Managerial Finance

Quality investing in the Indian stock market

Vaibhav Lalwani, Madhumita Chakraborty,
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 Quality Investing in the Indian Stock Market

Structured Abstract:
Purpose: To explore whether stock selection strategies based on four fundamental quality
indicators can generate superior returns compared to overall market.

Design/methodology/approach: The sample of stocks comprises of the constituents of BSE-500

index, which is a broad based index consisting of highly liquid stocks from all 20 major
industries of the Indian economy. Portfolios are constructed on the basis of quality indicator
rankings of companies and the returns of these portfolios are compared with the overall market.
Excess returns on quality based portfolios are also determined using OLS regressions of quality
portfolio returns on market, size, value and momentum factor returns.
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Findings: The results suggest that two of the four quality strategies, namely Grantham quality
indicator and Gross profitability have generated superior returns after controlling for market
returns as well as common anomalies such as size, value and momentum. Combining value
strategies with quality strategies do not yield any significant gains relative to quality only
strategies.

Practical Implications: For investors looking to invest in the Indian stock market for a long
term, this study provides evidence on the performance of some fundamental indicators that can
help predict long run stock performance. The findings suggest that investors can distinguish
between high performing and low performing stocks based on stock quality indicators.

Originality/Value: This is the first such study to look into the performance of quality investing
in the Indian stock market. As most quality investing studies have been focused on developed
economies, this paper provides out-of-sample evidence for quality investing in the context of an
emerging market.

Keywords: Quality Investing, Indian stock market, investment strategies, fundamental

indicators, stock selection
 1. Introduction

As opposed to strategies such as value, growth and momentum etc., there is no generally

agreeable definition of quality in the context of stocks. However, the intuition behind quality is

simple: high quality stocks should deliver better returns than low quality stocks. Thus the

objective of quality investing is to separate high performing stock from low performing stocks

using pre-defined metrics of quality. The quality problem dates far back to the 1930s when

Benjamin Graham, considered the father of value investing, was one of the first to recognize

quality characteristics in equity stocks. Graham categorised stocks as either high quality or low
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quality. He also recognised the benefits of buying quality over buying cheap (value). Novy-Marx

(2014) argues on similar lines to suggest that quality investing is dissimilar to value investing in

the sense that quality investing is akin to buying high quality assets at fair prices while value

investing deals with buying average quality assets at discounted prices.

Further difference between value and quality strategy is highlighted in Piotroski (2000). He

claims that the empirical performance of high book to market (value) strategy is mainly due to

strong performance of very few firms. It is documented that less than 44% of all High B/M firms

earn positive risk-adjusted returns in two years following portfolio formation. Given such a wide

dispersion among returns achieved by firms in the value portfolio, the question arises whether

other fundamental indicators can help in discriminating between strong and weak companies

within such a portfolio. Quality investing tries to such questions.

Quality investing lies in the domain of bottom-up investing. The “bottom-up” approach to active

investing assumes that numerous pricing inefficiencies (also called anomalies) exist in the capital

markets. Bottom-up investors search through statistics of an entire set of available stocks with no

initial focus on the economy and create portfolios based on these statistics (financial

metrics/ratios). Some of the commonly examined ratios include the price-to-earnings (PE), price-
 to-book (PB), earnings yield (EY), Cyclical adjusted P/E (CAPE), and earnings growth yield

(EGY) etc.

Some other popular measures of quality are discussed below. These measures differ in their final

outcomes but the basic idea remains same: Identify stocks with high profitability, low leverage

and/or low earnings volatility.

Some of the popular measures of quality are:

• Magic Formula: This metric as a measure of quality has been made popular by Greenblatt
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(2006) in his “Little book that beats the market”. Magic formula investing involves

ranking firms on the basis of return on invested capital (ROIC) and earnings yield (EY),

respectively, and only buying stocks with the highest combined ranks.

• Piotroski’s F-score: The F-score was developed by Piotroski (2000) and is constructed by

summing nine binary variables taking values of 0 or 1. Four of the employed variables

are designed to capture profitability, three to capture liquidity, and two to capture

operating efficiency. Each component takes on the value zero, indicating weakness, or

one, indicating strength. The value of the F-score thus ranges from zero to nine, with

higher numbers indicating stronger financial performance (or quality).

• Gross profitability: Novy-Marx (2013) shows that a simple quality metric, gross profits-

to-assets, has roughly as much power predicting the relative performance of different

stocks as tried-and-true value measures like book-to-price.

• Grantham’s quality score: This score is calculated by averaging the ranks of companies

based on three measures i.e. returns-on-equity, asset-to-book equity, and the inverse of

ROE volatility. ROE is net income-to-book equity. ROE volatility is the standard

deviation of ROE over the preceding five years. The objective of this score is to capture
 companies with high profitability, low leverage and stable earnings. The development of

this measure is attributed to Grantham, Mayo, Van Otterloo & Co. LLC (US).

