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New wave of IPOs expected
for growth market
Taking AIM
Responding to
Pressure
How prime brokers are
managing industry chal...
n Equity MarkEt
18 www.finance-monthly.com
Concentration & Volatility:
Concentrated vs. diversified approaches are often d...
ExpEriMEntPrice-based NAV excludes impact of dividends.
Dividends paid on the scrips are assumed to be in
March only, henc...
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Sourajit Aiyer - Finance Monthly Magazine, UK - Concentration and Volatility, An Equity Market Experiment - Sept 2013

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Sourajit Aiyer - Finance Monthly Magazine, UK - Concentration and Volatility, An Equity Market Experiment - Sept 2013

  1. 1. New wave of IPOs expected for growth market Taking AIM Responding to Pressure How prime brokers are managing industry challenges Concentration & Volatility An experiment in equity markets Also inside… Venture Capital Distressed Real Estate Retail Banking Issues in Capital Markets SEPTEMBER 2013 ISSN 2052-6482
  2. 2. n Equity MarkEt 18 www.finance-monthly.com Concentration & Volatility: Concentrated vs. diversified approaches are often debated in investment exposure. While diversified portfolios help to reduce risk, concentrated portfolios help enhance upside. Depending on the market environment and investors’ risk-return appetite, both have their importance. Diversified portfolios are believed to work best if the prices of its underlying typically move in opposite directions. Nevertheless, the ultimate performance of portfolios may still depend on the outlook of the underlying and market conditions, which may be ever-changing during volatile times, and impact companies’ financial performance, prices and sentiments despite the best of management decisions. The intention behind this portfolio idea is to see if the term ‘consistent’ can be brought into equity portfolio approaches in volatile markets, using a simple strategy that can be replicated each year. By Sourajit Aiyer he ‘Consistent Dividends Consistent Fundamentals (CDCF)’ idea is based on the premise that investing in a concentrated portfolio of consistent dividend paying stocks, which have achieved consistency in fundamental performance with low leverage, is better in volatile times. This exercise is done for academic interest without any intention of investment solicitation. It seeks companies which delivered ‘consistent’ growth in financial metrics, 'consistent' margins, ‘consistently’ paid dividends to reward shareholders who may have missed booking gains by capital appreciation by not liquidating at opportune times, and with low leverage which gives headroom for expansion and maintain their growth track record, if needed. It screens the universe of listed Indian scrips using annual financial data of the last 3 rolling fiscal years. Since annual financials are used, the underlyings’ data will remain as such till the next year. That is when the constituents will churn. Hence, this basket may be termed as ‘Semi-Active’ and not really ‘Active’. The screening methodology itself does not really require high-caliber active management as it's a set methodology and replicable. Scrips with market cap above INR 250 crores as of March 2012 are taken (1 Crore = 10 Million). Critics might argue this is low, however it may be justified given the market cap sizes of some holdings of Small Cap funds. We take stocks which had revenues of over INR 100 crores in FY2012, and showed revenue growth in the last 3 rolling years of over 10% (CAGR basis), including in the immediate previous fiscal. The growth rate criteria is repeated for operating profits and PAT to ensure consistency in margins. At PAT level, we tweak this only for the immediate year wherein we take those which clocked at least positive growth. We drill on the threshold level of profit margins for companies which achieved at least 10% PAT Margin in each of the previous 3 fiscals. The PAT assumptions may be justified given the Opex challenges since the last couple of years. We target dividend percent of over 20% and dividend yield of over 2% - consistently in each of the previous 3 rolling fiscals. An exception was made for ITC, whose dividend yield in FY2012 was marginally lower at 1.98%. We target companies with debt: equity ratio of less than 2x, which allows some headroom for future capitalization. Lastly, some qualitative screening was done on average yearly turnover and on recent returns generated by the scrips. Post stock-screening, weights and scrip units are assigned as per free-float market capitalization with a cap of 10% per individual stock. NAV back-testing is done on a quarter-end basis. Scrip-units at the end of each quarter are rebalanced to calculate the new ‘Price-based NAV’ for the next quarter-end using next quarter’s prices. Once the new NAV is set, the scrip units for that new quarter-end will be balanced using this new NAV, new market cap and prices. T A Special Feature 18 www.finance-monthly.com
