Abstract to of a page Literature review (2 to 5 pages) Methodology Analysis Conclusions in relation to objectives Recommendations Overall report between 40 to100

00 pages

UNIVERSITY OF NAIROBI SCHOOL OF MATHEMATICS USING P/E RATIOS AND MARKOWITZ DIVERSIFICATION AS THE BUILDING BLOCKS FOR STATISTICAL ARBITRAGE SAC 420: PROJECT IN BSc. ACTUARIAL SCIENCE SUBMITTED BY: CAROLINE MUMBI DENIS MOKAYA BYRON W. OGUTU ANGELA KELLY I07/. I07/.. I07/2247/2007

SUPERVOSOR: DR. JOSEPH MWANIKI IVIVI Submitted in partial fulfillment of the requirements for the Degree of the Bachelor of Science in Actuarial

DECLARATION This project is our original work and has never been presented for a degree in any other university for examination CANDIDATES: Signature.. Caroline Mumbi (I07/) Signature. Denis Mokaya (I07/.) Date.. Date..

Signature.. Date Byron W. Ogutu (I07/2247/2007) SUPERVISOR: This project has been submitted for examination with my approval as supervisor. Signature Dr. Joseph Mwaniki Iviv Date

ACKNOWLEDGEMENT First and foremost, we would like to the Almighty God for giving us knowledge, strength and wisdom to undertake this project. We cannot fully express our gratitude to the incomparable Dr. Mwaniki, our supervisor, for his generosity, faith and superb guidance throughout our research. For their support and unwavering assistance, we would like to acknowledge the Nairobi Stock Exchange, the Macmillan Public Library and the National Archives. We would be remiss if we did not mention our family members. It is their moral support and encouragement that spurred us on whenever we felt fatigued. And for that we will be eternally grateful. Last but not least, to ourselves for our tireless efforts and teamwork that saw us through the entire period

To ..

TABLE OF CONTENTS ABSTRACT 1.0 INTRODUCTION 1.1 Background information 1.2 Problem statement 1.3 Objectives of the study 1.4 Significance of the study 2.0 LITERATURE REVIEW 2.1 P/E ratios 2.2 Markowitz diversification and tangent portfolios 2.3 Statistical arbitrage 3.0 METHODOLOGY 3.1 Data base and sample selection criteria 3.2 Division of stocks into P/E groups 3.3 Markowitz Diversification and Tangent Portfolios 3.4 Formation of Zero Beta Portfolios 3.5 Performance Ratios 3.5 Tests of Hypothesis 3.6 Stastical arbitrage 4.0 DATA ANALYSIS AND EMPIRICAL RESULTS 5.0 CONCLUSION, LIMITATIONS AND RECOMMENDATION 5.1Conclusion 5.2 Limitations 5.3 Recommendation BIBLIOGRAPHY APPENDICES

ABSTRACT

1 INTRODUCTION 1.1 Background Information In an efficient capital market, security prices fully reflect available information in a rapid and unbiased fashion and thus provide unbiased estimates of the underlying values. While there is substantial empirical evidence supporting the efficient market hypothesis, many still question its validity. One such group believes that price-earnings ratios are indicative of the future investment performance of a security. Proponents of this hypothesis claim that low P/E securities will tend to outperform high P/E stocks. In short, prices of securities are biased, and the price-earnings ratio is an indicator of this bias. A finding that the returns on stocks with low P/E ratios tend to be larger than warranted by the underlying risks, even after adjusting for any additional search and transactions costs, and differential taxes, would be inconsistent with the efficient market hypothesis. As a consequence of the existence of market inefficiency, then at particular instances arbitrage opportunities arise. Within the equities market, statistical arbitrage is employed. As a trading strategy, statistical arbitrage is a heavily quantitative and computational approach to equity trading. It involves data mining and statistical methods, as well as automated trading systems. Historically, statistical arbitrage evolved out of the simpler pairs trading strategy, in which stocks are put into pairs by fundamental or market-based similarities. When one stock in a pair outperforms the other, the poorer performing stock is bought with the expectation that it will climb towards its outperforming partner. The other is sold short. This hedges risk from wholemarket movements. In other words, the investor is market neutral. Statistical arbitrage considers not pairs of stocks but a portfolio of a hundred or more stockssome long, some shortthat are carefully matched by sector and region to eliminate exposure to beta and other risk factors. Portfolio construction is automated and consists of two phases. In the first or "scoring" phase, each stock in the market is assigned a numeric score or rank that reflects its desirability; high scores indicate stocks that should be held long and low scores indicate stocks that are candidates for shorting. The details of the scoring formula vary and are highly proprietary, but, generally (as in pairs trading), they involve a short-term mean reversion principle. In the second or "risk reduction" phase, the stocks are combined into a portfolio