Non-financial Measures of quality: -

Qualitative analysis of a firm usually involves in-depth study of a firm’s business model,

products or services, market positioning, corporate governance, customer satisfaction, market

share etc. Critics of traditional (financial) measures argue that drivers of success in many

industries are “intangible assets” such as intellectual capital, rather than the “hard assets” on

balance sheets. Also, qualitative indicators are much closely linked to a firm’s long term
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strategy. As per Ittner and Larcker (1998), non-financial measures can actually help in predicting

future financial performance. Despite the difficulty in quantifying non-financial quality

measures, there are multiple indicators that have been developed. Some of them are

Sustainalytics environment score, Fortune best places to work, CR magazine’s top 100 corporate

citizens list, percentage of women on board, and % of independent directors etc.

In this study, we test the performance of 4 financial quality indicators in the Indian stock market

for the period 2001 – 2015. The choice of quality indicators is inspired from Novy-Marx (2014)

who analyses 7 quality strategies. Due to lack of available data, we do not test Graham’s G-score

and Earnings quality strategies. We also exclude defensive equity strategy tested by Novy-Marx

(2014) as we are limiting our study to quality indicators that are based on company

fundamentals. This leaves us with a total of four quality indicators, namely Grantham quality,

Piotroski F-score, Magic Formula and Gross Profitability. Our results show that portfolios based

on Grantham quality indicator and Gross Profitability have shown superior overall performance

as compared to benchmark market portfolio.

 2. Literature Review

A large body of finance literature has documented that investors can benefit from trading on

various signals of financial performance. These strategies include, but are not limited to, post–

earnings announcement drift (Bernard and Thomas, 1989), low beta (Black, Jensen, and Scholes,

1972), accruals (Sloan, 1996), and seasoned equity offerings (Loughran and Ritter, 1995). Lev

and Thiagarajan (1993) used 12 financial signals they claimed to be useful to financial analysts

and showed that these signals are correlated with stock returns. Abarbanell and Bushee (1997)

suggest that an investment strategy based on these 12 fundamental signals yields significant
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abnormal returns.

Novy-Marx (2014) empirically tests the performance of 7 quality strategies, namely Graham

Quality, Grantham Quality, Sloan’s Accruals, Piotroski’s F-score, Defensive equity, Magic

Formula and Gross Profitability in the US stock market for a period covering July 1963 to

December 2013. The results imply that quality measures appear to have some power in

predicting returns, especially when combined with value strategy. Only gross profitability,

however, generates significant excess returns as a stand-alone strategy, and has the largest Fama

and French (1993) three-factor alpha, especially among large cap stocks. Gross profitability also

incorporates most of the power of the other quality measures.

In further tests of efficacy of quality investing, Hanson and Dhanuka (2015) show that the P/E

value factor is effective, but among the financial quality factors only ROIC generates statistically

significant alphas in the US stock market. According to them, the most plausible explanation of

these findings is that the explanatory value of financial quality metrics as a returns strategy has

been arbitraged away. In addition to using financial indicators, they also examine whether non-

financial indicators of quality such as corporate culture, Environmental-Social-Governance

 (ESG) or “sustainability” practices can be used to predict either superior operating or market

performance. As per their analysis, Bloomberg governance disclosure scores, and the Percentage

(%) of Independent Directors on Board are significant variables in explaining ROIC, thus

making them effective signals of firm quality.

On similar lines, Edmans (2010) analysed the relationship between employee satisfaction and

long-run stock returns. He reported that a portfolio of the ‘‘100 Best Companies to Work For in

America’’ earned an annual four-factor alpha of 3.5 per cent from 1984 to 2009. Becchetti and

Ciciretti (2009) analysed the performance of a large sample of Socially Responsible (SR) stocks
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relative to a Control Sample (CS) of equivalent size for 14 years. Their results indicate no

significant differences in risk-adjusted returns between the two buy-and-hold strategies.

However, individual SR stocks are found to be less risky when controlling for conditional

heteroscedasticity.

To study the attractiveness of quality investing to institutional investors, Gallagher et al. (2014a)

investigates how the quality of stocks owned by mutual funds affects the performance of those

funds during 2000–2009. Their findings indicate that quality of a stock is positively related to

size and inversely related to volatility. Stocks in the lowest quality decile perform particularly

poorly amidst volatile market conditions with a mean monthly Daniel, Grinblatt, Titman and

Wermers (DGTW) alpha 1.93 per cent less than high-quality stocks.

Furthermore, funds which hold the lowest quality stocks exhibit substantial underperformance,

particularly during market downturns, with funds in the highest decile of quality generating a

mean annual DGTW alpha 12.14 per cent higher than their low quality counterparts. They

discover a trend to funds investing in higher quality stocks over time.

Gallagher et al. (2014b) also extended the US study to Australian markets. In Australian market,

average DGTW-alpha for the top quality tercile of small stocks is 14.02 per cent. Positive
 DGTW-alphas are also reported for quality micro and large stocks. The quality analysis was also

applied to a sample of Equity Mutual Funds’ stock holdings. Weak evidence of quality premium

was reported in Fund returns.

Zaremba (2015, 2016) extends the concept of quality to country-level (as opposed to stock level)

selection. His reported findings can be summarized as follows:

First, the markets with low-leveraged companies outperform highly leveraged markets.

