Securities Analysis Introduction
The entire process of estimating return and risk for individual securities is known as securities analysis. Securities analysis is concerned with the problem of making a selection of optimum investments in respect of a particular investor, taking into account the anticipated returns and risks associated with them, and the requirements of the investor in the short, medium and long term and his attitude towards risk.
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Approaches:
Technical Approach:
Price of stock depends on supply and demand in the market place. It has little co-relation with its intrinsic value. The technical analyst will use the following approaches in analysis of securities.·
(i) Dow Theory:
According to "Charles Dow" stock price behavior is 90% psychological and 10% logical. It is the mood of the crowd, which determines the way in which prices move and move can be, identify by analyzing the price and volume of transaction. If price is rising with high volume, we are in bull market and if price is declining with high volume, we are in bear market. There may be other combinations also which reflects short term to medium term price trend.
Market is always considered as having 3 movements, all going at the same time. The first is the narrow movement, which runs from day to day. The second is swing, which runs from two weeks to a month or more; and the third is the main movement, covering at least 4 years in its duration. Basic features of Dow theory are as follows:
(a) The Index discounts everything except "acts of God", because they reflect combined market activities of thousands of investors and traders.
(b) The price of shares in general, swings in trend, which may be major or primary, secondary and minor.
The primary trends are the extensive up or down movements, which generally last by 20% or more. Movements in direction of the primary trend are interrupted at intervals by secondary swings in the opposite direction. Finally, the secondary trends are composed of minor trends or day-to-day fluctuations.
(c) So long as each successive rally or price advance reaches a higher level than the one before it, and each secondary correction stops at higher level than the previous one, the primary trend is up. This is called as bull market.
(d) When a price decline carries prices to successively lower levels and each intervening rally (secondary correction) fails to bring them back up to the top level of preceding rally, the primary trend is down and that is called as bear market.
(e) Normally, Secondary correction last from 3 weeks to as many months and generally retrace from 1/3 to 2/3 of the gain or loss in prices recorded in the previous swing in the primary direction.
(f) Minor trends generally last for 6 days but rarely for 3 weeks. They are meaningless in themselves but go to make up the secondary or intermediate trend.
(g) A trend should be assumed to continue in effect until such time as its reversal has been definitely signaled.
The end of a bull market is signaled when a secondary correction carries prices lower than the level recorded during the earlier correction and the subsequent recovery fails to carry prices above the top level of the preceding recovery.
The end of a bear market is signaled when an intermediate rally or recovery carries prices to a level higher than the one registered in the previous rally and the subsequent decline halts above the level recorded in the earlier correction.
(ii) Advance Decline Theory:
This approach takes in to consideration the total number of stocks traded during a session and compares the number of stock whose prices advanced with those whose prices declined. High percentage of stock whosel prices advanced to total number of stocks traded indicates a technically strong bullish market and vice versa.
(iii) Short Selling (Interest) Theory:
According to this approach, short selling is a sentiment indicator. Large outstanding short sale is a bearing indicator for short term but long-term bullish indicator. As when the short seller begins to cover their position, the increased demand for the security, which will cause the price to rise higher. Generally, if short sale position is greater than twice of average daily trading volume of a stock, it is treated as high ratio and indicates bullish ness in the market.
(iv) Reversal Effect:
There is a tendency for poorly performing stocks on one time period to perform well in the subsequent time periods and vice versa. This can be utilized in investment strategy in maximization of returns. Buy stock that have recently done poorly and sell shares in those that have done well.
(v) Relative Strength:
The empirical evidence shows that certain stocks or sector perform better than other stocks in a given market environment and that this behavior will remain relatively constant over time. It embodies the "momentum idea" or "band wagon effect". It has also been observed that the sector displaying greatest relative strength in good markets (bull) also show the greatest weakness in bad markets (bear). These relative strong firms have high betas.
(vi) New Highs and New Lows:
This method can be used to know the trend of the market and can play investment strategy accordingly,
(vii) Filter Theory:
Filters are designed to isolate the primary trends from minor price changes arising from random factors, If the price of a share moves up at least "X" percent from a low point, it should be bought and held until its price moves down at least "X" percent from a subsequent high, at which time it should be sold.
