hedge funds by tripti sao, sibm- b

8/14/2019 Hedge Funds by Tripti Sao, SIBM- B

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Introduction

Hedge Funds:

Hedge funds, primarily a historical name that suggests that these funds try to minimize the downside risks of a bear market by taking short positions in securities, but this is no longer true.Today, hedge funds follow at least a dozen different strategies to earn positive returns for theirinvestors, so the name hedge fund does not go well with the actual business of hedge funds inpresent scenario.

Hedge funds are basically products for the richest of the rich who wish to remain rich and do notwant to let market crash or any other similar event affect their returns.

Hedge funds, in most of the parts of the world, are unregulated because they cater tosophisticated investors who are assumed to be well informed about the happenings of the market.

Key Characteristics of Hedge Funds

For reducing the correlation between stock and bond markets and between national andforeign markets, hedge funds use a variety of financial instruments. These may be basic

securities like equity, debentures, bonds or derivatives as well.

Many hedge funds are flexible in their investment options i.e. they can use short selling,leverage, derivatives such as puts, calls, options, futures, etc.

The returns on investments, degree of volatility in returns, risks, strategy are the factorswhich make a hedge fund completely unique. Still, most of the hedge funds tend to hedge

against down turns in the market.

Many hedge funds have the ability to deliver non-market correlated returns. In fact,hedge funds are best known for delivering absolute returns even at the times when

markets dont perform well.

Many hedge funds have as an objective consistency of returns and capital preservationrather than magnitude of returns.

Most hedge funds are managed by experienced investment professionals who aregenerally disciplined and diligent. Such managers prefer trading in markets and securities

which they are specialized at.

Though hedge funds benefit by heavily weighting hedge fund managers remunerationtowards performance incentives, thus attracting the best brains in the investment


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business; there is a practice of high water mark also in the hedge fund industry, which

ensures that fund managers do not get paid for poor performance.

In addition, hedge fund managers usually have their own money invested in their fund.

Hedge Funds Investors:

Qualified clients, institutions, endowments, fund of funds, family offices and pensions invest inhedge funds.

Hedge Funds are restricted from accepting partners who are not "qualified clients."

Presently, if an individual can meet one of the following criteria, he is a qualified client

He has an individual net worth, or he and his spouse have a combined net worth, in excess of$1.5 million.

He had individual income, excluding any income attributable to his spouse, of more than$200,000 in the previous two years, and he reasonably expects to do the same this calendar year.

He and his spouse had joint income of more than $300,000 in the previous two years andreasonably expect to do the same in this calendar year.

Hedge Fund Manager/ Administrator: The hedge fund manager or administrator acts as ananalyst keeping track of the hedge funds news, bonus returns, quotes, valuations and returns. Thehedge fund statistics include a careful research on all these factors to avoid any kind of fraud inthe valuations.

Typical Hedge Fund Investment Procedure:

Investor chooses and decides hedge fund investment Subscription amount is paid to the custodian. Custodian confirms receipt of payment to fund administrator. Fund administrator instructs issue of share to investor. Fund administrator issues reports on hedge fund performance.


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Investment manager instructs custodian to move funds to prime broker for investment inmarket.

During the process the prime broker and custodian are in direct contact with fundadministrator.

Hedging Strategies:

A hedge fund is a term which is generally used to describe any fund that isn't a conventionalinvestment fund - that is, any fund using a strategy or set of strategies other than investing longin bonds, equities (mutual funds), and money markets (money market funds). Among thesealternatives are:

Hedging by selling short it means selling shares without owning them, hoping tobuy them back at a future date at a lower price in the expectation that their price will

drop

Using arbitrage - seeking to exploit pricing inefficiencies between related securitieswithout any probabilities of losses.

Trading options or derivatives dealing in contracts whose values are based on theperformance of any underlying financial asset, index or other investment

Using leverage without using own capital for buying securities trying to make asmuch profit as would have been if the capital has been invested. For doing so, hedge

funds borrow money for a bigger share of the investment and put their own capital as

margin money.

Investing in out-of-favor or unrecognized undervalued securities (debt or equity) forbenefitting from undervalued securities intrinsic value, hedge funds try to identify

and invest in such securities.

