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Innovative Journal of Business and Management 2 : 3 May – June (2013) 40 - 43. Contents lists available at www.innovativejournal.in INNOVATIVE JOURNAL OF BUSINESS AND MANAGEMENT Journal homepage:http://www.innovativejournal.in/index.php/ijbm ANALYZING THE PERFORMANCE OF HIGH AND LOW BOOK-TO-MARKET RATIO FIRMS WITH SPECIFIC REFERENCE TO INDIAN IT, PHARMACY AND BANKING STOCKS Venkatesh. C. K1*, Madhu Tyagi2, Ganesh. L3 1Research Scholar, IGNOU, Maidan Ghari, New Delhi of Management, IGNOU, Madain Ghari, New Delhi. 3Institute of Management, Christ University, Hosur Road, Bangalore-560 030. 2School ARTICLE INFO Corresponding Author: Venkatesh. C. K Research Scholar, IGNOU, Maidan Ghari, New Delhi [email protected] Key Words Fundamental analysis, Financial Statements, Return on assets, Book to market ratio. ABSTRACT This paper tries to explore the Financial Performance of High and Low Book-to-Market ratio firms with specific reference to Indian IT, Pharmacy and Banking Stocks. Previous Literature has documented that all High Book-to-Market ratio firms are financially distressed. It is also been proved that high Book-to-Market stocks are those with poor historical performance and have not received enough attention from the investors. Investors tend to be over pessimistic about the future performance of these stocks. Envisaging all these, the current research tries to prove all documented facts in the Indian Stock Market with specific reference to mentioned stocks. In this research work a simple financial score is designed to capture short term changes in firm’s Profitability, Solvency, Liquidity, Earnings Stability and Accounting Conservatism. For this purpose Historical Financial Information is derived from various financial statements. Using Historical Financial Information is a method adopted in fundamental analysis which is helpful in predicting future stock returns and for explaining the momentum phenomenon in stock prices. The goal of this paper is to show that investors can create a stronger value portfolio by using simple historical financial performance and identify winning and losing stocks. ©2013, IJBM, All Right Reserved INTRODUCTION Financial Statements A Financial Statement is a collection of data organized according to logical and consistent accounting procedures. Its purpose is to convey an understanding of some financial aspects of a business firm. It may show a position at a moment in time, convey profit status at another point in time or may show inflow and outflow of cash/funds. Financial statements are the outcome of summarizing process of accounting. Thus, Financial Statements generally refers to the two statements: ( i) the position statement or the balance sheet and (ii) the income statement or the profit and loss account. These statements are used to convey to management and other interested outsiders the Profitability, Solvency and Financial Position of a firm. Fundamental Analysis Fundamental analysis is a method of finding out the future price of a stock which an investor wishes to buy. It relates to the examination of the intrinsic worth of a company to find out whether the current market price is fair or not, whether it is overpriced or under priced. It believes that analyzing the economy, strategy, 40 management, product, financial status and other related information will help to choose shares that will out perform the market and provide consistent gains to the investor. It is the examination of the underlying forces that affect the interest of the economy, industrial sectors and companies. It tries to forecast the future movement of the capital market using signals from the Economy, Industry and Company. It requires an examination of the market from a broader perspective. The presumption behind fundamental analysis is that a thriving economy fosters industrial growth which leads to development of companies. Estimate of real worth of a stock is made by considering the earning potential of the company which depends on investment environment and factors relating to specific industry, competitiveness, quality of management, operational efficiency, profitability, capital structure and dividend policy. Review of Literature The origin of Fundamental analysis for the share price valuation can be dated back to Graham and Dodd (1934) in which the authors have argued the importance of the fundamental factors in share price valuation. Analyzing the Performance of High and Low Book-to-Market Ratio Firms with specific reference to Indian IT, Pharmacy and Banking Stocks Theoretically, the value of a