Indira Gandhi National Open University

School of Management Studies FINANCIAL TECHNOLOGIES KNOWLEDGE MANAGEMENT CO.

M.FP-1EQUITY MARKETS

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"Education is a liberating force, and in our

age it is also a democratising force, cutting
across the barriers of caste and class,
smoothing out inequalities imposed by birth
and other circumstances."
- I ndira Gandhi
 ~
Indira Gandhi
National Open University
MFP-l
~ School of Management Studies Equity Markets

Block

5
SPECIAL ISSUES
Unit 19
Investment Style and Trading Strategies 5
Unit 20
Portfolio Management 19

Unit 21
Corporate Actions 35
 COURSE DESIGN AND DEVELOPMENT
COMMITTEE
Prof. M.S. Narasimhan Mr. Shrikant Koundinya
Indian Institute of Management Asstt. Vice President, FfKMC
Bangalore Mumbai
Prof. G. Balasubramanian Ms. ShiJpa Rasquinha
Institute for Financial Management Domain Expert and Asstt. Manager
and Research FfKMC, Mumbai
Chennai
Mr. Vinit Singh Kaler
Mr. Raghu Iyer Domain Expert and Senior Executive
Derivatives Consultant FfKMC, Mumbai
Mumbai
Prof. G. Subbayarnma
Mr. Amitabh Chakraborty Director
Managing Director and School of Management Studies
Chief Investment Officer IGNOU, New Delhi
Kitara Capital Private Limited
Prof. S. Narayan
Mumbai
School of Management Studies
Dr. Bandi Ram Prasad IGNOU, New Delhi
President, FfKMC
Prof. K. Ravi Sankar
Mumbai
School of Management Studies
Dr. Jinesh Panchali IGNOU, New Delhi
Sr. Vice President, FfKMC
Dr. Kamal Vagrecha
Mumbai
School of Management Studies
Mr. Abhinav Chopra IGNOU, New Delhi
Asstt. Vice President, FfKMC
Mumbai
Mr. Venkat Giridhar
Team Leader
Asstt. Vice President, FfKMC
Mumbai

Print Production
B.Natarajan 5.Burman 5udhir Kumar
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June 2011 (Reprint)

, lndira GUII£/lIi Nationul Ufl~/1 University, 2010 &
Financial Technology Knowledge Management Company

ISBN: 978-81-266-4509-1
All rights reserved. No part of this work may be reproduced in any form, by mimeograph or any
. other means, without permission in writing from the lndira Gandhi National Open University.
Further information on the lndira Gandhi National Open University courses may be obtained from
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Printed and Published on behalf of the Indira Gandhi National Open University, New Delhi By Registrar. MPOD.
Printed At :- Print Pack (India),215/21 ,Ambadker Gali Moujpur Delhi _ 53 .
,

BLOCKS SPECIAL ISSUES

Investing in financial 'markets requires a comprehensive approach that includes
quantitative as well as qualitati ve aspects. After looking at evolution, types, and institutional
structure for financial markets, in Block 1, primary markets and various processes in
Block 2, trading mechanisms and clearing and settlement processes in Block 3, and
valuation in Block 4, we will deal with investment style and trading strategies, portfolio
management, and corporate actions in Block 5. As one moves away from the basics of
financial markets, one needs to blend quantitative as well as qualitative skills in taking a
call on investment. Valuation is one part of the investment while investment style is
another part and the third dimension is how to optimize the returns when various assets
class come together as portfolio. To take investment consultant or trader in market as a
full time professional one needs to know the traits and style of all time great investors in
the financial markets and the way they manage their portfolio to provide optimum returns
to their investors. Value ofthe investors' portfolio varies considerably due to "corporate
action" by the manag~ment of the company. This involves generally corporate benefits
arising out of dividend decisions, investment decisions and corporate restructuring
decisions. Often as part of signaling as well as increase liquidity in the markets, share
repurchase and split decisions are respectively taken.
Unit 19 explains the need for investment philosophy and its application in following
particular investment style which ultimately leading to trading strategies. It explains the
process of determining investment philosophy. It documents various investment styles
and how it affects selection of investment thereof. Finally, it explains various kinds of
trading strategies adopted by the investors in the markets. It also briefly touches upon
the investment style of all time great investors in the markets, like, Warrant Buffet, Ben
Graham, etc.
Unit 20 provides conceptual framework on portfolio management. It starts with premise
of efficient market hypothesis, computation various statistical measures, rationale and
application of Capital Asset Pricing Model. This unit provides quite a few real life numerical
problems required in portfolio management, like, covariance, portfolio risk, etc. It also
explains the concept of diversification, stages and process of diversification.
Unit 21 elaborates on the concept of corporate action and the adjustments requite for
various kinds of corporate actions taking examples from equity markets. It explains how
dividend, bonus, split, merger, rights, etc. affect the existing share prices. It shows with
various real life example how corporate action impact the underlying prices of shares
and how and when to make these adjustments ..
••

. .

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 \
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UNIT 19 INVESTMENT STYLE AND
.J
TRADING STRATEGIES
Objectives
After studying this unit, you should be able to:
• describe the various investment styles;
• explain the different types of investment and strategies;
• understand the impact of behavioral issues on investment style; and
• identify relationship between investment philosophy, investment style and trading
strategies.

Structure
19.1 Introduction
19.2 Investment Philosophy
19.3 Investment Styles
19.4 Style Determinants
19.5 Trading Strategies
19.6 Summary
19.7 Self Assessment Questions
19.8 Further Readings

19.1 INTRODUCTION
Result of one's investment depends largely on investment philosophy one is following
and trading strategies one adopts. There is a difference between investment style and
trading strategy. Investment styles or investment strategies go to the core of the investment
decision and have grounding in the psyche of the investor, which comes about after an
investment philosophy has been fixed. When it comes to trading strategies we go to the
actual nuances of investing after having identified the underlying risk taking ability. We
also need to gain know ledge of the popular styles and strategies adopted by the successful
investors in the market. It is important for the student of financial markets to appreciate
various investment philosophies, its suitability, behaviour nuances, and then evaluate
investment style suitable to time period and behaviour profile of one self and ultimately
adopt suitable trading strategies to maximize returns from investment.
There are various approaches to investment depending upon what one focus on, like,
value investing, growth investing, contrarian investing, momentum investing, investment
based on quantitative modeling based on historical relationship, etc. Besides, investment
style and trading strategies also involves premise on following fundamental or technical
analysis or both optimally.
An investment philosophy is a coherent way of thinking about markets, how they work
and the types of mistakes that consistently underlie investor behaviour. The investment
philosophy consists of human behaviour as well as market behaviour. In brief we can
say that it is an overall set of principles or strategy that guides an investor and it underlies
the investment strategies or styles. .

5
 ..

Special Issues All active philosophies are based on assumptions that markets are inefficient, they differ
in their views as to which segment of the markets the inefficiencies are most likely to
show up and how long these inefficiencies will last. One view is that markets are correct
most of the time but they overreact when new information emerges. Another view is
that markets can make mistakes in the aggregate (market exuberance) and this can be
very hazardous to an investor and finally the third view is that markets can do a good job"
of pricing stocks when there is a substantial amount of information and regulation. Free
markets with intelligent regulations conform to these views.

19.2 INVESTMENT PHILOSOPHY

For every investor who tends to follow the crowd (the herd mentality), it is assumed that
there are some investors who benefit by having contrarian views. Selection of investment
and assets class depends largely on behavioural profile of the investors. Some typical
examples are given below.
Risk-averse investors always prefer investments in:
• High dividend stocks: High grade corporate bonds and some government bonds
cater to risk averse investors.
• Stocks with low price-earnings ratios: Normally, stocks with low PIE ratio are
viewed as cheap and safe investment a perfect choice for someone who does not
want to take risk.
• Stocks that trade at less than book value: Considered as bargain stocks but
one need to analyse as to why they are trading at below book value. A risk adverse
investor will be looking at such scripts from a long term prospective.
• Stable earnings: Stable and regular earnings suggest that the companies product
development and marketing functions have reached a mature stage.
In financial markets, some investors might want to take advantage of buoyant markets
and are willing to take high risks with the hope of making high returns. Usually these
kinds of investors emphasize risks as follows:
• Companies which are market favourites: Investors who seek risk usually buy
stocks of companies depending on their financial yardsticks; usually these are
companies that earn high accounting rates of return.
• Hidden bargains: Using analysis identifies those stocks which very few investors
are aware of the hidden potential in them. In mature financial systems thousands
of professional money managers and analysts track stocks. However, there are
many stocks in smaller companies that are neither tracked by analysts nor held by
institutions but such (unpolished diamonds) stocks could give better returns.
Classical investment theories focus on the psychological aspect, such as motivational
and emotional aspects, financial conditions of the individual investors and group behaviour.
Emotions must be kept out of decision making because once it gets involved with
investments it could lead to dangerous results. For example, in the melt down of 2008-
2009, those investors who had their emotions in check were able to hold their ground.
There has been a complete change of economic scenario within a year. Stock prices are
on the way to recovery. Similar events have occurred in the past, black Monday in
October 1987, South East Asian economic crisis 1999-2000 are examples.
Motivation is an another important criteria, those who have come up the hard way and
wish to continue living in their current lifestyle would be cautious about their future and
1
plan for retirement and invest accordingly. On the other hand for baby boomers, there
1i
would be a lower level of motivation to invest as they were perhaps born with a lot of
wealth. ~
6 .1
Influence of group behaviour is another threat to happy outcome. When the markets Investment Style and
+un wildly bullish and when one hears buy calls at every turn, it becomes difficult to Trading Strategies
ignore market exuberance. The classical theorists have always maintained that the
financial plan should be specifically designed to suit the financial conditions of an individual
investor, since every person's financial responsibility and financial background is different.
For example, a bachelor will be willing to take a greater amount of risk as opposed to
say a married man in his middle age with children who would be looking for stable
returns with relatively less risk.
In the absence of an investment philosophy, one will tend to shift from strategy to strategy
simply based upon a strong sales pitch from a proponent or from a perceived recent
success. The negative consequence of not having a philosophy is that one will switch
from portfolio to portfolio thereby incurring high transaction costs and tax liability. Money
managers would have a problem in carrying all the investors together and since investors
have their own risk perceptions, a changed strategy may not appeal to all investors and
finally, not having a core set of beliefs, is not advisable for consistency in performance
of the portfolio manager.
Therefore, it is important to assess one's belief of functioning of markets and profile of
behavioural attributes to develop investment philosophy. From investment philosophy
emanates investment style while trading strategy emanates from investment style as
depicted in the following diagram:

Investment Investment
Trading
Philosophy Style or
Style
Strategy

Three crucial steps in developing an investment philosophy

1) Understand the fundamentals of risk and valuation.
2) Develop a point of view about the way markets work.
3) Find a philosophy that provides the best fit for the investor.

Three aspects that determine an investment philosophy

1) Personal characteristics: (Patience, Risk aversion, Time one is willing to spend
on investment decisions and Age).
2) Financial standing: (Job security, Investment options available, cash needs and
tax status).
3) Beliefs about the market (Personal beliefs, views about the markets from market
stalwarts).

The Warren Buffet Philosophy

When investing in stock market, Warren Buffett is very careful. He sets very strict
requirements to select stocks. So, stocks that fulfill his requirements are seldom being
found. Earnings versus growth, high return on equity, minimal debts, strength of
management and simple business model are five main criteria, which are used by Buffett '
to select stocks to invest. He usually concentrates in a few solid stocks, which able to
give high return of investment. These few stocks usually are in the industries that he
understands the most.
Buffett is the most successful and trusted investors. When Buffett invests in stocks,
underlying fundamentals of a company are the must will be investigated by him rather
than market sentiment. Because of his astute investment skill, he is dubbed as "The
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Special Issues Oracle of Omaha". Intrinsic value of a business is always determined by him and he is
willing to pay a good price for it as long as the business has the intrinsic value. Buffett is
very prudent and holds a principle that if he cannot understand the operation of the
business; he will not invest in it. That's why; he escaped the dotcom market crash. He
will check the fundamentals of the companies that he intends to invest by analyzing the
companies' annual reports. This is his simple investment principle .
.He is the chairman of Berkshire Hathaway and this company's stock is the most
expensive on Wall Street. In a letter to his shareholders, he stated that Berkshire was
looking to invest to the companies, which had competitive advantage in a stable industry
for long-term prospects. His philosophy is that the stock price will increase as long as
the business does well. Investment in PetroChina, which is an oil and gas firm in China,
was one of his most successful investments. He bought the stake for this company for
an initial sum ofUS$500 mn and then sold it for USD 3.5 bn. Investments in companies
such as Coca-Cola, American Express and Gillette are also among his successful
investments. His investment principle consists of the following:

• Buy the business not shares.

• Invest in few good businesses rather than having a portfolio of bad businesses.
• Risk arises from not knowing what you are doing.
• Time is the only factor diluting market risk.
• Judge the business as an owner.
• Intrinsic value of the business is the deciding factor.
• Depressions in the market provide opportunities to leverage on irrational behaviour.
• Irrational behaviour provides arbitrage opportunities.
• Patience is the key; incorporate the quality and the sophistication.
• Time to get out of a good business ... NEVER.

Absence of an Investment Philosophy

In absence of an investment philosophy, one will tend to shift from strategy to strategy
simply based on a strong sales pitch from a proponent or perceived recent success.
Lacking a core set of beliefs will make an investor an easy prey for charlatans and
pretenders, who claim to have found magic strategy that beats the market. Another
problem of frequently switching strategy would involve higher administrative costs,
transaction costs and tax liabilities. Absence of a philosophy might work for some investors
however; it cannot be suitable for every individual investor given his objectives, risk
aversion and personal characteristics.

