Investment Notes

Fundamentals of Investment

Investment Definition

• An investment is an asset acquired to generate income or appreciation.
• From an economic perspective, it's the purchase of goods for future wealth generation.
• In finance, it's a financial asset bought with the expectation of future income or sale at a higher price.

Features of Investment

• Risk Factor
  • Risk is inherent in every investment, including loss of principal, delayed payment, or variability of return.
  • Investments vary in risk levels; investors generally prefer less risky options.
• Return
  • Return is the expected income from an investment and the primary objective for investors.
  • Benefits can be regular yields or capital appreciation.
• Safety
  • Safety is the assurance of return or protection of the principal amount without loss.
  • It's a crucial factor in investment tool analysis.
• Liquidity
  • Liquidity is how quickly an investment can be sold for cash without loss.
  • Investors prefer liquid assets.
• Tax Benefits
  • Tax implications on investment income are a key consideration.
  • Real return is the income left after taxes.
  • Investors seek securities with lower tax burdens to maximize returns.
• Legality
  • Investment securities must be legally sound.
  • Investors should choose legally approved securities like those from LIC, UTI, and Post Office.

Importance of Investment

• Generates Income
  • Provides periodic and regular income.
  • Investors aim for better returns at lower risk.
• Wealth Creation
  • Helps in wealth creation through capital appreciation over time.
  • Enables accumulating funds by selling assets at higher prices.
• Economic Development
  • Mobilizes resources into productive means.
  • Connects those with funds to those needing funds.
  • Leads to capital creation and economic development.
• Meet Financial Goals
  • Supports long-term financial goals.
  • Provides financial stability, wealth growth, and retirement funds.

Types of Investment

1. Equity
   • Represents an ownership position.
   • Investors are entitled to a residual share of profits.
   • Divided into direct (capital markets) and indirect (institutions) equity investment.
2. Debentures
   • Investors seek secured and regular returns through instruments like Non-Convertible Debentures (NCDs).
   • NCDs are fixed-income debt papers with a fixed interest rate.
3. Bonds or Fixed Income Securities
   • Long-term investments with specified interest rates and maturity dates.
   • Marketable legal contracts promising interest and principal repayment at maturity.
   • Types include Government Bonds, PSU Bonds, and Private Sector Bonds.
4. Non-Marketable Financial Assets
   • Include bank deposits, post-office deposits, PPF, NSC, etc.
5. Real Estate
   • Sought-after investment with attractive price appreciation.
   • Forms include residential, commercial, agricultural, suburban land, and timeshares.
6. Mutual Funds
   • Pool savings from investors into a common fund.
   • Invested in shares, debentures, and government securities.
   • Income and capital appreciation are shared among unit holders.
   • Diversification reduces risk.
7. Precious Objects
   • Small but highly valuable items, such as gold, silver, precious stones, and art objects.
   • Traditional stores of wealth.
8. Pension Funds
   • Qualified retirement plans by corporations, unions, or governments.
   • Investors contribute periodically for retirement income.

Process of Investment Decisions

The investment process involves activities leading to the purchase of securities.

1. Framing of the Investment Policy

   • Involves investible funds, objectives, and knowledge about alternatives.

   • (a) Investible funds: Funds are generated through savings or borrowings.

     • If borrowed, returns must exceed interest payments.

   • (b) Objectives: Based on required return rate, income needs, risk perception, and liquidity.

     • Risk-takers aim for capital appreciation, while risk-averse seek principal safety.

   • (c) Knowledge: Knowledge of investment alternatives and markets is crucial.

     • Alternatives range from securities to real estate, with varying risks and returns.
     • Equity is high-yielding but riskier than fixed income securities.
     • Tax-sheltered schemes offer tax benefits.

2. Security Analysis

   • Securities are scrutinized through market, industry, and company analyses.

   • (a) Market analysis: The stock market reflects the economic scenario.

     • GDP growth and inflation are reflected in stock prices.
     • Recession leads to a bear market.
     • Technical analysis helps fix entry and exit points.

   • (b) Industry analysis: Industries vary in growth rates and contribution to economic activity.

     • Some industries grow faster than GDP, like information technology.
     • Economic significance and growth potential are analyzed.

   • (c) Company analysis: Aims to help investors make better decisions.

     • Earnings, profitability, efficiency, capital structure, and management are screened.
     • These factors affect stock prices and investor returns.

3. Valuation

   • Helps determine return and risk expected from stock investment.

   • (a) Intrinsic value: Measured through book value and price-earning ratio.

     • Discounting models are used to value shares.
     • Real worth is compared with market price for investment decisions.

   • (b) Future value: Estimated using trend analysis.

     • Analysis of historical price behavior helps predict future value.

4. Portfolio Construction

   • A portfolio is a combination of securities meeting investor goals.
   • Investors aim for maximum return with minimum risk through diversification.
   • Diversification reduces risk of capital and income loss.
   • Modes: Debt and equity, industry, and company diversification.

5. Portfolio Evaluation

   • Efficient management requires portfolio evaluation, appraisal, and revision.
   • (a) Appraisal: Return and risk performance are measured and compared over time.
     • Economic, industry, and company developments are appraised.
     • Warns of potential losses and enables preventive measures.
   • (b) Revision: Low-yielding, high-risk securities are replaced with high-yielding, low-risk ones.
     • Periodic revision maintains return levels.

