Do High Book-To-Market Stocks Offer Returns To Fundamental Analysis in Indi...

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Do High Book-to-Market Stocks Offer Returns to

Fundamental Analysis in India?
Navdeep Aggarwal
Mohit Gupta
The objective of this paper is to investigate if an accounting-based fundamental analysis strategy can help
investors earn excess returns on a portfolio of high book-to-market companies in India. The strategy we
adopt is based on Piotroski (2000) who identified 9 fundamental signals to form a composite score
(F_SCORE) capable of separating out ex-post winners from losers among high book-to-market companies
in the US stock market. However, it is not clear whether the results of such a strategy could be directly
applied to Indian stock markets,since there is evidence that market efficiency in India is at the most weak
form. Also, during the 1990s when trading and investments were mostly domestic, the markets experienced
scams like the Harshad Mehta scam. However, of late, India has been among the most favoured investment
destinations in the world. Using the F_SCORE framework from Piotroski (2000) but a different approach
to portfolio formation (for practical purposes) we find convincing evidence that a fundamental analysis
based investment strategy for high book-to-market companies can separate winners from eventual losers.
We show that portfolios with high F_SCORE (7 to 9) provide excellent returns far superior to market returns
and risk-adjusted returns. Portfolios with low F_SCORE (0 to 3) offer very poor returns and often
underperform the markets or required risk-adjusted returns. A value investor could shift distribution of
returns rightwards by investing only in high F_SCORE companies. Shorting low F_SCORE could further
enhance returns.
Keywords: High book-to-market stocks, fundamental analysis, Indian stock market
Introduction
Investment strategies based on book-to-market ratio have been investigated quite often in
finance and accounting literature. Since the work by Graham and Dodd (1934), investment
strategies that focused on buying stocks with low price-to-book (called value stocks) have
produced higher returns than strategies based on growth stocks. In fact, evidences show a
positive and relatively strong correlation between the book-to-market ratio of a firm and its
future stock performance. Many studies such as Rosenberg et al. (1984), Fama and French
(1992; 1993; 1996), Lakonishok et al. (1994), Piotroski (2000), and Lopes and Galdi (2007)
document the success of the high book-to-market strategy though the explanation about
value-based strategies outperforming growth-based strategies has still remained a controversy
(Doukas et al., 2002). For example, Fama and French (1992) attribute the book-to-market
effect to unobserved risk factors captured by this ratio, but Lakonishok et al. (1994) argue
in favor of mispricing.
Navdeep Aggarwal is Professor at the Department of Business Management, Punjab Agricultural University,
Ludhiana. E-mail: [email protected]
Mohit Gupta is Assistant Professor at the Department of Business Management, Punjab Agricultural
University, Ludhiana.
Decision, Vol. 36, No.2, August, 2009

