Chapter 4: Fundamentals of Research – NISM-Series-XV Research Analyst Exam Study Notes Download PDF Book
What is Investing in the Securities Market
Investment in the securities market refers to the upfront commitment of money to earn returns over time, necessitating a thorough analysis of the underlying security in terms of safety/risk, income, and growth potential. Investing is distinct from trading or speculative activities.
- Upfront Money Commitment: Investing begins with allocating a sum of money with the expectation of future returns.
- Return Over Time: The objective is to generate returns over a specific period.
- Security Analysis:
- Safety/Risk: Evaluate the level of risk associated with the investment.
- Income Potential: Assess the potential for generating income.
- Growth Potential: Consider the possibility for appreciation in value.
- Distinct from Trading:
- Trading: Involves earning a profit from the price spread in a short time frame, focusing on short-term asset price movements.
- Speculative Activities: Traders often speculate on short-term market fluctuations.
- Investment Focus: Seeks long-term value increase in an asset.
- Higher Cash Flow: Assets that can generate more cash flow without significantly increasing risk.
- Decreased Risk: Assets where the risk decreases without a corresponding reduction in cash flow.
- Rigor in Analysis: Investing requires a higher level of detailed analysis, either at the broad asset class level or drilling down into individual stocks.
What is Active Investing
Active investing is the process of selectively buying and selling specific securities based on their valuation. It involves continuous assessment of each security within an investment portfolio to identify and sell overvalued securities and purchase undervalued ones. Active investing requires more effort and often results in more transactions compared to passive investment strategies, aiming to achieve returns higher than the average return of the broader asset class.
- Security Selection: Focused on picking individual securities for investment.
- Constant Portfolio Evaluation:
- Sell Overvalued Securities: Identifying and selling securities that are priced above their perceived fair value.
- Buy Undervalued Securities: Seeking out securities priced below their fair value for purchase.
- Active Management: Requires continuous monitoring and decision-making regarding the portfolio’s composition.
- Effort and Transactions:
- Increased Effort: More intensive in terms of research and analysis.
- Higher Transaction Volume: Involves more buying and selling actions than passive strategies.
- Performance Objective: Striving to outperform the average return of the broader asset class, not just match it.
What is Passive Investing
Passive investing is a strategy that involves investing in a broad range of securities representing a specific asset class, typically through an indexing approach. The goal is to replicate the return of the selected asset class, rather than trying to outperform it. Unlike active investing, passive investors do not focus on individual security selection but rather on the overall asset class.
- Broad Security Investment: Involves diversifying investments across a wide range of securities within an asset class.
- Indexing Strategy:
- Index Replication: Investing in all the securities that constitute a particular index.
- Objective: To mirror the performance of the chosen index.
- Return Objective: Aiming to achieve returns that are consistent with the overall performance of the selected asset class.
- Limited Analysis:
- Focus on Asset Class: Analysis is confined to understanding and selecting the appropriate asset class.
- No Individual Security Selection: Decisions are not based on the prospects of individual securities but on the asset class as a whole.
What is the Role of Research in Investment Activity
The role of a fundamental research analyst includes two parts: (i) Research and (ii) Analysis. Research involves obtaining all the necessary information, while analysis involves analysing this information to arrive at a conclusion.
- Research vs. Analysis:
- Research: Gathering necessary information.
- Analysis: Evaluating the gathered information to form conclusions.
- Sources of Information:
- Company’s annual report as a primary source.
- Recognizing limitations of annual reports (e.g., outdated information, lack of in-depth industry or economic data).
- Broader Research Scope:
- Researching the economy, industry, and the company.
- Includes speaking to industry experts, accessing market research reports, and conducting secondary research.
- Primary Research Techniques:
- Visiting company facilities.
- Interacting with customers, suppliers, employees, etc.
- Ethical Considerations:
- Avoiding the use of insider information, defined as price-sensitive information not available to the public.
What is Insider Information vs Mosaic Analysis
Insider information is material non-public information that significantly impacts an investor’s decision. Mosaic analysis, on the other hand, involves collating various pieces of information, which may be public or non-public but individually insignificant, to form a comprehensive insight.
- Insider Information Characteristics:
- Materiality: Must be significant enough to influence investment decisions.
- Non-public: Not known to the general public.
- Source Reliability: The trustworthiness and reliability of the information’s source.
- Impact and Certainty: The information’s potential effect on security prices and its certainty.
- Mosaic Analysis:
- Combining various pieces of information (both public and non-public) that are individually not significant.
- Legally acceptable practice in financial analysis.
- The aim is to gain a comprehensive understanding without relying on insider information.
- Distinguishing Between the Two:
- Importance of understanding the source and nature of information.
- Analysts must ensure insights are derived from mosaic analysis, not from direct access to sensitive non-public information.
Example: A CEO discussing an unpublished acquisition proposal is insider information, as it is material and non-public, likely to influence investment decisions. In contrast, an employee commenting on increased workload, suggesting higher business activity, doesn’t necessarily constitute insider information. In mosaic analysis, an analyst might combine such employee observations with other public data to derive insights, without crossing into insider information territory.
What is Technical Analysis
Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. It operates on the assumption that all influencing factors are already reflected in stock prices.
- Assumption of Technical Analysis:
- All information affecting a share (e.g., company fundamentals, economic factors, market sentiments) is reflected in stock prices.
- Focus on Price and Volume:
- Analysis of historical market data, especially price and volume.
