THEMATIC October 05, 2015 Style-based long and short ideasreports.ambitcapital.com/reports/Ambit_QuantStrategy_Styleanalysis... · Through our work on style analysis, we have been

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THEMATIC October 05, 2015

Style-based long and short ideas

Through our work on style analysis, we have been highlighting that the Indian equity markets have remained unusually defensive in positioning since mid-2014 even in the wake of rising indices (click here for the latest note). We had expected this divergence to be resolved through a market correction, given our view of a slower recovery in both economic growth and corporate earnings vs consensus expectations. Similarly, our long/short baskets had reflected this defensive view as well. Since our 3rd June 2015 initiation note, this basket has delivered absolute returns of 23.6%, with the long basket rising by 7.5% and the short basket declining by 16.1%. Given the sharp correction since (which has already led to sharp outperformance of our defensive baskets) and given the recent change in factor performances in favor of bullish factors (basis 1 month performance), we now moderate our defensive stance and reflect the same in the new baskets. Analysis of style factors captures investor preferences Investors’ style preferences change depending on the state of the economy and the markets. This has significant bearing on stock performances for fairly prolonged periods of time, thus necessitating an understanding of style factors in addition to traditional security analysis. For example, what worked from 2003 to end-2007 was different from what worked between 2008 and September 2013. Factor positioning had forewarned about the recent market turmoil The current market rally, having begun in September 2013, was similar in nature to the one in 2004-07 until May 2014. Since then, however, the performance of style factors changed dramatically and even in the wake of rising indices, market positioning turned very defensive (see the exhibit below) during late-2014 and early-2015. This suggests that whilst liquidity, helped by domestic and global factors, drove markets higher, investors did not really have confidence in the Indian economy, leaving benchmark indices susceptible to a major correction. Divergence resolved through market correction Our view of a slower recovery in economic growth and corporate earnings led us to assign a higher likelihood to market correction vs a change in the underlying factor positioning as a resolution to the divergence in defensive positioning and rising indices. The recent correction, which saw the Nifty correct 16% from its Mar’15 highs, has thus brought a natural resolution to this divergence. Stellar performance of defensive baskets; moderating stance now Our defensively positioned baskets, since initiation on 3rd June 2015, have delivered overall returns of 23.6% (with the long basket up 7.5% and the short basket down 16.1%). Given the recent sharp correction (which has already led to this stellar outperformance of defensive baskets) and given the recent change in factor performances in favor of bullish factors, we now moderate our defensive stance and reflect the same in the new baskets (shown in the right hand margin)

Quant Strategy

Long Basket

Ticker Name MCap

(US$ mn)

IGL IN Indraprastha Gas 1,003

BJFIN IN Bajaj Finserv 4,301

MRF IN MRF Ltd 2,709

BHE IN Bharat Electronics 4,210

UTCEM IN UltraTech Cement 11,670

GPPV IN Gujarat Pipavav Port 1,370

MSIL IN Maruti Suzuki 21,216

GUJS IN Guj State Petronet 1,010

ACC IN ACC Ltd 3,924

SHTF IN Shriram Transport Fin 3,234

Source: Ambit Capital research, Bloomberg

Note: We have bottom-up SELLs on the following stocks: Ultratech Cement (UTCEM IN), ACC Ltd (ACC IN) and Shriram Transport Finance Co Ltd (SHTF IN)

Short Basket

Ticker Name MCap

(US$ mn)

HUVR IN HUL 27,088

POWF IN Power Finance Corp 4,582

IFCI IN IFCI Ltd 539

DIVI IN Divi's Laboratories 4,583

PAG IN Page Industries Ltd 2,292

HAVL IN Havells India Ltd 2,409

CLGT IN Colgate 4,010

MRCO IN Marico Ltd 3,955

DLFU IN DLF Ltd 3,669

IBREL IN Indiabulls Real Estate 445


Note: We have bottom-up BUY on Page Industries (PAG IN)

Analyst Details

Gaurav Mehta, CFA

+91 22 3043 3255

[email protected]

Prashant Mittal, CFA

+91 22 3043 3218

[email protected]

Market positioning basis factor performances – Quarterly frequency

Source: Ambit Capital research. Note: Grey/Red represents the proportion of bullish/bearish factors working in every quarter. For e.g. In Sep’15 quarter-end, almost 70% of the factors working were bearish.

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mailto:[email protected]


http://reports.ambitcapital.com/reports/Ambit_QuantStrategy_Styleanalysis_04Sept2015.pdf

http://reports.ambitcapital.com/reports/Ambit_QuantStrategy_Thematic_03Jun2015.pdf

Quant Strategy

October 05, 2015 Ambit Capital Pvt. Ltd. Page 2

Market positioning basis style factors Investors’ style preferences change depending on the state of the economy and the markets. This has significant bearing on stock performances for fairly prolonged periods of time, thus necessitating an understanding of style factors in addition to traditional security analysis. An analysis of the historical performance of various factors leads to the following findings:

During the bull phase of Jan’03 – Dec’07, investors preferred high leverage, medium valuations and medium beta over high return ratios. Moreover, during this phase, future growth was preferred over current dividend whilst small-caps and cyclicals outperformed large-caps and defensives respectively.