Additional sorts on profitability and leverage significantly improved the performance of cross-

national value strategies. The findings in Zaremba (2016) suggest that the inter-market variation
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in returns may be explained with profitability and debt ratios: the more profitable and the less

indebted is the stock market, the better is its performance. Furthermore, the performance of

country-level value, size and momentum strategies may be improved by additional sorting on

quality parameters.

Finally, Asness et al. (2013) utilise a quality-minus-junk (QMJ) portfolio mimicking factor that

goes long high-quality stocks and shorts low-quality stocks and show that this factor earns

significant risk-adjusted returns in the U.S. and globally across 24 countries. In their results,

controlling for quality also resurrects the insignificant size effect.

The literature related to quality investing is immense and there is substantial evidence regarding

the effectiveness of quality investing strategies. However, the studies are largely restricted to

U.S. and other developed stock markets. These strategies may or may not work in an emerging

market like India. Given that there is no current empirical analysis regarding performance of

quality investing in such a market, our study fills this research gap by providing a test of

suitability of quality investing strategies in the Indian stock market. According to data from

world federation of exchanges, India is the 10th largest stock market in the world as per market

capitalisation. A recent report by credit rating agency ICRA suggests that India is likely to attract
 USD 15-20 billion in FII Inflows during 2017-2018. Given the current and future expected level

of economic growth and foreign capital inflows in Indian stock market, this study will appeal to

present and prospective investors in Indian stocks. Understanding the impact of quality on stock

returns can help long-term investors in making better investment decisions.

3. Data and Methodology:

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To represent the Indian stock market, stocks which are constituents of the BSE -500 index from

2001 to 2016 are considered in our sample. BSE-500 is a broad-based index that represents

nearly 93 per cent of market capitalisation on the Bombay Stock Exchange and cover about 20

industries. Thus, this index can be considered to be adequately representative of the Indian stock

market. Also, as a large number of listed stocks in India are thinly traded, taking BSE-500 stocks

allows us to pick the most liquid stocks in the market for our study. Stocks belonging only to

non-financial companies are considered as some of the accounting ratios used in quality

indicators are not meaningful in the context of financial companies. We also remove firms that

don’t have their financial year ending in March. As the portfolios are created on 01st October of

every year, taking only March ending companies ensures that the accounting data would have

been available to a real-time investor while creating the portfolio. Nonetheless, more than 80%

companies in our sample have their financial year ending in March and removing other firms is

not likely to have significant impact on overall results. The data for index constituents, stock

returns (including dividend) and financial statements of companies is taken from the Prowess

database of CMIE. The data on 91-day Treasury bill rate is taken from Economic and Political

Weekly’s time series database. All the returns are denominated in Indian rupees and the risk free

rate pertains to treasury bills issued by Government of India.

 The time period covered under the study is from 1st October 2001 to 30th September 2016.

Portfolios are constructed on 1st October of each year after ranking firms on the 4 discussed

metrics of quality using recent annual financial data. Following Harshita, Singh and Yadav

(2015), it is assumed that all companies release their annual reports within 6 months of the end

of financial year. Only stocks which were a part of BSE-500 as on the date of portfolio formation

are considered. For Grantham quality indicator, Gross Profitability and Magic Formula, a long

only portfolio of top 30% stocks as per quality ranking is created. For piotroski’s F-score, only

those firms with a score of 7 or more make the cut. Detailed description of calculation of quality
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indicators in given in Appendix A. The created portfolios are equally weighted and rebalanced

annually on 1st October each year based on new quality rankings based on current year financial

data. Thus, we have a total of 15 annual portfolios for each strategy.

The data for stock returns is collected from Prowess Database on a daily basis. The return for ith

day is calculated as:

 +  − ,

 =


Where Rit is one day return for stock i for day t. Dit is the dividend paid (if any) and Pit is the

stock price on day t. Returns for periods more than one day (say, a month or an year) are

calculated by compounding the daily returns in the following manner:

 = 1 +
  ∗ 1 +
,  ∗ … . . 1 +
,  − 1

Where n is the no. of trading days that lie in the period for which returns are to be calculated.

The performance of portfolios based on quality strategies are compared with a passive

benchmark i.e. an equally weighted portfolio of all stocks taken in the sample. The returns are

also analysed by comparing the alpha of the portfolio after regressing the portfolio returns

against the Fama French Carhart 4 factors. The reason behind using the 4-factor model is that
 many well-known profitable trading strategies are really just different expressions of three basic

underlying anomalies (size, value and momentum), mixed in various proportions and dressed up

in different guises. As noted by Novy-Marx (2013), a multi factor model employing the value,

momentum and size factors performs remarkably well pricing a wide range of observed asset

pricing anomalies. We would like to know if the quality investing strategies generate excess

returns after controlling for the returns that an investor could have generated by trading on these

3 basic anomalies.

The key takeaway is that for a quality investing strategy to make sense, the returns generated by
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that strategy should generate alpha when tested against this four factor model (as opposed to

CAPM). The monthly values of 4 factors have been calculated for the sampled stocks using the

methodology given in Fama and French (1993, 2012). For testing the 4 factor alpha, we run OLS

regressions of the form:

 −
 = ∝ +  
 −
  +   +  ! + " #! + $

We have also tested for CAPM alpha, wherein the returns are regressed only on the market risk

premium factor. To avoid potential biases in inferences due to heteroscedasticity and

autocorrelation in the error terms, t-statistics are calculated using Newey-west Heteroscedasticity

and autocorrelation (HAC) adjusted standard errors.

