Article Risk and Return

RISK AND RETURN ANALYSIS OF AUTOMOBILE AND OIL &GAS SECTORS – A STUDY

INTRODUCTION TO THE STUDY

The risk/return relationship is a fundamental concept in not only financial analysis, but in every aspect of life. If decisions are to lead to benefit maximization, it is necessary that individuals/institutions consider the combined influence on expected (future) return or benefit as well as on risk/cost. The requirement that expected return/benefit be commensurate with risk/cost

is

known

as

the

"risk/return

trade-off"

in

finance.

This discusses the trade-off and, using conventional statistical tools, provides a method for quantifying risk. Two categories of risk borne by the firm's stockholders, business risk and financial risk, are discussed and demonstrated, as is the concept of leverage. The session also examines risk reduction via portfolio diversification and what requirements need to be met for firms to experience the benefits of diversification. The Capital Asset Pricing Model (CAPM) is used to demonstrate the risk/return trade-off by relating the required return on the firm's investments to its beta (or market) risk.

The relationship between risk and return is an essential factor inall human decision making. Each investment a firm undertakes, for example, must offer a return that is at least as high as the return on a similarly risky investment on financial markets. Otherwise shareholders would choose to invest in the financial markets rather than in the firm.

The aim of this essay is to give students an overview of the relationship between risk and return in modern portfolio theory.

After a conclusion in the first section, there are definitions given about the types of risk and the composition of the expected return of an asset and its relation to standard deviation. The second section will give an overview on modern portfolio theory and in particular on how the Capital.

Types of risk There are two different types of risk. We need to distinguish between: • Market risk and • Unique risk. Market (Systematic) risk affects a large number of assets in the economy and is generally market wide. Uncertainties about the general economy, such as GDP, interest rates, inflation, etc. Affect systematic risk. Market risk cannot be eliminated by holding a well-diversified portfolio; it’s non diversifiable. Firms that produce for example long-living goods such as aircraft are highly sensitive and thus have high market risk. Conversely, firms that produce goods for daily needs have a lower market risk.

INTEREST RATE RISK Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. the root cause of interest rate risk lies in the fact that ,if the RBI increase or decrease the interest rate (repo rate ) the interest on government securities rise or fall ,the rate of return demanded on alternative investment vehicle ,such as stocks and bonds issued in the private sector ,rise or fall .in other words as the cost of money changes for nearly risk free securities, the cost of money to more risk prone issues will also change.

INFLATION RISK (PURCHASING POWER RISK) The loss of purchasing power due to the effects of inflation. When inflation is present, the currency loses its value due to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value. LIQUIDITY RISK The uncertainty associated with the ability to sell an asset on short notice without loss of value. A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers and sellers in the market. An illiquid asset is hard to sell because there there few interested buyers. This type of risk is important in some project investment decisions but is discussed extensively in Investment courses.

FOREIGN EXCHANGE RISKS Uncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks.

TRANSLATION RISKS Uncertainty associated with the translation of foreign currency denominated accounting statements into the home currency. This risk is extensively discussed in Multinational Financial Management courses.

TRANSACTIONS RISKS Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values. This risk is extensively discussed in the Multinational Financial Management courses.

Unique Risk (unsystematic risk) Affects only a single firm or a small number of firms. Uncertainties about a firm’s labor contracts or suppliers are part of unsystematic risk. Unique risk describes a firm’s specific risk related to the market, which is assumed to be diversified away. It has already been mentioned that you can eliminate unique risk by holding a well-diversified portfolio. Hence, diversification is a means of reducing risk. If we hold a large enough portfolio, unsystematic risk of individual companies cancel each other out, leaving just the systematic risk associated with each company. This will be the risk in that portfolio.

Statistics gives us the opportunity to measure risk and how to translate risk into a risk premium. BUSINESS RISK The uncertainty associated with a business firm's operating environment and reflected in the variability of earnings before interest and taxes (EBIT). Since this earnings measure has not had financing expenses removed, it reflects the risk associated with business operations rather than methods of debt financing. This risk is often discussed in General Business Management courses. Business risk can be divided into two board categories: external and internal .internal business risk is largely associated with the efficiency with which a firm conduct its operation within the border operating environment imposed upon it .each firm has it s on internal risk, and the degree to which it is successful in coping with them is reflected in operating efficiency.

