Functions of Stock Market and Investment Fundamentals

1
Dr. Mahmood Osman Imam
Stock Exchange/Market is an organized market for trading of stocks,
bonds/debenture & other securities of the listed companies. It brings buyers and
sellers to aid in the transfer of financial assets. he functions of stock market are!
Stock market based financing" companies can raise funds by issuing tradable
securities #in the primary market$ and offering seasoned #%&'$ &/or right
issues(
Stock market pro)ides a channel for the marketability of the issues and
liquidity as well--price continuity & depth e)entually(
Stock market is supposed to determine fair price of the trading securities
through the interaction of demand for and supply of securities by adjusting
prices rapidly to new information;
%educes costs of capital formation( and
*s stock market pro)ides the indication of the gro+th and most profitable
industrial sector, it ensures channeling of funds to these industrial sectors.
Primary Market vs. Secondary Market
Primary Market
,e+ Issuance of Security(
&roceeds of Security issuance go to issue company(
,e+ Issue increases existing financial assets in the economy.
Secondary Market
Subse-uent sale of security(
&roceeds of sale go to the seller not the issuer(
Existing securities change hands.
here is a debate +hether secondary market contributes to capital formation and
hence national economy or not. It does indirectly through I&'s in primary market,
+hich are going to be listed and traded in the secondary market, as good secondary
market is a pre.re-uisite for the I&' market. he funds that are raised by issuing
companies in the primary market and funds that are raised by issuing right
offerings & repeat public offerings #%&'$ are re-uired to be used for further
1
Mahmood Osman Imam Ph.D., FCMA is a Professor and Ex-Chairman, Department of Finance, and
Executive Director, Center for Corporate overnance and Finance !tudies, "niversit# of Dha$a.
expansion and gro+th, and are indeed a part of capital formation for
industrialization. *ll these are also part of market capitalization. /o+e)er, a ma0or
part of high rocketing market capitalization in recent times is indeed an asset price
bubbles in capital market rather than a response to gro+th in real sectors. It needs
to be handled prudently and 0udiciously +ith strictest care by regulators because of
market sensiti)eness and conse-uent of loss/restoration of confidence by in)estors
upon the market.
Motivation and conomics of Securities !rading
Security market pro)ides li-uidity to in)estors +ho ac-uire securities in the
primary market
Security market results in lo+er re-uired returns than if issuers had to
compensate for lo+er li-uidity
Security market helps determine market pricing for ne+ issues and hence
pro)ides security )alue & re-uired return
Security market pro)ides price disco)ery to facilitate independent )aluation
and monitoring of issuers.
"angladesh Stock Market---Status# $eatures# and "ehavior%all at a glance
Market 1apitalization, urno)er, 2i-uidity, 3epth of the market and their
implications need to be understood!
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It is characterized by a high information asymmetry and increasing
depth having moderate market capitali&ation ratio.
his situation is traceable to the high degree of speculative trading#
moderate level of institutional investment# lack of variety of trading
instruments# and lack of financial analysts and fund managers +ho
furnish superior information re)elation.
Cangladesh stock market #CSM$ is really an e-uity market
CSM is highly )olatile market #inter.day )s. intra.day )olatility$
!rend 'hase "ehavior (!'") and *erding "ehavior do exist in CSM.
%ecently role of institutional in)estors and financial intermediaries has been
remarkably significant in re)italizing the securities market.
Investment Fundamentals
In general stock In)estment occurred based on
. Speculation
. Dundamentals
Speculative +nvestment, antamount to gambling, a transaction fuelled by
the greed of the in)estor.
$undamental +nvestment, Cased of facts, published data and detailed
future analysis of future performance.
%isk is related +ith in)estorEs time horizon
Fno+ing ype of In)estor you are
* fundamental analyst finds under)alued securities that may not ad0ust
their prices as -uickly
conomic# +ndustry -inks to 'ompany .nalysis
1ompany analysis is the final step in the top.do+n approach to in)esting.
Macroeconomic analysis identifies industries expected to offer attracti)e
returns in the expected future en)ironment. *nalysis of firms in selected
industries concentrates on a stockEs intrinsic )alue based on gro+th and risk.
If trends are fa)orable for an industry, the company analysis should focus on
firms in that industry that are positioned to benefit from the economic
trends.
Dirms +ith sales or earnings particularly sensiti)e to macroeconomic
)ariables should also be considered.
%esearch analysts need to be familiar +ith the cash flo+ and risk of the
firms.
!ips in company analysis and stock valuation
6ood companies are not necessarily good in)estments
1ompare the intrinsic )alue of a stock to its market )alue
Stock of a great company may be o)erpriced
Stock of a gro+th company may not be gro+th stock
/rowth 'ompanies and /rowth Stocks
/ro0th companies ha)e historically been defined as companies that
consistently experience abo)e.a)erage increases in sales and earnings
Dinancial theorists define a &ro0th company as one +ith management and
opportunities that yield rates of return greater than the firmEs re-uired rate
of return
* &ro0th stock has a higher rate of return than other stocks +ith similar
risk. Superior risk.ad0usted rate of return occurs because of market
under)aluation compared to other stocks.
