Mba fm 02 - security analysis and portfolio---introduction

PGDM FM 04-- Security analysis
and Investment management
By : Aniruddha Ghosh

1

Topics for today’s discussion
• What is Security Analysis and Portfolio Management
all about?
• Why should we read this subject in a course like MBA
, PGDM , CFA and other professional courses?
• What is the relation of this subject with other fields?
• What is a Stock?
• What is a Share ?
• What is a market ? Classification of markets.
• What are the various types of markets available in
India?
3

What is a Stock?
• When an investor gives a corporation money
in return for part of ownership, the
corporation issues a certificate of ownership
interest to the stock holder. This certificate is
known as stock certificate, Capital stock or
Stock.

4

What is a share?
• Some investors have large ownership interests
in a given corporation, while other investors
own a very small part. To keep track of each
investor’s ownership interest, corporations
use a unit of measurement referred to as a
“Share” (or “share of stock”).
• The no. of shares that an investor’s own is
printed on the investor's stock certificate.
5

Types of stock --- in terms of returns
•
•
•
•
•
•
•

Blue Chip stocks
Green chip stocks
Red chip stocks
Growth stocks
Cyclical stocks
Fixed income stocks
Stable stocks
6

Types of stock --- in terms of sector
•
•
•
•
•
•
•
•
•

Infra stocks
Banking stocks
PSU stocks
IT stocks
FMCG stocks
Cement Stocks
Automobile stocks
Steel Stocks
Oil stocks
7

Relation of SAPM with other fields of study
•
•
•
•
•
•

Economics
Mathematics esp. statistics
Science esp. Brownian movement
English literature
Psychology esp. human behavior
Politics

8

What is Investment?
• In layman terms it is the process of sacrificing
something now for the prospect of gaining
something later.
• As per Graham & Qadd- “ An investment
operation is one which upon thorough analysis
promises safety of principal and an adequate
return. Operations not meeting these
requirements are speculative”. So from the above
lines we can infer that investment means some
monetary commitment for adequate return in
future.
9

Characteristics & Objectives of
Investment
•
•
•
•
•
•
•
•

• Stability of income
Risk
•Tax benefits
Safety
Return
Liquidity
Marketability
Concealability
Capital growth
Purchasing power ability
10

Scope of Investment
•
•
•
•
•
•
•
•
•
•

Safety of principal
Liquidity & collateral value
Stability of income
Purchasing power
Adequacy of income after tax
Capital growths
Legality
Possible appreciation
Tangibility
Conceivability
11

NEED & IMPORTANCE OF INVESTMENT
•
•
•
•
•
•

Longer life expectancy
Increasing rates of taxation
Interest rates
Inflation
Income
Investment channels

12

Approaches to investment decision
making
•
•
•
•

Fundamental approach
Psychological approach
Academic approach
Eclectic approach

13

Investment Process
• Step 1:
– Generating Utility function , bearing the following things
into mind;
• Client analysis i.e. risk taker or averser
• Investment horizon
• Tax code

• Step 2:
– Asset allocation, taking into a/c the following factors;
•
•
•
•

A view on markets
An analysis of various asset classes i.e., Shares , debt ,G.Secs, etc.
in domestic or international market
Taking inflation factor into effect.
14

Investment Process (contd.)
• Step 3:
– Security selection
• Which share?
• At what price?
• At what time?
• Valuation bases:
– Comparable ratios
– Cash flows
– Charts
– indicators

• Private information

15

• Step 4:
– Execution; while asking a few questions to yourself or
the investor;
• How often do you trade?
• How large do you trade?
• Do you use instruments such as Derivatives to hedge against
trade?
• Trading costs
– Commission
– Brokerage
– Bid/ask spread

• Trading systems
16

• Step 5:
– Performance Evaluation; again asking a few
questions;
•
•
•
•
•

How much risk did the portfolio manager take?
What return did the portfolio manager make?
Did the portfolio manager outperform / underperform?
Market Timing
Stock selection

17

Investment Activities
• FINANCIAL ASSETS
– Cash, bank deposits, PF, LIC scheme, Pension
Schemes, PO certificates & Deposits.

• PHYSICAL ASSETS
– House, land, building , bullion , consumer
durables, etc.

• MARKETABLE SECURITIES
– Shares, bonds, & G.Secs
18

Investment Alternatives
• Non-marketable financial assets
– PFs,
Bank
Deposits,
Insurance
Deposits, NSC, Company Deposits.

,

PO

• Marketable financial assets
– Equity Shares, Bonds, Money market instruments
like (T-Bills, Commercial Papers, ICDs)

19

Investment Alternatives
• Non-marketable financial assets
– PFs,
Bank
Deposits,
Insurance
Deposits, NSC, Company Deposits.

,

PO

• Marketable financial assets
– Equity Shares, Bonds, Money market instruments
like (T-Bills, Commercial Papers, Certificate of
Deposits),
MFs,
Real
Estate,
Precious
Objects, Financial Derivatives.

20

What do you mean by the term “Market” ?
• Definition as per ‘Oxford Lexicon’– A common
place where buyers and sellers meet to
exchange goods against a common
denomination (currency).
• Definition in terms of Finance – A place where
financial instruments are traded under a
legalized body following certain norms against
a denomination (currency).

21

Different types of market
•
•
•
•
•

The capital market
The credit market
The money market
The FOREX market
The commodity market

22

Market Snapshot Table
SEGMENT

PURPOSE

PLAYERS

REGULATORS

Money market

ST finance, high liquidity, Banks, FIs, Govt., FIIs,
maturity period of funds Corporate, MFs,
(1 day – 1 year)
Individuals

RBI

Capital Market

LT finance, maturity
period of funds ( > 1
year) , liquidity depends
on the term of the
financial asset.

Banks, FIs, Govt., FIIs,
Corporate, MFs,
Individuals

SEBI

Forex Market

Both ST & LT finance in
foreign currency

Banks, Corporates ,
Forex Dealers

RBI

Credit Market

Both ST & LT finance,
Banks, FIs, NBFCs
Provides loan of ST & MT
to corporate &
individuals.

RBI

Commodity
Market

Exchange of
Corporate, Broking
Commodities esp. metals houses

SEBI

23

Role of Financial Intermediaries
• Transfer of funds from lender to borrower.
• They generally eases the flow of fund in the
market.
• The presence of intermediaries increases the
cost of lending and borrowing.
• they help in the issuance of securities
• They help to migrate risk of the Co. whose
securities are going to be issued.
24

List of some Intermediaries Operating in
Financial markets
Intermediary

Market

Role

1. Stock Exchange

Capital market

Secondary market to securities.

2. Investment
Bankers

Capital Markets

Corporate advisory services, issue of
securities.

3. Underwriters

Capital market &
Money Market

Subscribe to unsubscribed portion of
securities.

4. Registrars,
Depositories,
Custodians

Capital Markets

Issue securities to the investors on
behalf of the Co. & handle share
transfer activity

5. Primary Dealers

Money Market

Market making in G.Secs.

6. Forex Dealers

Forex Market

Ensure exchange in currencies.
25

Stock Exchange
• Let us understand this term through KWA method, the
term “stock exchange” comprises of 2 words – stock &
exchange. As discussed earlier, Stock means a fraction
of capital of a company & the word exchange means a
place for purchase and selling.
• The Securities Contract Regulation Act 1956 defines a
“Stock Exchange” as an association, organization or
body of individuals, whether incorporated or
not, established for the purpose of assisting, regulating
and controlling business in buying, selling and dealing
in securities.
26

Stock Exchange (Contd.)
• According to Hastings “ Stock Exchange or
security market comprises all the places
where buyers and sellers of stocks and bonds
or
their
representatives,
undertake
transactions involving sales of securities”.

27

Characteristics of Stock Exchange
•
•
•
•
•
•

Place of transaction
Voluntary AOP
A platform for business
A custodian
Autocracy & draconianism
Large no. of official & unofficial bodies are
connected.
28

Functions of Stock Exchange
•
•
•
•
•
•
•
•

Ready market
Mobilization of savings
Evaluation of securities
Capital formation
Proper channelization of capital
Fair dealings
Control of corporate sector
Barometer of business progress
29

Advantages / Benefits of Stock
exchanges
•
•
•
•

Benefits to the Cos.
Benefits to the investors
Benefits to the community or society
Limitations of Stock Exchange
– Lack of uniformity and control
– No restriction in membership
– Gap in regulations

30

Markets under Stock Exchanges in
India
• Primary Market
• Secondary Market

31

Primary Market vs. Secondary Market
Feature

NIM

Secondary market

1. Issue of
securities

Deals only with new issue of Deals in existing securities
securities. Issues are considered
fresh or new provided such issues
are made for the first time either
by the existing co. or by the new co.

2. Location

No fixed
needed.

3. Transfer of
securities

Securities are created & transferred Securities are transferred from
from corporates to investors for the one investor to another through
first time.
stock exchange mechanism.

4. Entry

All Cos. can enter NIM and make For the securities to enter the
fresh issue of securities.
portal of stock exchanges for the
purpose of trading listing is
mandatory.

geographical

location Needs a fixed place to house the
secondary market activities , viz.,
trading.

32

Primary Market vs. Secondary Market [contd.]
Feature

NIM

Secondary market

5. Administration

Has no tangible form
administrative set up.

of Has a definite form of administrative
set-up
that facilitates trading in
securities.

6. Regulation

Subject to regulations mostly Subject to regulation both from within
from outside company– SEBI, & outside the stock exchange
Stock Exchanges, Cos Act ,etc.
framework.

7. Aim

Creating LT investments for Providing
liquidity
through
borrowing.
marketability of those instruments.

8. Price
movement

Stock price movement in Both macro & micro factors influence
secondary market influences the stock price movement.
the pricing of issues.

9. Depth

Depends on number and the Depth depends upon the activities of
volume of issue.
the primary market as it brings into
the fore more corporate entities and
more instruments to raise funds.