company, hence its share price, Statement of the Problem is the sum of the present value of future cash flows Analyzing the stock returns is a matter to discounted by the risk adjusted discount rate. This contemplate among the equity researchers. To analyze the conceptual valuation frame work is the spirit of the predictability of stock returns the researchers use various renowned dividend discount model developed by Gordon tools and techniques which might not give assured results. (1962). However, the dividend discount model valuation Therefore, to facilitate such prediction Academicians as involves the forecast of future dividend payment which is well as the Equity Researchers have developed several difficult due to the changes in firm’s dividend policy. Thus, innovative techniques and two such techniques are F_Score the subsequent studies along this line of literature searched and G_Score as developed by Piotroski (2000) and for the cash flow that is unaffected by the dividend policy Mohanram (2005) respectively. The current research work and can be obtained from the financial statements. emphasizes on the work of these two authors in the Indian Ou and Penman (1989) use financial statement analysis of context. These two techniques is applied to the Indian income statement and balance sheet ratios to forecast Banking, Pharmacy and Information Technology stocks and future earnings. The primary motivation for this research is the process is evaluated as suggested by Piotroski (2000) to identify mispriced securities. However, these authors and Mohanram (2005). demonstrate that the information in the earnings In addition to this, the current research tries to prediction signals is helpful in generating abnormal stock examine the returns variation among each group of high returns. and low book-to-market ratio stocks by using financial Fama and French (1992) show that value stocks (high statement analysis. book/market) significantly outperform growth stocks (low Objective of the study: book/market). The average return of the highest Constructing F_Score and G_Score to book/market decile is reported go be one percent per evaluate Information Technology, Pharmacy and month higher than the average return for the lowest Banking firms in the Indian context. book/market decile. Specific Objectives: Jagadeesh and Titman (1993) document that over The objectives of the study can be concluded by a horizon of three to twelve months, past winners on an • Usage of various fundamental signals to measure Five average continue to outperform past losers by about one Areas of Firm’s Financial Status: Profitability, Solvency, percent per month. Operating Efficiency, Earnings Stability and Accounting Lev and Thiagarajan (1993) use conceptual arguments to Conservatism study their ratios. They demonstrate that the earnings • Examining returns variation among each group of high prediction signals in variables like growth in accounts and low book-to-market ratios stocks by using receivables relative to sales growth and gross margin rate financial statement analysis ( this objective is set as a are incrementally associated with contemporaneous stock part of Fundamental Analysis) returns and are significant in predicting future earnings. • Classification of companies as “Good” or “Bad” Joseph. D. Piotroski (2000) examines whether a depending on the signal’s implications for future prices simple accounting based Fundamental Analysis strategy, and profitability. when applied to a broad portfolio of high Book to Market • Constructing aggregate signal to measure the overall firms, can shift the distribution of returns earned by an strength of the firm’s financial position. investor. The research shows that the mean returns earned Methodology by a high Book to Market investor can be increased by at The current research work is contemplated after least 7.5% annually through the selection of financially thoroughly reviewing the above mentioned literature. For strong high Book to Market firms. the purpose of this work firms are broadly categorized as Pascal Nguyen, (2003) constructs a simple Information Technology, Pharmacy and Banking. At the financial score designed to capture short term changes in first instance Book-to-Market ratio is calculated to identify firm operating efficiency, profitability and financial policy. firm’s having High/Low Book-to-Market ratio. After this a The scores exhibit a strong correlation with market comprehensive F_SCORE/G_SCORE was constructed for adjusted returns in the Current fiscal period and the same those firms having High/Low book-to-market ratio. Firms continues in the following