Institute of Chartered Financial Analysts of India (ICFAI) University 2006 Certification Finance Security Analysis - I - Question Paper

In auction markets, active market makers do not exist and demand and supply of the securities is directly related to the transaction price. The trading of the stocks will not be on a continuous basis and any stock can be traded only once or a few times per day. This kind of market is called call or fixing market, in which orders are batched together until the auction and are executed at a single price that matches the demand and supply.

Two major kinds of orders are submitted in an auction market, i.e., market order and limit order. In market order, customer will accept the price fixed in the auction. On the other hand, in limit order system, the price is determined by the maximum price which a customer is willing to provide or the minimum price at which the customer is willing to sell the share. When the bourses official writes a higher price, a few limit sell orders will be removed from the supply of stocks and a few limit buy orders will be added to the demand for shares. This process outcomes in an equilibrium price. In Tokyo, the call auction system determines the morning and afternoon starting price. A call auction market is also called order driven market because all traders openly post their orders and the transaction price is derived through equilibrating the demand and supply of the stock.

Microstructure of the Market

All stock exchanges in the world are using the electronic technology to automate the trading process. The main purpose of any trading procedure is to discover the best price for investors. The convenient system of trading helps in getting a fair price without providing any favorable term to any counterparty.

Again a good trading procedure helps in reducing the transaction cost and provides a transparent and liquid market. There are several controversial problems in the microstructure of stock trading system. For example, there is a lot of disagreement on how to measure transaction cost. Sometimes, it is called the difference ranging from the price, including commissions and the price of the previous market. In other words, it can be taken as a sum of commissions, taxes and other market impacts.

Price-Driven vs Order-Driven Systems

Computerized trading systems basically follow 2 various approaches depending on the dominance of either the dealers or brokers. The London Stock Exchanges Automated Quotation (LSEAQ) and the National Association of Securities Dealers Automated Quotation (NASDAQ) are price-driven or quote-driven systems. In this type of trading system, there are no automatic quotes because the market maker does not know the form of the final contract. The quote-driven system allows the market maker to buy a limit order at the bid price and sell it at the offer price.

The Paris, Tokyo and most of the European and Asian markets are order-driven markets. The limit order book is the heart of these trading systems. After assessing the standing orders, a trader can judge the nature of the trade. The NYSE follows a mixture of these 2 systems. In NYSE, the limit order is in private knowledge of the specialist, and the brokers are likely to keep their limit orders a secret and keep them with their floor brokers to trade in the most suitable manner. In all cases, a limit order provide a free trading choice to other market participants. In an order-driven market, it is the trader who submits the order but in a price-driven market, the dealer posts a firm quote and provides free choice.

info Emission And Transparency

Transparency in the market is of utmost importance because it provide the market a type of stability and proper info about the past and the r cent trades. Automation enhances the transparency in the market because a large amount of info is available to the public. The New York Stock Exchange is less transparent, as the limit order book is a private info and cannot be revealed to everybody. a few traders trade on the basis of private information, while a few trade with the help of the publicly available info. The presence of the informed traders can create trouble for the normal traders. A well informed trader can pick-up a few shares after getting a few private info. On the London market, dealers quote for big transactions and the well informed investors can trade with several traders before any of them comes to know about the transaction. Informed traders do not want to disclose the info.

Market Fragmentation

Liberalization and automation of the equity markets have increased the competition among domestic markets as well as the international markets. For example, the London Stock Exchange accounted for 20% to 50% of the total quantity of trades in French, Dutch and German shares. different overseas stocks are traded on the floor of the NYSE. Buying futures on a few index is sometimes an option to buying a diversified portfolio of shares and this causes fragmentation in the market. Domestic markets are protecting their interest by imposing certain rules to off-exchange trades. The obvious presence of fragmentation and competition has improved the efficiency of the markets.

Internationalization

Development of the global equity market is the 1st step in the internationalization of equity trading. Many developed countries have opened overseas branches to cater to their foreign investors. The US, Britain, Japan are the main countries to attract the foreign investors. a few stock markets believe that they can safeguard their global interest by establishing links with other markets. This trend is most famous among the futures and choices market. The NASDAQ system is available to the investors in England and Singapore. The international stock exchange in London and the NASDAQ have agreed not to enforce competition among themselves by ignoring the quotes and trading for common shares. Automation of trading procedure has allowed a few stock exchanges to attract a significant amount of the foreign company shares.