33

Types of Public Issues
NIM- Methods of marketing securities
PPM

OSM

PPM
RIM

IPOM
BIM

BBM

SOM

BODM

NIM
NIM- Methods of marketing securities

SECONDARY

MARKETS

PPM = Private placement method
PPM= Pure Prospectus method
OSM = Offer for Sale method
IPOM = IPO method
RIM = Rights Issue method
BIM = Bonus issue method
BBM = Book Building method
SOM= Stock Option Method
BODM= Brought-out Deals method

34

Markets Available in India
• NSE
– Nifty 50, Nifty futures, NSE 100, etc.

• BSE
– SENSEX, BSE BANKEX, BSE 500, BSE 100, BSE
FMCG , etc.

• OTCEI
– Bullion , metals, commodities.

35

Listing of Securities
• Listing means admission of securities to dealings
on a recognized stock exchange of any individual
co., central and state governments , quasi
governments and other FIs , etc.
• Advantages of listing:
– 1. To the company:
• Tax concessions
• National & international presence
• Term loan facility from both domestic and non-domestic
banks
• Mobilizing resources
• Ensures wide share holding pattern
36

• Advantages of listing: (contd.)
– 2. To the Investors
•
•
•
•
•
•
•
•

Ensurement of liquidity
Rights entitlement
Loan factor
Tax assessment
Avoidance of secrecy
Investors protection
Publication of quarterly reports
M&A, takeover offers enables investors to exercise their
discretion.

37

Functions of SEBI
•
•
•
•
•
•
•
•
•
•
•
•

Regulating the business
Registering & regulating the working of workers who are associated with securities
market
Registering & regulating the workings of depositories, participants, custodian of
securities, FIIs, credit rating agencies, etc.
Registering & regulating the working of venture capital funds & collective investment
schemes including MFs.
Prohibiting fraudulent & unfair trade practices relating to securities market.
Promoting investor’s education & training.
Prohibiting insiders trading in securities
regulating substantial acquisition of shares & takeover of Cos.
Performing of such functions & exercising such powers under the Securities Contracts
(Regulation) Act 1956, as may be delegated to it by the Central Govt.
Levying fees or other charges for carrying out the regulations in Securities market.
Conducting research relating to securities market.
Registration of FIIs.
38

Powers of SEBI
•
•

•

•
•

The discovery & production of any books of a/c or documents.
Summarizing & enforcing the attendance of persons & examining them on
oath.
Inspection of any books, registrars and other documents of co. or any public
co. intending to get its securities listed on a stock exchange where the board
suspects the co. to be involved in insider trading/ fraudulent & unfair trade
practices related to the securities market.
Issuing commission for the examination of witnesses or documents.
During an investigation / a pending enquiry, in order to protect the interest of
the investors or the securities market, the board may:
–
–
–
–
–

Suspend trading of a stock in a stock exchange.
Restrict persons in trading securities.
Suspend any office bearer / self regulatory authority of the stock exchange.
Impend any or retain the proceeds of securities of any transaction under investigation .
Attach after the specified process, for a period not exceeding 1 month, the bank a/c s or
any other intermediary or person associated with the securities market in a matter
involving violation of the provisions of the SEBI Act.
– Direct any intermediary or person associated with securities market not to dispose off or
alienate an asset forming past of any transaction under investigation.
39

Powers of SEBI [contd…]
• The board may specify the requirements for listing & transfer
of securities
• w.r.t. to prospectus, offer documents & advertisements
soliciting money, the board may for the protection of
investors;
– Specify by regulation:
• Matters relating to issue of capital transfer of securities & matters
incidental there to.
• The manner in which such matters are disclosed

– Specify by special orders:
• Prohibit any co. from issuing prospectus any offer document or issue
advertisement, soliciting money for issue of securities
• Specify the conditions subject to which these documents can be issued
40

NSE at a Glance
•
•
•
•
•
•

Inception date: 3rd Nov. 1994 in Mumbai
Type of trading: NEAT (National Exchange for Automated Trading)
Clearing house: NSCCL (National Securities Clearing Corporation Ltd.)
> than 800 trading members
Largest trading VSAT network worldwide
Trading terminals spread across 379 cities with more than 6,500
concurrent uses daily.
• Min. market capitalization of Rs. 5 billion in order to get included in the
index.
• Other bodies, S&P CNX Defty (Dollar-denominated version of Nifty). Nifty
Junior (comprising 50 stocks which are highly liquid in nature).
• S&P CNX 500, India’s first broad-based benchmark, representing 90% of
the total market capitalization & about 98% of NSE ‘s total turnover.

41

BSE at a Glance
• Oldest stock exchange in Asia, established in 1875 in the name
of “The Naïve share & stock Brokers Association”.
• In 1956 BSE became the 1st Stock exchange to be recognized
by the Indian Govt. under Securities Contract regulation Act.
• The main BSE sensex Index comprises of 30 scrips.
• Other stock indices of BSE are BSE 500, BSEPSU, BSE MIDCAP,
BSE SMLCAP & BSE BANKEX
• Clearing house: BOISL (Bank of India Shareholding Ltd.)
• Type of trading : BOLT (BSE Online Trading)

42

Methods of trading system in Stock
Exchanges
• Online stock market trading
– Installable software based stock trading
– Web based trading application

• WAP trading
– Wireless Application Protocol

• SLB Scheme
– Standardized contracts
– Introduced by SEBI, 1997 to provide mechanism for borrowing
of securities to enable settlement of securities sold short.
– Clients needs to be registered with approved intermediaries
– Tenure of contracts = 7 days
– Settlement period = t +1 days

43

Short Selling
• Short selling can be defined as selling a stock
which the seller does not own at the time of
trade. Short selling is the sale of a security
that is not owned by the seller, but with a
promise to deliver the same.
– 20th Dec. 2007, SEBI allowed this short selling
– Types of short selling:
a) Naked short selling- No intention of returning the shares /
delivery.
b) Day trading / Intraday Trading.

44

Types of trading [ Contd….]
• Screen based trading system (SBTS)
• Scripless trading
– Settlement takes place via book entry instead of
physical exchange & delivery of securities certificates.
– Advantages:
•
•
•
•
•

Decrease in paper work of stock brokers & stock exchanges
Safety from theft, fakeness & mutilation.
Improves liquidity
Greater speed of exchange of securities certificate
Decrease in cumbersome transfer procedures
46

Demat Trading / Dematerialization of
Shares
• Regulated by “ the Depositories Act , 1996”
• The various participants are:
– NSDL (National Securities depository Ltd.)
– CDSL (Central depository services Ltd.)
– DPs
– Registrars & share transfer agents
– Investors

47

Alternative trading system (ATS)
FIRM A (Seller)
Puts a message on his site for the
availability of WIPRO securities @
Rs. 100/-

CONFIRMATION

ESCROW a/c

RECONFIRMATI
ON

EXECUTION

Firm B (Buyer)
Evincing interest in buying of
shares . Places an order for buying
on seller’s site.

• ATS software will confirm the availability of securities from the sellers DP a/c
balance in bank a/c of the buyer.
• ATS software generates 2 escrow a/c ( A type of A/c where legal money is kept
separately for some definite course of action here it is mainly trading of
securities); one of seller “for securities” & other of buyer “for funds”.
• ATS software will flash a message on the screen of both buyer and seller to
reconfirm their willingness.

• Upon reconfirmation of willingness by both the parties, ATS software will settle
the obligations of both parties instantly & simultaneously.
48

SEBI (Disclosure & investors
protection)
• The guidelines consists of framework of capital issuances as
follows:
–
–
–
–
–
–
–
–
–
–

Preliminary ( chapter –I)
Eligibility Norms for Cos. Issuing securities ( Chapter –II)
Pricing by Cos. Issuing securities (Chapter-III)
Promoter’s contribution & lock-in requirements (Chapter- IV)
Pre-Issue Obligations (Chapter – V)
Contents of offer documents (Chapter – VI)
Issue of IDRs ( Chapter VIA)
Post Issue Obligations (chapter- VII)
Other issue requirements (Chapter – VIII)
Green Shoe Option (Chapter- VIIIA)
49

SEBI (Disclosure & investors
protection) [contd…..]
–
–
–
–
–

–
–
–
–
–
–
–

Guidelines on advertisements (Chapter-IX)
Guidelines for Issue of debt instruments (Chapter –X)
Guidelines on Book Building (Chapter XI)
Guidelines on E-IPO (Chapter XIA)
Guidelines on issue of capital by designated financial institutions (Chapter
XII)
Shelf prospectus (Chapter XIIA)
Guidelines for Preferential issues (Chapter XIII)
Guidelines for QIPs (Chapter XIIIA)
Guidelines for OTCEI issues ( Chapter XIV)
Guidelines for Bonus issues (Chapter XV)
Operational Guidelines (Chapter XVI)
Miscellaneous (Chapter XVII)
50

Types of Orders
A.



A.

Orders at BSE
Limit order
Market order
Stop loss order
Orders at NSE


 Quantity conditions:
 DQ Order
 MF order
 AON order

Time related conditions:







Day order
GTC order / open orders
GTD order
IOC order

Price related conditions:




Limit order
Market order
Stop loss order

51

Some Confusing terms
• Investor
• Investment
• Speculator
– Types of Speculators :
•
•
•
•

•
•
•
•

Bull / Tejiwala
Bear / mandiwala
Stag
Lame duck

Speculation
Gambling
Arbitrageur
Arbitrage
52

Understanding the concept of Return
• Return can be defined as the motivating force,
inspiring the investor in the form of rewards,
for understanding the investment.
• There are 2 components of return
– Yield
– Capital appreciation

54

Types of return
•
•
•
•
•
•

Post returns
Ex-ante returns
Actual return
Expected return
Estimated return
Average return

55

Case to watch for
• Case 1
– If a share of ACC ltd. Is purchased for Rs 3580/- on 8th
Feb last year , and sold for Rs 3800/- on 9th Feb this year
and the co paid a dividend of Rs 35/- for the year. What
is the rate of return in the hands of the investor?

• Case 2
– Mr. X purchased Rs 1000/- par value bond for Rs 900/-.
The coupon rate on this bond is 8% p.a. one year later
he sells the bond for Rs 800/-. Calculate the rate of
return for Mr. X.
57

How to calculate Probability return?