FINANCIAL RISK The uncertainty brought about by the choice of a firm’s financing methods and reflected in the variability of earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. This risk is often discussed within the context of the Capital Structure topics.

By Engaging in debt financing the firm changes the characteristics of the earning stream available to the common stock holders, specifically ,the reliance in debt financing ,called financial leverage ,has at least three important effect on common stock holders.

1) Increase the variability of their return 2) Effect their expectation concerning to the return 3) Increase the risk of being ruined.

Risk-Free Interest Rate and Risk Premium Short-term Treasury bills (e.g. 3-month U.S. Treasury bills) can be seen as risk-free investments. They bring out benchmarks of risk-free interest rates. As a result, the beta (describing asset riskiness) for risk-free assets is 0. If an investor prefers to invest in an asset which is riskier than treasury bills, he is likely to demand a higher yield. In other words, an investment in risky assets like stocks should give a higher return than that of a risk-free asset. The difference between the market risk and the riskfree rate is called risk premium.

The risk premium can be seen as a reward for investors. This reward is what they may expect for bearing systematic risk. Therefore, it is systematic risk alone which is critical and will be higher for riskier projects than for safer projects. Risk premium represents the extra return (beyond the risk-free interest rate) investors demand for moving their funds away from a riskfree asset to a risky asset. The risk premium should increase with the risk aversion of an investor and the average riskiness of the investment.

Expected Return and Standard Deviation

Expected return is the weighted average of possible outcomes where the weights represent the outcome probabilities. Standard deviation describes the risk that expected return will or will not happen. This means that risk-free assets have a standard deviation of 0. Assuming an investor with the opportunity to choose between two possible investments.

Say investment A and B. Both investments give you an expected return of 10%, but A has a standard deviation of 15% and therefore a wider spread of possible outcomes than B with its 7.5%. Obviously, everybody would invest in B rather than in A to avoid unnecessary risk. If you get the chance to invest in investment A or C with an expected return of 15% and a standard deviation of 10% it’s clear that in that situation everybody would prefer C to A. In real life where there are an almost unlimited range of possibilities to invest money – and not just in one asset, as in the example above. This leads us to the next section.

Portfolio Theory Modern portfolio theory is based on an article Harry Markowitz released in 1952. His Portfolio Selection Model describes how an investor can reduce the standard deviation of portfolio returns while selecting stocks that are correlated differently. The Capital Asset Pricing Model (CAPM)

The theory behind the CAPM and all other modern finance theories are based on the portfolio theory, developed in the early 1950`s by Harry Markowitz. His statement was that an investor can reduce the standard deviation of portfolio returns by choosing stocks that do not move exactly together (that are correlated differently).

Furthermore, expected returns and standard deviation are the only two variables that need to be considered in an investment decision. The intuition behind the CAPM is the insurance motive of risk adverse investors. The main statement of the CAPM is that one can reduce risk nicely diversifying one’s portfolio.

Capital Market Line (Security Market line)

In the following model it is assumed that an investor can choose portfolios which consist of a share of a risk-free asset like a treasury bill and a share of risky assets. Capital market line connects the risk-free asset with the risky market portfolio. This combination creates a greater set of possible portfolios and a 'new' efficient frontier line.