19.3 INVESTMENT STYLES

Styles in investment are nothing but different ways of classifying investments. For instance
here we will be looking at various styles such as an active style, passive style, growth,
value creation, small cap and large cap style amongst others. One must remember that
there are a number of ways in which investments differ and the investment managers
employ a wide variety of styles and trading strategies. Managers also have access to
various markets both domestic and international, instruments and techniques. These
allow for the creation of variety in styles.
However, one should remember that it is only after an investment philosophy is fixed,
that one develops investment style or strategy. Investors who believe that markets
overreact might develop a strategy of buying stocks after large negative earnings surprises
hit the markets and selling after positive earnings surprises similarly there might be
8
some investors who prefer to stick to blue chips stocks or remain fully invested at all Investment Style and
times and others who believe in timing the markets. Whatever their belief, it will define Trading Strategies
their style.
Now, we will look at few common investment styles:

Active vs passive
Investors believe in their ability to outperform the overall market by picking stocks they
believe may perform well. Investors ate actively ideritifying new opportunities and
churning their portfolio. On the other hand, the passive investors feel that simply investing
in a market index fund may produce potentially higher long-term results. A passive
investor would therefore wait for the market to come around to his point of view once
the investment is made.
The strategy for an active investor would be to have a bias for large-cap shares or
larger blue-chip firms which he would consider to be more efficient. The strategy followed
by a passive investor on the other hand would be to invest in smaller companies. He
would be prepared to wait for a longer period. There are off course strategies which
combine and form a mix of passive and active strategies. The core-and satellite concept
combines a passive style in efficient market and an active Style in less efficient markets.

Growth vs Value
Growth' and 'Value' share selection techniques are both ways of using fundamental
analysis to find exceptional shares which will outperform the market.
Growth investing focuses on industry sectors and shares which are already doing well
but which have the potential to do even better. The approach focuses on analysing
companies with'rising market price and earnings, looking for the next wave of dominant
companies. Value investing uncovers shares which are currently out offavour but which
have the potential to do much better - sleepers or neglected companies.
The terminology is somewhat misleading because both styles are actually looking to
discover 'good value' shares with exceptional growth potential. But the growth style
will select shares which are already rising in price and attracting positive publicity, but
are judged to be 'cheap at any price'; whereas the value approach will tend to buy
neglected or scorned stocks which are currently out of favour - shares with a historically
low and even falling price.
For this reason, value investing needs a greater emphasis on the financial analysis of
balance sheets to find evidence of strong performance potential which the market as a
whole has not seen; whereas growth investing relies far more on qualitative judgments
about socio-economic and industry trends.
A growth portfolio will often tend to be more volatile across the short term than a value
portfolio - as it will comprise of shares with high public visibility which are frequently
traded. Value investing tends to steer investors away from popular sectors, so in the
short term it will tend to be 'flat' , without the highs and lows of the sectors and companies
which are the centre of investor attention, rapidly coming into and falling out of favour.
Value portfolios tend to do better in times when the market is not rising fast because
when the market is rising fast, by definition, a growth portfolio will do much better. But
when a market starts falling, a growth portfolio can crash heavily, leaving a value portfolio
as a more 'defensive' short-term performer. Over the longer term, of course, both
styles should outperform the market average.

I
 Special Issues GROWTH STOCK VALUE STOCK
,-'t...
p p

T T

• rising market price • stablelfalling price

• strong socio-economic trend • strong tinancials
• cheap at any price • cheap at current price

Small Cap vs Large Cap

Size of a company can be used as the basis for investing. Studies of stock returns have
suggested that "smaller is better." On average, the highest returns have come from
stocks with the lowest market capitalization. But since these returns tend to run in
cycles, there have been long periods when large-cap stocks have outperformed smaller
stocks". Small-cap stocks also have higher price volatility, which translates into higher •
risk. Some investors choose the middle ground and invest in mid-cap stocks, seeking a
tradeoff between volatility and return. In so doing, they give up the potential return of
small-cap stocks.

Bottom-up investing
In a bottom-up investing style, investors make investment decisions after a through
review of the company, which involves getting familiar with the company's products,
services, and its environment. Here the emphasizing is on the fundamental analysis.
Having completed a fundamental analysis for various companies, the investor goes about
selecting the right stock.

Top-down investing
In a top-down investment strategy, the analyst looks at the 'Big Picture' in the economy,
such as the geographies, the size, the environment, and then goes on to breaking these
components into minor details to finally identify superior segments for investing.

TOP DOWN APPROACH BOTTOM UP APPROACH

v - A
V ASSESSMENT OF A
V THE ECONOMY A
V A
V 1
./
A
V
V - _. A
A
V INDUSTRY/SECTOR A
V I ANALYSIS A
V A
V 1\
V A
V "A
V
V
V ~
~
SPECIFIC
".
COMPANIES
-. I~
Thematic style
I~ a thematic strategy, the investor identifies sectors that have prospects of achieving
high growth and then goes on to invest in companies that operate within these sectors.
These sectors could be industry segments or location wise segments.
10
Often portfolio manager advocates no particular view as many conventional notions are Investment Style and
defied such as: Trading Strategies

• Growth strategies are pessimistic and value strategies work better during economic
recession often it is the reverse that works.
• Low quality companies can never make good stock, or low beta stocks are better,
small caps stocks outperform may not always hold good.
So it is advisable to tilt the investment style as per market conditions and not get into a
habit of blindly following a particular style based on specific notions. One should propound
the belief on the basis of its consistent market research and objective inferences.

19.4 STYLE DETERMINANTS

The reasons for the ever evolving styles are many. However, in brief, it is the human
desire for classification that guides the development of investment styles. As we know
there are thousands of companies listed on the stock exchanges and therefore an investor
is confronted with a plethora of investment opportunities from which he has to choose.
An investor then identifies a theme for investment that appeals to him and if it satisfies
him by way of providing adequate forecasted returns, it gets established as an investment
style.
Investment consultants, marketing consultants and fund houses have helped in popularizing
various investment concepts and marketing themes. In the process they have coined
various catch words which have appealed to investors.
Academic research has also contributed to style creation where researchers have
expounded various investment theories supported with analysis and simulations on live
markets and these theories have caught the fancy of investment consultants and investors
alike and some have become conventional investment styles.
Correlations within asset classes sometimes by virtue of being in the same geographical
zone or same industry segment has created styles such as the 'emerging markets' or
the Technology sector as investment opportunity. Here the growth perception of these
segments creates the investment style. Endless numbers of possible style classifications
are available to an investor due to the various asset classifications. The challenge is to
identify growth and create an investment opportunity.
Some popular styles commonly employed by investors are explained as follows:

Value Investing
Also described as bargain hunting, it identifies cheap stocks that are out-of-favour, such
as cyclical stocks that are at the low end of their business cycle. A value investor is
primarily attracted by valuation measures like price-to-book value. Value stocks tend to
have lower price-to-earnings ratios and potentially higher dividend yields than the overall
market. In short, the value of the firm is derived from two sources, firstly from the
current investments (assets in place) and secondly, from expected future investments
(growth opportunities).
Ben Graham: Known as the father of value screening emphasized on quantitative
screening which stressed on passive investing, contrarian value investing and active
value investing. Graham's student Warren Buffet too used value screening but stressed
on qualitative factors, his tenets for qualitative screening stress on business model,
managements of companies, sound financials and the state of markets.

Investing for growth

This investment style focuses on stocks with excellent growth potential. Look for
companies that expect to increase earnings by over 15%. Growth investors are more
11

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Special Issues willing to pay a premium for higher returns and considered as risk seekers. Growth
investors buy into companies whose growth potential is being undervalued by the market.
They follow a strategy of buying companies with high growth, high PE, low PEG ratio.
They also have a liking for picking up stocks through initial public offerings (IPO's) and
from companies which have a small market capitalization (Small-cap). Peter Lyncy:
Occupies a prominent place as a votary of growth stocks.
T.Rowe Price: Has defined growth stocks as those which have demonstrated favourable
', e; underlying long term growth in earnings and which after a careful research give indications
of continued secular growth the future.

Deep Value Investing

As mentioned earlier some popular catch phrases help in establishing styles. Deep value
investing is a high risk strategy employs an approach characterized by holding the stocks
of companies with very low valuations. Some investors in this category are known for
taking an 'activist approach' to investing that will build value for the stock (such as
management changes) and structural changes (such as the spin-off of a subsidiary).High
risk can translate into high returns but in the final analysis it boils down to the risk
averseness of the investor.

Focus Investing
Focus investing is best described as the creation of a portfolio of a few stocks that are
likely to produce above average returns over a long haul, allocate the bulk of your
investments to this portfolio and hold steady during short term volatility. This school of
thought states, that diversification beyond ten or fifteen stocks only reduces the risk but
it increases the costs attached besides dilution of attention.
Tenets of focus investing can be put forth as:
• Find outstanding companies
• Understand the business
• Bet big on high probability events
• Be patient
• Do not panic over market volatility

Momentum Investing
Richard Driehaus is known as the father of momentum investing which is defined as
identifying and buying stocks in strong upward price move and staying with the investment
-. as long as the upward move continues.

Scientific style of Scott Sterling Johnston

Scott believes in early discovery by searching for companies which have a huge upside
potential. His investment criteria is a bottom-up stock picking with a focus on strong
industry segments and strongest stocks and then remain invested at all times. The logic
here is that strong companies would decline less in a bear market and come out of the
starting block faster during a rebound.

Examples from the Mutual fund Industry

Schemes according to Investment Objective
An investment scheme can also be classified as growth scheme, income scheme, or
balanced scheme considering its investment objective. Here are a few examples of
investment styles from fund houses. '
12
1) You could invest in a large cap, mid cap or small cap fund, select a growth or a Investment Style and
value fund. Or, you could choose the five-in-one Fidelity Equity Fund. The fund Trading Strategies
invests across cap sizes and in value and growth stocks as well. True to Fidelity's
tradition, we pick stocks 'bottom-up', basing our selection on first-hand, in-depth
research carried out by our unrivalled global team of investment professionals. As
a core investment, the Fidelity Equity Fund can add real quality to your portfolio.
2) Special situations are unusual circumstances that a company or its stock can face.
These could be turnaround stories, mergers or acquisitions, new products or new
business streams being launched or simply stocks that are out of favour. The list of
special situations can go on but the real challenge is identifying them. The fund
house in managing special situations' funds and the 'bottom-up' stock picking
approach underpinned by 360-degree research means we are ideally placed to
unearth and seize these hidden treasures.
Of the many kinds of special situations, some of them are:

Recovery situations Companies that are turning around from a bad performance
history
Unrecognised growth Companies whose growth characteristics have not yet been
recognized
Asset plays Companies which sell at a significant discount to their
underlying assets
New product or new Companies launching a unique product or using existing
business stream resources to generate a new business stream
Corporate actions Companies that are potential candidates for mergers and
acquisitions or restructuring
Out-of-favour stocks Unfashionable companies, which are fundamentally very strong

3) Sector specific schemes are the schemes which invest in the securities of only
those sectors or industries as specified in the offer documents. e.g., Pharmaceuticals,
Software, Fast Moving Consumer Goods (FMCG), Petroleum stocks, etc. The
returns in these funds are dependent on the performance of the respective sectors/
industries. While these funds may give higher returns, they are more risky compared
to diversified funds. Investors need to keep a watch on the performance of those
sectors/industries.
4) IncomelDebt Oriented Scheme, the aim of income funds is to provide regular and
steady income to investors. Such schemes generally invest in fixed income securities
such as bonds, corporate debentures, Government securities and money market
instruments. Such funds are less risky compared to equity schemes. These funds
are not affected because of fluctuations in equity markets. However, opportunities
of capital appreciation are also limited in such funds. The net asset values (NAVs)
of such funds are affected because of change in interest rates in the country. If the
interest rates fall, NAYs of such funds are likely to increase in the short run and
vice versa. However, long term investors may not bother about these fluctuations.
5) The aim of balanced funds is to provide both growth and regular income as such
schemes invest both in equities and fixed income securities in the proportion indicated
in their offer documents. These are appropriate for investors looking for moderate
growth. They generally invest 40-60% in equity and debt instruments. These funds
are also affected because of fluctuations in share prices in the stock markets.
However, NAVs of such funds are likely to be less volatile compared to pure
equity funds.

13

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Special Issues
I 19.5 TRADING STRATEGIES
As investing in financial markets can be dangerous it pays to understand the rules which
are listed below.
• Worry about the return of your money as well as the return on it.
• . Be disciplined in your decision making.
• Avoid all or nothing bets and maintain diversification.
• Exploit repeating phenomena.
• Take into consideration costs associated with investment and dis-investment
decisions.
• Distrust rumors and tall stories.
• Liquidity and near liquid positions must not be overlooked.
• Pay attention to preparation and execution.

Day Trading
Day trading is a trading strategy that involves constantly moving into and out of stocks.
Using technical analysis, professional day traders try to anticipate where a stock will go
in the near future and trade accordingly. Usually, day traders sell all their stocks and
move to cash by the end of each day. If you are an investor you should be looking at
what the investment is going to do but if you are a speculator then you are focusing on
the price of the object. You take a call based on your stand as either a speculator or an
investor.

Market Timing
This involues anticipating the market. For example, if you believe that the market will
rise in the following week, you will shift your money out of cash or bonds and into
stocks. The idea is to shift your money to the most profitable investment before it goes
up.