On the contrary, during the defensive phase of Jan’08 – Aug’13, factors like high profitability, low leverage and low beta worked well, with high valuations not really deterring investors. Seeking safety, investors also preferred current dividend over future growth. Small-caps and cyclicals lagged large-caps and defensives during this period.

The current market rally that began in September 2013 was similar in nature to the bull phase of 2003-2007, with most of the bullish factors working until mid-2014. However, after June 2014, the market positioning turned decisively defensive even amidst rising indices with bullish factors like high leverage giving way to defensive factors like high profitability, high price to book and low beta. This marked shift suggests that whilst liquidity (driven by domestic and global factors) helped markets to move higher, investors did not really have confidence in the underlying strength of the Indian economy.

A historical performance summary of the various factors we have considered is discussed in a subsequent section of this note (‘Style factors analysis - Performance Analysis’).

A graphical depiction of the market positioning over time is plotted in Exhibit 1 below. ‘Grey’ shade indicates the proportion of bullish factors dominating market performance in that period, each period being a calendar quarter here, whilst ’red’ indicates the proportion of ‘bearish’ factors dominating in that quarter.

Exhibit 1: Market positioning basis factor performances – ‘Red’ indicates bearish positioning, ‘Grey’ indicates bullish

Source: Ambit Capital research; Note: We exclude the Price and Earnings Momentum factors as they work under all scenarios. Grey/Red colour in the bars represents the proportion of bullish/bearish factors working during every quarter. For e.g. in Sep’15 quarter-end, almost 70% of the factors working were bearish

The dominance of ‘grey’ from 2003 to 2007 suggests that bullish factors, as expected, dominated the market positioning in that period. Similarly ‘red’ dominance from 2008 to about September 2013 suggests defensive positioning over that challenging phase, again along expected lines. However, as discussed earlier, even with the Nifty continuing to climb higher, ‘red’ had come to dominate since mid-2014, suggesting a divergence in the market direction vs the underlying market positioning.

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Style factor positioning turned decisively defensive since June 2014, even amidst rising indices

Quant Strategy


The recent market correction: Resolution of divergence? The previous instance of such a divergence (i.e. rising indices and defensive positioning) was in the run up to the November 2010 peak, which was eventually resolved by a period of prolonged broader market correction.

Our view of a slower-than-expected recovery in both economic growth and corporate earnings had led us to assign a higher likelihood to market correction vs a change in underlying factor positioning as a resolution to the current episode of divergence between defensive positioning and rising indices as well. The recent correction, which saw the Nifty drop to levels closer to 7500, marking an overall correction of 16% from its Mar’15 highs, has therefore brought a natural resolution to this divergence.

Recent factor performance – 3month and 1month basis In Exhibit 2 below, we depict the factor performances over the past one month and three month periods ending in September 2015. As is readily seen from this exhibit, although defensive factors have continued to dominate on a three-month basis, there is a marked dominance of bullish factors in the most recent one-month period. Factors like high price to book, high RoE, high RoCE and low beta that outperform on a three month window, fail to do so over the last month. On the other hand, bullish factors like high retention ratio, low dividend yield and low market-cap did well on both three-month and one-month windows.

Exhibit 2: Factor performance computed as Long Q1/Short Q5 for the recent three-month and one-month period

Source: Ambit Capital research, Bloomberg; Note: For Market-cap and Sector factors the graph is shown as long large-caps/short small-caps and long cyclicals/short defensives respectively

This dominance of ‘bullish’ factors in September is in contrast to August 2015 when there was a 100% domination of defensive factors - please click here for our report on factor performances in August. Whilst it is too early to conclude whether this change in complexion of factor performance reflects just a temporary bounce-back from oversold conditions or an indication of a larger change in positioning, we do take cognisance of this to moderate our defensive bias - this is discussed in the next section on investment implications.

-15% -10% -5% 0% 5% 10%

RoE

PB Ratio

Earnings revison (3 month)

RoCE

Price Momentum (6 month)

Retention ratio

Debt to Equity

Dividend Yield

Working Capital to Sales

Turnover

Market Cap

Beta

Depreciation/(Sales-EBIT)

Sector

Total Volatility

Long Q1, short Q5 (3 month return) Long Q1,short Q5 (1 month return)

The recent market correction is a natural resolution of divergence between defensive positioning and rising indices

Dominance of bullish factors last month leads us to moderate our defensive stance


Quant Strategy


Investment implications Given the sharp declines in the stockmarket over the past few weeks, given the strong performance our defensively positioned baskets and given the return of bullish factors in the past month, we are tempted to take profits on our current baskets that have been running since 3rd June 2015. The performance of these baskets is shown on page 7- stocks in the long basket have moved up by 7.5% on average and stocks in the short basket have declined by 16.1% on average, leading to an aggregate performance of 23.6%.