Attempting to take advantage of the spread between the current market price and theultimate purchase price in event driven situations such as mergers or hostile

takeovers.


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Mechanism of Hedge Funds

How does a hedge fund "hedge" against risk?

Hedge funds not necessarily follow their name. The name Hedge Fund applies to a largenumber of funds which may or may not be interested in earning returns only by hedging againstrisks. For earning high returns for their investors, these funds may use high- risk strategies aswell, which may or may not provide adequate cover for inherent risks.

For example, a global macro strategy may speculate on changes in the economic andinternational trade policies of various nations which may have an impact on interest rates, whichultimately impact all types of financial instruments. This strategy also uses a high degree ofleverage. In this strategy, though the returns can be high, but chances are that the losses can alsobe high, as the leveraged directional investments (which are not hedged) tend to make the largestimpact on performance.

Most hedge funds, however, do seek to hedge against risk in one way or another, makingconsistency and stability of return, rather than magnitude, their key priority. In fact, less than 5percent of hedge funds are global macro funds.

Some hedge funds which follow event driven strategies like investing in distressed companies orspecial situations try to reduce risks by making their investments uncorrelated to the markets.

They may buy interest-paying bonds or trade claims of companies undergoing reorganization,bankruptcy, or some other corporate restructuring - counting on events specific to a company,rather than more random macro trends, to affect their investment. Thus, they are generally able todeliver consistent returns with lower risk of loss.Long/short equity funds, while dependent on the direction of markets, hedge out some of thismarket risk through short positions that provide profits in a market downturn to offset lossesmade by the long positions. Market neutral equity funds which invest equally in long and shortequity portfolios generally in the same sectors of the market, are not correlated to marketmovements.

A true hedge fund then is an investment vehicle whose key priority is to minimize

investment risk in an attempt to deliver profits under all circumstances.


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Investing Strategies of Hedge Funds:

There are approximately 14 distinct investment strategies used by hedge funds, each offeringdifferent degrees of risk and return. Understanding the characteristics of the many differenthedge fund strategies is essential to capitalizing on their variety of investment opportunities.

The predictability of future results shows a strong correlation with the volatility of each strategy.Future performance of strategies with high volatility is far less predictable than futureperformance from strategies experiencing low or moderate volatility.

1. Aggressive Growth: Hedge Funds following this strategy invest in equities expected toexperience acceleration in growth of earnings per share. These equities generally have highP/E ratios, low or no dividends; often smaller and micro cap stocks which are expected toexperience rapid growth. Investments include sector specialist funds such as technology,banking, or biotechnology.This strategy hedges by shorting equities where earnings disappointment is expected or by

shorting stock indexes. This strategy tends to be "long-biased."

Expected Volatility in performance of this Strategy: High

2. Distressed Securities: Hedge Funds which follow this strategy buy equity, debt, or tradeclaims at deep discounts of companies in or facing bankruptcy or reorganization.These hedge funds earn their huge returns from the market's lack of understanding of the truevalue of the deeply discounted securities and because of the fact that the majority ofinstitutional investors cannot own below investment grade securities. In fact, this sellingpressure on the issuer companies creates the deep discount.The results of such investments are generally not dependent on the direction of the markets,because the investment is made in such securities which the market generally not trade in.

Expected Volatility in performance of this Strategy: Low - Moderate

3. Emerging Markets: Hedge Funds following the strategy of investing in emerging marketsinvest in equity or debt of emerging or less mature markets that tend to have higher inflationand volatile growth. Generally short selling is not permitted in many emerging markets, and,therefore, effective hedging is often not available.

Expected Volatility in performance of this Strategy: Very High

4. Fund of Funds:

Rather than investing in individual securities, a Fund of Funds invests in other hedge funds.Technically any fund that pools capital together, while utilizing two or more sub managers toinvest money in equity, commodities, or currencies, is considered a Fund of Funds. Investorsallocate assets to Fund of Funds products mainly for diversification amongst the different


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managers' styles, while keeping an eye on risk exposure. One of the advantages is duediligence.Due diligence is a primary advantage because the fund of funds manager may spend hiswhole day evaluating strategies and speaking with individual fund managers. This would bean extremely hard task for an individual. The fund of fund also may combat risk by achieving

manager diversity, because of the different strategies employed by the underlying managers.

Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds.

Expected Volatility in performance of this Strategy: Low - Moderate - High

5. Income: Hedge Funds which follow this strategy invest with primary focus on yield orcurrent income rather than solely on capital gains. These funds may or may not utilizeleverage to buy bonds and sometimes fixed income derivatives in order to profit fromprincipal appreciation and interest income, but their main focus still remains the same-

current yields.

Expected Volatility in performance of this Strategy: Low

6. Macro: Hedge Funds following the macro strategy aim to profit from changes in globaleconomies, typically brought about by shifts in government policy that impact interest rates,in turn affecting currency, stock, and bond markets. These hedge funds participate in allmajor markets like equities, bonds, currencies and commodities, though not always at thesame time. These funds use leverage and derivatives to accentuate the impact of marketmoves as well as hedging, but the leveraged directional investments tend to make the largestimpact on performance.


7. Market Neutral - Arbitrage: Hedge Funds which prefer market neutral arbitrage strategy,attempt to hedge out most of the market risk by taking offsetting positions, often in differentsecurities of the same issuer.For example, they can be long in convertible bonds and short in the underlying equity of thesame issuer.These funds may also use futures to hedge out interest rate risk. They focus on obtainingreturns with low or no correlation to both the equity and bond markets. These relative valuestrategies include fixed income arbitrage, mortgage backed securities, capital structurearbitrage, and closed-end fund arbitrage.



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8. Market Neutral - Securities Hedging: These hedge funds invest equally in long and shortequity portfolios, generally in the same sectors of the market. Though this strategy reducesmarket risk to a large extent, it stresses on effective stock analysis and stock picking forobtaining meaningful results. Leverage may be used to enhance returns.Investment is made in securities which generally have very low or no correlation at all with

the market. But, the same strategy sometimes uses market index futures to hedge outsystematic (market) risk.


9. Market Timing: In this strategy, the managers of the hedge fund allocate assets amongdifferent asset classes depending upon the managers view of the economic or marketoutlook. Portfolio emphasis may swing widely between asset classes. Unpredictability ofmarket movements and the difficulty of timing entry and exit from markets add to thevolatility of this strategy.

Expected Volatility in performance of this Strategy: High

10.Opportunistic: The investment theme of hedge funds which follow opportunistic strategychanges from strategy to strategy as opportunities arise, to profit from events such as IPOs,sudden price changes often caused by an interim earnings disappointment, hostile bids, andother event-driven opportunities. The hedge funds may utilize several of these investingstyles at a given time and are not restricted to any particular investment approach or assetclass.

Expected Volatility in performance of this Strategy: Variable

11.Multi Strategy: Investment approach of the hedge funds following this strategy isdiversified by employing various strategies simultaneously to realize short- and long-termgains. Other strategies may include systems trading such as trend following and variousdiversified technical strategies. This style of investing allows the manager to overweight orunderweight different strategies to best capitalize on current investment opportunities.

Expected Volatility in performance of this Strategy: Variable

12.Short Selling: One of the very basic strategies of hedge funds, in it the fund manager sellssecurities short in anticipation of being able to re- buy them at a future date and at a lowerprice due to his assessment of the overvaluation of the securities, or the market, or inanticipation of earnings disappointments often due to accounting irregularities, newcompetition, change of management, etc. Often used as a hedge to offset long-only portfoliosand by those who feel the market is approaching a bearish cycle. It involves a very highdegree of risk.


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13.Special Situations: Hedge Funds following this investment strategy look for companieswhich are currently facing special event- driven situation such as mergers, hostile takeovers,

reorganizations, or leveraged buyouts.This strategy may involve simultaneous purchase of stock in companies being acquired, andthe sale of stock in its acquirer, expecting to profit from the spread between the currentmarket price and the ultimate purchase price of the company. The fund managers may alsoutilize derivatives to leverage returns and to hedge out interest rate and/or market risk.Results of such strategy generally are not dependent on direction of market.

