Investment Advisor Level 1 Module 3 PDF

Investment Advisor Level 1 Module 3 CHAPTER 7: INTRODUCTION TO INVESTMENT 7.1 Types of investment There are many investment opportunities. Broadly, investments can be classified into financial or non-financial investments. Non-financial investments include r...

Investment Advisor Level 1 Module 3 CHAPTER 7: INTRODUCTION TO INVESTMENT 7.1 Types of investment There are many investment opportunities. Broadly, investments can be classified into financial or non-financial investments. Non-financial investments include real estate, gold, commodities etc. Financial Investments are exchange of cash flows for a period of time. Financial instruments are essentially claims on future cash flows. On the basis of claims on the cash flows, there are two generic types of financial instruments: debt and equity. Financial investments can also be classified on the basis of the markets they trade: public versus private markets. Another popular way of classifying the financial opportunities is on the basis of their maturity profile: Capital market versus money market. 7.2 Equity Investment characteristics and role Equity Shares represent ownership in a company that entitles its holders share in profits and the right to vote on the company’s affairs. Equity shareholders are residual owners of the firm’s profit after other contractual claims on the firm are satisfied and have ultimate control over how the firm is operated. Equity Shareholders are residual claim holders. Investments in equity shares reward investors in two ways: dividend & capital appreciation. Investments in equities have proven time diversification benefits and considered to be a rewarding long-term investment. Time diversification benefits refers to the notion that fluctuation in investment returns tend to cancel out through time, thus more risk is diversified away over longer holding periods. It follows that investment in equities offer better risk-adjusted return if held for long time periods. LEARNING OBJECTIVES: After studying this chapter, you should know about: Types of investment Equity Fixed Income Commodities Real Estate Structured products Distressed securities Other investment opportunities Know the channels for making investments 132 In addition to equity shares, companies may also issue preference shares. Preference shares rank above equity shares with respect to the payment of dividends and distribution of company’s net assets in case of liquidation. However, preference shares do not generally have voting rights like equity shares, unless stated otherwise. Preference shares share some characteristics with debt securities like fixed dividend payment. Similar to equity share, preference shares can be perpetual. Dividends on preference shares can be cumulative, non-cumulative, participating, non-participating or some combination thereof (i.e., cumulative participating, cumulative non-participating, non-cumulative participating, non- cumulative non-participating). In case preference stock is cumulative, the unpaid dividends would accumulate to be paid in full at a later time, whereas in non-cumulative stocks the unpaid or omitted dividend does not get paid. A non-participating preference share is one in which a dividend is paid, usually at a fixed rate, and not determined by a company’s earnings. Participating preference share gives the holder the right to receive specified dividends plus an additional dividend based on some prespecified conditions. Participating preference shares can also have liquidation preferences upon a liquidation event. Preference shares can also be convertible. Convertible preference shares entitle shareholders to convert their preference shares into a specified number of equity shares. Since preference shares carry some characteristics of equity share and at the same time some of the debt securities, they are referred to as hybrid or blended securities. The chief characteristic of equity shares is shareholders’ participation in the governance of the company through voting rights. Generally companies issue only one kind of common shares, on the principle of ‘one share, one vote’. Some companies, however, issue shares with Differential Voting Rights (DVRs). Shares with DVRs can either have superior voting rights (i.e. multiple votes on one share) or inferior voting rights (i.e. a fraction of the voting right on one equity share) or differential rights as to dividend. Shares with DVRs are very popular in the western world for many decades. They have not really gained momentum in India. Though way back in 2000, the Companies Act, 1956, was amended to permit issuance of shares with DVRs, not many companies have issued shares with DVRs. Tata Motors was one of the first companies in India to issue DVRs in 2008. These DVRs carried 1/10 voting rights and 5% higher dividend than ordinary shares. Since then, Pantaloons Retail (currently Aditya Birla Fashion and Retail Limited), Gujarat NRE Coke Ltd., Jain Irrigation Systems Ltd. have issued DVRs. 7.3 Fixed Income Debt instruments, also called fixed income instruments, are contracts containing a promise to pay a stream of cashflows during the term of the contract to the investors. The debt contract can be transferable, a feature specified in the contract that permits its sale to 133 another investor, or non-transferable, which prohibits sale to another party. Generally, the promised cash flow of a debt instrument is a periodic payment, but the parties involved can negotiate almost any sort of cash flow arrangement. A debt contract also establishes the financial requirements and restrictions that the borrower must meet and the rights of the holder of the debt instruments if the borrower defaults. Debt securities are issued by companies, municipalities, states and sovereign governments to raise money to finance a variety of projects and activities. Debt instruments can further be classified on the basis of issuer into government debt securities and corporate debt securities where the issuer is a non-government entity. Government securities form the largest component of debt market in India as well as world over. Government versus corporate Debt Securities A Government Security (G-Sec) is a tradeable instrument issued by the Central Government or the State Governments. It acknowledges the Government’s debt obligation. Such securities are short term (usually called treasury bills, with original maturities of less than one year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both treasury bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). G-Secs carry practically no risk of default and, hence, are called risk-free gilt-edged instruments. A key source of funds for corporates is debt financing. Companies issue debt securities of various maturity profile. Many of these corporate debt papers are listed on stock exchanges. However a bigger component of corporate borrowings lies in the unlisted space. Corporate fixed income securities pay higher interest rates than the government securities due to default risk. The difference between the yield on a government security and the corporate security for the same maturity is called “credit spread”. Higher the probability of default greater would be the credit spread. Credit Spread could also be understood as the “Risk Premium” which the companies are paying to raise the debt, or the investors are charging for bearing default risk. High Yield versus Investment Grade The probability of default on a fixed income paper is captured by ratings given by rating agencies. Table 7.1 gives the rating symbols given by CRISIL a rating agency registered with SEBI. 7.1 Rating Scale and description Rating Description CRISIL AAA (Highest Safety) Instruments with this rating are considered to have the highest degree of safety regarding timely servicing 134 of financial obligations. Such instruments carry lowest credit risk. CRISIL AA (High Safety) Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk. CRISIL A (Adequate Safety) Instruments with this rating are considered to have adequate degree of safety regarding timely servicing of financial obligation. Such instruments carry low credit risk. CRISIL BBB (Moderate Safety) Instruments with this rating are considered to have moderate degree of safety regarding timely servicing of financial obligation. Such instruments carry moderate credit risk. CRISIL BB (Moderate Risk) Instruments with this rating are considered to have moderate risk of default regarding timely servicing of financial obligation. CRISIL B (High Risk) Instruments with this rating are considered to have high risk of default regarding timely servicing of financial obligation. CRISIL C (Very High Risk) Instruments with this rating are considered to have very high risk of default regarding timely servicing of financial obligation. CRISIL D (Default) Instruments with this rating are in default or are expected to be in default soon. As can be observed in the rating description, higher rating denotes lower default risk and vice versa. The convention in the market is to classify bonds with rating BBB and above as investment grade and bonds below the BBB as high yield or junk bonds. Many institutional investors are prohibited from investing in junk bonds as they involve high default risk. 7.4 Commodities Investments in soft commodities which are grown like corn, wheat, soybean, soybean oil, sugar and also used as inputs in the production of other goods; and hard commodities which are mined like gold, silver, oil, copper and aluminium are other investment avenues available to investors. Soft commodities are perishable hence they exhibit high volatility in their prices. These commodities are subject to higher business cycle risk as their prices are determined by the demand and supply of the end products in which they are consumed. Soft commodities 135 historically have shown low correlation6 to stocks and bonds. Hence, they provide benefits of risk diversification when held in a portfolio along with stock and bonds. Prediction of weather is an important factor while investing in soft commodities. Exposure to these commodities can be taken through derivative contracts like forwards or futures. Hence investors must carefully understand the risk involved in the same. Prices of hard commodities are determined by the interaction between global demand and supply. Hard commodities like gold and silver have been the investment avenues for centuries, as reserve assets. Due to its global acceptability gold has acquired the status safe haven asset. It is viewed as an attractive investment in times of economic uncertainty and geopolitical crisis. Gold has shown diversification benefits historically. Unlike most of the financial investments commodities do not generate any current income and the investor in these commodities would have to count only on capital appreciation. 7.5 Real Estate Real estate is the largest asset class in the world. It has been a significant driver of economic growth. It offers significant diversification opportunities. It has been historically viewed as a good inflation hedge. Investors can invest into real estate with capital appreciation as an investment objective as well as to generate regular income by way of rents. It is usually a long-term investment. Real estate is classified into two sub-classes: commercial real estate or residential real estate. It can be further broken down into terms of tier I, tier II and tier III cities. Real estate investments often involve large commitments. Real estate funds or Real Estate Investment Trusts (REIT) have emerged as a good option to enable investors to take exposure to this asset class with smaller outflow commitments. 7.6 Structured products Structured products are customized and sophisticated investments. They provide investors risk-adjusted exposure to traditional investments or to assets that are otherwise difficult to obtain. Structured products greatly use derivatives to create desired risk exposures. Many structured products are designed to provide risk-adjusted returns that are linked to equity market indices, sector indices, basket of stocks with some particular theme, currencies, interest rates, commodity or a basket of commodities. Structured products can be designed for a short term or for long terms. The terms can be customized to meet the requirements of the investing community. These products require investments of a larger denomination. They may offer investment protection from 0% to 100% and/or attractive yields. The performance of the structured product is largely driven by the underlying strategy subject to market conditions. Hence, they must not be taken as capital protection or guaranteed or assured return products. 