(viii) Chartism:
Chart patterns are used to predict the market movements. The basic concept underlying the chart analysis is persistence of trends, relationship between volume and trend & resistance and Support levels. The chartists believe that stock prices move in fairly persistent trends. There is an in built inertia the price movement continues along a certain path until it meets an opposing force due to supply demand changes. Chartists also believe that generally volume and trend go hand in hand. When a major up trend begins, the volume of trading increases and so also the price.
However, it may be pointed out that mood of investors vary unpredictably and so excessive reliance on technical indicators can be hazardous for investors. At best, movements, coupled with historical data may help in predicting probabilities, but not the exact course of future events.
(ix) Resistance and Support level:
Resistance level is a price level to which stock rises and then falls from repeatedly. This occurs during an up trend or a sideways trend. It is a price level to which stock rallies repeatedly but cannot break through. At this level selling increases, which cause the price, fall.
A support level is a price level to which a stock or the market prices falls or bottom out repeatedly and then bounces up again. Demand for the stock increases as the price approaches a 'support level.
(x) Head and Shoulders Pattern:
The head and shoulders pattern indicates the reversal of an up trend. Here the share price rises on buying pressure from investors who have specialist knowledge of the company. The formation begins with a price advance, which is supported by a high volume of trading. After that a pause or slight decline appears. Other investors jumping on the bandwagon later reinforce this. Then the price advances to a higher level but supported by lighter trading volume. After that again a price decline appears. This is followed by a rally to a lower peak as the investors who led the formation starts profit booking.
(xi) Moving Average:
Technical analysts often compute moving averages of a series to determine its general trend: Moving averages are one of the oldest technical indicators in existence. A basic definition of a moving average is that it is the average price of a security at a specific point in time. A moving average shows a trend. .
The user specifies the time span. The most common time periods are 10 days, 30 days, 50 days, 100 days and 200 day moving averages. Analysts use variations of these numbers to suit their individual needs. There really isn't just one "right" time frame. The shorter the time span, the more sensitive the moving average will be to price change. In the case of individual stocks a fairly popular series is the 200
days moving average of prices.
Perhaps the best way to understand a moving average is with an example. Let us assume that we have been tracking the closing price of Infosys for the past 100 days and we want to create a 30-day moving average. First we add the closing prices together for the first 30 days. Then we divide this amount by 30. This is the first point we would plot on the chart. Then we add the closing prices together for day 2 through day 31. We then divide this amount by thirty. This is the second point on the chart and so on. All the points plotted will be connected in a line.
A valid buy signal is given when price crosses above the moving average and the moving average is directed upward. A valid sell signal is given when price crosses below the moving average and the moving average is directed downward. Valid buy and sell signals are not given when the' moving average changes direction but prices does not cross above and below the moving average.
Specifically, the market is considered to be over bought when 80% or more of the stocks being analyzed are trading above their 200-day moving average and an overbought market is indication is usually followed by a correction. In contrast, if less than 20% of the stocks are selling above their 200 day moving average, the market is oversold, and investors should look for positive corrections.
(x) Random Walk Theory
Technical analysts generally argue that market prices can be predicted if their patterns can be properly understood. However according to Random Walk Hypothesis, the behavior of stock market. prices is unpredictable and that there is no relationship between the present prices of the shares and their future prices. Stock prices are independent and each outcome is statistically independent of the past history. In the layman's language it may be said that prices on the stock exchange behave exactly the way a drunk would behave while walking i.e. up and down, with an unsteady way going in any direction he likes, bending on the side once and the other side the second time.
Fundamental Approach:
Contrary to the technical approach, the fundamental approach suggests that every stock has an intrinsic value. Estimate of real worth of a stock is made by considering the earning potential of a company, which depends on investment environment and factors relating to specific industry, competitiveness, quality of management, operational efficiency, profitability, capital structure an a dividend policy. In Fundamental approach some of the popular ratios like ROI, EPS, PIE ratio, Book Value, Debt-Equity Ratio, Dividend payout ratio, Dividend yield, Interest and Dividend cover etc. are widely used for analysis.