Further, we moderate our defensive bias in the new baskets that we publish in this note, as discussed next.

Long and short baskets based on recent style performance With the divergence in three-month and one-month factor performance suggesting a likely shift in the underlying positioning, we use the factors that have worked well over the recent one-month period to arrive at our latest iteration of long and short baskets. We use a total of nine factors to guide our stock selection for this iteration. On the basis of these nine factors, we recommend long and short baskets comprising 10 stocks each.

For factors like Price to Book ratio, RoE, RoCE and beta, we assign maximum preference to medium quintile stocks, given the fact that the medium quintiles perform the best in a bull market (low RoE/RoCE/PB and high beta stocks do not outperform in either bull or bear market conditions on a sustainable basis; please refer to ‘Style factors – Methodology and historical performance’ for details).

These long and short baskets along with the selection criteria are displayed in Exhibits 3 and 4 respectively. The long basket has also been cleaned for accounting quality using our forensic accounting model. Further, for a sense on the magnitude of various factors (P/B, Debt to Equity, RoCE, etc.) across quintiles, please refer to Exhibit 5 on the next page.

Exhibit 3: Long Basket

Ticker Name ROE ROCE Earnings revision

WC to sales

Mkt Cap Depreciation/ (Sales - EBIT)

Beta Retention

Ratio Price to

Book Ratio

IGL IN Indraprastha Gas Ltd

BJFIN IN Bajaj Finserv Ltd

MRF IN MRF Ltd

BHE IN Bharat Electronics Ltd

UTCEM IN UltraTech Cement Ltd

GPPV IN Gujarat Pipavav Port Ltd

MSIL IN Maruti Suzuki India Ltd

GUJS IN Gujarat State Petronet Ltd

ACC IN ACC Ltd

SHTF IN Shriram Transport Finance

Source: Ambit Capital research; Note: The tick marks against a stock reflects whether the stock is a part of top 40% universe sufficing the requisite conditions for that factor. For e.g. a tick against MSIL N under Beta reflects that this stock is in the medium 40% of stocks on Beta (medium beta being consistent with a bullish positioning).

Note that we have bottom-up SELLs on the following stocks: Ultratech Cement (UTCEM IN), ACC Ltd (ACC IN) and Shriram Transport Finance Co. Ltd (SHTF IN).

Booking profits on current baskets on back of a strong performance and sharp market correction

Quant Strategy


Exhibit 4: Short Basket

Ticker Name ROE ROCE Earnings revision

WC to sales

Mkt Cap Depreciation/ (Sales - EBIT)

Beta Retention

Ratio Price to

Book Ratio

HUVR IN Hindustan Unilever Ltd

POWF IN Power Finance Corp Ltd

IFCI IN IFCI Ltd

DIVI IN Divi's Laboratories Ltd

PAG IN Page Industries Ltd

HAVL IN Havells India Ltd

CLGT IN Colgate-Palmolive India Ltd

MRCO IN Marico Ltd

DLFU IN DLF Ltd

IBREL IN Indiabulls Real Estate Ltd Source: Ambit Capital research; Note: The tick marks against a stock reflects whether the stock is a part of the bottom 40% universe sufficing the requisite conditions for that factor. For e.g. a tick against HAVL IN under Depreciation/(Sales - EBIT) reflects that this stock is in the bottom 40% of stocks on Depreciation/(Sales - EBIT) ratio (low Depreciation/(Sales - EBIT) ratio being a poor performer in a bullish phase).

Note that we have a bottom-up BUY on Page Industries (PAG IN).

The current median quintile values for each factor are given in Exhibit 5 below.

Exhibit 5: Median parameter values by Quintile

Quintile Q1 Q2 Q3 Q4 Q5

Price to Book Ratio(x) 12.4 5.8 3.0 1.4 0.4

Debt to Equity 202% 88% 32% 2% 0%

Working Capital to Sales 72% 30% 14% 4% -16%

Depreciation/(Sales - EBIT) 14% 5% 3% 2% 1%

Return on Equity 32% 22% 15% 10% 2%

Return in Capital Employed 41% 27% 17% 10% 6%

Beta 1.48 1.18 0.95 0.80 0.64

Dividend Yield 3.7% 1.7% 1.0% 0.6% 0.1%

Earnings Retention Ratio 93% 82% 78% 66% 43%

6m Price Momentum 18.1% 2.8% -7.5% -16.6% -29.0%

Earnings Estimate revision (3 month) 4.5% 0.0% -3.3% -8.1% -18.2%

Market Cap (Size) (in US$ mn) 15,257 4,649 3,007 1,462 762


Quant Strategy


A financial snapshot of the stocks recommended in the long and short baskets based on Bloomberg estimates is provided in Exhibit 6 below.