6a technical term used to measure movement between two variables. The benefits of diversification rests on correlation between investments. Lower the correlation between investments, higher the benefits of diversification i.e. reduction in risk. 136 7.7 Distressed Securities Distressed securities are the securities of the companies that are in financial distress or near bankruptcy. Investors can make investments in the equity and debt securities of publicly traded companies. These may be available at huge discounts, however investments in them require higher skills and greater experience in business valuation than regular securities. These securities can be considered from the perspective of diversification of risk. These securities are also referred to as ‘fallen angels’ and many types of funds and institutional investors are prohibited from holding these securities because of the high risk involved. It is a popular investment segment among hedge fund managers as they have deep experience in valuation and credit analysis. 7.8 Other investment opportunities Art and paintings and rare collectibles are emerging as an attractive long-term investment opportunity. This category of investment has been generating moderate return in the long term. It also has low correlation with financial investment like equities and bonds. Hence it provides a good risk diversification benefit. However, these are big ticket investments. Also, art is not a standard investment product as each work is unique. The market for the same is unregulated. These investments do not provide any income and just like gold, capital appreciation is the only way of reward. In terms of liquidity, this category is relatively more illiquid. To make the rewarding investment decisions, specialized knowledge in arts is more crucial than in traditional financial assets due to higher levels of information asymmetry and adverse selection problems. There are art and painting based investment funds. Investors can take exposure through these funds. Investments are also permitted abroad under the Liberalised Remittance Scheme (LRS) wherein an individual can invest upto $ 250,000 abroad every year. This route allows for geographical as well as currency diversification and also opens up several new choices for investors. 7.9 Channels for making investments Investors can invest in any of the investment opportunities discussed above directly or through intermediary providing various managed portfolio solutions. Direct investments Direct investments are when investors buy the securities issued by companies and government bodies and commodities like gold and silver. Investors can buy gold or silver directly from the sellers or dealers. In case of financial securities, a few fee-based financial intermediaries aid investors buy or sell investments viz. brokers, depositories, advisors etc., for fees or commission. 137 Understanding the role of RIAs Investors can take the advice from SEBI Registered Investment Adviser (RIA). As per the SEBI Regulation relating to RIA which came in the year 2013, only qualified professionals who are licensed by SEBI as Registered Investment Advisers (RIAs) can act as ‘advisers’. These advisers are paid fees by the investors who hire them for investment advice. After this regulation, the distributors of financial products like mutual fund distributors, share brokers and insurance agents who would earlier act as investment advisers, can no longer claim the title. These advisers, like other fee-based professionals, are only accountable to their investors. They are required to follow a strict code of conduct and offer advice in the investors’ best interests. They are also required to disclose any conflict of interest. Advisers do basic risk profiling, assess the needs and requirements of the investors, understand their financial health and develop ‘financial plans’. They help in inculcating a sense of discipline in investors. Thus Investment advisers can help investors create an optimum investment portfolio and help them in making rational investment decisions. Investments through managed portfolios Alternatively, investors can invest through investment vehicles which pool money from investors and invest in a variety of securities and other investments on their behalf. In other words, investors make indirect investments. These investment vehicles are professionally managed. Through these managed portfolios they can avail the professional expertise at much lower costs. The following are examples of managed portfolio solutions available to investors in India: Mutual Funds (MFs) Alternative Investment Funds (AIFs) Portfolio Managers (PMs) Collective Investment Schemes (CISs) Mutual Fund A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Money collected through mutual fund is then invested in various investment opportunities like shares, debentures and other securities. The income earned through these investments and the capital appreciation realized are shared by its unit holders in proportion to the number of units owned by them. Mutual fund is a pass-through intermediary in the true sense. The following are the benefits of investing through mutual funds: Professional investment Management Risk reduction through diversification Convenience 138 Unit holders account administration and services Reduction in transaction costs Regulatory protection Product Variety However, mutual fund products are not ‘get rich quick’ investments. They are not risk-free investments. Mutual funds are strictly regulated by SEBI under Mutual Fund Regulation 1996. Mutual fund industry offers tremendous variety. There are products for different types of investment objectives and goal. Alternative Investment Fund Alternative Investment Fund or AIF is a privately pooled investment vehicle which collects funds from sophisticated investors, for investing it in accordance with a defined investment policy for the benefit of its investors. The words ‘privately pooled’ denote that the fund is pooled from select investors and not from the general public at large. These private investors are institutions and high net worth individuals who understand the nuances of higher risk taking and complex investment arrangements. The minimum investment value in AIF is one crore rupees. Portfolio Management Services A portfolio manager is a body corporate who advises or directs or undertakes on behalf of the investors the management or administration of a portfolio of securities. There are two types of portfolio management services available. The discretionary portfolio manager individually and independently manages the funds of each investor whereas the non- discretionary portfolio manager manages the funds in accordance with the directions of the investors. The portfolio manager enters into an agreement in writing with the investor, clearly defining the relationship and setting out their mutual rights, liabilities and obligations relating to the management of funds or portfolio of securities. Portfolio management services are regulated by SEBI under Portfolio Manager Regulations. The regulations have not prescribed any scale of fee to be charged by the portfolio manager to its clients. However, the regulations provide that the portfolio manager shall charge fee as per the agreement with the client for rendering portfolio management services. The fee so charged may be a fixed amount or a return based fee or a combination of both. The portfolio manager is required to accept minimum Rs. 50 lakhs or securities having a minimum worth of Rs. 50 lakhs from the client while opening the account for the purpose of rendering portfolio management service to the client. Portfolio manager cannot borrow on behalf of his clients. Portfolio managers provide investment solutions unique to the needs of the investors. 139 Compare and Contrast between Mutual Funds, Alternate Investment Funds and Portfolio Managers Mutual Funds, Alternate Investment Funds (AIFs) and Portfolio Managers (PMs) are managed portfolios. All three provide indirect ways of investing in securities and other investments to investors. All three are regulated by SEBI. However, Mutual funds are more stringently regulated compared to AIF and PMS as mutual funds cater to retail investors. In case of AIF, the minimum amount required for investment is Rs. one crore and in case of PMS it is Rs. Fifty lakhs. AIF and PMS cater to institutional and high net worth investors. These investors are expected to understand complex investment strategy and risks involved. The investment restrictions of PMS and AIF are also relatively less compared to mutual funds. So though, there are some similarities between them, there are important differences too. AIFs and PMS are popularly referred to as rich man’s mutual fund. 140 CHAPTER 8: INVESTING IN STOCKS 8.1 Equity as an investment There are two broad types of securities that are issued by seekers of capital from investors: Equity and Debt. Equity securities are issued by companies providing ownership to the investor in their company, and Debt securities are issued by companies providing the rights of a lender to the investor. The features of both these securities differ due to the inherent difference in the claim of the investors on the company. Equity investors also known as shareholders have residual claim 7 in the business. Because they are the owners of the company and not lenders, the company which issues equity securities, is not contractually obligated to repay the amount it receives from the shareholders. It is also not contractually obligated to make periodic payments to shareholders for the use of their funds, like interest payments in the case of lenders. Equity investors get voting rights. When equity investors own a sizable amount of shares in a company, they get an opportunity to participate in the management of the business. Investors who purchase equity shares look for capital appreciation and dividend income. There is no assurance of both by the company to the equity investor. While dividend payment depends on the profitability of the company, capital appreciation depends on the conditions of the stock market. Because all residual benefits of deploying capital in a business go to the equity investor, It is usually expected that the return to equity investors should be higher than that of the debt investors (lenders). Choosing between equity and debt is a trade-off for investors. Investors desiring lower risk choose debt, at the cost of lower but stable return. However, if they seek a higher returns they choose equity investment, but they may not be able to earn it without taking on the 7 Claim on the company’s net assets, i.e. the value of assets after all liabilities have been paid. LEARNING OBJECTIVES: After studying this chapter, you should know about: Understand Equity as an investment Diversification of risk through equity instruments - Cross sectional versus time series risks of equity investments Overview of Equity Market Know the equity research and stock selection Understand combining relative valuation and discounted cash flow models Know about Technical Analysis Qualitative evaluation of stocks 141 additional risk of the equity investment. Most investors tend to allocate their capital between these two choices, depending on their expected return, their investing time period, their risk appetite and their needs. 