Do High Book-to-Market Stocks Offer Returns to Fundamental Analysis in India? 156
It is well established in practice and literature that value stocks have outperformed growth
stocks. However, the practical problem that can potentially be faced by many investors is:
“Are all stocks, which are high in book-to-market ratio, value stocks1?” Piotroski (2000)
emphasizes that less than 44% of all high book-to-market companies2 earn positive market
adjusted returns in two years following the formation of the portfolio. Clearly, there is
something more than just the book-to-market ratio for a stock to be classified as value stock
and this very ‘something’ could help investors discriminate, ex ante, between eventual strong
and weak companies.
Mohanram (2005) argues that financial statement analysis attempts to separate ex-post winners
from losers on the basis of information from financial statements that is not correctly reflected
in stock prices. Piotroski (2000) applies financial statement analysis (accounting-based
fundamental analysis) on a broad portfolio of high book-to-market (HBM) American firms and
shows that investors can create a stronger value portfolio. He argues that such analysis is
especially effective in HBM firms for three reasons:
1. HBM firms are often ignored by market participants and are hardly followed by
analysts
2. HBM firms have limited access to most informal information dissemination channels;
therefore, published financial statements represent the most reliable and most accessible
source of information
3. HBM firms tend to be financially distressed, which causes their valuation to be primarily
based on published accounting information.
From a valuation perspective also value stocks are inherently more conducive to financial
statement analysis than growth stocks. Growth stock valuations are typically based on long-
term forecasts of sales and the resultant cash flows, where non-financial information plays a
vital role. Moreover, most of the predictability in growth stock returns appears to be momentum
driven (Asness, 1997). In contrast, the valuation of value stocks focuses on recent changes
in firm fundamentals (such as financial leverage, liquidity, profitability, and cash flows). The
assessment of these characteristics is most readily accomplished through a careful analysis
of financial statements.
As all the arguments presented above are universal in nature, accounting based fundamental
analysis, thus, should work well in any market, including emerging markets where market
efficiency tends to be lower and the amount of predictability of returns tends to be higher
(Coorey and Wickremsinghey, 2007; Harvey, 1995).
India, a strong emerging market, offers a unique opportunity to apply and test the profitability
of accounting based fundamental analysis. This is so because in the 1990s, when trading and
1
In this paper, the terms value stocks/ portfolio and high book-to-market stocks/ portfolio have been used
synonymously.
2
Though literature distinguishes the two, in this paper, the terms value stocks and value companies have
been used synonymously

investments were largely domestic only, the markets weathered financial scams like the Harshad
Mehta scam pointing towards the extremely poor efficiency in the market. Literature too has
established weak market efficiency in India (Gupta and Basu, 2007; Pandey, 2003). On the
other hand the country is a constituent of the BRIC nations and has attracted huge investments
and trading activity from the world. Whether domestic or foreign, the size of investments has
been swelling at a large rate. For example, from January 1999 to August 2008 the net FII
purchases stood at Rs. 217,282 crores in equities with total purchases of Rs. 2,555,981 crores
and net sales of Rs. 2,337,850 crores. During the same period mutual funds had net purchases
of Rs. 36,269 crores in equities with total purchases of Rs. 637,203 crores and net sales of Rs.
604,305 crores. Similarly, very hectic activity both by mutual funds and FIIs has been observed
in debt markets making India the biggest capital market in the region. Additionally, the number
of companies accessing global markets for raising capital through ADRs or GDRs or commercial
borrowings etc. has seen a rise at a frantic pace. This is not likely to happen if the markets were
still prone to scams. Amidst these conflicting scenarios of reportedly weak market efficiency
and strong investment inflows, one would wonder if an accounting based fundamental analysis
strategy would really help investors creating a portfolio of value stocks that could earn them
excess returns in the Indian capital market.
The results of our study suggest that accounting based fundamental analysis can help investors
discriminate between eventual strong performing and weak HBM stocks. A portfolio of such
strong stocks could help investors outperform the market both on gross and risk adjusted
returns basis.
The structure of the rest of the paper is as follows - in the next section we review past research
on value strategy / book-to-market effect and fundamental analysis. We then present the data
and methodology detailing the fundamental signals, selection of companies and performance
analysis. In the proceeding section we present the empirical results followed by conclusions.
Past Research
For more than two decades, the value strategy has attracted significant attention from both
academics and practitioners. Many of them focus on the vary book-to-market effect. For
example, Fama and French (1992; 1993; 2006) provide evidence that value stocks earn positive
risk-adjusted returns and also outperform growth stocks. Other researchers, such as Piotroski
(2000) and Lopes and Galdi (2007) lay emphasis on the very process behind the value strategy,
called as fundamental analysis. The past research in the area therefore, has been classified
into two subgroups, namely, the book-to-market effect and the fundamental analysis.
The Book-to-Market Effect
The value strategy involves buying stocks that have low prices relative to earnings, dividends,
historical prices, book assets, or other measures of value. A number of researchers including
Aggarwal and Wang (2006), Chan and Chen (1991), Fama and French (1992; 1993; 1996;
2006), LaPorta (1996), LaPorta et al. (1997) and Rosenberg et al. (1984) provide convincing
evidence that stocks with high book values of equity relative to their market values outperform