in carefully matched proportions so as to eliminate, or at least greatly reduce, market and factor risk. Broadly speaking, statistical arbitrage is actually any strategy that is bottomup, beta-neutral in approach and uses statistical/econometric techniques in order to provide signals for execution. Signals are often generated through a contrarian mean-reversion principle but can also be formed by lead/lag effects, extreme psychological barriers, corporate activity, as well as shortterm momentum. Because of the large number of stocks involved, the high portfolio turnover and the fairly small size of the effects one is trying to capture, the strategy is implemented in an automated fashion and great attention is placed on reducing trading costs. Statistical arbitrage is only demonstrably correct as the amount of trading time approaches infinity and the liquidity, or size of an allowable bet, approaches infinity. To put it another way, it suffers from the same problems as the martingale betting system. Over any finite period of time, a series of low probability events may occur that impose heavy short-term losses. If those short-term losses are greater than the liquidity available to the trader, default may even occur, as in the case of Long-Term Capital Management. Statistical arbitrage is also subject to model weakness as well as stockspecific risk. The statistical relationship on which the model is based may be spurious, or may break down due to changes in the distribution of returns on the underlying assets. Factors, which the model may not be aware of having exposure to, could become the significant drivers of price action in the markets, and the inverse applies also. The existence of the investment based upon model itself may change the underlying relationship, particularly if enough entrants invest with similar principles. The exploitation of arbitrage opportunities themselves increases the efficiency of the market, thereby reducing the scope for arbitrage; so continual updating of models is necessary. Nonetheless, statistical arbitrage has become a major force at both hedge funds and investment banks. Indeed, many bank proprietary operations now center to varying degrees around statistical arbitrage trading.

1.2 Problem Statement The purpose of our project is to determine whether significant arbitrage opportunities exist in the Nairobi Stock Exchange and also how long do they last. We will do this by empirically determining whether the investment performance of common stocks is related to their P/E ratios. We will then construct market neutral portfolios using Markowitz diversification strategy. In cases of disequilibrium, statistical arbitrage, which emphasizes on strong mean reversion, will then be employed. The primary audience of this project will be academics in the financial field as well as investment practitioners actively involved in the field of portfolio management. Statistical arbitrage will for sure be an part of their array of investment strategies. .
1.3 Objectives of the Study

1.4 Significance of the Study To the investor community: the study will help individual and corporate investors appreciate the importance of P/E ratios and Markowitz diversification in their portfolio formation process. Moreover, the project will make investors be on the look for any arbitrage opportunities that may arise and how to exploit them effectively. To policy makers: the study will offer an opportunity for the review of statistical arbitrage practices by the NSE and CMA in Kenya and also assist other securities exchanges most notably in Kampala, Uganda & Dar-es Salaam Tanzania, who are in the process of automating their bourses, gain an insight into the implications of automated arbitrage practices in emerging markets. To academicians- The study will broaden their knowledge on arbitrage and its pricing mechanisms in Kenya and also provide a basis for future research.