8.2 Diversification of risk through equity instruments - Cross sectional versus time series Equity is inherently riskier compared to bonds and many other asset classes. However there are ways to mitigate the risks in stocks. The most meaningful way to risk reduction is through diversification – both on cross sectional (i.e. across business sectors and industries) as well as on time series basis (i.e. across various time periods). Empirical research has demonstrated that a significant portion of risk can be reduced through diversification. Conceptually, it is achieved due to the relatively less correlated behaviour of various business sectors which underlie each equity investment. This is what the old adage ‘Don’t put all your eggs in one basket’ means. Cross sectional risk diversification is reducing risk by holding equities in many different kinds of businesses at a point in time and also across various geographies of the world. Reaping the benefits of time diversification requires investing in equities for a long period of time. The belief is that bad times will get cancelled out by good times. This is why “time in the market” is suggested for equity investment as against “timing the market”. Underlying the word ‘diversification’ is the concept of business cycles and counter-cyclical businesses, and the phenomenon of lag and lead between the behaviour of investments returns and countries’ economic performance. In the Figure 8.1, a business cycle is shown as a dark line. Some businesses may be at peak when the business cycle is in its trough, as shown by the broken line. These products or businesses are called ‘counter-cyclical’ or defensive businesses. Businesses that do better in a recession are called ‘recession-proof’ businesses. Some products, sectors or countries come out of a recession faster than others (these are called as leading sectors); other products, sectors or countries may go into recession later than others (these are called lagging sectors). Figure 8.1 Counter-cyclical products 8.3 Risks of equity investments Equities are often regarded as riskier than other asset classes. The main types of risks discussed in the context of equity investments are discussed below: 142 8.3.1. Market risk Market risks arise due to the fluctuations in the prices of equity shares due to various market related dynamics. These factors affect all the listed, market traded, assets, irrespective of their business sector. The degree of impact may be different. Beta is a proxy measure for market risk. Market risks cannot be diversified away, though it can be hedged. 8.3.2. Sector specific risk Risks due to sector specific factors are not part of market risks. These risks can be diversified away by investing in different business sectors. Sector specific risks arise due to factors that affect the performance of businesses in a particular sector/industry. Factors affecting certain sectors might not impact certain other sectors. Such risks are also called “idiosyncratic risks”. Say for instance there are restrictions on the movement of international tourists, the airline industry and hospitality industry are going to be affected. But industries and business sectors dependent on domestic customers are not affected by such restrictions. 8.3.3. Company specific risk Risks arising due to company specific factors are also non-market risks. These risks can also be diversified away by investing in different companies. Company specific risk arises due to factors that affect only the performance of a single company and other firms might not be affected by them. Though, overall, the airline industry goes through turbulent times, time and again, certain airlines withstood the rough weather and other exited helplessly. Such corporate debacles are due to company specific factors. Same is now being seen in telecom sector. 8.3.4 Transactional risk Risks due to the other party not fulfilling the terms of the contract while buying or selling equities is often referred to as transactional risk. This can happen when the other person is either not able to pay the money or deliver the shares. This type of risk can be mitigated by transacting through the stock exchange where there are robust risk mitigation procedures present to take care of such situations. 8.3.5. Liquidity risk Liquidity risk is the risk of not being able to find a buyer or seller for the equity holdings. Liquidity risk is measured by impact cost. The impact cost is the percentage price movement caused by a particular order size (let’s say an order size of Rs.1 Lakh) from the average of the best bid and offer price in the order book snapshot. The impact cost is calculated for both, the buy and the sell side. Less liquid stocks are more thinly traded, and a single large trade can move their prices considerably. Such stocks have high impact costs. A lower market impact implies the stock is more liquid. 143 8.3.6 Currency Risk Prima Facie it appears that currency risk is not directly related to prices of equity. However, once the financial markets are open to the international investors currency risk sets in. Currency risk arises due to uncontrollable, unpredictable and volatile exchange rates of various pairs of currencies. When a significant proportion of players in a financial market belong to the international institutional investors groups, then that financial market is bound to be related to exchange rate movements. Many times we here that stock market reacts to FPIs’ buy and sell pressure, and FPIs move in and move out of a country with changes in their home country interest rates, or due sudden unfavourable exchange rate movements, like deep depreciations in their host countries or due to any other socio- politico-economic, industry or market shocks. Apart from the above most prominent risks, all other macro economic factors like inflation, fuel prices, interest rates, economic growth, economic slowdown, do influence stock markets. 8.4 Overview of Equity Market Equity securities represent ownership claims on a company’s net assets. A thorough understanding of the equity market is required to make optimal allocation to this asset class. The equity market provides various choices to investors in terms of risk-return- liquidity profile. There are opportunities in listed as well as unlisted equity space available. 8 There are about 66,000 unlisted public limited companies and over 5,000 listed domestic companies. Investments in listed companies are relatively more liquid than investment in unlisted companies. Listed companies have to abide by the listing norms, making this investment space more regulated with better disclosures. 8.5 Equity research and stock selection As there are thousands of opportunities available to investors in the equity market, equity research and stock selection process plays a very important role in identifying stocks which suit the risk-return-liquidity requirements of the investors. Equity research involves thorough analysis and research of the companies and its environment. Equity research primarily means analysing the company’s financials and non-financial information, studying the dynamics of the sector the company belongs to, competitors of the company, economic conditions etc. The idea behind equity research is to come up with intrinsic value of the stock to compare with market price and then decide whether to buy or hold or sell the stock. There are many frameworks/methodologies available for stock selection. Analysts use fundamental analysis - 8 Listingis a process through which the companies fulfilling the eligibility criteria prescribed by the Exchange are admitted for trading on the Exchange. 144 top-down approach or bottom-up approach - quantitative screens, technical indicators etc., to select stocks. 8.5.1. Buy side research versus Sell Side Research Though both Sell-side and Buy-side researchers and analysts take up similar works, but they differ in terms of for whom they work, how accurate they need to be, and for what are they paid. Sell-side Analysts work for firms that provide investment banking, broking, advisory services for clients. They typically publish research reports on the securities of companies or industries with specific recommendation to buy, hold, or sell the subject security. These recommendations include the analyst’s expectations of the earnings of the company and future price performance of the security (“price target”). In essence the sell-side analysts are paid for providing useful information to be acted upon. In this regard the expectations from the sell-side research is broad guidance on multiple sectors, rather than accurate price predictions. Buy-side Analysts work for fund managers like those of mutual funds, hedge funds, pension funds, or portfolio managers that purchase and sell securities for their own investment accounts or on behalf of their clients. These analysts generate investment recommendations for their internal consumption viz. use by the fund managers within organization. Research reports of these analysts are generally circulated among the top management/investment managers of the employer firms as these reports contain recommendations about which securities to buy, hold or sell. Therefore the buy-side researchers need to be more accurate and they are paid for their investment recommendations. 8.5.2. Fundamental Analysis Fundamental analysis is the process of determining intrinsic value for the stock based on the fundamentals that drive its intrinsic value. These values depend on underlying economic factors such as future earnings or cash flows, interest rates, and risk variables. By examining these factors, intrinsic value of the stock is determined. Investors should buy the stock if its market price is below intrinsic value and do not buy, or sell, if the market price is above the intrinsic value, after taking into consideration the transaction cost. Investors who are engaged in fundamental analysis believe that intrinsic value may differ from the market price but eventually market price will merge with the intrinsic value. An investor or portfolio manager who can do a superior job of estimating intrinsic value will generate above-average returns by acquiring undervalued securities. Fundamental analysis involves Economy Analysis, industry analysis, company analysis. 145 Top Down approach versus Bottom up Approach Analysts follow two broad approaches to fundamental analysis – top down and bottom up. The factors to consider are economic (E), industry (I) and company (C) factors. Beginning at company-specific factors and moving up to the macro factors that impact the performance of the company is called the bottom-up approach. Scanning the macro economic scenario and then identifying industries to choose from and zeroing in on companies, is the top-down approach. EIC framework is the commonly used approach to understanding fundamental factors impacting the earnings of a company, scanning both micro and macro data and information. 