58

Illustration
• Calculate the expected return for stock A from
the following information:
•Return (%) -24 -10
0
12
18
22
30
Probability
of
Occurrence

0.05

0.15

0.15

0.20

0.20

0.15

0.10

59

A few more concepts
• Portfolio
• Portfolio theory
• Asset allocation
– Traditional allocation
– Core-satellite allocation
– Reverse asset allocation

• Portfolio management

60

Measuring expected return on a
Portfolio

61

Illustration
Stock

Price as on
1/4/2001

Price as on
31/3/2002

Yearly
dividend

X

20

30

2

Y

30

40

3

Z

50

60

5

From the above table calculate the rate of return on each stock
and also calculate the portfolio return.
62

Understanding the term Risk
• Definition of Risk
– As per “Oxford lexicon” the term risk means the
possibility of loss.
– As per Security Analysis the term Risk can be
defined as – “the future happening that can be
assumed under the probability of the likelihood of
future outcomes that can be quantified”.

• So, what is Uncertainty?
– It refers to what will happen in future & it cannot
be quantified.
63

Types of Risk
Systematic

Unsystematic

Market risk

Business risk

Interest rate risk

Liquidity risk

Purchasing power risk

Default risk

Internal Risk

Financial risk
External Risk

64

Types of Risk (contd.)
Cases of Internal Business Risk Cases of External Business Risk

1. Fluctuation in sales
2. R&D
3. Personnel management
4. Fixed cost
5. Single product

1. Social & regulatory
factors
2. Political risk
3. Business cycle
4. Exchange rate

65

Calculating Risk- various concepts
• There are two ways of assessing risk
– Behavioural view
• Sensitivity analysis
• Probability distribution

– Quantitative / Statistical view
• Standard deviation
• Coefficient of variation
• Coefficient of correlation

66

Behavioural View
• Sensitivity analysis:
– Assessing risk using a no of possible return estimates
– Assessing variability among returns
• Worst (pessimistic)
• Expected (most likely)
• Best (Optimistic)

– Range = Difference b/w Optimistic & pessimistic
outcomes.
– Greater the range, more is the risk and so on .
– Again, the level of risk may be related with the state of
economy.
67

Sensitivity analysis (Illustration)
State of
Economy

Particulars
Initial Outlay

Asset X

Asset Y

50

50

14
16

8
16

18
4

24
16

Annual return (%)
Recession

Pessimistic

Normal

Most Likely

Boom

Optimistic
Range =(Optimistic –
Pessimistic)

Decision : From the investors view point the Asset Y is more risky than the
Asset X, since the RANGE of ASSET Y > ASSET X.
68

Behavioural View
• Probability Distribution:
– width of the probability distribution of rates of
return is the measure of risk.
– The wider the probability distribution the greater
is the risk or greater is the variability of return the
greater is the variance.
– The variance can be appraised visually.

69

Illustration
RET--A
38
23
8
-7
-22

PA
0.05
0.2
0.5
0.2
0.05

RET--B
90
50
20
-10
-50

PB
0.1
0.25
0.3
0.25
0.1

The above table is the probability distribution of the
rates of return of Cos. A & B.
70

0.6
Probability of Stocks A & B

0.5
0.4

0.3
Stock of Co.A
0.2
Stock of Co.B
0.1
0

-100

-50

0

50

100

Return of Stocks A & B
71

Quantitative /Statistical View

72


73


74


75


76


77

Does diversification reduces risk?
σp

UNIQUE
RISK
MARKET
RISK

TOTAL RISK

No. of
Securities

79

SD of L

Weights

1

L
H
100.00 0.00
%
%

2

ρ

ρ

ρ

ρ

ρ

SD of H

Portfoli
o No.

16

20

1

0.5

0

-0.5

-1

Portfolio
Average Returns Return
L
H

Portfolio Risk (σp) when the correlation
coefficent is
ρ= +1 ρ= 0.5

ρ=0

ρ= -0.5

ρ= -1

12

16

12

16

16

16

16

16

90.00% 10.0%

12

16

12.4

16.4

15.50

14.54

13.51

12.4

3

80.00% 20.0%

12

16

12.8

16.8

15.20

13.41

11.34

8.8

4

70.0% 30.0%

12

16

13.2

17.2

15.12

12.71

9.71

5.2

5

60.0% 40.0%

12

16

13.6

17.6

15.26

12.50

8.91

1.6

6

50.0% 50.0%

12

16

14

18

15.62

12.81

9.17

2

7

40.0% 60.0%

12

16

14.4

18.4

16.18

13.60

10.40

5.6

8

30.0% 70.0%

12

16

14.8

18.8

16.92

14.80

12.32

9.2

9

20.0% 80.0%

12

16

15.2

19.2

17.82

16.32

14.66

12.8

10

10.0% 90.0%

12

16

15.6

19.6

18.85

18.07

17.26

16.4

11

0.0% 100.0%

12

16

16

20

20.00

20.00

20.00

80

20

Expected Return on Portfolio's

25
20
15

r=+1
r= 0.5
r= 0
r= -0.5
r= -1

10
5
0
0
5
10
15
20
S.D. under different degrees of Correlation

81

Return

Risk & Return Trade-off theory
Equity
Shares
Debentures
Bank & PO
Certificates
& Deposits

Rf

Bond

PPF A/c

Bank & PO
Savings A/c

Preference
Shares

RD A/c

Venture
Capital
Capital
Structure

Dividend

Factors influencing
the Risk & Return
Trade-off

Investment

σp

82

Markowitz Theory
• This theory was developed by Harry Markowitz. Also known as the
Mean-Variance Model. According to him, investors are mainly;
concerned with 2 properties of an asset: risk & return , but by
diversification of portfolio it is possible to trade-off b/w them.
• This concept helps one to determine the feasible set of portfolios or
the portfolio opportunity set or the minimum variance portfolio set.
Graphically these are summarized by the minimum variance
frontier of risky assets. Each point along the minimum variance
frontier represents the lowest possible variance that can be
attained for a given portfolio’s expected return. The point to the
extreme left on the minimum-variance frontier represents the
global minimum variance portfolio. Similarly, the highest point
represents the global maximum return portfolio. The line segment
b/w the global minimum variance portfolio and the global
maximum return portfolio constitutes the Efficient Frontier.
83

Markowitz Theory
• Assumptions :
– The rate of return from the investment is the most
important outcome. Investors conceptualize the
possible rates of return from an investment as a
probability distribution of rates of return either
consciously or subconsciously.
– Investors are averse to risks. They seek the highest
level of return for a given risk class.
– Investors estimate risk in terms of the variability of
the expected returns.
– Investors base their decisions solely on two decisions
parameters – expected return and variance ( or SD).
84

Efficient Frontier & its Utility
• The Efficient Frontier represents the efficient portfolios
i.e., portfolios having maximum return at each level of
risk (σ).
• Efficient portfolios dominate all other portfolios and
individual assets, which lie below the efficient frontier.
• Dominant portfolios offer maximum return for the given
level of risk or, conversely, the minimum risk for the
selected rate of return.
• The Efficient frontier is convex towards the vertical axis
(i.e., axis of expected return) as all assets have a
correlation between +1 and -1.
• The Efficient frontier can never be concave to the
vertical axis.
85

E(r)

Efficient Frontier
F
E

Efficient
portfolios
C

D
Global maximum return portfolio
Global minimum variance portfolio

Dominant
portfolios

B

Minimum variance frontier
A

σp

CAPM [Capital Asset Pricing Model]
• Model is based on the portfolio theory
developed by Harry Markowitz. The model
emphasizes that the risk factor in the portfolio
theory is a combination of 2 risks
i.e., systematic and unsystematic risks.
• The model states that a securities’ return is
directly related to its systematic risk, which
cannot be neutralized through diversification.

Assumptions of CAPM
• Efficient capital market exists.
• Investors base their portfolio investment decision on security, its expected
return and s.d. criteria.
• Investors may borrow & lend without limit at risk free rate of return.
• Identical expectations about future outcomes.
• Market wide influences that affect all assets to some extent such as the
state of economy.
• No transaction costs involved.
• Capital markets are in equilibrium.
• No market imperfections. Investments are infinitely divisible, information
is costless, there are no taxes or interest rate changes and there is no
inflation.
• Investors are risk averse & maximize expected utility of wealth.
• Securities doesn’t faces any bankruptcy.

Return

Expected/ required rate of return

CAPITAL ASSET PRICING MODEL (CAPM)

Ks = Rf + βs ( Km – Rf)

Ks = Expected rate
SML

of return on
security ‘s’

Km = Required rate

Km

Risk
premium

of return /
Return on
Market portfolio

Rf = Risk free rate
of return

Rf

( Km – Rf) =
Slope of the SML

Riskβ
Defensive
Securities

1.0 β

Aggressive
Securities

Concept of CML & SML
• CML
• SML
• How one differs from the other?

91

•
•
•

•

•

•
•

•
•

CML vs. SML
CML stands for Capital Market Line, and SML stands for Security Market Line.
The CML is a line that is used to show the rates of return, which depends on risk-free rates of
return and levels of risk for a specific portfolio. SML, which is also called a Characteristic
Line, is a graphical representation of the market’s risk and return at a given time.
One of the differences between CML and SML is how the risk factors are measured. While
standard deviation is the measure of risk for CML, Beta coefficient determines the risk factors
of the SML.
The CML measures the risk through standard deviation, or through a total risk factor. On the
other hand, the SML measures the risk through beta, which helps to find the security’s risk
contribution for the portfolio.
While the Capital Market Line graphs define efficient portfolios, the Security Market Line
graphs define both efficient and non-efficient portfolios.
While calculating the returns, the expected return of the portfolio for CML is shown along the
Y- axis. On the contrary, for SML, the return of the securities is shown along the Y-axis. The
standard deviation of the portfolio is shown along the X-axis for CML, whereas, the Beta of
security is shown along the X-axis for SML.
Where the market portfolio and risk free assets are determined by the CML, all security
factors are determined by the SML.
Unlike the Capital Market Line, the Security Market Line shows the expected returns of
individual assets. The CML determines the risk or return for efficient portfolios, and the SML
demonstrates the risk or return for individual stocks.
92

Portfolio B

Slope
Portfolio C

SML
Returns

Returns

CML

Slope
Security D
Security B

Security C

Rf

Security F

Portfolio A

Rf

σi

Security E

Security A

βi

APT Theory
• The various factors identified by experts are:
– Changes in the level of industrial production in the
economy
– Changes in the shape of the yield curve
– Changes in the default risk premium (i.e., changes
in the return required on bonds with different
perceived risks of default).
– changes in the inflation rate
– Level of personal consumption
– Level of money supply in the economy.
95

Portfolio Revision
• The term Portfolio Revision will exist if the
following conditions are evident:
i. The art of changing the mix of securities in a
portfolio is called as portfolio revision.
ii. The process of addition of more assets in an
existing portfolio or changing the ratio of funds
invested is called as portfolio revision.
iii. The sale and purchase of assets in an existing
portfolio over a certain period of time to
maximize returns and minimize risk is called as
Portfolio revision.
102

Need for Portfolio Revision
• The self need for investment.
• Change in investment goal of the investor.
• Due to fluctuations in the financial markets.

