Contrarian Investing Strategies in The Indian Stock Market

Master Thesis
Aarhus School of Business and Social Sciences, Aarhus University
Msc in Finance, Department of Business Studies
July 2011
Contrarian Investing Strategies in the Indian Stock Market
Dziugas Tornau
Supervised by:
Stig Vinther Møller
Aarhus School of Business and Social Sciences, Aarhus University 2011

Contents
Section 1 - Introduction....................................................................................................................... 4
Abstract ........................................................................................................................................... 4
Objectives and goals ....................................................................................................................... 6
Problem statement ......................................................................................................................... 7
Empirical research, limitations and basis of theory and literature reviewed ................................. 8
Structure.......................................................................................................................................... 8
Section 2 – Classical and Behavioral finance theory overview ......................................................... 10
Classical finance theory ................................................................................................................. 10
Market Efficiency....................................................................................................................... 10
Random Walk Hypothesis ......................................................................................................... 12
Capital Asset Pricing Model (CAPM) ......................................................................................... 13
Behavioral finance theory ............................................................................................................. 16
Prospect Theory ........................................................................................................................ 16
Herding and overreaction ......................................................................................................... 19
Limits to Arbitrage ..................................................................................................................... 20
Section 3 – What is contrarian investing? ......................................................................................... 21
Motivation towards stock markets ............................................................................................... 21
Value super investors .................................................................................................................... 22
Review of literature on market inefficiencies and value premium............................................... 23
Section 4 – Empirical research .......................................................................................................... 27
India’s position in the global economy ......................................................................................... 27
Bombay Stock Exchange and Sensex index ................................................................................... 30
Data applied .................................................................................................................................. 32
Mean Reversion testing ................................................................................................................ 34
Discussion on mean reversion testing results ........................................................................... 38
Value premium and Betas ............................................................................................................. 39
One year holding strategy ......................................................................................................... 41
Equally weighted portfolios and Betas...................................................................................... 41
Value weighted portfolios and Betas ........................................................................................ 44
Two year holding strategy ......................................................................................................... 46
2
3 years holding strategy ............................................................................................................ 50
Portfolio Market Values ............................................................................................................ 54
Summary of the results ................................................................................................................. 55
Section 5 - Discussion on the reasons behind the results ................................................................. 57
Classical finance approach ............................................................................................................ 57
Emerging markets study............................................................................................................ 58
Bad states of the economy........................................................................................................ 58
Behavioral finance approach......................................................................................................... 60
Section 6 – Discussion on rationality in economics and conclusion ................................................. 67
Rationality in economics, other disciplines and further research ................................................ 67
Conclusion ..................................................................................................................................... 70
Literature ........................................................................................................................................... 72
Appendixes ........................................................................................................................................ 79
3
Section 1 - Introduction
Abstract
For a few decades value stock return premium over the growth stocks was
reported in separate developed markets, internationally and in emerging markets
by studies of J. Lakonishok et al (1994), E. Fama and K. French (1992, 1998) and
others. B. Graham and D. Dodd started arguing on value investing as a successful
investing discipline already in the early 1930s. 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.
The main objective of this thesis is to see whether value premium is present in the
Indian stock market since the liberalization of it in the early 1990s. I failed to find
any similar research done on the Indian stock market. Additionally, I look into the
reasons for the value premium – whether it can be explained by higher levels of
fundamental risk and classical (also called modern) financial theory or can the
reasons for market inefficiencies be based on irrationality of market participants
and the groundwork of behavioral finance theorists. The concept of rationality in
economic theory is also discussed.
My empirical research is based on the Bombay Stock Exchange Sensex index

composed of 30 large capitalization and liquid stocks from major sectors of
economic activity. After sorting the stocks to value and growth portfolios and
analyzing the holding strategies of one, two and three years I report an existing
value premium, however the statistical tests do not confirm it to be significant.
Extreme persistent volatility in the returns and small data sample can partly explain
such test results. I also find an indication of value stocks carrying more
fundamental risk, yet only for some cases of portfolios sorted on Price to Book
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Value and Price to Cash Earnings ratios. Consequently, the behavioral finance
theory is used to explain the reasons for the value premium found comparing value
and growth portfolios sorted on Price to Earnings and Asset Growth financial ratios.
Such factors as extrapolation, herding, overconfidence, framing, cultural
differences, corporate governance and corruption are discussed as possible
reasons for inefficiencies in the Indian stock market which lead to deviations from
fundamental values and the existence of value premium.
5
Objectives and goals
The main objective of this thesis is to prove that value investing strategies
outperform growth strategies in Indian stock market and to compare the findings to
similar studies carried out by J. Lakonishok et al (1991, 1994, 2004), Fama and
French (1992, 1998 and others) and others which report existence of value
premium in such markets as USA, developed European countries, Japan and
some of emerging markets. Since India is one of the major developing markets in
the world now, it is interesting to see whether similar 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 version of method of J. Lakonishok et al (1994) while
comparing the value and growth portfolios. Additionally, for explanations of the
value premium I use a wide selection of behavioral finance theory in contrast to
classical financial explanations and aim to get a better understanding of how
markets work in general and how the concept of rationality is developing in
economic theory. By analyzing the value premium and market inefficiencies, the
goal is not only to create a study with precise empirical outcome, but also to try to
understand and explain the main psychological, social, cultural and other
behavioral factors driving the financial markets and what reasoning lies under the
choices made by market participants. By trying to achieve above goals, I am also
willing to get a better understanding of yet quite untouched by academic financial
literature 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. Also, it would strengthen the
idea that better performance of value stocks is not just sample related outcome
and does not come from data mining.
6
Problem statement
The main, leading, questions in this study are the following:
Do the value investment strategies produce better results than growth investment
strategies in the Indian stock markets? What is the reason for that – greater risk or
irrational choices made by market participants?
While trying to answer the main questions a number of additional problems arise:
What is value investing as such and what is the philosophy behind it? What
financial theory is relevant to analyze it?
Does the performance of value and growth stocks in Indian stock market goes in
parallel with the findings of studies carried out with stock market data from USA,
European markets, Japan and other emerging markets?
What is the history of Indian stock market? Does it show a tendency to mean
revert? Are there opportunities for successful long term value investing?
After reviewing the results of the empirical study I will try to discuss whether the
behavioral finance theories can explain the value premium, or it can be better
explained by classical financial theory. Since the irrationality of market participants
is a subject of my keen interest, the problem of perception of the concept of human
mind in economics will also be touched.
7
Empirical research, limitations and basis of theory and literature reviewed
The empirical research is based on data for companies listed in Bombay Stock
Exchange Sensex Index which is extracted from DataStream database and
therefore is susceptive to any changes or errors in the database. A full description
of data extracted and financial measures used follows alongside the empirical
research part of my work. I want to emphasize that I do not aim to create new
theories or methods, but I am trying to use the ones already developed in the field
and apply it to an unexplored market. I also try to put higher emphasis on reviewing
behavioral theories as these studies are currently emerging as mainstream and
historically were less touched and discussed in relation to standard finance which
has been taught and analyzed for decades.
Trying to get more insight to the field of research, I review not only large number of
scientific articles published in solid academic journals and academic books related
to the topic, but also sources of statistical data from governmental websites of
United Kingdom, publications of inter-governmental organizations such as
International Monetary Fund and non-governmental organizations such as
Transparency international.
Structure
The structure is set to lead from the introduction to the main ideas of classic
financial theories, comparing it to behavioral finance theory and presenting what
are the contrarian investment strategies. The overview of the Indian stock market
introduces the empirical part of the thesis followed by statistical tests on mean
reversion, value premium and systematic risk in the market. The interpretation of
the test results are provided afterwards. Before the main conclusions I also provide
a discussion on the concept of rationality in economic theory.
The sections will be set not only to follow each other in a continuous string, but
also to complement and in some ways contradict with each other. Section 1 is
introductory and sections 2 and 3 will be based on presenting different theories and
strategies based on the reviewed literature. Section 4 is my own empirical study in
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the Indian stock market. Section 5 will provide a discussion on the reasons of the
results of the empirical research and section 6 will conclude the whole study, point
out the most interesting lessons learned and insights gained and also discuss the
opportunities of future research in the field.
Structure scheme:
Section 1
Abstract, objectives and goals, literature and data used, structure of the thesis
Section 2
Introduction to main classical financial theories and behavioral finance theories
Section 3
What is contrarian investing? Main investors and philosophy behind it
Section 4
Empirical research, glance at the Indian market development since its

liberalization, mean reversion, value premium and fundamental risk testing
Section 5
Discussion on the results of the empirical research - classical finance explanations

and behavioral finance explanations
Section 6
Discussion on rationality in economic science, concluding remarks
9
Section 2 – Classical and Behavioral finance theory overview
Classical finance theory
In this section I want to present some of the fundamental theories of standard

finance as I believe that they can give some good starting insights in understanding
why the markets work one or another way in practice. Below I review main ideas of
Efficient Market Hypothesis, Random Walk and Capital Asset Pricing Model.
Market Efficiency
The Efficient Market Hypothesis (EMH) has been one of the cornerstone theories
on market behavior since it has been developed by Eugene Fama in the 1960s till
the 1990s when the behavioral finance started emerging with the emphasis on
psychology and behavioral principles of market participants. E. Fama (1965)
describes the efficient market as “a market where there are large numbers of
rational profit-maximizers actively competing, with each trying to predict future
market values of individual securities, and where important current information is
almost freely available to all participants“. Under this assumption there is no
speculation in the markets, if everyone is rational. The only difference among the
investors is the information that is available for them – there will be no trade if there
will be no information, that is, the reason to trade.
This causes the market values to float around the real or fundamental values. The
basic idea of the theory is that “a capital market is said to be efficient if prices in the
market fully reflect available information. When this condition is satisfied, market
participants can not earn an economic profit (that is unusual or risk adjusted
profits) on the basis of available information” (Levich, 2001). The assumption is
that the equilibrium model must exist in order for prices to fully reflect all the
information available to market participants and therefore the real prices or returns
of assets should always conform to their equilibrium prices/returns. According to R.
Shiller (2008) the simplest version of EMH implies that the true value of the stock
equals the present value of optimally discounted future dividends. So we can see
10
the price as the forecast of future dividends of the stock. Of course not all
companies pay dividends, but theoretically they should be paying at some point,
otherwise their shares would not have value – investors would not like to give away
money for shares without receiving any return in the future. People are looking for
future income and stock prices go up if there is information about future dividends
or earnings. Following EMH it could be said that for example if the Price to
Earnings ratio of the stock is low, something negative is expected to happen to the
company’s earnings or dividends in the future. Therefore a low Price to Earnings
ratio can be seen as a forecaster of bad company results in the future.
According to Elton et. al. (2003), the stock market crash of 1987 was one of major
events to raise doubts in EMH as it was totally not in line with what the theory
states. The EMH postulates that there is no point in trying to seek profits higher
than those of the market itself, because all the new information is already
incorporated in the prices. Most analytics agree that the information flow nowadays
is much more efficient, than for example in 1929 when the Great Depression
started, which implies that the markets should be more efficient in modern times
and would not achieve such high volatility as in 1929. Indeed it would be naive to
think that it is possible to beat the market after getting information from weekly or
even daily newspapers when due to technological advance the trading nowadays
is performed in a matter of seconds. Nevertheless, the stock market crashes of
1987 as well as a recent one in 2008-2009 show that there are factors causing
market inefficiency and it makes the market untrustworthy which is against the
whole idea of EMH where the market participant should ideally stick to the market
portfolio to optimize the returns. Therefore further in this study the biases both of
human nature and of institutional origin are reviewed as factors opposing market
efficiency.
Furthermore, when it comes to testing market efficiency, researchers get to a

situation where there is no true answer. To test efficiency one should assume
some sort of equilibrium model to define normal security returns. “If efficiency is
rejected, this could be because the market is truly inefficient or because an
11
incorrect equilibrium model has been assumed”, J. Campbell at. Al. (1997).
Moreover, the joint hypothesis means that it is impossible to test if markets are
truly efficient as “market efficiency as such can never be rejected”. The full market
efficiency is quite unrealistic in practice - if costs for information carrying are
involved, there are opportunities to achieve abnormal returns. J. Campbell et. al.
(1997) discusses using such measures as relative efficiency, for example
measuring one market against the other (e.g. Indian Bombay Stock Exchange vs.
London stock exchange). The idea of market efficiency being an idealistic and
unrealistic phenomenon although useful for relative measures is adequately
described by comparison stating that “a few engineers would ever consider
performing a statistical test to determine whether or not a given engine is perfectly
efficient – such an engine exists only in the idealized frictionless world of the
imagination.”
Nonetheless, though the existence of the perfect market efficiency is not fully
realistic to be proven in the economic world, it might be helpful for obtaining
relative measures and theoretical insights for further market analysis.
Random Walk Hypothesis
The Efficient Market Hypothesis is consistent with the Random Walk Hypothesis.
An example of Random Walk can be taken from a drunken sailor – a man starts at
a point zero and takes a step in any direction. He then takes a second step, at any
randomly oriented angle to the first, then a third to any direction, and continues for
a while. If we assume that the person continues walking randomly for let’s say 15
minutes, the best estimate would be that he’ll end up in the same place where he
started. The same might be applied for the stock prices if rises follow the falls and
they do not depend on any given data. In this case there is no chance to earn any
abnormal profit and the best investment strategy would be holding the market
portfolio, Shleifer A. (2000). It is impossible to earn a profit from trading, because
you cannot predict the change in the prices – the market is precisely responding to
the new information. This means that if the reality of the market is that the prices
12
follow the Random Walk, then trying any other trading strategies, which rely on
some sort of historical sequence to predict the stock market movements in the
future is a waste of time. However, according to E. Fama, 1965, the faster the
analyst can identify situations with differences between the prices and their intrinsic
value the longer he will do better than the investor just using a buy and hold
strategy. Following this, the more sophisticated analysts exist in the market, the
more efficient the market is and it is more likely to follow the Random Walk. Such
assumption throws the fundamental analysis, which depends on analyzing the
quality of management, economy or industry factors, out of the picture.
Later in this paper I will test the Bombay Stock Exchange Sensex index returns for
mean reversion and see if there exist any implications of Random Walk.
Capital Asset Pricing Model (CAPM)
The CAPM is probably the most famous model in the discipline of finance,
assuming that people are rational and that they should always stick to holding the
optimal portfolio. Below I provide the basic assumptions of the CAPM, as
presented in Corporate Finance textbook by J. Berk and P. DeMarzo (2007).
1. All investors are risk averse and rational, aiming to maximize their economic
utility function. They choose only the portfolios which maximize the expected
return with the level of volatility or risk taken. Likewise, the premise is that while
choosing between two portfolios with the same expected returns, the investors
would go with the one which is less risky, or has a lower level of volatility.
Moreover, the investors are highly diversified to minimize the risk.
2. All investors can buy and sell unlimited amounts of securities at competitive
market prices, in other words trade without any costs for tax or transactions.
They can also lend and borrow without limits at the risk free interest rate.
3. All investors share homogenous expectations concerning the expected future

