THE COPPERBELT UNIVERSITY

SCHOOL OF GRADUATE STUDIES

(EVENING PROGRAMME)

GAF 720: Investment Analysis and Portfolio

Management
TOPIC 5 & 6: SECURITY ANALYSIS

The aim of security analysis is essentially to make judgements as to whether any particular
security is efficiently priced at any particular time, meaning that the questions being asked
are: Is the security’s prospective return higher than its risk level warrants?”, “Does it lie
below or above the SML?” If it lies below the SML, it means that the security is under-priced
and if it lies above the SML, it means that the security is over-priced.

Security analysis is about deciding what securities to buy and when to buy them. This
analysis basically tries to estimate what the future price is going to be. Thus on the basis of
these estimates of future prices, a decision is made on whether to buy or sell or hold one’s
current investment.

There are two major approaches to security analysis namely Fundamental Analysis (Top to
bottom analysis) and Technical Analysis.

1. FUNDAMENTAL ANALYSIS

Fundamental analysis is the examination of the underlying forces that affect the well being of
the economy, industry groups and companies. As with most analysis, the goal is to develop a
forecast of future price movement and profit from it. At the company level, fundamental
analysis may involve examination of financial data, management, business concept and
competition. At the industry level, there might be an examination of supply and demand
forces of the products. For the national economy, fundamental analysis might focus on
economic data to assess the present and future growth of the economy.

To forecast future stock prices, fundamental analysis combines economic, industry, and
company analysis to derive a stock’s fair value called intrinsic value. If fair value is not
equal to the current stock price, fundamental analysts believe that the stock is either over or
under valued. As the current market price will ultimately gravitate towards fair value, the fair
value should be estimated to decide whether to buy the security or not. By believing that
prices do not accurately reflect all available information, fundamental analysts look to
capitalize on perceived price discrepancies.

Fundamental Analysis is a method of evaluating a security by attempting to measure its

intrinsic value by examining related economic, financial and other qualitative and
2
quantitative factors. Fundamental analysts attempt to study everything that can affect the
security’s value, including macroeconomic factors (like the overall economy and industry
conditions) and individual specific factors (like the financial condition and management of
companies).

OBJECTIVES OF FUNDAMENTAL ANALYSIS

 To predict the direction of national economy because economic activity affects the
corporate profit, investor attitudes and expectation and ultimately security prices.
 To estimate the stock price changes by studying the forces operating in the overall
economy, as well as influences peculiar to industries and companies.
 To select the right time and right securities for the investment.

THREE PHASES OF FUNDAMENTAL ANALYSIS

1) Understanding of the macro-economic environment and developments (Economic
Analysis)
2) Analyzing the prospects of the industry to which the firm belongs (Industry Analysis)
3) Assessing the projected performance of the company (Company Analysis)

The three phase examination of fundamental analysis is also known as an EIC (Economy-
Industry-Company analysis) framework or a top-down approach.

Here the financial analyst first makes forecasts for the economy, then for industries and
finally for companies. The industry forecasts are based on the forecasts for the economy and
in turn, the company forecasts are based on the forecasts for both the industry and the
economy. Also in this approach, industry groups are compared against other industry groups
and companies against other companies. Usually, companies are compared with others in the
same group.

Thus, the fundamental analysis is a 3 phase analysis of:

a) The economy
b) The industry and
c) The company

3
Phase Nature of Purpose Tools and techniques
Analysis
FIRST Economic To assess the Economic indicators:
Analysis general economic  Global Economy
situation of the -Export prospects/earnings
-Competitiveness of the issuer’s
nation. products
-Political risks in the international
markets
-Trade policies and protectionism
-FX rates
-Commodity prices
 Local economy
- GDP
- Employment/unemployment
- Interest rates
- Inflation rates
- National budget deficits
- Sentiments
SECOND Industry Analysis To assess the  Industry life cycle
analysis (i.e devt
prospects of
stage, introduction
various industry stage, growth stage,
maturity stage,
groupings.
decline stage.)
 Competitive
analysis of
industries
(e.g.Porter’s 5
forces model), etc.
THIRD Company Analysis To analyse the  Analysis of
Financial aspects:
Financial and Non-
Sales, Profitability,
financial aspects of EPS etc.
 Analysis of Non-
a company to
financial aspects:
determine whether management,
corporate image,
to buy, sell or hold
product quality etc.
the shares of a
company.