103

Portfolio Revision Strategies
• There are two types of Portfolio Revision Strategies.
• Active revision strategies
– Active Revision Strategy involves frequent changes in an
existing portfolio over a certain period of time for
maximum returns and minimum risks. It helps a portfolio
manager to sell and purchase securities on a regular basis
for portfolio revision.

• Passive revision strategies
– Passive Revision Strategy involves rare changes in
portfolio only under certain predetermined rules. These
predefined rules are known as formula plans. According
to this strategy a portfolio manager can bring changes in
the portfolio as per the formula plans only.
104

Active Revision Management
• It is holding securities based on the forecast
about the future.
• The portfolio managers vary their cash
position or beta of the equity portion of the
portfolio based on the market forecast.
• For e.g.- IT or FMCG industry stocks may be
given more weights than their respective
weights in the NSE-50.
105

Passive Revision Management
• It is a process of holding a well diversified
portfolio for long term with the buy and hold
approach.
• It also refers to the investor’s attempt to construct
a portfolio that resembles the overall market
returns.
• For e.g.- If Reliance Industry’s stock constitutes
5% of the index, the fund also invests of 5% of its
money in Reliance Industry Stock.
106

Formula Plans
• The formula plans provide the basic rules and
regulations for the purchase & sale of securities.
• These predetermined rules call for specified
actions when there are changes in the securities
market.
• In this, the investor divide his investment funds
into 2 portfolios i.e. one aggressive(portfolio
consists of equity shares)& other conservative or
defensive ( bonds & debentures)
107

Basic Rules of Formula Revision
1) Formula plans require the investor to divide his
investment funds in two portfolios i.e.
aggressive & Conservative (defensive).
2) The volatility of aggressive portfolio must be
greater than that of conservative portfolio, the
larger the difference between the two, the greater
the profits the formula plan can yield.
3) The conservative (defensive) portfolio must
include high- grade bonds having a high degree
of safety and stability of the returns.

4) The conservative portfolio tends to decline
during periods of prosperity, owing to falling
interest rates. While the stock prices are
rising, therefore, the aggressive portfolio also
rises.
5) The basic premise of formula plans is that
stock and bond prices of the portfolios move in
opposite direction. If they move in same direction
then this phenomenon certainly impairs
profitability of the formula plans.
6) The formula plans do not deal with the
selection of stocks or bonds

Different types of Formula Plans
•
•
•
•

Rupee Cost Averaging
Constant Rupee Plan
Constant Ratio Plan
Variable Ratio Plan

Utility of Formula Plans
• Formula plans help an investor to make the
best possible use of fluctuations in the
financial market. One can purchase shares
when the prices are less and sell off when
market prices are higher.
• With the help of Formula plans an investor
can divide his funds into aggressive and
defensive portfolio and easily transfer funds
from one portfolio to other.
111

PORTFOLIO EVALUATION
&
MUTUAL FUNDS

112

What is a Mutual Fund?
• According
to
SEBI
regulations
act
1996, “Mutual Fund means a fund established
in the form of a trust to raise monies through
the sale of units to the public or a selection of
public under one or more schemes for
investing in securities, in accordance with
regulations”.

113

SBI Group/
Templetion
International Inc.
SBI MF /
Templetion MF
SBI Funds Management Pvt. Ltd.
/ Templetion AMC (India) Pvt.
Ltd.

SBI MF Trustee
Co. Pvt. Ltd. /
Templetion
Services Pvt.
Ltd.

JP Morgan Chase /
Deutsche Bank is the
Custodian of ABN
Amro MF.

Out source to
SEBI who assists
them as it has its
own registered
houses like
Karvy, CAMS

In-house

115

How a MF is set up?
• The MF is set up in the form of a trust, which has a
sponsor, trustees, AMC & custodian. The trust is established by a
sponsor or more than one sponsor who is like promoter of a Co. The
trustees of a MF hold its property for the benefit of the unit holders.
• Asset Management Co. (AMC) approved by SEBI manages the funds by
making investments in various types of securities. Custodian, who is a
registered with SEBI, holds the securities of various schemes of the fund
in its custody.
• The Trustees are vested with the general power of superintendence &
direction over AMC. They monitor the performance & compliance of
SEBI regulations by MF.
• SEBI regulations requires that at least 2/3rds of the Directors of Trustee
Co. or Board of a Trustees must be independent i.e., they should not be
associated with the sponsors.
• Also, 50% of the directors of AMC must be independent. All MFs are
required to be registered with SEBI before they launch any scheme.
116

Players & their functions
• Sponsors
–
–
–
–
–

Akin to the promoter of the Co.
Establishes the MF
Gets it registered with SEBI
Forms a Trust & appoints the Board of Trustees
Contribute at least 40% of the networth of the AMC.

• Trustees
– Board of trustees hold the property of MF on behalf of the unit
holders
– Appointment of AMC and ensure that all the activities of the AMC are
in accordance with the SEBI regulations.
– Appoint the custodian of the fund. However it must be remembered
that a sponsor cannot be appointed as a custodian if he holds 50%
voting rights in the Custodian Co.
– Accountable for funds & property of the respective schemes.
117

Players & their functions
• AMC
– Floatation of various MF schemes matching with the requirements of
investing public.
– Management of MFs in accordance with SEBI guidelines
– For carrying out asset management activities , the AMC charges fee to
the schemes it manages with the ceiling prescribed under regulations.

• Custodians
–
–
–
–

Holds the funds and securities in safe keeping.
Settles securities transactions of the fund.
Collects interests & dividends paid on securities.
Records information on stock splits and other corporate actions.

• Distributors /Agents
– Sells units on behalf of the fund.
– Distributors comprising of banks, NBFCs & other distribution
Cos., individual constitute the agency force.
118

Players & their Functions
• Banker
– Facilitates the financial transactions
– Provides remittance, facilitates

• Registrars & Transfers Agents
– Maintains records of unit holders A/Cs and transaction
– Receive funds from the investing public and allotted
units.
– Disburses the fund to the unit holders
– Handles communication with the unit holders
– Provide unit holders transaction services.
119

Difference b/w MFs & ULIPs
Points of
Difference

Mutual Funds

ULIPs

1. Regulations Body

SEBI

IRDA

2. Agents

Untied agents who can still
products offered by more than
one company.

Tied agents attached to one
particular insurer /Co.

3. Transparency

Strict Transparency

Less transparency

4. Flexibility

Less flexible as if we opt to invest
in MF and a term policy. Then the
life cover cannot be increased
without investing a less amount
i.e., the investor has to purchase
a new policy & paying a far more
administration costs.

High flexible, as, if suppose an
investor has a risk cover of Rs. 5
lakh & would like to increase it
up to Rs.6 lakh, we can still pay
the same amount of premium.
The only difference would that
the amount deducted towards
the risk cover would be more &
therefore, the amount invested
would be less.
121

Points of
Difference

Mutual Funds

ULIPs

5. Focus of
investment

Medium term

Long term

6. Expenses

The charges are comparatively
less than that of ULIPs. FMC,
Admin. Fee, Distribution Fee,
Brokerage Cost, Interest Cost,
Loads—Front end & Close end,
Redemption / Transaction Fee,
A/C Maintenance Fee.

The charges are mostly front load,
i.e., most of the charges are
recovered within the few years.
Premium
Allocation
Charges,
Mortality Charges, Policy Admin
Charges, Surrender Charges, Fund
Switching Charges.

7. Income Tax
benefits
a. Investment
amount

b. Maturity
proceeds

Only ELSS scheme u/s 80C
eligible for deduction.

is Eligible for deduction for u/s 80C all
plans.
Some plans avail deduction u/s 80D
also , if medical benefit rider is
provided.

Fully taxable. Capital Gains Tax of Exempted u/s 10(10d)
10% on net proceeds If
investment is made for ST , else
20% if Investment made for LT.

122

Some useful RATIOS for evaluating MF
performance

Where,
S= Sharpe’s Index
Rp= Portfolio Return
Rf= Risk-free return
σp= Portfolio Risk

125

• Treynor’s performance Index / Treynor’s Ratio:
– To understand the above measure one needs to
understand the concept of Characteristic line or SML.
– The SML explains the relationship b/w a given market
return and the fund’s return.
– The funds performance is measured in relation to the
market performance.
– The whole crux lies in the fact that an ideal fund’s return
rises at a faster rate than the general market
performance.
– The relationship b/w the market return & fund’s return is
assumed to be linear.
– The SML or Characteristic line can be drawn by plotting
the fund’s rate of return.
– A steep slope indicates that the fund is very sensitive to
the market.
126

Fund returns

Market returns

128

• Sortino’s Ratio / Index:
– This ratio was introduced be Sortino & Price in 1994.
– This ratio measures the adjustment return of an investment assets or
portfolio.
– The above authors were of the view that other measures like the Sharpe’s
Ratio calculates the degree of risk covered by excess return over the risk
free-asset. However from the investor’s point of view Sortino assessed that
there are 2 types of volatility upside and downside. On Behavioural
analysis, they found out that, psychologically investors are glad to bear the
upside volatility but unhappy to bear the downsided volatility.
– They devised an assessment tool to depict the true psychology of the
investor towards the fund, i.e. the Sortino Ratio.

