big institutions.
INVEST DON'T TRADE OR SPECULATE:
The stock market is not a casino, but if you move in or out of stocks every time they
move a point, the market will be your casino. And you may lose eventually, or
frequently,
Buy value, not market trends or the economic outlook: Ultimately, it is the individual
stocks that determine the market, not vice versa. Individual stocks can rise in a bear
market and fall in a bull market. So buy individual, stocks, not the market trend or
economic outlook.
BUY LOW:
When prices are high, a lot of investors are buying a lot of stocks. Prices are low when
demand is low. But, if you buy the same securities everyone else is buying, you will have
the same results as everyone else. BY definition, you can't outperform the market.
Never invest on sentiment or solely on a tip:
You would be surprised how many investors do exactly this.
Do homework or hire experts:
People will tell you: investigate before you invest. Listen to them. Study companies to
learn what makes them successful.
Diversify by company, by industry:
In stocks and bonds, there is safety in numbers. No matter how careful you are, you can
neither predict nor control the future.
Invest for maximum total real return:
This means the return after taxes and inflation. This is the only rational objective for
long-term investors.
Learn from mistakes:
The only way to avoid mistakes is not to invest which is the biggest mistake of all. So
forgive yourself for your errors and certainly don't try to recoup your losses by taking
bigger risks. Instead, turn each mistake into a learning experience.
Aggressively monitor investment:
Remember, no investment is forever. Expect and react to change. And there are no
stocks that you can buy and forget. Being relaxed doesn't mean being complacent.
Remain flexible and open minded:
There are times to buy blue-chip stocks, cyclical stocks, convertible bonds, and there are
times to sit on cash. The fact is there is no one kind of investment that is always the best.
Don't panic:
Sometimes you won't have sold when everyone else is buying, and you will be caught in
a market crash. Don't rush to sell the next day. Instead, study your portfolio. If you can't
find more attractive stocks, hold what you have.
An investor who has all the answers may not even understand the entire
questionnaire:
Abrazen approach to investing will lead, probably sooner than later, to disappointment
if not positive disaster. The wise investor recognizes that success is a process of
continually seeking answers to new questions.
Do not be fearful or negative too often:
There will, of course, be corrections, perhaps even crashes. But over time, stocks do go
up. In this century or the next, the best advice will still be "By low, sell high".
KEY PLAYERS
Market is played by the following players
VALUE BASED TRANSACTORS:
A value based transactor (VBT) carries out extensive analysis of publicly available
information to establish values. He trades when the difference between the values
assessed by him and the prevailing market price so warrants.
INFORMATION BASED TRANSACTORS:
An information based transactor (IBT) transacts on the basis of information. Since he
expects this information to have a significant impact on prices, he is keen to transact
soon. To him, time is of great value. The IBT is bothered about how soon the market
price will move up or down in response to new information.
LIQUIDITY BASED TRANSACTORS:
A liquidity based transactor (LBT), however, trades primarily due to liquidity
considerations. He trades to deploy surplus funds or to obtain funds or to rebalance the
GUIDELINES
The following guidelines must be born in mind while executing transactions.
Since securities are ranked from highest excess return to beta to lowest. If a particular
security belongs to the optimal portfolio, all higher-ranked securities also belong in the
optimal portfolio. Now proceed to calculate values of a variable Ci as if the first-ranked
securities were in the optimal portfolio (i = 1), then the first-and second-ranked
securities were in the optimal portfolio (1 = 2), and so on. These Ci are candidates for C*.
We found that excess returns to beta above Ci and all securities not used to calculate Ci
have excess return to betas below Ci. For example, in column (7) of table one can see the
Ci for which all securities used in the calculation i[rows (1) through (5) in the table) have
a ratio of excess return to beta above Ci and all securities not used in the calculation of Ci
[rows (6) through (10) in the table] have an excess return-to- beta ratio below Ci C5
serves the role of a cutoff rate in the way a cutoff rate was defined earlier. In particular,
C5 is the only Ci that when used as a cutoff rate selects only the stocks used to contract it.
There will always be one and only one Ci with this property and it is C*.
FINDING CUTOFF RATE
Where:
m2 = variance in the market index
2 ei = variance of a stocks movement that is not associated with the movement of the
market index; this is the stock's unsystematic risk
Ci is cut=off Rate for a portfolio of i stocks.
Putting all this information together yields
The second expression determines the relative investment in each security, and the first
expression simply scales the weights on each security so that they sum to 1 (ensure full
investment). The residual variance on each security plays an important role in
determining how much to invest in each security. Applying this formula to the example.
Dividing each Zi by the sum of the Zi we would invest 23.5 percent of our funds in
security 1, 24.6 percent in security 2, 20 percent in security 3, 28.4 percent in security 4,
and 3.5 percent in security 5.
The characteristics of a stock that make it desirable can be determined before the
calculation of an optimal portfolio is begun. The desirability of any stock is solely a
function of its excess return-to-beta ratio.
The value of a portfolio and its proportions of stock and bond components may change
as prices fluctuate. In response to such price changes portfolio rebalancing may be
necessary. There are three basic policies for portfolio rebalancing:
Under this policy, the initial mix (for example, the stock: bond mix may be 50: 50) that
is bought is held. This is essentially a do nothing policy. Irrespective of what happens
to relative values, no rebalancing is done.