returns, risk and correlations of the securities. It is also assumed that the new
13
information is available to all investors at the same time, an assumption going
in line with what the Efficient Market Hypothesis postulates.
Put simply, the optimal portfolio is the best diversified portfolio, assuming that it
maximizes the return and minimizes the risk. According to Elton et. al. (2003),
CAPM assumes that the only portfolio a rational investor would hold would be the
market portfolio and each investor can create his preferred risk-return combination
and adjust for risk by adding lending or borrowing at a risk free rate to the market
portfolio.
The main equation of the model is stated below:
ri=rf+βi(rm-rf)
The above risk-return relationship means that the expected return on the i’th asset
equals the risk free rate plus beta of the i’th asset times the difference between the
expected return of the market portfolio and the return rate of the risk free asset.
The market portfolio is theoretically a portfolio of everything in the world - it
includes all assets: all stocks, all bonds, real estate, oil assets and everything else
available to invest in. The risk free asset is an asset that does not carry any risk for
its return, for example one year US government bond, which of course requires the
government to be trustworthy, meaning that it won’t default on its debt.
The measure that is most important from this model to my study, called Beta, β, is
the regression coefficient obtained by regression of the return of the i’th asset on
the return of the market portfolio. It shows how much the stock reacts or relates to
the market portfolio movements. For example, if the Beta equals one, it means that
the stock moves in the same manner as the market portfolio – if the market prices
rise by 10%, the price of the stock also rises by 10%. If the Beta is 2, then if the
market rises by 10%, the stock price rises by double of that amount – 20% in
value. In CAPM, Beta is the only risk measure affecting the return of the portfolio,
also called the market or fundamental risk - all the other risk is excluded assuming
14
that it can be diversified away. Later in this paper, while testing the value premium
of the contrarian strategies, I will compare the betas for value and growth portfolios
trying to get an insight whether the value portfolios are riskier than the growth
portfolios.
Finally, I find it important to stress that the CAPM is based on very strict
assumptions which usually do not hold in real life. The markets are constrained by
laws, various cultural differences, different regulations, politics and other factors
which contradict with the main assumptions in the model. Therefore, in the next
section I continue with the basic ideas of Behavioral Finance proponents putting
more emphasis on the irrationality of the investors and their decision making
process.
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Behavioral Finance theory
The behavioral finance ideas started emerging in the early 1990s opposing the
Efficient Market Hypothesis with research based on the judgment and decision
making process of the participants of the financial markets. R. Thaler (1993) called
behavioral finance as "simply open-minded finance". What makes behavioral
finance theory different from the classical finance is that it is not only based only on
mathematical calculus, but it applies all other social sciences as psychology,
sociology, anthropology, political science or, since recently, neuroscience. The
main ideas of this discipline were inspired by the breakthrough studies by
psychologists D.Kahneman and A. Tversky on human biases and cognitive errors,
which later developed to what is called a prospect theory. In this section I will
review the main aspects of prospect theory, human biases influencing their
irrational behavior in the markets and provide some ideas on arbitrage. There is a
huge number of aspects that behavioral finance is scoping, so in the following
pages I review only those ones which I see relevant for my further analysis.
Prospect Theory
The prospect theory is an alternative theory to the classical expected utility theory,
describing the decision making process under risk. The expected utility theory,
developed by Neumann and Morgenstern in the 1940s, states that while making a
decision people look at the final states of wealth they can end up with. According to
the prospect theory, when the stakes are small relative to investor’s wealth, the
investors do not think in terms of wealth, they think in terms of what might be
gained or lost. Moreover, people’s attitudes to gains and losses are different. The
prospect theory suggests that people look at the change in wealth, or ”gains and
losses relative to some reference point, which may vary from situation to situation,
and display loss aversion - a loss function that is steeper than a gain function” -
Shleifer (2000).
16
Figure 1. Standard Utility Function (Fisher & Statman 1999)
Figure 2. Value Function – Prospect Theory (Fisher & Statman 1999)
By introducing a value function, which is different for losses and gains, the
prospect theory brought to the light one of the fundamental feature in behavioral
finance – that people are loss averse. The value function for losses is convex and
steeper than the one for the gains, whilst the one for gains is concave. This implies
that the feeling of pain of losing some amount is more intense than the feeling of
satisfaction while gaining the same amount. Following this rationale proved by
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numerous experiments of D.Kahneman and A. Tversky, people are willing to risk
more when facing losses than when facing winning situations. In the stock market
this can be seen when market participants do not sell stocks when stock prices are
falling in order to avoid or postpone losses and otherwise try to sell the winning
stocks too early, without exploiting them to the end, Tvede (1999). This often leads
to results which are not in line with the best interest of investors. What more, the
decisions depend on the way the problems are framed. The reference point might
be defined both as a positive or a negative outcome and based on that the decision
makers might become either risk averse when the outcome is seen as a gain or
risk seeking if the outcome is seen as a loss, which causes a so called framing
effect, S. Plous (1993).
Another important finding coming from the prospect theory and many experiments
by A. Tversky and D. Kahneman is that people are overconfident about their
abilities. When the markets are booming and everyone is earning money, people
tend to attribute these achievements to their own ability to choose a winning stock.
This can be explained by a wish to stay in control even when people are not in
control and underestimate the risks of the market. Moreover, when individuals get
overconfident they trade more than they should and lose huge amounts due to
costs. T.Odean and B. Barber (2000) find that individual households in the US
which trade at a highest rate on average earn 6% less than the market portfolio
and this underperformance can be explained by overconfidence. According to R.
Shiller (2000) overconfidence is one of the main factors why high trading volumes
can be observed in markets - "Another aspect of overconfidence is that people
tend to make judgments in uncertain situations by looking for familiar patterns and
assuming that future patterns will resemble past ones, often without sufficient
consideration of the reasons for the pattern or the probability of the pattern
repeating itself."
To sum up, the prospect theory is more about how the human decisions under
uncertainty are made in reality and the classical utility function is based on how
those decisions should be made if everyone was rational. I do not state that the
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behavioral finance opposes everything what is created by the classical theories in
finance. However it relaxes the strong assumption of market participant rationality
to make the theory closer to the reality of the human world.
Herding and overreaction
Individual investors tend to gain interest in the same stocks at the same time and
lose their interest in the same stocks at the same time, something that is called a
herding behavior. According to T. Odean et. al. (2007), the investors do not spend
time to analyze each stock in the market - they tend to buy the ones that already
are in the centre of attention. People wait for a stock to draw their attention and
then buy it if it suits their preferences. Therefore the individual investors are usually
buying stocks which are circulating in the media or are traded in huge quantities. In
the 2007 research on Taiwan market, T. Odean et al, find the relationship between
the overall size of investments in the market and the market performance. The
results show that when the investors as a group invested more funds in the market,
it performed worse in the next 6 months. When the money started to be pulled out
of the market, the market started doing better. Similar research by T. Odean et al
was conducted in United States market in 2007 with the individual stocks. The
outcome was that if many investors buy a stock one year, it underperforms in the
following year. In contrast, when the investors started selling the stock, it
performed better the upcoming year.
Herding behavior comes to the light when people think they do not have sufficient
information and believe that the knowledge of other people can make the decision
on investment easier and faster. T. Odean mentions investment clubs, where
usually some people pitch on a few stocks and in order not to embarrass
themselves amongst others, tend to go with the stocks which have a strong
rationale - good past performance, success stories in the media - stocks that other
investors are also buying in the market. Usually, such practice ends up in pushing
the stock’s price too high and in the end the stock gets overpriced and is going to
underperform. The research held by T. Odean and his colleague’s shows that there
19
is a connection between the herding behavior and the deviations from the
fundamental values in the stock markets.
Limits to Arbitrage
Following the Efficient Market Hypothesis, the prices reflect their fundamental
value. This means that there are no discrepancies in the pricing of securities and
therefore no chance to earn excess risk adjusted profits in the markets – there is
no so called "free lunch". Behavioral finance theory argues against it, stating that
there might be situations in the market where prices do not reflect their
fundamental values and these are caused by the market participants which are
driven by investor sentiment and are irrational. The longstanding classical view is
that the deviations from fundamental value are very quickly fixed by the rational
traders in the market – whenever a deviation from a fundamental value is appears,
the rational traders spot the good opportunity to invest and quickly use this
opportunity bringing the price back to its fundamentals or correcting the mispricing.
The behavioral finance theorists do not agree with the first part of this situation –
that the deviation from the fundamental price is always a good investment
opportunity. They argue that "even when an asset is wildly mispriced, strategies
designed to correct the mispricing can be both risky and costly, rendering them
unattractive. As a result, the mispricing can remain unchallenged", N. Barberis & R.
Thaler (2003).
I believe it is enough theory to get an insight on main views which are used in this
study and I will use more of behavioral finance and behavioral economics ideas
while analyzing the results of my empirical research on the performance of the
contrarian strategies in the Indian stock market. In the next section I try to review
the contrarian or value investing strategies and philosophy behind this type of
investing, which is mainly based on exploiting deviations from the fundamental
values of securities.
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Section 3 – What is contrarian investing?
Motivation towards stock markets
Jeremy Siegel in his book "Stocks for the long run" (2007) studies US stock returns
for the period of 1802 -2006 and finds that average stock return through those
years was 6.8% while the same measure for risk free asset, short term government
bonds was 2.8%. He also finds similar evidence in other developed markets. It
shows that stocks have a significant 4% higher yearly return than bonds, which is a
phenomenon called equity premium or equity premium puzzle in other studies. J.
Siegel concludes that the optimal portfolio should be heavily concentrated towards
stocks.
The book might be criticized due to the fact that 200 years of historical data is a too
long period to look back and that most of the insights come from the 20th century,
which was the most successful in US economy. Also, most today’s long term
investors invest for periods not longer than 20-30 years, which according to R.
Shiller’s "Irrational Exuberance" (2000) is not necessarily a risk free period.
According to R. Shiller (1998), assuming the rationality of investors the equity
premium could be easily related to higher risk carried by stocks in the short runs.
Instead, he points to J. Siegel’s book, and the evidence that in the long runs long
term bonds have carried more risk. According to J. Siegel, long term bonds were
not so volatile on the short term basis, however very volatile in long periods of time.
Shiller (1998) and S. Benartzi and R. Thaler (1995) relate the equity premium to
the framing bias and myopic loss aversion – people frequently review new data
about the companies they invest in and tend to concentrate on not losing in short
investment horizons such as 1 year horizon. Instead they could plan for a longer
period in the future and increase their investing horizon while making peace with
smaller short term losses.
Such indication of stock market producing higher returns motivates me to look into
the investing strategies in the stock universe.
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Value super investors
The value investing has its roots in the 1930s following the Great Depression,
when Benjamin Graham and David Dodd laid foundations for this investment style
in their book called "Security Analysis" (1934) and B. Graham’s book "The
Intelligent Investor" (1949). These authors argue against the efficiency in the
markets, stating that due to market not holding all the information about the
company, there might be discrepancies in how companies are valued. The main
idea is to buy stocks which are undervalued in the market and hold them till their
value is corrected.
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.
22
Review of literature on market inefficiencies and value premium
The contrarian investors in the long run see the low Price to Earnings, Price to
Book Value, Price to Cash Earnings and other financial ratios as an indication that
the stock is undervalued and that in the future it will regain the true value or what is
called their intrinsic, fundamental value. It is contradictory to classical view that
assets are priced rationally in the market and that high price measures signal a
persistent strong expected performance of such securities.
Market analysis related to contrarian investing can be traced back to S. Basu