131

• Target Return = Minimum acceptable return or Risk Free rate= Rf
• Portfolio Return = Rp
• Downside Risk= Semi standard deviation, or the square root of
the 2nd lower partial moment.
• Lower Sortino Ratios signify investments with a greater risk of
large losses and should be avoided by risk-averse investors.

132

EFFICIENT MARKET HYPOTHESIS

133

Topics to be discussed
•
•
•
•
•

Efficient Market Concept.
What is Efficient Market Hypothesis all about?
Different forms of Efficient markets?
Tests of different forms.
Anomalies related to EMH Theory

134

Efficient Market Concept
• Information is Power:
– Street professionals seek bargain stocks
24/7
– information is serious business

• Coin Flipping Contest:
Investment metaphor for gambling
– short-term speculation in stocks and
bonds = buying lottery tickets
– winning tips are probably wrong

Definition of Efficient Markets
• An efficient capital market is a market that is efficient in
processing information.
• We are talking about an “informationally efficient” market, as
opposed to a “transactionally efficient” market. In other
words, we mean that the market quickly and correctly adjusts
to new information.
• In an informationally efficient market, the prices of securities
observed at any time are based on “correct” evaluation of all
information available at that time.
• Therefore, in an efficient market, prices immediately and fully
reflect available information.

Definition of Efficient Markets (cont.)
• Professor Eugene Fama, who coined the phrase
“efficient markets”, defined market efficiency as
follows:
– "In an efficient market, competition among the many
intelligent participants leads to a situation where, at any
point in time, actual prices of individual securities already
reflect the effects of information based both on events that
have already occurred and on events which, as of now, the
market expects to take place in the future. In other
words, in an efficient market at any point in time the
actual price of a security will be a good estimate of its
intrinsic value."

History
• Prior to the 1950’s it was generally believed that the
use of fundamental or technical approaches could
“beat the market” (though technical analysis has
always been seen as something akin to voodoo).
• In the 1950’s and 1960’s studies began to provide
evidence against this view.
• In particular, researchers found that stock price
changes (not prices themselves) followed a “random
walk.”
• They also found that stock prices reacted to new
information almost instantly, not gradually as had
been believed.

The Efficient Markets Hypothesis
• The Efficient Markets Hypothesis (EMH) is
made up of three progressively stronger
forms:
– Weak Form
– Semi-strong Form
– Strong Form

The EMH Graphically
• In this diagram, the circles
All historical prices and returns
represent the amount of
information that each form of
S tro n g F o rm
the EMH includes.
• Note that the weak form
S em i-S tro n g
covers the least amount of
information, and the strong
W eak F o rm
form covers all information.
• Also note that each
successive form includes the
previous ones.
All information, public and private

All public information

The Weak Form
• The weak form of the EMH says that past prices, volume, and
other market statistics provide no information that can be used
to predict future prices.
• If stock price changes are random, then past prices cannot be
used to forecast future prices.
• Price changes should be random because it is information that
drives these changes, and information arrives randomly.
• Prices should change very quickly and to the correct level when
new information arrives (see next slide).
• This form of the EMH, if correct, repudiates technical analysis.
• Most research supports the notion that the markets are weak
form efficient.

Price Adjustment with New
Information
At 10AM EST, the U.S. Supreme Court refused to hear an appeal from
MSFT regarding its anti-trust case. The stock immediately dropped. This
example, one of hundreds available every day, illustrates that prices adjust
extremely rapidly to new information.
But, did the price adjust correctly? Only time will tell, but it does seem
that over the next hour the market is searching for the correct level.

Notes: Each bar represents high, low, and close for one-minute. Each solid gridline represents the top of an hour, and each dotted
gridline represents a half-hour.

Tests of the Weak Form
•
•
•
•
•

Serial correlations / Auto Correlation Test.
Runs tests.
Filter rules.
Relative strength tests.
Many studies have been done, and nearly all
support weak form efficiency, though there
have been a few anomalous results.

Serial Correlations
• The following chart shows the relationship (there is none)
between S&P 500 returns each month and the returns from
the previous month. Data are from Feb. 1950 to Sept. 2001.
• Note that the R2 is virtually 0 which means that knowing last
month’s return does you no good in predicting this month’s
return.
• Also, notice that the trend line is virtually flat (slope =
0.008207, t-statistic = 0.2029, not even close to significant)
• The correlation coefficient for this data set is 0.82%

Serial Correlations (cont.)
Unlagged vs One-month Lagged S&P 500
Returns
y = 0.008207x + 0.007451
2

R = 0.000067

Unlagged Returns

20.00%
10.00%
0.00%
-10.00%
-20.00%
-30.00%
-30.00%

-20.00%

-10.00%

0.00%

10.00%

One-month Lagged Returns

20.00%

The Semi-strong Form
• The semi-strong form says that prices fully reflect all publicly
available information and expectations about the future.
• This suggests that prices adjust very rapidly to new
information, and that old information cannot be used to earn
superior returns.
• The semi-strong form, if correct, repudiates fundamental
analysis.
• Most studies find that the markets are reasonably efficient in
this sense, but the evidence is somewhat mixed.

Tests of the Semi-strong Form
• Event Studies
– Stock splits
– Earnings announcements
– Analysts recommendations

• Cross-Sectional Return Prediction
– Firm size
– BV/MV
– P/E

Analysts’ Performance

This chart from the Wall Street Journal, shows that when analysts issue sell
recommendations, those stocks frequently outperform those with buy or hold
ratings. If the professionals can’t get it right, who can?

Mutual Fund Performance
• Generally, most academic studies have found that mutual
funds do not consistently outperform their
benchmarks, especially after adjusting for risk and fees.
• Even choosing only past best performing funds (say, 5-star
funds by Morningstar) is of little help. A study by Blake and
Morey finds that 5-star funds don’t significantly outperform 3and 4-star funds over time.
• However, it does seem that you can “weed out” the bad funds
(1- and 2-stars). Funds that have performed badly in the past
seem to continually perform badly in the future.

The Strong Form
• The strong form says that prices fully reflect all
information, whether publicly available or not.
• Even the knowledge of material, non-public
information cannot be used to earn superior
results.
• Most studies have found that the markets are
not efficient in this sense.

Tests of the Strong Form
•
•
•
•

Corporate Insiders.
Specialists.
Mutual Funds.
Studies have shown that insiders and
specialists often earn excessive profits, but
mutual funds (and other professionally
managed funds) do not.
• In fact, in most years, around 85% of all
mutual funds underperform the market.

Anomalies
• Anomalies are unexplained empirical results
that contradict the EMH:
– The Size effect.
– The “Incredible” January Effect.
– P/E Effect.
– Day of the Week (Monday Effect).

The Size Effect
• Beginning in the early 1980’s a number of
studies found that the stocks of small firms
typically outperform (on a risk-adjusted basis)
the stocks of large firms.
• This is even true among the largecapitalization stocks within the S&P 500. The
smaller (but still large) stocks tend to
outperform the really large ones.

The “Incredible” January Effect
• Stock returns appear to be higher in January
than in other months of the year.
• This may be related to the size effect since it is
mostly small firms that outperform in January.
• It may also be related to end of year tax
selling.

The P/E Effect
• It has been found that portfolios of “low P/E”
stocks generally outperform portfolios of
“high P/E” stocks.
• This may be related to the size effect since
there is a high correlation between the stock
price and the P/E.
• It may be that buying low P/E stocks is
essentially the same as buying small company
stocks.

The Day of the Week Effect
• Based on daily stock prices from 1963 to 1985 Keim
found that returns are higher on Fridays and lower on
Mondays than should be expected.
• This is partly due to the fact that Monday returns actually
reflect the entire Friday close to Monday close time
period (weekend plus Monday), rather than just one day.
• Moreover, after the stock market crash in 1987, this
effect disappeared completely and Monday became the
best performing day of the week between 1989 and
1998.

Summary of Tests of the EMH
• Weak form is supported, so technical analysis cannot
consistently outperform the market.
• Semi-strong form is mostly supported , so fundamental
analysis cannot consistently outperform the market.
• Strong form is generally not supported. If you have secret
(“insider”) information, you CAN use it to earn excess returns
on a consistent basis.
• Ultimately, most believe that the market is very
efficient, though not perfectly efficient. It is unlikely that any
system of analysis could consistently and significantly beat the
market (adjusted for costs and risk) over the long run.