Figure 72 shows the payoff diagram for a do nothing policy if the initial stock: bond mix
is 50: 50. This exhibit illustrates the following features of the do nothing.
The value of portfolio is linearly related to that of the stock market.
While the portfolio value cannot fall below the value of the initial investment in
bonds, its upside potential is unlimited.
When stocks outperform bonds, the higher the initial percentage in stocks, the
better the performance of the 'buy-and-hold policy.
On the other hand, when sticks underperform bonds, the higher the initial percentage in
stocks, the worse the performance of the buy-and hold' policy.
DO SOMETHING POLICY
The constants mix policy calls for manipulating an exposure to stocks that is a constant
proportion of portfolio value. If the desired constant mix of stocks and bonds is say
50:50, this policy calls for rebalancing the portfolio when relative values of its
components change, so that the target proportions are maintained. Thus, this policy,
unlike the buy-and-hold policy is a do something policy.
The payoff associated with the constant mix policy is shown graphically in figure 73.
convex payoff curve (that increases at an increasing rate as one move from left to right.).
This is shown in Figure 74.
COMPARATIVE EVALUATION:
As discussed earlier, the payoffs associated with the do nothing policy, constant mix
policy, and CPPI policy are represented respectively by a straight line, a concave curve,
and a convex curve. Figure 75 shows these payoffs. A look at this exhibit suggests that if
the stock market moves only in one direction, either up or down, the best policy is the
CPPI policy and the worst policy is the constant mix policy. In between lies the do
nothing policy.
1. One can try to evaluate every transaction. Whenever a security is bought or sold,
we can attempt to assess whether the decision was correct and profitable.
2. One can try to evaluate the performance of a specific security in the portfolio to
determine whether it has been worthwhile to include it in our portfolio.
3. One can try to evaluate the performance of the portfolio as a whole during the
period without examining the performance of individual securities within the
portfolio.
PERFORMANCE EVALUATION
The key dimensions of portfolio performance evaluation are the rate of return and risk.
How should the rate of return be measured? How should risk be measured? How should
the rate of return and risk measures be combined to develop a performance index?
RATE OF RETURN
The rate of return from a portfolio for a given period (which may be defined as a period
of one year) is measured as follows:
To illustrate the calculation of the rate of return, let us look at the following data:
Rs 100,000
: Rs 25,000
Rs 155,000
To calculate the average rate of return over a period of several years, arithmetic average
of annual rates of return can be employed. The calculation of these measures may be
illustrated with the help of the data given in Exhibit.
The arithmetic average of annual rates of return is simply the sum of annual rates of
return divided by the number of years.
The arithmetic average of annual rates of return in the above case is: (15.0 + 0.0 + 36.8
+ 26.7 +15.7)/5 = 18.8 percent.
RISK
The performance of a portfolio can be measured in various ways. The two most
commonly used measures of risk are: variability and beta.
VARIABILITY:
The Bank Administration Institute of the U.S. recommended the use of variability (as
measured by the mean absolute deviation) of the quarterly rates of return of the
portfolio. Sharpe and others have also advocated the use of variability. However, their
preferred measure of variability is standard deviation.
BETA:
A measure of risk commonly advocated is beta. The beta of a portfolio is computed the
way the beta of an individual security is computed. To calculate the beta of a portfolio
regress the rate of return of the portfolio on the rate of return of a market index. The
slope of this regression line is the portfolio beta. Remember that it reflects the
systematic risk of the portfolio.
PERFORMANCE MEASURE:
For evaluating the performance of a portfolio it is necessary to consider both risk and
return. This is what the Treyner measure, the Sharpe measure, and the Jensen measure
the three popularly employed portfolio performance measures precisely do.
SHARPE'S PERFORMANCE MEASURE
The Sharpe measure is similar to the Treynor measure except that it employs standard
deviation, not beta, as the measure of risk. Thus,
Hence, the Sharpe measure reflects the excess return earned on a Portfolio per unit of
its total risk (standard deviation).
The Sharpes performance measure makes a measurement of the risk Premium of
portfolios. His measure adjusts the performance of risk. Thus, Sharpes Index is given by
the following equation:
St = Sharpe Index.
Rt = Average return of portfolio 't'.
r = Riskless rate of interest.
t = Standard deviation of risk of the returns of portfolio t.
The risk premium is the return required by the investors for the assumption of risk
relative to the total amount of the risk in the portfolio
Figure 76 gives a graphic presentation of Sharpe's Index. Larger the St. the better the
performance of the portfolio, according to the Sharpe Index. The graphical
representation shows the amount of St. on the portfolio.
TREYNER'S PERFORMANCE MEASURE:
According to Jack Treyner, systematic risk or beta is the appropriate measure of risk.
The Treyner measure of portfolio performance relates the excess return on a portfolio to
the portfolio beta.
The numerator of the Treyner measure is the risk premium earned by the portfolio; the
denominator, the systematic risk (beta).
Hence, the Treyner measure reflects the excess return earned per unit of risk. As
systematic risk is the measure of risk, the Treynor measure implicitly assumes that the
portfolio is well diversified.
