Investing Styles And Returns

Increase in ROE can be caused by many of the factors like higher profit margins, higher capital turnover, higher financial cost ratio, higher financial structure ratio and, lastly, due to change in tax structures.Since shareholders are interested in return on the money they have invested, they should prefer to invest in stocks with higher ROE.

There are many different styles for selecting stocks. Many stalwarts strongly believe in selecting stocks on the basis of promoter holding, i.e. place the bet on the master of the ship! Some others believe in selecting stocks that are trading at very low PEratio and expect mean reversion to take the prices of the stock upward. Sometimes, we select stocks on the basis of industry growth prospects or want to take an early mover advantage in a sunrise industry. Another method is selecting value stocks (low PB or PE ratio) or growth stocks (high growth rate) or just going with the flow with momentum trading. Whatever is the investment philosophy, over a period of time; we observe that some of these stock selection techniques work at some point of time, but there is no technique that works all the time. And if at all there was a full-proof strategy, then obviously with so many intelligent readers and investors, it would have been explored and exploited.

In this article, we are making an attempt to examine which of these investment strategies have worked in the last 15 years, starting 2004. We identified top 200 companies on the basis of market capitalisation as on July 4, 2019. Since we are evaluating which of the six strategies of stock selection has generated higher returns, we construct portfolios considering each one of these strategies based on financial information of the previous year with a holding period of one year.

First strategy that we test is momentum trading, which is defined as investing in stocks that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period. In our study,we sorted the stocks on the basis of returns generated in the previous year and invested in top 10 percentile stocks which have generated maximum return with a holding period of one year.

Second technique of stock selection is based on selecting companies with high growth rate in sales. The assumption here is the stockprices of companies where the topline is growing at the fastest rate should generate higher returns. In this technique; we select top 10 percentile stocks which have generated maximum percentage increase in sales over the previous year sales and invested in those 20 stocks for a holding period of one year.

The third technique is investing in stocks with high growth rate in operating profits. It is possible that sales are growing at nominal rate, but the costs are also increasing at a higher rate and hence the profits may be going down. So, in this method of investing, we focus on companies where profits are growing at the fastest rate. Hence, we select a stock which has maximum increase in operating profit over the previous year. As a methodology followed earlier, we selected 20 stocks which had maximum increase in operating profits and calculated price returns with one year of holding.

The fourth technique of selecting stocks is based on return on equity (ROE). ROE measures profitability earned on the shareholder funds and is a benchmark for comparing one company with its peers. It is also used to monitor the company’s performance over the years. Increase in ROE can be caused by many of the factors like higher profit margins, higher capital turnover, higher financial cost ratio, higher financial structure ratio and, lastly, due to change in tax structures.Since shareholders are interested in return on the money they have invested, they should prefer to invest in stocks with higher ROE. In this method, we select stocks which have generated maximum ROE in the previous year and obtain price appreciation with one year of holding.

The fifth style of investing is based onprice earnings ratio (PE ratio) which is calculated by dividing the current price of the share with its earnings per share. Thus, PE ratio indicates a number which is unit of company earnings that an investor is willing to pay and hence it should be used to compare if the stock is cheap or expensive verses other stocks in the same industry, all other factors remaining the same.Value investing on the basis of price-earnings ratio is a simple technique where we select stocks which have low PE ratio and hold the 20 stocks with the lowest PE ratio for one year.

Selecting stocks using a low price-tobook ratio (PB), is a technique where the investor believes that the stock is trading at a price lower than its book value and that the price will appreciate soon. Hence, the investor prefers a low PB stock. Every year, we selected companies that have lowest PB ratio among the 200 companies and calculated return for a holding period of one year.



Let’s analyze the table.If in 2004, aninvestor invests using momentum strategy; after one year of holding, the returns in 2005 would be close to 96%. If the same investor constructs a portfolio using strategy of sales growth; the portfolio of top 20 stocks would generate a return on 104%. But, as we can see, there is no single method which outperforms other methods of constructing a portfolio every year. Hence, it is important to see what the returns are over the period from 2004 to 2019 if an investor investsRs 1,000 in 2004 and continues to invest using the same technique every year. The results are in the last column of table-1 and, as we can see, `1,000 becomes `87,709 in 2019 using momentum investing style, whereas the next best result is `51,313 by investing in stocks where there is maximum growth in operating profits. All other strategies on constructing portfolio are not generating returns as good as momentum investing. It is also interesting to observe that in none of the last 15 years, momentum investing has generated negative returns. In fact, the CAGR of momentum investing (between 2004-2019) is nearly 35% This is a phenomenal return when we compare it to the average CAGR return of 21% generated by the portfolio of world renowned investor Warren Buffet.

Please note that returns as measured between 2004-2019 work only if you invest in top 20 stocks with equal weights in respective categories. Further, we have not factored in the cost of trading and tax on short term capital gains while calculating the portfolio’s return. Retail investor who wishes to replicate the findings should ensure that they have access to financial data and should also consider the cost of trading as well as impact of taxation on the returns. Further, we would like to add a word of caution that past cannot be full-proof predictor for the future performance.

Many retail investors would be happy to know that they can find options of choosing their investment styles and play relatively safe by investing in mutual funds that are categorized based on their investment philosophy. 


Prof Ruzbeh. J. Bodhanwala and Prof Shernaz Bodhanwala are faculty at School of Business, FLAME University, Pune.