8.5.3. Stock Analysis Process The value of an investment is determined by its expected cash flows and the investor’s/analyst’s required rate of return (i.e., its discount rate). The expected cashflows as well as required rate of return are influenced by the economic environment. The analyst needs to have a good understanding of important economic variables and economic series. The macroeconomic analysis provides a framework for developing insights into sector and company analysis. Economy Analysis Macro-economic environment influences all industries and companies within the industry. Monetary and fiscal policy influences the business environment of the industries and companies. Fiscal policy initiatives like tax reduction encourages spending while removal of subsidies or additional tax on income discourage spending. Similarly, monetary policy may reduce the money supply in the economy affecting the expansionary plans and working capital requirements of all the businesses. Hence a thorough macro-economic forecast is required to value a sector/firm/equity. Any macro-economic forecast should include estimates of all of the important economic numbers, including: Gross Domestic Product Inflation rates Interest rates Unemployment The most important thing an analyst does is to watch for releases of various economic statistics by the government, Reserve Bank of India and private sources. Especially, they keep a keen eye on the Index of economic indicators like the WPI, CPI, monthly inflation indices, Index of Industrial Production, GDP growth rate etc. Analysts assess the economic and 146 security market outlooks before proceeding to consider the best sector or company. Interest rate volatility affects different industries differently. Financial institution or bank stocks are typically placed among the most interest-sensitive of all sectors. Sectors like pharmaceuticals are less affected by interest rate change. The economy and the stock market have a strong and consistent relationship. The stock market is known as a leading economic indicator. A leading economic indicator is a measure of economic recovery that shows improvement before the actual economy does because stock price decisions reflect expectations for future economic activity, not past or current activity. Industry/Sector Analysis Industry analysis is an integral part of the three steps of top-down stock analysis. Industry analysis helps identify both unprofitable and profitable opportunities. Industry analysis involves conducting a macroanalysis of the industry to determine how different industries relate to the business cycle. Performance of industries is related to the stage of the business cycle. Different industries perform differently in different stages of the business cycle. On the basis of the relationship different sectors share with the business cycles, they are classified as cyclical and noncyclical sectors. For example, banking and financial sector perform well towards the end of a recession. During the phase of recovery, consumer durable sectors like producers of cars, personal computers, refrigerators, tractors etc., become attractive investments. Cyclical industries are attractive investments during the early stages of an economic recovery. These sectors employ high degree of operating costs. They benefit greatly during an economic expansion due to increasing sales, as they reap the benefits of economies of scale. Similarly, sectors employing high financial leverage also benefit during this phase, as debt is good in good times. At the peak of the business cycle, inflation increases as demand overtakes supply. Inflation impacts different industries differently. There are industries, which are able to pass on the increase in the costs of products to their consumers by increasing prices. Their revenue and profits may remain unaffected by inflation. Industries producing basic materials such as oil and metals benefits the situation. Rising inflation doesn’t impact the cost of extracting these products. These industries can increase prices and experience higher profit margins. However, there are industries that are not able to charge the increased costs of production to their consumers. Their profitability suffer due to inflation. During a recession phase also, some industries do better than others. Defensive industries like consumer staples, such as pharmaceuticals, FMCG, outperform other sectors. Even 147 though the spending power of consumer is going down, people still spend money on necessities. Analysts also see the stage of the Industry is in its life cycle. The number of stages in the life cycle of the industry are depicted in Figure 8.2: Figure 8.2: Industry Life Cycle Introduction: during this stage industry experiences modest sales and very small or negative profit. The market of the products of the industry is small and the firms in the industry may have high development costs. Growth: during this stage, market develops for the products or services of the industry. Number of firms in the industry is less during this phase and hence they may have little competition. Profit margins at this stage are generally high. This stage is followed by mature industry growth. The rapid growth of the earlier phase attracts competitors contributing profits margins to go to normal levels. Maturity: This is generally the longest phase in the life cycle of the industry. During this stage, growth rate in the industry normally matches with the economy’s growth rate. Firms in the industry differ from one another given their cost structure and ability to control costs. Competition is high during this stage reducing the profit margin to normal levels. Deceleration of growth and decline: This stage observes decline is sales due to shift demand. Profits margins are under pressure and some firms may even witness negative profits. Similar to life cycle analysis, competitive structure of the industry is to be analysed by the analysts. It is a key factor affecting the profitability of the firms in the industry. Competition influences the rate of return on invested capital. If the rate of return is "attractive" it will encourage investment. Michael Porter looked at forces influencing competition in an industry and the elements of industry structure. He described these forces as the industry’s micro- environment. 148 Figure 8.3 Porter’s Model Michael Porter suggests that five competitive forces determine the intensity of competition in the industry. Which in turn affects the profitability of the firms in the industry. The impact of these factors can be different for different industries. The first factor is rivalry among the existing competitors. Every industry is analyzed to determine the level of rivalry amongst its firms. Rivalry increases when the industry has many firms of the same size. And hence firms may compete very hard to sell at full capacity. Generally, when rivalry is very high the rates of return would be low. The second factor is the threat of new entrants. The entry barriers influence the entry of new player to the industry. The analysts examine them, as they influence the future competitive structure of the industry and in turn profitability of existing firms. Generally, when an industry is well protected by high level of entry barriers, then the existing players can sustain higher growth rates and profitability. The third factor is the threat of substitute products. Substitute products influence the prices firms can charge for their products. Greater the substitutability of the product, lower the sustained earnings growth rate, and profit margins. The fourth factor is bargaining power of the buyers, which influences the profitability. Buyers can influence the profitability of an industry when they are in position to demand lower prices or higher quality by showing a susceptibility to switch among competitors. Higher the bargaining power lower the ability of the company to set the prices and hence profits. 149 The fifth factor is the bargaining power of the supplier. Suppliers are more powerful if they are few and large in size. They can influence future industry returns if they increase prices or reduce the quality of the product. Hence higher the power of supplier, higher would be the cost of production and operation thereby decreasing profits. Company Analysis Company analysis is the final step in the top-down approach to Stock Analysis. Macroeconomic analysis prepares us to understand the impact of forecasted macro- economic environment on different asset classes. It enables us to decide how much exposure to be made to equity. Industry analysis helps us in understanding the dynamics of different industries in the forecasted environment. It enables us to identify industries that will offer above-average risk-adjusted performance over the investment horizon. If trends are favourable for an industry, the company analysis focusses on firms in that industry that are positioned to benefit from the economic trends. The final investment decision to be made is with regard to which are the best companies in the desirable industries? And are they attractive investments in terms of risk-adjusted returns. Company analysis is to be differentiated from stock valuation. Company analysis is conducted to understand its strength, weaknesses, opportunities and threats. These inputs are used to determine the fundamental intrinsic value of the company’s stock. Then this value is compared with the market price of the stock. If the intrinsic value is higher than the market price, the stock is bought and vice versa. It is very important to note that stocks of good companies need not make good investment opportunities. The stock of a good company with superior management and strong performance measured by current and future sales and earnings growth can be trading at a price much higher to its intrinsic value. It may not make a good investment choice. Company analysis is needed to determine the value of the stock. There are many components to company analysis. Financial statement analysis of the company is often the starting point in analysing a company. Analysing the profit and loss account, balance sheet and the cash flow statement of the company is imperative. The financial performance numbers of a company, as presented in the financial statements, can be used to calculate ratios that give a snapshot view of the company’s performance. The ratios of a company have to be seen in conjunction with industry trends and historical averages. Another important component of company analysis is SWOT Analysis. SWOT analysis involves examination of a firm’s strengths, weaknesses, opportunities, and threats. Strengths and weaknesses deal with a company’s internal ability, like a company’s competitive advantage or disadvantages. Opportunities and threats deal with external situations and factors the company is exposed to. Opportunities include a favourable tax environment, favourable change in consumer preference. An example of threat is stringent government regulation, or 150 a big sized competitor, or changing technology etc. Company analysis also involves analysing its competitive strategies. A firm may follow a defensive strategy. A defensive strategy is one where the firm positions itself in such a way that its capabilities provide the best means to deflect the effect of competitive forces in the industry. Alternatively, a firm may follow an offensive strategy in which the firm attempts to use its strengths to affect the competitive forces in the industry. Michael Porter suggests two major strategies: Cost Leadership and Differentiation. Cost Leadership: under this strategy the firm seeks to be the low-cost producer, and hence the cost leader in its industry. Cost advantages vary from industry to industry. Differentiation Strategy: Under this strategy, the firm positions itself as unique in the industry. Again, the possibilities of differentiation differ from industry to industry. Another very important component of company analysis is understanding the business model of the company. As part of it the following questions need to be asked. What does the company do and how does it do? Who are the customers and why do customers buy those products and services? How does the company serve these customers? Almost all successful investors and fund managers repeat this thought that one must invest only in such firms where one understands the business. In the checklist for research, this is one of the most prominent questions – ‘Do I understand the business?’ No analyst should move to the next question if he/she can’t address what a company does in a line with preciseness and clarity. There are over 5,000 companies listed on Indian exchanges. It is not possible to track and understand all of them. Investors should consider buying shares of few companies they understand rather than invest in a number of companies they don’t understand. Further, each sector has its own unique parameters for success, sales growth and profitability. For the retail sector, footfalls and same store sales (SSS) are important parameters, whereas for banking it is Net Interest Income (NII)/ Net Interest Margin (NIM). For telecom, it is Average Revenue per User (ARPU) and for hotels, it is average room tariffs and room occupancy etc. Analysts must possess an in-depth knowledge of the sectors while researching companies. Further, each company will have its unique way of doing business. The efficiency with which products and services are produced and delivered to the customers may vary from one business to another and will significantly impact its earnings. Therefore, it becomes imperative for analysts to understand the entire business model of companies. 