 4. Results and Findings

In a span of 15 years (2001 – 2015), portfolio based on Grantham quality indicators

outperformed the market portfolio for 11 years. Other strategies like Magic Formula, Piotroski F-

score and Gross Profitability outperformed the market for 7, 8 and 8 years respectively. Table 1

shows the annual excess returns of the 4 quality strategies along-with the market excess returns.

Excess returns are calculated after subtracting 91-day T-bill rate for the corresponding period

from the actual portfolio returns. Annual returns are calculated by compounding daily returns.

Table 1 shows the annual excess returns generated by each of the 4 strategies and the market
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portfolio for the study period.

[Insert Table 1 here]

 As per findings in table 1, average annual outperformance of Grantham over market portfolio is

4.34 per cent per annum. Magic formula strategy has on average underperformed the market by

.82 per cent per annum while Piotroski and Gross Profitability have an average outperformance

2.20 per cent and 4.38 per cent per annum.

On basis of cumulative performance over 15 years, Grantham and Gross Profitability have come

out to be the best strategies while Magic Formula has turned out to be the worst. It should be

noted that Grantham indicator was leading all strategies for about 13 years out of 15. It is only

the recent performance of the gross profitability strategy that has placed it at par with the
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Grantham indicators.

When evaluating portfolio performance, risk characteristics should also be considered alongside

returns to get a complete picture of performance. Table 2 highlights the annualised Sharpe ratio

of all portfolios for the period 2001 to 2015. If we consider annual Sharpe ratio instead of just

returns, then Grantham quality indicator has achieved superior Sharpe ratio for 12 years when

compared to Sharpe ratio of market portfolio. Magic formula has better Sharpe ratio for 9 out of

15 years while F-score and Gross profitability have outperformed on the basis of Sharpe ratios

for 10 years.

The average Sharpe ratio generated by Grantham is 14.72 per cent higher than that of market

portfolio. Similarly excess Sharpe ratio for Magic Formula, Piotroski and Gross Profitability

strategies is 8.70, 14.98 and 8.59 per cent respectively.

Table 3 shows the correlations between monthly returns of the four quality portfolios and market

portfolio. The linear correlation among all 5 strategies is significantly positive, which suggests

that merging multiple quality strategies with each other is unlikely to improve risk adjusted

performance of these portfolios.

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[Insert Table 2 on this page]

 [Insert Table 3 here]

Apart from Sharpe ratio, performance of quality portfolios has also been measured by regressing

the monthly portfolios returns on market portfolio (CAPM factor) as well as on Fama French
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Carhart 4 factors based on size, value and momentum. The alpha, or the intercept obtained from

these regressions gives an indication of superiority of portfolio performance.

The obtained coefficients of the alpha of quality strategies as per CAPM and 4-factor analysis

are shown in table 4 along with the factor loadings of the quality portfolios on the size, value and

momentum factors. The broad inferences from both CAPM and 4 factor model alphas are

identical.

As per CAPM, only Gross Profitability and Grantham quality indicator have outperformed the

market. Gross profitability has an alpha of about .51% while Grantham has alpha .38% per

month. The results are similar for the 4-factor alpha. The Gross Profitability strategy has a

monthly alpha of.42% with a t-stat of 3.18 while Grantham alpha is .28% with t-stat of 2.44. So,

as per this analysis, it can be concluded that Gross Profitability has the best performance of the 4

quality strategies followed closely by the Grantham Quality strategy. Piotroski has a positive

alpha but it is not statistically significant whereas Magic Formula has a negative alpha.

[Insert Table 4 here]

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It is observed that Gross Profitability strategy’s relative performance has improved when

compared with Grantham quality’s performance. The reason for this could be that the Grantham

quality indicator is taking a significant loading on the momentum factor. A positive loading on

the momentum factor suggests that the Grantham quality portfolios are taking a long position in

momentum portfolios themselves. Some of the returns generated by Grantham strategy are

subsumed in the momentum strategy’s returns. Thus, after controlling for returns attributable due

to momentum factor returns, the excess returns from Grantham quality indicator are reduced. As

per results in table 4, Gross Profitability is the best quality strategy followed closely by

Grantham quality.

4.1 Sub-Period Analysis

To get a better idea of persistence of performance of quality investing strategies, the total study

period is divided into three 5-year periods consisting of years 2001 – 2005, 2006 - 2010 and

2011 – 2015 and the performance of quality strategies is measured across these 3 periods. This

division is done in order to test the authenticity of results obtained. It is possible that very high

(or low) performance of an indicator in one period may affect its overall results. This makes it
 necessary to test for robustness across time periods. Table 5 shows the Compounded annual

average excess returns of 4 quality and a market portfolio for three five-year sub-periods.

[Insert Table 5 here]

As per the sub-period results, only Grantham quality indicator strategy has consistently
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outperformed the market benchmark whereas Magic Formula’s underperformance has persisted.

