http://www.slideshare.net/sourajitaiyer_mosl/uk-finance-monthly-sept-2013-cdcf-theme-short-version

1. New wave of IPOs expected
for growth market
Taking AIM
Responding to
Pressure
How prime brokers are
managing industry challenges
Concentration
& Volatility
An experiment in
equity markets
Also inside…
Venture Capital
Distressed Real Estate
Retail Banking Issues in
Capital Markets
SEPTEMBER 2013 ISSN 2052-6482

2. n Equity MarkEt
18 www.finance-monthly.com
Concentration & Volatility:
Concentrated vs. diversified approaches are often debated in investment
exposure. While diversified portfolios help to reduce risk, concentrated
portfolios help enhance upside. Depending on the market environment and
investors’ risk-return appetite, both have their importance. Diversified
portfolios are believed to work best if the prices of its underlying typically move
in opposite directions. Nevertheless, the ultimate performance of portfolios
may still depend on the outlook of the underlying and market conditions,
which may be ever-changing during volatile times, and impact companies’ financial performance,
prices and sentiments despite the best of management decisions. The intention behind this portfolio
idea is to see if the term ‘consistent’ can be brought into equity portfolio approaches in volatile
markets, using a simple strategy that can be replicated each year.
By Sourajit Aiyer
he ‘Consistent Dividends
Consistent Fundamentals (CDCF)’
idea is based on the premise that
investing in a concentrated
portfolio of consistent dividend
paying stocks, which have
achieved consistency in fundamental performance
with low leverage, is better in volatile times. This
exercise is done for academic interest without
any intention of investment solicitation. It seeks
companies which delivered ‘consistent’ growth in
financial metrics, 'consistent' margins, ‘consistently’
paid dividends to reward shareholders who may
have missed booking gains by capital appreciation
by not liquidating at opportune times, and with low
leverage which gives headroom for expansion and
maintain their growth track record, if needed.
It screens the universe of listed Indian scrips using
annual financial data of the last 3 rolling fiscal years.
Since annual financials are used, the underlyings’
data will remain as such till the next year. That is
when the constituents will churn. Hence, this basket
may be termed as ‘Semi-Active’ and not really
‘Active’. The screening methodology itself does not
really require high-caliber active management as it's
a set methodology and replicable. Scrips with
market cap above INR 250 crores as of March 2012
are taken (1 Crore = 10 Million). Critics might argue
this is low, however it may be justified given the
market cap sizes of some holdings of Small Cap
funds. We take stocks which had revenues of over
INR 100 crores in FY2012, and showed revenue
growth in the last 3 rolling years of over 10% (CAGR
basis), including in the immediate previous fiscal.
The growth rate criteria is repeated for operating
profits and PAT to ensure consistency in margins. At
PAT level, we tweak this only for the immediate year
wherein we take those which clocked at least positive
growth. We drill on the threshold level of profit
margins for companies which achieved at least 10%
PAT Margin in each of the previous 3 fiscals. The
PAT assumptions may be justified given the Opex
challenges since the last couple of years. We target
dividend percent of over 20% and dividend yield of
over 2% - consistently in each of the previous 3
rolling fiscals. An exception was made for ITC,
whose dividend yield in FY2012 was marginally
lower at 1.98%. We target companies with debt:
equity ratio of less than 2x, which allows some
headroom for future capitalization. Lastly, some
qualitative screening was done on average yearly
turnover and on recent returns generated by the scrips.
Post stock-screening, weights and scrip units are
assigned as per free-float market capitalization with
a cap of 10% per individual stock. NAV back-testing
is done on a quarter-end basis. Scrip-units at the end
of each quarter are rebalanced to calculate the new
‘Price-based NAV’ for the next quarter-end using
next quarter’s prices. Once the new NAV is set, the
scrip units for that new quarter-end will be balanced
using this new NAV, new market cap and prices.
T
A
Special Feature
18 www.finance-monthly.com