AUTOMOBILE INDUSTRY PROFILE Maruti Suzuki Profile Maruti Suzuki is India and Nepal's number one leading automobile manufacturer and the market leader in the car segment, both in terms of volume of vehicles sold and revenue earned. Until recently, 18.28% of the company was owned by the Indian government, and 54.2% by Suzuki of Japan. The BJP-led government held an initial public offering of 25% of the company in June 2003. As of 10 May 2007, Govt. of India sold its complete share to Indian financial institutions. With this, Govt. of India no longer has stake in Maruti Udyog Tata Motors Profile 1998 - Indian manufacturers Tata Motors have quite the history under their belt, starting with the company's foundation in 1945 as a locomotive producer. Tata Motors is just one part of the business group Tata, formerly known as TELCO (Tata Engineering and Locomotive Company), which also has several other ventures, including a steel making plant and even a tea producing company. Tata got into the motoring business in 1954 when it starting producing heavy trucks in a joint venture with Daimler-Benz AG. So, in 1960. the first truck rolled out of the factory's door in Pune, India, a copy of a German Daimler truck. Tata starting exporting heavy-duty trucks but for the local market, they had to come up with lighter versions because of the infrastructure of the country. The first LCV (Light Commercial Vehicle) model, the Tata 407, began production in 1986. Mahindra & Mahindra Profile Mahindra & Mahindra was set up as a steel trading company in 1945. It soon expanded into manufacturing general-purpose utility vehicles, starting with assembly under license of the iconic Willis Jeep in India. Soon established as the Jeep manufacturers of India, M&M later branched out into the manufacture of light commercial vehicles (LCVs) and agricultural tractors.

Today, M&M is the leader in the utility vehicle segment in India with its flagship UV Scorpio and enjoys a growing global market presence in both the automotive and tractor businesses. Over the past few years, M&M has expanded into new industries and geographies. They entered into the two-wheeler segment by taking over Kinetic Motors in India. M&M also has controlling stake in REVA Electric Car Company and acquired South Korea's SsangYong Motor Company in 2011. Hero Honda Profile Hero” is the brand name used by the Munjal brothers for their flagship company Hero Cycles Ltd. A joint venture between the Hero Group and Honda Motor Company was established in 1984 as the Hero Honda Motors Limited At Dharuhera India. Munjal family and Honda group both own 26% stake in the Company. In 2010, it was reported that Honda planned to sell its stake in the venture to the Munjal family. During the 1980s, the company introduced motorcycles that were popular in India for their fuel economy and low cost. A popular advertising campaign based on the slogan 'Fill it Shut it - Forget it' that emphasized the motorcycle's fuel efficiency helped the company grow at a double-digit pace since inception. The technology in the bikes of Hero Honda for almost 26 years (1984–2010) has come from the Japanese counterpart Honda. Hero Honda has three manufacturing facilities based at Dharuhera, Gurgaon in Haryana and at Haridwar in Uttarakhand. These plants together are capable of churning out 3 million bikes per year. Hero Honda has a large sales and service network with over 3,000 dealerships and service points across India. Hero Honda has a customer loyalty program since 2000, called the Hero Honda Passport Program.

Bajaj Auto Profile Bajaj Auto is a major Indian vehicle manufacturer started by a Rajasthani merchant. It is based in Pune, Maharashtra, with plants in Chakan (Pune), Waluj (near Aurangabad) and Pant agar in Uttaranchal. The oldest plant at Akurdi (Pune) now houses the R&D centre ahead. Bajaj Auto makes and exports automobiles scooters, motorcycles and the auto rickshaw. The Forbes Global 2000 list for the year 2005 ranked Bajaj Auto at 1,946 although it does not feature in the 2010 list. Over the last decade, the company has successfully changed its image from a scooter manufacturer to a two wheeler manufacturer. Its product range encompasses scooterettes, scooters and motorcycles. Its real growth in numbers has come in the last four years after successful introduction of a few models in the motorcycle segment. Bajaj Auto came into existence on 29 November 1945 as M/s Bachraj Trading Corporation Private Limited. It started off by selling imported two- and three-wheelers in India. In 1959, it obtained license from the Government of India to manufacture two- and threewheelers and it went public in 1960. In 1970, it rolled out its 100,000th vehicle. In 1977, it managed to produce and sell 100,000 vehicles in a single financial year. In 1985, it started producing at Waluj near Aurangabad. In 1986, it managed to produce and sell 500,000 vehicles in a single financial year. According to the authors of Globality: Competing with Everyone from Everywhere for Everything, Bajaj has grown operations in 50 countries by creating a line of value-for-money bikes targeted to the different preferences of entry-level buyers Auto Mobile Industry Information Driving the most luxurious car has been made possible by the stiff competition in the automobile industry in India, with overseas players gathering the same momentum as the domestic participants.