Treyner's Model is on the concept of the characteristic straight line. Figure 77 gives the
graphical description of Treyner's performance measure. It gives both the liner and
curvilinear relationship. According to his model, the inter-section at 45 degrees angle
represents that return which is equivalent to the return on the market portfolio. The
ideal fund is shown to the left of 45 degrees line. This is also above the imaginary 45
line. The return on this line is higher than that which is earned on the market portfolio.
According to this model, if the market portfolio that shows a negative return the return
under this method is positive but if the market return is positive the return under the
model of the characteristic line is still higher. This line is filled with the least square
regression model, as shown by the Sharpe's Single Index Model. The characteristic line
draws a relationship between the market return and a specific portfolio without taking
into consideration any direct adjustment for risk. This line has a slope which consists of
the beta co-efficient which, as already discussed, forms the part of the systematic risk.
The systematic risk fluctuates and changes because it is volatile. When the investors
make a comparison of the characteristic lines by taking into consideration their slopes,
then the steeper the line higher the volatility or the movement in the fund. This has been
measured by Treyner through the following equation:
Tn = Treyner's Index
Rn = Average return of portfolio 'n.
rt = Riskless rate of return.
JENSENS MEASURE:
Like the Treyner measure, the Jensen measure or Jensen's alpha is based on the capital
asset pricing model. It reflects the difference between the return actually earned on a
portfolio, and the return the portfolio was supposed to earn, given its beta.
Thus, the Jensen measure is:
Return the portfolio is supposed to earn as per the capital asset pricing model.
Illustration: To illustrate the calculation of the above measures, consider the following
information:
Average rate of return earned on portfolio
Average risk-free rate of return
Standard deviation of portfolio return,
p, Rp = 18.0%
Rf = 11.0%
p = 13.0%
Beta of portfolio, p
= 0.95
= 17.0
Rm
It is not feasible to evaluate the ability of a money manager over a short period of one to
three years when it should he appraised over a period of five to seven years. As Peter
O.Dietz and Jeannette R Kirschman Wrote: "For accuracy of computations,
performance should be computed as often as practical, but results should not be taken
as significant by the investor or the investment manager until a reasonable period of
time, such as a market cycle for equities or an interest rate cycle for fixed income
securities, has elapsed".
An investor purchases stock according to his return risk framework. The prices of each
stock having its own cycle of fluctuations. If an investor is able to develop careful
analysis of the behaviour of stock prices he is in a position to make a higher profit. The
portfolio which is once selected has to be continuously reviewed over a period of time
and then revised depending on the objectives of the investor. The important factor to
take into consideration is the timing for revision. The timing for revision is found out by
the use of formula plans. These plans are predetermined with distinctive objective and
rigidity of rules. Each of these has its own methodology and is useful for investors to
make a profit. These are Constant Rupee Value, Constant Ratio Value, and Variable
Ratio Formula Plans. The investor uses I formula plans to help him in making decisions
for the future by exploiting the fluctuations in prices. The three-formula plans which are
useful in making decisions are (a) the Constant Rupee Value, (b) the Constant Ratio,
and (c) the Variable Ratio Formula Plans.
GUIDELINES FOR REVISION
RULES FOR FORMULA PLANS:
1. The formula plans are useful for making a decision on the timing of investments.
These plans, however, do not help in the selection of securities.
2. The formula plans are strict, rigid and straight forward but they are not flexible.
3. The formula plans cannot be used or found useful for short periods of time.
4. The formula plans do not eliminate the need for making forecast; the kind of
forecasting technique will be different.
5. The formula plans work according to a methodology which is related for the
working of each plan.
The formulations of the formula plans are discussed below:
a. There should be a pool of funds which the investor has with him and would like
to invest. If there are no funds the formula plans or techniques are useless.
b. The investment fund of an investor should be divided through the technique of
formula plans to achieve the highest possible return and to meet with the
investors expectations.
c. The methodology adopted by the formula plans is to find out the difference in the
movements of the aggressive portfolios as well as the conservative and also helps
to assess the future course of action.
d. After assessing the difference in the movements between the aggressive and
conservation portfolio, the investor should find out whether the difference in
movements is large or small. The large and greater the difference between the
movements of the two portfolios the higher the profit that is derived from the
formula plan.
e. Bonds are useful investments for current income. Their prices fall in a boom
period. Their interest rates also rise. The situation is just the opposite during
depression. Stock prices fluctuate more than the bonds but give good capital
appreciation. In boom periods the prices of stock rise and during depression fall.
An ideal combination of safety in capital and capital appreciation is to be devised
under the formula plan.
f. The methodology adopted by the formula plans is to transfer the securities from
conservative portfolio to aggressive portfolio and aggressive to conservative at
appropriate time.
g. The formula plans also show when the stocks should be purchased and sold.
h. Formula plans indicate that greater profits are determined when it is noticed that
the stock prices and bond prices move in the opposite directions than if the
movement is in the same direction.
i.
If stock prices continue to be constant then the profits will also be very small and
when the stock prices continue to move and there are greater fluctuations, stocks
are said to be volatile in the market and the investor will make large profits.
j.
The investor should note that fluctuations in prices will not always move in
opposite directions between bonds and stocks.
k. The investor should note that the 'turning points' show the direction which the
investor should take decisions regarding purchase or sale of stock. These turning
points sometimes coincide and sometimes do not coincide.
l.