Short the Rallies

A very effective, but rather risky, trading strategy is to short the rallies. Instead of
buying more stock when the market falls (buying on the dip), you do the opposite. When
the market or your stock goes up a lot, you sell short (i.e., you sell the stock, then buy it
back at a lower price). Shorting the rallies is extremely risky, although it worked quite
well for several years. After all, stocks go down faster than they go up. Short positions
indicate that you have a sell position in the market that is open. You will sell or go short
only when you hold a perception that the prices will fall.

Long positions
Long positions indicate that you have a buy position in the forward market that is open.
You will buy or go long only when you hold a perception that the prices will rise. For
example if your perception, based on analysis, suggests that the stock will rise in the
following quarter than the trading strategy would be to go long or in other words buy
now and sell later, when the perception comes true.

Hedging
Hedging is taking a position in the derivatives market, a position that is opposite to the
exposure in the cash market. The objective behind this mechanism is to offset a loss in
one market with a gain in the other. On a stock exchange platform, you can buy or sell
stock futures and options. Some investment managers invest in derivatives instruments
14
as part of their strategy. Often mixed up with diversification, hedging is a part of price Investment Style and
r': ." management, where the net position does not change. Trading Strategies

Arbitrage
Arbitrage means locking in a profit by simultaneously entering into transactions in two
or more markets. If the prices are' different on two exchanges for the same stock, it
gives rise to arbitrage opportunities.
The factors affecting the trading strategy are listed below:

Objectives
The objective of trading will determine trading strategies. If the objectives involve frequent
rotating of portfolio then the trading strategy will differ from, say, a growth based strategy
where changes in the trading decisions will be infrequent in comparison.

Quantum of risk
Risk is an omnipresent factor and frequent trading will take on a greater incidence of
risk. Trading strategies will need to factor in this risk by providing trading guidelines
which would set limits on volumes, price, scrips and financial instruments to be used.

Exchange membership

The fund manager will be limited by the accessibility to different exchange platforms
and access to broking firms. The management must have in place all the infrastructure
to facilitate the trades that the fund manager has in mind or else the fund manager might
have to design strategies to circumvent this problem.

Familiarity with financial instruments

Trading strategies will be limited by the level of knowledge that exists regarding the
instruments. For example while dealing in derivative instruments the type of knowledge
and experience ~ill be high quality.

Volatility of markets situation

Trading strategies will differ in volatile markets, here the risks involved are very high
and trading decisions are usually split second decisions with very little time for detailed
discussions and meetings. The trader is usually under tremendous stress and all options
need to be considered well in advance.

Role of Fundamental and Technical Analysis

Trading strategies give importance to both fundamental and technical analysis. As far
as fundamental analysis is concerned, the style or strategy chosen, decides upon the
dependence of this analysis. For example, in a bottom-up analysis understanding the
company and its worth is critical. Do note that the dependence on fundamental analysis
varies from strategy to strategy however when it comes to trading strategies it is the
technical analysis that assumes importance as the actual implementation or execution of
the buy-sell decision is better delivered through a technical analysis.
So what is this fundamental analysis? As discussed in Block 4, fundamental analysis
pertains to valuing the intrinsic worth of a stock, i.e.: focusing on the proper price a
stock is likely to command in the long run, Analyzing a stock requires an examination of
economic, financial and other qualitative and quantitative micro and macro factors. Once
a value is identified, it becomes a benchmark for an investor.

15
.•...
,
Special Issues There is a simple rule, if the value is below the stock's current price, short or sell it and
if its value is above its current price, it means the stock is undervalued, so buy it to gain
from its future price rise. An investors' task is to create a picture of the company's
current state and evaluate its stock value thus know whether it is currently over- or
under-valued.
This approach implies that the investor is ready with the true valuation before the market
reacts one way or other. Fundamental investing is a long-term approach the investor
focusing on a particular stock needs to apprise him of broad factors such as the industries
past performance and the expectations. for its future and its products market trends. In
addition, corporate specific factors such as financial performance in the preceding five
years, corporate management policies, cash flow, dividend payouts, return on assets,
history of profit retention for funding future growth and soundness of capital management
for the maximizing of shareholder earnings and returns. Alongside dividend yield are
book value and price/earnings ratio. In conclusion, it can be stated that fundamental
analysis cannot be overlooked and has an extremely important role to play in investment
strategy.
Here is a list of factors, fundamental analysis will consider:
• Dividend payments -past and present
• Price to earnings ratio (PIE)
• Market to Book value
• Stability of earnings
• Product Quality and range
• Quality of management
• Growth rates
So what is technical analysis? Technical analysis is a complicated sounding name for
a very basic approach to investing. Simply put, technical analysis is the study of prices,
with charts being the primary tool. In one word technical analysis = charts. The idea is
that a person can look at historical price movements and based on the price can determine
at some level where the price will go. By looking at the charts with historic prices you
can identify trends and patterns which can help you find good trading opportunities.
The most important thing you will learn in technical analysis is the trend, hence the
saying' trend is your friend'. The reason is that you are much more likely to make
money when you find a trend and trade with the trend. Technical analysis can help in
identifying these trends in its earliest stages and therefore provide you with profitable
trading opportunities.
The roots of modern-day technical analysis stem from the Dow Theory developed around
1900 by Charles Dow. Stemming either directly or indirectly from the Dow Theory,
these roots include such principles as the trending nature of prices, prices discounting all
known information, confirmation and divergence, volume mirroring changes in price,
and support/resistance.
So what type of analysis is better? There will be those who will say that fundamentals
alone drive the market and any patterns that the charts depict are only a coincidence.
On the other hand there are those who argue that it is the technical's that traders pay
attention to and find value through predicting future price movements.
In conclusion, trading strategists need to know how to effectively use both types of
analysis.
Steps to building a Growth Portfolio:
1) The Basic screening: Portfolio managers and analysts must begin by screening
hundreds of companies whose stock prices are growing faster than the overall
economy.
16
2) Industry screening: Preliminary quantitative analysis ensures sound financial Investment Style and
standing and this should be backed up with a qualitative analysis focusing on Trading Strategies
companies with competitive positions, diverse sales markets and customer bases
with strong growth potential and innovative corporate cultures.

3) Detailed financial modeling: Portfolio managers and analysts then should make
three to five-year projections on income statement, balance sheet and cash flow
and then do a rigorous analysis of growth opportunity and risk using simulation, risk
management and scenario analysis.

4) The buy recommendation: Based on the analysis a few stocks may then be
selected which meet growth criteria and these can then be included in a portfolio
of other high potential growth stocks. Steps to building a Value portfolio are as
follows:
a) Bargain identification: Identify companies whose stock looks under-valued
compared to their earnings expectations and industry competitors.
This identification is the outcome of a basic screening.

b) Only the cheapest make it through: The lowest undervalued say 30% of
roughly 800 stocks will be advance to this stage and then the companies are
subject to a balance sheet scrutiny. Based on the results a few probable's will
get identified and they will be further scrutinized by a special team at the next
step.

c) Team approach: Senior fund managers will approves the stock under
consideration and give the go ahead to the implementation! investment team
who will then commence buying.

d) Review and assessment: The stock selected is reviewed frequently by the

investment team, subject to new analysis and news. Any fundamental change
in the company's outlook then fresh look at the investments is taken.
Thus, we have analyzed the different styles of investment and the philosophy propounded
by some of the leading investors in the world.

19.6 SUMMARY
Investment philosophy postulates investors' premise on the market behaviour. Investor's
investment philosophy is also decided by a number of behavioural traits he possesses.
Investment selection and decisions are generally then emanates out of this philosophy.
Particularly, investment style and trading strategy arise out of the confidence in the
market the investor has and his belief on market behaviour.
There are many successful investors who have relied on two totally opposite premise -
technical analysis and fundamental analysis - value lies in the projected cashflows of
the company. Some of them would like to trade on the basis of appropriate mix of the
two approaches. There are various popular styles of investment. This includes contrarian
investor, momentum investors, value investor, growth investors, active and passive
investors.
Warren Buffet stands out as one of the richest person in the world. He has propounded
the theory of fundamental investing or technical analysis, etc. Richard Dreihaus has
advocated momentum strategies while Graham Ben liked quantitative approach to screen
the companies for value investing. Some of this style is also reflected on investment
objectives and management of specific funds with specific style. Trading strategies
guide the investors about entering in and exiting out of the markets. This include at one
I7
Special Issues extreme hedging depending on the exposure to hedge and on the other hand intraday or
day trading where in investors tries to move frequently in and out of the market during
the day. Whatever be the philosophy,' style or trading strategies, one needs to have
common sense and ability to understand the trend in the market. One is required to do a
lot of hard work in screening out the company as well as look at them objectively
without much of behavioral biases.

19.7' SELF ASSESSMENT QUESTIONS

1) Why should one develop an investment philosophy?
2) What is investment style and what it indicates?
3) How trading strategies differ from investment style?
4) Describe five popular investment styles?
5) What are the different strategies one may adopt while investing in the stock market?
6) What is a thematic strategy?
7) What is a momentum strategy?
8) What role does technical analysis play in trading strategies?
9) Explain the process of Value investing and Growth investing.
10) What kinds of investment styles reflect on the basis of products offered by fund
houses?

19.8 FURTHER READINGS

1) Aswath Damodaran, 2003, Investment Philosophies: Successful Investment
Philosophies and the Greatest Investors who made them work, John Wiley &
Sons, Hoboken, New Jersey.
2) R. G. Hagstrom, 1999, Warren Buffet Portfolio, John Wiley & Sons, Hoboken,
New Jersey.
3) Richard Bernstein, 1995, Style investing, Unique Insight into Equity
Management, (Frontiers in Finance Series), Wiley, John & Sons.
4) Richard Phalon, 2001, Great Investing Stories, John Wiley & Sons, Hoboken,
New Jersey.
5) Charles Babin & William Donovan, 1999, Investing Secrets of the Masters,
McGraw Hill Publications.

j
18
. ~
UNIT 20 PORTFOLIO MANAGEMENT
Objectives

After studying this unit, you would be able to:

• understand the concept and relationship among risk, return and diversification;
• understand the conceptual framework of portfolio management and measurement
of risk;
• explain the difference between security and portfolio analysis;
• analyze various asset pricing models; and
• describe responsibilities of portfolio manager.

Structure
20.1 Introduction
20.2 Risk, Return and Diversification
20.3 Portfolio Analysis
20.4 Asset Pricing Models
20.5 Steps in Portfolio Management
20.6 Diversification and Portfolio Risk
20.7 Fiduciary Responsibilities of a Portfolio Manager
20.8 Summary
20.9 Self Assessment Questions
20.10 Further Readings

20.1 INTRODUCTION
Determining an efficient mix of assets to hold in a portfolio is referred to as portfolio
management. A fundamental aspect of portfolio management is choosing assets which
are consistent with the portfolio holder's investment objectives and risk tolerance. The
purpose of portfolio management is to achieve the optimum return for a given level of
risk. Fund managers need to strike an effective trade off between risk and return in
making portfolio management decisions.
One of the major advances in the investment field during the past few decades has been
the recognition that the creation of an optimum investment portfolio is not simply a
matter of combining numerous securities. Specifically, it has been shown that an investor
must consider the relationship among the investments to build an optimum portfolio that
will meet investment objectives.
Portfolio composition has not only become mix of asset classes but also a mix of assets
from developed and developing markets. Besides, a portfolio manager who is in charge
of these investments holds them in fiduciary capacity for the benefit of the investor or a
group of investors.
Portfolio management provides a structured method for managing investments. If an
investor was to go it alone, that is invest without any structured and professional method
then the pit falls are many. Let us look at some of them:

19

1
Special Issues While managing a portfolio, an investor spreads the invested amount of money among
different investments in order to reduce the risk of loss from a decline in the investments.
Its goal is to reduce overall risk in a portfolio. When diversification is properly applied,
then it is expected that volatility is optimized. The act of diversification reduces a portfolio's
swings as well as both upside arid down side potential, thus allowing for more consistent
performance under a wide range of economic conditions. There is a human tendency to
invest in industry segments, geographies and companies we are familiar with. This reduces
the chance of optimization.
Efficient Market Hypothesis (EMH) is the subject of debate among academics and
financial professionals. The Efficient Market Hypothesis states that at any given time,
security prices fully reflect all available information. The implications of the efficient
market hypothesis are profound. Most individuals that buy and sell securities (stocks in
particular), do so under the assumption that the securities they are buying are worth
more than the price that they are paying, while securities that they are selling are worth
less than the selling price. But if markets are efficient and current prices fully reflect all
information, then buying and selling securities in an attempt to outperform the market
will effectively be a game of chance rather than skill.
The Efficient Market Hypothesis evolved in the 1960s contributed by Eugenq Fama.
Fama persuasively made the argument that in an active market that includes many well-
informed and intelligent investors, securities will be appropriately priced and reflect all
available information. If a market is efficient, no information or analysis can be expected
to result in outperformance of an appropriate benchmark.
There are three forms of the efficient market hypothesis:
1) The "Weak" form asserts that all past market prices and data are fully reflected
in securities prices.
2) The "Semi strong" form asserts that all publicly available information is fully
reflected in securities prices.
3) The "Strong" form asserts that all information (public and private) is fully reflected
in securities prices.
Securities markets are flooded with thousands of intelligent, well-paid, and well-educated
investors seeking under and over-valued securities to buy and sell. More the participants
and the faster the dissemination of information, the more efficient a market would be,
• The paradox of efficient markets is that if every investor believes that the market
was efficient, then the market would not be efficient because no one would analyze
securities. In effect, efficient markets depend on market participants who believe 1I
that the market is inefficient and trade securities in an attempt to outperform the
market.
• If markets are efficient, the serious question for investment professionals is what
role can they play and be compensated for.
• The primary role of a portfolio manager consists of analyzing and investing
appropriately based on an investor's tax considerations and risk profile. Optimal
portfolios will vary according to factors such as age, tax bracket, risk aversion, and
employment. The role of the portfolio manager in an efficient market is to tailor a
portfolio to those needs, rather than to beat the market.