Exhibit 6: Long and short basket – Financial snapshot

Ticker Name Mcap

US$ mn Estimated

P/E (FY16) Estimated P/B (FY16)

Estimated EPS CAGR

(FY15-17)

Estimated RoE (FY16)

Estimated Operating

Margin (FY16)

IGL IN Indraprastha Gas Ltd 1,003 13.9 2.7 8.8 20.8 20.5

BJFIN IN Bajaj Finserv Ltd 4,301 14.2 2.1 17.0 17.2 55.8

MRF IN MRF Ltd 2,709 11.0 2.5 7.7 22.8 DNA

BHE IN Bharat Electronics Ltd 4,210 21.1 3.0 9.8 14.9 13.5

UTCEM IN UltraTech Cement Ltd 11,670 26.6 3.6 40.1 14.0 15.1

GPPV IN Gujarat Pipavav Port Ltd 1,370 22.0 4.1 24.0 20.2 51.1

MSIL IN Maruti Suzuki India Ltd 21,216 26.7 4.9 32.1 20.8 12.4

GUJS IN Gujarat State Petronet Ltd 1,010 13.0 1.6 17.9 13.0 73.5

ACC IN ACC Ltd 3,924 27.9 3.0 5.5 10.7 10.2

SHTF IN Shriram Transport Finance Co Ltd 3,234 15.4 2.0 29.8 13.6 41.9

HUVR IN Hindustan Unilever Ltd 27,088 38.8 38.7 9.8 105.9 16.5

POWF IN Power Finance Corp Ltd 4,582 4.4 0.8 12.4 19.5 91.7

IFCI IN IFCI Ltd 539 6.3 0.6 5.9 8.8 DNA

DIVI IN Divi's Laboratories Ltd 4,583 28.0 7.2 23.7 26.9 36.0

PAG IN Page Industries Ltd 2,292 58.8 29.5 30.5 56.6 20.2

HAVL IN Havells India Ltd 2,409 28.5 7.5 34.1 27.9 9.1

CLGT IN Colgate-Palmolive India Ltd 4,010 42.6 29.9 14.1 75.5 19.8

MRCO IN Marico Ltd 3,955 36.0 11.3 22.1 34.9 15.2

DLFU IN DLF Ltd 3,669 32.7 0.8 40.3 2.6 33.6

IBREL IN Indiabulls Real Estate Ltd 445 9.2 0.4 31.1 4.2 27.8

Source: Bloomberg

Quant Strategy


Performance of the previous iterations In the iteration dated 03 June 2015, we had constructed long and short baskets based on the factors that had worked in the previous one-month and three-month periods, reflecting our view that defensive positioning would continue. In the subsequent iterations dated 02 July 2015 and 04 September 2015, given our view on sustenance of such a defensive positioning, we continued with the same baskets. Since initiation, these baskets have given a strong performance, with total returns of 23.6% (with stocks in the long basket moving up by 7.5% on average and stocks in the short basket declining by 16.1% on average) vs BSE200 return of -2.7%. Given a sharp fall in the markets on expected lines and the strong performance achieved by the baskets designed to benefit from the same, we recommend booking profits on these positions.

Exhibit 7: Long and short basket returns since June 03, 2015

Ticker Name Returns

Long Basket

BRIT IN Britannia Industries 24.5%

CSTRL IN Castrol India -2.2%

PAG IN Page Industries -13.9%

SKB IN GSK Consumer -5.1%

HCLT IN HCL Technologies -10.0%

LPC IN Lupin 17.1%

KKC IN Cummins India 21.1%

CDH IN Cadila Healthcare 13.5%

GRHF IN GRUH Finance 12.8%

BJFIN IN Bajaj Finserv 17.1%

Average returns 7.5%

Short Basket

JI IN Jain Irrigation 1.0%

JSP IN Jindal Steel & Power -47.5%

ADANI IN Adani Power -32.7%

GMRI IN GMR Infrastructure -2.9%

IFCI IN IFCI Ltd -28.8%

IOB IN Indian Overseas Bank -10.4%

DLFU IN DLF Ltd 18.7%

RCOM IN Reliance Communications 8.5%

JPA IN Jaiprakash Associates -32.8%

OBC IN Oriental Bank of Commerce -34.4%

Average returns -16.1%

Total long/short return 23.6%


Previous iterations’ baskets gave total returns of 23.6% vs BSE200 return of -2.7% since 03 June 2015

http://reports.ambitcapital.com/reports/Ambit_QuantStrategy_Thematic_03Jun2015.pdf

http://reports.ambitcapital.com/reports/Ambit_QuantStrategy_Styleanalysis_02Jul2015.pdf


Quant Strategy


Style factors analysis - Methodology and historical performance Methodology For our study of the past, we have primarily looked at the period starting 2003

and decomposed it into two periods: (1) the period from January 2003 to December 2007, denoting a bull run for equites and characterised by high GDP growth, robust credit growth and rising but moderate inflation; and (2) the period from January 2008 to September 2013, denoting low and falling GDP growth, low credit growth, high inflation and high policy rates.