(1977) investigating the performance of US stocks based on their Price to Earnings
(P/E) ratio. He concludes that over the 14 year period of 1957-1971, the stocks
with lower P/E ratio earn higher absolute and risk-adjusted rates of return than the
stocks with higher P/E. Assuming that his models were correct such finding was
one of the first indications about the inefficiency in the markets. The P/E
information was not fully absorbed by the market, therefore creating disequilibrium
and an opportunity to invest and gain an abnormal profit.
The "old and gold" US market analysis by J. Lakonishok et. al. (1994) incorporates
more financial ratios of the past performance of securities. In addition to Earnings
to Price (E/P), they use Book to Market (B/M), Cash Flow to Price (C/P) and Past
Growth of Sales (GS) measures. Over the 22 year period 1968-1990, they find that
value stock portfolios (the ones with higher E/P, B/M, C/P, and lower G/S)
outperform the growth stock portfolios, which they also call glamour portfolios.
Moreover, they do not find differences in fundamental risk of portfolios. Set aside
the risk and data snooping bias explanations, the authors conclude that the market
participants make judgmental errors and overestimate the expectations on the
returns of growth portfolios based on their good ratios of past performance. This
also brings out the agency problem in the institutions. It is easier for managers to
advocate for investing in growth stocks as they seem to be a more prudent
investment for majority of investors. Growth stocks seem safer and less likely to be
distressed in the future. This way a lot of value stocks are removed from the
possible investment perspective as there are e to run into financial troubles due to
23
their poor past performance. Moreover, most investors may have shorter horizons
than required for value investing, they want to earn abnormal profits in a few
upcoming months rather than wait for on average smaller pay-off for a few years.
J. Lakonishok and L. Chan review their findings in 2004 and come back to the
same conclusions as in 1994. They also test whether the value premium has a
time specific nature and do not find it time-specific.
L. Chan et. al. (1991), provides similar findings for the stock market in Japan as for
the US and especially large value premium is observed for portfolios sorted by
Price to Book Value ratio – over 1% per month. Of course, the conditions in US
and Japan are different as Japans stock market was on a high rise in the 1980s so
it is hard to conclude that value premium is an international phenomenon just after
these two studies.
E. Fama and K. French (1992, 1993, 1995, 1996, 1998 and 2006) introduce some
empirical contradictions to the classical CAPM. They mention size effect, meaning
market capitalization having an extra impact on returns together with β. Their
findings contradict to the fact that over the period of 1963-1990 the average
security returns are positively related to market fundamental risk β. They conclude
that the variation in market returns can be associated with the size factor, Earnings
to Price, Book to Market and leverage ratios. R. Banz (1981) also finds that the
average returns for small cap stocks are too high and the average returns for large
cap stocks are too small given their beta.
Moreover, Fama and French (1998) examine 13 markets outside US, specifically
Europe, Asia and Australia and conclude that for the period 1975 to 1995, the
value premium can be found in twelve of thirteen markets and that the value
premium of the global portfolios is more than 7% per year. Again, they conclude
that CAPM cannot explain the value premium and the authors argue that the value
premium comes due to risk not picked up by the model - "this conclusion is based
on evidence that there is common variation in the earnings of distressed firms that
is not explained by market earnings, and there is common variation in the returns
24
on distressed stocks that is not explained by the market return". Value premium in
various markets is also found by studies of Bird and Whitaker (2003 & 2004,
developed European markets), O.Risager (2008, 2010, Denmark) and other
researchers, therefore this phenomenon is becoming widely accepted and value
investing is becoming a popular investing strategy among market practitioners.
What is interesting, that the results of the above studies show that the value
premium also exists in the most emerging markets (Fama & French, 1998). A
contradicting example is H. Gonenc and M. Karan (2003) study in Istanbul stock
exchange, which finds that growth portfolios outperform value portfolios. I have not
found a thorough research made on the value premium in India over the years
since the market was liberalized, so this is one of the first attempts to analyze this
huge market.
Another research I want to mention is based on asset growth ratio of the company
and its implications to the returns of the company. Cooper et al. (2008), compare
Asset Growth ratio to ratios which are determined as predictors of returns by
previous researches such as Book to Market ratio and find that Asset Growth itself
is a solid predictor of the stock returns in the US markets. They find an almost 20%
yearly return premium for stocks with lower Asset Growth ratio, which is a
significant spread. Cooper et al concludes that such results are "most consistent
with the interpretation that investors over extrapolate past gains to growth". The
Asset Growth ratio is quite new to research in comparison with other ratios I use,
therefore I found it interesting to use for the analysis of the Indian market and see if
the findings are consistent with the ones in the US market.
Before continuing to the next section on the empirical research, a short

presentation of the concept of market mean reversion is needed. One of the basic
researches done in the field by J. Poterba and L. Summers, 1988, provide a wide
study in eighteen markets on market mean reversion. Their results show that the
returns in the market auto correlate positively in short horizons and negatively over
the long horizons. However, their statistical tests do not reject the Random walk. I
will test the mean reversion in the Indian stock market in the beginning of my
25
empirical part, as mean reversion is one of the core foundations needed for
successful long term value investing, firstly meaning that there are deviations
between stock prices and their fundamental values and secondly that they are
changing and in the long term stock prices get to their fundamentals.
The empirical research which I will present in the following pages differs from the
studies presented above in a way that it chooses an Index which holds fewer
stocks - only 30 stocks constitute the Bombay Stock Exchange Sensex index. To
have a reasonable number of stocks in one portfolio, I form only two portfolios, one
for value and one for growth stocks. Therefore in a way it is a much simpler study
to compare with others, however it is limited within a scope of a master thesis. A
more thorough study with more stocks, fragmented portfolios and cross-sectional
return analysis could be achieved while taking PhD studies, which the author
considers as an attractive opportunity in the future.
Next section starts with a glance at the Indian perspective in the world’s economy
and introduction to Bombay Stock Exchange Sensex Index.
26
Section 4 – Empirical research
India’s position in the global economy
Since India is often referred as an economy that together with China will overtake
worlds economic leader’s status in the future, I find it necessary to have a quick
glance at India’s perspective in the world’s economy and what are the projections
for its future. Since my study’s main scope is not the economic analysis of a
country, I review only some factors, numbers and studies that seemed most
interesting and representative of the state of Indian economy and relevant for
interpreting the Indian stock market.
Interesting studies about the movement of the centre of global economic activity
were carried out by a professor from London School of Economics Danni Quah.
His 2010 research based on calculations of all GDP produced on planet, shows
that the center of global economic activity on earth in 3 decades moved from being
west of London, somewhere Atlantic in between of UK and USA, towards Asia,
which can be explained by continuing rise of China, India and other Asian
Economies.
Figure 3 Shifts in Global Economic Center
27
The same study also provides data comparing growth of combined Indian and
Chinese economies to the growth of US economy:
Table 1 Growth of China and India against growth in USA
Ratio of absolute growth 1960-1990 1991 1991-2000 2001 2001-2008
(China+India)/US 0,13 -3,2 0,33 1,67 0,93
The data that author uses here is the inflation-adjusted GDP at market exchange
rates. Interestingly, the US economy shrank in 1991 at the same time as China’s
and India’s economies grew, therefore the figure is negative. US were in recession
in 2001 also, therefore the numbers for these dates are provided separately. From
the table above we can see that the ratio of absolute growth, comparing China and
India to US grew from 0,13 in the period 1960-1990 to 0,93 in period 2001-2008,
just before the Credit Crunch crisis.
In his 2011 study D. Quah draws projections to the future to see where the world
economic center will be in 2050s. For these calculations growth indicators from
almost 700 locations on the planet are used. Below we can see the global
economy’s center of gravity shifting towards the area just between China and India
in the 2050s, black color spots changing to red ones.
Figure 4 Projected center of world economic activity in 2050
28
The research of D. Quah is a novel view towards changing powers in world
economy and it reasonably shows that the center of world economic activity is
moving towards Asia, and India’s placement in it can be clearly seen.
In a shorter horizon, according to the data from International Monetary Fund World
Economic Outlook (2011), India is experiencing rising credit growth and increasing
inflation and the growth of the economy should slow down a bit, however still keep
up above the trend of whole Asia. It is projected that the GDP will grow 8% in 2011
and 7% in 2012 with infrastructure and favorable conditions for corporate
investment being the main driving forces behind it.
Since this study’s main target is investing strategies in Indian stock market, I am
not putting much emphasis on analysis of Indian economic growth in the past.
However, factors such as English language being de facto one of Indian national
languages and immigration numbers in Great Britain (around 2% of whole Great
Britain population in the last decade were Indians - http://www.statistics.gov.uk)
imply better opportunities for communicating with international business and a rise
of outsourcing possibilities that international companies undertake in India. Also, a
factor of being only one of 2 countries in the world where the population is above 1
billion people remains a notable estimate of the potential economic power of the
country. Having that in mind an important figure seems to be the age of Indian
population. According to http://www.statistics.gov.uk (2007), in Great Britain Indian
population age estimation is lower than that of native white British or white Irish
and the majority of Indians in Great Britain are 20 to 50 years old, around third of
them having managerial and professional occupations. According to United States
Census Bureau, International Data Base (2010) the overall Indian population is
estimated to be around 1.1 billion with more than a quarter of it being below 25
years old and more than 65% younger than 35, which implies that India has a huge
labor potential.
With positive projected growth numbers, huge labor potential and optimistic
sentiments in the market, India is becoming one of the major economic forces in
the world.
29
Bombay Stock Exchange and Sensex index
In this study I use data form Sensex Index, which is the first benchmark index of
the Indian stock market, calculated at Bombay Stock Exchange. Established in
1875 Bombay Stock Exchange (BSE) is the oldest stock exchange in Asia. It has
the largest number in the world of listed companies (around 5000) and was among
10 of the world’s leading exchanges in number of electronic trading system’s
transactions in December 2009. The total market capitalization of companies listed
in BSE was around 1.3 Trillion USD in February 2010 (www.bse.com).
The Sensex Index consists of 30 stocks with the idea to represent large and
financially strong companies across major economic sectors, as per charts below.
Figure 5 Sectorwise Market Capitalisation in BSE Sensex Index
30
Figure 6 Sectorwise distribution pie chart for BSE Sensex Index
The Sensex index was first calculated in 1986, however I chose to pick up data
starting in early 1990s when the economic liberalization in India started. At first the
index was calculated as a market value weighted index, and since 2003 it is
calculated under free float market capitalization weighted methodology, the main
difference being that the first method weights its components according to their full
market capitalization and the second one considers only shares available for public
trading.
31
Data applied and methodology
All the data for empirical research was taken from Thomson Reuters DataStream
database. It is the largest statistical financial database in the world containing
around 140 million time series, more than 10.000 data types and 3.500 million
indicators and instruments. 30 constituents of Bombay Stock Exchange Sensex
Index are analyzed. While looking up historical data for Sensex constituents,
DataStream provides data for only those constituents which compose the index at
the present time. Therefore I found it necessary to extract the data for each
company which was included in the index since January 1991 separately, trying to
avoid the survivorship bias. During 25 years around 80 companies were listed in
the index and all the companies composing the Sensex index and the historical
changes are provided in the appendices. It might be argued that an index with
more stocks could have been chosen, however since the 30 stocks in Sensex
index are of large capitalization and liquid I find the Index representative and
believe that if the value premium can be find in this index, it might as well be found
in other Indian Stock Market indexes too.
Yearly time series data for Return Indexes, Price to Earnings, Price to Book Value,
Price to Cash Earnings, Total Asset size, Market Value and Beta measures were
all extracted from the database. For more details on specific calculations,
everything is provided in the attached Excel sheets in Appendices. The returns for
mean reversion testing were calculated from Price Index which’s daily, monthly and
yearly equivalents were also extracted from the database. Yearly Gross Domestic
Product (GDP) data was also taken form DataStream – it is valued in billions of
Rupees, all the data and calculations based in this research are in local currency. It
was impossible to collect data for all the companies composing the index each
year, so most of the years the value and growth portfolios are formed of less than
30 stocks. Not all beta figures were found also, e.g. I could not find this statistic for
Reliance Industries Ltd., which is one of the largest companies considering market
value. Therefore a measure of 1 is chosen for all years – given that the company’s
market value is large and its movements follow similar patterns as the market.
32
The Ljung Box test is presented in the beginning of section testing Mean reversion.
I also use two different t-tests to compare the means of value and growth portfolio
returns. A paired two sample t-test for means is chosen because similar pricing
factors can be assumed for both value and growth portfolios. On the other hand,
one can also assume that both portfolio returns are not related and therefore I also
choose to use the unpaired t-test. This t-test also assumes that the variances in the
returns of both portfolios are unequal. However, as can be seen in the results, the
t-test statistics are obtained quite similar. To compare portfolio Betas I use only
one kind of t-test – a paired two sample t-test for means as I assume the market
risk being a factor influencing both data sets compared. The t-tests are processed
using Excel’s Data Analysis function. The main hypotheses are stated below:
H0: mean value – mean growth = 0, indicating that the returns of two strategies do
not differ. This hypothesis has no direction and therefore is two sided.
H1: mean value – mean growth > 0, implying that value portfolios earn higher
returns.
The t-statistic is t-distributed with one degree of freedom, therefore to reject the 0
hypothesis with 95% accuracy the t-statistic has to be higher than the critical value
of 1.96. I proceed with the same method while comparing the Betas and market
values of value and growth portfolios. The calculated t-test statistics are reported in
later section covering value premium.
It is important to emphasize that no transaction charges and taxes are taken in