Piotroski and Gross Profitability have generated returns lower than benchmark for the 1st 5 year

period. However, interestingly this trend is completely reversed in the later years. Both the

strategies have marginally outperformed the benchmark in the period 2006 – 2010 whereas in the

2011-2015 period, they have outperformed all other strategies, including benchmark, by a huge

margin. As per the results in table 5, Grantham quality based strategies have a significant

outperformance during a boom period as characterised by high overall market returns. We

believe that the reason for this outperformance lies is the significant loading of Grantham quality

portfolio on the momentum factor as seen in the 4-factor regressions. Cooper, Gutierrez Jr., and

Hameed (2004) and Hanauer (2014) find that momentum strategy yields positive returns

following periods of positive returns and negative returns following negative market returns.

Thus, the significant loading on momentum has possibly caused Grantham quality portfolio to

have higher returns during a bull market. The Gross Profitability strategy, on the other hand

seems to do well in times of poor market performance. During times of financial turmoil,

investors have displayed affinity to sell high risk assets in exchange for low risk assets. This

phenomenon is known as flight to quality in financial parlance. As we can observe in table 4,

Gross profitability strategy has a negative loading on size and value factors. These stocks are
 considered riskier and often fall during bearish periods as a result of flight to quality. A negative

loading on such stocks implies that the strategy will gain when these stocks fall. Thus, we

observe a jump in returns of Gross Profitability portfolio during bearish market condition.

CAPM and 4-factor analysis for the sub-periods echo similar inferences about the performance

of quality investing strategies. Table 6 gives the estimates of CAPM and 4-factor Alpha of

quality strategies along with the loadings of the quality portfolios on market, size, and value and

momentum factor in 4-factor regressions.

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[Insert Table 6 on this page]

 For the First two 5-year periods, only Grantham quality strategy has generated a positive and

significant 4-factor alpha (.54 and .44 per cent respectively). In the latest sub-period, Grantham

quality has a negative, albeit statistically insignificant alpha. Gross profitability has positive

alpha for all three sub-periods but it is only significant in the 2011-2015 where this strategy has a

0.89 per cent monthly alpha with t-statistic of 6.89. This evidence raises a question. Given the

variation in performance of quality strategies over time, will the returns from these quality

investing strategies persist in the future? Only a long period of out of sample evidence can
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satisfactorily answer this question. Still, if the current evidence is to be believed, we suggest that

the variation in performance is due to market conditions rather than declining usefulness of

quality indicators.

Grantham quality indicator has significant loadings on the momentum factor in all three sub-

periods. This observation suggests a possible future research question: Can fundamental based

indicators such as Grantham quality explain momentum returns? Novy-Marx (2015) is one such

study which claims that momentum is driven by momentum in fundamentals rather than in prices

themselves.

4.2 Combining Quality with Value

Piotroski (2002), Piotroski & So (2012) and Novy Marx (2013) have combined quality strategies

with value strategy in order to select stocks that score well on both quality and value dimension.

In this study, we have combined value and quality strategies by forming a 50:50 portfolio of

value (high book to market) with all the quality strategies. The performance metrics of these

strategies are shown in table 7 & 8.

 [Insert Table 7 here]

Our findings suggest that addition of value portfolio to the quality portfolio has diminished the

overall performance of quality strategy. The average annual outperformance of Grantham quality

portfolio has reduced to 3.34 per cent after combining with value. Magic formula’s
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outperformance frequency is 40 per cent although the annual average outperformance has

improved to .97 per cent. On the other hand Gross Profitability has outperformed the market 10

times but the magnitude of outperformance has fallen to 2.21 per cent.

As shown in table 8, combined value and quality strategy has generated superior Sharpe ratios

for the Grantham and Gross Profitability Strategies being gross profitability based strategy

having superior Sharpe ratio for 11 out of 15 years.

To compare the performance of quality-value portfolios with their quality only counterparts,

spanning tests similar to those in Novy-Marx (2014) are conducted to determine whether

combining value with quality generates any incremental alpha for the quality strategy. Returns

from a test strategy, based on quality and value are regressed on the Fama French 4 factors as

well as returns from an explanatory strategy, based on quality indicator only. For e.g. a spanning

test for Grantham indicator would be conducted by running the following regression:

,%&' '( =

∝ +  
 −
  +   +  ! + " #! +
,%&' '

+ $
 A positive (and significant) alpha obtained from this regression would suggest that an investor

trading on quality only strategy can gain by adding value portfolio in her strategy. The results of

these spanning tests are illustrated in table 9.

Negative and insignificant alpha obtained from spanning tests indicate that investors trading on

quality only strategy wouldn’t have gained from shifting to a quality-value combined strategy.