period also. having highest F_SCORE/G_SCORE were given the first rank Partha.S.Mohanram (2005) combines traditional followed by those having lower F_SCORE/ G_CORE. For fundamentals, such as earnings and cash flows, with these firms Stock Returns, Earnings per Share and Price measures tailored for growth firms, such as earnings Earning were ascertained for ten years. Later top 10 and stability, growth stability and intensity of research and bottom 10 firms were chosen for analysis. The period of development, capital expenditure and advertising, to create study is 01st April 2001 to 31st March 2010. an index called – GSCORE. A long–short strategy based on An insight into F_SCORE GSCORE earns significant excess returns, though most of F_SCORE is a composite indicator which incorporates the returns come from the short side. High GSCORE firms various fundamental aspects of the firm and it is have greater market reaction and analyst forecast surprises constructed to examine the future performance of the firm. with respect to future earnings announcements. Further, The concept of F_SCORE was developed the results are in consistent with a risk based explanation JOSEPH.D.PIOTROSKI, Professor, The University of Chicago, as returns are positive in most years, and firms with lower Graduate School of Business, in the year 2000. The goal of risk earn higher returns. Finally, a contextual approach this research work is to show that investors can create towards fundamental analysis works best, with traditional stronger value portfolios by using simple historical analysis appropriate for high Book to Market stocks and financial performance. growth oriented fundamental analysis appropriate for low Professor Piotroski identifies three broad heads to measure Book to Market stocks. the financial performance of a company which are 41 Analyzing the Performance of High and Low Book-to-Market Ratio Firms with specific reference to Indian IT, Pharmacy and Banking Stocks identified as Financial Performance Signals. They are, GSCORE is also constructed using the eight fundamentals as Profitability, Solvency and Operating Efficiency variables. laid down by Piotroski (2000), these signals are related to Thus, the final score is represented as follows; firm’s Profitability, Earnings stability, Sales stability and FSCORE= Accounting Conservatism. GSCORE emphasizes on the ROA+AROA+CFO+ACCRUAL+DMARGIN+DTURN+DLEVER+ firm’s future performance and accounts for its growth DLIQUID+EQOFF factor. The GSCORE is constructed by three categories of An insight into G_Score eight signals which include Return on Assets (ROA), Cash The investment strategy based on the FSCORE does not suit Flow from Operations (CFO) and Accrual. The definition of for the low book-to-market ratio stocks as documented by these variables is identical to those used in FSCORE but Mohanram (2005). Mohanram further extended the with the difference in assigning indicator values. These FSCORE measurement to examine the fundamentals for the profitability related variables are assigned a value of one if low book-to-market stocks. He argued that the financial they are larger than that of the industry median, and zero statement analysis using FSCORE is not appropriate for the otherwise. low book-to-market stocks because it failed to consider the Similar, to the construction of the FSCORE, the composite growth fundamentals of these firms. Growth firms are GSCORE is the sum of these eight fundamental signals. usually those with stable earnings and sales growth, larger GSCORE=ROA1+CFO1+ACCRUAL+ 𝜎 N1+ 𝜎 SG+RDINT+ADINT+ Research and Development expenses and capital CAPINT A higher F_Score/G_Score indicate more good fundamental expenditure, and more analysts following. Mohanram (2005) constructed GSCORE measurement signals of a firm and thus better financial health for the which accounts for the financial variables that concern the value stocks/growth stocks. A lower F_Score/G_Score future performance of the firms. The results of this indicate less good fundamental signals of a firm resulting in research showed that for the low book-to-market stocks, lesser financial health. Mohanram (2005) showed that an high GSCORE firms are more likely to beat the earnings investment strategy with long position in high GSCORE forecasts and thus earn higher excess return than the low stock and short position in the low GSCORE stocks generate excess returns up to two years after the portfolio GSCORE firms. formation. Analysis and Interpretation Table 1showing Descriptive Statistics of firms involved in high and low F and G_Score Top F Bottom F Top G Bottom G Average