- Forecasting price direction based on patterns in this data.
- Role of Technicians (Chartists):
- Use indicators in price trends to predict future stock price movements.
- Three Essential Elements in Price Behaviour:
- Past Prices: Indicate underlying trend and direction.
- Trading Volume: Reflects the strength of the trend.
- Time Span: Accounts for long-term factors impacting prices.
- Tools in Technical Analysis:
- Price charts, support and resistance levels, and trend analysis.
- Support and Resistance Levels:
- Key buying (support) and selling (resistance) points, and implications of breaking these levels.
- Use of Volume in Confirming Trends:
- Strong volumes validate trends; weak volumes may indicate trend weakness.
- Conversion of Data into Charts:
- Line charts, bar charts, candlestick charts.
- Identification of trends, reversals, and triggers for buying or selling.
- Importance of Moving Averages:
- Used to smooth out daily price fluctuations and identify trends.
- Application for Short-term vs. Long-term Investing:
- More suitable for short-term investing due to reliance on technical signals.
- Less reliable for long-term investing as business fundamentals can change.
Example: If a stock price approaches a known resistance level with high trading volume, a technician might predict that the price will retract upon reaching this level, suggesting a potential selling opportunity. Conversely, if a support level is broken with strong volume, it might indicate a significant shift in the supply and demand dynamic, hinting at a continuing downward trend.
What is Fundamental Analysis
Fundamental analysis is a method of evaluating a stock’s intrinsic value by examining related economic, financial, and other qualitative and quantitative factors. It focuses on long-term investing, with the premise that a company’s share value should be driven by its returns on share capital.
- Long-Term Investment Focus:
- Evaluates stock based on the company’s long-term performance.
- Contrasts with technical analysis, which is more short-term and price pattern-oriented.
- Fair Price Evaluation:
- Determines the fair value of a stock based on business performance expectations.
- Buying opportunity if market price is below fair value; selling advised if above.
- Contradiction to Efficient Market Hypothesis (EMH):
- EMH states that share prices reflect all relevant information.
- Fundamental analysis suggests profits can be made from market price deviations from fair value.
- Comprehensive Study Areas:
- Economic Analysis: Macro-economic trends affecting the industry.
- Industry Analysis: Competitive intensity and industry conditions.
- Company Analysis: Company’s positioning, cost structure, financial strength, management capabilities, and governance.
- Key Factors in Fundamental Analysis:
- Cyclical and secular trends’ impact on industry growth.
- Competition intensity and its effect on existing players.
- Company’s competitive position relative to its peers.
- Impact of cost structure on profitability under varying business conditions.
- Financial strength to fund growth or endure crises.
- Management’s ability to identify and execute effective strategies.
- Governance ensuring management acts in shareholders’ best interests.
Example: If a fundamental analyst evaluates a technology company, they might look at overall tech industry growth trends, the company’s position compared to its competitors, its financial stability, and the strength of its management and governance. If the analysis suggests the company is undervalued by the market, it would be considered a good investment opportunity. Conversely, if the company is overvalued, the analyst might recommend selling or not investing.
What is Quantitative Research in Equity Analysis
Quantitative research in equity analysis involves a rigorous and systematic approach to studying financial data using econometric methods. This approach can be applied to both technical and fundamental analysis.
- Role in Fundamental Research:
- Fundamental research includes both quantitative (numerical data-focused) and qualitative (subjective factors-focused) studies.
- Application in Technical Analysis:
- Focuses on analyzing underlying data rather than chart interpretation.
- Studies relationships between price movements, volume, and other parameters.
- Finance and Operational Metrics in Quantitative Research:
- Analysts examine financial and operational metrics of a company.
- These metrics can act as leading indicators of a company’s performance.
- Methods Used:
- Simple methods like time series analysis and regression to forecast future earnings.
- More sophisticated econometric approaches for refined analysis.
- Limitations in Fundamental Analysis:
- Challenges due to the availability of comparable information.
- Frequent changes in accounting standards and business models reduce past data relevance.
- Pure quantitative approach is less common in fundamental analysis due to these limitations.
Example: In applying quantitative research to fundamental analysis, an analyst might use regression analysis to forecast a company’s future earnings based on historical data. However, due to changes in accounting standards and business models, the analyst may find that past data is not entirely reliable for predicting future performance, highlighting the limitations of a purely quantitative approach.
What is Behavioral Approach to Equity Investing
The behavioral approach to equity investing considers how psychological factors and cognitive biases of market participants influence investment decisions and cause stock prices to deviate from their fair values.
- Influence on Investment Decisions:
- Decisions are often influenced by psychological biases, leading to suboptimal investment choices.
- Effect on Securities Prices:
- Prices may diverge from fair values due to the emotional responses of market participants, notably fear and greed.
- Common Behavioural Biases:
- A range of well-documented biases affect investment decisions, leading to irrational behavior and market inefficiencies.
- Objective of Behavioral Finance:
- To understand and mitigate the impact of psychological biases on investment decisions and market outcomes.
- Importance in Equity Investing:
- Recognizing and accounting for these biases can lead to more informed and rational decision-making in equity investment.
Example: While the specific biases are detailed in another chapter, a general example might be an investor overreacting to bad news due to loss aversion and selling a stock at a loss, causing its price to fall below its intrinsic value. Similarly, excessive optimism might lead to overvaluation of a stock. Both scenarios provide opportunities and risks for investors aware of these behavioural patterns.