consideration therefore the results of other studies taking taxes and transactional
charges might be different than this one. The financial ratios used sorting the
portfolios are assumed widely known however short descriptions of these are also
provided in the Appendices alongside other data extracted from DataStream. The
Price to Earnings, Price to Book Value and Price to Cash Earnings ratios are
chosen due to their use in other acknowledged studies, mainly by J. Lakonishok
and E. Fama and K. French. The motivation under choosing the Asset Growth ratio
is provided while reviewing the theory on value premium, specifically the M.
33
Cooper et. al. (2008). More on portfolio formation technique is provided before
reviewing the main results of the tests on value premium.
Mean Reversion testing
To test mean reversion in the Indian Stock market I calculated the daily, monthly
and yearly returns of the Sensex index and applied a Ljung Box test to this data.
The return calculations can be found in the Appendix. Since the Ljung Box test is
applicable to data samples of small sizes it was chosen as the sample for yearly
data is just 21 years. It is a test of overall randomness based on the number of
lags, testing whether there exists any autocorrelations in the time series, in other
words if the autocorrelations in time series differ from zero.
The autocorrelation statistic of a time series pt is defined as:
𝐶𝑜𝑣(𝑝𝑡 , 𝑝𝑡+1 )
q𝑡 =
𝑉𝑎𝑟(𝑝𝑡 )
The Ljung Box test statistic is defined as:
𝑀
𝑞𝑘2
𝑄𝑀 = 𝑁(𝑁 + 2) �
𝑁−𝑘
𝑘=1
Where:
N is the sample size
qk is the autocorrelation at lag k
M is the number of lags tested
The tests are performed with IBM SPSS software for statistical analysis. The Ljung
Box test statistic is calculated for a number of lags, meaning that the correlation
between error in time k and errors back in time is tested.
The Ljung Box statistic follows a chi square distribution with m degrees of freedom.
In order to reject the H0 of randomness, the test statistic QM has to be greater than
34
the significance level of the H0, which in this case must be higher than the critical
5% level of the chi square distribution, as I want to be 95% sure that the
autocorrelation coefficients are not 0. The critical value of the chi square
distribution under such conditions and 1 degree of freedom is 3.84.
The main hypotheses in my tests are:
H0: The data in time series is random and follows a Random Walk, q=0
H1: The data in time series is not random; it does not follow Random Walk and q ≠0
Graphs
The graphs for daily, monthly and yearly returns in Sensex Index are provided
below:
Figure 7 Daily returns in BSE Sensex index
25
20
15
10
5
0
-5
-10
-15
01-01-1990
01-01-1991
01-01-1992
01-01-1993
01-01-1994
01-01-1995
01-01-1996
01-01-1997
01-01-1998
01-01-1999
01-01-2000
01-01-2001
01-01-2002
01-01-2003
01-01-2004
01-01-2005
01-01-2006
01-01-2007
01-01-2008
01-01-2009
01-01-2010
01-01-2011
Figure 8 Monthly returns in BSE Sensex index
60
40
20
0
-20
-40
01-01-1990
01-11-1990
01-09-1991
01-07-1992
01-05-1993
01-03-1994
01-01-1995
01-11-1995
01-09-1996
01-07-1997
01-05-1998
01-03-1999
01-01-2000
01-11-2000
01-09-2001
01-07-2002
01-05-2003
01-03-2004
01-01-2005
01-11-2005
01-09-2006
01-07-2007
01-05-2008
01-03-2009
01-01-2010
01-11-2010
35
Figure 9 Yearly returns in BSE Sensex index
100
80
60
40
20
0
-20
-40
-60
While looking at the graphs it looks like there is an indication of mean reversion in
the returns of Sensex index as it looks like positive returns are often followed by
years of negative returns. However, especially while looking at the yearly data
graph, it can be also seen that in some years this tendency does not hold and we
need to check that with more specific tests. Nonetheless, the graphs do provide
some indication towards the overall tendency.
Ljung Box test results for daily returns
The test results for daily returns are provided in the table below:
Table 2 Test results for daily BSE Sensex returns
Lag Autocorrelation Ljung Box Statistic

1 0,078 33,814
2 -0,019 35,727
3 0,006 35,951
4 0,025 39,550
5 0,002 39,571
As we can see from the results, the Ljung Box statistic is clearly higher than the
critical value of 3.84 for 5 lags taken. The autocorrelation coefficient for the 1st lag
is positive indicating that there might be some momentum effect in the daily return
pattern and that stock returns might move in the same direction for a number of
days. The autocorrelation coefficient for the lag 2 is negative, which indicates that
the returns reverted at that point. Having these statistics calculated we can say
36
with 95% confidence that the H0 of randomness in the daily data can be rejected
and that the daily returns do not follow the Random Walk. Calculations for lags 3, 4
and 5 also provide the same result.
Ljung Box test results for monthly returns
The test results for monthly returns can be seen in the table below:
Table 3 Test results for monthly BSE Sensex returns
Ljung Box
Lag Autocorrelation
Statistic
1 0,164 6,935
2 0,028 7,143
3 -,083 8,924
4 -,028 9,124
5 0,007 9,135
Test results for the monthly data also present similar results. The Ljung Box test
statistic is clearly higher than the critical value of 3.84. However, it is also clearly
seen that the test statistic is much lower than one calculated for the test performed
on daily data. This indicates that the less data is used, the lower the test statistic is,
or that the power of test is improving with more data. Autocorrelation is positive in
the first two lags and negative for lags 3 and 4, what again implies that there might
be some momentum effect in the Sensex index, this time in monthly returns. Lag 5
is again positive, meaning that the market mean reverted at this point. The H0 of
randomness and Random Walk movement in the monthly returns is again rejected.
Ljung Box test results for yearly returns
It might be argued that the test of such a small sample (only 20 year returns are
taken into consideration for the period of 1991-2011) might be insignificant.
However, small sample is one of the reasons why particularly Ljung Box test is
chosen and I decided to test this sample too.
37
The test results are provided below:
Table 4 Test results for monthly BSE Sensex returns
Ljung Box
Lag Autocorrelation
Statistic
1 -0,193 ,900
2 0,031 ,924
3 -0,028 ,945
4 0,065 1,067
5 -0,316 4,074
It is clearly seen that the test statistic is way lower than the critical value of 3.84 for
the first 4 lags. In this case I can with 95% confidence say that there is no
autocorrelation in the yearly return data and the H0 hypothesis is not rejected,
which indicates the existence of Random Walk in the yearly data. The test statistic
is greater than the critical value for the 5th lag, however I do not consider it
significant as the sample size is only 21 years. Again, the results of this last Ljung
Box test are subject to critique as it might be argued that it is impossible to test
randomness for such a small sample.
Discussion on mean reversion testing results
Both graphs and results of the Ljung Box test performed on daily and monthly data
indicate that there is correlation in the BSE Sensex index returns and show that the
market returns are not random and does not follow the Random Walk. The results
for the yearly data, however, show opposite results where the indication of
randomness is found, though these results can be critiqued due to a small sample
size. There was also an indication of momentum effect found in the first two data
sets what means that there might be some predictability in the BSE Sensex
market, what does not comply with Random Walk. Since the daily and monthly
return tests show effect of mean reversion, negative stock returns are likely to
follow the positive returns after some number of days or months and vice versa.
This trail of predictability in the market might imply that there is some inefficiency in
it if it does not reflect risk – making the market attractive for contrarian investing.
38
Value premium and Betas
In this section I present the main part of my research, the testing of existence of
the value premium in the Indian stock market. For this purpose I manually formed a
number of portfolios based on Price to Earnings, Price to Book Value, Price to
Cash Earnings and Asset Growth financial ratios of the companies constituting the
BSE Sensex index starting year 1992. The stocks, which are in the index before
the financial year starts, are sorted according to different financial ratios into two
portfolios – value and growth. One half of the stocks having lower Price to Book
Value, Price to Earnings, Price to Cash Earnings or Asset Growth ratios comprise
the value portfolio and the other half with higher corresponding ratios comprise the
growth portfolio, sometimes also called glamour portfolio. Only two portfolios are
formed due to the size of the Index and unavailability of some data – most of the
years I found data for less than 30 companies, therefore I did not find it plausible to
form smaller portfolios consisting of 2-3 stocks, since the main target of this thesis
is to see if the value premium in Indian market exists overall. Other mainstream
studies on contrarian investment strategies held by J.Lakonishok et al or E. Fama
and K. French apply more advanced portfolio building techniques, however the
scope of those studies is much wider and in order to keep a reasonable number of
shares in each portfolio, I proceed with two portfolios.
The strategy used in this study is the simplest buy and hold strategy - no changes
are done in regards to occurring transactions or changes in the index during the
holding period and the portfolios are rebalanced each year. The holding period of
each portfolio tested is one, two and three years. I chose to start constructing the
portfolios when India’s market became liberalized in 1992 however some missing
data did not let me construct the portfolios for all those years. Therefore the first
portfolios sorted by Price to Earnings ratio are formed in 1993, based on ratio
measures of 1992. For the rest variables, the date of the first portfolios formation is
1995, based on ratios from year 1994. I made no adjustments for the data
therefore the value premium is simply the value portfolio return minus the growth
portfolio return, as the main goal or this thesis is to test the raw value premium
39
existence in the Indian Stock Market. The portfolios are calculated on both the
equally weighted and value weighted techniques. I provide the results for one, two
and three year strategies for both equally and value weighted portfolio outcomes.
The corresponding Betas for these portfolios as a measure of fundamental risk
follow.
40
One year holding strategy
Equally weighted portfolios and Betas
The table below presents the value premium and test results of the one year
holding strategy for equally weighted portfolios. In the bottom of the table the
average as the arithmetic mean of the value premiums over the years, the
standard deviation of the value premium and the t-test results are provided.
Table 5 Equally Weighted Portfolios, one year holding strategy
Equaly Weighted Portfolios

Form. Year PE PTBV PC Asset G
1993 14,09879
1994 29,58869
1995 3,504186 -23,3475 -21,7971 12,81523
1996 -7,88265 -10,205 -15,1915 0,965125
1997 7,866627 9,698995 13,6368 -8,60927
1998 -32,18 -25,4153 -12,0547 -5,95687
1999 -53,2187 -54,3161 -55,1119 25,90632
Value Premium
2000 -46,9657 -28,9205 -37,9107 -148,062

2001 22,82034 9,154052 21,31856 -13,584
2002 4,972939 0,867931 16,04804 -3,21862
2003 24,24788 20,48488 22,6971 7,524659
2004 68,81046 65,42309 62,56475 33,63332
2005 -4,65968 -10,0174 -12,838 4,182568
2006 11,12116 3,031599 -4,03158 7,257582
2007 -4,65895 14,81108 12,10599 5,7154
2008 23,44274 39,33362 38,67703 78,14534
2009 4,398111 -14,7147 -4,86271 21,93487
2010 89,06773 64,67562 -7,18098 -11,021
Average 8,576331 3,784022 1,004321 0,476807
ST Deviation 34,72376 32,66665 28,90888 45,50412
t-stat paired 1,047879 0,46335 0,138964 0,041913
t-stat unpaired 0,519659 0,207496 0,055395 0,024727
As we see from above the one year strategy for equally weighted portfolios
provides positive results for value premium. The highest value premium is 8.6%
calculated for portfolios sorted by Price to Earnings ratio and the lowest is for the
41
Asset Growth portfolios which show that the returns were almost the same for the
value and growth portfolios for a formation period of 1995 - 2010. For all data both
paired and unpaired t-test statistics are too small to conclude that there was a
significant value premium for all these strategies. I reason this is due to the fact
that the value premium varies significantly over the years. The highest standard
deviation can be seen for Asset Growth portfolios which is 45.5%. The portfolios
sorted by Price to Earnings ratio show the value premium measures ranging from
89.1% to -53.2% with the standard deviation of 34.7% and the value premium for
portfolios based on Price to Book value ranges from 65.4% to -54.3% with a
standard deviation of 32.7% which I perceive as a huge volatility in market returns.
Generally the value investing strategy in one year equally weighted portfolios
seems to be an effective strategy, especially for portfolios based on Price to
Earnings and Price to Book Value measures - respectively 8.6% and 3.8%
reported value premium on average for 17 and 15 years is a proper result.
42
Below we can see the equally weighted Betas calculated for one year holding
strategy.
Table 6 Betas for Equally Weighted Portfolios, one year holding strategy
Equaly Weighted Betas

1993 0,171818
1994 0,093545
1995 0,064 -0,13778 -0,03556 -0,09
Value Portfotlio Beta - Growth Portfolio Beta
1996 -0,01212 -0,10985 -0,13455 -0,02625

1997 0,272115 0,198397 0,288141 0,16375
1998 0,248974 0,308269 0,184872 0,084167
1999 0,295 0,316429 0,073571 0,089167
2000 0,054286 0,277143 0,108571 -0,04571
2001 -0,19159 0,020549 -0,12786 -0,06643
2002 -0,26231 0,029286 -0,15214 -0,1878
2003 0,057143 0,176429 0,006571 -0,1039
2004 -0,34313 -0,08429 -0,15571 -0,06571
2005 -0,19071 0,020714 -0,04357 0,160714
2006 0,062818 0,112143 0,125 0,109286
2007 0,116099 0,144286 0,087912 0,025604
2008 0,114615 0,251099 0,148736 0,177692
2009 -0,23667 0,181762 0,01881 -0,19643
2010 0,121524 0,531667 0,034524 -0,377
Average Difference 0,024189 0,139766 0,026708 -0,0218
t-stat paired 0,536423 3,119055 0,819252 -0,57044
From the table it is clear that only the calculations for portfolios sorted on Price to
Book Value ratio show that value stocks are more risky than the growth stocks and
the paired t-test proves it with t-statistic of 3.11 which is significantly higher than
the critical value of 1.96%. Therefore, we can say with a 95% confidence that the
value portfolio constructed on this ratio is riskier than the growth portfolio. As for
portfolios based on other ratios it is also clearly seen that the beta difference is
very small for both strategies and the t-tests confirm that.
43
Value weighted portfolios and Betas
Table 7 Value Weighted Portfolios, one year holding strategy
Value Weighted Portfolios