The stock universe used for the exercise is the rolling BSE 200 universe as at the start of every year (instead of using a constant, current BSE200 universe to remove survivorship bias, if any).

For each factor, we have divided the universe into quintiles. Quintile returns are calculated as median stock returns for that quintile. Factor quintiles rebalancing and performance calculations are done on a calendar quarter basis.

The table below provides a list of the factors in use currently. Exhibit 8: Factors used for this analysis

Category Factors Definition

Valuation Price to book ratio Ratio of stock price to trailing book value; a measure of valuation

Leverage Debt to Equity Total Debt to Total shareholder equity; a measure of financial leverage

Depreciation/(Sales - EBIT) Ratio of depreciation cost to total operating costs; a simplistic proxy for operating leverage

Profitability and efficiency Return on equity Ratio of net income to shareholders’ equity

Return on capital employed Ratio of EBIT to total assets minus current liabilities

Working capital to sales Ratio of current assets minus current liabilities to sales

Volatility of Returns Beta Regression coefficient basis weekly returns over the previous two years

Total stock volatility Standard deviation of daily stock returns over the previous two years

Cash vs growth Dividend yield Ratio of dividend paid over the year to stock price

Earnings retention ratio The proportion of net income retained vs being paid out as dividends; high retention suggests lower repayment today in favour of future growth

Momentum Six-month price momentum Stock returns over the previous 180 days

Three-month earnings estimates revision Change in consensus annual earnings estimates over the last three-month period for a stock

Market Cap Large-caps vs Small-caps Nifty is used as a proxy for large-caps and CNX Small-cap Index is used as a proxy for small-caps

Liquidity Turnover Average turnover over the last three months

Sector Cyclicals vs Defensives Sectors classified as cyclicals: Auto, Infrastructure, Construction, Financials, Power and Media

Sectors classified as defensives: Pharma and FMCG

Source: Ambit Capital research; Note: (1) Banks and financial services stocks have been excluded for back-testing the following factors - Debt to equity, Working capital to sales, Depreciation/(Sales – EBIT) and Return on capital employed. (2) IT, Metals and Mining and Oil and Gas have not been classified as either Cyclical or Defensive for back-testing.

Quant Strategy


Performance analysis To back-test the performance of factors in conducive as well as challenging macro environments, we divided the period starting 2003 into two sub-periods:

The period from January 2003 to December 2007 denotes a bull run for equities and is characterised by high GDP growth, robust credit growth and rising but moderate inflation; this period is referred to as the ‘Bull Phase’ here.

The period from January 2008 to September 2013 denotes low and falling GDP growth, low credit growth, high inflation and high policy rates; this period has been referred to as the ‘Defensive Phase’ here.

Bull Phase (January 2003 – December 2007)

The Bull Phase returns using the methodology described earlier are shown in Exhibit 9 below. In this phase, which lasted from January 2003 to December 2007, investors preferred stocks with high leverage (high debt equity and high depreciation to total costs worked well), whilst they were also willing to compromise on current cash in favour of future growth (low dividend yield and high earnings retention worked well). Whilst investors shunned stocks with high valuations in general, medium P/B stocks did well.

Parameters like profitability (medium RoE and RoCE worked well) and beta (medium beta worked well), on the other hand, took a back seat (in spite of a common misperception in the Indian market that high beta stocks deliver outperformance in bull markets).

Finally, as would be expected of such a period, small-caps and cyclicals outperformed their large-cap and defensive counterparts respectively.

Exhibit 9: Factor quintile performance summary during the bull phase of Jan’03- Dec’07 (in annualised returns %)

Category Factors Q1 Q2 Q3 Q4 Q5 Conclusion

Valuation Price to Book Ratio 32% 41% 50% 42% 36% Medium P/B worked best

Leverage Debt to Equity 50% 47% 38% 39% 32% High Debt to Equity worked well

Depreciation/(Sales - EBIT) 35% 48% 40% 33% 39%

Performance is mixed; Higher Depreciation to total operating cost ratio worked slightly better

Profitability and efficiency

Return on Equity 35% 37% 45% 44% 36% Medium RoE worked well

Return on Capital Employed 38% 37% 44% 40% 37% Medium RoCE worked well

Working Capital to Sales 27% 38% 44% 53% 41%

Low Working Capital to Sales worked well

Market Sensitivity Beta 27% 45% 51% 42% 31% Medium Beta worked well

Total stock Volatility 29% 39% 43% 43% 36%

Medium Total Volatility worked well

Investment in Growth

Dividend Yield 39% 36% 40% 40% 43% Low Dividend Yield worked well

Earnings Retention Ratio 42% 45% 47% 37% 34% High Earnings Retention Ratio worked well

Momentum 6m Momentum 69% 55% 53% 51% 38% Price Momentum worked well

Earnings Estimate revision (3 month)

