Can buying cheap NIFTY stocks beat the index?

Legendary value investors, past and present, and the best value investing blogs offer this as the one consistent message.

Focus on buying stocks trading at relatively lower valuations to the market and the returns will take care of themselves.

Ironically, the most-quoted “value investor” in the world, Warren Buffett deviated from this simplistic strategy a long time ago when he started buying “wonderful businesses” (brand, pricing power, future ability to generate cash with minimal capital) at fair prices over fair businesses at “wonderful prices” (current low price to book / other earnings multiples”. The term “wonderful business” has since then been abused by a legion of value investors justifying obscene valuations for their stocks, but that’s a topic for another post.

The question I had was, what if we admit to ourselves to not being able to tell a wonderful business from a merely fair one? Would an investment strategy focused on just buying “cheap” stocks beat the market?

In an Indian context, does buying cheap NIFTY stocks work as a portfolio strategy? I did some analysis of how such a strategy would have performed compared to the broader NIFTY, in short, a quick and dirty backtest.

Hypothesis – what the test was meant to (dis)prove:

An investment strategy of buying a set of relatively cheaper stocks will outperform buying the broader market over the long term

Set up constraints / assumptions / caveats:

  • The universe considered for this test was the 50-stock benchmark NIFTY minus banking and finance stocks
  • Time period considered; from Sep 2008 to Aug 2017, statistically speaking a short time frame, but covers a nine year business cycle

The ‘Value Portfolio’ strategy:

  • The value portfolio is equal-weighted (not market cap weighted) and constructed from the “x” cheapest stocks from the NIFTY once in the year. x can be any number, for this test I’ve considered portfolios consisting of the cheapest 5, 10, 15 stocks
  • Rebalancing occurs annually every September, because Financial Year results of many companies are not published until several months into the next fiscal
  • Returns have been calculated using average price for the last week of August. Dividends, taxes and transaction costs have not been considered. Same applies to the benchmark NIFTY, costs of investing in an ETF have been ignored

Defining what are “cheap” stocks

There are several possible metrics for relative valuation: Price to Sales, Price to Earnings, Price to Free Cash Flow and so on. For this test, I’ve used Joel Greenblatt’s metric of EBIT (Earnings before Interest and Taxes) / TEV (Total Enterprise Value), since it doesn’t give an inherent advantage to specific business models (high vs low CAPEX) and includes debt and equity in the metric to avoid artificially bumping up companies with high borrowing. In a nutshell, higher the EBIT / TEV ratio, cheaper the stock.

Executing the “value portfolio” strategy or The difference between theory and practice

The NIFTY Value Portfolio strategy we are testing is simple. Rank the index stocks in descending order of their price (EBIT / EV) and invest equal amounts in the top 5 / 10 / 15 stocks. Hold for a year and rebalance in September.

First, the competition: The NIFTY 50 benchmark

The Calm Investor | Value Investing

The NIFTY 50 has delivered 10% annual returns with 15% standard deviation (volatility) from Sep 2008 to Aug 2017.

How does it do? I downloaded the list of 51 NIFTY stocks, removed the banking and finance stocks. Next, their historical daily prices going back to Aug 2008 till present day, then annual results for each financial year to compute the cheapest 5-10-15 stocks each year.

NIFTY vs “Naive” Value Portfolio

Comparing the annual returns of the Value Portfolio strategy with the NIFTY

The Calm Investor | Best Investment Blog

A whopping 32% annual return from the 5-stock portfolio! Even the 10 and 15 stock portfolios delivers more than double the NIFTY over the nine year period. Case closed! Or is it?

The performance is not surprising considering the 5-stock portfolio had blockbusters like Asian Paints that returned 37%, 127%, 33%, 26%, 24% from 2009 to 2013. Problem is, Asian Paints was not part of the NIFTY until 2012. (Asian Paints was excluded from the NIFTY in 2002, re-inducted in 2012).

For this to be a fair test, in any given year, the Value Portfolio can only hold stocks that were part of the NIFTY at that time. Take a look at the list of NIFTY stocks each year from 2007 to 2017.

The Calm Investor | NIFTY Changes 2007 to 2017

NIFTY vs “Real” Value Portfolio

In each September, we identify the cheapest NIFTY stocks at that point in time (so no Asian Paints before 2012) and build a portfolio with a subset of these stocks. We repeat the process in subsequent Septembers and track the results.

Chart below shows annualised returns for portfolios holding between 1 and 15 of the cheapest NIFTY stocks each year from 2008 to 2017.

The Calm Investor | India Value Investing Strategy

Looks like buying inexpensive stocks as rule works better than buying the broader index. Returns range between 16% to 28% depending on the number of stocks held. Given the returns seem to settle between 16-18% after 6 stocks and beyond, it might be that the success of the value portfolio comes from the stocks it causes us to avoid.

How many stocks is too few / many?

If you’d invested100 split between the two cheapest NIFTY stocks every year for the 9 year period, you’d end up with ₹913 (a 28% annual return) compared to 231 (9.8% return) from the NIFTY, but would the lost sleep be worth it?

I compared three value portfolios against the NIFTY, each with 5, 10 and 15 stocks. Chart below shows how  ₹100 invested in each of them in Sep 2008 do until Aug 2017.  
The Calm Investor | Value Investing StrategyAll the value portfolios comfortably outperform the NIFTY with the 10-stock portfolio outperforming slightly. But it’s important to look at other aspects like volatility and maximum drawdown in portfolio value.The Calm Investor | India Value Investing StrategyThe table shows choosing to follow a strategy that buys a small subset of the universe has it’s downsides in the form of increased volatility and more extreme swings in portfolio value. However, the Sharpe ratio (a measure of performance considering volatility), shows each of the three value portfolios has a higher Sharpe ratio than the NIFTY. Note how the NIFTY was the worst relative performer five years out the nine.