1993 50,62254
1994 -3,2194
1995 -13,9271 -24,9594 -17,0402 23,1065
1996 -17,0505 -11,0082 -21,1007 16,81667
1997 -6,94299 -11,664 3,549474 3,599618
1998 -34,62 -22,6875 -10,4429 -14,6855
1999 -33,4075 -41,2103 -42,1876 0,38591
Value Premium
2000 -4,30337 5,216237 -10,5172 -93,3194

2001 34,12018 21,50188 27,48794 -21,7525
2002 3,135595 3,227326 10,02248 -1,74856
2003 19,2413 16,59407 17,83119 6,713545
2004 80,09183 80,5484 83,83367 39,75992
2005 -12,9509 -17,0737 -18,6362 -1,46084
2006 20,30091 10,60721 5,888464 9,172699
2007 0,276861 9,413361 9,06311 0,004895
2008 39,94846 46,58148 45,86442 73,28938
2009 11,64958 -1,48399 2,108064 18,44024
2010 68,66024 26,56929 5,724844 15,18542
Average 11,20142 5,635756 5,715544 4,594253
ST Deviation 32,68857 29,68613 29,47536 34,20202
t-stat paired 1,45383 0,759379 0,775637 0,537308
t-stat unpaired 0,780493 0,376787 0,384627 0,308169
The results above show that the value premium for value weighted portfolios is
much higher than the one for equally weighted portfolios. This provides some
insight into the size effect of companies as the companies sorted in value portfolio
with higher market value might have a higher rate of return. Again the highest
value premium is for the portfolios sorted by Price to Earnings ratio, which is
11.2%. Portfolios sorted on other measures show the value premium of around
5%. The t-tests again reject the value premium for all the portfolios formed and
again I believe it is due to high variation of returns which vary from 80.1% to -
33.4% for Price to Earnings portfolios and 83.8% to -18.7% for Price to Cash
Earnings portfolios which produce a second highest average value premium of
44
5.7%. The standard deviation is highest for Asset Growth portfolios being 34.2%
being in line with the findings from the equally weighted portfolio analysis.
The one year value investing strategy in the value weighted portfolios also seems
to be a good strategy as it provides decent average yearly return premiums over
growth portfolios ranging from 4.6% to 11.2% based on different sorting ratios.
Table 8 Betas of Value Weighted Portfolios, one year holding strategy
Value Weighted Betas

1993 0,054609
1994 -0,06187
1995 0,035982 -0,08782 -0,1111 -0,07616
1996 -0,14363 -0,0767 -0,1429 -0,01573

1997 0,334078 0,287045 0,407264 0,173492
1998 0,26416 0,291916 0,224051 0,154397
1999 0,418781 0,269235 0,068348 0,29986
2000 0,204047 0,30311 0,206822 0,081459
2001 -0,30836 -0,15137 -0,21135 0,059796
2002 -0,29319 -0,08056 -0,16861 -0,22747
2003 0,030857 0,117681 0,015968 0,01461
2004 -0,45101 -0,32163 -0,31776 -0,45838
2005 -0,20377 -0,05104 -0,07424 -0,03584
2006 0,099007 0,053719 0,070479 0,043769
2007 0,168801 0,192167 0,163162 0,120089
2008 0,203602 0,358649 0,238531 0,104214
2009 -0,17104 0,060233 0,004638 -0,17554
2010 0,145277 0,410621 0,110876 -0,25563
t-stat paired 0,32065 1,848979 0,625211 -0,25334
Looking at the value weighted betas of the portfolios it is again clear that only the
value portfolio sorted by Price to Book Value ratio has a higher beta, which is
higher than the one of the growth portfolio sorted on the same ratio by almost 0.1.
The t-test statistic does not find this difference significant, neither for portfolios
sorted on other ratios, which again show a very small difference in Betas of value
and growth portfolios.
45
Two year holding strategy
Table 9 Equally Weighted Portfolios, two year holding strategy

1993 4,943335
1994 22,16753
1995 6,724858 -23,6454 -22,1998 8,568219
1996 -7,84541 -29,0737 -23,413 3,073349
1997 -7,78983 -7,96236 2,470305 4,749779
1998 -54,5164 -51,5155 -42,9966 21,9029
1999 -240,271 -233,99 -239,58 -32,0082
Value Premium
2000 0,281166 13,50428 11,43736 -127,036

2001 15,53158 5,77193 17,06891 -12,5284
2002 30,47137 27,16508 42,83512 -1,17842
2003 119,0043 120,9367 129,3687 59,1319
2004 84,55003 90,12036 67,46314 27,81666
2005 -18,891 -20,7841 -34,6068 16,33258
2006 21,76919 21,11643 5,207835 26,77352
2007 36,19889 51,0171 65,04635 -4,82318
2008 -14,0857 -11,2616 -6,50768 25,60151
2009 36,32625 -0,26151 7,842554 10,74083
Average 2,03347 -3,25748 -1,37093 1,807795
ST Deviation 73,93196 78,38652 79,89751 41,32207
t-stat paired 0,113404 -0,16095 -0,06646 0,169439
t-stat unpaired 0,077149 -0,11019 -0,04608 0,073206
The results from the above table for the two year holding strategy of equally
weighted portfolios do not prove it to be a good value investing strategy. The
highest value premium is again the one for Price to Earnings ratio based portfolios
and it is just above 2 %. Moreover, the value premium for Price to Book Value and
Price to Cash Earnings is negative, respectively -3.3% and -1.4%. The t-tests
confirm that the difference between the value and growth investing strategies is
insignificant in this case with all t-statistics being reported way below the critical
value. Again, a huge variation in returns can be seen, with value premium ranging
from 119% to -55.4% for Price to Earnings portfolios, from 120.9% to -29% for
46
Price to Book Value portfolios and from 129.4% to -34.6% for Price to Cash
Earnings portfolio with respective standard deviations 73.9%, 78.4% and 79.9%.
The least volatile seem to be the Asset Growth portfolios with standard deviation of
41.3%, opposite to the results of one year holding strategies.
Table 10 Betas of Equally Weighted Portfolios, two year holding strategy

1993 0,161364
1994 0,087545
Value Portfotlio Beta – Growth Portfolio Beta
1995 0,065 -0,15667 -0,05778 -0,03833

1996 -0,00216 -0,07973 -0,12227 -0,02688
1997 0,244519 0,193237 0,247724 0,1575
1998 0,294808 0,276378 0,185032 0,035417
1999 0,276786 0,261786 0,091071 0,030417
2000 0,056429 0,234286 0,112857 -0,09929
2001 -0,20865 0,021291 -0,13786 -0,08071
2002 -0,25346 0,040357 -0,12321 -0,21091
2003 0,064643 0,176405 0,00931 -0,0984
2004 -0,25533 -0,03857 -0,07357 -0,01929
2005 -0,09286 0,063571 0,042857 0,152857
2006 0,095773 0,1275 0,139643 0,126071
2007 0,163187 0,190632 0,163187 0,038571
2008 0,168297 0,327775 0,255082 0,221538
2009 -0,22224 0,21069 0,053262 -0,25964
t-stat paired 0,850258 3,355971 1,51934 -0,13545
The value portfolio sorted by the Price to Book Value ratio again proves to be
riskier than the growth portfolios, showing an average difference in betas of 0.12.
The t-test confirms this with a t-statistic of 3.36. Portfolios sorted on other ratios do
not show such high differences in betas and t-test statistics are all lower than the
critical value.
47
Table 11 Value Weighted Portfolios, two year holding strategy

1993 58,39409
1994 -25,2506
1995 -1,21546 -20,0474 -17,7128 0,080949
1996 -20,2877 -20,2873 -28,8762 2,354019
1997 -20,1312 -33,1023 -15,8682 12,53567
1998 -55,734 -49,2852 -48,4749 4,484361
1999 -65,8375 -69,1899 -86,6334 -31,0579
Value Premium
2000 9,461502 15,59212 7,978644 -84,0718

2001 31,33842 21,2497 26,5417 -26,1863
2002 21,52491 22,41345 31,62514 1,57046
2003 95,11868 102,3237 107,1155 66,76118
2004 83,48242 82,54646 82,4874 21,52299
2005 -17,2526 -13,5859 -25,355 1,501305
2006 50,24515 27,63309 16,99767 22,96886
2007 78,53738 95,02638 98,62971 65,56701
2008 11,00209 4,156836 11,5761 34,70232
2009 40,53782 8,358837 6,074314 16,56804
Average 16,11373 11,58684 11,07371 7,286746
ST Deviation 47,56514 50,46787 53,64689 37,16286
t-stat paired 1,396792 0,889192 0,799455 0,759399
t-stat unpaired 0,738124 0,517482 0,488376 0,345428
The 2 year strategy based on value weighted portfolios again proves to be much
more successful for value investing with value premium ranging from 16.1% for
Price to Earnings ratio based portfolios to 7.3% for Asset Growth ratio based
portfolios. This is again implying on the effect of market value on the portfolio
returns. However, the t-tests show that he differences between returns are not
significant with all the t-statistics being less than the critical value. The highest t-
statistic calculated is in a paired t-test for Price to Earnings based portfolios what is
in accord with the highest value premium calculated for these portfolios. Again, the
standard deviations for the value premium are very high, ranging from 53.6% for
Price to Cash Earnings portfolios to 37.2% for Asset Growth portfolios what I find
48
as a suitable explanation for t-tests showing the value premium insignificant.
However, value premiums seem to be quite high and that the 2 year value
investing in the value weighted portfolios strategy seems to be a good strategy as it
provides better average returns than the strategy of investing in growth stock
portfolios.
Table 12 Betas of Value Weighted Portfolios, two year holding strategy

1993 0,049102
1994 -0,06971
1995 0,021696 -0,09635 -0,12731 -0,02873

1996 -0,13135 -0,06682 -0,12929 0,00646
1997 0,283007 0,268268 0,366166 0,154022
1998 0,324151 0,249849 0,190176 0,081704
1999 0,403052 0,271553 0,112574 0,238211
2000 0,159047 0,233449 0,186948 0,01642
2001 -0,34252 -0,17205 -0,23635 0,039905
2002 -0,29531 -0,07661 -0,15612 -0,23986
2003 0,029117 0,114119 0,013781 0,015015
2004 -0,33917 -0,23547 -0,21593 -0,36498
2005 -0,08721 0,030553 0,034562 -0,02031
2006 0,142055 0,116617 0,139341 0,117152
2007 0,24295 0,270161 0,252458 0,173984
2008 0,189019 0,368675 0,264175 0,143835
2009 -0,17787 0,065698 0,017548 -0,23039
Average Difference 0,023532 0,089442 0,047515 0,006829
t-stat paired 0,417757 1,855276 0,975307 0,156798
The portfolios sorted on Price to Book Value ratio again show the biggest
difference in average Betas, 0.09. However the t-test rejects this difference as
being significant, the same with differences for other portfolios which are much
smaller.
49
3 years holding strategy
Table 13 Equally Weighted Portfolios, three year holding strategy

1993 48,08825
1994 23,33146
1995 18,60606 -38,2909 -38,1423 36,85888
1996 -14,4661 -49,8963 -31,991 -16,2489
1997 -59,3427 -55,8705 -42,2142 9,879033
1998 -35,1271 -22,9409 -92,1789 -29,2233
Value Premium
1999 -143,772 -174,39 -137,871 -8,0944

2000 11,07073 18,66298 17,76922 -96,8494
2001 33,05178 27,5945 39,27687 -23,3845
2002 115,5277 135,2972 163,8168 60,85633
2003 174,36 170,709 186,8089 76,97101
2004 108,1001 81,48738 94,29464 -13,4703
2005 -41,317 -2,66663 -40,5397 44,04663
2006 103,6044 127,3677 54,9431 104,2514
2007 -8,39272 -14,099 -7,29869 23,12466
2008 -3,72758 0,909982 7,117361 39,23017
Average 20,59972 14,56244 12,41368 14,85338
ST Deviation 77,98397 90,58478 90,66325 51,26802
t-stat paired 1,056613 0,60151 0,512311 1,084034
t-stat unpaired 0,560552 0,368542 0,313396 0,39715
The three year holding strategy shows the value premium for all strategies higher
than 12%, with the highest being 20.6% for Price to Earnings portfolios and the
lowest 12.4% for Price to Cash Earnings portfolios. The t-tests again do not pick up
such value premiums as significant, however the average standard deviations of
value premium are also very high ranging from 51.3% for Asset Growth portfolios
to more than 90% for Price to Book Value and Price to Cash Earnings portfolios.
50
Table 14 Betas for Equally Weighted Portfolios, three year holding strategy