So, there is no significant gain from shifting a 100 per cent quality strategy to a 50:50 mix of

quality and value. This is because the total excess returns of value strategy over the 15 year

period stand at 634 per cent. Relatively, this return is lower than the worst performing quality
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strategy Magic Formula which generated a total return of 685 per cent. The worst performing

quality indicator has a better performance than value indicator as defined by book-to-market

ratio. In such a case, the approach of adding value portfolios in the quality portfolios is unlikely

to yield significant gains. Interpreted another way, these findings point out that value strategies

can be improved by trading on quality however their combined performance is still nonetheless

inferior to quality only strategies. The evidence of underperformance of high B/M stocks in India

is also provided by Kumar & Sehgal (2004). Hou, Karolyi and Kho (2011) also report that High

B/M stocks generate lower returns than the market portfolio for Indian stocks. There could be

many possible reasons for the failure of value investing in our study. One reason could be that

book to market ratio as a proxy for value doesn’t deliver returns. Though out of scope for our

study, one could consider combining quality with value strategies based on other indicators such

as Price-to-earnings or Cash flow-to-price. Another possible reason is highlighted in a report by

Ambit Capital titled “Can ‘value’ investors make money in India?” (2015). Findings of the report

suggest that value firms underperform in India because of poor earnings growth, excessive

leverage and poor accounting quality (low forensic accounting scores).

[Insert Table 8 here]

 [Insert Table 9 here]

To summarise, there is evidence of superior performance of Grantham quality and Gross

Profitability based portfolio strategies for the overall period of study, however given the returns
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generated by the Grantham strategy in the most recent 5 year period, its past performance may

not be replicated in future.

The results are somewhat similar to Novy-Marx (2014) who finds Grantham and Gross

Profitability to be the best performing quality strategies after conducting spanning tests

comparing 7 quality strategies head to head. Combining quality strategies with value doesn’t

seem to be improving the overall performance of quality strategies. Our results are contrary to

Hanson and Dhanuka (2015) who find that returns for Grantham quality and gross profitability

have diminished or arbitraged away in the U.S. stock market. Mclean and Pontiff (2016) study

the performance of a gamut of anomalies and report that returns from these anomalies fell about

58% in the post-publication period. The reason for superior performance of Grantham quality

and Gross profitability in India could be tied to the fact that the superior performance of these

measures has not been reported in published literature on Indian stock markets. Once the

superior performance of these strategies is reported in India, the returns may diminish there as

well.
 The overall conclusion has positive implications for investing based on quality. Thus, further

measures of quality such as in Asness et al (2014) should be explored so as to arrive at a

consistent definition of quality for the entire cross section of stocks.

4 Conclusion

The idea behind quality investing is to be able to differentiate future winner stocks from loser

stocks. However, the question still remains: What constitutes quality? There are multiple metrics

that pass on as measures of quality. This study aims to test the performance of 4 quality
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indicators in the Indian stock market from 2001 to 2015. Portfolios are formed based on the

ranking obtained from these indicators and the performance of these portfolios are compared

with a market benchmark. For the full 15 year period, Grantham quality indicator and gross

profitability have generated significant excess returns. These returns are robust to size, value and

momentum factors as the 4-factor alpha of both strategies is significant. Of all the 4 strategies

tested, Magic Formula has performed the worst, with an average underperformance of 0.37%

p.a. compared to the market portfolio. Despite being the best performing strategy overall,

Grantham’s relative performance in the recent 5-year period has declined when compared to

gross profitability based strategy. This suggests that the strategy may not yield superior returns in

the future. While only out-of-sample testing can provide sufficient evidence to confront this

apprehension, evidence from factor loadings in 4-factor regressions seem to suggest that the

Grantham strategy performs well in bull markets while the gross profitability strategy performs

well in bear markets. So, the poor performance of Grantham strategy in the later period might be

only because of poor overall market performance rather than declining usefulness of the strategy.

Following Novy-Marx (2013, 2014), we test if combining value with quality strategy yields

improvement in overall investment performance. We don’t find any evidence of improvement in

 quality strategy’s performance by adding value stocks to the quality strategy portfolios. The

reason behind this observation is the poor overall performance of value investing strategy for the

stocks under study. Altogether, the cumulative wealth creation by quality strategies (especially

Grantham and Gross profitability) is significantly higher than the market as well as value

portfolio. Future research can further build on this study to refine the definition of quality by

including other financial as well as non-financial indicators and identify the most appropriate

quality indicator which can explain the cross section of stock returns.
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 Appendix: Calculation of Quality Indicators

1. Grantham Quality Indicators: The ranking of grantham quality is generated by averaging

the ranks of 3 indicators, namely ROE, Asset/Net Worth and ROE Volatility. ROE is

calculated as Profit after tax divided by Net Worth. ROE volatility is the standard

deviation of ROE in the last 5 years (including current year).

2. Magic Formula: Following Greenblatt (2005), Magic formula ranking is the combined

ranking based on two financial ratios, Return on invested capital (ROIC) and Earnings

Yield (EY). ROIC is calculated as EBIT / Tangible Assets. In our case, EBIT is
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calculated as Profit after tax + Financial Service expenses + Provision for direct tax.

Tangible assets are calculated as sum of Plant & machinery, computers and electrical

assets, Land and buildings, Transport & communication equipment and infrastructure,

Furniture, social amenities and other fixed assets, Current assets less Current liabilities.

Earnings yield is EBIT divided by Enterprise Value.

3. Piotroski F score is based on combined score on nine binary variables which can take

values of 0 & 1. For detailed methodology, see Piotroski (2000).

