Security Analysis: An Introduction

Course Handout
What is this course about?

Part 1
• Investment-Philosophy
• Role of financial markets and Indian Investment Environment
• Financial Markets: Method of security Issue, Market structures

Part 2
• Fixed Income Securities i.e. Bond Types and Pricing
• Term Structure of Interest rates
• Portfolio Management of Fixed Income securities
Part 3
Fundamental Analysis
• Economic, Industry and company Analysis
• Correcting expenses misclassification, Accounting earnings Vs True earnings
• Valuation methods i.e. DCF, Comparables, etc.
• Estimation of risk parameters, cashflows, growth rate, etc.
• Measuring equity value
Course Outcomes

The objective of the course is to provide the conceptual foundation to undertake Investment
analysis for securities, both equity and debt.

CO1: Understand the role and structure of financial markets in an economy.

CO2: Analyze fixed-income securities in terms of their characteristics, pricing, yield and yield
curve.
CO3: Analyze risk in fixed-income securities.
CO4: Understand concepts related to economic, industry, and company analysis.
CO5: Apply discounted cash flow method to value companies.
CO6: Apply the relative valuation method to value companies.
Assessment Components

No. Parameter Weightage Conducting on

1 MidTerm 20 End of 10
sessions
2 Group Project 20 Due end of
sessions
3 Class participation (10-Pre+10-Post) 20 10- Pre-Mid
term.

10- Post-Mid
term.

4 Comprehensive Examination 40
Total 100
History of the Discipline

• Benjamin Graham (teacher of Warren Buffett) is credited with starting the discipline of
security Analysis.

• Wrote the book titled “Security Analysis” in 1934.

• “Margin of Safety” the most important principle.

• Investing Vs Speculation
Investment Vs Speculation

Sacrificing something now for the prospect of gaining something later.

"An investment operation is one which, upon thorough analysis promises

safety of principal and an adequate return. Operations not meeting these
requirements are speculative."
Graham & Dodd

Speculation: The activity of forecasting the psychology of the

market.
John Maynard Keynes
Transformation of discipline

• Fundamental Analysis

• Technical Analysis

• Efficient market hypotheses

Investment Environment

In this session we cover the following:

• Role of Financial Markets

• Investment Process
• Saving and Financing statistics for Indian Market
• Trends in the Investment field
What is a Financial Market?

• Place for buying and selling financial assets.

• Provide financing source
• Provide Investment avenue

Why can’t this function be administered by Government or banks or Financial

Institutions?
What would happen in the absence of markets?

• One institution makes the decision about funding or not funding and the
related variables without taking into consideration the views of the participants
(buyers or sellers).

• For example if only banks or Government are the only suppliers of capital, then
a small few officials would decide whether to provide financing or not and also
the rate of financing. This may or may-not consider all the factors. There may
be favoritism or personal biases as well.

• As against the above if a company raises money through a bond market, the
participants can make the individual decision of funding, as well as the amount
and the interest rate. This way it is not based on decision of a few officials like
bank or Government.
Financial Market Role 1
Assume the following:

• A listed oil & Gas company has found a major oil reserve.

• A top official of a listed company has been caught bribing Govt officials.

• In both cases the information will be quickly reflected in prices through increased buy/
sell orders.

• When the investment decision has to be made by wide variety of participants then the
demand or the supply would be based on the information available by all the market
participants.

• In the absence of markets the above information may or may not be considered if decision
is being made by few.

• Thus the market is playing the role of “information aggregation”. Also termed as price
discovery.
Financial Market Role 2
Consider the following

• A 25-year old is earning Rs.2 lakh and consuming just Rs.50,000. He wants to purchase a
house after 5 years.

• A 45-year old also earns more than he spends but want money for post-retirement years i.e.
after 20 years.

• By investing in different instruments for different maturities the above participants may
decide to buy or sell assets based on their requirement.

• Thus the market plays a role of “storing value and helping to transfer consumption to future”.
Financial Market Role 3
• A 20-year old wants to multiply her money fast and is willing to take higher risk. She
invests in a bio-technology company working on wonder drug

• A 60-year old wants to play safe and is fine with lower return. She invests in a utility
company.

• The market participants can choose to invest based on their different risk appetite. The
market performs the role of “risk allocator”.

