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 –
58 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.
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Figure 10 India’s GDP, Bn Rupees
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, %
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
0 10000 20000 30000 40000 50000 60000 70000 80000 90000 100000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
0 0,05 0,1 0,15 0,2 0,25
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
60 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
61 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
62 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
63 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
64 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
65 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.
66 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.
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.