Every other day, we have been hearing about some new launches, some low cost cars - all customized in a manner such that the common man is not left behind. In 2009, the automobile industry is expected to see a growth rate of around 9%, with the disclaimer that the auto industry in India has been hit badly by the ongoing global financial crisis. The automobile industry in India happens to be the ninth largest in the world. Following Japan, South Korea and Thailand, in 2009, India emerged as the fourth largest exporter of automobiles. Several Indian automobile manufacturers have spread their operations globally as well, asking for more investments in the Indian automobile sector by the MNCs. Potential of the Automobile industry In 2008, Hyundai Motors alone exported 240,000 cars made in India. Nissan Motors plans to export 250,000 vehicles manufactured in its India plant by 2011. Similar plans are for General Motors. OIL AND GAS INDUSTRY Chennai Petroleum Corporation Profile Chennai Petroleum Corporation Limited (CPCL), formerly known as Madras Refineries Limited (MRL) is located at Manali (Tamil Nadu), near Chennai, Tamilnadu. It was formed as a joint venture in 1965 between the Government of India (GOI), AMOCO and National Iranian Oil Company (NIOC) having a share holding in the ratio 74%: 13%: 13% respectively. From the grassroots stage CPCL Refinery was set up with an installed capacity of 2.5 Million Tonnes Per Annum (MMTPA) in a record time of 27 months at a cost of Rs. 43 crore without any time or cost over run. In 1985, AMOCO disinvested in favour of GOI and the shareholding percentage of GOI and NIOC stood revised at 84.62% and 15.38% respectively. Later GOI disinvested 16.92% of the paid up capital in favor of Unit Trust of India, Mutual Funds, Insurance Companies and Banks on 19 May 1992, thereby reducing its holding to 67.7 %.

The public issue of CPCL shares at a premium of Rs. 70 (Rs. 90 to FIIs) in 1994 was oversubscribed to an extent of 27 times and added a large shareholder base of over 90000.As a part of the restructuring steps taken up by the Government of India, Indian Oil Corporation Limited ( IOCL) acquired equity from GOI in 2000-01 Currently IOC holds 51.88% while NIOC continued its holding at 15.40%. Indian Oil Corporation Profile Indian Oil began operation in 1964 as Indian Oil Company Ltd. The Indian Oil Corporation was formed in 1964, with the merger of Indian Refineries Ltd. Feroze Gandhi was the first chairman of Indian Oil Corporation Limited. Product Indian Oil’s product range covers petrol, diesel, LPG, auto LPG, aviation turbine fuel, lubricants, naphtha, bitumen, paraffin, kerosene etc. Xtra Premium petrol, Xtra Mile diesel, Servo lubricants, Indane LPG, Autogas LPG, Indian Oil Aviation are some of its prominent brands. Recently Indian Oil has also introduced a new business line of supplying LNG (liquefied natural gas) by cryogenic transportation. This is called "LNG at Doorstep". LNG headquarters are located at the Scope Complex, Lodhi Road, Delhi Bharat Petroleum Corporation Profile The 1860s saw vast industrial development. A lot of petroleum refineries came up. An important player in the South Asian market then was the Burmah Oil Company Ltd. Though incorporated in Scotland in 1886, the company grew out of the enterprises of the Rangoon Oil Company, which had been formed in 1871 to refine crude oil produced from primitive hand dug wells in Upper Burma. The search for oil in India began in 1886, when Mr. Goodenough of McKillop Stewart Company drilled a well near Jaypore in upper Assam and struck oil. In 1889, the Assam Railway