Anonymity and Reputation

a few investors and traders would prefer to maintain anonymity to get a better price in their deal. On the other hand, market makers and brokers would like to build a reputation for their skills. They try to advertise their competency and skills to attract more clients. In NASDAQ, for small orders, brokers can give their, option for the particular market makers. But this is a dangerous practice since it weakens the dealer's incentive to publish the best price.

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8. Key Characteristics In An Industry Analysis

The most important of the characteristics that are to be evaluated in an Industry Analysis can be enumerated as provided below:

1. Past sales and earnings performance.

2. Permanence of the industry.

3. The attitude of the government towards the industry.

4. Labor conditions within the industry.

5. The competitive conditions as reflected by the existence of the entry barriers and

6. The stock prices of the firms in the industry relative to their earnings.

Past Sales and Earnings Performance

For an analyst, the past sales and earnings performance of the firm form a crucial input in forecasting future patterns. This is not to say that the firm is going to repeat the identical performance again. Rather, the analyst is more interested in examining the contribution of the different factors in the past so that the relevance of these factors individually and relatively can be properly evaluated under current conditions.

In any firm, sales and the earnings play an important role. These variables will exhibit a degree of consistency only when the firm has weathered a variety of economic conditions. The analyst from the observation of these variables will be able to judge the stability of the performance in terms of sales and earnings as well as the growth rates. a different crucial factor is that of the relationship ranging from the sales and the fixed costs. The more the fixed costs, the higher will be the break even point and higher will be the sales quantity to be achieved.

Permanence

By permanence, we understand the products and the technology of a particular industry not becoming obsolete in a short span of time. If the industry is not permanent, then investing in that industry altogether becomes a losing proportion. In a few of the cases a product with additional features manufactured by employing superior technology makes the existing product totally irrelevant or at lowest outcomes in the manufacturing process becoming a commercially enviable proposition.

In this age of rapid technological developments, this factor plays a crucial role in Industry Analysis. The Government's role is also an important factor affecting the permanence of the industry.

The Attitude of the Government towards theIndustry

It is imperative for an Analyst that he should be well aware of the different Government policies and regulations with reference to an industry in which he is going to invest. The government policies like deregulating an industry by allowing foreign investment, imposing high tariffs on imports and restrictive legislation have a bearing on their performance. a few of the legal restrictions outcome in the profits being very low for a particular industry. Thus an analyst, for that matter an investor also should be thorough with different government regulations and their implications and should be able to predict, at lowest broadly, the modifications likely to take place in the regulations in the near future.

Labor Conditions

This is an important factor to be considered in industries which are labor intensive. An analyst should examine the different provisions of the labor laws and also go into the possible reasons that may halt the production process and its fallout on the profits of the industry. In case of a prolonged strike, a labor intensive firm will not only lose its customers and goodwill but also may not be able to cover its fixed costs in certain cases.

Competitive Conditions

While analyzing this situation, the 3 general kinds of barriers that an analyst should concentrate on, are

1. Existence of product differentiation

2. Absolute cost advantages and

3. Advantages rising from economies of scale.

The existence of the 1st barrier assures that a new entrant will not be able to charge as much as the existing firms. Also he has to spend large amounts of money on advertising to capture an acceptable share of the market as this situation is usually obtained in cases where the customers exhibit a high degree of brand loyalty. By absolute cost advantages, we understand that the existing firms are capable of producing and distributing the products at lower costs than the new entrants irrespective of the quantity produced. As a result, they enjoy wider profit margins. This may be due to the fact that the existing firms may have exclusive patents, own the resources or superior management skills that are not available to the new entrants.

Economies of scale are usually realized when the production levels are quite high. A new entrant in this case also has to garner a significant market share so that he can avail the benefits from economies of scale. If he fails to do so, he will be able to compete with te prices offered by the existing players.

Industry Share Prices Relative to its Earnings

In addition to the different factors we have been looking at, the analyst also has to look at the current share prices. In this case under priced share would be the best bet. Also he should examine the fact that the share prices are not high due to the overzealous nature of the investors to acquire the shares of the firms in a new industry. Usually the shares of these companies experience high fluctuations depending on the crowd behavior.

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