20.2 RISK, RETURN AND DIVERSIFICATION

Return and Risk of a single asset
The rate of return on an asset/investment for a given period, for example, one year is
the annual income received plus the change in market price of the asset/investment.
20 Symbolically, the one period return(R) will be as below:
 Portfolio Management
R= D+(P, -P'-I)
P'-I
/
Where,
D= Income/ Dividend received during the holding period
Pt = Price of the asset/security at time period t.
pt.I=Price of the asset/security at time period t- L

Activity 1
If price of Reliance share (on I" April 2009 was Rs.1313.95/-, the annual dividend
received at the end of the year is Rs.l3, and the year end price on 3pt March, 2010 is
Rs. 2265.8/- then calculate the annual rate of return. •

Risk
. The variability of the actual return from the expected return associate with a given
asset/security is known as risk. The higher the variability the higher is the risk and vice
versa.

Measurement of risk
Risk associated with a single asset can be measured by using behavioural and quantitative/
statistical point of view. The behavioural view of risk can be calculated by using: (i)
Sensitive analysis, and (ii) Probability distribution. The statistical measures of risk are:
(i) Standard deviation, and (ii) Coefficient of variation.

i) Behavioural Risk
a) Sensitivity Analysis: The level of outcome may be related to the state of the
economy, namely, recession, normal and boom conditions. The difference between the
optimistic and pessimistic outcome is the range which, according to sensitive analysis is
the basic measure of risk.
b) Probability Distribution: Risk associated with an asset can be more accurately
measures by using probability distribution. If the expectation of a given outcome will
occur six out of ten times, it can be said to have a sixty per cent chance (0.60) of
happening. Similarly if an outcome is certain to happen, the probability is 100 per cent
(1) and if a outcome will never occur, the probability is zero.
Based on the probability to the rate of returns the expected rate of return is weighted
average of all possible returns multiplied by their expected return ..
Symbolically,
n
R= £...
~ RxP f n
;-1

Where,
R = Return for the ithpossible outcome
j

P=n Probability associated with its return

n= Number of outcome considered.
21
Special Issues The following table shows expected rate (\~ ""''1S (probability distribution) of an asset
"X".

Possible Outcomes Returns (%) Probability Expected Returns

(1) (2) r(
(%) 1)*(2)}

Pessimistic (Recession) 13 0.20 2.6

Most likely (Normal) 14 oeo 8.4
Optimistic (Boom) 18 0.20 3.6

Total = 1 LA X P,.;= 14.6

i-I

ii) Statistical Risk

a) Standard deviation: Risk refers to the dispersion of return from the mean return
(expected return). The most common statistical measure of risk is standard deviation
from the mean/expected return. It represents the square root of the average squared
deviation of the individual returns from the expected returns. The greater the standard
deviation the higher is the dispersion of return and greater the risk of the investment.
However, standard deviation is an absolute measure of risk and does not consider
variability of return in relation to expected values. It may be misleading in comparing the
risk of two alternative assets if they differ in size of expected return.
Symbolically, the standard deviation is denoted as:

a = L(RI - R)2 X P'i

i-I

The following table presents the calculation of standard deviation for monthly returns of
the script Reliance.

Possible Outcomes RJ%) R R (%) R;- R (R;- RY Pn (R( R Y*Pr;

i Pessimistic (Recession) (-3.53) 1.77 (-5.3) 28.09 0.2 5.618

! Mmt likely (Normal) 4.2 1.77 2.43 5.9049 0.6 3.54294
.. I +--
,
Optimistic (Bou:.;; i 4.1:>4 : 1.77 2.87 8.2369 0.2 1.64738
I

~~(RI-R/XP,.; = .)10.80832 =3.287601 percent. Total = 10.80832

b) Coefficient of variation: This is the measure of risk per unit of expected return
which converts standard deviation of expected returns to relative values to enable
comparison of risks associated with assets having different expected returns. The
coefficient of variation is computed by dividing the standard deviation ( 0') by the mean
return (R).
Symbolically,
0'
C,.==
R
The coefficient of variation of Reliance script is (3.287601/1.77)= 1.86

Return 'and Risk of Portfolio

The portfolio expected return is equal to the weighted average expected return off all
22 assets in the portfolio. The weight, which sum up to I, reflects the fraction of total
portfolio invested in each asset. Therefore, there are two determinants of portfolio return. Portfolio Management
They are
i) ~xpected rate of return on each asset in the portfolio, and
ii) The relative share of each asset in the portfolio.
Symbolically the expected return fOTan-asset portfolio is:

11

E(rp) = 2,W; xE(rJ

;=1

Where,
E(r p)= Expected return on portfolio.
Wj= Proportion invested in asset i.
E(r)= Expected return for asset i.
n= Number of asset in the portfolio.

Example: Suppose the expected yearly return on two stocks, Reliance and Infosys are
39 and 45 per cent respectively. If the corresponding weights are 0.55 and 0.45, the
expected return on the portfolio is = [(0.55*0.39) + (0.45*0.45)] = 0.417 or .41.7%

Activity 2
Suppose expected returns on three stocks are 14, 17 and 12 per cent respectively. If the
corresponding weights are 0.22, 0.32 and 0.46 then what will be the portfolio expected
return?

Portfolio Risk
Two basic concept in statistics, covariance and correlation, must be understood before
we discuss the variance of rate of return of a portfolio.

Covariance
For two random variables x and y having means E{x} and E{y}, the covariance is
defined as:
Cov (x,y) = E{ l x - E(x) l[ y - E(y)]}
The covariance calculation begins with pairs of x and y, takes their differences from
their mean values and multiplies these differences together. For instance, if for XI and YI
this product is positive, for that pair of data points the values of x and y have varied
together in the same direction from their means. If the product is negative, they have
varied in opposite directions. The larger the magnitude of the product, the stronger the
strength of the relationship. The covariance is defined as the mean value of this product,
calculated using each pair of data points Xj and yj' If the covariance is zero, then the
cases in which the product was positive were offset by those in which it was negative,
and there is no linear relationship between the two random variables.
23
Special Issues Because the number representing covariance depends on the units of the data, it is
difficult to compare covariance among data sets having different scales. A value that
might represent a strong linear relationship for one data set might represent a very weak
one in another. The correlation coefficient addresses this issue by normalizing the
covariance to the product of the standard deviations of the variables, creating a
dimensionless quantity that facilitates the comparison of different data sets.

. Correlation coefficient
The correlation coefficient P xy between two random variables X and Y with expected
values Il'x and 11yand standard deviations a x and a y is defined as:

p = Cov~, y)
xy a x ay
Where,
Cov(x,y) = Covariance of x and y.
a x and ay = Standard deviation of x and y.
The correlation is defined only if both of the standard deviations are finite and both of
them are nonzero. The correlation is 1 in the case of an increasing linear relationship,
- 1 in the case of a decreasing linear relationship, and some value in between in all other
cases, indicating the degree of linear dependence between the variables. The closer the
coefficient is to either -1 or 1,the stronger the correlation between the variables. If the
variables are independent then the correlation is zero
Example: The standard 7000 ...,--------------
deviation of returns on Nifty 6000 -1--====--- __::::------
and the standard deviation 5000 +---------~~~=~ ....
4000 +-------------
of returns on Reliance for
the month of January 3000
2000 -t:::==::==:::s~===
+ -Reliance

2008 is 0.034 and 0.041 1000 +------------- -Nifty

respectively the covariance

O+---..-----.....----r----..-
of Nifty and Reliance
return is 0.00121. So the
correlation coefficient is
0.00121 (0.034*0.041)=0.87

Portfolio variance
Now that we have discussed the concept of covariance and correlation, we can consider
the formula for computing the variance of return for a portfolio of assets, our measure
of risk for a portfolio. As we have calculated the expected return of the portfolio that is
the weighted average return of each individual asset in the portfolio. One might assume
it is possible to derive the variance of the portfolio in the same manner, which is by
computing the weighted average of variance for the individual assets. This would be a
mistake. Markowitz (1959) derived the general formula for the variance of the portfolio
as follows:
a! = LW/a; + 2 LLW;wp;O'/~j
j j

Where,
a p2 =Variance of the portfolio
Wi,Wj=The weights of an individual asset in the portfolio
a 2= The variance of rate of return for asset i
1

P=
lJ
The covariance between the rates of return of asset i and J'.
24
,.- .. '

Portfolio Management
20.3 PORTFOLIO ANALYSIS
When a portfolio manager is evaluating two or more portfolios, he can combine securities
in a portfolio in a number of ways by simply changing the proportions of the funds
allocated to them.

Portfolio Proportion A Proportion B Expected return Standard Deviation

1 100% 0% 12% 20%

2 900/0 10% 12.80% 17.6%
3 75.9% 24.1% 13.9% 17.6%
4 50% 50% 16% 20.50%
5 25% 75% 18% 29.40%

When the expected returns and the standard deviation are plotted graphically it ends up
in a hyperbola and the line along the upper edge of this region is known as the efficient
frontier (sometimes "the Markowitz frontier").

Hnc ient Froatier

•
••

risk free rate

1
Best possible CAL

In example portfolio 3 represents the minimum variance portfolio (MVP). It is the MVP
because the X axis represents the standard deviation. No investor would like to invest in
a portfolio whose expected returns are less than the MVP. In other words, portfolios 1&
2 will not be invested in however they will consider portfolios 3 to 4. Please note that all
points lying on the efficiency frontier curve provide the same level of satisfaction.
Markowitz portfolio analysis gives as output an efficient frontier on which each portfolio
is the highest return earning portfolio for a specified level of risk. It basically calculates
the standard deviation and return for each of the feasible portfolios and identifies the
efficient frontier, the boundary of the feasible portfolios of increasing returns. The portfolio
managers arrive at the risk level that suits their investors, If the investor specifies his
risk level in terms of standard deviation of the portfolio return, the appropriate portfolio
for him can be identified using the efficient frontier. Hence the final portfolio selection
for an investor requires the combination of portfolio analysis and fmancial planning.
For performing the portfolio analysis using the Markowitz method we need:
• Expected return for the period of holding for each of the securities to be considered
for inclusion in the portfolio.
• Standard deviation of the return for each security.
• Covariance (or correlation coefficient) between each pair of securities among all
securities from which we have to form the portfolio.
Creating an efficient frontier from historical or forecast statistics about asset returns is
inherently uncertain due to errors in statistical inputs. This uncertainty is minor when
compared to the problem of projecting investor preferences into mean-standard deviation
,25

I
Special Issues space. Economists know relatively little about human preferences, especially when they
are confined to a single-period model. We know people prefer more to less, and we
know most people avoid risk when they are not compensated for holding it. Beyond that
is guess-work. We don't even know if they are consistent, through time, in their choices.
The theoretical approach to the portfolio selection problem relies upon specifying a
utility function for the investor, using that to identify indifference curves, and then finding
the highest attainable utility level in the feasible set. This turns out to be a tangency point.

20.4 ASSET PRICING MODELS

In this section, we shall discuss the Capital Asset Pricing Model and Arbitrage Pricing
Theory.

Capital Asset Pricing Model

Assumptions of CAPM
All investors:
1) Aim to maximize economic utility.
2) Are rational and risk-averse.
3) Are price takers, i.e., they cannot influence prices.
4) Can lend and borrow unlimited under the risk free rate of interest.
5) Trade without transaction or taxation costs.
6) Deal with securities that are all highly divisible into small parcels.
7) Assume all information is at the same time available to all investors.
8) Perfect Competitive Markets.

Systematic and unsystematic risk

The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and
unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic
risk refers to the risk common to all securities - i.e., market risk. Unsystematic risk is
the risk associated with individual assets. Un systematic risk can be diversified away to
smaller levels by including a greater number of assets in the portfolio (specific risks
"average out"). The same is not possible for systematic risk within one market. Depending
on the market, a portfolio of approximately 30-40 securities in developed markets will
render the portfolio sufficiently diversified such that risk exposure is limited to systematic
risk only. In developing markets a larger number is required, due to the higher asset
volatilities.
A rational investor should not take on any diversifiable risk, as only non-diversifiable
risks are rewarded within the scope of this model. Therefore, the required return on an
asset, i.e., the return that compensates for risk taken, must be linked to its riskiness in a
portfolio context i.e., its contribution to overall portfolio riskiness - as opposed to its
"stand alone riskiness." In the CAPM context, portfolio risk is represented by higher
variance i.e., less predictability. In other words the beta of, the portfolio is the defining
factor in rewarding the systematic exposure taken by an investor.