151 8.5.4. Estimation of intrinsic value Once the analysis of the economy, industry and company is completed, the analyst can go ahead with estimating intrinsic value of the firm’s stock. Price and value are two different concepts in investing. While price is available from the stock market and known to all, value is based on the evaluation and analysis of the entity that is undertaking the valuation of the stock at a point in time. It may be noted that Price is a Fact but Value is an Opinion. There are various approaches to valuation. They are explained in the subsequent paragraphs. There are uncertainties associated with the inputs that go into these valuation approaches. As a result, with due diligence, the final output can at best be considered an educated estimate. That is the reason, valuation is often considered an art as well as a science. It requires the combination of knowledge, experience, and professional judgment in arriving at a fair valuation of any asset. The purpose of valuation is to relate the market price of the stock to its intrinsic value and judge whether if it is fairly priced, over-priced or under- priced. Three most popular approaches to valuation viz., discounted cashflow approach, asset based approach and relative multiple based approach are discussed below. 8.5.4.1. Discounted Cash Flow Model Conceptually, discounted cash flow (DCF) approach to valuation is the most appropriate approach for valuations when three things are known: Stream of future cash flows Timings of these cash flows, and Expected rate of return of the investors (called discount rate). Once these three pieces of information are available, it is simple mathematics to find the present value of these cash flows which a potential investor would be willing to pay today to receive the expected cash flow stream over a period of time. Typically, any investment involves the outflow of cash. Later the investor expects, cash inflows during the investment horizon. Finally, at the time of disinvestment, the investor expects a large cash inflow - preferably larger than the original investment - representing the return of original investment with some appreciation. The same framework can be applied to valuing businesses. Popularly, profits are compared to the regular inflows from traditional investments. However, it should be appreciated that profits are accounting estimates rather than facts. Because accounting standards and tax authorities permit accrual accounting, there can be many valid adjustments to the figure of profit without any involvement of cashflows. Therefore profits in business and returns in the form of cashflows in financial investments are not comparable. This gave birth to the philosophy of estimating cashflows in business from the profit figures. 152 Business valuation professionals applied the philosophy of discounting to valuation of business entities, drawing from the postulates of time value of money and the fundamental framework, that “the intrinsic value of any asset, should be equal to the present value of future benefits that accrue from owning it”. For instance, when one holds a real asset, like land and buildings, its value should logically depend on the future rental income and resale value that could be generated from it, measured in present value terms. In case of a Bond, the intrinsic value of a bond should depend on the future coupons and the redemption value, measured in present value terms. In both the cases, the entity that estimated the intrinsic value, uses a particular discounting rate, which includes, the minimum risk free rate, the compensation for the term period of the investment, the premia for the asset specific risks, the transaction costs, and the taxes. The aggregate of all these components are referred to as required rate of return. However, in common parlance the transaction costs and taxes are taken as given, so they are ignored. Extending the logic to business valuation or equity valuation, the investor should logically discount the future benefits accruing to the business or by being an equity investors. In case of a business that has not taken any debt in its capital structure, the entire profits belong to the owners. However when the company engages borrowed capital in the business, then the lenders also have a claim in the assets and profits of the business. If booked profits are considered to be the future benefits, then Earnings Before Interest Tax Depreciation and Amortisation (EBITDA) are the profits left for both the lenders and owners to share along with government for tax. Earnings of After Tax (EAT or PAT) are the profits left for only the owners of the business, as other stakeholders (lender, and government) have taken away their dues. As discussed earlier, the inherent weaknesses with the EBITDA and EAT figures, valuation experts preferred cashflow versions of the two accounting figures mentioned above. FCFF represents the cashflow left for both the lenders and owners, out of which lenders can take their interest and principal repayments, and the owners can take their dividends. FCFE represents the cashflow left only for the owners of the business. Therefore depending on the purpose of valuation, i.e. to value a firm or equity, either FCFF or FCFE is used, respectively. FCFF for a future year is calculated as = Expected EBIT (1-Tax Rate) + Expected Depreciation + Expected Non-Cash Expenses – Expected Capex by the firm –Expected Increase in Working Capital FCFE for a future year is calculate as = [(Expected EBIT – INTEREST EXPENSE) * (1 – Tax Rate)] + Expected Depreciation + Expected Non-Cash Expenses – Expected Capex by the firm – Expected Increase in Working Capital – Expected Debt Repayments + Expected Fresh Borrowings OR 153 FCFE = Expected FCFF – (Interest Expenses * (1- Tax Rate)) + (Expected Fresh Borrowings – Expected Debt Repayments) OR FCFE = Expected FCFF – (Interest Expenses * (1- Tax Rate)) + Expected Net Debt Issues OR when the company has preference shares also in the capital, it is calculated as FCFE = Expected FCFF – (Interest Expenses * (1- Tax Rate)) – Expected Preference Dividend + Expected Net Debt Issues + Expected Net Preference Share Issues Apart from depreciation, other non-cash charges include amortization of intangible assets and loss on sale of assets, which are added back. Unrealised Gains on assets are deducted from the FCFF and FCFE calculations. The FCFF and FCFE figures are known as “free” because all the other stakeholders, leaving the financiers of the business, are paid their dues before arriving at the figures. Further, the business is also treated as a stakeholder, and the funds required for its growth and sustenance are also provided in the form of CAPEX, and working capital. Therefore what is left is for the financiers’ to claim free of all encumbrances. Rarely, FCFF may be negative, but there are reasonable chances that FCFE may be negative. In such cases the FCFF may be used for valuing the firm, and then the value of equity can be calculated by deducting the value of debt from it. Valuation requires forecasting cashflows into the future. This can be done by applying historical growth rate exhibited by company or a rate estimated by the analysts based on their information and analysis. A firm may show a period of high growth in revenues, profitability, capex and other performance parameters, and then stabilize to a steady growth. It may be noted that growth rate in one parameter like sales, should not be considered as growth in assets, similarly the growth in assets cannot be considered as growth in profits or cashflows. However a good proxy that is used in the valuation industry for growth in profits is the product of retention ratio and return on equity as follows Growth in profits in a dividend paying firm = Retention Ratio * Return on Equity OR (1 – DPR) * ROE SInce equity is for perpetuity and it is not possible to forecast the cash flows forever, the practice is to calculate a terminal value of the firm. This terminal value is calculated as at the end of the year, till which time one could comfortably forecast the cash flows with all the available information. The terminal value may be calculated using the formula of a perpetually growing annuity. In this case cash flows are expected to grow, forever, at a steady though 154 modest rate. The average long term GDP growth rate or inflation rate is a good proxy for this growth rate. The terminal value is calculated by multiplying the cash flow for the last year of forecasted period, by (1+ Normal Growth rate) and dividing the resultant value by (Discounting rate- Growth rate). The terminal value is added as an additional independent component, to the stream of cash flows projected during the growth period or the projection period, and then aggregate of all these cashflows are discounted to today (the day of valuation). Say for instance one could confidently forecast cashflows for the next 5 years. Then 5th year is the last year of the confident forecast, and from the 6th year onwards the cashflows are expected to grow constantly at a particular rate as described above. The terminal value is calculated as at the end of 5th year and finally this value is discounted to today, when the valuation exercise is undertaken. The other method to calculate the terminal value is by applying a multiple to either a financial or non-financial metric of performance of the firm, such as the EBITDA, at the end of the confident forecasted year. Meaning in the 5th year as discussed in the previous paragraph. The multiple of a comparable firm is used for the purpose. The discount rate used in the DCF valuation should reflect the risks involved in the cash flows and also the expectations of the investors. In most of the valuation exercises, cost of debt is taken as the prevailing interest rates in the economy for borrowers with comparable credit quality. And, cost of equity is the rate of return on investment that is required by the company's common shareholders. Capital Asset Pricing Model - CAPM, which establishes the relationship between risk and expected return forms the basis for cost of equity. As per Capital Asset Pricing Model (CAPM), the cost of equity is computed as follows: Ke = Rf + β * (Rm – Rf) Where: Rf = Risk Free Rate, (usually the ongoing 10 years government bond yield), (Rm – Rf) = Market risk premium (MRP), and (which is a historical average value for a particular market or country) β = Beta (it is the sensitivity of a security’s return to an index’s return, which is chosen as a proxy for market portfolio) The Weighted Average Cost of Capital of the firm (WACC) is then calculated as under: 155 WACC = [Ke * Equity / (Equity+ Debt)] + [Kd * (1-Tax)* Debt / (Equity+ Debt)] = [Ke * We] + [Kd * (1-Tx)*Wd] Where Ke = Cost of Equity, Kd = Cost of Debt, Wd = Weight of Debt, We = Weight of Equity To calculate the value of the firm, its FCFF is discounted by the weighted average cost of capital (WACC). To calculate the value of equity, its FCFE is discounted using the cost of equity. 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝐹𝑖𝑟𝑚= Σ𝐹𝐶𝐹𝐹(1+𝑤𝑎𝑐𝑐)𝑖𝑛𝑖=1+ 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒𝑛+1(1+𝑤𝑎𝑐𝑐)𝑖 Where, i = the period for which confident projects of cashflows are done, starting from 1 to n number of years in future n = the last year for which the cashflows are projected year wise ‘FCFF’ and ‘wacc’ are as explained above 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒= 𝐹𝐶𝐹𝐹𝑛+1𝑤𝑎𝑐𝑐 − 𝑔 Where ‘g’ = is the constant growth rate of the FCFF in future. The same equations are used to calculate the value of equity of the firm. The only changes are ‘FCFF’ is replaced with ‘FCFE’; ‘wacc’ is replaced with ‘ke’; ‘g’ is the constant growth rate of ‘FCFE’ 8.5.4.2. Asset Based Valuation Asset Based valuation methodology is used in some businesses where the business is asset heavy, and the assets are usually reflected in the financial statements at fair market value, like financial institutions, firms in real estate and gold, gems and jewellery. Under this method the value of the firm is equal to the “adjusted current market values of Net Tangible, intangible, Financial, and Net Current Assets”. Value of equity is “value of firm less value of all outsider liabilities”. Significantly the issue with this approach is that it does not recognise the value of future profits and cashflows of the firm, and all future possible value creation the firm can do due to its research and innovation. 