2.0 LITERATURE REVIEW 2.1 P/E ratios The research on price to earnings ratio begun in the late 1970s when Sanjoy Basu, building on the work of S.F Nicholson (1960) discovered that stocks with low price to earnings ratio have significantly higher returns in the long run as compared to stocks with high earning per share ratios even after accounting for the risk factor. Price-earnings ratio is a measure of the market price of a share in relation to the net income earned by the firm per share. It is used to determine the fair value of a stock in a perfect market. It is also a measure of expected, but not realized, growth. The P/E gives you an idea of what the market is willing to pay for the companys earnings. The higher the P/E the more the market is willing to pay for the companys earnings. Stocks with a high P/E ratio are known as growth stocks. This is because firms with a high P/E ratio are expected to have high earnings growth. A high growth company should have a high share price and therefore a high P/E ratio. On the other hand, stocks with a low P/E ratio are labeled as value stocks. This is because they may represent good investment value in the future. Low P/E stocks are often viewed as inexpensive to current earnings. Krueger T. and Johnson K. (1991) in their research found that that stocks issued by firms with low price/earnings ratios earned a higher return than firms with high price/earnings ratios after adjusting for risk and transactions costs. Graham and Dodd (1934) also stated in their journal that people who

habitually purchase common stocks at more than about sixteen times their average earnings are likely to lose considerable money in the long run. Jeremy J Siegel (2008) carried out a research on dividend yields among S&P 500 stocks, he computed the P/E ratios for all 500 firms in the index on December 31st of each year by dividing the last twelve months of the earnings by year end prices. He then ranked these firms by P/E ratios and divided them in to five quartiles, computing their subsequent returns over the next twelve months. He found that stocks with high P/E ratios, which implied a low earnings yield, are on average over valued and gave low returns to the investors.

2.2 Markowitz diversification The relationship between the market performance of a portfolio and the number of stocks held in the portfolio has long been of interest to many financial economists ever since Markowitz (1952 and 1959) proposes his modern portfolio theory. Markowitz describes how increasing the number of stocks held in the portfolio can effectively reduce the diversifiable risk of a portfolio. Samuelson (1968) shows that if returns are identically distributed, an equally weighted portfolio can reach the optimum. Along the line of diversification, early studies on portfolio management focus on how efficient diversification can be achieved. Evans and Archer (1968) examine how the portfolio risk for randomly selected portfolios can be reduced as a function of the number of securities included in the portfolio. They find that 10 randomly selected stocks can functionally achieve diversification and thus raise the doubt concerning the economic justification of increasing portfolio size beyond 10 stocks. Elton and Gruber (1977), extending Markowitzs work, derive an exact analytical expression for the relationship between portfolio size and risk. Elton and Gruber find that conventional wisdom that most of the advantages of diversification with 10-20 stocks in a portfolio may be misleading. They show that increasing

the number of stocks from 15 to 100 can significantly reduce the portfolio variance. De Wit (1998) suggests that one can still significantly benefit from diversification even when adding stocks to an already-large portfolio Although practitioners and academicians generally accept portfolio diversification since the proposition of Markowitzs portfolio theory in 1952, over-diversification can potentially incur marginal costs to investors from at least three aspects. Firstly, over-diversification is likely to increase monitoring costs of fund management team as the staff is mostly minimized to only necessary manpower. Consequently, fund management may transfer, either explicitly or implicitly, the additional monitoring cost to the investors by increasing the expense ratio. Secondly, over-diversification may raise transaction costs as fund managers have to routinely rebalance the portfolio according to stipulated investment strategy. Thirdly, including too many stocks in a portfolio may dilute, or even distort, the fund managers best investment idea, thus reducing the fund value. Mayshar (1979) first notices the issue of over-diversification and argues that diversification is meaningless if the marginal costs of diversification, such as increasing transaction costs, exceed the marginal benefits in risk reduction. He develops an equilibrium model that shows it is optimal to limit the number of assets in the presence of transaction costs. After Mayshars research in 1979, later studies mostly turn to answer the question of optimal portfolio size in terms of the number of stocks held in a portfolio. For instance, Statman (1987) exhibits that a portfolio including 30-40 stocks is sufficient to effectively achieve efficient diversification. Chung (2000), based on the data of Malaysian stocks from 1988-1997, concludes that a well-diversified portfolio will contain at least 27 randomly chosen securities based on the Statman technique, and 22 according to the Markowitz model. Shawky and Smith (2005) approach the problem of optimal portfolio size by empirically investigating the U.S. equity mutual funds from Morningstar data during 1992-2000. They find that the optimal portfolio size can be obtained with 481 stocks in a portfolio and that any significant deviations from that number are suboptimal. The preceding studies reveal quite different results regarding the optimal portfolio size, ranging from 20 to 700 stocks. Just like the words said by Warren Buffett, Diversification is protection against ignorance, but if you dont feel ignorant, the need for it goes down dramatically

