A solid investment strategy can make you a lot of money. One popular investment strategy is investing in low valuation stocks as they offer a higher margin of safety and can give higher risk-adjusted returns. We have back-tested an investment strategy that invests in select Nifty 50 stocks ranked on the basis of lowest valuations. The strategy has been back tested for September 2010 to September 2018.
The strategy is simple:
i) Take the EV/Ebitda of every Nifty 50 company as on 1st September of every year
ii) Rank the companies in terms of lowest to highest consolidated EV/EBITDA ratio (Lowest ratio gets rank 1 and so on)
iii) Remove companies with negative ratios
iv) Invest an equal amount in every stock
v) Hold for 1 year and then shuffle the portfolio
If 1st of September is a market holiday then we consider the next working day.
We tried out this strategy for portfolios with 5, 10, 15 and 20 stocks to see if diversification made any difference and we compared the returns with the total returns index (TRI) of the Nifty 50. The results are as follows:
As you can see, this investment strategy has worked the best when the portfolio has been invested in 20 stocks. The strategy has resulted in a loss when invested in just the top 5 stocks. The top 20 portfolio has had the lowest drawdown in terms of year-on-year returns.
However, the Nifty total returns index has out-performed even the top-20 strategy! What could be the reason?
- Misses on the top performing stocks like Bajaj Finance, HDFC bank
- Misses on companies with higher earnings growth
- Mostly consists of Oil market companies, public sector companies, etc
Therefore, this backtest shows that low valuation should not be the only reason to invest in a stock because the market is usually assigning a premium to stocks that deliver higher returns.
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