Equity Analysis & Valuation

158

Three vital steps of Fundamental Analysis
• Macroeconomic analysis: evaluates current
economic environment and its effect on
industry and company fundamentals
• Industry analysis: evaluates outlook for
particular industries
• Company analysis: evaluates company’s
strengths and weaknesses within industry

Macroeconomic Analysis
• Business Cycles
– Expansion, Peak, Contraction, Trough
– Impact of Inventory and Final Sales

• Economic Indicators (see Table 7-2 on page 7.7)
– Leading (10): new orders, building permits, first time
unemployment claims, stock prices, rate spreads
– Coincident (4): Non-ag payroll, industrial production
– Lagging (7): Inventory-to-sales, labor cost

Fiscal & Monetary Policy
• Fiscal Policy (Keynesians)
– Government expenditures (demand)
– Tax & Debt policies

• Monetary Policy (Monetarists – M. Friedman)
– Interest rates (discount, fed funds)
– Money supply (Open market ops): M1, M2
– Reserve requirements (commercial banks)
– Margin requirements (brokerage accounts)

Goals of Policy
• Full Employment
– Interest Rates
– Money Supply

• Price Stability (control inflation)
– Interest Rates
– Money Supply

• Economic Growth
– Interest Rates
– Money Supply

Impediments to Effective Policy
• Time lags between [stimulus] and [desired
effect]
• Unintended consequences
– “irrational” expectations on part of policy makers
– Adverse influence of speculators
– Adverse global responses

• Consumer behavior (rational expectations)
• Incorrect analysis, actions, or timing by policy
makers

Industry Analysis
• Classifying industries
– Cyclical industry - performance is positively
related to economic activity
– Defensive industry - performance is insensitive to
economic activity
– Growth industry - characterized by rapid growth in
sales, independent of the business cycle

Industry Analysis
• Industry Life Cycle Theory:
– Birth (heavy R&D, large losses - low revenues)
– Growth (building market share and economies of
scale)
– Mature growth (maximum profitability)
– Stabilization (increase in unit sales may be
achieved by decreasing prices)
– Decline (demand shifts lead to declining sales and
profitability - losses)

Industry Analysis
• Life Cycle of an Industry (Marketing view)
– Start-up stage: many new firms; grows rapidly
(example: genetic engineering)
– Consolidation stage: shakeout period; growth
slows (example: video games)
– Maturity stage: grows with economy (example:
automobile industry)
– Decline stage: grows slower than economy
(example: railroads)

Industry Analysis
• Qualitative Issues
– Competitive Structure
– Permanence (probability of product obsolescence)
– Vulnerability to external shocks (foreign
competition)
– Regulatory and tax conditions (adverse changes)
– Labor conditions (unionization)

Industry Analysis
• End use analysis
– identify demand for industry’s products
– estimates of future demand
– identification of substitutes

• Ratio analysis
– examining data over time
– identifying favorable/unfavorable trends

• Regression analysis
– determining the relationship between variables

Company Analysis: Qualitative Issues
• Sales Revenue (growth)
• Profitability (trend)
• Product line (turnover, age)
– Output rate of new products
– Product innovation strategies
– R&D budgets

• Pricing Strategy
• Patents and technology

• Organizational performance
– Effective application of company resources
– Efficient accomplishment of company goals

• Management functions
– Planning - setting goals/resources
– Organizing - assigning tasks/resources
– Leading - motivating achievement
– Controlling - monitoring performance

• Evaluating Management Quality
– Age and experience of management
– Strategic planning
• Understanding of the global environment
• Adaptability to external changes

– Marketing strategy
• Track record of the competitive position
• Sustainable growth
• Public image

– Finance Strategy - adequate and appropriate
– Employee/union relations
– Effectiveness of board of directors

Company Analysis: Quantitative Issues
• Operating efficiency
– Productivity
– Production function

• Importance of Q.A.
– Understanding a company’s risks
• Financial, operating, and business risks

• Financial Ratio Analysis
– Past financial ratios
– With industry, competitors, and

• Regression analysis
– Forecast Revenues, Expenses, Net Income
– Forecast Assets, Liabilities, External Capital Requirements

“Financial statements are like fine perfume;

To be sniffed but not swallowed.”

• Balance Sheet
– Snapshot of company’s Assets, Liabilities and
Equity.

• Income statement
– Sales, expenses, and taxes incurred to operate
– Earnings per share

• Cash flow statement
– Sources and Uses of funds

• Are financial statements reliable?
– G.A.A.P. vs Cleverly Rigged Accounting Ploys

• Financial Ratio Analysis
– Liquidity (ability to pay bills)
– Debt (financial leverage)
– Profitability (cost controls)
– Efficiency (asset management)

• DuPont Analysis
– Top-down analysis of company operations
– Objective: increase ROE

Liquidity Ratios
• Measure ability to pay maturing obligations
• Current ratio
– Current assets / current liabilities

• Quick ratio
– (Current assets less inventories) / current liabilities

Debt Ratios
• Measure extent to which firm uses debt to finance asset
investment (risk attribute)
• Debt-equity ratio
– Total long-term debt / total equity

• Total debt - total assets ratio
– (Current liabilities + long-term debt) / total assets

• Times interest earned
– EBIT / interest charges

• Fixed charge coverage ratio
– (EBIT + Lease Exp.) / (Int. Exp. + Lease Exp.)

Profitability Ratios
• Measure profits relative to sales
• Gross profit margin ( % ) = Gross profit / sales
• Operating Profit Margin = Operating profits /
sales
• Net profit margin = Net profit after taxes / sales
• ROA = Net Profit / Total Assets
• ROE = Net Profit / Stockholder Equity*
* Excludes preferred stock balances

Efficiency Ratios
• Measure effectiveness of asset management
• Average collection period (in days)
– Average receivables / Sales per day

• Inventory turnover (times per year)
– Cost of Goods Sold / average inventory

• Total asset turnover
– Sales / average total assets

• Fixed asset turnover
– Sales / average net fixed assets

Other Ratios
• Earnings per share (EPS): (Net income after taxes –
preferred dividends)/ number of shares
• Price-earnings (P/E): Price per share/expected EPS
• Dividend yield: Indicated annual dividend/price per share
• Dividend payout: Dividends per share/EPS
• Cash flow per share: (After-tax profits + depreciation and
other noncash expenses)/number of shares
• Book value per share: Net worth attributable to common
shareholders/number of shares

DuPont Analysis of ROE
Net profits

Common stockholde rs' equity

ROE

Net profits after taxe s

Common equity

Net Profit s
Equity

Ratio 1 = NPM

Sales

Total Assets

Sales

Total Assets

Equity

Ratio 1

ROE

Net Profit s

Ratio

Ratio

Ratio 2 = TATO

2

3

Ratio 3 = Equity Kicker

The DuPont System suggests that ROE (which drives stock price) is a function
of cost control, asset management, and debt management.

Estimating Earnings and
Fair Market Value for Equity
• Five Steps
1.
2.
3.
4.

Estimate next year’s sales revenues
Estimate next year’s expenses
Earnings = Revenue - Expenses
Estimate next year’s dividend per share
• = Earnings Per Share * dividend payout ratio

5. Estimate the fair market value of stock given next
years earnings, dividend, ROE, and growth rate for
dividends.
• Using Gordon Growth model or P/E Model

Woerheide’s Conclusions
• Fundamental Analysis vs. Market Efficiency
– Fundamental analysis critical when dealing with
private companies
– Necessary condition for market efficiency of
publicly traded companies (although worthless at
the margin)
– Earnings surprises major component of
performance
• How much is real?
• How much is C. R. A. P.?

Technical Analysis:
• Technical analysis is the study of historical prices for the purpose of
predicting prices in the future
• Technical analysts frequently utilize charts of past prices to identify
historical price patterns
• These price patterns are then used to forecast prices in the future
• A basic belief of technical analysts is that market prices themselves
contain useful and timely information
– Prices quickly reflect all available fundamental information, as well as
other information, such as traders’ expectations and the psychology of the
market

Role of Technical Analysis
• Identify and predict changes in direction of price trends
• Determine the timing of action – entry and exit decisions

Technical Analysis:
Chart Analysis
Chart Analysis - the basic tool of technical analysis
• A price chart is a sequence of prices plotted over a specific time frame.
In statistical terms, charts are referred to as time series plots
• Chart analysts plots historical prices in a two-dimensional graph in
order to identify price patterns which can then be used to predict the
futures direction of prices
– The goal of any chart analyst is to find consistent, reliable, and logical
price patterns with which to predict future price movements

• Chart analysts rely primarily on three bodies of data
– Prices (monthly, weekly, daily, and intra-day)
– Trading volumes, and
– Open interest

Technical Analysis:
Chart Analysis
Price Pattern Recognition Charts
The most commonly used price pattern recognition charts are: bar
charts, line charts, candlestick charts, and point-and-figure charts
 On these charts, the Y-axis (vertical axis) represents the price scale and
the X-axis (horizontal axis) represents the time scale. Prices are plotted
from left to right across the X-axis with the most recent plot being the
furthest right.
Bar Charts:
 Bar charts mark trading activity of a specified trading period
(e.g., day) by a single vertical line on the graph
 This line connects the high and low prices for the trading period
 The closing price is indicated by a horizontal bar


Technical Analysis:
Chart Analysis – Bar Chart

Technical Analysis:
Chart Analysis – Bar Chart



Bar charts can also
be displayed using
the open, high, low
and close. The
only difference is
the addition of the
open price, which
is displayed as a
short horizontal
line extending to
the left of the bar.

Technical Analysis:
Chart Analysis – Bar Charts
Bar Charts: One-Day Price Reversals
 Bar charts are frequently used to identify one-day price reversals.
 A one-day price reversal occurs in a rising market when prices make
a new high for the current advance but then close lower than the
previous day’s close
 A one-day price reversal occurs in a falling market when prices make
a new low for the current decline but then close higher than the
previous day’s close

Technical Analysis:
Chart Analysis – Line Charts
Line Charts:
 In a line chart, only the
closing prices are
plotted for each time
period.
 Some investors and
traders consider the
closing level to be
more important than
the open, high or low.
 By paying attention to
only the close, intraday
swings can be ignored.

Technical Analysis:
Chart Analysis – Candlestick Charts
Candlestick Charts:
 Originating in Japan over 300 years ago, candlestick charts have
become quite popular in recent years.
 For a candlestick chart, the open, high, low and close are all required.
 Hollow (clear) candlesticks form when the close is higher than the
open and Filled (solid) candlesticks form when the close is lower than
the open.
 The white and black portion formed from the open and close is called
the body (white body or black body). The lines above and below are
called shadows and represent the high and low.
 A daily candlestick is based on the open price, the intraday high and
low, and the close. A weekly candlestick is based on Monday's open,
the weekly high-low range and Friday's close.

Technical Analysis:
Common Shapes of Candles

Technical Analysis:
Bulls vs. Bears
•

A candlestick depicts the battle between Bulls (buyers) and Bears (sellers) over a given
period of time.
1. Long white candlesticks indicate that the Bulls controlled trading for most of the
period – buying pressure.
2. Long black candlesticks indicate that the Bears controlled trading for most of the
period – selling pressure.
3. Small candlesticks indicate that neither the bulls nor the bears were in control of
trading – consolidation.
4. A long lower shadow indicates that the Bears controlled trading for some time, but
lost control by the end and the Bulls made an impressive comeback.
5. A long upper shadow indicates that the Bulls controlled trading for some time, but
lost control by the end and the Bears made an impressive comeback.
6. A long upper and lower shadow indicates that both the Bears and Bulls had their
moments during the trading period, but neither could put the other away, resulting
in a standoff.