Portfolio managers are of the opinion that every investor should have some
amount maintained as cash or savings balance accumulated in the conservative
portfolio.
m. It should be recalled that the formula plans do not have a selection procedure for
the stocks. The aggressive portfolio represents common stock and the
conservative portfolio bonds. These have to be selected through some other
procedure as it does not form the purview of the formula plans.
n. If the investor chooses to have a-good current income which is stable he should
consider the choice of a more conservative portfolio which is less volatile in
nature.
o. The investor should know that if he wants to make a higher profit he is faced by
greater risk and higher volatility.
Apart from using the formula plans the investor should consider every stock that
he puts in his portfolio with respect to growth potential of the securities.
q. The investor before conducting the formula plans should be aware that he is to
make a reading of the history of the movements of stocks with the movement in
market index. This will help in assessing the volatile nature of the stocks.
TECHNIQUES OF PORTFOLIO REVISION
CONSTANT RUPEE VALUE PLAN
The constant rupee value plan has the following advantages:
1. It is the simplest form of formula plan. An average investor would find it easy to
cope with this formula plan.
2. This plan brings before the investor a fund which is ready for investment, with
certain percentage of investment in aggressive portfolio.
The methodology of the Constant Rupee value Plan is as follows:
a. This plan indicates the rupee value which remains constant in the total portfolio.
The aggressive portfolio should remain constant in the total portfolio.
b. Whenever the stock value rises the shares should be sold to maintain a constant
portfolio. The investor, according to this formula, should buy shares when prices
fall to maintain a constant portfolio.
c. Although the aggressive portfolio has to remain constant to the total portfolio,
according to this plan, a portion of the total funds should be invested in a
conservative fund.
d. According to this plan, the investor is guided by "action points". These action
points are also called revaluation points. These action points help the investor to
take decisions of transfers from aggressive to conservative portfolio and viceversa in order to be able to maintain the constant rupee value.
e. This plan states that timing of stocks and their turning points are the most
crucial.
f. This formula plan indicates the action points, transfer decisions that is the period
of the when action should be taken. If the action points are too close together
then there will be no profit as the transfers will be expensive and the transaction
cost will be high.
g. The action points can be said to be a trade-off between stock and 20%
profitability. A certain range of fluctuations (say) is specified. If the fluctuations
of stock are within this range no change will be made by the investor from
aggressive to conservative portfolio or vise versa. But when the fluctuations move
out beyond this range the investor will have to plan a change or transfer.
h. The investor will require the knowledge of how 'low' the fluctuations may go but
it does not require the forecasting of an upward movement.
i. If the investor begins his constant rupee fund when the stock he acquires is not
priced too high above the lowest values to each they might fluctuate. The investor
can get better overall result from the constant rupee plan.
j. All formula plans are applied usually to a single common stock. The movement of
the single common stock is similar to the movement of the total common stock.
The investor has to use then formula plan for a full identical circle to make his
plans useful. Using the formula plan for a full circle helps the investor to make
comparisons of the plan adopted by him in different conditions.
CONSTANT RATIO PLAN
This ratio plan is slightly different from the constant rupee value plan. This plan is a
method of identifying the ratio of the value in the aggressive portfolio to the value of the
conservative portfolio, the market value of aggressive portfolio divided by the market
value of the total portfolio should be held constant.
METHODOLOGY
1. According to this method, the stock should be sold when value rises to make it
constant with the value of the conservative portfolio. And the investor should
transfer funds to common stock when the stock value falls. In this way he should
also change from conservative to aggressive value.
2. Under this plan the aggressive value is always to be kept by the investor constant
(of the portfolio's total value) and have to shift from conservative to aggressive
value if the prices of stock fall.
3. The formula plan based on constant ratio does not require the investor to make
forecasts of the lower levels at which the prices Fluctuate
4. Contrary to the constant rupee plan draws a relationship which results in the
purchasing of stock in a less aggressive manner as the prices fall down because
constant ratio plan is applicable in the case of total fund which is decreasing in
value.
5. The constant ratio plan operates in a less aggressive manner. The reason for
being less aggressive in nature is that under the constant ratio the value of the
total fund increases in a manner to allow large rupee value in the stock portfolio.
6. The middle ranges of fluctuations are deciding favors for the sales and purchases
of aggressive stock m the constant ratio plan. When the fluctuations are just,
above, he middle range of the sales that take place it is identified as the most
aggressive point. Similarly, when the fluctuations are just below the middle range
it is considered to be the most aggressive.
7. The optimum, formula plan is when the stock prices are sold aggressively as their
prices fluctuate above the middle range of fluctuations and by purchasing
aggressively when the prices move below the middle range of fluctuations.
8. In the constant ratio plan if the fluctuations of stock take a long time to move in a
direction which is either upwards or downwards then this plan does not work at
its optimum value.
9. This formula plan will work optimally if it is forecasted carefully. But if an
investor begins to forecast then it goes against the assumption of that there is no
requirement for forecasting.
10. In the constant ratio plan, the investor will get high profile if there is a
continuous sustained rise or fall in prices. This large profit is due to the fact the
ratio under this formula itself leaves the investor into a more optimum position
as there is a larger investment during boom and lower investment in depression
periods under this formula plan.
