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Security Analysis By Saqib Omer Saeed

M.Com University of Karachi Gold Medallist (2005)M.Phil / Ph.D. in line from CBM

Professional Designations:Investment Advisor & Director Strategic Planning M One International Sharjah U.A.E.Director M One Investments Karachi, Pakistan

Adjunct Faulty:• College of Business Management (CBM, IoBM)• University of Karachi • Shaheed Zulfiqar Ali Bhutto Institute of Science & Technology (SZABIST) Karachi• BIZTEK Karachi

Website : www.bizomer.com Email address : saqibomersaeed@bizomer.comStudent Group : http://groups.google.com/group/saqibomersaeedGroup Email : saqibomersaeed@googlegroups.com

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Lecture # 1 Part 1Introduction to Investment & Markets

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Investment

Investment is defined as a sacrifice made now to obtain a return later

It is current consumption that is sacrificed

Two forms of investment can be definedReal investment is the purchase of land, machinery, etcFinancial investment is the purchase of a "paper" contract

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Investments

Real investments and financial investments are linked

The share issue of a firm finances the purchase of capitalThe commitment to a mortgage finances the purchase of property

Financial investment can provide finance for real investment decisionsFinancial investment can guide real investment decisions

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Financial InvestmentThere are numerous components to financial investmentMarkets: where assets are bought and sold, and the forms of tradeSecurities: the kinds of securities available, their returns and risksInvestment process: the decision about which securities, and how much of eachFinancial theory: the factors that determine the rewards from investment (and the risks)

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MarketsA market is any organized system for connecting buyers and sellersThere are many security markets Markets may have a physical location

The Karachi Stock Exchange

May exist only as computer networks The London Stock Exchange

Markets vary in the securities that are traded and in the way securities are traded

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Characteristics of MarketsThere are a number of ways to classify marketsPrimary/Secondary

Primary markets are security markets where new issues of securities are tradedA secondary market is a market where securities are resold

The London Stock Exchange is a secondary marketMost activity on stock exchanges is in the secondary market

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Characteristics of MarketsTrades on the primary market raise capital for firmsTrades on the secondary market do not raise additional capital for firmsThe secondary market is still important

It gives liquidity to primary issues. New securities would have a lower value if they could not be subsequently tradedIt signifies value. Trading in assets reveals information and provides a valuation of the assets. This helps to guide investment decisions

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Characteristics of Markets

A second way to classify markets is the times of tradingCall/continuous

In a call market trading takes place at a specified time intervals Some call markets have a provision that limits movement from the prior price. This is to prevent a temporary order imbalance from dramatically moving the priceIn a continuous market there is trading at all times the market is open

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Characteristics of MarketsMarkets can also be characterized by the lifespan of the assets tradedMoney/Capital

Money market: the market for assets with a life of less than 1 yearCapital market: the market for assets with a life greater than 1 year

Some assets, such as most bonds, have a fixed lifespanCommon stock have an indefinite lifespan

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BrokersA broker is a representative appointed by an individual investor

Brokers have two conflicting rolesAn advisor: a broker can offer investment advice and informationA sales person: brokers are rewarded through commission and have an incentive to encourage trade

A full-service broker is a brokerage house that can offer a full range of services including investment advice and portfolio management

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Brokers

A discount broker offers a restricted range of services at a lower priceTo complete a trade additional brokers are neededA floor broker is located on the floor of the exchange and does the actual buying and sellingA specialist ensures trade happens by holding an inventory of stock and posting prices

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SecuritiesThe standard definition of a security is:

"A legal contract representing the right to receive future benefits under a stated set of conditions"The piece of paper defining the property rights held by the owner is the security

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SecuritiesMoney market securities

Short-term debt instruments sold by governments, financial institutions and corporationsThey have maturities when issued of one year or lessThe minimum size of transactions is typically large, usually exceeding PKR 10,000,000

1. Treasury BillsGOP Treasury Bills are the least risky and the most marketable of all money markets instrumentsThey represent a short-term IOU of the Government of PakistanSimilar bills are issued by many other governments

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SecuritiesNew 91- and 182- day T-bills are issued weekly, by auction whereas 52-week T-bills are issued monthly.An active secondary market with very low transactions costs exists for trading T-billsT-bills are sold at a discount from face value and pay no explicit interest payments.