Technical Analysis:

Hollow vs. Filled Candlesticks




Hollow candlesticks, where the close is higher than the open, indicate
buying pressure.
Filled candlesticks, where the close is lower than the open, indicate
selling pressure.

Long vs. Short Bodies


Generally speaking, the longer the body is, the more intense the
buying or selling pressure.





Long white candlesticks show strong buying pressure – buyers are aggressive.
Long black candlesticks show strong selling pressure – sellers are aggressive.

Conversely, short candlesticks indicate little price movement and
represent consolidation.

Technical Analysis:
White vs. Black Marubozus
• Even more potent long candlesticks are the
Marubozu brothers, Black and White.
• Marubozu do not have upper or lower shadows
and the high and low are represented by the open
or close.
• A White Marubozu forms when the open equals
the low and the close equals the high.
– This indicates that buyers controlled the price
action from the first trade to the last trade.

• A black Marubozu forms when the open equals the
high and the close equals the low.
– This indicates that sellers controlled the price action
from the first trade to the last trade.

Technical Analysis:
Long vs. Short Shadows
•
•
•

•

Candlesticks with short shadows indicate that most of the
trading action was confined near the open and close.
Candlestick with long shadows show that trades extended
well past the open and close
Candlesticks with a long upper shadow and short lower
shadow indicate that buyers dominated during the
session, and bid prices higher. However, sellers later forced
prices down from their highs, and the weak close created a
long upper shadow.
Conversely, candlesticks with long lower shadows and short
upper shadows indicate that sellers dominated during the
session and drove prices lower. However, buyers later
resurfaced to bid prices higher by the end of the session and
the strong close created a long lower shadow.

Technical Analysis:
Doji
•

•

•

Doji form when a security's open and close are virtually
equal. The length of the upper and lower shadows can vary
and the resulting candlestick looks like a cross, inverted cross
or plus sign. Alone, doji are neutral patterns.
Doji convey a sense of indecision or tug-of-war between
buyers and sellers. Prices move above and below the opening
level during the session, but close at or near the opening level.
The result is a standoff. Neither bulls nor bears were able to
gain control and a turning point could be developing.
Doji indicate that the forces of supply and demand are
becoming more evenly matched and a change in trend may be
near. Doji alone are not enough to mark a reversal and further
confirmation may be warranted. The relevance of a doji
depends on the preceding trend or preceding candlesticks.

Technical Analysis:
Doji and Trend
• After an advance or long white candlestick, a doji
signals that buying pressure may be diminishing and
the uptrend could be nearing an end. However, even
after the doji forms, further downside is required for
bearish confirmation. This may come as a decline
below the long white candlestick's open.
• After a decline or long black candlestick, a doji
indicates that selling pressure may be diminishing and
the downtrend could be nearing an end.
However, further strength is required to confirm any
reversal. Bullish confirmation could come as an
advance above the long black candlestick's open.

Technical Analysis:

•

•

Long Shadow Reversal
There are two pairs of single candlestick reversal patterns
made up of a small real body, one long shadow and one short
or non-existent shadow. Generally, the long shadow should
be at least twice the length of the real body, which can be
either black or white.
Hammer and Hanging Man: consists of identical candlesticks
with small bodies and long lower shadows.
– The Hammer is a bullish reversal pattern that forms
after a decline. A Hammer signals a potential trend
reversal - that buying pressure is starting to increase. In
addition, hammers can mark bottoms or support levels.
– The Hanging Man is a bearish reversal pattern that
forms after an advance. Hanging Man signals that selling
pressure is starting to increase. It can also mark a top or
resistance level.

Technical Analysis:

•

•

•

Inverted Hammer and Shooting Star
The Inverted Hammer and Shooting Star look exactly
alike, but have different implications based on previous
price action. Both candlesticks have small real bodies
(black or white), long upper shadows and small or
nonexistent lower shadows. These candlesticks mark
potential trend reversals, but require confirmation before
action.
The inverted hammer is a bullish reversal pattern that
forms after a decline or downtrend. In addition to a
potential trend reversal, inverted hammers can mark
bottoms or support levels.
The shooting star is a bearish reversal pattern that forms
after an advance. A shooting star signals that selling
pressure is starting to increase. It can also mark a top or
resistance level.

Technical Analysis:
Chart Analysis – Point-and-Figure Charts
Point-and-Figure Charts:








Point-and-figure charts are constructed by filling in boxes with either
a X or an O.
A price increase or decrease is defined as a price change that exceeds a
specified magnitude – a price change less than that magnitude does
not receive an X or O in the chart
If prices are rising, the appropriate Xs are entered in a particular
column. When prices begin to decline, a new column is started, and Os
are entered in that column
 Each price reversal results in the start of a new column
Point-and-figure Charts are based solely on price movement, and do
not take time into consideration. There is an x-axis but it does not
extend evenly across the chart.

Technical Analysis:

Technical Analysis:
Point-and-Figure Charts:




The objective of point-and-figure chart is to provide a smoothing
effect on the price changes that appear in a bar chart in order to detect
significant price trends and reversals.
Point-and figure charts can also be used to generate buy and sell
signals.






A buy signal occurs when an X in a new column surpasses the highest X
in the immediately preceding X column.
A sell signal occurs when an O in a new column is below the lowest O in
the immediately preceding O column.

This focus on price movement makes it easier to identify support and
resistance levels, bullish breakouts and bearish breakdowns.

Technical Analysis:
Common Technical Price Patterns
• Chart analysis uses both trend lines and geometric formations to
predict market tops and bottoms, as well as future price movements
• The most popular technical price patterns are
–
–
–
–

Support and Resistance,
Trend lines,
Double tops and bottoms, and
Head-and-shoulder.

• Support and Resistance
– A support level is a price level at which there appears to be substantial buying
pressure to keep prices from falling further
– A resistance level is a price level at which there appears to be substantial selling
pressure to keep prices from rising further
– A congestion area occurs when prices move sideways, fluctuating up and down
within a well defined range for a considerable time period

Technical Analysis:
Support and Resistance
• A support level is a price level at which there appears to be substantial
buying pressure to keep prices from falling further
– As the price declines towards support and gets cheaper, buyers become more
inclined to buy and sellers become less inclined to sell. By the time the price
reaches the support level, it is believed that demand will overcome supply and
prevent the price from falling below support.
– Support can be established with the previous reaction lows.

• A resistance level is a price level at which there appears to be
substantial selling pressure to keep prices from rising further
– As the price advances towards resistance, sellers become more inclined to sell and
buyers become less inclined to buy. By the time the price reaches the resistance
level, it is believed that supply will overcome demand and prevent the price from
rising above resistance.
– Resistance can be established with the previous reaction highs.

Technical Analysis:
Common Technical Price Patterns

Technical Analysis:
• Another principle of technical analysis is that support can turn into
resistance and visa versa.
• Once the price breaks below a support level, the broken support level
can turn into resistance. The break of support signals that the forces of
supply have overcome the forces of demand. Therefore, if the price
returns to this level, there is likely to be an increase in supply, and
hence resistance.
• The other turn of the coin is resistance turning into support. As the
price advances above resistance, it signals changes in supply and
demand. The breakout above resistance proves that the forces of
demand have overwhelmed the forces of supply. If the price returns to
this level, there is likely to be an increase in demand and support will
be found.

Technical Analysis:

Technical Analysis:
Congestion Area – Trading Range
A congestion area occurs when prices move sideways, fluctuating up
and down within a well defined range for a considerable time period
• A congestion area signals that the forces of supply and demand are
evenly balanced.
–

– When the price breaks out of the congestion area , above or below, it
signals that a winner has emerged - A break above is a victory for the bulls
(demand) and a break below is a victory for the bears (supply).
– When the price breaks out of the congestion area by penetrating the support it is a
signal to sell.
– When the price breaks out of the congestion area by penetrating resistance it is a
signal to buy.

Technical Analysis:
Congestion Area – Trading Range

Technical Analysis:
Support and Resistance Zones
• Because technical analysis is not an exact science, it is sometimes
useful to create support and resistance zones.
• Sometimes, exact support and resistance levels are
best, and, sometimes, zones work better.
• Generally, the tighter the range, the more exact the level.
• If the trading range spans less than 2 months and the price range is
relatively tight, then more exact support and resistance levels are best
suited.
• If a trading range spans many months and the price range is relatively
large, then it is best to use support and resistance zones.
• These are only meant as general guidelines, and each trading range
should be judged on its own merits.

Technical Analysis:
Support and Resistance Zones

Technical Analysis:
• Identification of key support and resistance levels is an essential
ingredient to successful technical analysis.
• Even though it is sometimes difficult to establish exact support and
resistance levels, being aware of their existence and location can greatly
enhance analysis and forecasting abilities.
• If a futures contract is approaching an important support level, it can serve
as an alert to be extra vigilant in looking for signs of increased buying
pressure and a potential reversal.
• If a futures contract is approaching a resistance level, it can act as an alert
to look for signs of increased selling pressure and potential reversal. If a
support or resistance level is broken, it signals that the relationship
between supply and demand has changed.
• A resistance breakout signals that demand (bulls) has gained the upper
hand and a support break signals that supply (bears) has won the battle.

Technical Analysis:
Trend Lines
• Technical analysis is built on the assumption that prices trend.
• A common trading strategy is to identify a price trend and then go

with the trend.
• A trend line is a straight line that connects periodic highs or lows on a
price chart and then extends into the future to act as a line of resistance
or support.
• Two common types of trend lines
– Uptrend lines
– Downtrend lines

Technical Analysis:
Uptrend Lines
• An uptrend line has a positive slope and is formed by connecting two
or more low points. The second low must be higher than the first for
the line to have a positive slope.
– Uptrend lines act as support and indicate that net-demand (demand less
supply) is increasing even as the price rises.
– A rising price combined with increasing demand is very bullish, and
shows a strong determination on the part of the buyers.
– As long as prices remain above the trend line, the uptrend is considered
solid and intact.
– A break below the uptrend line indicates that net-demand has weakened
and a change in trend could be imminent.