1993 0,152121
1994 0,08597
1995 0,066333 -0,13741 -0,04556 -0,04889
1996 0,052449 -0,06639 -0,08879 -0,02292
1997 0,246645 0,207115 0,204444 0,154167
1998 0,315342 0,262457 0,154551 0,003333
1999 0,245476 0,225476 0,099762 -0,04083
2000 0,056429 0,211667 0,105476 -0,13357
2001 -0,21526 0,028535 -0,13357 -0,095
2002 -0,24179 0,045 -0,11405 -0,21881
2003 0,096905 0,194397 0,038349 -0,06246
2004 -0,16222 -0,00738 0,014048 0,022143
2005 -0,03786 0,084048 0,078333 0,138333
2006 0,129182 0,179286 0,185952 0,143571
2007 0,212179 0,252234 0,252234 0,002509
2008 0,20848 0,374634 0,301941 0,223333
t-stat paired 1,814975 3,443116 2,048071 0,140986
The 3 year average equally weighted Betas show similar results to previously
discussed strategies. Again, the most risky are value portfolios sorted by Price to
Book Value which have Betas higher than the growth portfolios by 0.13. Also the
value portfolios for Price to Cash Earnings sorting ratio show a significant Beta
premium – 0.08. Both these risks are calculated to be significant by t-tests with
respective t-statistics of 3.4 and 2 letting us be 95% sure that the value portfolios
based on Price to Book Value and Price to Cash Earnings ratios are riskier than
the growth portfolios sorted on the same measures. The average Beta premium of
value portfolio sorted by Price to Earnings ratio is also quite high of almost 0.08,
however the t-statistic for this one is 1.81 which is slightly lower than the critical
value of 1.96 and therefore does not allow us to state with confidence that these
portfolios are riskier than the growth portfolios.
51
Table 15 Value Weighted Portfolios, three year holding strategy

1993 127,5439
1994 -14,1144
1995 -8,19627 -33,2044 -28,5464 29,52881
1996 -25,9001 -29,7374 -31,984 -44,2124
1997 -60,4134 -68,6345 -57,7712 36,12415
1998 -26,1628 -12,0295 -87,6482 -46,3137
Value Premium
1999 -46,7149 -54,3912 -56,1663 -31,1376

2000 18,16461 20,87914 9,802978 -81,0259
2001 45,87148 38,91973 44,17933 -28,1682
2002 93,77961 111,8727 128,6049 61,24468
2003 129,2214 128,7897 138,4084 77,46122
2004 145,2594 112,6371 139,9443 -2,11954
2005 -20,5736 6,843037 -19,8453 -5,46818
2006 160,5702 192,0356 143,7348 168,6659
2007 21,80639 20,29707 22,52486 45,44217
2008 26,4924 8,092991 28,44306 46,44608
Average 35,41463 31,59787 26,69151 16,17625
ST Deviation 73,05921 76,9439 81,21029 64,0897
t-stat paired 1,938955 1,536553 1,229776 0,944395
t-stat unpaired 1,03243 0,95464 0,790621 0,494658
The last strategy tested is the strategy of 3 year investing in value weighted
portfolios. The calculations reasonably show the highest value premiums among all
strategies tested ranging from 35.4% for Price to Earnings portfolios to 16.2% for
Asset Growth portfolios. The t-test statistics again do not prove the value premium
to be significant however the t-statistic for the Price to Earnings ratio portfolios is
almost the same as the critical value of 1.96, being 1.94. This strategy seems to be
a successful one and again draws attention to very high standard deviations in
value premium, above 64% for portfolios of each sorting measure.
52
Table 16 Betas of Value Weighted Portfolios, three year holding strategy

1993 0,043665
1994 -0,08056
Value Portfotlio Beta - Growth Portfolio Beta 1995 0,023391 -0,07885 -0,11757 -0,03073
1996 -0,10038 -0,07421 -0,10929 0,058747
1997 0,243811 0,250105 0,280039 0,147584
1998 0,349132 0,236728 0,172464 0,051021
1999 0,340785 0,227415 0,122597 0,13193
2000 0,159507 0,222162 0,189959 -0,00454
2001 -0,36814 -0,18556 -0,24999 0,045282
2002 -0,28664 -0,07081 -0,1482 -0,24073
2003 0,063453 0,137944 0,043687 0,043057
2004 -0,21369 -0,1376 -0,09698 -0,26571
2005 -0,01571 0,073125 0,085227 0,012652
2006 0,205688 0,190964 0,213667 0,179299
2007 0,261736 0,297535 0,291457 0,139631
2008 0,186137 0,383893 0,272551 0,14132
t-stat paired 0,930793 2,16044 1,397843 0,806644
Again, the Beta of Price to Market Value value portfolios is higher than the one of
the growth portfolios by 0.11 and it is proved to be significantly different by the t-
test outcome of 2.16. The paired t-test does not confirm the differences for Betas in
portfolios based on other sorting measures to be significant.
53
Portfolio Market Values
I also compare the market values of value and growth portfolios for all sorting
measures and the outcome is provided in the table below:
Portfolio Market Values

1993 31296,34
1994 137331,9
1995 34556,18 99849,76 202667 -111415
Growth Portfolio MV - Value Portfolio MV
1996 175676,7 172888,5 245268,4 176751

1997 12514,88 -114301 -172995 -183985
1998 -3040,79 28895,51 -198100 181060,8
1999 215684,7 142953,5 -6925,74 616381,1
2000 552622,9 548498,7 394669,7 467707,9
2001 1185201 1334039 1488134 645055,1
2002 546370,2 750137,7 638241 417176,3
2003 370765 625407,6 613242,9 728091,3
2004 2597,75 128412,6 205829,7 424905,9
2005 -1324969 -499438 -751024 2527008
2006 -1163951 -652928 -640078 -291602
2007 -1874070 -842714 -1140664 -1358303
2008 1212899 -1263795 118437,1 1800909
2009 5209186 5769355 6376924 4613909
2010 296520 1697817 -3365177 -3998645
t-stat paired 0,405011 -0,35157 -0,1762 -0,30567
The growth portfolios have a larger market capitalization based on all sorting
measures. Even though the t-tests find this difference insignificant, I find it
interesting having in mind that in years where I had an unequal number of
companies to sort in value and growth portfolios, I chose to place more shares into
the value portfolio which would of course increase the value portfolio’s market
value. One of the reasons for that might be that the growth companies achieved
good results before the date I formed portfolios and in result got more investment
in their shares allowing them to expand. This implies that investors tend to invest
into companies if they were successful in the past, expecting them to keep on
54
delivering good results and in such way overpricing stocks or in other words,
raising their price above their true or fundamental value.
Summary of the results
The results obtained show that there exists a value premium in the BSE Sensex
index in most of the cases analyzed, except for the two year holding strategy for
equally weighted portfolios. Moreover, the analysis shows that the value weighted
portfolios produce a higher value premium than the average weighted portfolios
implying that there is an effect of market capitalization. It seems that the stocks
with higher market capitalization produce higher returns in the value portfolios.
Nevertheless, after all the statistical tests performed, the paired and unpaired t-test
assuming unequal variances show that the value premium is not statistically
significant. The Indian stock market is a very volatile market as the value premiums
for returns significantly deviate from the mean in all strategies tested as shown in
the values of the standard deviations – it is a strong explanation for the t-tests
concluding that the value premium is not significant.
For value weighted portfolios the most successful strategy proves to be the one
where the portfolios are sorted on the Price to Earnings portfolio providing a value
premium of 11.2%, 16.1% and 35.4% for value weighted portfolios for respectively
one, two and three year holding periods. The least successful strategy is the one
based on Asset Growth ratio which provides value premiums of 4.6%, 7.3% and
just above 16% for respective one, two and three year holding periods. This implies
that this measure might not be such a good predictor of future stock performance
as reported by M. Cooper et. al. on the US data in 2008.
The strategy based on sorting portfolios on Price to Earnings also proves to be the
best for equally weighted portfolios providing 8.6%, 2% and 20.6% value premium
for one, two and three year holding periods. The results of value premiums for
portfolios based on other ratios are similar among themselves therefore I do not
conclude which strategy is the least successful in this case.
55
Steady findings can be found while analyzing the Betas of all portfolios. It is clear
that the value portfolios based on the Price to Book Value have significantly higher
betas than growth portfolios sorted on the same measure. This is proved by a
paired t-test for all equally weighted portfolios and the same test for value weighted
portfolios with a holding period of 3 years. For the strategies of investing in value
weighted portfolios for one and two years value portfolio Betas also seem to be
higher than the ones for growth portfolio, however the t-test does not find this
difference significant albeit both t-statistics are 1.85, just slightly lower than the
critical value of 1.96. T-tests also find significant the difference between Betas for
equally weighted portfolios sorted on Price to Cash Earnings ratio however only in
a three year holding horizon. Such findings signal an existence of higher
fundamental risk in value portfolios, albeit the Betas for the rest portfolios do not
seem to be very different and t-tests confirm that.
Overall, I conclude that there exists a value premium in the BSE Sensex
investment universe. It is not confirmed by means of a t-tests performed, however I
assume that this is mainly due to extremely volatile returns in the market.
Consistent with higher volatility, the value premium is seems to be higher than the
one’s reported by studies of E. Fama and K. French and J. Lakonishok et. al.
Finally, it is worth mentioning again that the sample size is quite small and it might
have influence on the results. I continue with a more specific view into the reasons
for these results in the discussion section.
56
Section 5 - Discussion on the reasons behind the results
Classical finance approach
After performing the analysis of the beta values for the value and growth portfolios
it can be concluded that value portfolios sorted on Price to Book Value ratio carry
more fundamental or systematic risk than the growth portfolios. Also in on the case
of three year holding strategy of equally weighted portfolios same is reported for
Price to Cash Earnings portfolios. The t-tests do not find significant fundamental
risk differences in portfolios sorted on other measures. Generally, Price to Book
Value is a ratio that shows if one can buy shares in a company that has a lot of
assets for less or by how much more than those assets are valued in the books. In
other words, it compares the changes of the price during a year to a value of it at
single point of time. Therefore in value investing it is used as an indication whether
the stocks are under or overpriced, meaning how the stock price differs from its
fundamental or real value. It is particularly relevant for companies that have assets
that can be easily sold or their market value easily determined – cash, marketable
securities, machinery, plants, equipment – such assets are liquid. The other
mainstream studies, performed by J. Lakonishok (1994) and E. Fama & K. French
(1998) show that the Capital Asset Pricing Model does not explain the value
premium and that it might be related to some other risk, but not the fundamental β.
So what can be the reasons for Beta’s being higher for value portfolios in Indian
stock market? One possible answer is that such result might be just sample
specific, because the sample is just 15 years for Price to Book Value portfolios -
there is no way of knowing that it will not be different in the future results. Also, as
the markets have been so volatile in India, the Price to Book Value ratio might not
be the best ratio to use in such analysis, because the book value is calculated at
one point in time and the market price value is changing rapidly, therefore the
overall value of the ratio should be highly volatile too. Finally, it can be brought
back to the CAPM model, implying that the value premium for the Price to Book
Value portfolios comes from the higher market risk associated with these stocks –
57
they are more volatile than the growth portfolios implying that low Price to Book
Value ratio is a good predictor of the volatile future performance of the stock.
Emerging markets study
It is not a new finding that the returns in the emerging markets are very volatile. E.
Fama & K. French 1998 find that in the period of 1987 through 1995 ten out of 16
emerging markets show an annual return standard deviation of more than 50
percent. They also look into value premiums in India, among other countries,
where for the same period they find a negative annual value premium for portfolios
sorted on Price to Earnings ratio of -2.77% and a positive value premium for
portfolios sorted on Price to Book Value ratio of 1.53%. My study shows that in
most cases there exists a value premium in the Indian stock market – it might be
due to the fact that I use a longer sample. E. Fama & K. French use a sample of
only 8 years and it starts before the real liberalization of the Indian market – which
makes their results questionable, although they are consistent, finding value
premiums for most of the emerging markets.
My study also shows that the value weighted portfolios tend to have higher returns
than the equally weighted portfolios, which contradicts with findings of S. Heston
et. al. (1995). However, I would refrain from making conclusions here as my
sample covers only 30 stocks, so it might be a number too small to pick up the size
effect, albeit the findings imply it exists.
Bad states of the economy
Since the traditional Beta show some indication of value stocks being more risky
than the growth stocks I believe it is worth to see how the strategies performed
under bad states in the markets. It is difficult to make any cross sectional test with
only 2 portfolios and only 30 stocks in the index. However, just to get an insight, I
try to have a simple comparison of the performance of value portfolios to the
change of GDP through the years. If we would take India’s yearly GDP starting in
the 1990s it is impressively rising all the time as per the graph below.
58
Figure 10 India’s GDP, Bn Rupees
100000
90000
80000
70000
60000
50000
40000
30000
20000
10000
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
To see during which periods the economy is growing faster or slower, I chose to
look into the percentage change of the GDP. The graph below shows the
percentage change in India’s GDP starting in the 1990:
Figure 11 Change in India’s GDP, %
0,25
0,2
0,15
0,1
0,05
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
As we can see in the graph, the growth in India suffered a slowdown in 1995, the
period of 1997 to 2000 and then from 2006 to 2008. These fit naturally with the
years of Asian Crisis and the recent financial crisis. If I choose the most successful
portfolio for value premium – the P/E portfolio, I can see that the value premium for
59
period 1997-2000 is negative for both value weighted and equally weighted
portfolios. However, in the period of 2006 and 2008 the value premium is positive.
It is difficult to tell for the year 1995 as the premium for the equally weighted
portfolios is negative, but the same measure for value weighted portfolios is
positive, so no conclusion flows from here.
O. Risager (2008) argues that the value investing strategy generally has upside
risk features and performs better in the worse states of the economy. In this case,
GDP can explain the bad performance of value stocks in 1997-2000 indicating
downside risk – the portfolio might be getting riskier when the economy melts and
consumption is likely to decrease. However, since during the recent world crisis the
value stocks outperform growth stocks in Indian market, the conclusion remains
obscure - a positive value premium under slower economy would mean that value
portfolio is a good hedge against economic crisis.
Behavioral finance approach
As noted in sections before, some of the value premium might be explained by the
higher level of fundamental risk – tests prove value portfolios sorted on Price to
Book Value ratio and in one case on Price to Cash Earnings ratio to be more risky
than growth portfolios. However, tests performed for portfolios sorted on other
ratios do not find the beta difference of value and growth portfolios significant.
Therefore, I believe there is a need to look into alternative explanations, the ones
presented by behavioral finance.
According to the classical finance and mostly from the standpoint of the Efficient
Market Hypothesis, if there exist any deviations in the prices in the markets, these
should be always taken back to their fundamentals by the rational investors, or, in
other terms, corrected. The existence of value premium in the market implies that
the prices in the market do not really show the true value of the stocks – the value
stocks are undervalued and the growth stocks are overvalued. The fact that this
phenomenon holds for several years means that the rational investors do not
correct the prices in the market. As mentioned in the section about behavioral
60
finance, such situation in the markets was called the limits to arbitrage by N.
Barberis and R. Thaler (2003), who argue that bringing the prices back to their
fundamentals could be both risky and costly. Investors seeking arbitrage
opportunities might be afraid that the pessimism in the markets might continue and
the already undervalued stocks might get undervalued even more, not thinking that
the overvalued stocks might soon turn into losers as well. Of course such thinking
comes having in mind all associated costs, such as time and money spend while
collecting information, buying, holding and maintaining stocks – the factors not
taken in account in the calculations of this study.
Another reason of deviations from value fundamentals might be that investors tend
to extrapolate too far to the future. Naive investors tend to get too excited during
good times and based on past performance look too far in the future, therefore
overvaluing the stocks with good past behavior. Same applies for value stocks,
which get underpriced as investors tend to expect that they will continue
underperforming, when indeed they are likely to start earning profits and the results
of this study show that. R. Shiller (2009) provides an example of people
extrapolating too far in the future when the markets are doing well – just before the
credit crunch crisis the people of Los Angeles were surveyed about their
expectations of the future housing prices in the city. Surprisingly, on average the
survey subjects expected the house prices to increase by 23% a year for the next
five years, just before the bubble burst. There exists evidence that professional
analysts also tend to extrapolate past information too far into the future. According
to La Porta (1997) companies for which analysts projected high earnings growth,
showed price decrease after the announcements of the real earnings. Conversely,
the stocks for which poor earnings growth was projected showed increase in their
prices after the same announcements - making such stocks attractive to contrarian
investors.
When people once invest in stocks and get lucky, they will usually attribute the
success to their own ability of choosing the correct stock, not simple luck. As a
result we might get overconfident investors, who believe that good past
61
performance indicates a successful investment opportunity and in this way bring
the price of stocks way higher than their fundamentals, often trading too frequently
as mentioned before. People start thinking that they understand the market better
than others, “it is as if most people think they are above average” - Shiller (1998).
Also R. Shiller (1998) mentions that most market participants never study the
historical statistical data and consider the past irrelevant – people tend to decide
only on the factors which they collect or intuitively feel at present. It is also a form
of overconfidence leading to making the same mistakes as were done in the past.
However, there also exists the phenomenon in people decision making process
called anchoring – in stock markets it appears when the present price is partly
determined by the past prices. Such situation is quite common then dealing in
industries or with commodities where the value of the traded goods is very
ambiguous – the past price is important for current price determination. “People
may fail to appreciate the extent to which their own opinions are affected by
anchoring to cues that randomly influenced them, and take action when there is
little reason to do so”, R. Shiller (1998).
Tversky and Kahneman (1974) present representativeness heuristic - their