11. The constant ratio plan does not work with full efficiency when are noticed full
cycle of fluctuations or movements both upwards and downwards. The reason for
this inefficiency is that the plan does not have aggressive purchase or sale during
the turning plan.
12. The methodology adopted in this plan to reach the fluctuations and its readjustments is made by the percentage fluctuation and time of re-adjustments
just like the constant rupee value plan.
VARIABLE RATIO PLAN
The variable ratio plan is considered by the investor under following adopted for its
study:
METHODOLOGY
1. The investor should sell stock when the price of stock rises and bond should be
purchased. When stock prices fall they should be bought and the bonus should be
sold.
2. The methodology of the formula plan should have a pre-determined set of rules
and consist of different proportions of stock prices.
3. Under this plan the ratio of value of aggressive portfolio the value of conservative
portfolio decreases when the aggressive portfolio rises in value.
4. The aggressive portfolio consists of the total amount which the investor is able to
risk in investing in common stocks. Taking a median round which the future
fluctuations will move.
5. The complete programme of investments will be drawn by the investor from this
median.
6. The investor under this formula plan will have to make forecasts in the range of
fluctuations which move both above and below the median to find out the
different ratios at different levels of stock.
7. These stocks will have to be predicted with absolute accuracy or the investor will
not succeed in making profits. He will be left with a large number of stocks when
prices are falling or either he will find himself without any stocks when prices are
rising.
8. The most important tool of the variable ratio plan may be said to be "forecasting".
9. Under this plan the ratio has to be varied if purchases and sales have to be made
more aggressive. The varying ratio would lead to the movement of prices in
different directions which are either upwards or downwards and are away from
the median.
10. This plan is most profitable for an investor when there are a large number of
fluctuations.
11. Under this plan the ratios are varied whenever there is a change in the economic
or market index. The most important factor after forecasting is that this plan
takes into consideration "change". Whenever there is a growth trend for common
stocks then the variation can be accounted for by exploiting the fluctuations
around the long term trends.
The variable ratio plan moves with indicators. These indicators are the market index.
The biggest disadvantage of this formula plan is the dependency on a forecast.
MODIFICATIONS OF FORMULA PLANS
The formula plan on be modified under the following assumptions.
These assumptions are:
a. The formula plans are not flexible and many times changes occur when the
investor desires some change and flexibility according to the changed
circumstances.
b. The formula plans work under assumption that the emotions and feelings of an
investor are not taken into consideration.
c. The stock prices do not always fluctuate in the same manner. Window dressing
may be necessary to be made by the investor.
d. The reflection of historical data will not always indicate the same norms and the
investor may require some alterations.
The methodology adopted for modifications in formula plans are the following:
1. The investor can delay in making changes during the action points. This will
modify the basic formula plan under which he is operating.
2. The investor may continue to invest in the same securities although the action
point has arrived because he has a feeling and his emotions are involved that
there will be exploitation in the continuation of the trends.
3. The formula plans can be modified by putting some flexibility in it according to
the requirements of the investor and the environment in which he is operating.
QUESTIONS
1. What is investors portfolio?
2. do you think that the effect of a combination of securities .can bring about a
balanced portfolio? Discuss.
3. What is Marcowitz 'efficient frontier? Explain with illustrations.
4. Is Sharpe's model an improvement over Marcowitz Portfolio Theory?
5. What statistical techniques would you choose to calculate risk? Why?
6. Discuss the significance of 'Beta in an individual's portfolio.
7. How can an individual make an analysis of indifference curves to get the most
beneficial portfolio?
8. Discuss the Single Index Model as described by Sharpe to get the optimum
portfolio.
9. What is an efficient frontier? How does it establish an optimum portfolio?
10. Write notes on (a) Capital Market Theory, (B) Security Markel Line, (c) Beta.
11. Mutual Funds are better performers than individuals. Examine this statement.
12. What are the different kinds of Investment companies? Do their strategies in
portfolio management differ from individuals?
CASE MPT, Inc.,
MPT, Inc., is an investment counseling firm headquartered in Los Angeles with regional
offices in Seattle, San Francisco, and Phoenix. MPTs primary activity is to provide
portfolio management services to individuals and institutions with portfolios of $1
million or more. The firm also performs related custodial and performance monitoring
services, Annual fees are based upon a percentage of the market value of a client's
portfolio.
Since it is founding in 1980, the firm has enjoyed phenomenal growth. Today it has well
over $250 million under management. The professional staff consists of financial and
research analysts, information systems personnel, and regional portfolio managers.
Most of the analysts have earned the designation of Chartered Financial Analyst (CFA),
and most have graduate degrees in finance, economics, or computer science.
Merck had heard of the success Mpt had for its clients using sophisticated model and
had decided that his investments certainly could do no worse that they had in the hand
of Shitely and Howe. He asked MPT for a simple demonstration of how MPT created
portfolios for clients. The regional portfolio manager, Jennifer Corbett, prepared a list of
stocks with the essential ingredients used by the firm in the selection of efficient
combinations of candidate stocks. (See Exhibit-1) She felt that these would provide a
useful base for demonstrating the process to merck.