Primary Market

• The primary market is where companies issue new securities not previously traded.
• Companies offer securities to raise funds for long-term goals.
• Also called the New Issue Market (NIM).
• Securities are issued directly by companies through Initial Public Offers (IPOs) or Further Public Offers (FPOs).
• It enables companies to raise long-term funds by issuing shares to the public.

Raising Funds from the Primary Market

1. Public Issue
   • Securities are issued to the general public through an IPO.
   • Securities are listed on a stock exchange for trading.
2. Rights Issue
   • Companies offer existing shareholders more shares at a discounted price.
   • Offered on a pro-rata basis.
3. Preferential Allotment
   • Listed companies issue shares to a few individuals at a price related or unrelated to the market price.
   • The basis of allotment is decided by the company.

Secondary Market

• Existing shares, debentures, bonds, etc., are traded among investors.
• Securities offered in the primary market are traded here.
• Trade occurs between buyers and sellers, facilitated by the stock exchange.
• Issuing company is not involved.
• Can be an auction business or over-the-counter.

Primary Market vs. Secondary Market

Stock Market Participants

1. Regulator

   • Oversees the functioning and fairness of the stock market.
   • Ensures fraud prevention and investigation.
   • Keeps markets efficient and transparent.
   • Ensures fair treatment of investors.
   • Examples: Ministry of Finance, RBI, SEBI, IRDA, PFRDA.

2. Stock Exchanges

   • Trading platforms for registered stockbrokers and investors.
   • Facilitates electronic transactions in securities.
   • Examples: National Stock Exchange (NSE) and BSE Limited (BSE).

3. Companies

   • Issue shares that are available for purchase or sale.
   • Become publicly traded through an Initial Public Offer (IPO).

4. Investors and Traders

   • Individuals, corporations, and organizations from various backgrounds.
   • Categories: Retail investors, domestic institutions, asset management companies, foreign institutional investors, etc.

5. Market Intermediaries

   • Entities involved in financial transactions apart from buyers and sellers.
   • Help carry out investment activities smoothly.
   • Ensure compliance with regulatory rules.

6. Depositories and Depository Participants (DP)

   • Share ownership certificates are digitized through dematerialization (Demat).
   • Demat accounts hold stocks.
   • Examples: CDSL and NSDL.

7. Clearing Corporations

   • Ensure the fulfillment of trades and transactions.
   • Match debit and credit processes to complete trades.
   • Regulated by authorities.
   • Provide cash or shares to balance trade books.

Market Index

• Measures a section of the stock market.
• Measures changes in share prices of different companies.
• Gives insight into market trends and investor sentiment.
• Examples:
  • Benchmark indices: NSE Nifty and BSE Sensex
  • Broad-based indices: Nifty 50 and BSE 100
  • Market capitalization indices: BSE Smallcap and BSE Midcap
  • Sectoral indices: Nifty FMCG Index and CNX IT

Formation of an Index

• Combines equities with similar market capitalizations, business sizes, or industries.
• Computed based on stock picks.
• Index value is not determined by simply adding stock prices.

CNX NIFTY / NIFTY / NIFTY 50 (NSE)

• Consists of the top 50 largest and most frequently traded stocks on the NSE.
• Created in 1996.
• Owned and maintained by India Index Services & Products Limited (IISL).
• CNX stands for CRISIL and NSE.

Sensex (BSE)

• A blend of "sensitive" and "index."
• Introduced in 1986 and is the oldest in India.
• Consists of the top 30 largest and most frequently traded stocks on the BSE.

Risk and Return

• Risk
  • The probability that the expected return will not materialize.
  • Involves uncertainties due to political, economic, and industry factors.
  • Can be systematic or unsystematic.
  • Systematic risk affects the entire market.
  • Unsystematic risk is specific to an industry or company.

Types of Risk

• Systematic Risk
  • Caused by factors beyond the control of a specific company or individual.
  • Non-diversifiable.
  • Includes market risk, interest rate risk, purchasing power risk, and exchange rate risk.
    • Market Risk: Caused by herd mentality of investors.
      • Security prices tend to move together.
      • Dominant component of systematic risk.
    • Interest Rate Risk: Arises due to changes in market interest rates.
      • Affects fixed income securities.
      • Includes price risk and reinvestment risk.
        • Price Risk: is associated with changes in the price of a security due to changes in interest rate.
        • Reinvestment Risk: is associated with reinvesting interest/ dividend income.
    • Purchasing Power Risk (Inflation Risk): Arises due to inflation.
      • Inflation erodes the purchasing power of money.
      • Fixed income securities are highly subject to purchasing power risk.
    • Exchange Rate Risk: Uncertainty associated with changes in foreign currency values.
      • Affects securities of companies with foreign exchange transactions.
• Unsystematic Risk
  • Unique to a specific company or industry.
  • Also known as non-systematic, specific, diversifiable, or residual risk.
  • Can be reduced through diversification.
  • Total risk is unsystematic risk plus systematic risk.

Types of Unsystematic Risk

• Business Risk: Caused by internal and external issues.
• Financial Risk: Relates to the capital structure of a company.
• Operational Risk: Results from unforeseen or negligent events.
• Strategic Risk: Occurs when a business is stuck in a dying industry or enters a flawed partnership.
• Legal and Regulatory Risk: Risk that changes in laws or regulations will hurt a business.