2.3 Statistical arbitrage Statistical arbitrage is a trading strategy that employs time series methods to identify relative mispricing between stocks. Its success depends heavily on the modelling and forecasting of the spread of the series although fundamental insights can aid in the pre-selection step. The four main approaches used to implement statistical arbitrage are: The distance method The stochastic method The more extensive stochastic residual method The co integration method. The non-parametric distance method was adapted by Nath (2003) for empirical testing. Elliot Van Dert Hoek and Malcolm (2005) proposed more recently the stochastic spread and the stochastic residual spread approaches. The co integration approach is outlined in Vidyamurthy (2004). Under the distance approach, the co-movement in a pair is measured by what is referred to as the distance or the sum of squared differences between the pairs normalized price series. Gater et al(1999) constructed a cumulative total returns index for each security over the formation period and then chose a matching partner for each security by finding the security that minimized the sum of squared deviations between the two normalized price series. The distance approach purely exploits the statistical relationship between a pair of securities at a given price level. It is model free and consequently has the advantage of not being exposed to model mis-

specification and mis-estimation. However, this non-parametric approach lacks forecasting ability regarding the convergence time or expected holding period. Elliot et al (2005) outlines an approach to statistical arbitrage that models the mean reverting behaviour of the spread in continuous time setting. The spread is the difference between the two security prices and is driven by a latent state variable X that is assumed to follow a Vasicek process:

dXt = k ( - Xt)dt + dBt

where dBt is a standard Brownian motion in some defined probability space. The state variable Xt is known to revert to its mean at the rate k by making the spread equal to the state variable plus a Gaussian noise.

yt = Xt + Ht
The trader asserts that the observed spread is driven mainly by a mean reverting process plus some measurement error where t N(0,1). This approach offers three major advantages from an empirical perspective. To begin with, it captures mean reversion, which underpins pairs trading/ statistical arbitrage. It is a convenient vehicle for forecasting purposes since it is a continuous time model and therefore the trader can compute the expected time that the spread converges back to its long term mean. Finally, the model is completely traceable, with its parameters estimated by the Kalman Filter in a state space setting. On the other hand, this approach also has fundamental limitations in that it restricts the long-term relationships between two stocks or portfolios to one of return parity. That is, in the long run, the stock pairs chosen must provide

the same return such that any departure from it will be expected to be corrected in the future1. This severely limits the models generality since in practice it is rare to find two stocks or securities with identical return series. The Stochastic residual spread approach by Do, Faff and Hanmza (2006) differentiates itself from existing approaches by modelling mispricing at the return level as opposed to the traditional price level. The model also incorporates a theoretical foundation for stock pairs pricing relationship in an attempt to remove ad hoc trading rules that are prevalent in previous studies. The co integration approach outlined in Vidyamurthy (2004) is an attempt to parameterize statistical arbitrage of pairs by exploring the possibility of co integration. Co integration is a statistical relationship where two time series that are both integrated of some order d can be linearly combined to produce a stationary single time series which is integrated of order d b where b>0. Co integration incorporates mean revision into a statistical arbitrage framework so that if the value of a given portfolio deviates from its equilibrium value then a trade can be executed.