8.5.5. Relative Valuation These values are then converted into standardized values which are in form of multiples, w.r.t 156 any chosen metric of the company’s financials, such as earnings, cash flow, book values or sales. These multiples are then applied to the respective financials of the target company for valuation. Based on the value arrived and the market price of the equity shares of the company it is decided whether it is over-valued or under-valued. Relative valuation techniques implicitly contend that it is possible to determine the value of an economic entity by comparing it to similar entities on the basis of several important ratios. 8.5.5.1. P/E Ratio The most common stock valuation measure used by analysts is the price to earnings ratio, or P/E. For computing this ratio, the stock price is divided by the EPS figure. For example, if the stock is trading at Rs. 100 and the EPS is Rs. 5, the P/E is 20 times. Historical or trailing P/Es are computed by dividing the current market price of the equity share by the sum of the last four quarters ’ EPS. Forward or leading P/Es are computed by dividing the current market price of the equity share by the sum of the expected next four quarters of EPS. Current P/E Ratio is current market price of the equity share divided by the current or the immediate recent annual EPS of a company. For example, consider a company whose fiscal year ends in March every year. In order to compute the forward P/E for the financial year ending 2019 (technically called FY19), an investor would add together the quarterly EPS estimates for future quarters ending June 2019, September 2019, December 2019 and March 2020. Then the current market price of equity is divided by this number aggregate number to get a forward P/E Ratio. A stock's P/E tells us how much an investor is willing to invest in an equity share, per rupee of earnings. Therefore a P/E ratio of 10 suggests that investors in the stock are willing to invest Rs. 10 for every Re. 1 of earnings that the company generates. For judging whether the target firm is fairly valued, undervalued or overvalued, its PE ratio is compared with the market PE ratio (i.e. of Nifty 50, S&P Sensex, SX40, among others), or the average PE ratio of the industry to which it belongs, or with the PE ratios of peer group companies. For example the PE Ratio of the target company is 18, and that of the industry, market or the comparable firms is 22, then the firm is judged to be undervalued. There are certain limitations to using the PE ratio as a valuation indicator. The projected P/E ratios are calculated based on analyst estimates of future earnings that may not be accurate. PE ratios of companies that are not profitable, and consequently have a negative EPS, are difficult to interpret. P/E ratios change constantly and the ratio needs to be recomputed every time there is a change in the price or earnings estimates. The average P/E ratio in the market and among industries fluctuates significantly depending on economic conditions. 157 As a general guidance one is advised to approach relation valuation in this manner. For example, all things being equal, a Rs.10 stock is enjoying a P/E of 75, then it is should be considered "expensive" than a Rs.100 stock with a P/E of 20. 8.5.5.2. Price to Book Value Ratio Price to Book Value (P/BV) is another relative valuation ratio used by investors. It compares a stock's price per share (market value) to its book value of equity per share. The P/BV ratio is an indication of how the market is valuing the book value of equity or how much more less are the shareholders valuing the equity to be. The market price being above or below the book value is much to do with market players and investor’s expectations of the value currently not recognised in the books. The book value per share is calculated by dividing the reported shareholders' equity by the number of equity shares outstanding. Care should be taken, to exclude any existing miscellaneous assets in the balance sheet from the reported shareholder’s equity value. Because the value equity has already been eroded as per books, to the extent of value of miscellaneous assets. If a company's stock price (market value) is lower than its book value, it can indicate one of two possibilities. The first scenario is that the stock is being incorrectly undervalued by investors due to lack of information, and hence the company’s stock represents an attractive buying opportunity. On the other hand, if the company is being correctly valued in the opinion of the investors, then it is due to, the existence of some “value less” assets in the books or fictitious profits or reserves in the shareholder’s equity. The use of book value as a valuation parameter also has limitations because a company's assets are recorded at historical cost less depreciation. Depending on the age of these assets and their physical location, the difference between current market value and book value can be substantial. Also, assets like intellectual property are difficult to assess in terms of value. Hence, book value may undervalue these kinds of assets. Though P/B ratio has its shortcomings but is still widely used as a valuation metric especially in valuing financial services and banking stocks where the assets are marked to market. 8.5.5.3. P/S Ratio The price-to-sales ratio (Price/Sales or P/S) is calculated by taking a company's market capitalization (the number of outstanding shares multiplied by the share price) and dividing it by the company's total sales or revenue over the past 12 months. The logics applied for identifying the undervalued and overvalued shares are similar in this multiple too. Sometimes concerns are raised regarding the tendency of the firms to manipulate earnings. In such 158 situations, price to sales ratio can be used instead of earning based ratios as sales are less prone to manipulation. Also, in case of companies not earning profits yet, or companies in high volume low margin businesses instead of earning based ratios investors can look at the P/S ratio to determine whether the stock is undervalued or overvalued. Typically the forward Price to Sales ratio is given as below: Pt = end of the year stock price for the firm St+1 = expected annual sales per share for the firm for the next year. 8.5.5.4. PEG Ratio This valuation measure takes three factors into account - the price, earnings and earnings growth rates. The formula used to compute the PEG ratio is as below: (EPS is calculated as Profit after tax (PAT)/Number of outstanding common shares of the company) This ratio may be interpreted as the price that an investor is willing to pay for a company, is as justified by the growth in earnings. The assumption with high P/E stocks is that investors are willing to buy at a high price because they believe that the stock has significant growth potential. The PEG ratio is an improvisation of the PE ratio using a companion variable called growth. Using either the industry or the comparable firms’ PEG ratios one can decide whether the target firm’s equity is overvalued or undervalued. The PEG ratio may show that one company, compared to another, may not have the growth rate to justify its higher P/E, and its stock price may appear overvalued. The thumb rule is that if the PEG ratio is 1, it means that the market is valuing a stock in accordance with the stock's estimated EPS growth. If the PEG ratio is less than 1, it means that the stock's price is undervalued given its growth rate. On the other hand, stocks with high PEG ratios greater than 1 can indicate just the opposite - that the stock is currently overvalued. This is based on an assumption that P/E ratios should approximate the long- term growth rate of a company's earnings. The efficacy of the PEG ratio as a valuation measure will depend upon the accuracy with which the earnings growth numbers are estimated. Overestimation or underestimation of future earnings will lead to erroneous conclusions about the valuation of the share. 159 8.5.5.5. EVA and MVA There are many ways analysts can estimate the value of a company. EVA and MVA are the most common metrics used to determine a company's value. Economic value added (EVA) attempts to measure the true economic profit produced by a company. It is also referred to as "economic profit". Economic profit can be calculated by taking a company's net after-tax operating profit and subtracting from it the product of the company's invested capital multiplied by its percentage cost of capital. EVA provides a measurement of a company's economic success over a period of time. This measure is useful for investors who wish to determine how well a company has produced value for its investors. Market Value Added (MVA) is the difference between the current market value of a firm and the original capital contributed by investors. If the MVA is positive, the firm has added value. If it is negative, the firm has destroyed value. The amount of value added needs to be greater than the firm's investors’ opportunity cost. The opportunity cost is calculated by estimating the return the investors would have got by investment in the market portfolio adjusted for the leverage of the firm. 8.5.5.6. EBIT/EV and EV/EBITDA Ratio Enterprise Value is an important component of many ratios analysts use to compare companies, such as the EBIT/EV multiple and EV/EBITDA. The EV of a business is: Market capitalization of equity + Market Value of Debt - Excess cash and cash equivalents There can be two ways to understand EV. One is to understand how much capital is actually committed in the enterprise that is revenue generating. The other is when some entity is interested to acquire another firm, how much cash would be required to buy the target firm. The assumption is that no entity would be interested in paying cash to acquire cash. EV can be related to Earnings/Cash from Operations available to the (entire fund providers i.e. equity and debt holders) The appropriate financial metric would be - Earnings before Interest and Taxes EBIT. However EBIT is again influenced by the accrual mechanics of the accounting system, and hence to adjust it to make it a cashflow based measure, analyst have coined EBITDA (Earnings Before Interest Tax Depreciation and Amortisation). The EV/EBITDA multiple is extremely useful in valuing firms which are highly capital intensive and they are not yet making book profits at PAT level or at EBIT level, however, at a gross level and in terms of cash available to the fund providers (i.e. EBITDA) it is surplus. If one goes by the P/E ratio, then unless the company is profitable, the P/E ratio would not be meaningful at all for valuation. Though the company is listed and has a good price in the market, the earnings per 160 share is negative, which is not intuitive to analysts and investors. Investors can still be bullish and positive about such companies, because they understand the need to wait till the company breaks-even or till the impact of capital expenditure on the revenues and profits kicks off. EV/EBITDA accommodates this thought process, it can be used to judge whether the firm it is overvalued or undervalued by comparing its EV/EBITDA value with that of the industry average, or its relevant decile or quintile. 8.5.5.7. EV/S Ratio Enterprise value-to-sales (EV/sales) compares the enterprise value (EV) of a company to its annual sales. The EV/sales multiple enables investors to value a company based on its sales, while taking account of both the company's equity and debt. This ratio is more comprehensive than Price to Sales Ratio because it takes into consideration company's debt while P/S does not take into account the company’s equity and debt when valuing the company. This ratio is more meaningful when the firm is highly capital intensive and its sales and profits cannot be ascribed only to equity investments. 8.5.5.8 Dividend yield The dividend yield is obtained by dividing the dividend per share declared by the company by the market price of the company. Thus it will show what would be return from dividend for an investor why buys the shares of the company at the current market price. The dividend yield gives a better picture of the return from dividend for the investor as compared to just looking at the dividend per share. Dividend yield = Dividend per share/ Market price of the share *100 For example a company which is trading at Rs 40 and declaring a dividend of Rs 2 per share will have a dividend yield of 5 per cent. 8.5.5.9 Earnings yield The earnings yield for a company is determined by dividing the earnings per share of a company by the market price of the company. This shows the earnings that are generated by the company at the current market price. It is one of the factors that is seen to determine the undervaluation or overvaluation of a stock. Earnings yield = Earnings per share/Market price per share * 100 For example, a company with an earnings per share of Rs 2.5 when the market price if Rs 25 gives an earnings yield of 10 per cent. This ratio is the inverse of the P/E ratio. 