Portfolio Variance I
Script Name Variance (Equally Weighted Portfolio) I
I

TCS TCS+SBI TCS+SBI+RELIANCE I

TCS 0.002544 0.002544 0.00101679 0'(xx)429 j

SRI 0.000513 l
Reliance 0.000428
.26
I
, .
',
!
~
 In the above table we can see that as we keep adding new stocks to our portfolio the Portfolio Management
portfolio variance (risk) is decreasing.
~alculation of rate of return according to CAPM
The model was introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John
Lintner (1965 a,b) and Jan Mossin (1966) independently, building on the earlier work of
Harry Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz
and Merton Miller jointly received the Nobel Memorial Prize in Economics for this
contribution to the field of financial economics.
In finance, the capital asset pricing model (CAPM) is used to determine a theoretically
appropriate required rate of return of an asset, if that asset is to be added to an already
well-diversified portfolio, given that assets non-diversifiable risk. The model takes into
account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or
market risk), often represented by the quantity beta (a) in the financial industry, as well
as the expected return of the market and the expected return of a theoretical risk-free
asset. The required rate of return according to CAPM is as follows:
E (R) = R+f ~ (Rm-Rf)
Where,
E(R) 1
= Expected rate of return on the capital asset.
•

R, = Risk free rate of return.

~ = (the beta coefficient) is the sensitivity of the expected asset

A Cov(R, R )
returns to expected market returns, or also p = Var(Rm)m

R m = Market return.

Beta calculation:
Date Reliance Nifty Reliance Returns Nifty Returns

01-Sep-09 1980.85 4625.35

02-Sep-09 1971.15 4608.35 -0.004908917 -0.00368217
03-Sep-09 1930.8 4593.55 . -0.020682704 -0.00321673
04-Sep-09 1981.15 4680.4 0.025743059 0.01873043
07-Sep-09 2002.85 4782.9 0.010893682 0.02166348
08-Sep-09 2075.6 4805.25 0.035679102 0.00466201
09-Sep-09 2168.45 4814.25 0.043762358 0.0018712
10-Sep-09 2147.45 4819.4 -0.009731535 0.00106917
11-Sep-09 2140.85 4829.55 -0.003078145 0.00210386
14-Sep-09 2139.5 4808.6 -O'(XXl63079 -0.00434731
15-Sep-09 2180.9 4892.1 0.019165479 0.01721568
16-Sep-09 2184 4958.4 0.001420422 0.01346145 ,
17-Sep-09 2086.15 4965.55 -0.045837796 0.00144096
18-Sep-09 2102.55 4976.05 0.007830632 0.00211234
22-Sep-09 2097.95 5020.2 -0.002190216 0.00883337
23-Sep-09 2101.7 4969.95 0.001785864 -0.01005999
24-Sep-09 2100.95 4986.55 -0.(0)356918 0.00333451
~ = Covar ( Reliance Return, Nifty Return) / var (Nifty Return) = 0.78812551
Note 1: The expected market rate of return is usually estimated by measuring the Geometric
Average of the historical returns on a market portfolio (i.e., S&P 500).
Note 2: The risk free rate of return used for determining the risk premium is usually the arithmetic
average of historical risk free rates of return and not the current risk free rate of return.
27
 ,

Special Issues Arbitrage Pricing Theory

The theory was initiated by the economist Stephen Ross in 1976.Arbitrage pricing theory
(APT), in finance, is a general theory of asset pricing that has become influential in the
pricing of stocks.
APT holds that the expected return of a financial asset can be modeled as a linear
function of various macro-economic factors or theoretical market indices, where
sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
The model-derived rate of return will then be used to price the asset correctly - the
asset price should equal the expected end of period price discounted at the rate implied
by model. If the price diverges, arbitrage should bring it back into line. Risky asset
returns are said to follow a factor structure if they can be expressed as:
- -
E(R)=Rf +Pjl (rfl-rf)+Pj2 (rJ2 -rf)+",+Pjk v» -rf)
Where,
E(R) = Return on risky asset
R, = Risk free return.
Rfl,Rf2: ••••••• Rfk=Expected return to factor 1,2,3 .... ,K.
PjI' j2' Pjk=Sensitivity of an asset to factor 1,2,3, K.

Example: Suppose the risk free return is 12 per cent and market portfolios expected
return (rm) is 18 per cent. Assume further that beta coefficient for security j are P1=1.3
(in relation to market portfolio) P2=0.3 (in relation to growth rate of GDP) P3=0.2
(in relation to inflation). The expected growth rate in GDP is 6 per cent and inflation is
5 per cent.
Then the return on security j = 12% + 1.3(17%-12%) +0.3(6%-12%) +0.2(5%-5%)
=16.7%

20.5 STEPS IN PORTFOLIO MANAGEMENT

The investment process consists of five steps as given in the diagram below.

• Set investment policy ]

• Perform security analysis
• Construct a portfolio
• Revise the portfolio
l
)
• Evaluate the performance of the portfolio.

Investment policy
The initial step, setting investment policy, involves determining the investor's objective
and the amount of his/her investable wealth. Because there is a positive relationship
between risk and return for sensible investment strategies, it is not appropriate for an
investor to say his or her objective is to "make a lot of money". What is appropriate for
an investor in this situation is to state that the objective is to attempt to make a lot of
28
money while recognising that.there is some chance that large losses may be incurred. Portfolio Management
Investment objective should be stated in terms of both risk and return. This step in
investment process concludes with the identification of the potential category of financial
assets for inclusion in the portfolio.

Security analysis
This is basically a search for securities for inclusion in a portfolio and the portfolio
manager can employ various tools. While picking equity scripts, a portfolio manager my
employ technical or fundamental analysis. The process is a continuous one where the
analysts are constantly valuing scripts. However, in case of debt instruments such as
bonds, the decisions are based on mainly four factors, yields to maturity, liquidity, tax
concessions linked to the debt instrument, and risk associated with the issuer of the
instrument. Stock screening is necessary to reduce the huge number of potential
investments opportunities to a smaller number for deeper investigation. The lack of time
for decision making is the primary reason why screening is such an important part of the
portfolio management process. Price to earnings ratios, the dividend yield ratios and
other similar ratios are commonly used as screening criteria.

Portfolio construction
The third step in the investment process, portfolio construction, involves identifying those
specific assets in which to invest, as well as determining the proportion of the investor's
wealth to put into each one. Here the issues of selectivity, timing, and diversification
need to be addressed by the investor. Selectivity, also known as micro- forecasting,
refers to security analysis and thus focuses on forecasting price movement of individual
security. Timing also known as macroforecasting, involves the forecasting of price
movement of common stocks in general relative to fixed income securities, such as
corporate bond and treasury bills. Diversification involves constructing the investor
portfolio in such a manner that risk is minimised, subject to certain restrictions.

Portfolio revision
The fourth step in the investment process portfolio revision, concerns the periodic repetition
of the previous three steps, i.e., over time the investor may change his/her investment
objectives, which, in turn, may cause the currently held portfolio to be less than optimal.
Perhaps the investor should form a new portfolio by selling some securities that are
currently held and purchasing certain other securities. Another motivation for portfolio
revision is that over time the price of securities change, meaning that some securities
that initially were not attractive may become attractive and others that were attractive
at one time may no longer be so. Thus, the investor may want to add the former to his or
her portfolio, while simultaneously deleting the latter such a decision will depend upon,
among other things, the size of the transaction, costs incurred in making such changes
and the magnitude of the perceived improvement in the investment outlook for the revised
portfolio.

Portfolio performance evaluation

The fifth step in investment process, portfolio performance evaluation, involves
determining periodically how the portfolio performed, in terms of not only the return
earned but also the risk experienced by the investor. Thus, appropriate measures of
return and risk as well as relevant standards (benchmarks) are needed.
The commonly used performance measures are:
1) Rate of Return (ROI),
2) Risk measures 'Beta',
29

I
 ---- ~ --------------------;

Special Issues 3) Treynor measure & Sharpe measures which considers both risk and return.

Dividend and Interest + Capital Gain

ROI = Initial Value

Yeqr Market Dividend & Rate of Return

Value of Interest
Portfolio

0 . Rs.l00,OOO

1‫סס‬oo + (105000 -10‫סס‬00)

1. Rs.105,000 Rs.lO,OOO 105%
1<XXXX>
1‫סס‬oo + (95000 -105000)
2 Rs.95,000 Rs.lO,OOO 0%
105000
1‫סס‬oo + (12‫סס‬00 -95000)
3. Rs.120,000 Rs.1O,OOO 36.8%
95(0)

Excess return on a Portfolio (p)

Treynor Ratio =
Beta of a Portfolio (p)

Excess return on a Portfolio (p)

Sharpe Ratio =
Standard deviation of return of portfolio p

Application

Detail Fund A FundB

Mean 17.1 14.5
Standard Deviation 28.1 19.7
Beta 1.2 0.92

Initial investment 8.6

Fund A Fund B
17.1- 8.6 14.5- 8.6
Treynor Ratio: = =
1.2 0.92
= 7.1 = 6.4
Note:Treynors ratio reflects the excess returns earned per unit of risk. This ratio assumes
that the portfolio is a well diversified portfolio and therefore uses beta for risk.

17.1- 8.6 14.5 - 8.6

Sharpe Ratio: = =
1.2 0.92

= 0.302 = 0.299

Note: Sharpe ratio reflects the excess return earned on a portfolio per unit of its total
risk. Total risk is reflected by the standard deviation.

20.6 DIVERSIFICATION AND PORTFOLIO RISK

It's a portfolio strategy in which investor spread his 'money around among different
investments in order to reduce the risk of loss from a decline in the investments. Its goal
30

1
is to reduce the risk in a portfolio. When diversification is properly applied, then it is Portfolio Management
expected that volatility or fluctuations in portfolio value become subdued and limited.
The act of diversification reduces a portfolio's swings as well as both upside and downside
potential, thus allowing for more consistent performance under a wide range of economic
conditions.

1.0

0.75

Risk
(Standard
Deviation) 0.50

0.25

No Of securities 10 20 30

Figure 20.1: Portfolio Diversification

Portfolio diversification usually involves diversification through

a) Investment through assets classes
b) Investment through various industries
c) Investment in various geographies
The risk in investments is varied by applying portfolio diversification in the different
vehicles of investment. For example investment in mutual funds are diversified to funds
that use different strategies (Examples of such are growth funds, balanced funds, index
funds, small cap, and large cap funds)
In the equity market, the diversification is achieved by investing in various industries.
For example, instead of putting all invest mcnts in a certain property stock, the investments
are spread out in other industries (such as holdings, financials etc.)
Another way of diversification is by way of diversifying geographically. In this case
investments will be distributed in industrialized nations, emerging economies, among
others to maximize the rate of return.

Different Diversification Strategies

Diversify across asset classes: The most common way to diversify is according to
asset classes. When investors employ an asset allocation strategy, they are controlling
the level of risk that the money is exposed to since funds are spread around across
different forms of equities, bonds, cash and hard assets. Some of the common asset
classes include: equities, government bonds, corporate bonds, cash equivalents, real
estate, currencies, gold etc.

31
Special Issues

Diversify across asset class variants: Within each asset class, investor can practice
further diversification. For instance, equities have many representations in the mutual
fund world. Variants or subclasses also have varying characteristics .. Here are some
examples of the sources of diversification. Returns on equity may vary according to:
1) The size of companies represented in a "basket" (e.g., large vs medium vs small
cap stocks).
2) The way the stocks' prices move as the stocks chart their growth (e.g., growth vs
value stocks).
3) The geographical market in which the stock moves (e.g., domestic vs international).

Bonds can vary according to

1) Their maturity dates (e.g., short term vs long term bonds).
2) Their level of risk (e.g., junk bonds).
3) Who issues the bond (e.g., government vs corporate).
4) How they payout.

Diversify across industries and sectors: If an investor is interested in following a

particular sector or industry but do not want to put all investments into one company's
stock, he can buy sector stocks that specialize in a specific industry or stock group, such
as financial stocks, gaming stocks, internet stocks, semi-conductor stocks and the like.
Now investment is diversified within a group, but still fairly concentrated within a sector.

Correlation matrix for different indices

Nifty Bank Nifty CNXIT CNX Infra

Nifty 1
Bank Nifty 0.870382 1
CNXIT 0.786101 0.629482 1
•
CNXInfra 0.951675 0.82752 0.684391 1
32
Diversify across time horizons and levels of liquidity: Based on investor's various Portfolio Management
goals, it's a good idea to maintain different levels of liquidity. For your short term goals
such as funding a big ticket event (e.g.: wedding or travel) investor typically going to
save using a cash account. For medium term goals, investor can take some risk with
blended funds for example, while for the longer term goals (e.g.: kids' college fund,
retirement) investment can be less liquid, by getting into more aggressive stocks or real
estate
International Portfolio Diversification: The benefits of international portfolio
diversification have been recognized for decades. Using data on stock markets of major
developed countries various empirical studies have documented the benefits of
international portfolio diversification. Specifically, these studies have shown that global
diversification allows for reduced total risk without sacrificing expected returns. An
internationally diversified portfolio is less risky than a purely domestic portfolio because
stock returns display lower positive correlation across countries.
Large amount of foreign institutional flows invest in Indian equity markets on the basis
of the adjustments to their predetermined policy of international portfolio diversification.
One of such indices is Morgan Stanley Emerging Markets Index. It has predetermined
weightages for various emerging markets. When a particular market or group of markets
move, the proportion of weights to those various emerging markets get vary from the
predetermined weightages. In order to balance their portfolio, foreign institutional investors
bring in and take out investment from those markets and thus also influence those markets.