and Trading Company (ARTC) struck oil at Digboi marking the beginning of oil production in India. While discoveries were made and industries expanded, John D Rockefeller together with his business associates acquired control of numerous refineries and pipelines to later form the giant Standard Oil Trust. The largest rivals of Standard Oil - Royal Dutch, Shell, Rothschilds came together to form a single organisation....: Asiatic Petroleum Company to market petroleum products in South Asia. In 1928, Asiatic Petroleum (India) joined hands with Burmah Oil Company - an active producer, refiner and distributor of petroleum products, particularly in Indian and Burmese markets. This alliance led to the formation of Burmah-Shell Oil Storage and Distributing Company of India Limited. A pioneer in more ways than one, Burmah Shell began its operations with import and marketing of Kerosene. This was imported in bulk and transported in 4 gallon and 1 gallon tins through rail, road and country craft all over India. With motor cars, came canned Petrol, followed by service stations. In the 1930s, retail sales points were built with driveways set back from the road; service stations began to appear and became accepted as a part of road development. After the war Burmah Shell established efficient and up-to-date service and filling stations to give the customers the highest possible standard of service facilities. Hindustan Petroleum Corporation Profile Which has capacity of 9 Hindustan Petroleum Corporation (HPCL) is one of the leading petroleum companies in India. Established in 1953, its business activities ventures include exploration, production, and marketing of petroleum and petroleum-related products. It has two refineries -- one located in Mumbai with of 5.5 million metric tonnes per annum (MMTPA) capacity and another in Vishakhapatnam with 7.5 MMTPA capacity. It owns and operates the largest lube refinery in India with capacity of 335 TMT and accounts for 40% of India’s total lube oil production. HPCL has a 16% market share in refining and marketing in India. It holds 16.95% equity stake in Mangalore Refinery & Petrochemicals MMTPA.

ONGC Profile ONGC (Oil and Natural Gas Corporation Limited) is India's leading oil & gas exploration company. ONGC has produced more than 600 million metric tonnes of crude oil and supplied more than 200 billion cubic metres of gas since its inception. Today, ONGC is India's highest profit making corporate. It has a share of 77 percent in India's crude oil production and 81 per cent in India's natural gas production. The origins of ONGC can be traced to the Industrial Policy Statement of 1948, which called for the development of petroleum industry in India. Until 1955, private oil companies such as Assam Oil Company at Digboi, Oil India Ltd (a 50% joint venture between Government of India and Burmah Oil Company) at Naharkatiya and Moran in Assam, and Indo-Stanvac Petroleum project (a joint venture between Government of India and Standard Vacuum Oil Company of USA) at West Bengal, were engaged in exploration work. The vast sedimentary tract in other parts of India and adjoining offshore were largely unexplored. In 1955, Government of India decided to develop the oil and natural gas resources in the various regions of the country as part of the Public Sector development. To achieve this objective an Oil and Natural Gas Directorate was set up in1955, as a subordinate office under the then Ministry of Natural Resources and Scientific Research. The Industrial Policy Resolution of 1956 placed mineral oil industry among the schedule 'A' industries. In August 1956, to ensure efficient functioning of the Oil and Natural Gas Directorate, the Directorate was raised to the status of a commission with enhanced powers. In October 1959, the Commission was converted into a statutory body by an act of the Indian Parliament, which enhanced powers of the commission further. In 1960s, ONGC found new resources in Assam and established new oil province in Cambay basin (Gujarat). In early 1970s went offshore and discovered a giant oil field in the form of Bombay High. After liberalization in 1991, ONGC was re-organized as a limited Company under the Company's Act, 1956 in February 1994.

Recently, ONGC has made six new discoveries, at Vasai West (oil and gas) in Western Offshore, GS-49 (gas) and GS-KW (oil and gas) in Krishna-Godavari Offshore, Chinnewala Tibba (gas) in Rajasthan, and Laipling-gaon (oil and gas) and Banamali (oil), both in Assam. ONGC has a fully owned subsidiary, ONGC Videsh Ltd (OVL) that looks for exploration opportunities in other parts of the world. OVL is pursuing exploration of oil and gas in Russia, Iran, Iraq, Libya Myanmar and other countries. ONGC has also acquired 72% stake in MRPL with full management control of the 9.69 tonne, state-of-the-art refinery. Oil and Gas Information

