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 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
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.
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.
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 invested ₹100 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.
All 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 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.
Out: L&T, Tata Motors, Bharti Airtel
In: HCL Tech, M&M, Hindalco
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.
The stocks investing checklist link
Buying your first stock link
5 things not commonly known about the NIFTY link