experiments show that people tend to see different events as representative for
some known group and later while trying to estimate the probabilities of such
events or event groups, they put too much weight on such categorizations. In other
words, “this heuristic is a tendency for people to see patterns in data that is truly
random, to feel confident, for example, that a series which is in fact a random walk
is not a random walk”, R. Shiller (1998).
The regret theory about human tendency to feel pain after making mistakes also
provides some insight in the movement of stock market prices. Shefrin and
Statman (2000) predicate that people avoid selling underperforming stocks with a
falling price in order to avoid the moment when they have to acknowledge that they
have made an unfavorable investment decision. Conversely, investors tend to sell
the well performing stocks too early, to avoid regret if the stock starts
underperforming at some unknown time in the future. The cognitive dissonance
62
theory developed by L.Festinger in 1957 states that people experience negative
emotions - pain or regret, when proven that their beliefs or reasons under their
actions are wrong. Consequently, seeking to avoid such emotions people might
start acting irrationally – seek additional obsolete or biased arguments to prove
their decisions or neglect new or contrarian information, which might lead to
deviations from real value in the prices of stocks.
Additionally, R.Schiller and G. Akerlof (2009) argue that herding plays an important
role in deviations from fundamental values - people assume that they do not need
to do a lot of research, because they can trust the research of other participants in
the market. R. Shiller (1998) argues that this opens up opportunities for contrarian
investors looking for undervalued stocks, “if people are not independent of each
other in forming overconfident judgments about investments, and if these
judgments change collectively through time, then these “noisy” judgments will tend
to cause prices of speculative assets to deviate from their true investment value.”
According to R. Schiller and G.Akerlof (2009), when stock markets go up in the

markets, people get attracted by it and it generates certain thoughts causing
people to start communicating about such news among each other creating
overpricing or underpricing in the stock values. There is an emotional channel –
when prices go up, people who are not investing start getting feelings of envy, loss
of confidence, lack of fulfillment, excitement in life. Also, same authors argue that
a lot of numbers or important facts about investment opportunities are remembered
from stories of human interest – the human brain is indexed around such stories. In
times when everything looks good and prices start hitting the ceiling, people start
telling stories about winners – smart people achieving success, earning a lot of
money – these stories become driving forces for buying stocks with good past
performance and rising their prices, often causing the price to move way above its
fundamental value. It is interesting to notice that different kind of stories is a very
important integral part of Indian culture, it is well known for having some of the
oldest and major epics written on earth – Ramayana and Mahabharata, which for
63
their impact to the development of world civilization are compared to Homer’s or
Shakespeare’s writings and Bible or Quran.
Cultural differences might also explain some movements of the Indian Stock
Market. India is the biggest democracy in the world, however with its historical and
cultural heritage, religions, philosophy and values of life it is totally different from
the western countries. R.Shiller (1998) summarizes some findings from culture and
anthropological studies. Each interconnected group, would it be a nation or a social
group created in Facebook, develops a social cognition based on language,
symbols and rituals. “If one speaks to groups of people about ideas that are foreign
to their culture, one may find that someone in the group will know of the ideas, and
yet the ideas have no currency in the group and hence have no influence on their
behavior at large.”, R. Shiller 1998. Even the cleverest, most educated, people,
influenced by group thinking might make wrong decisions. While India is a very
unique country even in its own continent, some studies show interesting
differences between Asians and people from western cultures. Wright and Phillips
(1978) study if different cultures might have different attitudes toward uncertainty.
They find that generally Asians are more prone to overconfidence than the British
people. Moreover, Chuang and Wang (2000) provide findings that Asian investors
are often involved in overconfident trading. Such studies might provide insights to
further studies of the volatility in the Indian market.
Corruption is another factor mentioned in Animal Spirits (2009), which is seldom

discussed in finance theory and generally in economics. R. Shiller and G. Akerlof
argue that in high times of booming prices, the legal standards are let down, bad,
or less ethical behavior becomes more common and signs of greed in the markets
appear. While surrounded by good news while markets flourish, common investors
tend to get unusually naive and trusting. After the market correction, when prices
drop down people start feeling anger and they tend to change their behavior – they
start mistrusting the business environment and each other, which causes a
slowdown in the economy and again the deviations from price fundamentals. As
mentioned in the section on Prospect Theory, investors are loss averse and are
64
investing very carefully to avoid the pain of losing their money and that is why they
avoid companies with poor results in the past.
In the annual Corruption Perceptions Index a NGO Transparency International

investigates how corruption is perceived in various countries by interviewing people
involved in business field both inside and outside the country. In the index of 2010
India is ranked 87th among 178 countries analyzed. The result of the survey is
provided in the map below:
If we look only in Asia, India is one of the least corrupted countries. However, there
exists a high level of corruption in India if we compare it to the rest of the world.
High levels of corruption might have a strong impact on investor sentiment and
reflect in stock prices getting undervalued at the moment when people do not trust
the market. Moreover, high level of corruption leads to a problem when considering
the standards of corporate governance in the Indian companies. The controversies
between the stakeholders and management of the companies might also affect the
investor sentiment and poor management practices or abuse of managerial powers
might lead to pessimistic investor approach to the overall market.
65
Consequently, agency problem also must be mentioned here. It is always easier to
buy a stock which has been performing well in the past and if it performs badly,
blame it simply on bad luck. This way a safe investment is chosen – it is easy to
argument to other parties why such a decision has been made and easy to make
an excuse if it goes bad. R. Schiller (1998) argues that inside culture factors leads
to displacing the responsibility for the investment decisions of the organization and
that desire of the agents to be successful within the organization affects the overall
investing strategy.
Most of the above psychological and cultural issues lead to framing matters in
investor decision making process. The way the investment opportunity is framed in
investor’s mind plays a very important role. Media, relatives, colleagues or any
other resource of information shape the way the investors think of a company.
Therefore if the past messages about the company were mostly good, the investor
will have a picture of a good investment in her mind. Otherwise, if the information
flow is always negative about the company, then it might be perceived as a risky
opportunity. Therefore, there is a great deal of being disciplined and able to
separate the reality from our perceptions due to all the informational noise around
us in order to make an unbiased decision in the markets.
The behavioral finance explanations are appropriate to partly explain the value
premium and deviations from the fundamental values in the Indian market which
my study finds and which are small enough to be discarded as statistically
significant by the t-tests. However, the behavioral finance theories do not explain
why the value portfolios in some mentioned cases have a Beta which is
significantly higher than the one for the growth portfolios based on the same ratio.
This implies that such value portfolio might carry more fundamental risk and thus is
more volatile than the growth portfolio.
66
Section 6 – Discussion on rationality in economics and
conclusion
Rationality in economics, other disciplines and further research
My main personal goal of this thesis was to try to explore how the stock markets
pulsate, function and how the participants of the markets interact with each other
while reacting to changing states of economy. Inspired by the writings of behavioral
economists, mainly R. Schiller (1998, 2000 and 2009) and V. Smith (2008), I
provide a short overview of the future evolvement of economic theory and some
insights on how the research of human behavior is changing.
For a very long time the economic and in this case financial theory was led by
models based on assumptions that investors are rational maximizers of their utility.
Last two decades of research by behavioral scientists such as R.Schiller or V.
Smith among others inspires to look into different factors underlying the
movements of markets and the reasons behind the investors taking different
decisions under changing conditions. Both authors argue that most decisions in the
markets and in life overall are made under some kind of intuitive judgment,
because nobody knows the real probabilities of possible outcomes of most
problems. R. Schiller and G. Akerlof (2009) call the phenomenon driving the
markets “animal spirits”, a term coined by John Maynard Keynes in the 1930s. R.
Shiller states that most of the bubbles and major crashes in the markets, would it
be housing, commodities or stock markets, come from such intuitive judgment and
the overenthusiastic or pessimistic sentiments in the markets. The psychology in
the markets matters – the positive feelings lead to increased investing in the
markets and raising the prices too high which in turn leads to the system itself
correcting the prices and arousing negative feelings which consequently slows
down the economic activity.
As R. Shiller (1998) points out, people are not only rational profit seekers, but very
empathetic, tending to feel each other and having a need for such feeling. Similar
ideas flow from V. Smith’s book (2008) - self interest is a very important part of
67
human behavior, people are motivated by feelings of love, self esteem, desire for
honor and pride, the recognition of others and similar kind of things that are left
aside by most of the modern economic theory. Both authors argue for new
approach today’s economists should undertake, involving more open conversation
with people, trying to uncover their feelings and reasons behind their actions –
what people are indeed thinking, how they perceive changes in their life and what
is their approach to different decisions that they have to make.
The main idea of V. Smith (2008) is that usually people solve a lot of different
problems in their life, such as how to behave in markets, without a strict rational
basis and still manage to end up with outcomes with somewhat attractive
properties without even knowing how they get there. He argues that markets have
some kind of social brains – without really understanding themselves people have
ability to solve problems by interacting and reading what others offer or bid in the
markets. It’s the simple equilibrium theory of supply and demand which is the basis
of all such interaction, without individuals not being able to explain how they are
solving their problems while trying to improve their state of being. R. Shiller (1998)
discusses a similar phenomenon which he calls a “global culture” – “the
convergence of seemingly arbitrary fashions across nations is evidence that
something more is at work in producing internationally-similar human behavior than
just rational reactions to common information sets relevant to economic
fundamentals”. He raises the question why the stock and housing markets move
somewhat similar in whole world and suggests looking for answers in the global
nature of culture, not only in the intrinsic information about economic fundamentals.
V. Smith’s idea is that people are putting too much emphasis on improving the
markets, but maybe the markets are already working efficiently, however with its
participants being not rational as imposed by modern economic models. And it is
very difficult to get a full understanding of all the processes in the markets as
human mind has limits to piece together the whole system which is much more
complex and greater than the individual itself. V.Smith emphasizes that different
biases prevent people from understanding the whole construction of markets –
68
people tend to see markets biased towards buyers if they are selling and vice
versa, overlooking the discipline brought to the markets by the other side.
Under conditions of globalization, rapid technological development and increasing