Expected Volatility in performance of this Strategy: Moderate

14.Value: Hedge Funds following this strategy, invest in securities perceived to be selling at

deep discounts to their intrinsic or potential worth. Such securities may be out of favor orunderfollowed by analysts.It requires long-term holding, patience, and strong discipline until the ultimate value isrecognized by the market.

Expected Volatility in performance of this Strategy: Low - Moderate


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Hedge funds in India

In India, hedge funds have been almost non- existent even after substantial developments in thecapital market. A few hedge funds which operate in Indian Capital market are either subsidiaryof foreign hedge funds or have come through FII route.

Financial experts opine that India has tremendous potential for attracting global investments inhedge funds. The early entrants into the Indian markets have recorded encouraging returns whichin turn attracted other hedge fund players to step in. Renaissance Technologies, Vikram Pandit-founded Old Lane, DE Shaw, Och-Ziff Capital Management are some reputed internationalhedge funds firms in India. Here is a list of hedge funds operating in India.

Indea Capital Pte Ltd.Indea Capital Pte. Ltd (Indea) is a Singapore based investment advisor. Indea was formed

in 2002 to provide boutique fund management services to institutions, foundations,family offices and high net-worth individuals. In July 2003, Indea launched the IndeaAbsolute Return Fund (IARF), a directional fund investing in India and Indian companiesglobally. The principals have a combined over 30 years of experience in researching andinvesting in India. In addition to the Singapore office, Indea has a research presence inMumbai, India.

Indea employs a disciplined bottom-up and top-down approach to identify potentialinvestments to deliver superior risk-adjusted returns. We intend to achieve this goal byattracting and retaining the best investment talent and building thought leadership.

Strategy: not specified in website.

India Capital FundIndia Capital FundSM is an open-ended Investment Company incorporated in Mauritius

which has invested in India since 1994. Shares of the India Capital FundSM (the "Fund")

have not been registered under the U.S. Securities Act 1933, as amended. Nor has the

Fund registered under the U.S. Investment Company Act of 1940, as amended.

Accordingly, shares of the Fund are not offered or sold to the public in the United States.

Access to this site requires a password.

Strategy: not specified in website.


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India Deep Value FundIndia Investment Advisors, LLC was founded by Robin Rodriguez and Raj Agarwal in

2006 to pursue the number of significant investment opportunities presented by the

burgeoning Indian capital and real estate markets. As a result, the India Deep Value

Fund was launched in April 2006. The Fund's Managers seek to achieve long-termcapital gains by acting as pro-active deep value investors in publicly-traded Indian stocks.

The India Deep Value Fund is an excellent investment opportunity.

It offers investors the opportunity to invest in India Asias fourth largesteconomy and tenth largest worldwide.

Our Advisors have a proven track record as pro-active deep value investors. In addition, the Fund's Managers seek to minimize Fund volatility by

implementing strict portfolio monitoring and risk management procedures.

Strategy: The Fund will adhere to a classic deep-value investment philosophy selecting

stocks with strong balance sheets, but trading at significant discounts to their perceived

intrinsic liquidation or break-up value. The Fund will also focus on companies whose

valuation is at a substantial discount to industry peers or historical averages.

Fair ValueFocuses on Deep Value Investment, Risk Arbitrage and Special Situations in IndianEquity markets.

Fair Value Capital is a highly specialized and exclusive Investment Advisory Firmfocused on Deep Value Investment opportunities primarily in Indian equity markets.

Strategy: deep value strategy.

Naissance Jaipur (India) FundNaissance was founded in Switzerland in 1999 by R. James Breiding and the late Dr.

Francois Mayer with the assistance of a few families having considerable means.

Strategy: mixed/ opportunistic


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Avatar Investment ManagementAvatar Investment Management is the investment advisor to three funds. Headquartered inMauritius, the funds are focussed on the Indian public and private equity markets. In order tomeet the approval of various regulatory bodies around the world, only accredited investors may

apply to invest.

Strategy: not mentioned in website.

Passport India FundPassport Capital

Passport Capital LLC is a San Francisco based, global investment firm founded by John H.Burbank III in 2000. The firm manages approximately $2.3 billion in assets. Passport'sinvestment process uses a combination of macroeconomic analyses to develop major themes andrigorous fundamental research on individual companies to create global portfolios.

