For any investor the primary and perhaps the most significant decision to make in the process of investing is to decide on what investment strategy to adopt, such that is not too complex, such that would suit the risk profile of the investor and would still give the desired returns. Over the years of research scores of investment strategies have been designed and developed all proven to be effective in one market scenario or the other thus the task of an investor to select and adopt an investment strategy becomes challenging and here in lies the genesis of the problem of selecting a suitable investment strategy for an investor that compliments not only the needs of the investor but also the state of the economy in which the investor is investing, the trends of the stock markets, the policy making history of the state and a host of other micro and macro factors.
It is thus evident from past studies and trends that what strategy holds good in one country or region might fail to perform in other regions or countries where the state of the economy is different. What factors needs to be considered before adopting an investment strategy thus becomes an important question and the categorization of strategies that are efficient in a particular market setting is also important. One of such strategies that have emerged over the years is the Contrarian Investment Strategies or Value Investing.
For a reasonable period of time now value stock return premium over the growth stocks has been reported in separate developed markets, internationally and in emerging markets. Value investing is a process of buying stocks with low Price to Earnings, Price to Book Value, Price to Cash Earnings and other financial ratios and holding them to gain superior profits. It is also called contrarian investing style, in other words, looking for fundamentally undervalued stocks in the market. Most of the researchers and practitioners agree that such premium exists in the stock markets however there is no universal agreement on the causes of such phenomenon.
1.2 Major Concepts of the Study
The study is aimed at finding out whether the Contrarian Investment Strategy is suitable for Indian Markets in general and on a sector basis also. Thus the study revolves around the concept of value investing or Contrarian Investment Strategy.
Value investing as an investment paradigm was first introduced by Benjamin Graham and David Dodd at Columbia Business School in 1928. A pioneering text by these authors called Security Analysis was published in 1934. Generally, value investing involves buying securities that are underpriced by the market when compared with what is sometimes called an intrinsic value of the security, which an investor derives through some form of fundamental analysis. In the view of Graham and Dodd, equity prices include a rational component reflecting the fundamentals of a company and an irrational component capturing the emotions and psychology of investors at large. The rational component can be estimated with careful analysis, but the irrational component varies a great deal, and hence so does equity prices. They recommend buying a stock when it is underpriced by the market and then holding it for long time periods, thus creating a margin of safety against losses.
Intelligent Investor by Benjamin Graham (1949) includes the following piece of advice: "If you speculate, you will (most probably) lose your money in the end. Buy when most people are pessimistic and sell when they are actively optimistic. Investigate, and then invest. Rely on the time-tested principle of insurance, with wide diversification of risk." The relevance of this statement remains, because even though markets have changed, human nature and investment behavior is likely to have remained much the same.
In 1984 Warren Buffet published an essay called "The Superinvestors of Graham-and-Doddsville" as an opposition to the proponents of Efficient Market Hypothesis. In this publication he shows the returns achieved in the markets by nine investment funds including his own, run by people who were previously taught investing by Benjamin Graham in Columbia Business School in the 1950s. His research shows that all of these funds subsequently outperformed the S&P 500 market index in the long term. Of course, the technological advance and the speed of data exchange since those days have made the market absorb way more information, however as discussed before, it is still argued by behavioral finance proponents that there are discrepancies in the marked due to investor irrationality. The publication by W. Buffet might be criticized as being not a strictly academic paper, however it provides additional motivation to look into the academic research done on the topic since it was published and try to find a value premium in today's biggest emerging markets - specifically India in this study.
Value stocks are usually defined as companies that have low market-to-book ratio (M/B), price-to-cash ratio (P/C) or price-earnings ratio (P/E), or a high dividend yield. Value companies are often mature companies with not such high growth prospects. In fact, low sales growth is sometimes also used as a criterion to define value companies. Some may even call these companies dull and boring, as they are usually not the ones with the newest technologies and most exciting businesses. Growth stocks are usually of companies that are expected to grow at a rate that is higher than average, often having high P/C, B/M and P/E ratios and low dividend yields. These companies are the ones that appear a lot in the news with their newest technologies and exciting businesses models.
On the other hand an alternative investment strategy that can be adopted is to pick growth stocks for investment. A growth stock is a stock of a company that generates substantial and sustainable positive cash flow and whose revenues and earnings are expected to increase at a faster rate than the average company within the same industry. A growth company typically has some sort of competitive advantage (a new product, a breakthrough patent, overseas expansion) that allows it to fend off competitors. Growth stocks usually pay smaller dividends, as the company typically reinvests retained earnings in capital projects. A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects. Most technology companies are growth stocks.
1.3 Need for the study
The existence of value premium that is the excess of returns generated by value stocks over growth stocks has been notable in the past decades in the developed economies though what remains unclear is that whether value premium exists in the developing economies and more specifically does value stocks outperform growth stocks in the Indian market scenario needs to be seen. This study thus intends to answer this question and to find out whether the relatively successful investing concept of value investing be extended to Indian markets.
The need for the study can be highlighted from the fact that many studies have been conducted to prove the existence value premium in major developed economies but not much data is available on the extension of the philosophy in the Indian markets . Indian being one of the fastest growing economies of the world, this question needs to be answered.
1.4 Overview of the study
The structure of the study is set to lead from the introduction to the main ideas of value investing, comparing it to investment in growth stocks and presenting what are the contrarian investment strategies. The overview of the Indian stock market introduces the data collection and analysis part of the thesis followed by statistical tests for, value premium in the market. The interpretation of the test results will be provided afterwards before the main conclusions.
The main focus of this study is to prove that value investing strategies outperform growth strategies in Indian stock market. Since India is one of the major developing markets in the world now, it is interesting to see whether findings can be obtained here as so far I know of no similar research done on the data of stock markets in this country. I use a simplified method while comparing the value and growth portfolios. By analyzing the value premium and market data, the goal is not only to create a study with precise empirical outcome regarding the Indian market, but also to try to understand if the economy is feasible for value investing. By trying to achieve above goals, I am also willing to get a better understanding of Indian market by reviewing its recent development and position in today's world's economy.
The existence of value premium in Indian stock market would prove that it has similar movements to the rest of the world's markets.