• As against this if everyone (in the absence of markets) is investing is a bank deposit or
pension scheme of government, they are not able to choose the investment in line with
their risk-return requirement.
Financial Market Role 4
• You think that Real estate business has great future but do not want to start a real estate
company. What can you do?

• You can buy the shares , that represent the business. Each share represent some fraction of
the value. Ownership of the share brings the right but no legal responsibility.

• In the absence of market it is not feasible to raise capital from large pool of investors. The
market in this role helps to separate “ownership from management”

• However this benefit brings with itself the issue of agency cost, wherein the incentives of
owners are not aligned with those of the management.

• A CEO of company would like to run a bigger company rather than a very profitable
company. He may go for acquisitions which may not make economic sense but gives him
more clout. This behavior is unlike the owner who would be more interested in the company
being more profitable rather than being big.
Financial Markets and the Economy

• Information Role: Capital flows to companies with best prospects

• Consumption Timing: Use securities to store wealth and transfer consumption to the
future

• Allocation of Risk: Investors can select securities consistent with their tastes for risk

• Separation of Ownership and Management: With stability comes agency problems

Can you trust Financial Markets?

• Market reflects the mood of its participants. It continues to surprise the participants
who create it.

• In the words of Ben Graham, market is a “manic-depressive” creature given to mood

swings.

• In short term it is voting machine but in long term it is a weighing machine.

• Governments and corporates have tried to control it in the past but have achieved
limited success.

• Use markets for your purpose, fully realizing that it may surprise you anytime.
Attempt the Quiz titled “Role of Markets” in the Socrative.

How?

1. Go to www.b.socrative.com
2. Click on “Login” (top right)
3. Click on “Student Login”
4. Room Name: SAIMTA2023/SAIMTB2023
5. Enter your first Name
Players in Financial Markets

• Firms

• Households

• Government

• Financial Intermediaries
• Banks
• Investment Funds, Insurance companies
Investment Process

• Asset allocation
– Choice among broad asset classes
• Security selection
– Choice of which securities to hold within asset class
– Security analysis to value securities and determine investment
attractiveness
Saving and Financing Statistics
Real Assets Versus Financial Assets

• Real Assets
– Determine the productive capacity and net income of
the economy
– Examples: Land, buildings, machines, knowledge used
to produce goods and services

• Financial Assets
– Claims on real assets
– Fixed Income, Equity, derivatives
Real Asset Vs Financial Asset: Saving of Indian Household

USA households have close to 70% savings in financial assets

80%

70% 67% 65%

62%
59% 60% 59% 60%
60% 58% 57%
51%
50% 48%

40% 41% 39% 40%

39% 39%
40% 37%
31% 33%
30%

20%

10%
2% 2% 1% 2% 2% 2% 1% 1% 1% 2%
0%
2012 2013 2014 2015 2017 2018 2019 2020 2021 2022

Financial Physical Valuable

Source: RBI Annual Reports

Share of Financial Assets of Indian Households
2019-20 2020-21 2021-22
1. Total Deposits (a+b) 37% 40% 27% 6. Small
Savings
(a) Bank Deposits 34% 39% 26% (excluding
(b) Non-Bank Deposits 2% 1% 2% 5. Investments, 1. Total
PPF), 13%
9% Deposits
2. Life Insurance Funds 16% 18% 17%
(a+b), 27%
3. Provident and Pension Funds
(including PPF) 21% 17% 23% 4. Currency,
11%
4. Currency 12% 12% 11% 3. Provident 2. Life
5. Investments 4% 4% 9% and Pension Insurance
Funds Funds, 17%
of which: 0% 0% 0% (including
(a) Mutual Funds 3% 2% 6% PPF), 23%
(b) Equity 1% 1% 2%
6. Small Savings (excluding PPF) 11% 9% 13%

Year: 2021-22
Source: Reserve Bank Of India
Sources of financial resources to the Commercial Sector