Passport Capital is a federally registered investment advisor with the United States Securities and

Exchange Commission.

It follows different strategies for different investment avenues like agricultural, basic materials,

energy, renewable energy and rig sectors.

Its global strategy is a long-biased, value-oriented strategy seeking significant inefficiencies in

the worlds most promising capital markets

Through its own FII, Passport India Fund, it invests in Indian companies with a focus on

domestic economy sectors such as financial services, media, retail, consumer and special

situations.

Strategy: growth strategy.


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Atlantis India Opportunities Fund

The Atlantis India Opportunities Fund is a sub fund of the Atlantis International Umbrella fund -an open-ended umbrella unit trust established as a UCITS III and listed in Dublin.The Fund was launched on November 25th, 2005. The investment objective of the Sub-Fund isto achieve long term capital appreciation. The Sub-Fund will invest mainly in a portfolio ofequities and equity-related instruments (such as convertible bonds, preference shares or warrants)issued by companies located in India or deriving a preponderant part of their incomeand/or assets from India. Such securities will be principally listed or traded on one ormore recognized Exchanges located in India. To a lesser extent, these securities will be listed ortraded on recognized Exchanges located outside IndiaThe India Opportunities Fund is recognized by the Financial Services Authority and will qualifyfor distributor status

Strategy: growth strategy, long term holding.

Karma Capital Management, LLC

Strategy: mixed, a combination of long and short positions.

Karma Capital Management LLC, a US (SEC) registered Investment Advisor and an India(SEBI) registered Foreign Institutional Investor (FII), is a leader in alternative investments inthe Indian Capital Markets. Founded in 2003, we were one of the pioneers in the field and have

achieved over 4 years of consistent performance for our investors.


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My strategy as a Hedge Fund Manager

I will adopt a mixed/ multi strategy for the hedge fund I manage. The same strategy is being

followed by the Karma Capital Management, LLC. It is a combination of both short and longpositions in stocks.

Investment Process

The investment process will be based on an approach which is a combination of top- down

bottom- up stock selection; which means finding such stocks which are either undervalued or

over- valued as well as determining reasons for their re-rating or de- rating. The procedure for

finding such stocks will be one or the other or both of the following:

Analyzing the macro factors first, then the factors related to the specific company- top-down

approach. These macro factors include GDP growth rates, inflation, interest rates inside and

outside the country, productivity etc.

Analyzing the company irrespective of the macroeconomic and other factors, believing that

companys performance and the value of its stock is independent of these macro factors.

The basis of adopting such strategy would be the research on a wide range of stocks done by in-

house research analysts. This is called proprietary research. This helps taking long or short

positions which may or may not be possible when we take services of a separate stock analyzing

agency.

Proprietary research helps finding stocks which have asymmetric risk- reward characteristics and

also in arbitraging valuation anomalies.

I will take long/ short positions in all types of stocks- large cap, mid cap and small cap.


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The approach for taking such positions will be based on the analysis of the following factors:

Target Market: investment can be both in Indian as well as in foreign stock markets.

What matters most is the availability of such securities which are undervalued or over- valued

by majority of the players of that market.

Sectors: analysis of sectors which can perform well is another major area of research and would

be considered properly. It includes analyzing the impact that the macroeconomic and political

policies of a nation have on a particular sector.

I will look for such sectors which have potential to grow tremendously as well as have chances

of being benefitted by current policies of its parent nation.

Fundamental Analysis of the company: for making financial forecasts about the companies

that I select for investing in, I will do fundamental analysis of their profitability, financial health,

liquidity etc. This analysis helps in learning which stocks have been mispriced by the market,and what is their real price.

Technical Analysis of the Security: based on the trend of performance of the stock, assuming

that markets have valued the securities correctly. This process is mostly based on market

statistics.

These steps help in knowing how much a stock is valued at present and how much it must be

valued actually.


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Explanation of how I would invest and enhance the value of the investment:

Long Position:based on the analysis of current market situations and search for undervaluedstocks.