3. ExpEriMEntPrice-based NAV excludes impact of dividends.
Dividends paid on the scrips are assumed to be in
March only, hence the impact of dividends will be in
March quarter-end NAV. Dividend received per
scrip is based on scrip units and dividend per share.
We assume dividends are distributed and not
retained to purchase further units. Resultant NAVs
are compared with benchmark indices and dividend
funds. While returns from Gross NAV signify what
an investor actually earns, the Price-based NAV is
used for comparison to benchmark indices. This is
because the NSE Nifty is also a price based index,
hence shows the impact of price appreciation only.
This exercise was originally attempted in January
2012 using financials till FY2011 for back-testing. It
was repeated in January 2013 using financials till
FY2012 to test its performance during 2012. Thus,
15 stocks were shortlisted in the Jan 2013 exercise -
ITC, Corporation Bank, J & K Bank, Karur Vysya
Bank, VST Inds., eClerxServices, Swaraj Engines,
Colgate-Palmolive, Allahabad Bank, Dena Bank,
South Indian Bank, Gateway Distr., Grindwell
Norton, Hinduja Ventures and Kewal Kiran Cloth. 7
stocks were common to the shortlisted list when this
exercise was done in Jan 2012, i.e. ITC, Corporation
Bank, J & K Bank, Karur Vysya Bank, VST Inds.,
eClerxServices, Swaraj Engines. Companies
shortlisted in Jan 2012 but removed in Jan 13 were
Andhra Bank, Castrol, Crisil, Cummins India, Indian
Bank, Jagran Prakashan, Natl. Peroxide, Polaris
Finan., SBT and VST Till Tract.
Comparing the CDCF Concentrated Portfolio’s NAVs
with Benchmark Indices shows:-
• Delivered outperformance for the entire period
based on annualized returns from Mar 2008 to
Dec 2012.
• Delivered outperformance at similar levels of
volatility - CDCF’s annual standard deviation is
at similar levels to the standard deviation of the
benchmark indices
• Delivered positive excess returns in each annual
period - i.e. Dec 12-Mar12, FY12, FY11, FY10,
FY09 vs. benchmarks like Nifty, Midcap, CNX
500 and CNX Dividend Opportunity. The only
exception was in FY12 vs. Dividend Opportunity
Index although the negative excess returns were
a mere -0.5%. At most other times, the extent of
positive excess returns has been significant
• Delivered significant Alpha over all the
benchmark indices based on annualized returns
and beta from Mar 2008 to Dec 2012
• Achieved higher Sharpe ratio than indices, based
on annualized returns and volatility from Mar
2008 to Dec 2012
• On a quarterly basis, delivered positive excess
returns in approximately 75% of the quarters
with each of the benchmark indices
Comparison with Dividend Yield Mutual Funds
shows the CDCF basket delivered higher Annualized
Returns compared to most funds. It delivered better
returns than these peers MFs in most individual
fiscal years.
Rationale behind this CDCF idea is that these stocks
have demonstrated a consistent track record by
consistently showing fundamental growth and
dividend payouts for the rolling 3 years. It has
delivered better annualized returns over the period
at similar level of risk, and delivered positive excess
returns in almost each of the individual fiscal years.
Bloomberg Forward Estimates show the median
growth rates in revenues and profits are in line,
and in fact higher, than those assumed in stock
screening. Portfolio churn is only once a year when
annual financials are updated, hence largely
‘Semi-Active’ in terms of fund management as
it doesn't need high-level active management
skills. ‘Semi-Active only’ orientation might be
advantageous from the point of view of setting a
competitive TER/management fee for such a fund
portfolio.
Risk factors are that it loses out on high dividend-
yield companies whose recent financials may have
been hit. It has over 50% exposure to banking sector.
Minimum market cap used for screening (INR
250 crores) is low and the portfolio may share the
inherent risks of small cap stocks. Criteria for traded
volumes of underlyings (to measure liquidity) may
be low – yearly average over INR 0.1 crore. While
portfolio churning is done only once a year, impact
cost may still need to be factored in. Screening
doesn’t take into account the Return on Equity
component. Updating of financials on an annual
basis may ignore shifts in financial performance
visible on a quarterly basis.
In conclusion, every investment faces a challenge in
delivering consistent out-performance, more so
when market volatility makes it a struggle to beat
inflation - investors’ biggest enemy. Even many
low-risk asset classes often fail to beat inflation
consistently, as historical trends show. The premise
behind this entire exercise was to highlight the
‘consistent’ theme - to show that an approach based
on such a theme in the current volatile markets can
throw up opportunities to achieve out-performance
– all on a consistent basis.
About the Author
Sourajit Aiyer, works with a capital
markets company in India. The ideas
expressed are personal and are not to be
taken to represent those of the company.
This article does not construe to be any
investment advice or solicitation. Any
action taken on the basis of the information
contained herein is your responsibility
alone.
Email: sourajitaiyer@gmail.com
This article is only a synopsis of the exercise. For details, please contact the author directly. The author would like to thank Mr Vivek Sinha for his insights on the scrip-unit construction methodology.
an Equity Market Experiment