3.0 METHODOLOGY 3.1 Data base and sample selection criteria The general research design was to examine the relationship between the P/E ratios and investment performance of equity securities. For any given period under consideration, two or more portfolios consisting of securities with similar P/E ratios are formed. The risk-return relationships of these portfolios are compared and their performance is then evaluated in terms of pre-specified measures. Finally, as a test of the efficient markets hypothesis, the returns of the low P/E portfolio are compared to those of a portfolio composed of randomly selected securities with the same overall level of risk The primary data for this study is drawn from listed stocks and treasury bills at the Nairobi Stock Exchange. With the inclusion of de-listed firms the database represents over 88% companies that actually traded on the Nairobi Stock Exchange between the year 2000 and the year 2001. For any given year under consideration, three criteria were used in selecting sample firms: 1. The fiscal year end of the firm is December 31 (the fiscal years being considered are 2000 to 2009). For firms with other fiscal year ends, we annualized their latest earnings. 2. The firms actually traded on the stock exchange on the stock exchange as of the beginning of the portfolio-holding period. 3. The relevant investment return and financial statement data are not missing. 3.2 Division of Stocks Into P/E Groups Beginning with 2001, the P/E ratio of every sample security was computed. The numerator of the ratio was defined as the market value of common stock (market price times number of shares outstanding) as of December31and the denominator as reported annual earnings (before extraordinary items) available for common shareholders. These ratios were ranked and three portfolios were formed. Although the price-earnings ratios were computed as of December 31, it is unlikely that investors would have access to the firms financial statements, and exact earnings per share figures at that time, even though Ball and Brown (1968) among others indicates that the market reacts as though it possesses such information. Since over 90% of firms

release their financial reports within three months of the fiscal year end, the P/E portfolios were assumed to be purchased on the following April 1. The weekly returns on each of these portfolios were then computed for the next twelve months assuming an equal initial investment in each of their respective securities and then a buy and hold policy. The above procedure was repeated annually on each April 1 giving 10 years (April 2001 to April 2011) of return data for each of the P/E portfolios. 3.3 Markowitz Diversification and Tangent portfolio
The Markowitz model is based on several assumptions concerning the behavior of investors and financial markets: 1. Investors can estimate a probability distribution of possible returns over some holding period. 2. Investors have single-period utility functions in which they maximize utility within the framework of diminishing marginal utility of wealth. 3. Investors measure risk using variability about the possible values of return. 4. Investors care only about the means and variance of the returns of their portfolios over a particular period. 5. Expected return and risk as used by investors are measured by the first two moments of the probability distribution of returns-expected value and variance. 6. Return is desirable; risk is to be avoided1. 7. Financial markets are frictionless.
1

Markowitz model assumes that investors are risk averse. This means that given two assets that offer the same expected return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher expected returns. Conversely, an investor who wants higher returns must accept more risk. The exact trade-off will differ by investor based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-return profile - i.e., if for that level of risk an alternative portfolio exists which has better expected returns. Using risk tolerance, we can simple classify investors into three types: risk-neutral, risk-averse, and risklover. Risk-neutral investors do not require the risk premium for risk investments; they judge risky prospects solely by their expected rates of return. Risk-averse investors are willing to consider only riskfree or speculative prospects with positive premium; they make investment according the risk-return tradeoff. A risk-lover is willing to engage in fair games and gambles; this investor adjusts the expected return upward to take into account the fun of confronting the prospects risk.

Given any set of risky assets and a set of weights that describe how the portfolio investment is split, the general formulas of expected return for n assets is: E ( rP ) = wi E (ri )
i =1 n

where:

w
i =1

= 1.0; = the number of securities; = the proportion of the funds invested in security i; = the return on ith security and portfolio p; and

n wi ri , rP E(

= the expectation of the variable in the parentheses.