+ssues 0elating to +nvestment
Sometimes, accounts are cooked to manipulate earnings and hence one must
be careful to ad0ust financial statement information for informed decision
making
&erformance Indicators of listed companies needs be carefully analyzed!
E&S, 3&S, &ayout ratio, '1D, D1D, &/E %atioG #&ayout, k, g$,
&/E ratio of sector, Cook Halue per share, ,*Hps, &rice/,*Hps
3i). yield, Sales 6ro+thG #*/Sales, 2e)erage, &rofit Margin,
3i)idend &ayout$
Price arning 0atio (P1)
&/E ... relationship bet+een marketEs )aluation of a companyEs shares and
earnings capability of the company
* higher &/E ... high potential to impro)e its fundamentals and high
&ro0th prospects
* higher &/E is risky as current price does not reflect the companyEs
fundamentals( rather non$fundamental factors may support the price rise
& price may go do+n in the future.
Sector &/E ratio as on
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he significance of &/E matters +hen denominator E, +hose earning -uality raises
concern, is the critical issue.
arnings 2uality
'arnin& 3uality is typically defined in terms of 4persistence5 and
4sustaina6le5.
'arnin&s are considered to be high -uality +hen they are sustaina6le or
+hen they 7e8pect the reported level of earnin&s to 6e sustained or
continued9
It has relevance to valuation at its core:
3iscussion of earnings -uality look at the extent of a&&ressive or
conservative choices that ha)e been made in the financial
statement(
Mean ;eversion to 'arnin&s$$$ (3ata analyzed by ,issim and
&enman #<>>=$ sho+ that the pattern of mean re)ersion in earnings is
)ery per)asi)e.$
'arnin&s +ill re)ert back to normal le)el e)en -uicker +hen earnings
are largely comprised of accruals as opposed to cash flo+s.
System of $inancial 3isclosure nsuring arnings 2uality
System of financial disclosure +ould pro)ide information that is!
;elevant to the determination of fundamental )alue(
;eflective of the true economies of the transactions(
<erifia6le, such that estimates and assumptions are reasonable and
understood(
1eutral +ith respect to any predetermined result, such as analystsE
forecasts
=ompara6le, enabling the analyst to compare information among
companies and o)er time (
=omplete, pro)iding sufficient information to understand a companyEs
past, current, and future performance(
>nderstanda6le to all stakeholders.
4alue versus /rowth +nvesting
6ro+th stocks +ill ha)e positi)e earnings surprises and abo)e.a)erage risk
ad0usted rates of return because the stocks are under)alued.
Halue stocks appear to be under)alued for reasons besides earnings gro+th
potential. Halue stocks usually ha)e lo+ &/E ratio or lo+ ratios of price to
book )alue.
+nvestment !enets
*c-uire kno+ledge, search information, learn things and al+ays concern +ith
company fundamentals & sectorEs potential.
2ook for businesses you understand, +ith consistent earning history, and its
long term competiti)eness and prospects.
Is the management candid +ith its shareholdersI
Look for management who report their financial performance fully and
genuinely, who admits mistake as well as share success
Jatch the most important management act i.e. allocation of
companyEs capital and profit
2ook for companies +ith high profit margins.
*ccounting E&S represents the starting point for determining economic )alue
of business, not ending
?ook for cash flo0@ free cash flo0 and o0ner earnin&s #net
income plus depreciation minus cap. Exp and additional capital$
1an the business be purchased at a significant discount to its fundamental
intrinsic )alueI
In)est +ith a Margin of Safety
Expect Holatility and &rofit from It
2imit your in)estment to the number of companies you can truly understand.
!he 0ules of $ocus +nvesting
1oncentrate your in)estment in good performing companies run by strong
management
2imit yourself to the number of companies you can truly understand
&ick the )ery best of your good companies, and put bulk of your in)estment
there
hink at least medium term, if not long term
Holatility occurs. 1arry on.
5hen to Sell
/olding a stock too long may lead to lo+er returns than expected
If stocks decline right after purchase, is that a further buying opportunity or
an indication of incorrect analysisI
1ontinuously monitor key assumptions.
E)aluate closely +hen market )alue approaches estimated intrinsic )alue.
Fno+ +hy you bought it and +atch for that to change.
Cangladesh stock market is empirically found to be inefficient e)en in +eak form
and hence technical analysis that is used to discern past pattern likely to be
repeated matters in achie)ing excess return. /o+e)er, fundamental analysis
coupled +ith technical analysis is an added ad)antage for being more successful in
making abnormal return +hile taking the risk into account.