interconnectedness between people the economic research is getting broader and
more interdisciplinary, applying new findings from other sciences such as
psychology, sociology, political science, history, anthropology and, more recently,
neuroscience. Neuroscience is the latest discipline worth mentioning while
discussing the future prospects in study of human behavior in economics.
Numerous studies not mentioned in this thesis by such researchers as C.F.
Camerer, G. Loewenstein, A. Bechara, A. Damasio and others are providing
insightful results on human intuition and decision making. V. Smith argues that it
might be too early to discuss where can the analysis of human brain lead and what
outcomes it might bring, however it is very interesting to see how brain encodes
the value of money - similarly to values of other pleasures it uses reward centers
as for our basic needs. If real money is involved brain reward centers are strongly
activated and different parts of brain are known to be responsible for different risk
and monetary stimulus. Such research might provide valuable insights in studying
how people compare different outcomes with money involved, framed in different
ways.
To conclude, my purpose here is not to argue that the modern economic theory is
wrong and should be rejected –it is a very good starting standpoint for further
research, providing proper insights to the market mechanisms. However, the input
from other sciences is changing the way we perceive the whole concept of human
mind and consciousness and I believe that today’s economists and finance
researchers should choose a more open and multidisciplinary way.
69
Conclusion
After performing an empirical study on the Bombay Stock Exchange Sensex index
of 30 stocks an indication of value premium in Indian stock market was obtained.
For equally weighted portfolios the premium of the value stock portfolio over the
growth stock portfolio varied from 8% to 2% and 20% for the portfolios based on
Price to Earnings financial ratio for respectively 1,2 and 3 years holding periods.
Slightly smaller value premiums were obtained for value portfolios sorted on Price
to Book Value, Price to Cash Earnings and Asset Growth ratios. Even higher value
premiums are found for value weighted portfolios – 11%, 16% and 35% for
portfolios based on Price to Earnings ratios and slightly smaller for portfolios based
on other financial ratios corresponding to the findings on equally weighted
portfolios. Such numbers together with the indication that Indian stock market is
likely to mean revert signal that the Indian stock market is an attractive market for
contrarian investors.
However, the statistical t-tests used in this study do not support the value premium
as being significant. One of the reasons for this is the volatility of the return value
premium in the BSE Sensex index, with the smallest standard deviations for one
year holding strategy being 28% and 29% correspondingly for equally weighted
portfolios and value weighted portfolios, followed by same numbers for two year
strategy being 41% and 37% and 51% and 64% for a three year holding strategy.
Another reason for this might be a too small data sample as data of only 30
companies was analyzed and for most of the years data for less than 30 stocks
could be extracted from the DataStream database.
The indication that value stock portfolios carry more fundamental risk was also
found and proven statistically significant for some cases of portfolios sorted on
Price to Book Value and Price to Cash Earnings ratios. Again, overall volatility and
small data sample can be used as possible explanations for this result. However it
is a signal that value stocks are fundamentally riskier in the Indian stock market,
something which is not in line with findings of E. Fama and K. French (1998 and
other mentioned) and J. Lakonishok et al studies (1994).
70
Moreover, no conclusions flow from trying to compare the value premium with the
overall growth of the economy – the value premium was negative during the times
of Asian crisis and positive during the recent world crisis - periods when GBP
growth in India was slower. Therefore, it is difficult to say whether value stock
portfolio could serve as a good hedge in the Indian stock market during bad times
of the economy.
Reasons for the observed deviations from fundamentals in Indian market prices
and returns (existence of even small value premium itself signals that such exist)
are also discussed by presenting a number of behavioral finance principles such as
human tendency to extrapolate the prices too far to the future (used by Lakonishok
et. al. in 1994), herding, overreaction and overconfidence, framing matters and
culture. Corruption and corporate governance are also provided as possible
explanations for stock price deviations in Indian market. As contrarian investing
strategies are discussed, I believe that more contrarian reasons should be
analyzed to explain market inefficiencies and research in the field should become
more interdisciplinary.
To finalize, the indication of the value premium in India signals that the market has
similar movement to other markets in the world where the value premium existence
was reported before. However, the explanations for such findings differ. I believe a
more thorough study should be carried out to achieve more accurate results. A
larger index, such as BSE 100, BSE 200 or even BSE 500 could be investigated
and more structural portfolios could be formed to see how the value premium is
changing in different clusters. Applying cross sectional tests and involving more
macroeconomic factors might also provide interesting results. Such extended study
could be a great work for a PHD student, however it might also be too early to
conclude on the stock movements in the Indian stock market - only two decades
passed since its liberalization and the returns in the market are still extremely
volatile.
71
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78
Appendixes
1. Data description from DataStream Database
Price index – data type (PI)
The price index expresses the price of equity as a percentage of its value on the
base date, adjusted for capital changes.
Total Return Index – data type (RI)
A return index (RI) is available for individual equities and unit trusts. This shows a
theoretical growth in value of a share holding over a specified period, assuming
that dividends are re-invested to purchase additional units of an equity or unit trust
at the closing price applicable on the ex-dividend date. For unit trusts, the closing
bid price is used where available.
For all countries except the USA and Canada detailed dividend payment data is
only available on DataStream from 1988 onwards. Up to this time the RI is
constructed using the annualised dividend yield. This method adds an increment of
1/260th part of the dividend yield to the price each weekday. There are assumed to
be 260 weekdays in a year, market holidays are ignored:
Method 1 (using annualized dividend yield)
RI on the base date =100, then:
Where:
= return index on day t
= return index on previous day
= price index on day t
79
= price index on previous day
= dividend yield % on day t
N = number of working days in the year (taken to be 260)
From 1988 onwards (and from 1973 for US and Canadian stocks), the availability
of detailed dividend payment data enables a more realistic method to be used in
which the discrete quantity of dividend paid is added to the price on the ex-date of
the payment. Then:
Method 2 (using ex-dividend date)
except when t = ex-date of the dividend payment Dt then:
Where:
= price on ex-date
= price on previous day
= dividend payment associated with ex-date t
Gross dividends are used where available and the calculation ignores tax and re-
investment charges. Adjusted closing prices are used throughout to determine
price index and hence return index.
Note : where the detailed dividend payment data (after 1988 for countries other
than US and Canada) contains a mixture of dividends marked as net and gross,
the annualised dividend yield (method 1 above) continues to be used. The
80
net/gross markers can be identified using the data type DTAX (tax marker) or can
be displayed in the Dividend Payment Report in DS Advance. To display the total
return using the ‘ex-date’ method in these cases, the alternative total return
datatype RZ (return index as paid) may be used. RZ uses the ‘ex-date’ method
(method 2 above) irrespective of the tax markers.
Price to book value – data type (PTBV)
This is the share price divided by the book value per share.
Price/cash earnings ratio – data type (PC)
This is the share price divided by the cash earnings per share for the appropriate
financial period. Cash earnings are defined as “Funds from operations”.
Price/earnings ratio (PER) – data type (PE)
This is the price divided by the earnings rate per share at the required date.
Total Assets – data type (DWTA)
The DataStream Worldscope (DW) data types are a set of DataStream Global
Equity index and security valuation data types using Worldscope data. The data is
based on a trailing twelve month period if applicable and represents the sum of the
relevant item reported in the last twelve months. From the fiscal period 2002, the
items are populated from the quarterly, semi-annual and trimester time series
based on the availability of the underlying data. When trailing twelve month data is
unavailable or for values before fiscal period 2002, the annual Worldscope
datatype is used as indicated below.
All Industries: Total Assets represent the sum of total current assets, long term
receivables, investment in unconsolidated subsidiaries, other investments, net
property plant and equipment and other assets.
Banks: Total Assets represent the sum of cash & due from banks, total
investments, net loans, customer liability on acceptances (if included in total
81
assets), investment in unconsolidated subsidiaries, real estate assets, net property,
plant and equipment and other assets.
Insurance Companies: Total Assets represent the sum of cash, total investments,
premium balance receivables, investments in unconsolidated subsidiaries, net
property, plant and equipment and other assets.
Other Financial Companies: Total Assets represent the sum of cash & equivalents,
receivables, securities inventory, custody securities, total investments, net loans,
net property, plant and equipment, investments in unconsolidated subsidiaries and
other assets.
Market value / market capitalization – data type (MV)
Market value on DataStream is the share price multiplied by the number of ordinary
shares in issue. The amount in issue is updated whenever new tranches of stock
are issued or after a capital change. For companies with more than one class of

equity capital, the market value is expressed according to the individual issue.
Market value is displayed in millions of units of local currency.
82
2. List of files uploaded together with the thesis
1. PE portfolios.xlsx – value and growth portfolios sorted on Price to Earnings
ratio, their equally weighted and value weighted returns and betas.
2. PTBV portfolios.xlsx – value and growth portfolios sorted on Price to Book
Value ratio, their equally weighted and value weighted returns and betas.
3. PC portfolios.xlsx - value and growth portfolios sorted on Price to Cash
Earnings ratio, their equally weighted and value weighted returns and betas.
4. Asset G portfolios.xlsx - value and growth portfolios sorted on Asset Growth
ratio, their equally weighted and value weighted returns and betas.
5. T-tests for PE ratio.xlsx – testing for difference in equally and value wighted
returns and betas and market value of value and growth portfolios sorted on
Price to Earnings ratio.
6. T-tests for AssetG ratio.xlsx – testing for difference in equally and value
wighted returns and betas and market value of value and growth portfolios
sorted on Asset Growth ratio.
7. T-tests for PTBV ratio.xlsx – testing for difference in equally and value
wighted returns and betas and market value of value and growth portfolios
sorted on Price to Book Value ratio.
8. T-tests for PC ratio.xlsx – testing for difference in equally and value wighted
returns and betas and market value of value and growth portfolios sorted on
Price to Cash Earnings ratio.
9. India’s GBP.xlsx – Calculations of India’s GBP growth.
10. Mean Reversion.xlsx – calculations for daily, monthly and yearly returns and
mean reversion testing.
11. Asset Growth Rate.xlsx – calculations of yearly Asset Growth Rate.
12. Sensex.xlsx – Historical constituents of BSE Sensex Index (also provided
for BSE100, BSE 200 and BSE 500)
83
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Master Thesis

Aarhus School of Business and Social Sciences, Aarhus University

Msc in Finance, Department of Business Studies

Contrarian Investing Strategies in the Indian Stock Market

Stig Vinther Møller

Aarhus School of Business and Social Sciences, Aarhus University 2011

My empirical research is based on the Bombay Stock Exchange Sensex index

The main, leading, questions in this study are the following:

Introduction to main classical financial theories and behavioral finance theories

What is contrarian investing? Main investors and philosophy behind it

Empirical research, glance at the Indian market development since its

Discussion on the results of the empirical research - classical finance explanations

Discussion on rationality in economic science, concluding remarks

Classical finance theory

In this section I want to present some of the fundamental theories of standard

Furthermore, when it comes to testing market efficiency, researchers get to a

Random Walk Hypothesis

Capital Asset Pricing Model (CAPM)

3. All investors share homogenous expectations concerning the expected future

The main equation of the model is stated below:

Figure 2. Value Function – Prospect Theory (Fisher & Statman 1999)

Herding and overreaction

Motivation towards stock markets

In 1984 Warren Buffet published an essay called "The Superinvestors of Graham-

Market analysis related to contrarian investing can be traced back to S. Basu

Before continuing to the next section on the empirical research, a short

India’s position in the global economy

Figure 3 Shifts in Global Economic Center

Table 1 Growth of China and India against growth in USA

Ratio of absolute growth 1960-1990 1991 1991-2000 2001 2001-2008

(China+India)/US 0,13 -3,2 0,33 1,67 0,93

Figure 4 Projected center of world economic activity in 2050

Figure 5 Sectorwise Market Capitalisation in BSE Sensex Index

It is important to emphasize that no transaction charges and taxes are taken in

Mean Reversion testing

The autocorrelation statistic of a time series pt is defined as:

The Ljung Box test statistic is defined as:

N is the sample size

qk is the autocorrelation at lag k

M is the number of lags tested

The main hypotheses in my tests are:

Figure 7 Daily returns in BSE Sensex index

Ljung Box test results for daily returns

Table 2 Test results for daily BSE Sensex returns

Lag Autocorrelation Ljung Box Statistic

Ljung Box test results for monthly returns

Table 3 Test results for monthly BSE Sensex returns

Ljung Box test results for yearly returns

Table 4 Test results for monthly BSE Sensex returns

Discussion on mean reversion testing results

Equally weighted portfolios and Betas

Table 5 Equally Weighted Portfolios, one year holding strategy

Equaly Weighted Portfolios

2000 -46,9657 -28,9205 -37,9107 -148,062

Equaly Weighted Betas

1996 -0,01212 -0,10985 -0,13455 -0,02625

Table 7 Value Weighted Portfolios, one year holding strategy

Value Weighted Portfolios

2000 -4,30337 5,216237 -10,5172 -93,3194

Table 8 Betas of Value Weighted Portfolios, one year holding strategy

Value Weighted Betas

1996 -0,14363 -0,0767 -0,1429 -0,01573

Equally weighted portfolios and Betas