Page 9 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes The investment process is a key-process entailing the whole body of security analysis and
portfolio management. Let us understand the each of the five elements in the investment process.
1. Investment Objectives and Policy: The investor will have to work out his objectives first
and then evolve a policy with the amount of investible wealth at his command. An investor
might say that his objective is to have ‘large money’. You will agree that this would be a
wrong way of stating the objective. You would recall that the pursuit of ‘large money’ is
not possible without the risk of ‘large losses’. Hence, the objectives of an investor must be
defined in terms of risk and return.
The next step in formulating the investment policy of an investor would be the
identification of categories of financial assets he/she would be interested in. It is obvious
that they in turn, would depend on the objectives, amount of wealth, and the tax status of
the investor. For example, a tax-exempt investor with large investible wealth like a
pension/provident fund would invest in anything but tax-exempt securities unless
compelled by law to do so. Similarly, individual investors would, in general, have low
inclination to invest in preference shares.
2. Security Analysis: This step would consist of examining the risk-return characteristics of
individual securities or groups of securities identified under step one. The aim here is to
know if it is worthwhile to acquire these securities for the portfolio. Now, this would
depend upon the extent to which it is ‘mispriced’. And there are two broad approaches to
finding out the ‘mispriced status’ of individual securities. One approach is known as
‘technical analysis’. The analyst here studies part movements in prices of securities he is
interested in, to determine the trends and patterns that repeat themselves. Then he studies
more recent price movements to know about some emerging trend. The two are then
integrated to predict if a given trend will repeat in future. The current market price is
compared with the predicted price and the extent of ‘mispricing’ is determined. You
should note that there would be absence of ‘mispricing’ only if the current price is equal to
the predicted price. The second approach is known as ‘fundamental analysis’. The analyst
here works out a true or intrinsic value of a security and compares it with the current
market price. The intrinsic value is the present value of all cash flows that the owner of the
security expects to receive during and at the end of his holding period.

This, in effect, involves a two-step exercise: first, forecast the cash-flow i.e., expected
stream of dividends (in the case of equity shares) for which a forecast of earnings of the
company and its payout ratios would have to be obtained. A forecast of the real estate
price of the security at the end of the holding period would also be needed. This would
then be followed by a discounting of these forecast cash flows at some rate of discount
which may correspond to the investor’s required rate of return. The fundamental analyst
now compares the intrinsic value with the current market price as already observed. If the
current market price is more than the true value, the share is overvalued and vice versa.
Fundamental analysts believe that notable cases of mispricing will be corrected by the
market in future, which implies that prices of undervalued shares will increase and those
of overvalued shares will decline.
3. Portfolio Construction: This consists of identifying the specific securities in which to
invest and determining the proportion of the investor’s wealth to be invested in each. For
example, a conservative individual may decide to invest, say, 70% of his cash in debentures
and the remaining 30% in equity shares. On the other hand, an individual who is prepared
to assume greater risk may like to put, say 70% of his cash in equity shares with the
expectation of getting, say, 30% dividends on an average (note that this expectation may
or may not materialise) and the balance 30% in debentures with a relatively assured
return of, say, 14%. And within these broad groups of equity shares and debentures, he
may specifically select specific firms, say, debentures of L&T or equity shares of Reliance

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