Alpha Stocks

Turn to alpha stocks for excess returns

There are two ways to survive in an African jungle. Either you can graze for food or you can hunt for it. Grazing is a low-stress activity and fraught with much less uncertainty compared to hunting. However, if you are a grazer, you are unlikely to end up snagging a lion either. The same is true of the stock market, which, at the current moment, is in a manner of speaking, quite similar to an African jungle.

You can choose to be a beta grazer. Simply put, that means try and invest in stocks which are benchmarked to the index. Or you can choose to be an alpha hunter. Simply put, that means taking a more aggressive stance that’s based on the risk-adjusted return of an individual stock. And we believe this is the time to be an alpha hunter rather than a beta grazer.

So, what is alpha hunting all about? For that, we need to try and understand this new animal called alpha in slightly greater detail. It is the excess return on and above the risk-adjusted return of a stock. The performance of any portfolio is usually compared against some benchmark index on a riskadjusted basis. So, many a times, the portfolio manager loves to pick up those stocks which have the potential to generate returns in excess of their expected risk-adjusted returns. One of the measures of risk-adjusted return is the return obtained through the popular capital asset pricing model (CAPM).

For example, if the risk-free rate (the yield on 10-year treasury bill) is 7%, the return on index (Sensex or Nifty) is 20% and the beta of the stock is 0.9, then the risk-adjusted return by CAPM model equals to 18.7%. If the actual return by the stock is 20%, then the stock is said to have generated positive alpha of 1.3%.

For a savvy investor, any positive alpha means the excess return on and above the risk-adjusted return expected out of that stock. So, it is very important for any investor to be aware of the stocks which have the potential to generate positive and negative alpha.

To help our readers in identifying such stocks, ETIG carried out an analysis to find out the stocks which have generated positive alpha for the past seven years. To increase the universe of our analysis, we have considered a bigger sample — stocks forming part of the BSE 500 index.

The domestic stock market started evolving in a mature way from the beginning of this millennium and hence, we have considered the past seven years for the analysis. Since this is a statistical analysis, the consistency of all data points is very important. So, we have taken only those stocks within the BSE 500 index, which have been present in the index for the past seven years. We managed to find 270 stocks which met this criterion.

For calculating the return, we have considered the financial year as the annual period. To avoid any biased effect of a particular day, instead of considering the closing price on a particular day, we have considered the average monthly price for the month of April and calculated the annual returns. Then we calculated the annual return for each of these seven years.

While calculating the CAPM return for a particular year, we considered the beta of the individual stock for each fiscal year. Similarly, the yield on 10-year treasury bill has been considered as risk-free rate. The CAPM return is finally subtracted from the actual return for the year to arrive at the alpha.

The final analysis threw up some interesting results and surprises. There are only five stocks, which have consistently generated positive alpha for the past seven years. And surprisingly, these are not the most coveted stocks in the market.

These five stocks are Aban Offshore, Crompton Greaves, Kotak Mahindra Bank, HDFC and Asian Paints. The average alpha for all these stocks ranges from a low of 15% to as high as 108%.

To cross-check our analysis, we introduced another parameter called ‘Treynor ratio’. It is the excess return of a stock over a riskfree rate per unit of risk (which is measured in terms of stock beta). Though the top two stocks retained their position, Asian Paints moved up one notch from the fourth position to the third, by replacing the Kotak Mahindra Bank.

HDFC continued to be at the fifth position. The average annual return for all these stocks in the past seven years ranges from 42% to 132%.

There is no doubt that these five stocks are the top performers, but, there are still many stocks which have performed reasonably well. If we remove the constraint of consistency, there are around 23 stocks which have generated positive alpha in six out of seven years.

This means, there is a probability of more than 80% that these stocks can generate a positive alpha in any given year. Some of the prominent stocks in this list include Axis Bank, Bharat Heavy Electricals (Bhel), Siemens, Sun Pharma and Godrej Industries.

The average alpha for all these 23 stocks works out to 55%. However, the top three are relatively smaller stocks — Balkrishna Industries (148%), Jubilant Organosys (125%) and Godrej Industries (88%). While we talked so much about the best of the breed, one should also be aware about the laggards.

The good news is that there is not a single stock which has consistently generated negative alpha. But there are seven stocks which have generated negative alpha in six of the past seven years. These seven stocks are Castrol India, Cipla, Himachal Futuristic, MTNL, Mysore Cement, NIIT and Zee Entertainment.

Most of them have generated an average alpha of -15%. Investors are advised to be careful while picking up these stocks for their portfolio. Though the past performance is no guarantee for the future, it certainly increases the probability of success.

For that matter, any stock recommendation (whether fundamental or technical) is based on probability only. Hence, investors should keep a close watch on these five stocks and may add them to their portfolios at suitable entry points.

----- With due apologies and full credits to Economic Times