Overall, the 10 stock value portfolio offered the best return with the best Sharpe ratio and by not being worst performer in any of the years in the study.

Here are the stocks that were part of the 10-stock value portfolio from 2008 to 2017. The Calm Investor | India Value Investing StrategyApplying the same criteria, the hypothetical portfolio for Sep 2017 has three changes:

Out: L&T, Tata Motors, Bharti Airtel

In: HCL Tech, M&M, Hindalco

In conclusion

A portfolio strategy based on a subset of NIFTY stocks picked on the basis of price (cheapness) has a good shot at outperforming the broader index over the long term.

There are some caveats:

  • The time period considered for this study is extremely limited, just 9 years. An exhaustive study would need to go back to 1995, when the NIFTY was formed
  • Accuracy of data used could impact the applicability of the results (always a potential problem)
  • It excludes a large part of the NIFTY, banking and financial stocks reducing the addressable universe
  • This strategy is simplistic and purely works with one metric; EBIT / Enterprise Value. We should also consider the impact of using other price metrics like Price to Free Cash Flow, Price to Earnings to determine which metric. Ideally, a composite metric of these and others would make the “cheap” metric more robust

Any stock picking model should consider price and quality, this one only does the former. The next step would be to add “quality” metrics on financial robustness to weed out weak companies to potentially improve portfolio returns. A post on using other quantitative factors to improve portfolio returns coming up.

Please write in with your comments, especially if you spot any glaring errors in the analysis or data used.

This is a theoretical exercise, please do not consider this as a recommendation to invest in any specific stocks mentioned here. 

Further Reading:

The stocks investing checklist link

Buying your first stock link

5 things not commonly known about the NIFTY link

10 thoughts on “Can buying cheap NIFTY stocks beat the index?

  • September 26, 2017 at 12:00 am
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    Great analysis. 1. Are the returns of Nifty stock list starting from 2017 or from Nifty stock universe as that on 2008. If later than more precise as in 2017 as the futuristic list would not be know in 2008. ( Survivor-ship bias ) .
    2. Are the results significantly different for a broader universe say BSE100

  • September 26, 2017 at 9:35 am
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    Raghvendra, the list of stocks is picked from the NIFTY as on that date. i.e. the 2008 list consists of stocks that were part of the NIFTY at that time. No survivorship bias there. Still to see how it would look for a larger set of stocks like the BSE100, stay tuned.

  • September 26, 2017 at 11:08 am
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    You should add a few caveats that the chosen period was extraordinary, with QE pushing inflation in all financial assets worldwide. Future returns may not be the same. Also it would be prudent to check how much of the returns came from valuation expansion and how much from earnings expansion. The idea of rotating the portfolio every year to the cheapest stocks is good theoretically but one year is too small a time frame to let a business perform. For ex. Asian Paints would have only been in the portfolio in 2013. It would also be interesting to see the underperformance of the most expensive 10 in NIFTY. Overall this maybe one of the simplest ways to build a good portfolio with decent returns in the future. Thanks for sharing.

  • September 27, 2017 at 11:36 am
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    Thanks for the comment. I don’t quite agree about caveats about macro-economic events. For me as an investor they’re like weather events, not something I can pretend to be able to predict or to know the impact of. The objective of the exercise was not to recommend a strategy but to say “what if we adopted a purely price- value methodology to buy” and to report the results, so the one year rebalancing makes sense. If a stock continues to be cheap, it stays in the portfolio, might well work for longer holding periods, that’s analysis for another day.

  • October 2, 2017 at 5:56 pm
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    There seems to be some errors in this. If I am reading the table correctly Jindal Steel is shown as aNifty stock in 2017. It isn’t. Also we have tried to replicate this study at our end. We get a 12.92% between Sept 08-Sept 17 on 10-stock equal weighted portfolio

  • October 2, 2017 at 7:04 pm
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    Thank you for your comment Debasish. An honour to have you comment here.

    I checked the NIFTY graphic, and you’re right, I missed Wipro in the 2017 list. Have verified that was the only miss, updated accordingly. Also checked the mistake was only in the graphic and not in the model used to calculate returns.

    I did a quick check and my returns still come out at 18% for the 10 stock portfolio from Sep 2008 to Aug 2017. Possible reasons for the discrepancy with your number:
    1. Price returns have been calculated using average price from last week of Aug each year
    2. Valuation metric to pick cheap stocks is EBIT / EV (maybe using EBITDA or a different profit measure explains the difference?)
    Have posted the list of 10 stocks for each year at the bottom of the post. Maybe we can identify the discrepancy if we compare portfolios?

    Thanks again for pointing out the error.

  • October 2, 2017 at 10:37 pm
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    Hi I didnt do into identifying which were the cheapest. I took your 10 stocks and simply worked out the returns. If you share your email id I will email the xls working. I am not sure it can be uploaded here.

  • October 2, 2017 at 11:21 pm
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    Sure that’ll help. My id is thecalminvestor [at] gmail [dot] com

  • October 22, 2017 at 7:53 pm
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    Amazing analysis you have done, great work.
    But why do you leave banking & financial stocks, I couldn’t get the logic.
    As in these years banking stocks have major role to grow nifty.

  • October 23, 2017 at 8:34 am
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    Thanks Priyatam. Banking stocks can’t be valued using standard measures like EBIT / EV and so can’t be compared against non-banking stocks to identify the cheapest stocks. But you’re right, they are a big part of the NIFTY and there should be a way to normalize their financials for comparison.

What do you think?