The variance of a portfolio combination of securities is equal to the weighted average covariance2 of the returns on its individual securities: Var (rp )= s
2 p

i =1 j =1

wi w j Cov (ri , rj )

The efficient frontier is found by Min 2 = WW j ij i j p i

i =1 j =1 n n

Subject to:

W E (R ) = E
i i i =1 n

, where E * is the target expected return and

W
i =1

= 1.0

The first constraint simply says that the expected return on the portfolio should equal the target return determined by the portfolio manager. The second constraint says that the weights of the securities invested in the portfolio must sum to one. Having found the efficient frontier, how then do we deicide the best allocation of
2

High covariance indicates that an increase in one stock's return is likely to correspond to an increase in the other. A low covariance means the return rates are relatively independent and a negative covariance means that an increase in one stock's return is likely to correspond to a decrease in the other.

portfolio? One of the factors to consider when selecting the optimal portfolio for a particular investor is degree of risk aversion, investors willingness to trade off risk against expected return. This level of aversion to risk can be characterized by defining the investors indifference curve, consisting of the family of risk/return pairs defining the trade-off between the expected return and the risk. It establishes the increment in return that a particular investor will require in order to make an increment in risk worthwhile. The optimal portfolio along the efficient frontier is at the tangent of a utility curve and the efficient frontier. In order to simplify the determination of optimal risky portfolio(the tangency portfolio), we use the capital allocation line (CAL), which depicts all feasible risk-return combinations available from different asset allocation choices. The objective is to find the weights that result in the highest slope of the CAL ( i.e., the weights that result in the risky portfolio with the highest reward-to-variability ratio). E (rp ) rf Max CALS = p wi Subject to

=1.

For an asset i within the resulting tangency portfolio, a regression of its excess returns against excess returns on the market (asset T) produces the regression co-efficient:

cov( r T - r f , r i r f ) var( r T - r f )

The beta of the tangency portfolio is then given as:

P = xi i ; where xi is the amount invested in asset i.

i =1

If capital markets are dominated by risk-averse investors and portfolio (security) returns incorporate a risk premium, then the appropriate measures of portfolio (security) performance are those that take into account both risk and return. Three such evaluative measures have been developed by Jensen, Sharpe and Treynor, and are employed here2. While these measures were originally based upon the Sharpe Lintner version of the capital asset

pricing model(), recent empirical and theoretical developments in the area (..) suggest an alternative specification might be more appropriate. Accordingly, performance measures underlying both specifications of the asset pricing equation are estimated:

where rpt = continuously compounded return on portfolio p in month t rmt = continuously compounded return on the market portfolio in month t rft = continuously compounded risk free return in month t; measured by the natural logarithm of one plus the monthly return on 30 day treasury bills

3.6 Statistical Arbitrage 3.6.1. Co-integration testing Co-integration testing involves the estimation of the co-integration coefficient and ensuring that the spread series of the longshort portfolio constructed with this ratio is indeed stationary. If the integration of the spread series is nonstationary, this would show up in the spread series being nonstationary Our first measure for co-integration testing will be the distance measure. The distance measure we propose is the absolute value of the correlation of the returns of the low P/E portfolio and those of the high P/E portfolio. The formula for the distance measure is therefore given as

(3a) d(L,H) = p =
The closer the absolute value of this measure is to unity, the greater will be the degree of co movement. We require the market factor correlation between them must be +1 or 1. This is a rather tall order and is seldom satisfied in practice .If two portfolios do not have their factor exposures perfectly aligned, then any longshort portfolio composed of the two portfolios will have a nonzero component for the market factor returns. Our model for co integration relies on a zero value for the market factor returns, and the violation of this represents deviation from ideal conditions for co integration. Stating the above in formula form, we have (3b) (3c) The value of the above equation is nonzero. Consequently, the market factor spread is also a nonzero quantity. It is helpful to write this in equation form.