Question: Construct an optimum portfolio.
*Current market value is $19.50 and pays a $.60 per share dividend.
+Assume the current market price is par.
# purchased nine years ago; market value is $12,000.
QUESTIONS
To familiarize himself with the Aliens' situation, he reads the following memorandum
prepared by Perennials new business offer:
Mrs. Emily Allen, age 84, lives simply on the income from a trust created by her
husband, the Charles A. Allen Trust for Emily Allen. The present status of this trust is
shown in Exhibit. Mrs. Allen is the trusts only income beneficiary; on her death, the
assets go to her son, George free of taxes (which were paid at Charles A.Allen's death).
Mrs.allens contributes her excess members of his family. She feels George is somewhat
irresponsible although not comfortable in the present-day financial environment, and
has often said, suffered great hardship, yet my husband was able to build our fortune by
investing wisely over the years. The Allen Trust's only investment restriction is a
requirement that George Allen be consulted, as a courtesy, before any investment action
is taken.
George Allen, age 54, is married and has three children, all sons, one on prep school and
at two in college. Mr. Allen is not employed but volunteers his services to a variety of
civic and charitable organizations.
QUESTIONS
1. treating the Allen family as an entity, create an investment policy statement to fit
their combined situation.
2. based on your answer to Question 1, recommend and justify an asset allocation
strategy for each of the existing Allen portfolio your allocation strategy sum 100% for
each portfolio.
3. Assume the Emily Allen dies suddenly. Revise your allocate strategy for George
Allen. Your allocation must sum to 100%.
Capital market occupied a centre stage in financial sector the stress of the program is to
being about a real market economy with liberalization as objective .The core
components of the reforms programme are
1.
2.
3.
4.
5.
Financial sector reforms encompassed both banking and capital market sector.
Narasimharao committee aimed at improving the efficiency of the financial system
through prudential reputation. These include removal of Control of Capital Issues [CCD]
and statutory recognition to SEBI for regulating the market
The securities and Exchange Board of Indian Act 1992
The SEBI Act 1992 provides for the establishment of a statutory board (21-2-92) having
autonomous status with perpetual succession and common seal. The preamble of the
Act provides the Board to project the interest of the investors regulate securities and
monitor intermediaries such as brokers, merchant bankers, portfolio managers, mutual
funds, insider trading, registrars to issues and share Transfer agents, underwriters and
Debenture Trustees. SEBI Act provides that the intermediaries should get registration to
transact business in the market. SEBI has been vested with Exclusive power to regulate
both primary and secondary market. It can inspect and inquire into the affairs of the
stock exchanges and their members.
In regard to issue of capital as governance by the companies Act 1956, SEBFs role is to
ensure that proper guidelines are followed by the companies and they disclose
adequately in the offer documents to the investors.
Government has vested SEBI with powers concurrently with the Department of
Company Affairs authorizing it to file complaints against defaulting companies for
protecting investors. Thus powers require SEBI to prohibit fraudulent and unfair trade
practices, as also promote Investors education, training intermediaries and
establishment of self regulatory organizations (SROs)
APPROACH OF SEBI
1. SEBI shall create a proper and conducive atmosphere required for raising money
from the capital market. The atmosphere includes the rules, regulations, trade
practices, customs and relations among institutions, brokers, investors and
companies. It shall endeavour to restore the trust of the small investors. This can
be achieved by meeting the needs of the persons connected with the security
market and establishing proper coordination among the three main groups
directly connected with its operations, namely, (a) investors, (b) corporate
sectors, and (c) intermediaries.
2. SEBI shall educate investors and make them aware of their rights in clear arid
specific terms. It shall provide investors with information' and see that the
market maintains liquidity, safety and profitability of the securities which are
crucial for any investments.
3. SEBI shall create a proper investment climate and enable the corporate sector to
raise industrial securities easily, efficiently and at affordable cost.
4. SEBI shall develop a proper infrastructure to automatically facilitate expansion
and growth of business to middlemen like brokers, jobbers, commercial banks,
merchant bankers, mutual funds, etc thus; it will ensure efficient services to their
constituents, namely, investors and the corporate sector at a competitive price.
5. SEBI shall make the laws in the existing status as far as they relate to the
industrial securities, mutual funds, investments in Units, LIC saving plan. Chitfund companies and securities issued by housing/industrial societies and
corporation with the purpose of making investment in housing/industrial
projects.
6. SEBI shall create the framework for more open, orderly and unprejudiced
conduct in relation to takeover and mergers in the corporate sector to ensure fair
treatment to all the security holders.
7. It shall devise laws with a unified set of objectives, single administrative authority
and an integrated framework to deal with all the aspects of the securities market.
8. It shall also play an active role in interaction with the institute of Chartered
Accountants of India in upgrading and making more effective the accounting and
auditing standards. It shall try to bring in discipline in management in financial
reporting and act firmly with cases where window dressing and accounting tricks
are employed to the detriment of the interest of users of such financial
statements.
9. It shall introduce a system of two stage disclosure at the time of initial issue and
make compulsory for the companies to provide detailed information to all the
stock exchanges, journalists and investors on demand.
10. It will examine the feasibility of introducing a dealers net work by which
securities can be bought or sold over the counter as in retail shop. This will
smoothen liquidity and investment opportunities.