4. Gross Profitability: Gross Profitability indicator is calculated as Sales – Cost of goods

sold scaled by average total assets i.e. Average of opening and closing value of total

assets.
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 Table 1: Annual excess returns of quality based portfolios and market portfolio
Year Grantham Magic Formula Piotroski GP Rm-Rf

2001 53.95% 60.19% 57.54% 48.85% 54.41%

2002 76.83% 57.60% 64.50% 54.89% 65.37%

2003 60.22% 48.06% 44.63% 41.29% 52.78%

2004 91.72% 78.26% 64.86% 59.74% 81.66%

2005 19.01% 7.73% 12.46% 19.66% 13.32%

2006 47.19% 28.50% 35.28% 21.22% 34.01%

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2007 -33.93% -38.26% -39.84% -39.52% -37.60%

2008 44.34% 54.45% 36.20% 49.64% 40.67%

2009 25.25% 19.06% 24.74% 32.97% 18.82%

2010 -26.89% -32.48% -30.75% -21.55% -33.38%

2011 -8.18% -9.35% -0.43% 10.90% -3.84%

2012 -27.82% -32.33% -14.96% -9.32% -27.92%

2013 60.97% 74.03% 75.44% 69.83% 64.03%

2014 0.70% -7.99% 4.83% 12.00% -8.27%

2015 10.66% 13.09% 11.97% 12.00% 12.05%

CAGR 19.89% 14.73% 17.75% 19.93% 15.55%

Notes: CAGR refers to Compounded annual growth rate calculated as geometric average of the 15 annual
returns. Annual returns are calculated by compounding monthly excess returns of the equally weighted quality
and market portfolios. Returns corresponding to year 2001 refer to returns of portfolio from 01st October 2001 to
30th September 2002.
 Table 2: Annual Sharpe Ratio of quality based portfolios and market portfolio

Year Grantham Magic Formula Piotroski GP Rm-Rf

2001 1.85 1.75 1.85 1.75 1.61

2002 2.84 1.98 2.28 1.87 1.93

2003 1.61 1.24 1.11 1.25 1.33

2004 4.99 4.32 3.45 3.38 4.25

2005 0.61 0.26 0.41 0.68 0.45

2006 2.39 1.51 1.93 1.22 1.80

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2007 -0.77 -0.91 -0.91 -1.01 -0.83

2008 0.65 0.69 0.55 0.83 0.54

2009 1.53 1.01 1.48 2.06 0.99

2010 -1.37 -1.57 -1.60 -1.28 -1.60

2011 -0.30 -0.29 -0.02 0.54 -0.13

2012 -1.54 -1.67 -0.91 -0.70 -1.51

2013 2.64 3.18 4.36 5.10 2.77

2014 0.07 -0.68 0.53 1.08 -0.73

2015 0.55 0.63 0.56 0.68 0.55

Average 1.05 0.76 1.00 1.16 0.76

Notes: annualised Sharpe ratio is calculated as

      −     

.   =

    ℎ    − ℎ       ∗ √12
 Table 3: Correlation among monthly returns of quality based portfolios and market portfolio

Rm-Rf Grantham Magic Formula Piotroski GP

Rm-Rf 1.000

Grantham 0.989 1.000

Magic Formula 0.987 0.977 1.000

Piotroski 0.981 0.979 0.974 1.000

GP 0.971 0.966 0.970 0.975 1.000

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Table 4: CAPM and 4-factor Alpha along with factor loadings of quality strategies.

2001 - 2015 CAPM - α R2 - CAPM α Rm-Rf SMB HML WML R2-4Factor

Gross Profitability 0.005* 0.944 0.004* 0.881* -0.111* -0.233* 0.035 0.964

(2.84) (3.18) (46.13) (-2.9) (-6.12) (0.87)

Grantham Quality 0.004* 0.977 0.003* 0.953* -0.084* -0.017 0.110* 0.981

(3.3) (2.44) (69.79) (-2.37) (-0.54) (3.42)

Magic Formula 0.000 0.974 0.000 0.996* -0.124 -0.031 -0.148* 0.978

(-0.41) (0.21) (47.35) (-1.53) (-0.62) (-4.54)

Piotroski F-score 0.003 0.962 0.002 0.969* -0.127* -0.169* 0.063 0.973

(1.78) (1.22) (73.91) (-3.41) (-6.54) (1.84)

Notes: Figures in bracket are HAC consistent Newey west t-statistics of the estimated coefficient. * denotes significant values at 5% level of significance.
 Table 5: Annualised average excess returns of quality strategies for 3 sub-periods

Year Range Grantham Magic Piotroski GP Rm-Rf

Formula

2001 - 2005 58.34% 48.32% 47.36% 44.16% 51.69%

2006 - 2010 5.15% -0.30% -0.86% 2.73% -1.42%

2011 - 2015 3.52% 2.12% 11.76% 16.46% 3.16%

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Table 6: CAPM and 4-factor Alpha of quality strategies for three 5-year sub-periods.
Quality Indicator CAPM - α R2-CAPM α Rm-Rf SMB HML WML R2-4Factor

Panel A: 2001 - 2005

Gross Profitability 0.0009 0.943 0.0005 0.9064* -0.1691* -0.1806* -0.0050 0.964

(0.4) (0.26) (25.58) (-2.99) (-2.3) (-0.08)