Automobile sale have been surging every year. Car sales are up by nearly 30%, heavy & medium commercial vehicle sales have climbed an even more steep 40%, consumption of diesel and LPG are on a steep rise. That should be pretty good news for the industry, which is counting on surging sales and economic boom to absorb the huge refining capacity that has built up in the country. The interesting story is that oil products consumption has started picking up in line with the economic boom, though with a certain lag. Going forward, we should see much larger pick- up in sales of oil products in line with the GDP growth rate, feel analysts. High consumption has meant high profit margins for oil companies, particularly refining majors like Hindustan Petroleum Corporation (HPCL), Bharat Petroleum Corporation (BPCL), Indian Oil Corporation (IOC) and a host of other smaller refining companies. Refining margins are now ruling at their highest levels over the past decade. According to analysts tracking the sector, refining margins are now at $8 per barrel, one of the highest levels in many years. And these margins have stayed high despite a rise in prices of crude oil. For integrated refining & marketing companies, like HPCL, BPCL and IOC, the gains are even more substantial and their numbers may look very impressive. However, sentiment for the sector would be significantly impacted by the performance of the biggest oil company in the country- ONGC .The company is by far the biggest player in the

oil exploration & production sector and has a presence in the refining sector through its armMRPL. As crude prices have held firm in the global markets over the past months, the company should show good performance for the year. The company should benefit from a surge in demand in this region. According to CLSA. "While Asia (excluding, Middle East) accounts for only 10% of oil production, it accounts for as much as 25% of oil consumption and refining capacity. Oil consumption in Asia is returning, driven mainly by a surge in Chinese demand over the shorter term. With most Asian economies on track for a solid recovery, we would expect demand growth to top 3-4% in the next few years leading to a quick recovery. With Asia forming 45% of global incremental demand between 2000 and 2010, we expect Asian refining margins to remain at higher than global averages".

OBJECTIVES OF THE STUDY 

To evaluate the risk of the selected sectors.



To measure the return of the selected sectors.

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To ascertain the relationship between the share price and indices.

SCOPE OF THE STUDY 

The scope of the study is limited to Indian stock market. The recommendation in

this study only subject to the Indian capital market situation. The present studies will mainly focusing on the 2years performance of automobiles and oil & gas industry companies in India. This study reviles the various factors that are to be considering for the risk return of companies. 

In the investors point of view this study will help them to understand how a companies is evaluated against benchmark indices also this will definitely enable

them to find out how the companies had performed for the last two years. For the new investors the study will serve as a guideline to know about the investment pattern in companies.

REVIEW OF LITERATURE

In the area of risk and return analysis two well known economist made effort to study the relation between risk and return and they are the people who quantify the risk and return aspects of an instrument .they are Harry markowitz and William Sharpe. Very broadly the investment process consists of two tasks. The first task is security analysis which focuses on assessing the risk and return characteristics of the available investment alternatives. The second task is portfolio selection which involves choosing the best possible portfolio from the set of feasible portfolio. Portfolio theory, originally proposed by Harry markowitz in the 1950’s was the first formal attempt to quantify the risk of portfolio and develop a methodology for determining the optimal portfolio .prior to the development of portfolio theory ,investors dealt with the concept of return and risk somewhat loosely .Harry markowitz was the first person to show quantitatively why and how diversification reduce risk .in recognition of his seminal contribution in this field he was awarded the Nobel prize in economics in 1990.

Harry markowitz developed an approach that helps the investors to achieve his optimal portfolio position .in this contest William Sharpe and others try to find out an answer for a question ,what is the relationship between risk and return and they developed capital asset pricing theory .(CAPM)

The CAPM, in essence, predicts the relationship between the risk of an asset and its expected return .this relationship is very useful in two important ways .first, it produces a bench mark for evaluating various instrument .second it helps us to make an informal guess about the return that can be expected from an assets that has not yet been traded in the market.

De Bondt and Thayler study the price in relation to book value in a universe of all NYSE and American Stock Exchange equity issue. It has explained the relation between the market price and book value, with stock being assigned in quintiles from lowest price to book ratios. The earning yields effect on stock return is significantly positive only in January for the sub period.

Piotroski investigates whether fundamental analysis can be used to provide abnormal returns, and right shift the returns spectrum earned by a value investor. He focused on high book to 20 market securities, and show that the mean return earned by a high book to market investor can beshifted to the right by at least 7.5% annually

The authors developed portfolio based on four fundamental conditions namely: Single Value P/E, Market Price