>Low-risk, High-return Strategy (MORGAN STANLEY)

• Key Debate: We believe that Indian equities are likely to return positively in 2010. However, the rate of return is likely to slow over the 2009 levels In that context, stock picking is likely to be the key to portfolio returns. Are there some obvious candidates for an India portfolio?

• Stock picking is working: The influence of macro in determining the behavior of stocks best measured by the correlation of returns from individual stocks (market effect) with the market has been declining since its peak in May 2009. Conversely, the average relative volatility of the stocks in our coverage universe has risen from a decade low. This is growing evidence that stock picking is in vogue. The fall in market effect tells us that individual stocks are being influenced less by market performance-related factors and more by idiosyncratic or non-market performance-related issues. We expect this phenomena to continue for the rest of 2010.

• Trading beta may not be a panacea for making money…: With an upward biased market, one of the seemingly obvious ways to add portfolio performance would be to buy high beta stocks. However, high beta stocks come with high risk. Indeed, the work that we have done on our
coverage universe shows that low beta portfolios outperform the market over longer time frames. Why does this happen? We went back to 1994 using MS coverage as our data set. We constructed portfolios using the top and bottom quintile of beta. The portfolios are reset every month and we captured the equal-weighted 12-month forward returns of these two portfolios. The low beta portfolio has, on a cumulative basis, outperformed the high beta portfolio. Fundamentally this is because high beta stocks are implicitly stocks with a high hurdle rate and hence need a bigger cash flow surprise to perform whereas low beta portfolios have the opposite situation. Technically speaking, for a given beta, correlation with market returns could still be high (and hence relative volatility is lower) and hence it is not necessary for a low beta stock to underperform in a rising market. At market inflexion points, these portfolios tend to have extreme performance, i.e., when the market is turning from bearish to bullish the high beta portfolio outperforms low beta significantly and vice versa. However, in trending markets, the low beta portfolio does better most of the time. Of course, the practical difficulty with beta persists, which is that computed beta is backward looking and a constantly changing number and remains a challenge to beta-based portfolio construction.

• …but there is an interesting angle: We know that beta is a measure of systematic or market-related risks, i.e., risks that cannot be diversified away. Systematic risks are caused by socioeconomic and political events that affect the returns of all stocks, and beta is an estimate of how the returns from a stock will move relative to the return from the market. Mathematically speaking, beta is the product of the correlation of returns between a stock and the market and the relative volatility of the stock to the market. For a relative investor who is bullish, it could be argued that a low risk (and we take the liberty of equating volatility with risk here) is achieved in low volatility of the portfolio and, thus, low beta stocks with low relative volatility are the best options since they come with a higher return correlation. However, such stocks could fall/rise in line with or more than the market, and such a strategy could lead to outperformance even if it means lower volatility in portfolio performance. Hence, for bullish investors, within a low beta set, we think stocks with low relative volatility should be choices in the pursuit of better relative returns.

• Market Implications: Using our coverage universe and trailing 12M beta and its components, we derive a short list of stocks we believe could be outperformers in a rising market using the above logic (i.e., low beta and low relative volatility stocks).

To read the full report: INDIA STRATEGY