ratio 1.59 4.97 0.49107 0.580191 BM Average Returns Average Assets Average EPS Average PE ratio 366.65 6.67 630.24 20.43 19871.59 669.38 382593.4 5310.68 51.22 -4.37 27.71 -1.82 13.44 32.32 19.74 52.47 Above table compares the results of descriptive statistics pertaining to analysis of Top and Bottom F and G_Score firms. For this purpose of analysis common variables not relating to the construction of score is considered. As it is evident from the table, Top and Bottom F_Score firms are having higher BM ratio compared to the firms under G_Score. As proved by Piotroski (2000) F_Score is more suitable for firms having high BM ratio and Mohanram (2005) endorses the applicability of G_Score for firms with low BM ratio. Average returns given by top G_Score firms is almost double than the top F_Score firms, one interesting observation to note is that EPS given by high F_Score firms is almost double than the top G_Score firms. In the long run high F_Score firms have created wealth for their investors. The Mean of the BM ratio are 1.59 (4.97) and 0.49107 (0.580191) for the value and growth stocks having high and low scores respectively. The growth stocks has larger asset base than the value stocks. The average assets of high/low score value stocks 19871.59 (669.38) and 382593.4 (5310.68) with that of high/low score growths stocks. It is evident that growth stocks has larger asset base. Even low score growth stocks are having a healthy asset base than the low score value stocks. The sales and sales growth for the growth stocks are higher than those of the value stocks for the entire sample. This confirms the fact that growth firms grow at a faster rate than the other firms. The main contribution to the sales growth of these firms is the Research and Development intensity and the nature of investments these firms make into Research and 42 Average No. of trades 132762.71 9582.08 4383417 31222.73 Average PAT 217.77 -38.84 512.22 12.38 Development activities. Because of this reason there would be a larger future potential growth opportunities for these firms. Consistent with the previous findings in Piotroski (2000) and Mohanram (2005), future performance of the stock returns are positively correlated to the firm’s financial health. It is been noted in the current research that fundamental scores and future returns are positively correlated with F and G_Score firms, for a study period of ten years. The correlation results of F_Score firms are 0.06273 and G_Score 0.98457. Lakonishock, Shleifer and Vishny (1994) argued from the behavioral aspects that high book-to-market stocks are those with poor historical performance and have not enough attention from the investors. Investors tend to be over pessimistic about the future performance of these stocks and higher future returns are expected when the mispricing is corrected. To validate this statement in the current research Average Number of Trades of all the companies were compared with one another. It is very evident from the analysis that firms with high G_Score are associated with high number of trades. This indicates that there is huge investor following for these company shares, To conclude this analysis between F and G_Score firms, PE of these firms were considered and from the analysis it is concluded that high F_Score are having lower PE compared to the high G_Score firms which naturally indicates the ability of high F_Score firms in earning higher returns to its share holders in terms of maximizing the Earnings per share. The PE of high F_Score firms is recorded at 13.44 as Analyzing the Performance of High and Low Book-to-Market Ratio Firms with specific reference to Indian IT, Pharmacy and Banking Stocks compared to 19.74 for high G_Score firms. The accounted individual share holders. All these results are in consistent EPS is Rs.51.22 for high F_Score firms and 27.71 for the with the previous literature, which includes Fama and firms with high G_Score. As specified in the beginning of French (1992), Piotroski (2000) and Mohanram (2005), this section value stocks have out performed the growth Dr.Cheng Few Lee and Wei-Kang Shih (2009). stocks in terms of maximizing Earnings per share to the Examining Returns Variation among each group of high and low book-to-market stocks by using Financial Statement Analysis Table2 Showing Year-wise high and low book-to-market stocks by using Financial Statement Analysis Year MKT. Returns of z-value of Returns of z-value of Returns z-value of RET. High Returns of High G_Score Returns of of low Returns of F_Score High F_Score High G_Score F_Score Low F_Score C1 C2 C3 C4 C5 C6 C7 C8 2001 -17.87 