The bases of securities selection

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The bases of securities selection

Introduction

Security selection refers to the choice of the most suitable stocks for investment in anticipation of some future return. Normally, portfolio managers make investment decisions using various investment models such as a capital asset pricing model and arbitrage price model to evaluate the most desirable portfolios for investment (Lawton and Todd, 56). Additionally, the portfolio manager selects the most suitable portfolios basing on the firm’s objectives and associated risk from a given investment portfolio. From a financial perspective, high returns from a given portfolio leads to an increase in the risk inherent (Gibson, 36). Therefore, it is prudent to evaluate the anticipated returns and risks associated with a given portfolio prior to investment.

Bases of security selection

There are several bases on which both individual and corporate investors may use to select the most profitable securities for investment. Portfolio managers may conduct prior portfolio assessments basing their assessment on the investment objectives, firms’ risk tolerance, and the target industry. The basis of investment objectives varies among different firms (Maginn, 46). The basic investment objectives, which many firms apply when selecting investment portfolios, are several. They include capital appreciation objectives, speculation objectives, and current income objectives (Maginn, 65). Capital appreciation objectives involve investing in securities and holding those securities for a long period in anticipation of higher returns. Speculative objectives involve investing in securities while anticipating quick returns. Finally, the current income objectives involve investing in securities that pay high rates of dividends consistently. In addition, firms may select securities on the basis of the firms’ risk tolerance. Firms with high risk tolerance may go for securities with higher returns. On the other hand, firms with low risk tolerance may go for securities with insignificant returns (Elton, 69). This is because the higher the returns, the higher risk and vice versa. Securities may also be selected on the basis of industry. In this case, firms may diversify their portfolios by investing into different industries in order to minimize the investment risk (Elton, 78).

Stock analysis

Stocks analysis may help to determine the stocks that are undervalued, overvalued, and those stocks that are correctly priced. The undervalued stocks are those that give higher returns than anticipated. On the contrary, overvalued stocks tend to give lower returns than the anticipated. Finally, correctly priced stocks have anticipated returns equal to the actual returns (Lawton and Todd, 68). The four securities from the table below may help to determine the undervalued securities and overvalued securities.

Securities EPS E/P Expected market returns/Prices Risk free rate(RF) Beta(β)
A

 

60% 0.5 30 % 8 % 0.5
B

 

50% 0.5 25 % 8 % 0.7
C

 

70% 0.5 35 % 8 % 0.6
D

 

80% 0.5 40 % 8 % 1.5

Expected market returns/ prices

Price=EPS × P/E

Security A =60%× 0.5

=30%

Security B=50%×0.5

=25%

Security C=70%×0.5

=30%

Security D=80%×0.5

=40%

Actual returns/Price may be determined using both Capitals pricing model as shown below

CAPM=RF+ (MR-RF) β

Actual returns for stock A

CAPM=8+ (30-8)0.5

=19%     Overvalued

Actual returns for stock B

CAPM=8+ (25-8)0.7

=19.9%   Overvalued.

Actual Returns for stock C

CAPM=8+ (35-8)1.6

=43.2%     Overvalued.

Actual Returns for stock D

CAPM=8+ (40-8)0.8

= 33.6%     Undervalued.

Interpretation of the above computation

It can be noted that security stocks A, B and D were overvalued. This is because the three securities actual returns were lower than the expected returns. Security A was overvalued by 11%, while security B was overvalued by 5.5%. On the other hand, security D was overvalued by 6.4%. On the contrary, security C was undervalued by 8.2%. This is because the actual returns of this security stock are higher than the anticipated returns. However, there were no securities that were correctly priced based on the stock analyzed. Therefore, investors may select the best securities, not only on the basis of anticipated returns and risk associated with each security, but also on the basis of analysis of the undervalued and overvalued securities (Lawton and Todd, 86).

Firm activities that may help to increase stock prices

The firm activities that may help to increase the stock prices include historical price analysis. In this regard, the firm may analyze the past prices and compare them with the current prices. This is aimed to establish whether there will be a possibility of increasing stock prices (Lawton and Todd, 110). Additionally, the firm may participate in corporate social responsibilities so as to build its reputation that may indirectly lead to increase in company’s profits. Also, the firm may start may decrease dividends payout and reinvest for increased gains (Maginn, 112).

Conclusion

The basis of security selection and analysis vary from one company to another. This is because various companies have different ways of selecting the securities for investment. From the discussion above, it is clear how firms incorporate the various investment objectives and risk tolerance among other factors to evaluate the suitability of a given investment. The discussion further focuses on how assets may be selected based on the concept of undervaluation, overvaluation, and correctly priced securities. Notably, there are those activities that the firms may conduct to increase the securities prices.