2019-20 2020-21 2021-22

A. Adjusted Non-Food Bank Credit 38% 29% 47%
B. Flow from Non-Banks (B1+B2) 62% 71% 53%
B1. Domestic Sources 27% 48% 24%
i) Public & rights issues by non-financial entities 4% 2% 6%
ii) Gross private placements by non-financial entities 15% 18% 8%
iii) Net issuance of CPs subscribed to by non-banks -10% 3% 1%
iv) Systematically important non-deposit taking NBFCs and deposit
taking NBFCs and HFC (net of bank credit) 7% 15% 3%
v) Others 10% 11% 7%
B2. Foreign Sources 35% 23% 28%
i) Foreign Direct Investment to India 26% 25% 19%
ii) Others 10% -2% 9%
C. Total Flow of Resources (A+B) 100% 100% 100%
Capital market fund sources for Companies
APPENDIX TABLE 5: CAPITAL MARKET - PRIMARY
(Amount in ₹ crore)
2021-22 2022-23 (P)
Item
Number Amount Number Amount
1 2 3 4 5
I. PRIMARY MARKET
A. Public and Rights Issues 192 1,50,483.6 272 75,043.9
Issuer Type
(a) IPOs 120 1,12,552.5 164 54,772.4
(b) Listed / NCDs 72 37,931.2 108 20,271.5
B. Euro Issues (ADRs and GDRs) … … … …
C. Private Placement 1,493 6,32,226.7 1,654 8,82,826.2
(i) Equity^ 29 31,438.5 11 8,212.3
(ii) Debt 1,464 6,00,788.2 1,643 8,74,613.9
D. Qualified Institutional Placement 29 31,438.5 11 8,212.3
E. Mutual Funds Mobilisation (Net)# 2,46,729.6 76,225.5

Source: RBI Annual Report 2022-23

Source: RBI Annual Report 2022-23
Investor Profile: % holding of different Investor categories
Trends in Investments

• Globalization

• Securitization

• Financial engineering

• Digital Security

• Cryptocurrency

• ESG Investing
Globalization of Financial Markets

• Companies raising capital across borders i.e. FCCBs and ECBs

• Nifty Index was being traded in Singapore Stock Exchange till June-2023

• Foreign Portfolio Investments account for 20% of the MCAP of India.

• Global stock indexes like Morgan Stanley Capital International (MSCI) have allocated
weightages to many Indian stocks.
Securitization

• Pooling existing loans and creating a security out of it with a face value and
Interest rate.

• Selling this security to investors and earning a fee income.

• Used by banks/financial companies when opportunities for lending are

much more than the capital available.

• Investors attracted to these securities since they provide higher returns

than existing products.
Financial Engineering

• Creation of new financial products to meet investor and issuer needs.

• Principal protection plan: A product where the investor is unlikely to lose the principal
while at the same time have a possibility of uncapped gains.

• Zero coupon bond or convertible securities

Digital Security

• is a representation of financial asset i.e. equity, bond, derivative where investment

contracts are recorded and verified in a block-chain network.

• Helps in achieving transactional efficiency and also obviate the need for clearing and
settlement. Reduces compliance costs.

• Improves liquidity of illiquid investments, say a venture capital investment.

Cryptocurrency

• Not a fiat currency i.e. not issued by sovereign government

• Use decentralized control

• Gaining in prominence. If Bitcoin was a company it would be amongst the top 10

companies in the world.
..ESG Investing

• ESG assets under management are expected to reach to $53 trillion, making up to one-
third of the total assets under management by 2025.

• Exchange traded funds (ETFs) based on ESG are expected to reach $1 trillion AUM by
2025.

• ESG debt is expected to be around $11 trillion by 2025.

Source: Bloomberg
Attempt the Quiz titled “Investment Environment” in Socrative.

How?

1. Go to www.b.socrative.com
2. Click on “Login” (top right)
3. Click on “Student Login”
4. Room Name: SAIMTA2023/ SAIMTB2023
5. Enter your first Name
Rise of Systemic Risk

• Systemic Risk: a potential breakdown of the financial system in which problems in one
market spill over and disrupt others.
– One default may set off a chain of further defaults
– Waves of selling may occur in a downward spiral as asset prices drop
– Potential contagion from institution to institution, and from market to market
Broad Take-home

• Markets play an important role in an economy but they are ruthless both for the
companies (Jet airways, DHFL, IL & FS, other NBFC’s) as well as investors.

• Financial Market includes all kinds of participants, rational as well as emotional (more
emotional) who are acting on information and influencing the value of companies.

• A systematic approach should be adopted to invest and fund through financial

markets.

• Markets are not full proof. If things are not done right they can take the economy
down.

• Be careful of financial intermediaries, they are not Santa Klaus.