4
STRENGTHS OF FUNDAMENTAL ANALYSIS
1. Long-term Trends
Fundamental analysis is good for long term investments based on long-term trends. The
ability to identify and predict long-term economic, demographic, technological or consumer
trends can benefit investors and helps in picking the right industry groups or companies.

2. Value Spotting
Sound fundamental analysis will help identify companies that represent a good value.
Some of the most legendary investors think for long-term and value. Fundamental analysis
can help uncover the companies with valuable assets, a strong balance sheet, stable
earnings, and staying power.

3. Business Acumen
One of the most obvious, but less tangible rewards of fundamental analysis is the
development of a thorough understanding of the business. After such painstaking research
and analysis, an investor will be familiar with the key revenue and profit drivers behind a
company. Earnings and earnings expectations can be potent drivers of equity prices. A good
understanding can help investors avoid companies that are prone to shortfalls and identify
those that continue to deliver.

4. Value Drivers
In addition to understanding the business, fundamental analysis allows investors to develop
an understanding of the key value drivers within the company. A stock’s price is heavily
influenced by the industry group. By studying these groups, investors can better position
themselves to identify opportunities that are high-risk (tech), low-risk (utilities), growth
oriented (computer), value driven (oil), non cyclical (consumer staples), cyclical
(transportation) etc.

5. Knowing Who is Who

Stocks move as a group. Knowing a company’s business, investors can better categorize
stocks within their relevant industry group that can make a huge difference in relative
valuations. The primary motive of buying a share is to sell it subsequently at a higher price.
In many cases, dividends are also to be expected. Thus, dividends and price changes
5
constitute the return from investing in shares. Consequently, an investor would be interested
to know the dividend to be paid on the share in the future as also the future price of the share.
These values can only be estimated and not predicted with certainty. These values are
primarily determined by the performance of the company which in turn is influenced by the
performance of the industry to which the company belongs and the general economic and
socio-political scenario of the country.

Making a decision
An investor who would like to be rational and scientific in his investment activity has to
evaluate a lot of information about the past performance and the expected future performance
of companies, industries and the economy as a whole before taking investment decision. Each
share is assumed to have an economic worth based on its present and future earning capacity.
This is called its intrinsic value or fundamental value. The purpose of fundamental analysis
is to evaluate the present and future earning capacity of a share based on the economy,
industry and company fundamentals and thereby assess the intrinsic value of the share. The
investor can then compare the intrinsic value of the share with the prevailing market price to
arrive at an investment decision. If the market price of the share is lower than its intrinsic
value, the investor would decide to buy the share as it is underpriced. The price of such a
share is expected to move up in future to match with its intrinsic value.

On the contrary, when the market price of a share is higher than its intrinsic value, it is
perceived to be overpriced. The market price of such a share is expected to come down in
future and hence, the investor would decide to sell such a share. Fundamental analysis thus
provides an analytical framework for rational investment decision-making. Fundamental
analysis insists that no one should purchase or sell a share on the basis of tips and rumours.
The fundamental approach calls upon the investor to make his buy or sell decision on the
basis of a detailed analysis of the information about the company, the industry to which the
company belongs, and the economy. This results in informed investing.

6
2. TECHNICAL ANALYSIS
Fundamental analysis and Technical analysis are the two main approaches to security
analysis. Technical analysis is frequently used as a supplement to fundamental analysis rather
than as a substitute to it. According to technical analysis, the price of stock depends on
demand and supply in the market place. It has little correlation with the intrinsic value. All
financial data and market information of a given stock is already reflected in its market price.

Technical analysts have developed tools and techniques to study past patterns and predict
future price. Technical analysis is basically the study of the markets only. Technical
analysts study the technical characteristics which may be expected at market turning points
and their objective assessment. The previous turning points are studied with a view to
develop some characteristics that would help in identification of major market tops and
bottoms. Human reactions are, by and large, consistent in similar though not identical
reaction; with his various tools, the technician attempts to correctly catch changes in trend
and take advantage of them.

