I’ve been fascinated by the world of algorithmic trading, portfolio selection and the general use of computers and technology to make trading and investment decisions. Of late, I’ve also been dabbling with markets, and while my stock picking has been fairly decent – there have been some huge lemons picked up along the way as well. So I wondered if there was a way to systematically invest and diversify away the risk using historical data and trends.

Of course, investing in a  good mutual fund through a Systematic Investment Plan (SIP) is a no-brainer and I believe the corner stone of every portfolio (especially if you do not have the time to micro-manage your portfolio) should start there. However, I also believe it’s possible to augment returns from mutual funds through investing in stocks directly or through derivatives.

Which brings me back to the fundamental question – is there a fairly “sound” system for getting into the stock market and exiting profitably? From the little I know about the field, most academic research has been done in the “value investing” school of thought i.e. investing in stocks that are trading at less than their intrinsic values.

So I decided to investigate this further by building a “paper” portfolio of value stocks. I chose Benjamin Graham’s Net Current Asset Value (NCAV) per share as the criterion to filter stocks.  The NCAV per share is calculated as per the formula below:
NCAV formula
What the NCAV per share effectively indicates, is a “realistic” cash value that may be available to the shareholder once all liabilities have been met.  Graham recommends buying stock that trades at approximately 67% or less of the NCAV per share. A study by the State University of New York has shown that investors could have earned an average return of 29.4% over a 20 year period, by picking stocks by this method and holding them for a year.
Once the filter criterion was decided on, I needed a universe of stocks to choose from. For the universe of stocks to choose from, I restricted myself to the stocks that compose the BSE SMALL CAP index (which also served as my benchmark). I then ran a series of scripts that I wrote in Ruby to pull the data needed to calculate NCAV from Yahoo Finance. Once I had all the data in a spreadsheet, I calculated the NCAV for all the stocks.
While Graham recommends only picking up stocks that trade at values significantly below their NCAV, I chose to go with stocks that were trading at prices that were at the NCAV or below it. Using this filter, I got a portfolio of about 17 stocks. The next step in my opinion should have been either of the following:

  • Use the Markowitz optimum portfolio theory and allocate a fixed amount of capital among the stocks chosen so as to minimize portfolio risk OR
  • Do further fundamental analysis (which most investment “gurus” recommend) and pick only those that are “fundamentally” strong

However, since I was pressed for time – I took the easy way out.

I just created a “paper” portfolio containing 100 shares of each stock. Slightly “unscientific” I know, but bear with me.
So with this small little NCAV portfolio – I began tracking the performance of the portfolio. And the results have been interesting, to say the least.

NCAV Portfolio Performance

NCAV Portfolio Performance

The portfolio has significantly outperformed the benchmark over the last month. The returns from the benchmark BSE SMALL CAP index have been about -2.14% while the portfolio has returned about +9.09%.
While I agree that the time period is probably a bit short for significant analysis, I think the results warrant further investigation. Over the next few months, I will actively monitor my little test portfolio and update this blog. Lets see how it goes.

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  1. amit says:

    Hey Nice analysis .. I can just hope to”I wrote in Ruby to pull the data needed to calculate NCAV from Yahoo” do this . Edeleweiss also has a nice site(free for everybody)where you can see ranking of companies which you can sort on some criteria like P/E or book value-market value .

  2. tarvinder says:

    hey, just had a few initial thoughts on the approach and also regarding when you update the performance next –

    if the idea of value investing is to select shares which have inherent ‘value’ that has not been priced in, and will eventually get priced in, then a one month time period is too short a time period to judge the method on, which you’ve rightly acknowledged.

    an important metric to note while judging the suitability of a trading system is to note the maximum drawdowns it encounters during its tenure. ending at a +9% returns for a month is impressive, but the portfolio also encountered about -7% peak drawdown, which suggests that the portfolio is quite volatile, and the acceptance of the trading system will hinge upon the personal risk appetite of the trader to accept that such interim drawdowns can reduce the initial invested capital to those levels.

    further, in your analysis you should note the deviations of returns of individual stocks from the mean returns of the portfolio. if a portfolio return of +9% is composed of one or two extremely positive outliers whereas the other 15 shares have performed only as good as the index, then some measure of skepticism creeps in to the theory that this method of stock selection can outperform the index.

    i have zero experience in investing with, or even thinking about value investing strategies. i have, however, been doing some short term trading based on quantitative technical analysis over the past few months, and by virtue of that have been delving into historical testing of trading methodologies using various softwares. (tradestation and amibroker, specifically)

    my biggest question is this – what would constitute enough evidence to form a belief that a particular method can be reasonably expected to give better than average market returns in indian markets over the next n-month time period?

  3. enygmatic says:

    Excellent Points Tarvinder !! Will soon update it with charts showing the individual stocks that compose the portfolio and their performance vis-a-vis the index and the portfolio. Prima facie it seems difficult to say if there are outliers that influence the upside being shown now, as there a few stocks at both ends of the extremes. However like you rightly pointed out one or two extremely positive outliers may be responsible, but I think picking such stocks is what is really needed to drive upside performance – otherwise you’d just be better off investing in an index fund.
    By the way, do share your experiences with technical trading (over email?). Would definitely be interested…