Security Analysis & Portfolio Management Lesson 1-10 International Centre for Distance Education and Open Learning Himachal Pradesh University Gyan Path, Summer H ill, Shimla - 171005 1 CONTENTS SR. NO. TOPIC PAGE NO. Contents 1 Syllabus 2 CHAPTER - 1 ELEMENTS OF INVESTMENT 3 CHAPTER - 2 PORTFOLIO ANALYSIS 16 CHAPTER- 3 PORTFOLIO CHOICE 27 CHAPTER - 4 PORTFOLIO PERFORMANCE EVALUATION 37 CHAPTER - 5 FUNDAMENTAL ANALYSIS AND VALUATION 47 CHAPTER - 6 TECHNICAL ANALYSIS 61 CHAPTER - 7 MARKET EFFICIENCY 83 CHAPTER - 8 MARKET MODEL 94 CHAPTER - 9 CAPITAL MARKET THEORY 101 CHAPTER - 10 ARBITRAGE PRICING THEORY 113 “ASSIGNMENTS" 128 2 MC 4.2 SECURITY ANALYSIS& PORTFOLIO MANAGEMENT Max Marks: 80 Internal Assessment: 20 Note: There will be nine (9) questions in all. The first question is compulsory and consists often (10) short-questions having two (2) marks-each. The candidate will be required to attempt one question from each unit and each question carries' fifteen (15) marks. COURSE CONTENTS UNIT-I PORTFOLIO ANALYSIS: Estimating rate of return and standard deviation of portfolio. Effect of combining the securities, Markowitz Risk-return optimization. PORTFOLIO PERFORMANCE EVALUATION: Measure of return risk adjusted measures of return, market timing, evaluation criteria and procedures. Investment policies of individuals, Tax saving schemes in India. UNIT-II Fundamental Analysis, Technical Analysis and Efficient Market Hypothesis. UNIT-III SINGLE INDEX MODEL OR MARKET MODEL: Portfolio total risk/ portfolio market risk and unique risk, Simple Sharpe's optimisation solution. UNIT-IV CAPITAL-MARKET THEORY: Capital market line, security market line, risk free lending and borrowings. FACTOR MODELS: Arbitrage pricing theory, two factor and multi-factor models, Principle of arbitrage, arbitrage portfolios. SUGGESTED READINGS: Fischer, D.E. and Jordan R.J., Security Analysis and Portfolio Management, Prentice Hall, 1983. Reilly, F.K., Investment Analysis & Portfolio Management, Drygen Press, 1985. 3 CHAPTER - 1 ELEMENTS OF INVESTMENT Structure:- 1.0 Learning Objectives 1.1 Introduction 1.2 Types of Assets 1.3 Return and Risk 1.4 Investment Vs. Speculation 1.5 Jobs in Investment Analysis and Portfolio Management 1.6 Types of Information 1.7 Need for Information 1.8 Self Check Exercise 1.9 Summary 1.10 Glossary 1.11 Answers to Self Check Exercise 1.12 Terminal Questions 1.13 Suggested Readings 1.0 LEARNING OBJECTIVES After reading the chapter,you will be able to:- Describe the types of assets available for investment Understand the concept of risk assessment with investment Describe the sources of investment information 1.1 INTRODUCTION Investment is the commitment of funds for a period of time with the expectation of receiving more than the current outlay. The returns could be in the form of annual income and/or appreciation in price. Many readers would already have studied investment analysis from the perspective of the firm. In this chapter, we will examine financial decisions from the perspective of persons investing in corporate securities and other assets. These could be individuals, societies and trusts, mutual funds etc. Why invest? While the reasons for investing are unique to each individual, common reasons could be to have money for emergencies, to beat inflation, buy a car or house, pay for education, indulge in travel and hobbies, to give to children or charity and for retirement. It is important for each investor to have a financial plan in order to achieve these goals. Various types of assets are available for investment such as land, buildings, fixed deposits, shares, bonds, gold etc. As investors, we need to understand the implications of investing in various assets, and the associated risks and returns. Most investors hold a combination of assets, known as a portfolio. Since, a portfolio may have different risk and return characteristics as compared to the simple 4 aggregation of its component assets, we also need to analyse the risk/return characteristics of portfolios and select portfolios suited to individual risk and return preferences. As individual needs and the risk and return of the portfolio change over time, the selected portfolio needs to be reviewed periodically and revised if necessary. 1.2 TYPES OF ASSETS Assets can be broadly classified into tangible assets, financial assets and intangible assets. Tangible assets consist of real/physical assets such as buildings, land, precious metals, commodities and luxury or collector's items. Financial assets/paper assets represent a claim on physical assets or future cash flows. They include savings deposits, fixed deposits, cash back insurance policies, shares, bonds and derivative instruments. Intangible assets include patents, trademarks, goodwill etc. Some assets such as collector's items may have more sentimental value than financial value. In this chapter, we will be concentrating on financial assets, although majority of the concepts and techniques can also be applied to real assets. Financial assets can be further divided into debt and equity, based