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Fundamental analysis beats random walking

Burton Malkiel detonated a bombshell in the world of finance with his A Random Walk Down Wall Street. He theorised that in an efficient market it was impossible to win consistently. Every player would instantly discount all available information and, as a result, prices would move randomly. Malkiel's advice was to stick to Index-based strategies to guarantee market return with minimal effort.

Since every market throws up a few consistent winners, sceptics have reviewed Malkiel's theory. One suggestion is that these consistent winners are statistical aberrations. Indeed, the vast majority of fund managers do not beat the market. This argument is a reasonable defence of Malkiel.

The other more obvious possibility is that markets are simply not efficient. In fact, some academics classify markets as weakly or strongly efficient. George Soros attempted an explanation for inefficiency via the concept of "reflexivity". This postulates that markets over-react to trends because the entities trading them are, well, either human beings or computers programmed by human beings with the same biases.

Other observers have pointed out that different investors interpret the same information differently - so even perfect dissemination would not result in an efficient market.

All this is perhaps of little interest to the practical investor. All one can say is that while Malkiel appears theoretically irrefutable, it is evident that some people make money consistently in every sort of market. But any active strategy should be benchmarked against Malkiel's suggestion of index-mimicry. The passive index-tracker saves both commissions and headaches, after all. If ways of consistently beating the index can't be developed, why bother to waste make the effort?

In India you don't have an Index-fund as such. You do have quasi-Index funds with substantially the same return profiles as the Nifty or the Sensex. But these funds are more active than the classic US Index fund. Also India is an emerging market where extraordinary returns are often available. Even as the Indices have trailed downwards, ten-baggers have kept popping up. So, the rewards for independent efforts are higher.

What sort of strategy beats the Indian market? If it's very arcane and involves complicated quantitative models, you may be better off not trying. But if simple techniques can identify good stocks and exploit them, then there is a strong case for activity.

It appears that straightforward fundamental analysis can work. One can apparently set up a near-mechanical system for buying stocks and it could deliver better results than Index-mimicry. Before justifying my conclusions, let me state I did the groundwork for this column some six months before the Money Section of Rediff on the Net was even conceived!

It was the day of the Budget. I was involved in a large sector by sector sensitivity analysis. Since I had the data and the available computer-time, I idly ranked companies on the basis of some standard fundamental ratios. I restricted my compass to the A Group because I'm a lazy sort of guy.

I picked three common ratios - the Cash Earnings Per Share (CEPS), the Return on Equity and the Return on Capital Employed. The latter two can be reduced to comparable percentages for any company but the first is relevant only in conjunction with growth. So I inserted a growth factor by ranking on the Compounded Annual Growth rate (CAGR) in CEPS from financial year 1995-96 to Q3 1998-99.

When I isolated the Top Ten in each category, I discovered the huge overlap in the lists. Instead of 30 different companies, I had just 17 at the end of the exercise. Hero Honda, Punjab Tractors and Infosys Technologies featured in all three lists. Wipro, TVS Suzuki, Hindustan Lever, Smithkline Consumer, Castrol, NIIT and Satyam Computers all featured in at least two categories. No surprise really, but a confirmation that good businesses tend to have generally decent balance sheets.

At that time, I just archived the lists and forgot about them. But let us assume that I had decided to buy these stocks in an entirely mechanical fashion. I could have bought these three lists with an equal weightage to each component. This would have given me thirty positions with triple weights in Honda, Tractors and Infy and double weights in the seven scrips that appear in two lists. This strategy would, assuming I had the funds, cost me no trouble at all and little headache. It is completely mechanical.

I could, at the same time, have created an index mimicking portfolio in the 30 scrips of the Sensex or bought into some Mutual which closely tracked the Index. The Sensex has returned around 30.73 per cent between March 1, 1999 and October 29,1999. That is an annualised return of around 46.1 per cent in eight months. To prove that India isn't a "Malkiel market", my portfolio of fundamental toppers would have to produce a substantially better return than 46 per cent.

It does. The CEPS rankers portfolio alone yields 65.52 per cent annualised returns in capital appreciation. The ROE rankers portfolio returns 70.8 per cent. The ROCE rankers portfolio under-performs with only 41.48 per cent returns. The three portfolios clubbed together yields 59.3 per cent, which is approximately 29 percent better than the Sensex return. ‡ I'm neglecting dividend yields, which would have been around 1.2 per cent for the Sensex and slightly less for these stocks. It doesn't matter - the low-brain fundamental portfolio creation technique still outscores the Sensex hugely.

Does this prove anything? Not really. The samples are too small and the timeframe too short for academic rigeur. But it does suggest that simple low-brain mechanical methods can beat the no-brain option of index-mimicry, in India at least. To reach more definitive conclusions, one could backtrack and check over previous timeframes. Or else, one could continue the experiment forward into the next millennium. No doubt, some diligent academic can build a Ph.D thesis around this. But like I said, I'm a lazy sort of guy!

Top 10 companies ranked by CAGR EPS 1996-99

Wipro : 5:1 Split
Satyam : 1:1 bonus

Top 10 companies ranked by ROE in financial year 1998

Top 10 companies ranked by ROCE in financial year 1998

Devangshu Datta

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