20.7 FIDUCIARY RESPONSIBILITIES OF A

PORTFOLIO MANAGER
The portfolio managers are responsible for looking after someone else's money and
therefore, it is important that the responsibilities and liabilities are understood by them.
The underlying principle is that the portfolio manager must put the investor's needs
ahead of their own. Fiduciary responsibility and the code of conduct for portfolio managers
are governed by the SEBI Portfolio regulation of 1993.
SEBI (Portfolio Managers) Regulations, 1993 states that before taking up an assignment
of management of funds or portfolio of securities on behalf of the investor, the portfolio
managers must enter into an agreement in writing with the investor clearly defining the
relationship and setting out their mutual rights, liabilities and obligations relating to the
management of funds or portfolio of securities.
The portfolio manager may charge which could be a fixed amount or a return based fee
or a combination of both. The portfolio manager shall take prior permission from the
investor for charging such fees for each activity for which service is rendered by the
portfolio manager directly or indirectly.
An investor has to be informed of all the responsibilities and obligations including the
charges through a disclosure document. The disclosure document contains the quantum
and manner of payment of fees payable by the client for each activity for which service
is rendered along with normal disclosures The manner in which and the instruments
through which a portfolio managers may invest, it has to be communicated to the investor
by the portfolio managers.
Regulations allow a portfolio manager to invest in derivatives, including transactions for
the purpose of hedging and portfolio rebalancing, but through recognised stock exchanges,
nevertheless it is the responsibility of the portfolio manager to inform the investor.

33
Special Issues
20.8 SUMMARY
Determining an efficient mix of assets to hold in a portfolio is referred to as portfolio
management. A fundamental aspect of portfolio management is choosing assets which
are consistent with the portfolio holder's investment objectives and risk tolerance. Aim
of portfolio management is to diversify the portfolio optimally in order to reduce the
.systematic risk to maximum level and optimize the returns. Diversification of portfolio is
carried out at three levels: asset level, industry level, and geography level.
Portfolio management involves an application of a number of quantitative measures to
arrive at efficient portfolio construction. They involve computation of returns, risks,
correlation, covariance, portfolio risk and return, application of CAPM and ABT, etc.
Five steps are involved in efficient portfolio management. Setting up investment policy,
carry out security analysis, construction of portfolio, revise the portfolio, and continuously
monitor and evaluate the performance of the portfolio.
The portfolio managers are responsible for looking after someone else's money and
therefore it is important that the responsibilities and liabilities are understood by them.
The underlying principle is that the portfolio manager must put the investor's needs
ahead of their own.

20.9 SELF ASSESSMENT QUESTIONS

I) What is portfolio management?
2) Why is setting objectives a difficult process?
3) How does a portfolio manager arrive at an asset mix?
4) Describe the steps involved in portfolio selection?
5) What is an EIC analysis?
6) Which are the different strategies which can be adopted by a portfolio manager?
7) What are the basic differences between Sharpe and Treynors ratios?
8) What is an efficient market hypothesis?
9) What basic information do you need for performing the portfolio analysis using the
Markowitz method?
10) What is the fiduciary responsibility of a portfolio manager?
11) Who should hire a Portfolio Manager?

20.10 FURTHER READINGS

1) Harry M Markowitz, 1952, Early His!OI)" of Portfolio Theory. John Wiley &
Sons Inc
2) Zvi Bodie, 2004, Investments, McGraw HilllIrwin, USA
3) Aswath Damodaran, 1998, Portfolio Management, John Wiley & Sons Inc
4) Prasanna Chandra, 2010, Investment Analysis & Portfolio Management, McGraw
HilllIrwin, USA
5) Robert A Strong, 2005, Portfolio Management Handbook, Jaico Publishing
House, India
6) William F Sharpe, 2008, Risk, Market Sensitivity, and Diversification, Stanford
University, USA.

34
UNIT 21 CORPORATE ACTIONS
Objectives
After studying this unit, you shoul~ be able to:
• understand various types of corporate actions;
• discuss various adjustments to share price required for each such action;
• know various terms and players are involved corporate action process; and
• analyse how actuaJly the prices behave during some of the corporate actions.

Structure
21.1 Introduction
21.2 Rationale
21.3 Types
21.4 Basis for Adjustment
21.5 Dividends
21.6 Adjustment to Dividends
21.7 Stock Split
21.8 Adjustment for Stock Split
21.9 Bonus
21.10 Adjustment for Bonus
21.11 Rights Issue
21.12 Adjustment for Rights Issues
21.13 Takeover Offers and Mergers
21.14 Adjustment to Merger
21.15 Spin Off
21.16 Summary
21.17 Self Assessment Questions
21.18 Further Readings

21.1 INTRODUCTION
A corporate action is an event initiated by a public company that:
1) Provides additional return on the securities (equity or debt) issued by the company,
such as dividend or coupon on securities held.
2) Offers clubbing or dissecting the securities held, like split or consolidation.
3. Restructure the company's debt or capital or both and requires securities holder
perrrussion.
4) Seeks consent of the securities holder to initiate some action, say merger or spin off.
5) Often intends to give signal to the market about the price of the company, say, buy
back offer.
35
 Special Issues Some corporate actions such as a dividend (for equity securities) or coupon payment
(for debt securities (bonds)) may have a direct financial impact on the return to
shareholders or bondholders. While others may have indirect fmancial impact by dividing
the securities in more than one part, say, split or bonus, etc. there by increasing the
liquidity of the shares in the markets. One more example is a call (early redemption) of
a debt security, Some corporate actions such as name change have no direct financial
impact on the shareholders.
Corporate action represents either right or entitlement or both of the securities holders.
It requires to 'be communicated to the securities holder in specified time. It should give
the securities holder enough time to decide on the proposal under the corporate action.
Stock exchange disseminates the required information time to time for the benefits of
the owners of the securities. For institutional investors and other large investors, custodians
of the securities generally take care of the informing the owners of corporate action and
exercise the voting power as they are authorised to do so. For retail investors, they have
to manage their portfolio on their own and be vigilant about various announcements
made by the Exchange.

21.2 RATIONALE
Corporate actions are initiated for various reasons, primarily for following:
• To return profits to shareholders: A public company may declare a cash dividend
to be paid on each outstanding share.
• To influence the share price: If the price of a stock is too high or too low, the
stock's liquidity suffers. Overpriced stocks will not be affordable to all investors,
and underpriced stocks may be delisted. Corporate actions such as stock splits or
reverse stock splits increase or decrease the number of outstanding shares resulting
in a higher or lower stock price.
• For corporate restructuring: A merger is a corporate action in which two
competitive or complementary companies join to increase profitability. This synergy
can many times make shareholders wealthy.
• Signalling to the markets: A company may offer buy back programme to signal
that its shares are under priced.
When a company announces a corporate action it brings actual change to its securities
either in terms of number of shares in the market or a change to the face value of the
security. It is important for an investor to understand the different types of corporate
actions and their effects so as to have a clearer picture about a company's financial
affairs and how that action will influence the company's share price and performance.
"'{" .

21.3 TYPES
Corporate actions are agreed upon by a company's Board of Directors and authorized
by the shareholders. Following are the examples of a few corporate actions:

• Dividends

• Stock splits

• Rights issues

• Bonus issues

• Takeover offer

36
• Merger
/1

• Share repurchase Corporate Actions

• Spin off.

21.4 BASIS FOR ADJUSTMENT

The basis for any adjustment for corporate actions shall be such that the value of the
position of the market participants, on the cum and ex-dates for the corporation action,
shall continue to remain the same as far as possible. Cum and ex-dates are explained in
latter section.
This will facilitate in retaining the relative status of positions viz., in-the-money, at-the-
money and out-of-money. This will also address issues related to exercise and assignments.
1) Benefits of Corporate actions: Corporate actions may be broadly classified under
stock benefits and cash benefits.
The various stock benefits of corporate action include: bonus, rights, merger/de-merger,
amalgamation, splits, consolidations, hive-off, warrants, etc.
The cash benefits are declared by way of dividend, cash offer, etc.
2) Basis of the adjustment: The basis of the adjustment is decided on the basis
of terms of corporate action. For example, the bonus issues of I : 1 or merger in ratio of
I : 10.
The basis of adjustment includes the rate of dividend announced by the Board or the
Cash offer announced for the shares.

21.5 DIVIDENDS
An investor receives returns from equities in two forms:
a) Increase in the market price of the share, and
b) Dividends.
Dividend is distribution of part of a company's earnings of the company to their
shareholders, usually twice a year in the form of an interim as well as final dividend.
This is expressed on a 'per share' basis on its face value, for instance - Rs. 3 per share
or 30%. This tells the investors as to how much of the earnings are retained and how
much are distributed. So a company that has earnings per share in the year of Rs. 6 and
pays out Rs. 3 per share as a dividend is passing half of its profits on to shareholders and
retaining the other half. Directors of a company have discretion as to how much of the
earnings are to be distributed as dividend.

21.6 ADJUSTMENT FOR DIVIDENDS

There are four important dates that need to be taken care off while adjusting the stock
prices. They are:
The declaration date is the day the Board of Directors announces its intention to pay
a dividend. On this day, a liability is created and the company records that liability on its
books; it now owes the money to the stockholders.
When the declaration of dividend takes place, the investor's entitlement gets added into
the stock price. Therefore there is an increase in the prices of stock.
The cum-dividend date is the last day, which is one trading day before the ex-dividend
date, where the stock is said to be cum dividend ('with including dividend'). In other
37
Special Issues words, existing holders of the stock and anyone who buys it on this day will receive the
dividend. In the same manner, any share holder who sells the stock lose their right to the
dividend.
The ex-dividend date is the day on which all shares bought and sold loses the right of
or entitlement to receive the dividends. This makes reconciliation of who is to be paid
.the dividend easy. Existing holders of the stock will receive the dividend even if they
now sell the stock, whereas anyone who now buys the stock will not receive the dividend.
It is relatively common for a stock's price to decrease on the ex-dividend date by an
amount roughly equal to the dividend paid. This reflects the decrease in the company's
assets resulting from the declaration of the dividend. The company does not take any
explicit action to adjust its stock price, market will automatically adjust the price.
The payment date is the day when the dividend warrants are actually be mailed or to
the shareholders of a company or credited to brokerage accounts.
TO: Dividend Declared
TI: Cum Dividend (Stock available with dividend)
T2: Ex Dividend (Dividend detached)
T3: Investor's Account Credited

EJ
B TO
+ EJ Tl T2
B T3

Declaration date-In-dividend date-Ex-dividend date-Payment date

Figure 21.1: Dividend Timeline Example for Stock price adjustment:

Example for Stock price adjustment:

Day 1: Stock trades at Rs. 100.00
Day 2: Stock trades at Rs. 100.50
Day 3: Stock trades at Rs. 101.25
Day 4: Stock goes ex-dividend, and the dividend is Rs.0.75, and finishes trading at
Rs.100.50

Now, if we back adjust the data becomes: Day 1: Rs. 99 .25

Day 2: Rs.99.75
Day 3: Rs.lOO.50
Day 4: Rs. 100.50 (the ex-day is not adjusted)

Example: Colgate Palmolive

Colgate Palmolive Ltd. Has announced a Dividend of 8 Rs. per Share (Face value of 1).
On July 1 st 2009.

38

I
Closing Price on the Announcement Day: 644.15 Corporate Actions

Company Type Percentage Announcement Record Date Ex-Dividend

Date Date
Colgate Interim 800 17-July-2009 21-August- 20-August-
Palmolive 200) 200)
Ltd

So, Dividend Yield is (8 / 644.15) * 100 = 1.241 %

3 Days Before Ex-Dividend: Stock Closed at 601.8
2 Days Before Ex-Dividend: Stock Closed at 609.65
1 Days Before Ex-Dividend: Stock Closed at 605.85
On the day of Ex-Dividend: Stock Closed at 601.15, Dividend is 8 Rs. Per share. Next
Day (On The Record Date): Stock Closed at 611.6
Now, if we back adjust the data becomes: 3 Days Prior: 593.8
2 Days Prior: 601.65
1 Days Prior: 597.85
On Ex-Dividend: 593.15
On Record Date: 603.6
The movement of the scrip just on the basis of dividend adjustment is miniscule as the
other events of the day overshadow the event.
The timeline followed and various important dates during adjustment process are typically
same for other corporate actions also.

Dividend Yield
The Dividend Yield is a financial ratio that shows how much a company pays out in
dividends each year relative to its share price. In the absence of any capital gains, the
dividend yield is the return on investment for a stock. Dividend yield is calculated as
follows:
Annual Dividends Per Share
Dividend Yield =
Price Per Share

For example, historically Dividend Yield of Index NIFTY was 1.5%.

Concerns
• The prices do not represent reality.
• Many technical analysts like to view data without adjustment for dividends as
market behavior is not really affected by dividends.

Activity 1
Find out dividend yield on following companies as on 31 st March, 2010, taking the price
on the same day:
1) Reliance Industries .
2) Hindustan Unilever India Ltd .
3) Wipro .
4) Infosys .
5) Nicholas Piramal .
6) Dr. Ranbaxy .
7) ACC .
8) Indian Oil Corporation .
39

I
 o

Special Issues
21.7 STOCK SPLIT
A stock split is a corporate action which splits the existing shares of a particular face
value into smaller denominations so that the number of shares increases. However, the
market capitalization or the value of shares held by the investors post split remains the
same as that before the split.
For example, if a company has issued 5,00,000 shares with a face value of Rs. 10 and
the current market price being Rs. 100, a 2- for-l stock split would reduce the face value
of the shares to 5 (10/2: 1) and increase the number of the company's outstanding shares
to 10,00,000 (5,00,000*(2: 1)).
Consequently, the share price would also halve to Rs. 50 so that the market capitalization
or the value shares held by an investor remains unchanged.

Rs.lOO

TO Timeline TI

Figure 21.2: 2 for 1 Stock Split

There are basically two motives behind doing a stock split:

• Splitting the stock brings the share price down to a more "affordable" level thereby
luring investors to buy more shares.
• Splitting a stock may lead to increase in the stock's liquidity, since more number
of small investors are able to afford the share.