8.5.5.10. Industry/sector specific valuation metrices As discussed above, there are different valuation tools. No one method is perfect for all the sectors and companies. Different sectors are valued on different metrices. Non-cyclical sectors like FMCG and Pharma which generate predictable cashflows can be valued using 161 discounted cashflow technique. Replacement cost method is applied for valuing businesses which are capital intensive like cement and steel. Relative valuation tools like P/E Ratio are used as add on metrics across all sectors. It is also popularly used to comment on the valuation of market, comparing it with other markets and also doing comparison over a period of time. Often newspapers and media report the P/E ratio of the market and comment that it is expensive or cheap, compare to other emerging markets. P/B ratio is very popular among banks and financial service sector. Investors/analyst should understand the characteristics and attributes of the sector before they select a particular valuation tool. 8.6 Combining Relative Valuation And Discounted Cash Flow Models Discounted cash flow models are used to estimate the intrinsic value of the stock or entity. The relative valuation metrices are used to determine the value of an economic entity (i.e., the market, an industry, or a company) by comparing it to similar entities. Discounted cash flow models are dependent on (1) the growth rate of cash flows and (2) the estimate of the discount rate. Relative Valuation techniques compare the stock price to relevant variables that affect a stock’s value, such as earnings, cash flow, book value, and sales etc., A deeper look into the two techniques will reveal that multiples are merely a simplified version of DCF. All of the fundamental drivers of business value are incorporated in both techniques. Let us look at the P/E ratio to understand the connection between discounted cash flow techniques and relative valuation metrices: P/E Ratio = Price / Expected Earnings Per Share This ratio compares the price of the stock to the earning it generates. The rationale lies in the fundamental concept that the value of an asset is the present value of its future return. This ratio is also influenced by the same variables that influence the value under the discounted cash flow techniques. Intrinsic value is calculated as follow: Price is calculated as follow: D1= next period dividend calculated as D0*(1+g) where g denote expected growth in dividend, and D0 indicates current dividend, k is the discount rate. By dividing both the sides of the equation by (expected earnings during the next time 162 period) we will get- Thus P/E Ratio is affected by two variables: 1. Required rate of return on its equity (k) 2. Expected growth rate of dividends (g) Higher the expected growth rate of dividends, higher would be the P/E ratio. Higher the required rate of return on equity, lower would be the P/E ratio. Hence, we can conclude that these two approaches to valuation are complementary in nature rather than competing with each other. It often happens that the calculated intrinsic values are substantially above or below prevailing prices. As a small change in estimation of growth rate or discount rate, can have a significant impact on the estimated value. In these models, inputs are very critical as the saying goes “GIGO: garbage in, garbage out!” In such situations, relative valuation metrics can help in understanding the gaps. Relative valuation techniques provide information about how the market is currently valuing stock. 8.7 Technical Analysis Technical analysis is based on the assumption that all information that can affect the performance of a stock, company fundamentals, economic factors and market sentiments, is reflected already in its stock prices. Accordingly, technical analysts do not care to analyse the fundamentals of the business. Instead, the approach is to forecast the direction of prices through the study of patterns in historical market data - price and volume. Technicians (sometimes called chartists) believe that market activity will generate indicators in price trends that can be used to forecast the direction and magnitude of stock price movements in future. There are three essential elements in understanding price behaviour: 1. The history of past prices provides indications of the underlying trend and its direction. 2. The volume of trading that accompanies price movements provides important inputs on the underlying strength of the trend. 3. The time span over which price and volume are observed factors in the impact of long term factors that influence prices over a period of time. Technical analysis integrates these three elements into price charts, points of support and resistance in charts and price trends. By observing price and volume patterns, technical 163 analysts try to understand if there is adequate buying interest that may take prices up, or vice versa. Technical Analysis is a specialized stream in itself and involves study of various trends- upwards, downwards or sideways, so that traders can benefit by trading in line with the trend. Identifying support and resistance levels, which represent points at which there is a lot of buying and selling interest respectively, and the implications on the price if a support and resistance level is broken, are important conclusions that are drawn from past price movements. For example, if a stock price is moving closer to an established resistance level, a holder of the stock can benefit by booking profits at this stage since the prices are likely to retract once it is close to the resistance level. If a support or resistance is broken, accompanied by strong volumes, it may indicate that the trend has accelerated and supply and demand situation has changed. Trading volumes are important parameters to confirm a trend. An upward or downward trend should be accompanied by strong volumes. If a trend is not supported by volumes or the volumes decrease, it may indicate a weakness in the trend. Technical analysis converts the price and volume data into charts that represent the stock price movements over a period of time. Some of the charts used include line charts, bar charts, candlestick chart. The patterns thrown up by the charts are used to identify trends, reversal of trends and triggers for buying or selling a stock. Typically, chartists use moving average of the price of the stock to reduce the impact of day to day fluctuations in prices that may make it difficult to identify the trend. 8.7.1 Assumptions of technical analysis From the above discussion on what technical analysts do, the following assumption are delineated: 1. The market price is determined by the interaction of supply and demand. 2. Supply and demand are governed by many rational and irrational factors. 3. Price adjustments are not instantaneous and prices move in trends 4. Trends persist for appreciable lengths of time. 5. Trends change in reaction to shifts in supply and demand relationships. 6. These shifts can be detected in the action of the market itself. 8.7.2 Technical versus Fundamental Analysis Fundamental analysis involves determining the intrinsic worth of the stock and comparing it with the prevailing market price to make investment decisions. Fundamental analysts believe that prices will move towards their intrinsic value sooner or later. Technical analysis is not concerned whether the stock is trading at a fair price relative to its intrinsic value. It 164 limits itself to the future movements in prices as indicated by the historical data. It is used for short-term term trading activities and not necessarily long-term investing. 8.7.3 Advantages of technical Analysis Technicians feel that the major advantage of their method is that it is not heavily dependent on financial accounting statements. They feel that a great deal of information is lacking in financial statements. They also contend that a lot of non-financial information and psychological factors do not appear in the financial statements. Technicians also feel that unlike fundamental analysts, they do not need to collect information to derive the intrinsic value of the stocks. They only need to quickly recognize a movement to a new equilibrium value for whatever reason. Hence, they save time in collecting enormous information and data which is a prerequisite for fundamental analysis. 8.7.4 Technical Rules and Indicators There are numerous trading rules and indicators. There are indicators of overall market momentum, used to make aggregate market decisions. There are trading rules and indicators to be applied for individual securities. Some of the popular ones are: Trend-line analysis Moving averages Bollinger-Band Analysis Trend-Line Analysis The graph shows a peak and trough, along with a rising trend channel, a flat trend channel, a declining trend channel, and indications of when a technical analyst would ideally want to trade. Stock price trend line 165 Moving-Average Analysis Moving-Average Analysis is the most popular technical indicator. The moving average of a time series of past prices can provide a nonlinear graph of price movements. Generally, a 5, 10, 30, 50, 100, and 200 days moving averages are calculated. One simple strategy for using the moving-average analysis is to buy when the price is sufficiently below the moving average and sell when the price is sufficiently above the moving average. Bollinger-Band Analysis Bollinger bands use normal distribution to calculate the deviation of the market price from the moving average. For example, when the price goes two standard deviations above the moving average, the stock might be regarded as overbought. If the price goes two standard deviations below the moving average, the stock might be regarded as oversold. 8.7.5 Fixed income securities and Technical analysis Technical analysts use past prices and trading volume or both to predict future prices. A broad range of techniques and indicators based on price and volume data such as chart analysis, moving averages, filters and oscillators are used to identify predictable patterns in stock prices. The techniques depicted above can also be applied to the fixed income securities as long as price and volume data is available. The theory and rationale for technical analysis of bonds are the same as for stocks, and many of the same trading rules are in fact used by analysts in bond markets. 8.8 Qualitative evaluation of stocks While analysing companies, the qualitative aspects of the companies are equally important if not more. Corporate governance practices are the cornerstone in evaluating a business. Corporate governance has become a well-discussed topic in the business world. Newspapers and media report detailed accounts of corporate fraud, accounting scandals, and excessive compensation etc., some leading to even bankruptcy of the companies fraught in such mis governance. Corporate governance includes a wide array of mechanisms and expectations that are of importance to businesses, the economy, and society. World over economies are dominated by companies of different sizes. How these companies are governed affects not only the shareholders of the companies but also thousands of people who work with such companies, buy products of these companies or are affected by them implicitly. Governance aspects are reflected in acts, rules and regulations, contracts, and in important institutions such as stock exchange listing standards and the audit process. 