Grantham Quality 0.0071* 0.960 0.0054* 0.9075* -0.0533 -0.0118 0.1933* 0.968

(2.9) (2.22) (35.99) (-0.81) (-0.16) (3.34)

Magic Formula 0.0002 0.945 0.0002 0.9902* -0.1902 -0.1100 -0.0555 0.955

(0.13) (0.06) (28.89) (-1.93) (-1.45) (-0.37)

Piotroski F-score -0.0001 0.956 -0.0010 0.9861* -0.1485* -0.1527* 0.0656 0.970

(-0.03) (-0.46) (43.5) (-2.17) (-3.12) (0.82)

Panel B: 2006 - 2010

Gross Profitability 0.0024 0.968 0.0020 0.8570* -0.1025 -0.1224* 0.0360 0.971

(0.8) (0.72) (24.68) (-1.27) (-2.04) (0.59)

Grantham Quality 0.0049* 0.989 0.0044* 0.9649* -0.1051* -0.0439 0.0666* 0.991

(3.21) (3.72) (87.55) (-2.27) (-1.02) (3.67)

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Magic Formula 0.0011 0.988 0.0016 0.9748* -0.0220 0.0694 -0.1601* 0.992

(0.5) (0.93) (44.91) (-0.35) (1.79) (-4.17)

Piotroski F-score 0.0000 0.978 -0.0007 0.9608* -0.1667* -0.1655* 0.0397 0.984

(-0.02) (-0.39) (41) (-2.45) (-2.87) (1.07)

Panel C : 2011 - 2015

Gross Profitability 0.0107* 0.878 0.0089* 0.9595* -0.0632 -0.3760* 0.0433 0.970

(4.64) (6.89) (32.92) (-0.93) (-5.89) (0.49)

Grantham Quality 0.0004 0.967 -0.0012 0.9889* -0.1607* 0.0049 0.2063* 0.973

(0.22) (-0.64) (21.95) (-2.11) (0.11) (2.73)

Magic Formula -0.0008 0.983 0.0001 0.9588* 0.1130 0.0464 -0.0800 0.985

(-0.63) (0.11) (34.37) (1.61) (0.83) (-1.22)

Piotroski F-score 0.0070* 0.920 0.0059* 0.9957* -0.0396 -0.2186* 0.0354 0.943

(3.04) (2.62) (20.23) (-0.37) (-3.63) (0.49)

 Table 7: Annual Excess returns of value-quality combined portfolios

Year Grantham + V Magic Formula + V Piotroski + V GP + V Rm-Rf

2001 69.44% 73.31% 71.72% 67.44% 54.41%

2002 68.86% 59.27% 62.93% 57.91% 65.37%

2003 56.67% 50.58% 48.83% 47.13% 52.78%

2004 97.20% 90.16% 82.90% 80.08% 81.66%

2005 12.11% 6.65% 9.01% 12.48% 13.32%

2006 41.41% 32.07% 35.55% 28.37% 34.01%

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2007 -34.21% -36.40% -37.12% -36.95% -37.60%

2008 48.39% 52.97% 44.18% 51.58% 40.67%

2009 17.01% 14.03% 16.83% 20.66% 18.82%

2010 -34.08% -36.69% -35.85% -31.65% -33.38%

2011 -11.20% -11.94% -7.39% -1.96% -3.84%

2012 -35.69% -37.79% -30.05% -27.68% -27.92%

2013 76.45% 83.34% 84.62% 82.21% 64.03%

2014 -9.47% -13.52% -7.56% -4.40% -8.27%

2015 13.45% 14.66% 14.10% 14.15% 12.05%

CAGR 17.28% 14.66% 16.31% 17.50% 15.55%

Notes: “+V” after a Grantham refers to a 50:50 mix of Grantham quality portfolio and value portfolio. Same
follows for other columns.
 Table 8: Annual Sharpe Ratio of value-quality combined portfolios

Year Grantham + V Magic Formula + V Piotroski + V GP + V Rm-Rf

2001 1.77 1.82 1.83 1.81 1.61

2002 2.01 1.67 1.82 1.63 1.93

2003 1.51 1.33 1.25 1.33 1.33

2004 4.52 4.21 3.80 3.77 4.25

2005 0.40 0.22 0.30 0.43 0.45

2006 2.08 1.63 1.85 1.52 1.80

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2007 -0.72 -0.78 -0.78 -0.82 -0.83

2008 0.63 0.64 0.58 0.71 0.54

2009 0.84 0.66 0.84 1.05 0.99

2010 -1.52 -1.60 -1.62 -1.52 -1.60

2011 -0.31 -0.31 -0.21 -0.06 -0.13

2012 -1.62 -1.65 -1.43 -1.41 -1.51

2013 2.56 2.76 3.18 3.42 2.77

2014 -0.75 -1.01 -0.66 -0.36 -0.73

2015 0.62 0.65 0.62 0.67 0.55

Average 0.80 0.68 0.76 0.81 0.76

 Table 9: Alpha obtained from Spanning test regression for quality strategies.

Test Strategy Alpha t-stat

Gross Profitability + Value -0.0001 -0.373

Grantham Quality + Value -0.0003 -0.901

Magic Formula + Value -0.0002 -0.762

Piotroski + Value -0.0002 -0.632

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