  3. 3. ExpEriMEntPrice-based NAV excludes impact of dividends. Dividends paid on the scrips are assumed to be in March only, hence the impact of dividends will be in March quarter-end NAV. Dividend received per scrip is based on scrip units and dividend per share. We assume dividends are distributed and not retained to purchase further units. Resultant NAVs are compared with benchmark indices and dividend funds. While returns from Gross NAV signify what an investor actually earns, the Price-based NAV is used for comparison to benchmark indices. This is because the NSE Nifty is also a price based index, hence shows the impact of price appreciation only. This exercise was originally attempted in January 2012 using financials till FY2011 for back-testing. It was repeated in January 2013 using financials till FY2012 to test its performance during 2012. Thus, 15 stocks were shortlisted in the Jan 2013 exercise - ITC, Corporation Bank, J & K Bank, Karur Vysya Bank, VST Inds., eClerxServices, Swaraj Engines, Colgate-Palmolive, Allahabad Bank, Dena Bank, South Indian Bank, Gateway Distr., Grindwell Norton, Hinduja Ventures and Kewal Kiran Cloth. 7 stocks were common to the shortlisted list when this exercise was done in Jan 2012, i.e. ITC, Corporation Bank, J & K Bank, Karur Vysya Bank, VST Inds., eClerxServices, Swaraj Engines. Companies shortlisted in Jan 2012 but removed in Jan 13 were Andhra Bank, Castrol, Crisil, Cummins India, Indian Bank, Jagran Prakashan, Natl. Peroxide, Polaris Finan., SBT and VST Till Tract. Comparing the CDCF Concentrated Portfolio’s NAVs with Benchmark Indices shows:- • Delivered outperformance for the entire period based on annualized returns from Mar 2008 to Dec 2012. • Delivered outperformance at similar levels of volatility - CDCF’s annual standard deviation is at similar levels to the standard deviation of the benchmark indices • Delivered positive excess returns in each annual period - i.e. Dec 12-Mar12, FY12, FY11, FY10, FY09 vs. benchmarks like Nifty, Midcap, CNX 500 and CNX Dividend Opportunity. The only exception was in FY12 vs. Dividend Opportunity Index although the negative excess returns were a mere -0.5%. At most other times, the extent of positive excess returns has been significant • Delivered significant Alpha over all the benchmark indices based on annualized returns and beta from Mar 2008 to Dec 2012 • Achieved higher Sharpe ratio than indices, based on annualized returns and volatility from Mar 2008 to Dec 2012 • On a quarterly basis, delivered positive excess returns in approximately 75% of the quarters with each of the benchmark indices Comparison with Dividend Yield Mutual Funds shows the CDCF basket delivered higher Annualized Returns compared to most funds. It delivered better returns than these peers MFs in most individual fiscal years. Rationale behind this CDCF idea is that these stocks have demonstrated a consistent track record by consistently showing fundamental growth and dividend payouts for the rolling 3 years. It has delivered better annualized returns over the period at similar level of risk, and delivered positive excess returns in almost each of the individual fiscal years. Bloomberg Forward Estimates show the median growth rates in revenues and profits are in line, and in fact higher, than those assumed in stock screening. Portfolio churn is only once a year when annual financials are updated, hence largely ‘Semi-Active’ in terms of fund management as it doesn't need high-level active management skills. ‘Semi-Active only’ orientation might be advantageous from the point of view of setting a competitive TER/management fee for such a fund portfolio. Risk factors are that it loses out on high dividend- yield companies whose recent financials may have been hit. It has over 50% exposure to banking sector. Minimum market cap used for screening (INR 250 crores) is low and the portfolio may share the inherent risks of small cap stocks. Criteria for traded volumes of underlyings (to measure liquidity) may be low – yearly average over INR 0.1 crore. While portfolio churning is done only once a year, impact cost may still need to be factored in. Screening doesn’t take into account the Return on Equity component. Updating of financials on an annual basis may ignore shifts in financial performance visible on a quarterly basis. In conclusion, every investment faces a challenge in delivering consistent out-performance, more so when market volatility makes it a struggle to beat inflation - investors’ biggest enemy. Even many low-risk asset classes often fail to beat inflation consistently, as historical trends show. The premise behind this entire exercise was to highlight the ‘consistent’ theme - to show that an approach based on such a theme in the current volatile markets can throw up opportunities to achieve out-performance – all on a consistent basis. About the Author Sourajit Aiyer, works with a capital markets company in India. The ideas expressed are personal and are not to be taken to represent those of the company. This article does not construe to be any investment advice or solicitation. Any action taken on the basis of the information contained herein is your responsibility alone. Email: sourajitaiyer@gmail.com This article is only a synopsis of the exercise. For details, please contact the author directly. The author would like to thank Mr Vivek Sinha for his insights on the scrip-unit construction methodology. an Equity Market Experiment

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