21.8 ADJUSTMENT FOR STOCK SPLIT

We take an example of ABB Limited. On February 16, ABB Limited announced a
stock split in the ratio of 5: 1. It means a share of face value of Rs. 10 will be split into
five shares of face value of Rs.2.

Record Date Ex Date . No delivery start date No delivery end date

July 6,2007 June 28, 2007 June 28, 2007 July 5,2007
.. ,

Record Date
If you own shares on the record date, it means you will be entitled to receive a share
after stock splitting.

Ex Date
This is the date when ABB Limited shares will trade on Exchange at the new split
adjusted price. No delivery start and end date:
When company mentioned No delivery period, it means during this period only trading
has been taken place in securities but settlement happens only after no delivery period.
Therefore, in this case if anyone buys shares between June 28,2007 to July 5, 2007, hel
she will not be entitled for stock split.
40
Example Corporate Actions

ABB Limited announces a 5- for-l (5: 1) stock split. Shareholders will receive an additional
4 share for each share he/she holds. On June 27, 2007 (One day before stock split)
ABB stock price is Rs. 4800 (Open Price). Therefore, price after stock split will be Rs. 960.
Let us see, how it should theoretically behave,
Let A: B = 5: 1
Pad = Adjustment factor
P bss = Price before stock split
Pass = Price after stock split

Pad = B/A
= 1/5 = 0.2
P ass = P bss * Pad
= 4800 * 0.2
= Rs.960.
Hence, the base price after stock split is Rs. 960.

Date 5-for-l Split Pre-split Post-Split

June 27, 2007 Share Price (Rs.) 4800 -

June 27,2007 No. of shares 211908375 -
June 28, 2007 Share Price (Rs.) - 9ro
June 28, 2007 No. of shares - 42381675
Note: Here we have taken opening price.

21.9 BONUS ISSUES

Bonus issues are shares issued free of cost to shareholders and hence it is known as
bonus. The size of the issue reflects the improved value of the company's assets. They
may sometimes be issued instead of dividends. Then it is known as stock dividends.
These shares are issued in a certain proportion to the existing holdings. So, a 2 for 1
bonus would mean you get two additional shares - free of cost - for the one share
you hold in the company.

Activity 2
Is it actually a bonus? Why?

For example, if you hold 100 shares of a company and a 1: 1 bonus offer is declared, you
get 100 shares free. That means your total holding of shares in that company will now
be 200 instead of 100 at no cost to you.

Share 1 Share

G]+G] Share

TO Timeline T1
Figure 21.3: 1 for 1 bonus
41

I
 '.J

Special Issues Bonus shares are issued by cashing in on the free reserves of the company. A company
builds up its reserves by retaining part of its profit over the years (the part that is not paid
out as dividend).
After a while, these free reserves increase, and the company wanting to issue bonus
shares converts part of the reserves into capital. So the existing shareholder does not
have to pay; and the company's profits are not impacted.

Impact
The main advantage of bonus issues is that the stock becomes more liquid as there will
be many more shares to buy and sell.
Once a bonus is issued, the price of the shares is likely to drop as the value of the
company's assets is now spread. over a larger number of shares. Bonus shares dilute
the market price of the shares in direct proportion to the increase in the total number of
shares on issue.
This price adjustment occurs on the ex-bonus date. An investor who buys the existing
shares on or after the date is not entitled to the bonus shares - they belong to the
previous owner of the shares.
The ex-bonus date falls on the fifth trading day prior to and including the closing date for
the issue. The closing date is the date on which the company closes its books to determine
which shareholders are registered to receive the bonus.

21.10 ADJUSTMENT TO BONUS ISSUES

When the bonus issue is made the stock price decreases in proportion to the ratio of
bonus issue.

Example
Tata Consultancy Services (TCS), India largest software exporter announced a bonus
issue of shares at 1: 1 ratio.
Record date:
June 17,2009
Ex date:
June 16,2009
TCS declares a bonus issue of 1: 1. Shareholders will receive an additional 1 share for
every 1 share they held and receive 2 stocks. The stock price ofTCS is Rs. 778 (Closing
price) on June 15,2009, which is one day before when investor will get 1 free share.
Therefore, the theoretical TCS price on June 16,2009 (when actually bonus issues take
place) would be Rs.389.
LetA:B -1: I
P bbi = Price before bonus issue
Pabi = Price after bonus issue
Nbbi = Total number of share before bonus issue

Method I
P = Pbbi * Nbbi
abi A+B
778* 1
1+1

42
= Rs.389
Method 11 Corporate Actions

First calculate adjustment factor. Let Pad = Adjustment factor

B
Pad = ---A+B
1
2
=0.5

Pabi = Pbbi*Pad
= 778*0.5
= Rs.389
Date l-for-I Bonus issue Pre-Bonus issue Post-Bonus issue

June 15,2009 Share Price (Rs.) 778

June 15,2009 No. of shares 978610498
June 16,2009 Share Price (Rs.) - 389
June 16,2009 No. of shares - 19572'2ffJ96

Note: Here we have taken closing price. Closing price on June 16,2009 is Rs. 389.15
which is almost equivalent to theoretical price.

Difference between Stock Split and Bonus Issue

Although the net worth of the company remains same in case of Stock Split and Bonus
issue, however, they are different.
In stock split, the paid-up capital of the company remains the same. But a 1: 1 bonus
issue has the effect of doubling the paid-up capital of a company.

21.11 RIGHTS ISSUES

A rights issue entitles existing shareholders to take up additional shares in the company,
usually at a below-market price and without having to pay brokerage. Rights issues
enable the company to raise additional funds from shareholders, perhaps for expansion
or to repay debt. Shares are offered on a predetermined pro-rata basis, for example, 1
for 2. This means that for every two shares you own, you can purchase an additional
share at the discounted price.

Available at discount

Share
I I
Share Share
I I
Share + IGJ I
Share
I
1D Timeline ~1

Figure 21.4: 1 for 2 Right when Exercised

43
Special Issues Types of rights issues
A rights issue may be renounceable or non-renounceable.
• Renounceable means shareholders are entitled to sell their rights to other investors
on the share market if they do not wish to take up the additional shares themselves.
• Non-renounceable means only existing shareholders can participate and you must
either take up the shares or forfeit the rights. If you are not an existing shareholder
then one can purchase any available rights through a stock broking firm. Once
rights have been taken up, they are converted to ordinary shares at the discounted
price.

21.12 A;DJUSTMENT TO RIGHTS ISSUES

When the right issue is offered to the existing share holders, it is offered to them at a
lower price than the existing price of the stock at the stock market. But that does not
mean that the shareholders can make huge profit from this price difference. This is
because after the right issue is offered price of that particular stock falls in the stock
market. It happens because the number of stock of that company increases in the
market.

Example
Consider there is it company "C" having 1 00 outstanding shares. The share price
currently quoted on the stock exchange is Rs. 5 thus the market capitalization of the
stock would be Rs. 500 (outstanding shares times share price).
Assuming a 1: 1 rights issue at an offer price of Rs. 4 and if all the shareholders of the
company choose to exercise their stock option, the company's outstanding shares would
increase to 200. The market capitalization of the stock would increase to Rs. 900 (previous
market capitalization + cash received from owners of rights converting their rights to
shares), implying a share price of Rs. 450 (Rs. 900/2 shares). Thus, the stock price of
the company will fall to around Rs. 450 per share.

Example
Dish TV offered the Rights issue in January, 2009. Here are the excerpts from the
Letter of Offer.

Issue of 51,81,49,592 Equity Shares of the Company for cash at a price of Rs. 22 per Equity
Share including a premium ofRs. 21 per Equity Share aggregating upto Rs. 1,13,992.91 Iakhs to
the Equity Shareholders ofthe Company on rights basis in the ratio of 121 Equity Shares for
every 100 Equity Shares held on the Record Date i.e., October 16, 2008 as per the terms of the
Letter of Offer.
The total Issue Price is 22 times of the face value of the Equity Share.
The Issue Price for the Equity Shares will be paid in three installments: Rs. 6 will be payable on
application, Rs. 8 will become payable, at the option of the Company, after 3 months but within
9 months from the date of Allotment and the balance Rs. 8 will become payable, at the option
of the Company, after 9 months but within 18 months from the date of Allotment.

21 Jan, 2009 was the day when the issue was listed on exchanges.

Table 21.1: Data for DISH TV 20-01-2009 to 23-01-2009

Date Prev Close Open Price High Price Low Price Last Price Close Price
20-Jan-2009 18.90 18.40 19.95 18.35 18.90 18.95
21-Jan-2009 18.95 19.95 19.80 18.:'i(1 18.95 18.90
22 Jan-2009 18.90 19.00 19.50 18.20 18.40 18.40
23-Jan-2009 18.40 17.90 19.35 17.90 19.30 19.05
44 I
 Corporate Actions
21.13 TAKEOVER OFFER AND MERGERS

Merger
A merger occurs when two or more companies combineto form a single one. In a
typical merger, shareholders. of the target company exchange their shares for those of
the acquiring firm, after a shareholder vote approving the merger.

Company
A

Acquiers (All CashlExchange of Stock) Company

A

TO Timeline T1

Figure 21.5: Acquisition

Whenever merger takes place between two companies, it should be either financed
only by the issue of stock or financed by a mix of cash and stock. Here we analyse as
to what happens when merger is being financed only by issue of stock.

Takeover offer
A letter of offer is a document addressed to the shareholders of the target company
containing disclosures of the acquirer, target company, their financials, justification of
the offer price, the offer price, number of shares to be acquired from the public, purpose
of acquisition, future plans of acquirer, if any, regarding the target company, change in
control over the target company, if any, the procedure to be followed by acquirer in
accepting the shares tendered by the shareholders and the period within which all the
formalities to the offer would be completed.

Example
Here is an example when Tech Mahindra announced Letter of Offer for Sat yam. The
public announcement ("PA") is being issued by Kotak Mahindra Capital Company
Limited. The Acquirer proposes to acquire 19,90,79,413 (Nineteen Crores Ninety Lakhs
Seventy-Nine Thousand Four Hundred and Thirteen Only) Shares of the Target Company
representing 20% of the Fully Diluted Share Capital of the Target Company, at a price
of Rs. 58/- (Rupees Fifty-Eight Only) for each Share of the Target Company.
Generally, when the offer is made, the share price of the company tends to reach the
- offer price. If it is not then either there is some information asymmetry or there is an
arbitrauge opportunity. For example, if offer is made at Rs. 58 per share and share price
is 45, then investors will start buying from the market and accept the offer at Rs. 58.
This action of the investors will push up the price towards Rs. 58. '
If this does not happen then either market is inefficient or there is some information
which is held back by a few investors and the market at large do not wish to take any
risk by converging to the offer price.
Against this, if the price is Rs. 70 and the offer is at Rs. 58, no one would tender the
shares making the company to force to raise the offer-price to Rs. 70.
45
Special Issues
Example: Letter ofOfferfonnat SCSL (SATYAM COMPUTER SERVICES LIMITED)
This Letter of Offer is being sent to you as a shareholder of Satyam Computer Services Limited.

Venturbay Consultants Private Limited

a private limited company incorporated on July 16, 2004, under the provisions of the Act.
(Registered Office: Sharda Centre. Off Karve Road, Erandawane, Pune-411 004, India.
Telephone: +912066018100, Fax: +912066018313; Email: satyam
[email protected])
along with the following person acting in concert
Tech Mahindra Limited
a public limited company incorporated on Octohcr 24, 1986 under the provisions of the Act.
(Registered Office: Gateway Building, Apollo Bunder, Mumbai-400001, India)
(Corporate Office: Sharda Centre, OffKarve Road, Pune-411004, India, Telephone:
+9120660 18100, Fax: +912025424466; Email: satyam [email protected])
Make A Cash Offer At Rs. 58/- (Rupees Fifty-Eight Only)
Per Fully Paid up Equity Share to Acquire
19,90,79,413 (Nineteen Crores Ninety Lakhs Seventy-Nine Thousand Four Hundred and
Thirteen Only) Shares of face value Rs. 2/- each
(Rupees TWGonly) representing 20% of the Fully Diluted Share Capital of
Satyam Computer Services Limited
a public limited company incorporated on June 24, 1987 under the provisions of the Act.
(Registered Office: 1-8-303/36, Mayfair Centre, 1st Floor, S.P.Road, Secunderabad- 5‫סס‬003,
India,Telephone:+914030654343,Fax: +914027840058)
The Offer Opens At 10:30 a.m. Indian Standard TIme, Which is 01:00 a.m. New York city Time
on Friday, June 12,2009 and The Offer Expires at 4:30 p.m., Indian Standard Time,
and At 7:00 a.m., New York City Time, on Wednesday, July 1,2009.

MANAGERTOTHEOFFER REGISTRAR TO THE OFFER

Kotak Link Intime
Investment Banking India Pvt. Ltd.