13.22 -0.57 38.09 0.03 -11.41 -0.04 2002 3.52 9.48 -0.66 14.56 -0.48 -28.22 -1.36 2003 72.89 110.67 1.61 66.16 0.65 -10.54 0.03 2004 13.08 21.39 -0.39 46.98 0.23 -7.39 0.28 2005 42.33 44.34 0.12 24.12 -0.28 -22.89 -0.94 2006 46.70 38.20 -0.01 30.63 -0.13 -16.02 -0.40 2007 47.15 76.59 0.84 47.26 0.23 4.67 1.23 2008 -52.45 -49.60 -1.98 -53.08 -1.97 -25.03 -1.11 2009 81.03 80.63 0.93 129.84 2.04 11.01 1.73 2010 17.43 43.25 0.10 22.12 -0.32 -3.82 0.56 Mean 25.81 38.81 0 36.68 0 -10.96 0 S.D 41.08 44.75 1 45.60 1 12.71 1 As observed from the above table, the Z-value of Returns of High F_Score for the year 2001 is -0.57, standard deviation is below the mean, while the Z-value of high G_Score is 0.03 Standard Deviation is above the mean. This indicates that deviation is more than the mean with reference to high G_Score firms as compared to high F_Score firms. The negative z-value indicates that F_Score return of that particular period is lesser the mean F_Score and positive zvalue indicates the F_Score return is higher than the mean. Likewise, z-values of returns of high F_Score and high G_Score across years (from 2002 to 2010) show a similar pattern of negative and positive z-values with not much of a variation. However, in few years such as 2003, 2007 and 2010 F_Score is showing better result than G_Score. One Striking observation made from the above analysis is that, whenever, the market returns are falling, the returns of F and G_Score firms are also falling in tune with the market. For all those years Market Returns as well as Firm Returns are achieving negative Z value. On the other hand, with respect to low F_Score and G_Score return, it is seen that negative z-values of low G_Score are higher than that of low F_Score. Interestingly, in most of the years, both G_Score and F_Score are having negative z-values indicating lesser than overall mean. This clearly indicates the inability of low score firms in earning returns to the share holders. As like the high F_Score and G_Score, not much variation is observed between low F and G_Score. Return of Low G_Score C9 -32.11 -10.77 2.75 -3.701 -6.34 16.64 38.98 -9.33 18.97 13.73 2.88 19.88 z-value of returns of low G_Score C10 -1.76 -0.69 -0.01 -0.33 -0.46 0.69 1.82 -0.61 0.81 0.55 0 1 consistent with the evidence as shown by Piotroski (2000) and Mohanram (2005). REFERENCES 1. Gordon M.J. (1962), “ The Investment, Financing and Valuation of the Corporation” Irwin, Homewood Illinois. 2. Graham.B. and Dodd.D (1996), Security Analysis: The Classic 1934 Edition, McGraw-Hill, New York, NY. 3. Jegadeesh, N.Titman.S, 1993, Returns to buying winners and selling losers: Implications for stock market efficiency, Journal of Finance 48, 65-91. 4. Piotroski.J 2000, Value investing: The use of Historical financial statement information to separate winners from losers, Journal of Accounting Research. 5. Ou, J.Penman.S 1989, Financial statement analysis and Prediction of stock returns, Journal of Accounting and Economics 11, 295-329. 6. Lev.B, Thiagarajan.R. 1993, Fundamental information analysis, Journal of Accounting research 31, 190-215 7. Fama.E, Frenck.K., 1992, The cross section of expected returns, Journal of Finance, 47, 427-465. 8. Sloan, R., 1996, “Do stock prices fully reflect information in accruals and cash flows about future earnings”, The Accounting Review, vol. 71, pp 289-315. 9. Jaouida Elleuch, 2009, Fundamental Analysis Strategy and the Prediction of Stock Returns, International Research Journal of Finance and Economics, Issue 30, page 95-108. ( Faculty of Economics and Management Sciences, University of Sfax, Tunisia) http://www.eurojournals.com/finance.htm 10. Datar, V.T. Naik.N.Y. and Radcliffe.R (1998), Liquidity and stock returns: An alternative test, Journal of Financial Markets, 1 (2), 203-219. 11. Ababanell, J.S. and Bushee B.J. (1997), Fundamental Analysis, Future Earnings, and Stock Prices, Journal of Accounting Research, 35(1), 1-24. 12. Fama.E.F. and French K.R. (1992), The Cross Section of Expected Returns, Journal of Finance, 47 (2), 427-465. CONCLUSION At the bottom line it is concluded that high G_Score firms are leading the race in augmenting the returns. Over a period of 10 years high G_Score firms have given almost double the returns of their counterpart the high F_Score firms. One more important observation to note is that, all high G_Score firms are getting the maximum attention from the investors and investing community is behind these stocks to speculate. From this it is evident that the firms with low Book-to-Market ratio are getting the investor’s attention towards them. All the above results are in 43