Technical analysis is directed towards predicting the price of a security. The price at which a
buyer and seller settle a deal is considered to be the one precise figure which synthesises,
weighs and finally expresses all factors, rational and irrational, quantifiable and non-
quantifiable and is the only figure that counts.

Thus, the technical analysis provides a simplified and comprehensive picture of what is
happening to the price of a security. Like a shadow or reflection it shows the broad outline of
the whole situation and it actually works in practice.

ASSUMPTIONS OF TECHNICAL ANALYSIS

 The market value of a security is solely determined by the interaction of demand and
supply factors operating in the market.
 The demand and supply factors of a security are surrounded by numerous factors;
these factors are both rational as well as irrational.
 The security prices move in trends or waves which can be both upward or downward
depending upon the sentiments, psychology and emotions of operators or traders.

7
  The present trends are influenced by the past trends and the projection of future trends
is possible by an analysis of past price trends.
 Except minor variations, stock prices tend to move in trends which continue to persist
for an appreciable length of time.
 Changes in trends in stock prices are caused whenever there is a shift in the demand
and supply factors.
 Shifts in demand and supply, no matter when and why they occur, can be detected
through charts prepared specially to show market action.
 Some chart trends tend to repeat themselves. Patterns which are projected by charts
record price movements and these patterns are used by technical analysis for making
forecasts about the future patterns.

CHARACTERSITICS OF TECHNICAL ANALYSIS

Basically, technical analysis is done from the following four important points of view:
1) Prices: Whenever there is change in prices of securities, it is reflected in the changes in
investor attitude and demand and supply of securities.
2) Time: The degree of movement in price is a function of time. The longer it takes for a
reversal in trend, the greater will be the price change that follows.
3) Volume: The intensity of price changes is reflected in the volume of transactions that
accompany the change. If an increase in price is accompanied by a small change in
transactions, it implies that the change is not strong enough.
4) Width: The quality of price change is measured by determining whether a change in trend
spreads across most sectors and industries or is concentrated in few securities only. Study of
the width of the market indicates the extent to which price changes have taken place in the
market in accordance with a certain overall trends.

DOW THEORY
The Dow Theory, originally proposed by Charles Dow in 1900 is one of the oldest technical
methods still widely followed. The basic principles of technical analysis originate from this
theory.

According to Charles Dow “The market is always considered as having three movements,
all going at the same time. The first is the narrow movement from day to day. The second is
8
the short swing, running from two weeks to a month or more and the third is the main
movement, covering at least four years in its duration”.

The Theory advocates that stock behaviour is 90% psychological and 10% logical. It is the
mood of the Crowd which determines the way in which prices move and the move can be
gauged by analysing the price and volume of transactions.

The Dow Theory only describes the direction of market trends and does not attempt to
forecast future movements or estimate either the duration or the size of such market trends.
The theory uses the behaviour of the stock market as a barometer of business conditions
rather than as a basis for forecasting stock prices themselves. It is assumed that most of the
stocks follow the underlying market trend, most of the times.

A trend should be assumed to continue in effect until such time as its reversal has been
definitely signalled. The end of a bull market is signalled when a secondary reaction of
decline carries prices lower than the level recorded during the earlier reaction and the
subsequent advance fails to carry prices above the top level of the preceding recovery. The
end of a bear market is signalled when an intermediate recovery carries prices to a level
higher than the one registered in the previous advance and the subsequent decline halts above
the level recorded in the earlier reaction.

Example of a bull market trend

9
Example of a bear market trend

CHARTING
Charting is the basic tool in technical analysis, which provides visual assistance in defecting
changing pattern of price behaviour. The technical analyst is sometimes called the Chartist
because of importance of this tool. The Chartists believe that stock prices move in fairly
persistent trends. There is an inbuilt inertia, the price movement continues along a certain
path (up, down or sideways) until it meets an opposing force due to demand-supply 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 also the price and vice-versa.

The essence of Chartism is the belief that share prices trace out patterns over time. These are
a reflection of investor behaviour and it can be assumed that history tends to repeat itself in
the stock market. A certain pattern of activity that in the past produced certain results is likely
to give rise to the same outcome should it reappear in the future. The various types of
commonly used charts are:
a) Line Chart
b) Bar Chart
c) Point and figure Chart

10
Line Charts: The simplest form of chart is a line chart. Line charts are simple graphs drawn
by plotting the closing price of the stock on a given day and connecting the points thus
plotted over a period of time. Line charts take no notice of the highs and lows of stock prices
for each period.