50% 29% 27% 19% 26% Earnings momentum worked well

Size* Market-cap 39% 69% Small-caps outperformed Large-caps

Turnover 46% 38% 43% 36% 38%

High turnover stocks did slightly better than low turnover stocks

Sector* Cyclicals vs Defensives 45% 29% Cyclicals outperformed Defensives

Source: Ambit Capital research, Bloomberg; Note: - Dark to light shade denotes relatively higher to lower returns; * For factors Market cap and Sector, the cell ordering is Large-cap, Small-cap and Cyclicals, Defensives respectively

Quant Strategy


Defensive Phase (January 2008 – September 2013)

On the other hand, during the defensive phase, investors preferred stocks with: (1) high profitability (high RoE, high RoCE worked well) and (2) low leverage (low debt to equity and low depreciation to total costs worked well); high valuations did not deter investors (high P/B did well).

Seeking safety, investors preferred current cash over future growth (high dividend yield and low earnings retention worked well) and low beta. Similarly, large-caps and defensives outperformed their smaller-cap and cyclical counterparts respectively.

Exhibit 10: Factor quintile performance summary during the defensive phase of Jan’08-Sep’13 (in annualised returns %)


Valuation Price to Book Ratio 1% -8% -12% -10% -17% High price to book worked well

Leverage Debt to Equity -21% -17% -11% -4% -2% Low debt to equity worked well

Depreciation/(Sales - EBIT)

-22% -10% -5% -7% -7% High depreciation to total operating cost ratio underperformed

Profitability Return on Equity 2% -6% -10% -17% -24% High RoE worked well

Return on Capital Employed

5% -1% -14% -17% -25% High RoCE worked well

Working Capital to Sales -14% -14% -6% -8% -10%

Low working capital to sales worked well

Market Sensitivity Beta -23% -14% -12% -7% 6% Low Beta worked well

Total Volatility -26% -21% -11% -5% 6% Low total volatility worked well


Dividend Yield -7% -5% -12% -10% -22% High Dividend Yield worked well

Earnings Retention Ratio -19% -10% -10% -9% 1%

Low Earnings retention ratio worked well

Momentum 6m Momentum -6% -2% -5% -8% -14% Price momentum worked


-9% -6% -7% -7% -17% Earnings momentum worked

Size* Market-cap -1% -12% Large-caps outperform Small-caps

Turnover -16% -10% -8% -8% -7%

Low turnover stocks did better than high turnover stocks

Sector* Cyclicals vs Defensives -11% 10% Defensives outperform Cyclicals

Source: Ambit Capital research, Bloomberg; Note: - Dark to light shade denotes relatively higher to lower returns; * For factors Market-cap and Sector, the cell ordering is Large-cap, Small-cap and Cyclicals, Defensives respectively

Finally, momentum-related factors (6m price momentum, 3m earnings revision) and low working capital have in general worked well over both these phases. The exhibit below summarises the performance of each factor in the different market phases.

Exhibit 11: Summary of factor performances in different market phases

Factors Performance Summary

Price to book ratio High P/B ratio worked well in a defensive phase whilst medium P/B ratio worked well in the bull phase

Debt to Equity High D/E ratio worked well in the bull phase whilst it underperformed in the defensive phase

Depreciation/(Sales - EBIT) High Depreciation to total operating cost ratio worked well in the bull phase whilst it underperformed in the defensive phase

Return on equity High RoE worked well in the defensive phase whilst medium RoE worked well in the bull phase

Return on capital employed High RoCE worked well in the defensive phase whilst medium RoCE worked well in the bull phase

Working capital to sales Low working capital to sales worked well in both bull phase and defensive phase

Beta Low Beta worked well in the defensive phase whilst medium Beta worked best in the bull phase

Total stock volatility Low total stock return volatility worked well in defensive phase whilst medium volatility worked best in the bull phase

Dividend yield High dividend yield worked well in the defensive phase whilst low dividend yield worked in bull phase

Earnings retention ratio High retention ratio worked well in the bull phase whilst low retention ratio was preferred in defensive phase

Six-month price momentum Price momentum worked in both bull and defensive phases

Earnings estimates revision (3m)

Earnings estimates revision worked in both bull and defensive phases

Large-caps vs Small-caps Large-caps outperformed small-caps in defensive phase whilst small caps beat large caps during the bull phase

Turnover High turnover did well in bull phase whilst low turnover did well in the defensive phase

Cyclicals vs Defensives Cyclicals outperformed defensives in the bull phase and vice-versa in the defensive phase

Source: Ambit Capital research

Quant Strategy


Factor performance in recent rally The recent period has been characterised by a strong rally in Indian equities which began in September 2013, with the Sensex having risen from roughly 18,600 then to levels close to 30,000 earlier this year. An analysis of factor performances over this period should give interesting insights into what the market has already priced in and how that compares with the bull period of 2003-2007.