166 The components of corporate governance vary by country, over time, and by company type, size, and ownership. Analysts and investors play a very important role in driving good practices and highlighting companies with poor governance practices. There are some important aspects analysts should look for. For example, they should also pay attention to the quality of independent directors in a business. Analysts should focus on the qualifications and experiences of these independent directors, how many meetings they attend and what are their contributions to the business. It may be good practice to interact with some of them to understand them better. Good governance practices can also be used as filters for selecting the investment universe. CHAPTER 9: INVESTING IN FIXED INCOME SECURITIES 9.1 Debt market and its need in financing structure of Corporates and Government The Debt market refers to the market where the borrowers issue new debt securities and investors buy those new securities or buyers buy the already issued debt securities and sellers sell the various debt instruments already issued by entities like Governments and private firms in lieu of funding availed by them. The development of a vibrant debt market is essential for a country’s economic progress as the debt market helps to reallocate resources from savers to investors (high-risk takers). The banking channel is safer for savers as bank failures are not very common, but the debt market is a market for direct transfer of risk to the lenders. However, unlike the equity market, the debt market exposes an investor or lender to relatively moderate risk as the physical assets of the company are typically secured against such debt. The equity market that operates majorly through electronic trading platforms with efficient price discovery and significant involvement of intermediary brokers, the debt market is more like an opaque Over the Counter (OTC) market with institutions mostly trading directly with other institutions. Debt market is a large value market with a small number of entities but the equity market deals with a large number of investors with a smaller average stake. In order to expand and achieve faster economic and commercial growth, it is necessary for firms to get financial resources at a reasonable cost. Business owners can utilize a variety of financing resources, generally divided into two broad categories: debt and equity. "Debt" involves borrowed money to be repaid, plus interest, while "Equity" involves raising money by selling interests in the company. Debt is a charge on income for the firm while the return on equity is an allocation / appropriation of profit made by the company. Debt investors do LEARNING OBJECTIVES: After studying this chapter, you should know about: Debt market and its need in financing structure of Corporates and Government Know the Bond market ecosystem Various kinds of risks associated with fixed income securities Pricing of bond Traditional Yield Measures Concepts of Yield Curve Concept of Duration Introduction to Money Market Introduction to Government Debt Market Introduction to Corporate Debt Market  Small-savings instruments 168 not share profit while equity investors have a right over it. Similarly, governments also borrow so that they can finance higher spending for development of the society and country. Borrowing at both firm and government levels can be either to fund temporary liquidity shortfall or for funding long-term asset creation. Depending upon the duration and purpose of borrowing, a variety of debt instruments can be used for raising the funds. The debt market facilitates borrowing of funds using such instruments to investors having varied risk appetite. In any economy, the Government generally issues the largest amount of debt to fund its expenditure. The well developed debt market helps the Government to issue papers at a reasonable cost. A liquid debt market lowers the borrowing cost for all and it provides greater pricing efficiency. Equity and debt are two useful sources of financing for the corporate sector that cater to investors having different risk appetites and requirements. Investors in debt are typically very long investors, specifically investors on long gestation infrastructure projects which require substantial debt funding, while traditionally the equity holders look for short term gains. Debt is funded either by bank loans or bond issuances. A corporate bond market dealing in issuance of pure corporate papers helps an economic entity to raise funds at cheaper cost vis-à-vis syndicated loans from banks. The debt market brings together a large number of buyers and sellers to price the debt instruments efficiently. A well-developed debt market provides a good alternative to banking–support business models as risk is well distributed among many investors while in the banking support economy, the huge risk is on the banks. Since banks raise funds through deposits which are generally short or medium term, their obligations are generally short and medium term and hence these banks may not be able to fund very long period capital expenditure of corporates through bank loans. However, banks can easily invest in debt instruments issued by corporates and a well-developed debt market helps these investors to liquidate the instruments easily. The development of a liquid and well-functioning corporate debt market helps to channelize the collective investment schemes to invest in the market and also facilitate in bringing retail investors to invest directly in quality debt. The well developed and liquid debt market also helps various long term investors like pension funds, insurance companies which have different investment objectives as they invest very long term to match and immunize their liabilities. A well-functioning and liquid debt market makes the cost of debt efficient and cheaper. The primary debt market helps the Government and corporates to directly sell their securities to investors. Typically, Governments issue debt through “Auctions” while corporates issue debt papers through “Private Placement”. The secondary debt market provides an exit route to the investors and it also provides important information not only on price discovery but also on many other factors like credit risk appetite, spread, default probability, etc. The tradability of bonds issued by a borrower helps the market in getting required information on the firm. Traditionally, commercial banks have been providing capital to corporates and these banks play a very dominant role in developing and emerging market economies where the 169 debt markets are not very well developed. A liquid corporate debt market requires well defined insolvency codes / laws while availability of well-defined credit migration history / details help international investors compare the relative riskiness of the debt markets across the world. The establishment of a good Credit Default Swap (CDS) market helps investors to buy insurance against failures of companies and these investors participate in unbundling the inherent credit risk and reselling the same at the market driven rates. The failures of the companies can be well priced in the market through risk transfer. However, in practice, issuance of debt is a multi-level process adhering to various regulations. It may involve underwriting, credit rating, listing with stock exchanges, coordinating with issue managers to distribute to the right investors, liquidity in the market, banking support. A well-functioning debt market would require a developed and sustainable legal framework with clear bankruptcy codes. The regulatory cost of the debt can be at times prohibitive for smaller borrowers. Hence, small and medium firms usually prefer bank borrowing vis-a-vis debt issuances. Indian Debt market has typically has three distinct segments – (a) Government debt, known as “G-sec” market with Government of India issuing dated papers, Treasury Bills and State governments issuing State Development Loans of various maturities; (b) Public sector units (PSU) and Banks issuing instruments to raise resources from the market; and (c) private sector raising resources through issuance of debt papers. Government of India also issues Floating Rate Bonds, Inflation Indexed Bonds, Special Securities, and Cash management Bills while State Governments raise funds using UDAY Bonds. PSU Bonds are popular among investors because of their perceived low risk and Commercial Banks issue short term papers like Certificate of Deposits (CDs) as well as long term bonds to fund their various business needs. The private corporates issue instruments like Bonds, Debentures, Commercial Papers (CPs), Floating Rate Notes (FRNs), Zero Coupon Bonds (ZCBs), etc. 9.2 Bond market ecosystem Since bonds create fixed financial obligations on the issuers, they are referred as fixed income securities. The issuer of a bond agrees to 1) pay a fixed amount of interest (known as coupon) periodically and 2) repay the fixed amount of principal (known as face value) at the date of maturity. The fixed obligations of the security are the most defining characteristic of bonds. Most bonds make semi-annual interest payments, though some may make annual, quarterly or monthly interest payments (except zero coupon bonds which make no interest payment). Typically, par value of the bond is paid on the maturity date. Bonds have fixed maturity dates beyond which they cease to exist as a legal financial instrument. (except perpetual bonds, which have no maturity date). On the basis of term to maturity, bonds with a year or less than a year maturity are terms as money market securities. Long-term obligations with maturities in excess of 1 year, are referred to as capital market securities. Thus, long term bonds as they move towards maturity become money market securities. 170 The coupon, maturity period and principal value are important intrinsic features of a bond. The coupon of a bond indicates the interest income/coupon income that the bond holder will receive over the life (or holding period) of the bond. The term to maturity is the time period before a bond matures (or expires). All G-Secs are normally coupon (interest rate) bearing and have semi-annual coupon or interest payments with a tenor of between 5 to 30 years. Maturity period is also known as tenor or tenure. The principal or par value of the bond is the original value of the obligation. Principal value of the bond is different from the bond’s market price, except when the coupon rate of the bond and the prevailing market rate of interest is exactly the same. When coupons and the prevailing market rate of interest are not the same, market price of the bond can be lower or higher than principal value. If the market interest rate is above the coupon rate, the bond will sell at a discount to the par value. If the market rate is below the bond’s coupon, the bond will sell at a premium to the par value. The interest rate here is assumed to be for the remaining maturity of the bond. Another interesting thing about bonds is that unlike equity, companies can issue many different bond issues outstanding at the same time. These bonds can have different maturity periods and coupon rates. These features of the bonds will be part of the indenture.9 Bonds with options Bonds can also be issued with embedded options. Some common types of bonds with embedded options are: bonds with call option, bonds with put option and convertible bonds. A callable bond gives the issuer the right to redeem all or part of the outstanding bonds before the specified maturity date. Callable bonds are advantageous to the issuer of the securitybut they present investors with a higher level of reinvestment risk than non-callable bonds. The issuer will call the bond before its maturity only when the interest rates for similar bonds fall in market. The investor will receive the face value of the bond before its maturity, and will be forced to reinvest that money for the remaining period lower interest rates. This is called reinvestment risk. A put provision gives the bondholders the right to sell the bond back to the issuer at a pre- determined price on specified dates. Puttable bonds are beneficial to the bondholder by guaranteeing a pre-specified selling price at the redemption dates. 9 Indentureis the legal agreement between two parties, in case of bond indenture the two parties are the bond issuer (borrower) and the investors (lender). 171 A convertible bond is a combination of a plain vanilla bond plus an embedded equity call option. It gives the bondholder the right to exchange the bond for a speci