The following figure presents a typical line chart

Bar Charts: It is a simple charting technique. In this chart, prices are indicated on the
vertical axis and the time on horizontal axis. The market or price movement for a given
session (usually a day) is represented on one line. The vertical part of the line shows the high
and low prices at which the stock traded or the market moved. A short horizontal tick on the
vertical line indicates the price or level at which the stock or market closed.
The following figure shows a bar Chart.

11
Point and Figure Chart (PFC): Though the point and figure chart is not as commonly used
as the other two charts, it differs from the others in concept and construction. In PFC there is
no time scale and only price movements are plotted. As a share price rises, a vertical column
of crosses is plotted. When it falls, a circle is plotted in the next column and this is continued
downward while the price continues to fall. When it rises again, a new vertical line of crosses
is plotted in the next column and so on. A point and figure chart that changes column on
every price reversal is cumbersome and many show a reversal only for price changes of three
units or more (a unit of plot may be a price change of say one kwacha).
The following figure shows a point and figure chart:

12
TRENDS
A trend can be defined as the direction in which the market is moving. Up trend is the
upward movement and downtrend is the downward movement of stock prices or of the
market as measured by an average or index over a period of time, usually longer than six
months. Trend lines are lines that are drawn to identify such trends and extend them into the
future. These lines typically connect the peaks of advances and bottoms of declines.
Sometimes, an intermediate trend that extends horizontally is seen.

Upward trend chart

Downward trend chart

13
SIDEWAY TREND
A sideway trend is characterised by stock prices trading in a range where successive peaks
occur at the same level and successive troughs occur at the same level. The two levels create
parallel trend lines. During this time the investor should be extra careful and wait for more
definite indicators of the future market movement.

Sideway trend chart

Trend lines encompass advances and declines by joining successive tops and bottoms.
Sometimes, it is useful to trap trends by drawing trend lines on both the sides of an upward or
downward trend. These parallel lines drawn to encompass trends from both the sides are
called channels.

14
EFFICIENT CAPITAL MARKETS

The Efficient Market Hypothesis

Markets are said to be efficient if they reflect all available information. The efficient market
hypothesis is the hypothesis that the stock market reacts immediately to all the information
that is available. This information could be political information, profits, management
information, etc.

Definition of Efficiency

a) Allocative Efficiency: If financial markets allow funds to be directed towards firms

which make the most productive use of them, then there is allocative efficiency.
b) Operational Efficiency: Transaction costs are incurred by participants in the financial
markets, for example, commissions on share transactions, margins between interest
rates for lending and for borrowing, and loan arrangement fees. Financial markets have
operational efficiency if transaction costs are kept as low as possible. Transaction costs
are kept low where there is open competition between/among brokers and other market
participants.
c) Informational Processing Efficiency: The informational processing efficiency of a stock
market means the ability of a stock market to price stocks and shares fairly and quickly.
An efficient market in this sense is one in which the market prices of all securities
reflect all the available information.

Features of Efficient Markets

For a market to be efficient, the following characteristics have to hold:

1. The prices of securities bought and sold reflect all the relevant information which is
available to the buyers and sellers. In other words, share prices change quickly to
reflect all new information about future prospects. This is the concept of rapidity of
price response to information.
2. No individual dominates the market. Investors compete freely with each other in their
efforts to predict future value of individual stocks.

15
3. Transaction costs of buying and selling are not so high as to discourage trading
significantly i.e. there are low transaction costs.
4. There is a large number of rational investors i.e. they are profit seeking and at the same
time they are risk averse, meaning that they only invest when risk is commensurate
with return.
5. There are low, or no, costs of acquiring information.
6. The trading is fairly continuous.

Impact of Efficiency on Share Prices

If the stock market is efficient, share prices should vary in a rational way:

a) If a company makes an investment with a positive NPV, shareholders will get to know
about it and market price of its shares will rise in anticipation of future dividend
increases.
b) If a company makes a bad investment, shareholders will find out and so the price of its
shares will fall.
c) If interest rates rise, shareholders will want a higher return from their investments, so
market prices will fall.