(3d) The market factor spread may very well be non-stationary, violating the co integration condition of spread stationarity. But we can still make do with less than perfect conditions of co integration. To do this we have to quantify the deviation. Let us say that the spread series is composed of a stationary component (typically the specific spread) and a non-stationary component (typically the market factor spread). Let the variances of the two components be 2stationary and 2 non-stationary, T. Note that the variance of the non-stationary component is specified for a time horizon T. Also, let t be the trading horizon. If the change in the nonstationary component of the spread is small, we could treat it more or less as a constant and say that we have a co-integrated pair. A measure of the deviation from co-integration is captured in the signal-to-noise ratio : (3e) The ideal is to have the non-stationary component as close to zero as possible. If it is exactly zero, then the signal-to-noise ratio would be infinity. In practice, a very large number for the ratio would make our assumption of co-integration reasonable. Given that the variance of the nonstationary component increases linearly with the trading horizon, then, all things being equal, having a shorter trading horizon is definitely closer to the ideal condition of co-integration. This is of course determined by the dynamics of the spread and the rate at which the spread oscillates about the mean. Based on equation (3d) the overall spread may also be interpreted as the specific return spread with a varying mean that is dictated by the market factor spread. If the market factor spread is a nonstationary time series, then the overall spread is equal to the specific spread with a stochastic drift to its mean value. Thus, deviation from ideal co-integration conditions results in what we shall call mean drift. The fallout from mean drift is that trading with symmetric bands may not be optimal because the movement of the spread series may be skewed. The worse part is that it could skew either way depending on the movement of the market factor spread, and it is not possible to know in advance. Also, if the market factor spread is nonstationary, then the variance of the skew scales linearly with time. An important insight to be gleaned in the process is that the mere passage of time represents an increase in risk in pairs trading and must be taken into account to design time-based stop orders.

EMPIRICAL RESULTS RELATIVE PERFROMANCE OF THE P/E PORTFOLIOS .Equations (1) and (2) were estimated by ordinary least squares (OLS) using .168 months of return data ( April 19 to March 19) . Table 1 shows the scores of the three performance measures and selected summary statistics for the .. Five P/E portfolios (A= highest, B, C, D and E= lowest) Highest P/E portfolio (A) excluding firms with negative earnings , A* Sample, S NSE 20- share index

The following results observations on the results in Table 1 seem pertinent3. TABLE 1 Performance Measures & Related Summary Statistics (April 1995 March 2011)

Median P/E ratio Inter-quartile p/e ratio range Average annual rate of return() Average rf annual excess return() rz Systematic risk(.) Jensens differential return(.)an d t-value in parenthesis Beta(t bill) Beta(zero beta)

Treynors tbill reward to volatility measure(..) beta

The following observations on the result in table 1 seem pertinent: 1. Considering the median P/E ratios and the inter-quartile range for each of the P/E portfolios over the 16-year period ending March, 2011, we found that the differences in P/E ratios for the various portfolios are, of course, ..significant. Since these statistics are based on 1995-2011 pooled data, the inter-quartile range reflect the dispersion of the P/E ratios over the 14-year period. 2. The low P/E portfolio,.E earned on average 14% per annum over the 16 year period: whereas the high P/E earned ..9% per year. In fact, table one indicates that the average annual rates of return decline ( to some extent monotonically) as one moves from the low P/E to high P/E portfolios. 3. Contrary to capital market theory, the higher returns on the low P/E portfolios were not associated with higher levels of systematic risk; the systematic risk of the low P/E portfolio was lower than that of the high P/E portfolio. 4. Jensens measure (differential return) indicate that, if we ignore differential tax effects regarding dividends and capital gains, the low P/E portfolio .E earned about 4.5% per annum more than that implied by their levels of risk, while the high P/E portfolio earned .. 2% less than that implied by their level of risk. Furthermore, assuming normality, these differential returns are statistically significant at the 0.05 or higher level of significance. 5. Given that the relative systematic risks of the P/E portfolios are not substantially different, relative performance as indicated by Treynors

measure(reward-to-volatility) is consistent with that indicated by the Jensens measure. 6. As would be expected, all of the P/E portfolios are well diversified the correlation co efficient for the return of the various portfolios and the NSE 20 share index are all greater than 0.95 7. The Sharpe measure (reward-to-variability) also show that the low P/E portfolio is superior to that of its high ratio counterpart. 8.