on the timing and nature of expected cash flows. Debt is a fixed period loan, which comprises of periodic or cumulative interest payments and return of the principal on maturity. Equity, on the other hand, represents ownership of a company, where returns are received in the form of dividends and capital appreciation. Over the years, a variety of financial instruments have evolved in response to the needs of borrowers and investors. Financial assets can be held in the form of personal contracts or in the form of securities. In personal contracts, the amount of money invested, rate of interest and period of deposit etc. are based on mutually agreeable terms between the borrower and the lender. For example, the bank announces interest rates applicable for various periods and amounts invested, while the investor decides the amount of money and time period for his deposit. The principal is paid back on maturity or on premature withdrawal with a penalty. Such deposits normally cannot be sold or transferred to a third party. Securities on the other hand, are issued in fixed denominations and are fungible (each unit is indistinguishable from the other) and tradable. Examples of securities include shares and bonds. The choice of investment depends on many things including the investment period, the amount of money available for investment, need for liquidity, current income versus capital appreciation, tax considerations and ability to take risk. The features of some commonly held assets are briefly described below: Tangible Assets Real Estate can be viewed as an investment that provides regular income in the form of rental and appreciation in value. In India, there is scarcity of land and the value of property normally appreciates in the long run. The rate of appreciation and rental depend on whether the property is commercial or residential, the city/town and exact location. Since all individuals require housing services, one way to hedge against fluctuations in rentals is to purchase a house. Tax benefits are available on payments for housing loans; self-occupied houses are also given concessions in property tax. However, real estate requires a large investment and may need to be financed. The disadvantages are that it cannot be liquidated in parts, it also takes time and effort to sell because each property is unique. At the time of purchase, the buyer must ensure that the title deed is genuine, and provide for transaction costs such as stamp duty and brokerage. After purchase, arrangements need to be made for its physical safety to prevent encroachment, fire, theft of contents etc. Although property forms a major part of the investment portfolio for many individuals, there is no historical data on property returns in India due to the lack of transparency. Real Estate Investment Trust (REITs) and Real Estate Mutual Funds recently introduced in India should help overcome many of these disadvantages. Gold is a very liquid asset that has been traditionally held by central banks all over the world. Gold jewellery is also a common investment in most Indian households. The disadvantage of 5 investment in gold is that it requires expenditure for safe storage and its purity can only be guaranteed if purchased and stored in the form of certified bars. Investors can invest in gold exchange traded funds to overcome these disadvantages. Art: Appreciation is value depends on the painter and future demand and supply for the paintings. The market is unorganized and there is the problem of fakes, for which proper documentation and authentication is necessary. Financial Assets - Personal Contracts Savings bank accounts offer a safe deposit facility for cash and a nominal interest rate, with facilities for instant withdrawal and transfer. Fixed deposits in banks offer a higher rate of interest. However, the funds are locked in for a fixed period of time and there is a penalty for premature withdrawals. There are also some flexible plans, which combine the features of savings and fixed deposit accounts. Tax saving instruments u/s 80C Public provident fund: Contributions to the fund qualify for deduction from income up to the permissible limit and interest and withdrawals are tax free. The disadvantage isthe lock in period of 15 years, with limits on loans and withdrawals before maturity. Pension plans: These are annuity schemes where contributions qualify for deduction in the years when payments are made but the interest and principal are taxable at the time of withdrawal (pension payments). Insurance: Some life insurance plans build in an investment component, which offer periodic and/ or terminal cash benefits. The returns can be compared with other investments if the payment for pure insurance is deducted from the annual premium before calculating returns. In all such schemes, the individual investor should consider the alternative investment avenues and decide whether it is better to pay tax and invest elsewhere or invest in these schemes. The liquidity, and returns and risks of alternative investment avenues need to be considered.