Levels of Efficiency

There are three degrees of ‘forms’ of efficiency:

1. The Weak Form Efficiency: under the weak form hypothesis of market efficiency, share
prices reflect all available information about past changes in share prices. This form hold
that successive changes in stock prices are essentially independent of each other and that
the information content of historical market data is already embedded in the existing
prices. The market information, apart from historical information, includes historical price
changes and the historical volumes of securities traded associated with each historical
price level and change.

16
 In the weak form, an investor cannot use past information to predict the future prices
because the current prices already reflect the historical data. Information that affects share
prices will come randomly and the prices will also change randomly. It is recommended
that market participants have an ear to the ground to know what is happening. This weak
form concludes that there is no need to consider security analysis because yesterday’s
price changes have no relationship to tomorrow’s prices.

2. The Semi-strong Form Efficiency: if a stock market displays semi-strong form

efficiency, current share prices reflect both:
- all relevant information about past price movements and their implications;
- all knowledge which is available publicly.

This means that individuals cannot ‘beat the market’ by reading the newspapers or annual
reports, since the information contained in these will be reflected in the share prices.

The semi-strong form encompasses the weak form. In semi-strong form, any investor who
reacts quickly to new information is going to get above average returns i.e. the investor
would buy when the prices are cyclically low and sell when they are cyclically high. This
is because stock prices adjust rapidly to all new publicly available information and action
taken after an event is known will produce no more than random results.

3. The Strong Form Efficiency: if a market displays a strong form of efficiency, share
prices reflect all information whether publicly available or not:
- from past price changes;
- from public knowledge or anticipation;
- from specialists’ or experts’ insider knowledge (e.g. investment managers).

So the level of information reflected in stock prices is broader in the sense that private
information is also reflected in stock prices unlike in the other two forms of efficiency.

In this strong form hypothesis, markets are assumed to be both efficient and perfect.
Information is available to all market participants at the same time. No single investor has
a monopolistic advantage. In the strong form, there is no insider dealing possible. There is
no single group of investors that can consistently get above average returns because
everyone in the market has the same information at the same time.

17
Implications of the ECM on Technical and Fundamental Analysis

1. The fundamental theory of share values: the fundamental theory of share values is
based on the theory that the realistic market price of a share can be derived from a
valuation of estimated future dividends. The value of a share will be the discounted
present value of all future expected dividends on the shares, discounted at the
shareholders’ cost of capital.

If the fundamental analysis theory of share values is correct, the price of any share
will be predictable, provided that all investors have the same information about a
company’s expected future profits and dividends, and a known cost of capital.

2. Charting or technical analysis: chartists or technical analysts attempt to predict share

price movements by assuming that past price patterns will be repeated. There is no
real theoretical justification for this approach, but the degree of success is greater than
could be expected merely from chance.

Chartists do not attempt to predict every price change. They are primarily interested in
trend reversals, for example, when the price of a share has been rising for several
months but suddenly starts to fall.

One of the main problems with chartism is that it is often difficult to see a new trend
until after it has happened. By the time the chartist has detected a signal, other
chartists will have as well, and the resulting mass movement to buy or sell will push
the price so as to eliminate any advantage.

With the use of sophisticated computer programs to simulate the work of a chartist,
academic studies have found that the results obtained were no better than those
obtained from a simple buy and hold strategy of a well diversified portfolio of shares.

This may be explained by research that has found that there are no regular patterns of
cycles in share price movements overtime – they follow a random walk.

18
RANDOM WALK THEORY
Random walk theory is consistent with fundamental theory of share values. It accepts that a
share should have an intrinsic price dependent on the fortunes of the company and the
expectations of investors. One of its underlying assumptions is that all relevant information
about a company is available to all potential investors who will act upon the information in a
rational manner.

The key feature of random walk theory is that although share prices will have an intrinsic or
fundamental value, this value will be altered as new information becomes available and that
the behaviour of investors is such that the actual share price will fluctuate from day to day
around the intrinsic value.

Other factors that affect share prices

i) Marketability and liquidity of shares
ii) Availability and sources of information
iii) Market imperfections and pricing anomalies
iv) Market capitalisation
v) Behavioural finance (investor speculation)

19