the market. In fact, Fama and French (2006) find that a value premium exists for 1926 to 2005
and that it is not confined to small firms.
Though there seems to be a consensus on the superior performance by high book-to-market
stocks, different explanations for value premium have been proposed in the extant literature.
The first one to appear among these was from Fama and French (1992; 1996) who related the
HBM effect to compensation for greater risk faced by these firms. Vassalou and Xing (2004)
also document that the book-to-market risk is a proxy for default risk. However, Ohlson (2005)
explores the framework provided by the residual income valuation model and shows that the
discount factor relates negatively to the book-to-market ratio.
Another major explanation proposed for the HBM effect lies in market inefficiency leading to
mispricing of these stocks (Griffin and Lemmon, 2002; Lakonishok et al., 1994; LaPorta et al.,
1997). According to theses researchers HBM are neglected stocks where prior performance
creates pessimistic expectations about future performances and real potential may actually be
missed. Ali et al. (2003) show that the book-to-market effect is greater for stocks with higher
idiosyncratic return volatility, higher transaction costs and lower investor sophistication.
Other factors leading to such market inefficiency could be small-cap stocks (Kothari, Shanken,
and Sloan, 1995; Loughran, 1997), stocks with greater short-sales constraints (Nagel, 2005),
and stocks with lower institutional ownership (Phalippou, 2007). Data-snooping biases (Conrad,
Cooper, and Kaul, 2003) and greater divergence in investors’ opinions (Doukas, Kim, and
Pantzalis, 2004) have also been demonstrated as plausible reasons behind the high book-to-
market effect.
Fundamental Analysis
As it is widely recognized that every high book-to-market stock cannot be a good performer3,
researchers try finding ways and means of identifying potentially good performers. One such
approach to separate ultimate winners from losers focuses a firm’s intrinsic value and/or
systematic errors in market expectations (Frankel and Lee, 1998). This strategy requires investors
to go long on stocks whose prices appear to be lagging their fundamental values. Here,
undervaluation is identified by using analysts’ earnings forecasts in conjunction with an
accounting-based valuation model (for example, residual income model), and the strategy is
successful at generating significant positive returns over a three-year investment window.
However, in general, financial analysts are less willing to follow poor performing, low-volume,
and small firms (Hayes, 1998; McNichols and O’Brien, 1997). At the same time, managers of
distressed firms could face credibility issues when trying to voluntary communicate forward-
looking information to the capital markets (Koch, 1999; Miller and Piotroski, 2000). Therefore,
a forecast-based approach, as suggested by Frankel and Lee (1998), has limited application
for differentiating value stocks.
3
Traditionally, these stocks have been called as winners and losers