11. It shall work as an authoritative institution to see that the intermediaries are
financially sound and equipped with professional and competent manpower.
AN APPENDAGE OF GOVERNMENT
SEBI is only an appendage of the Central Government .Under Section and 5 the Board of
Directors of SEBI will consist of the Chairman, two members representing the
Ministries of Finance and Law and one member from the Reserve Bank of India. Two
Other members will be appointed by the central Government. The term of office and
other conditions will be described by the Government. The Central Government will
have a right to terminate the service of the Chairman or the member at any time before
the expiry of the period prescribed. The Government has the right even to supersede the
entire Board and reconstitute it.
Second, the Central Government will frame rules under the provisions of Section 23(1)
for the registration of all the Intermediates in the securities market.
Third the SEBI will frame regulations only with prior approval of the Central
Government and they must be consistent with the provisions of the ordinance and the
rules made by the central government as provided in Section 30(1) of the ordinance.
Fourth, the SEBI will file criminal complaints for violation the rules and regulations
only with the previous sanction of the Central Government under section 26 of the
ordinance.
Fifth, it is significant to note that under Section 16(1),"the Board shall, in exercise of its
powers or the performance of its functions under this ordinance, be bound by such
directions or questions or policy as the Central Government may give in writing form
time to time and under Section 16(2),"the decision of the Central Government whether a
question is one of policy or not shall be final.
"Sixth, under section 20(1), "any person aggrieved by an order made under this
ordinance or the rules and regulations made there under may prefer an appeal to the
Central Government within such time as may be prescribed."
Finally, under section 32, "the provisions of the ordinance shall be in addition to and not
in derogation of the provisions of any other law for the time being in force This is
evidently to permit the Company Law and Control Capital Issues Act to operate side by
side with the provisions of the ordinance.
Thus, the Government will have complete control over the constitution, functions and
the working of SEBI.
RECENT MEASURES TAKEN BY SEBI
ABOLITION OF CO:
SEBI has become a focal point for regulating Issues of capital by the corporate sector
with the abolition of CCI. SEBI has abolished the control on pricing of issues and access
to the market
DISCLOSURE OF INFORMATION:
To look after the interest of investors, the format of the prospectus had been redesigned
to include information relating to specific areas such as terms of objects .cost of the
project, means of financing, history, background of the company management and
promoters, infrastructure facilities schedule of implementation .capacity utilization
stock market data for existing companies within the same measurement, details of
outstanding litigation and defaults, material developments after the data of latest
balance sheet and its impact on the performance and prospects of the company. Similar
requirements have also been laid down in respect of letters of offer covering the rights
issue. A memorandum in the shape of abridged prospects is required to be printed and
supplied to Investors with application forms.
A concept of risk factors has been introduced. These factors cover aspects such as
management/promoters, track record, specific economic aspects affecting the industry,
supply of raw materials statutory approvals relating to environment/Pollution, financial
data projections, explanation towards the gaps between promises and performances
along with perceptions of the management. The highlights are vested to ensure that they
would not present rosy picture to the investors. To enable the investor, effort is made to
see that disclosures are not only adequate but authentic and accurate. The emphasis is
to improve the levels of disclosures and to see that financial accounting statements more
towards international standards.
This applies to disclosures by way of advertisements in newspapers, hoardings in public
places and advertisements and slots in T.V. etc. A set of guidance series has also been
issued to the investors explaining factors that they need to take into account while
considering investment in the primary market, as also to be alert about the illegal
transactions taking place in the so called 'Unofficial Premium.
INTRODUCTION OF "STOCKINVEST
The grievance of the investors is limited opportunities of getting allotment in issues
applied for, due to oversubscription many a time. This led to the blocking of their funds
for periods upto 4/6 months in a good number of cases where they were required to be
refunded to them. This not only disabled the investors form rolling over their funds at a
faster pace. To provide relief to the investors in this regard as also to remove the
motivation form the issues to delay the allotment/refunds, SEBI introduced with the
support of the Government of India and Reserve Bank of India a new instrument in the
primary market namely 'Stock invest from March 1992. While the instrument is not per
se negotiable, it has the characteristics of bank draft with the special feature being that
its proceeds are not collected except in the event of allotment.
making multiple/benami applications. This step has been reinforced by providing that
the minimum application amount aggregate shall be Rs. 5,000 against Rs. 1000 earlier
that the number of investors wishing to play in the market could be reduced to a fairly
manageable level. These measures shall be gearing up the process of institutionalization
of the market.
It has also recently supported the moves for introduction of nonvoting shares,
observation of equitable norms for the approval and pricing of preferential allotments to
promoters, allowing flexibility in pricing by way of a bond etc.
EURO ISSUES
In keeping with the pace of liberalization a number of Indian companies have made
issues of capital in the Euro market by way of GDRs and Euro-convertibles. Since June
1992 till March 1994, 25 companies have accessed the Euro market for an aggregate
amount of about US$ 2.5 billion with GDRs, Euro Bonds and Warrants.