• When price falls below the uptrend line, this is a signal to sell
or go short.

Technical Analysis:
Uptrend Line

Technical Analysis:
Downtrend Lines
• A downtrend line has a negative slope and is formed by connecting
two or more high points. The second high must be lower than the first
for the line to have a negative slope.
– Downtrend lines act as resistance, and indicate that net supply (supply
less demand) is increasing even as the price declines.
– A declining price combined with increasing supply is very bearish, and
shows the strong resolve of the sellers.
– As long as prices remain below the downtrend line, the downtrend is solid
and intact.
– A break above the downtrend line indicates that net-supply is decreasing
and that a change of trend could be imminent.

• When price breaks above the downtrend line, this is a signal
to buy or go long.

Technical Analysis:
Downtrend Line

Technical Analysis:
Trend Lines - Conclusions
• The general rule in technical analysis is that it takes two points to
draw a trend line and the third point confirms the validity.
• It can sometimes be difficult to find more than 2 points from which to
construct a trend line.
• Even though trend lines are an important aspect of technical analysis,
it is not always possible to draw trend lines on every price chart.
Sometimes the lows or highs just don't match up, and it is best not
to force the issue.
• Trend lines can offer great insight, but if used improperly, they can
also produce false signals
• Trend lines should not be the final arbiter, but should serve
merely as a warning that a change in trend may be imminent.

Technical Analysis:
Double Tops or Bottoms
• Double tops or bottoms are frequently used to identify a price reversal.
• In an uptrend, the failure of prices to exceed a previous price peak on
two occasions is considered a double top.
– This is a warning signal that the uptrend may be about to end and a
downtrend to commence
– However, the formation of a double top is not considered confirmed until
falling prices penetrate the previous low from the above.

• A double bottom is just the mirror image of a double top.
• In a downtrend, the failure of prices to penetrate previous support
levels on two occasions is considered a double bottom.
– This is a warning signal that the downtrend may be about to end and an
uptrend to commence

Technical Analysis:
Double Tops

Technical Analysis:
Double Tops
•
•
•
•

•
•
•

•

Prior Trend: In the case of the double top, a significant uptrend should be in place.
First Peak: The first peak should mark the highest point of the current trend.
Trough: After the first peak, a decline takes place that typically ranges from 10 to 20%.
Second Peak: The advance off the lows usually occurs with low volume and meets
resistance from the previous high. Resistance from the previous high should be expected.
Usually a peak within 3% of the previous high is adequate.
Decline from Peak: The subsequent decline from the second peak should witness an
expansion in volume and/or an accelerated descent, perhaps marked with a gap or two.
Support Break: Breaking support from the lowest point between the peaks completes the
double top. This too should occur with an increase in volume and/or an accelerated descent.
Support Turned Resistance: Broken support becomes potential resistance and there is
sometimes a test of this newfound resistance level with a reaction rally. Such a test can offer
a second chance to exit a position or initiate a short.
Price Target: The distance from support break to peak can be subtracted from the support
break for a price target. This would infer that the bigger the formation is, the larger the
potential decline.

Technical Analysis:
Double Bottoms

Technical Analysis:
Double Bottoms
•
•
•
•

•
•
•
•

Prior Trend: In the case of the double bottom, a significant downtrend should be in place.
First Trough: The first trough should mark the lowest point of the current trend.
Peak: After the first trough, an advance takes place that typically ranges from 10 to 20%.
Second Trough: The decline off the reaction high usually occurs with low volume and meets
support from the previous low. Support from the previous low should be expected. While exact
troughs are preferable, there is some room to maneuver and usually a trough within 3% of the
previous is considered valid.
Advance from Trough: Volume is more important for the double bottom than the double top.
There should be clear evidence that volume and buying pressure are accelerating during the
advance off of the second trough.
Resistance Break: Breaking resistance from the highest point between the troughs completes the
double bottom. This too should occur with an increase in volume and/or an accelerated ascent.
Resistance Turned Support: Broken resistance becomes potential support and there is
sometimes a test of this newfound support level with the first correction. Such a test can offer a
second chance to close a short position or initiate a long.
Price Target: The distance from the resistance breakout to trough lows can be added on top of
the resistance break to estimate a target. This would imply that the bigger the formation is, the
larger the potential advance.

Technical Analysis:
Double Tops and Bottoms
• 60-70% reliable
• Frequently seen in grains and livestock commodities
• On 2 consecutive days or across several weeks

Technical Analysis:
Head-and-Shoulders Tops or Bottoms
• Head-and-Shoulders formations are among the most frequently used
technical patterns for identifying a price reversal.
• Head-and-Shoulders formations consist of four phases:
–
–
–
–

The left shoulder
The head
The right shoulder
The penetration of the neckline

• A head-and-shoulder reversal pattern is complete only when the
neckline is penetrated, either in an upward or downward direction.
– Head-and-Shoulder top: The formation is complete when price penetrate the
neckline from above indicating a reversal from a uptrend to a downtrend.
– Head-and-Shoulder bottom: The formation is complete when price penetrate the
neckline from below indicating a reversal from a downtrend to an uptrend.

Technical Analysis:
Head-and-Shoulders Top

Technical Analysis:
Head-and-Shoulders Tops
•
•

•

•

•

Prior Trend: Without a prior uptrend, there cannot be a Head and Shoulders reversal pattern.
Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point
of the current trend. After making this peak, a decline ensues to complete the formation of the
shoulder (1). The low of the decline usually remains above the trend line, keeping the uptrend
intact.
Head: From the low of the left shoulder, an advance begins that exceeds the previous high
and marks the top of the head. After peaking, the low of the subsequent decline marks the
second point of the neckline (2). The low of the decline usually breaks the uptrend
line, putting the uptrend in jeopardy.
Right Shoulder: The advance from the low of the head forms the right shoulder. This peak is
lower than the head (a lower high) and usually in line with the high of the left shoulder. While
symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the
peak of the right shoulder should break the neckline.
Neckline: The neckline forms by connecting low points 1 and 2. Low point 1 marks the end
of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and
the beginning of the right shoulder. Depending on the relationship between the two low
points, the neckline can slope up, slope down or be horizontal.

Technical Analysis:
Head-and-Shoulders Tops
•

•
•
•

Volume: As the Head and Shoulders pattern unfolds, volume plays an important role in
confirmation. Ideally, but not always, volume during the advance of the left shoulder should
be higher than during the advance of the head. This decrease in volume and the new high of
the head, together, serve as a warning sign. The next warning sign comes when volume
increases on the decline from the peak of the head. Final confirmation comes when volume
further increases during the decline of the right shoulder.
Neckline Break: The head and shoulders pattern is not complete and the uptrend is not
reversed until neckline support is broken. Ideally, this should also occur in a convincing
manner, with an expansion in volume.
Support Turned Resistance: Once support is broken, it is common for this same support
level to turn into resistance. Sometimes, but certainly not always, the price will return to the
support break, and offer a second chance to sell.
Price Target: After breaking neckline support, the projected price decline is found by
measuring the distance from the neckline to the top of the head. This distance is then
subtracted from the neckline to reach a price target. Any price target should serve as a rough
guide, and other factors should be considered as well. These factors might include previous
support levels, Fibonacci retracements, or long-term moving averages.

Technical Analysis:
Head-and-Shoulders Bottom

Technical Analysis:
Head-and-Shoulders Bottoms
•
•

•

•

•

Prior Trend: Without a prior downtrend, there cannot be a Head and Shoulders Bottom
formation.
Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks a new
reaction low in the current trend. After forming this trough, an advance ensues to complete
the formation of the left shoulder (1).
Head: From the high of the left shoulder, a decline begins that exceeds the previous low and
forms the low point of the head. After making a bottom, the high of the subsequent advance
forms the second point of the neckline (2).
Right Shoulder: The decline from the high of the head (neckline) begins to form the right
shoulder. This low is always higher than the head, and it is usually in line with the low of the
left shoulder. When the advance from the low of the right shoulder breaks the neckline, the
Head and Shoulders Bottom reversal is complete.
Neckline: The neckline forms by connecting reaction highs 1 and 2. Reaction High 1 marks
the end of the left shoulder and the beginning of the head. Reaction High 2 marks the end of
the head and the beginning of the right shoulder. Depending on the relationship between the
two reaction highs, the neckline can slope up, slope down, or be horizontal.

Technical Analysis:
Head-and-Shoulders Bottoms
•

•

•

•

Volume: While volume plays an important role in the Head and Shoulders Top, it plays a
crucial role in the Head and Shoulders Bottom. Without the proper expansion of
volume, the validity of any breakout becomes suspect.
– Volume on the decline of the left shoulder is usually pretty heavy and selling pressure
quite intense.
– The advance from the low of the head should show an increase in volume
Neckline Break: The Head and Shoulders Bottom pattern is not complete, and the
downtrend is not reversed until neckline resistance is broken. For a Head and Shoulders
Bottom, this must occur in a convincing manner, with an expansion of volume.
Resistance Turned Support: Once resistance is broken, it is common for this same
resistance level to turn into support. Often, the price will return to the resistance break, and
offer a second chance to buy.
Price Target: After breaking neckline resistance, the projected advance is found by
measuring the distance from the neckline to the bottom of the head. This distance is then
added to the neckline to reach a price target. Any price target should serve as a rough
guide, and other factors should be considered, as well.

Technical Analysis:
Head-and-Shoulders Tops or Bottoms
•
•
•
•
•

70-80% reliable in terms of significant move after neckline is broken
Time required to complete can be days or up to several weeks
Frequently seen in grains and livestock commodities
Easy to recognize
Low trading volume on each side of the “head” confirms the formation

Market Trend Analyses:

• Market trend analyses use more complex price charts as well as
volume and open interest figures to determine both the existence of
price trends and the strength of these trends.
– Moving Averages
– Rate of Change Indicators: Momentum and Oscillator
– Volume and Open Interest

Mba fm 02 - security analysis and portfolio---introduction

Mba fm 02 - security analysis and portfolio---introduction

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