In this very direction, a more dynamic investment approach involving use of multiple pieces
of information from the firm’s financial statements is suggested by Ou and Penman (1989).
They show that an array of financial ratios created from historical financial statements can
accurately predict future changes in earnings. Similarly, Holthausen and Larcker (1992) show
that a similar statistical model could be used to successfully predict future excess returns
directly. However, extremely complex methodologies and the need for vast amount of historical
information make use of these approaches limited. To overcome these calculation costs and
avoid over-fitting the data, Lev and Thiagarajan (1993) utilize only 12 financial signals and
provide evidence that these fundamental signals are correlated with contemporaneous returns
after controlling for current earnings innovations, firm size, and macroeconomic conditions.
However, Abarbanell and Bushee (1997) contend that markets may not completely capture
impound value-related information in a timely manner and therefore investigate the ability of
Lev and Thiagarajan’s (1993) signals to predict future changes in earnings and future revisions
in analyst earnings forecasts. They find evidence that these factors can explain both future
earnings changes and future analyst revisions. Consistent with these findings, Abarbanell
and Bushee (1998) document that an investment strategy based on these 12 fundamental
signals yields significant abnormal returns.
Piotroski (2000) aggregates the HBM effect to financial statement analysis and shows that the
mean return earned by a HBM investor can be increased by at least 7.5% annually through the
selection of financially strong HBM firms. Mohanram (2005) combines traditional fundamental
analysis with measures tailored for low book-to-market firms and documents significant excess
returns.
Beneish, Lee and Tarpley (2001) use a two-stage approach towards financial statement
analysis. In the first stage, they use market based signals to identify likely extreme performers.
In the second stage, they use fundamental signals to differentiate between winners and
losers among the firms identified as likely extreme performers in the first stage. Their results
indicate the importance of carrying out fundamental analysis contextually. Beneish et al.
(2001) and more recently Lopes and Galdi (2007) also use market based signals to identify
likely extreme performers and then they use financial statement analysis to differentiate
between winners and losers among these firms.
Given the scenario that has prevailed in India, it is not obvious that fundamental analysis in
India will posses the same relevance as documented in previous researches, though many
other researches document that investors can benefit from trading on various signals of
financial performance. In contrast to a portfolio investment strategy based on equilibrium risk
and return characteristics, these strategies seek to earn “abnormal” returns by focusing on
the market’s inability to fully process the implications of these financial signals. Examples of
these strategies include but are not limited to ‘Dogs of the Dow’ strategy (Sahu, 2001), month
and turn-of-mouth effect (Karmakar and Chakraborty, 2000), contrarian and momentum
strategies (Sehgal and Balakrishnan, 2002) and size of stock effect (Mohanty, 2002). However,
evidence on the success or failure of fundamental analysis in India is rather scant4. A systematic
research in this direction is therefore, warranted.

Data and Methodology

The average high book-to-market firm is financially distressed (Chen and Zhang, 1998; Fama
and French, 1995). This distress is associated with declining and / or persistently low margins,
profits, cash flows, and liquidity and rising and / or high levels of financial leverage. Intuitively,
financial variables that reflect changes in these economic conditions should be useful in
predicting future firm performance. This logic is used to identify the financial statement
signals incorporated in this paper.
Specifically, we followed the methodology suggested by Piotroski (2000) who builds a
composite score (F_SCORE) comprising nine fundamental signals reflecting changes in three
areas of the firm’s financial performance: profitability, financial leverage / liquidity, and
operating efficiency. These signals are intended to be useful in predicting future firm
performance. Each firm’s signal realization is classified as either “good” or “bad” depending
on the signal’s theoretical impact on future prices and performance. If the signal realization is
“good” an indicator variable for that signal is equal to one (1); zero (0) if the signal is “bad”.
We call the indicator variable as F_variable. For example, the indicator variable of return on
assets (ROA) is F_ROA and the indicator variable for leverage is F_LEVER. The aggregate of
these signals is termed as the F_SCORE, which is nothing but the sum of the nine binary
signals. It is important to state that the decision to classify a signal as “good” or “bad” is
driven by the presumption that high book-to-market firms are financially distressed.
Financial Performance Signals for Profitability
The four variables used to measure profitability are ROA, CFO, ∆ROA and ACCRUAL. ROA
is defined as net income before extraordinary items scaled by beginning-of-the-year total
assets, while CFO is defined as the cash flow from operations also scaled by beginning-of-
the-year total assets. If the firm’s ROA and CFO are positive, the indicator variables F_ROA
and F_CFO are equal to one respectively, zero otherwise. ∆ROA is the current year ROA less
the previous year ROA. If “ROA is positive, the indicator variable F_∆ROA equals one, zero
otherwise. Sloan (1996) shows that earnings driven by positive accrual adjustments (that is,
profits are greater than cash flow from operations) is a bad signal about future profitability
and returns. Accordingly, we also considered the relationship between earnings and cash
flows. Here, the variable ACCRUAL is defined as current year’s net income before extraordinary
items less cash flow from operations, scaled by beginning of the year total assets. The
indicator variable F_ ACCRUAL equals one (“good”) if CFO>ROA, zero (“bad”) otherwise.
Financial Performance Signals for Leverage and Liquidity
The three financial signals used to measure changes in capital structure and liquidity include
∆LEVER, ∆LIQUID, and EQ_OFFER. As Piotroski (2000) states, most HBM firms are financially
distressed. Therefore, increase in leverage, weakening of liquidity and additional public
offerings of equity are “bad” signals. The change in the firm’s long-term debt level is
4
We apologise for any omissions