Unfortunately, however, most factors show a mixed performance over this period. This is owing to the fact that although over this 21-month period the benchmark indices have broadly trended up, in terms of the nature of factors at work, this period actually comprised of two very distinct sub-periods. What worked in the initial part of the rally from October 2013 to June 2014 is very different from what has worked since then. As will be seen in what follows below, in the first sub-period, the factors that worked were those that had worked well in the previous Bull phase. However, in the second sub-period, defensive factors (that had worked in the previous Defensive phase) seem to have taken leadership.

Sub-period 1, October 2013 – Jun 2014 After years of consolidation, this period marked the start of an impressive market rally on the back of high expectations. The appointment of Raghuram Rajan as the RBI Governor (he took charge of the RBI in September 2013) and expectations of a pro-reform, stable NDA-led Government at the Centre fuelled the rally. The nature of this rally was very similar to the previous bull market with most factors that had worked well then working well here as well.

As can be seen from the factor performance summary below, factors such as high leverage, low profitability, small-caps and cyclical sectors worked well during this period. However, as the underlying economic conditions were still benign, some factors like high dividend yield (indicating preference for cash) that generally work well in a bearish scenario also worked, suggesting a mixed market positioning with a bullish bias. However, it was only after June 2014 (i.e., after the NDA won the General Elections) that the market positioning changed decisively towards a defensive positioning even in the wake of rising indices.

Exhibit 12: Factor quintile performance summary during Oct’13-Jun’14 (in annualised returns %)


Valuation Price to Book Ratio 29% 44% 79% 77% 154% Low Price to Book ratio worked well

Leverage Debt to Equity 85% 70% 47% 63% 26% High Debt to Equity Worked well

Depreciation/(Sales - EBIT)

70% 50% 64% 47% 56% High Depreciation to total operating cost ratio worked well

Profitability Return on Equity 46% 54% 78% 81% 87% Low RoE worked well


31% 45% 68% 78% 76% Low RoCE worked well

Working Capital to Sales 45% 58% 49% 68% 64%

Low Working Capital to Sales worked well

Market Sensitivity Beta 140% 92% 68% 53% 19% High Beta worked well

Total Volatility 118% 97% 90% 49% 31% High Total Volatility worked well

Investment in Growth Dividend Yield 114% 66% 81% 61% 43% High Dividend Yield worked well


Medium Earnings retention ratio worked well

Momentum 6m Momentum 83% 64% 85% 76% 118% Price Momentum didn't work well


68% 67% 57% 76% 90% Earnings momentum didn’t work well

Size* Mcap 46% 146% Small-caps outperform Large-caps

Turnover 70% 55% 85% 62% 68% Medium turnover worked well

Sector* Cyclicals vs Defensives 81% 21% Cyclicals outperform Defensives

Source: Ambit Capital research, Bloomberg; Note: - Dark to light shade denotes relatively higher to lower returns; * For factors Mcap and Sector, the cell ordering is Large-cap, Small-cap and Cyclicals, Defensives respectively

Quant Strategy


Sub-period 2, Jul 2014 – Mar 2015 This period saw the markets continuing the impressive run from the previous period; however, some of the exuberance of the previous period started waning off, with ‘defensive’ factors coming to the fore once again. Factors such as high debt to equity and high depreciation to total cost ratio, which are usually associated with an optimistic positioning, started giving way to factors such as high profitability, low beta and high price to book, all of which point to a defensive positioning. Most importantly, small-caps and cyclical stocks gave away leadership to large-caps and defensives respectively.

Therefore, given the performance summary of the factors during this period, as shown in the exhibit below, this phase marked a market positioning with a decisive defensive bias.

Note that this pattern is unusual. In most cycles, as recovery progresses, the market leadership moves towards small-caps, cyclicals and lower P/B stocks (as investors gain confidence in the economy). Hence, the fact that we have seen style factors change in this counterintuitive fashion in the recent rally clearly suggests that investors lack confidence in the Indian economy but have been pumping in money due to lack of options in other markets and/or a global glut of liquidity.

This defensive positioning has continued in the quarters ending Jun’15 and Sep’15 as well as is captured by our ‘Sentimeter’ chart in Exhibit 1.

Exhibit 13: Factor quintile performance summary during Jul’14-Mar’15 (in annualised returns %)


Valuation Price to Book Ratio 42% 48% 35% -5% -35% High Price to book ratio worked well