MUTUAL FUNDS
In the field of Mutual Funds, SEBI requires registration -whether in the public or private
sector. A code of Advertisement has been laid down and Mutual Funds are required to
disclose risk factors. They are also required not to give rosy picture of high returns. They
have to follow prudential accounting and reporting requirements. The Mutual Funds
have to establish themselves strongly in the minds of the small investors as the major
vehicle for channelizing their investments.
Foreign Institutional Investors (Flls)
As mentioned earlier. FIIs have been permitted to make investments in the primary and
the secondary markets by the Government of India under the guidelines issued by them
in September 1992. So far over 195 FIIs have been registered with SEBI and the amount
invested by them in the capital market in India has been over RS. 1000crores.
Measures in the Secondary Market
SEBI has taken several masseurs covering the secondary markets. Since this has been
the older market more visible to the average investor in having its presence in over 20
centres in India. It has attracted immediate public attention vis-a-vis SEBI as the
regulator authority. The secondary market, at the outset, the institutional mechanism of
which was inadequate, non transparent, hardly regulated is rarely geared for investor
protection. There are number of areas in which SEBI had to intervene to bring about
reforms using its regulatory authority provided to it n terms of the Securities
Contracts(Regulations) Act of 1956(SCRA) and the SEBI Act of 1992.
Reconstitution of Governing Boards
Some companies are found to be indulging into malpractices like price rigging, insider
trading, unethical practices in terms of private placement/promoter's quota, etc. The
high volatility and speculative practices, and large scale trading irregularities like nondelivery of shares/debentures against payment made etc. by the brokers, sub-brokers
and their agents have generated a large number of complaints from the investors.
Investors have also been facing a lot of hardships in the primary market on account of
non-receipt/delay in receipt of refund order/allotment advice, share/debenture
certificates after transfer/allotment/endorsement/ conversion, etc, non receipt or
delayed receipt of declared dividend, non-receipt of principal amount of debenture after
redemption, non-receipt or delayed receipt of interest on fixed deposits and non
repayment of fixed deposits on maturity, non-receipt of Rights forms, etc.
SEBI has evolved a system of redressal of investor grievances and is taking up investors
complaints. Some of the other measures taken in this regard include an appointment of
public representatives to oversee the allotment process, updating of information into
offer documents, etc.
One very important step taken recently by SEBI is to share the information on investor
complaints with recognized investors Associations, including Consumer Fora, to
facilitate filling by them of case action suits in Consumer Court against erring
companies.
SEBI has also taken steps by way of investor education. It has issued a number of
investors guidance advertisements and published a book regarding Investor
Grievances-Rights Remedies. The latest guidance series issued in March 1994 covered
the aspects of Grey Market.
Operations, precautions to be taken for risk-free transactions in the secondary market
and additional guidelines on the Stock invest Scheme. SEBI is also working on a more
specific Education Programme to be brought to the Investors through the medium of
TV/Video. To increase investors awareness and to make them strong, SEBI has also
given certain active investors a place on its Advisory Committees.
SEBI protection
Indian regulators are wary of giving too much accessibility to foreign institutional
investors (FIIs). SEBI limits their cumulative investments in any Indian company to 24,
per cent and ceiling of 5 per cent is imposed on individual FIIs.
SEBI has also introduced a set of six tenets to protect the rights of minority
shareholders in the event of a hostile acquisition. and these are:
Raiders must reveal their ultimate intentions when buying it to a public
company.
Predators cannot use shells or fronts to corner stakes.
Clandestine deals between principal shareholders and bidders are prohibited.
A hostile raider with a 10 per cent stake cannot purchase more shares without
making a public tender offer.
Foreign investors cannot sell more than 1 per cent stake in an Indian company
without a public notice.
Directors cannot refuse to register shares without shareholder's approval.
SEBI had insisted that only companies with three year dividend track record out
of the previous five years can have access to the primary market. This was to
weed out fly-by-night operators. The rule was relaxed only for manufacturing
companies, if public financial institutions or banks had appraised the project and
participated in it.
Now it is relaxed further for any company whose project has been appraised by
public financial institutions or banks and who participate in the project in the form
of loan or equity for at least 10 per cent.
Only finance companies are left out. They can access the market only if they have a
three year dividend track record.
ii.
For considering the dividend track record, any dividend paid in cash will to be
considered. This is to avoid manipulations to show a track record.
iii.
Earlier only the public sector banks were exempted from the dividend norm for
entry. Now private sector banks which have received in principle approval or
license form RBI on or before 16 April 1996, are exempted from the dividend
track record norm. They can access the primary market. Here again, SEBI has
been partial to the public sector. Probably, after some representation, this will be
extended to private sector banks as in the case of entry norms.
b. Premium issues
SEBI has reduced the three year consistent profitability track record for premium issues
to two years in the case of public sector banks. However, there is no relaxation for
private sector banks.
c. Vetting of documents
SEBI has decided not to vet the offer documents submitted by companies with a three
year dividend track record. Also, offer documents of companies seeking listing in OTCEI
will not be vetted by SEBI. However Companies will have to submit the offer documents
to SEBI which will communicate its observations and comments to the lead manager
and issuer. They can proceed with the issue if no communication is received within 21
days.
d. Housing finance companies
SEBI has decided that housing finance companies eligible for refinance form National
Housing Finance would be treated in the same manner as finance companies registered
with SEBI or RBI
- End Of Chapter -