Kotak Mahindra Capita Company Limited Link Intime India Private Limited
Bakhtawar, 3rd Floor, 229, Nariman Point C-13, Pannalal Silk Mill Compound, LBS Marg
Mumbai-400021, India Bhandup (West), Mumbai-400078
Tel: +91226634,Fax: +912222840492 Tel: +912225960320-28; Fax: +912225960329
Contact Person: Chandrakant Bhole Contact Person: Mr. Pravin Kasare
Email: [email protected] Email: [email protected]

Schedule (as per PA) Revised Schedule

Activity Date Day Date Day

Public Announcement April 22, 2009 Wednesday April 22, 2009 Wednesday
Specified Date May 20, 2009 Friday May 22, 2009 Friday
Last date for dispatch of Letter of June 03, 2009 Wednesday June 09, 2009 Tuesday
offer to the Shareholders of the
Target Company
Offer Open on June 12, 2009 Friday June 12, 2009 Friday
1st date for revising the Offer Price June 22, 2009 Monday June 22, 2009 Monday
Last date for withdrawalby Shareholders June 29, 2009 Saturday June 26, 2009 Friday
Offer Closes on June 01, 2009 Wednesday June 01, 2009 Wednesday
Last date by which acceptance I July 16, 2009 Thursday July 16, 2009 Thursday
rejection would be intimated and
corresponding payment for acquired
shares and I or the share certificate I
demat delivery instruction for
rejected Shares will be dispatched/issued

Disclosure and detailed information is given on:

• Risk factors
• Summary Term Sheet
•
• Disclaimer Clause
46
 Corporate Actions
• Details of the Offer
• Background of the Acquirer and PAC
• Option to the Acquirer in terms of regulation. Background of the Target Company
• Offer Price and Financial Arrangements
• Terms and Conditions of the Offer
• Procedure for Acceptance and Settlement of the Offer
• Summary of Significant Differences between U.S. GAAP and Indian GAAP
• Documents for Inspection

Source: SEBI Website

21.14 ADJUSTMENT DUE TO MERGER

Suppose there are two companies: X and Y, which merges with each other. In the
merger, Y merged with X, in other words we can also say that company X will buy
company Y. Therefore, in this process, X is the merged company and Y is the merging
company. Generally, larger firm will be the merged company and comparatively small
company will be merging company.

Company 'X' Company'Y'

Number of securities HID 500

Price per share 100 so

In this case there are two things happens:

a) The shareholder of company X receives Y and for this, they will swap certain
number of shares .•
b) The shareholder of company Y completely swaps their ownership over Y and gets
an ownership over new entity X + Y.
As mentioned earlier the entire merger would be financed only by stock swap. Therefore,
both firm have to decide what would be the swap ratio. Suppose both firm decided the
swap ratio of 1 :2, it means shareholder of company Y will receive one stock of X for
every two stock of Y. Hence, the total number of securities for a new entity X + Y
would be 1250 (1000 stock for X and 250 stock for Y) and price per share is Rs.100.
NI = total number of securities of company X
N2 = total number of securities of company Y
PI = company X stock price
P2 = company Y stock Price s = swap ratio
P 12 = stock price of new entity X + Y

NI *P1 + N2*P2
P12=-----
NI + s*N2
All the data are given in the above-mentioned table except sand s = 112= 0.5.

1000* 100 + 500*50

PI2= -------
1000 + 0.5*500

125000
= 1250
= Rs.100
47

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 ".

Special Issues Actually, the price of X+Y mayor may not be equal to Rs.l00. It may be either more
than Rs.100 or less than Rs.100. Whenever any merger taken place, the one of the
important purpose of both the firm would be to create more value or at least keep the
value same. If we analyse from company X point of view, the shareholders of company
X will agree to go for the merger only if the stock price of X increases due to merger
activities. 'It means shareholder of company X will accept merger if P 12> c- P 1 or
price' of new entity will be greater than or equal to Rs.l00,

NI *Pl + N2*P2
. NI + s*N2
* s> = PI

If we analyse company Y point of view, the shareholders of company Y will agree to go

for the merger only if the each stock price they get in new entity will be more than Y
stock price. It means shareholder of company Y will accept merger if PI2*s>=P2 or
PI2*s will be greater than or equal to Rs. 50.

NI *PI + N2*P2
*s> = PI
NI + s*N2

Example
Centurion Bank of Punjab merged with HDFC Bank in June, 2008. In this merger the
shareholder of Centurion Bank of Punjab got I share of HDFC Bank for every 29
shares of Centurion Bank of Punjab. The name of the merged entity would remain as
HDFC Bank.

HDFC Bank . Centurion Bank of Punjab

Number of securities before merger 354432920 19(X)586483

Number of securities after merger 424616776 0
\
.
\The boards of HDFC. Bank and Centurion Bank of Punjab announced this merger in
February, 2008. After announcement, the HDFC Bank stock price is approximately 29
times more than Centurion Bank of Punjab (CBoP), till the CBoP stock is traded. Centurion
Bank of Punjab stock is traded till June 6, 2008.

Date CBOP HDFC Ratio

25-Feb-08 48.35 1421.75 ·29.41
26-Feb-08 48.8 1454.9 29.81
27-Feb-08 48.6 1452.3 29.88
28-Feb-08 48.95 1472.55 30.08
29-Feb-08 49.15 1456.75 29.64
3-Mar-08 46.5 1389.9 29.89
4-Mar-08 , 44.55- 1351.75 30.34
5-Mar-08 44.4 1332.75 30.02
7-Mar-08 41.65 1282.25 30.79
IO-Mar-08 42.6 1311.5 30.79
Il-Mar-08 43.55 1333.j 30.61
12-Mar-08 44.65 1370.55 30.70
13-Mar-08 41.6 1299.15 31.23 '
14-Mar-08 42.5 1315.45 30.95
17-Mar-08 39.5- 1226 31.04
18-Mar-08 39.6 1230.95 31.08
19-Mar-08 40.45 1272.6 31.46
48
""

24-Mar-08 1341.9 31.76 Corporate Actions

42.25-
25-Mar:.o8 45.8 1414 30.87
26-Mar-08 46.75 1439.2 30.79
27-Mar-08 46.6 1433.2 30.76
28-Mar-08 45.95 1407 30.6
I-Mar-08 .43.25 1331.25 30.78
I-Apr-08 43.05 1309.55 30.42
2-Apr-08 43.65 1328 30.42
3-Apr-08 43.7 . 1331.15 30.46
4-Apr-08 42.45 1293.85 30.48 .
7-Apr-08 42.85 1303.4 30.42
8-Apr-08 42.95 1308.55 30.47
9-Apr-08 445 1379.85 31.01
10-Apr-08 43.35 1326.55 3O.ro
ll-Apr-08 42.9 1330.05 31.00
15-Apr-08 42.8 1303.3 30.45
16-Apr-08 42.75 1308.3_ soeo
17-Apr-08 45.25 1401.2 30.97
21-Apr-08 46.65 14ro.75 31.31
\
22-Apr-08 47.9 1508.25 "" 3~.49
23-Apr-08 47 1445.35 30.75
24-Apr-08 47.8 1442.6 30.18
25-Apr-08 49.05 1500.4 30.59
28-Apr-08 49.85 1523.35 . 3056
29-Apr-08 50.4 1547.8 30.71
30-Apr-08 50.25 1524.15 30.33
2-May-08 51.35 1540.4 30.00
5-May-08 50.7 152855 30.15
6-May-08 50.9 1542.85 30.31
7-May-08 50.85 1541.9 30.32
8-May"08 49.95 1508.35 30.20
9-May-08 47.95 14525 30.29
12-May-08 48.6 1468.05 30.21
13-May-08 49 1480.25 30.21
14-May-08 48.4 1464.8 30.26
15-May-08 48.65 14785 30.39
16-May-08 495 1500.4 30.3
20-May-08 48.05 1461.2 30.41
21-May-08 47.55 1410.05 29.65
22-May-08 4655 1383.75 29.73
23-May-08 46.45 1381.5 29.74
26-May-08 45.05 1347.6 29.91
,
27-May-08 44.05 1332.7 30.25
28-May-08 44.95 1351.35 3O.<X>
29-May-08 4355 131955 30.30
30-May-08 45.1 1368.7 30.35
2-Jun-08 43.9 13105 29.85
3-Jun-08 425 1266.4 29.80
4-Jun-08 40.7 1215 29.85
5-Jun-08 41.5 1248.15 30.08
6-Jun-08 41.4 1232.45 29.77
49
Special Issues We can see here that the multiple is largely in range of 29 to 31. There is some arbitrauge
opportunity for some time but only a marginal. Had that remained or widen, actions of
the investors would bring it back to this range. The marginal difference which is available
in the market will vanish once one incorporate brokerage and other transaction fees.

21.15 . SPIN OFF

A spin off is a corporate action that occurs when a company distributes part of its assets
or distributes new shares in order to form a new publicly traded company. Often the
new shares will be offered through a rights issue to existing shareholders before they
are offered to new investors.

Example
When any firm creates a new firm out of one of its existing divisions or subsidiaries,
then it is known as spin off process and the owners of parent firm will be the owner of
new firm.
Suppose company X business is divided into three divisions: Construction, Cement and
IT. The stock price of X is Rs.500. Firm X announced that they will separate their IT
division and established it as a new company name Y and announced right issues, each
shareholder of X will get same number of shares in Y that they held in company X. It
means if a investor has 100 shares of company X, so he/she will receive 100 shares of
company Y. It will affect the company X price and it will come down by approx. Rs.
100.

Activity 3
Find out from various corporate actions, whether market adjust the share prices as postulated by
the theoretical framework?

21.16 SUMMARY
This unit was to introduce corporate actions and how it adjusts the market prices. If
market is efficient, then it adjusts ex-ante market price of the share equivalent to the
benefits of the corporate actions. However, if market is weakly efficient or inefficient in
incorporating the information provided in corporate action, then it offers advantage to
one who buys the share cum bonus or buys the shares cum dividend.
We saw that corporate actions may be broadly classified under stock benefits and cash
benefits. The various stock benefits declared by the issuer of capital are: bonus, rights,
merger/de-merger, amalgamation, splits, consolidations, hive-off, warrants and secured
premium notes among others.
The example of cash benefit by the company is cash dividend or share repurchase
through cash.
We saw how the dividends, split, bonus and merger took place along with price
adjustments. We have also observed the timeline followed and the system of postal
ballot used during AGM in recent times.

50
 Corporate Actions
21.17 SELF ASSESSMENT QUESTIONS
1) What are Corporate Actions?
2) What are the types of Corporate Actions?
3) Discuss the adjustment process for following corporate actions:
a) Dividends
b) Split
c) Bonus
d) Merger
4) What is Dividend Yield? Why it is usually so low?
5) How market efficiency play its role in adjustment of share prices due to corporate
actions?'

21.18 FURTHER READINGS

1) Breily and Myres, Principles of Corporate Finance, McGraw Hill Publication.
2) Chandra, P. Corporate Finance, Tata McGraw Hill Publication.
3) Pathak, Bharati V. (2008) The Indian Financial System, Markets Institutions
and Services, Pearson Education.
4) Endo, Tadashi (1998) Indian Securities Market, Vision Books.
5) Wikipedia:http://en.wikipedia.org.
6) Investopedia:http::llinvestopedia.org.

51

I
Special Issues Annexure

Voting Right (Section 87 of the Companies Act, 1956)

Every member of a company limited by shares and holding any equity share capital therein
shall have a right to vote in respect of such capital on every resolution placed before the
company; and his voting right on a poll shall be in proportion to his share of the of the paid-
up capital of the company (Section 87 of the Companies Act, 1956). The member can freely
bind himself by contract to a third party to vote, or not to vote, in a particular way. Section 176
of the Act provides that the instrument of proxy should be in any of the forms set out in
Schedule IX of the Act.

Example: Voting Right by nse of postal ballot in AGM

Postal Ballot for .

D-Link during AGM

This postal ballot announcement will be used to transfer the Sales and Marketing of Gigabyte
Motherboards to the Subsidiary if approved.

52
 Corporate Actions
Example: Announcement of postal ballot result by HCI
Declaration of the results of Postal Ballot pursuant to Postal Notice dated August 23, 2007

The Board of Directors of the Company as decided in its meeting held on August 23, 2007 and
vide postal ballot notice dated August 23, sought the consent of the Shareholders by way of
Postal Ballot pursuant to Section 192A of the Companies Act, 1956, read with the Companies
(Passing of the Resolutions by 'Postal Ballot) Rules, 2001, for the special/ordinary resolutions
with respect to following business:

1. Change in Objects Clause of the Memorandum of Association under section 17 of the

Companies Act, 1956. (Special resolution)
2. Increase in the borrowing limits under section 293(1 )(d) of the Companies Act, 1956.
(Ordinary resolution)
3. Creation of mortgages and charges on the properties of the Company under section
293(1 )(a) ofthe Companies Act, 1956. (Ordinary resolution)

Mr. Vineet K. Chaudhary, was appointed as the Scrutinizer for this process and has submitted
his report to the Company. I am pleased to announce the result of the voting conducted
through postal ballot on all resolutions i.e. special or ordinary on the basis of the report
submitted by the Scrutinizer as under:

Resolution no.1 Resolution no.2 Resolution no.3

No. of No. of No. of No. of No.oflI No. of
postal shares postal shares postal shares
ballot ballot ballot
forms forms forms
Total postal ballots 1,513 101,557,765 1,513 101,557,765 1,513 . 101,557,765
Received

Number of invalid 74 1,308,659 % 1,314,WJ 102 1,314,931

postal ballots

Number of valid 1,439 100,249,106 1,417 100,243,156 1,411 100,242,834

postal ballots

Votes in favour of 1,421 100,246,660 1,372 100,099,768 1,348 100,224,062

the Resolution (99.99%) (99.86%) (99.98%)

Votes against the 18 2,446 45 143,388 63 18,772

Resolution (0.0024%) (0.14%) (0.019%)

The proposed resolutions are carried with requisite majority and passed as Special Ordinary
Resolutions.
Place: New Delhi Ajai Chowdhry
Date: October 15, 2007 Chairman

53

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 "
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MPDD/IGNOU/P.O.5H/June.2011 (Reprint)

lSBN-978-81-266-4509-J