Leverage Debt to Equity -9% 18% 14% 40% 19% Low Debt to Equity ratio worked well

Depreciation/(Sales - EBIT) -20% 16% 15% 37% 31%

Low Depreciation to total operating cost ratio worked well

Profitability Return on Equity 46% 32% 13% -4% -25% High RoE worked well


43% 26% 32% -7% -18% High RoCE worked well

Working Capital to Sales -11% 36% 31% 25% -3%

Medium Working capital to sales worked well

Market Sensitivity Beta -23% -3% 14% 44% 37% Low Beta worked well

Total Volatility -26% -1% 30% 21% 36% Low Total volatility worked well


Dividend Yield -4% 8% 12% 34% 14% Low Dividend Yield worked well


Performance is mixed- Low Earnings Retention ratio worked slightly better

Momentum 6m Momentum 31% 5% 13% 20% 8% Long-term Price Momentum worked well


19% 45% 21% 11% -2% Long-term Earnings revision worked well

Size* Mcap 16% 6% Large-caps outperform Small-caps

Turnover -1% 9% 9% 24% 42% Low turnover did better than high turnover

Sector* Cyclicals vs Defensives 21% 50% Defensives outperform Cyclicals

Source: Ambit Capital research, Bloomberg; Note: - Dark to light shade denotes relatively higher to lower returns; * For factors Mcap and Sector, the cell ordering is Large-cap, Small-cap and Cyclicals, Defensives respectively

Quant Strategy


Institutional Equities Team Saurabh Mukherjea, CFA CEO, Institutional Equities (022) 30433174 [email protected]

Research

Analysts Industry Sectors Desk-Phone E-mail

Nitin Bhasin - Head of Research E&C / Infra / Cement / Industrials (022) 30433241 [email protected]

Aadesh Mehta, CFA Banking / Financial Services (022) 30433239 [email protected]

Abhishek Ranganathan, CFA Retail / Mid-caps (022) 30433085 [email protected]

Achint Bhagat, CFA Cement / Roads / Home Building (022) 30433178 [email protected]

Aditya Bagul Consumer (022) 30433264 [email protected]

Aditya Khemka Healthcare (022) 30433272 [email protected]

Ashvin Shetty, CFA Automobile (022) 30433285 [email protected]

Bhargav Buddhadev Power Utilities / Capital Goods (022) 30433252 [email protected]

Deepesh Agarwal Power Utilities / Capital Goods (022) 30433275 [email protected] Gaurav Mehta, CFA Strategy / Derivatives Research (022) 30433255 [email protected]

Girisha Saraf Mid-caps / Small-caps (022) 30433211 [email protected]

Karan Khanna Strategy (022) 30433251 [email protected]

Kushank Poddar Technology (022) 30433203 [email protected] Pankaj Agarwal, CFA Banking / Financial Services (022) 30433206 [email protected]

Paresh Dave, CFA Healthcare (022) 30433212 [email protected]

Parita Ashar, CFA Metals & Mining (022) 30433223 [email protected]

Prashant Mittal, CFA Derivatives (022) 30433218 [email protected]

Rakshit Ranjan, CFA Consumer (022) 30433201 [email protected]

Ravi Singh Banking / Financial Services (022) 30433181 [email protected]

Ritesh Gupta, CFA Oil & Gas / Chemicals (022) 30433242 [email protected]

Ritesh Vaidya, CFA Consumer (022) 30433246 [email protected] Ritika Mankar Mukherjee, CFA Economy / Strategy (022) 30433175 [email protected]

Ritu Modi Automobile (022) 30433292 [email protected]

Sagar Rastogi Technology (022) 30433291 [email protected]

Sumit Shekhar Economy / Strategy (022) 30433229 [email protected]

Utsav Mehta, CFA E&C / Industrials (022) 30433209 [email protected]

Sales

Name Regions Desk-Phone E-mail

Sarojini Ramachandran - Head of Sales UK +44 (0) 20 7614 8374 [email protected]

Dharmen Shah India / Asia (022) 30433289 [email protected]

Dipti Mehta India / USA (022) 30433053 [email protected]

Hitakshi Mehra India (022) 30433204 [email protected]

Krishnan V India / Asia (022) 30433295 [email protected]

Nityam Shah, CFA USA / Europe (022) 30433259 [email protected]

Parees Purohit, CFA UK / USA (022) 30433169 [email protected]

Praveena Pattabiraman India / Asia (022) 30433268 [email protected]

Shaleen Silori India (022) 30433256 [email protected]

Singapore

Pramod Gubbi, CFA – Director Singapore +65 8606 6476 [email protected]

Shashank Abhisheik Singapore +65 6536 1935 [email protected]

USA / Canada

Ravilochan Pola - CEO Americas +1(646) 361 3107 [email protected]

Production

Sajid Merchant Production (022) 30433247 [email protected]

Sharoz G Hussain Production (022) 30433183 [email protected]

Joel Pereira Editor (022) 30433284 [email protected]

Nikhil Pillai Database (022) 30433265 [email protected]

E&C = Engineering & Construction












































Quant Strategy


Explanation of Investment Rating

Investment Rating Expected return (over 12-month)

BUY >10%

SELL <10%

NO STANCE We have forward looking estimates for the stock but we refrain from assigning valuation and recommendation

UNDER REVIEW We will revisit our recommendation, valuation and estimates on the stock following recent events

NOT RATED We do not have any forward looking estimates, valuation or recommendation for the stock

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