T-bills are considered to have no risk of default, have very short-term maturities, and have a known return T-bills are the closest approximations that exist to a risk-free investment

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SecuritiesCapital market securities

Instruments having maturities greater than one year and those having no designated maturity at all

1. Fixed income securitiesFixed income securities have a specified payment scheduleBonds promise to pay specific amounts at specific timesFailure to meet any specific payment puts the bond into default with all remaining payments. The creditor can put the defaulter into bankruptcy

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Securities

Fixed income securities differ from each other in promised return for several reasons

• The maturity of the bonds• The creditworthiness of the issuer • The taxable status of the bond

Income and capital gains are taxed differently in many countriesBonds are designed to exploit these differences

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Securities

1.1 Treasury notes and bondsThe government issues fixed income securities over a broad range of the maturity spectrumBoth notes and bonds pay interest twice a year and repay principal on the maturity date

1.2 Corporate bondsThese promise to pay interest at periodic intervals and to return principal at a fixed dateThese bonds are issued by business entities and thus have a risk of default

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Securities

2. Common stock (shares, equity)Common stock represents an ownership claim on the earnings and assets of a corporation After holders of debt claims are paid, the management of the company can either pay out the remaining earnings to stockholdings in the form of dividends or reinvest part or all of the earningsThe holder of a common stock has limited liability – the most they can lose is the value of the shares

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Securities3. Derivative instruments

Derivative instruments are securities whose value derives from the value of an underlying security or basket of securities The instruments are also known as contingent claims, since their values are contingent on the performance of underlying assets The most common contingent claims are options and futures 3.1 An option on a security gives the holder the right to either buy (a call option) or sell (a put option) a particular asset at a future date or during a particular period of time for a specified price

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Securities3.2 A future is the obligation to buy or sell a particular security or bundle of securities at a particular time for a stated price A future is simply a delayed purchase or sale of a security3.3 The corporation can issue contingent claims. Corporate-issued contingent claims include rights and warrants, which allow the holder to purchase common stocks from the corporation at a set price for a particular period of time

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Securities5. Indirect investing

The purchase of a shares of an investment portfolio A mutual fund holds a portfolio of securities, usually in line with a stated policy objective.Unit trusts invest depositors' funds in bonds or equities. Size is determined by inflow of funds.Investment trusts Issue a certain fixed sum of stock to raise capital. This fixed capital is then managed by the trust. The initial investors purchase shares, which are then traded on the stock marketHedge funds actively manage deposits in large sum of money. Trade in all financial markets, including derivatives.

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Lecture # 1 Part 2Efficient Capital Markets

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Efficient Capital MarketsLearning Objectives

What is meant by the concept that capital markets are efficient?Why should capital markets be efficient? How do you test the weak-form efficient market hypothesis (EMH) and what are the results of the tests?How do you test the semistrong-form EMH and what are the test results?How do you test the strong-form EMH and what are the test results?What are the implications of the results?

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Efficient Capital Markets

In an efficient capital market security prices fully reflect all available information.Prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the securityWhether markets are efficient has been extensively researched and remains controversial

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Why Should Capital MarketsBe Efficient?

The premises of an efficient marketA large number of competing profit-maximizing participants analyze and value securities, each independently of the othersNew information regarding securities comes to the market in a random fashionProfit-maximizing investors adjust security prices rapidly to reflect the effect of new information

Conclusion: the expected returns implicit in the current price of a security should reflect its risk

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Alternative Efficient Market Hypotheses (EMH)

Random Walk Hypothesis – changes in security prices occur randomlyFair Game Model – current market price reflect all available information about a security and the expected return based upon this price is consistent with its riskEfficient Market Hypothesis (EMH) - divided into three sub-hypotheses depending on the information set involved

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Efficient Market Hypotheses (EMH)

Weak-Form EMH - prices reflect all security-market informationSemistrong-form EMH - prices reflect all public information Strong-form EMH - prices reflect all public and private information

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Weak-Form EMH

Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated informationThis implies that past rates of return and other market data should have no relationship with future rates of return

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Semistrong-Form EMH

Current security prices reflect all public information, including market and non-market informationThis implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions

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Strong-Form EMH

Stock prices fully reflect all information from public and private sourcesThis implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of returnThis assumes perfect markets in which all information is cost-free and available to everyone at the same time

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Implications of Efficient Capital Markets

Overall results indicate the capital markets are efficient as related to numerous sets of informationThere are substantial instances where the market fails to rapidly adjust to public information

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Efficient Markets and Fundamental Analysis

Fundamental analysts believe that there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities and these values depend on underlying economic factorsInvestors should determine the intrinsic value of an investment at a point in time and compare it to the market price

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Efficient Markets and Fundamental Analysis

If you can do a superior job of estimating intrinsic value you can make superior market timing decisions and generate above-average returnsThis involves aggregate market analysis, industry analysis, company analysis, and portfolio managementIntrinsic value analysis should start with aggregate market analysis

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Aggregate Market Analysis with Efficient Capital Markets

EMH implies that examining only past economic events is not likely to lead to outperforming a buy-and-hold policy because the market adjusts rapidly to known economic eventsMerely using historical data to estimate future values is not sufficientYou must estimate the relevant variables that cause long-run movements