DIFFERENTIAL TAX EFFECTS The results in table 1 ignore the effects of the differntial treatment given to the taxation of dividends and capital gains. Empirical evidence on whether capital asset prices incorporate this differential tax effect is conflicting. Brennan (7) concluded that differential tax effects are important are important in the determination of security yields. Black & Scholes (4), on the other hand, question Brennans analysis. On the basis of their empirical results, they argue that there are virtually no differential returns earned by investors who buy high dividend yielding securities or low dividend yielding ones. Nonetheless, to verify the sensitivity of the results in table 1 the following approach was used. Assuming the tax rate on capital gains and dividends to be .25 and .5 respectively, the monthly returns, net of tax, for each of the P/E portfolios, the sample ,the risk free asset4 and the market portfolio (NSE 20 share index) were computed. Equation (1) was then reestimated by OLS employing the 168 months of after-tax return tax. Selected summary statistics from these regressions appear in table 2.

TABLE 2 Performance measures, net of tax, and related summary statistics (CAPM: RM RF; APRIL 1994- MARCH 2010 ) POTFOLIO A

A* B C D E Tangent S NSE 20 share index SUMMARY AND CONCLUSON

In this project an attempt was made to determine empirically the relationship between investment performance of equity securities and their P/E ratios. While the efficient market hypothesis denies the possibility of earning excess returns, the price-ratio hypothesis asserts that the P/e ratios, due to exaggerated investor expectations, may be indicators of future investment performance. During the period . April 19-March 19, the low P/E portfolios seem to have on average, earned higher absolute and risk adjusted rates of return than the high P/E securities. This is also generally true when the bias on the performance measures resulting from the effect of risk is taken into account. These results suggest a violation on the joint hypothesis that (1) the asset pricing models employed in this paper have descriptive validity and (2) security price behavior is consistent with the efficient market hypothesis. If (1) above is assumed to be true, conclusions pertaining to the second part of the joint hypothesis may be stated more definitively. We therefore assume that the asset pricing models are valid. The results reported in this paper are consistent with the view that the P/E ratio information was not fully reflected in security prices in as rapid a manner as postulated by the semi-strong form of the efficient market hypothesis. Instead, it seems that disequilibria persisted in the capital markets during the period studied. Securities trading at different multiples of earnings, on average, seem to have been inappropriately priced vis--vis one another, and opportunities for earning abnormal returns were afforded to investors. Tax-exempt and tax-paying investors who entered the securities

market with the aim of rebalancing their portfolios could have taken advantage of the market disequilibria by acquiring low P/E stocks. From the point of view of these investors a market inefficiency seems to have existed. On the other hand, .transaction and search costs and tax effects hindered traders or speculators from exploiting the markets reaction and earning net abnormal returns which are significantly greater than zero. Accordingly, the hypothesis that capital markets are efficient in the sense that security price behavior is consistent with the semi-strong version of the fair game model cannot be rejected unequivocally. In conclusion, the behavior of security prices over the .14-year period studied is, perhaps, not completely described by the efficient market hypothesis. To the extent that low P/E portfolios did earn superior returns on a risk-adjusted basis, the propositions of the price-ratio hypothesis on the relationship between investment performance of equity securities and their P/E ratios seem to be valid. Contrary to the growing belief that publicly available information is instantaneously impounded in security prices, there seem to be lags and frictions in the adjustment process. As a result, publicly available P/E ratios seem to possess information content and may warrant attention at the time of portfolio formation or revision.

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