A. Current Market Situation:

Due to the upcoming Commonwealth Games in New Delhi in the year 2010, large sums arebeing spent on infra-structure like road building, extension and renovation of airports, extendingthe METRO to further areas in the National Capital Region and in the construction industry inparticular. Industrial activity has also taken off with high growth rates in manufacturing. This is avery promising outlook especially for the national tube and pipe industry.

B. Information about the company and fundamental Analysis:

Name of the company:Welspun Gujarat Stahl Rohren Ltd. (WGSRL)

Industry Name Steel - Tubes/PipesHouse Name Welspun Group CollaborativeCountry Name- IndiaYear Of Incorporation 1995Year Of Commercial Production N.A.

Fundamental Analysis Tools

For this stock, below given are the ratios:

Market Cap 3,656.25 * EPS 16.11 * P/E 12.16 * P/C 8.58

* Book Value 92.56

*

Price/Book 2.12 Div(%) 30 Div Yield(%) 0.77

Market Lot 1 Face Value 5

Industry

P/E 8.33* As per latest stand alone adjusted profit after extra-ordinary items.

PEG Ratio= Price Earning to Growth Ratio= 0.26

(taken directly from http://www.stockmarketupdates.in)


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Conclusion: Companys current performance is good and having a below 1 PEG Ratio showsthat the company has a good growth prospectus but has been undervalued by the market.

C. Technical Analysis of the stock

Historical Prices

Stock prices and tradable volume one year back

Price Data for Welspun Gujarat Stahl Roh on 17-07-2008

BSE NSE

Open Price Rs.279.90 Rs.282.50

High Price Rs.292.00 Rs.293.00Low Price Rs.277.00 Rs.276.50

Close Price Rs.286.40 Rs.285.75

Volume 209634 573725

Source: moneycontrol.com


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Stock prices and tradable volume one week back

Price Data for Welspun Gujarat Stahl Roh on 10-07-2009

BSE NSE

Open Price Rs.192.80 Rs.195.70High Price Rs.195.80 Rs.196.50

Low Price Rs.180.10 Rs.179.15


Volume 707625 1599167


Conclusion: technical analysis of the companys stock price shows that it has been following themarket index, but the fundamentals reflects that it should have been much above the index.

Therefore, this stock is good for going long in.


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Short Position

A. Current Market Situation:

Indian pharmaceutical industry has been a booming industry, especially after 1980. In past onedecade Indian pharma companies have been experiencing a growth rate of 6%-10% p.a. in theirsales.As per Deutsche Banks research, this sector is about to experience an 8% p.a. growth by 2015.The new focus of Indian pharmaceutical companies is on self developed drugs and contractresearch and/ or production for western drug companies.

B. Information about the company and fundamental Analysis:

Company Name - Divis Laboratories

Industry Name- Pharmaceuticals

House Name- N.A.

Year of Incorporation- 1990

Year of Commercial Production- N.A.

Fundamental Analysis Tools

For this stock, below given are the ratios:

Market Cap 6,977.64 * EPS 64.96 * P/E 16.56 * P/C 14.87

* Book Value 134.78

*

Price/Book 7.98 Div(%) 200

Div

Yield(%) 0.37

Market Lot 1 Face Value 2

Industry

P/E 16.87

* As per latest stand alone adjusted profit after extra-ordinary items.

PEG Ratio= Price Earning to Growth Ratio= 1.13

(taken directly from http://www.stockmarketupdates.in)


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Conclusion: a very high price to book value ratio and a above 1 PEG ratio show that this stock isover-valued by the market.

Technical Analysis:

Historical Prices

Stock prices and tradable volume one year back

Price Data for Divis Laboratories on 17-07-2008

BSE NSEOpen Price Rs.1324.75 Rs.1339.70

High Price Rs.1344.00 Rs.1345.00

Low Price Rs.1310.00 Rs.1310.00


Volume 11423 53138



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References:

Book: Investment Banking- Pratap C. Subramanyam

Websites:

1. http://www.hedgefundlawblog.com/what-is-a-qualified-client-qualified-client-definition.html

2. http://www.stockmarketguide.in/2008/06/10-best-undervalued-companies.html

3. http://www.stockmarketupdates.in

4. http://www.moneycontrol.com

hedge funds by tripti sao, sibm- b

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