represented by ∆LEVER. It has been measured as the change in the ratio of long-term debt to
total assets in relation to the previous year. An increase in leverage (∆LEVER > 0) is a “bad”
signal (therefore, F_∆LEVER =0) while a decrease is “good” (F_∆LEVER=1). The variable
∆LIQUID captures the changes in the firm’s current ratio in relation to the previous year. The
current ratio is defined as the ratio of current assets to current liabilities at the end of the
financial year. An improvement in liquidity, that is, ∆LIQUID > 0 is considered a “good” signal
(therefore, F_∆LIQUID=1), “bad” (F_∆LIQUID =0) otherwise. The variable EQ_OFFER
represents the use of equity financing. If the firm did not issue additional equity in the
previous year, it is a “good” signal (EQ_OFFER equals one), “bad” (EQ_OFFER equals zero)
otherwise. This is so because financially distressed firms that raise external funds only signal
their inability to generate sufficient internal funds to service future obligations.
Financial Performance Signals for Operating Efficiency
Operational efficiency of a company is as important as its profitability or liquidity. Two variables
which reflect two key constructs underlying a decomposition of return on assets have been
used to measure change in the operational efficiency of the company. These include ∆MARGIN
and ∆TURN. ∆MARGIN is defined as the current year gross margin ratio (gross margin
scaled by total sales) less previous year current gross margin ratio. A positive change in gross
margin ratio means a “good” signal, while a negative change is classified as “bad”. This is so
because an improvement in margins reflects an improvement in factor costs, reduction in
inventory costs, or a rise in the price of the firm’s product. Accordingly, the variable
F_∆MARGIN is given a value of one or zero respectively. Finally, we define ∆TURN as the
change in the firm’s current year asset turnover ratio (total sales scaled by beginning of year
total assets) as compared to previous year. As earlier, an improvement in asset turnover
shows greater productivity from the asset base. This can arise from more efficient operations
(fewer assets generating the same levels of sales) or an increase in sales (which could also
signify improved market conditions for the firm’s products). Therefore, an improvement in
assets turnover is a “good” signal, thus indicator variable F_∆TURN equals one, or zero
otherwise.
The Composite Score
As discussed earlier, the composite score is called F_SCORE and represents the sum of all
indicator variables mentioned above. Therefore,
F_SCORE = F_ROA + F_CFO + F_∆ROA + F_ACCRUAL + F_LIQUID + F_ ∆LEVER
+ EQ_OFFER + F_∆MARGIN + F_ ∆TURN
Since there are nine fundamental signals, F_SCORE can range from 0 (all “bad” signals) to 9
(all “good” signals). Low F_SCORE represent firms with poor expected future performance

and stock returns, while high F_SCORE is associated with firms expected to outperform the
market. The investment strategy analyzed in this paper is similar to Piotroski (2000) and is
based on selecting firms with high F_SCORE5.
Selection of Companies and Portfolio Formation
The research was carried out for the period of financial year ending 2003 to financial year
ending 2007. As on 31st March, 2004, all the companies listed on the National Stock Exchange
were arranged in descending order of book-to-market ratio using the CMIE database Prowess.
On the basis of book-to-market ratio, these companies were divided into five quintiles. As the
study was based on high book-to-market companies, the focus remained on the first quintile
(that is, highest book-to-market ratio). Out of these companies those were selected which met
the following criteria:
z The company had a sufficient stock price.
z The company had a positive book-to-market ratio.
z The company did not delist during the next three years.
z There was no stock split, reverse split, stock bonus etc.
z All the data as required in the study was available.
This resulted in 104 companies being selected for the study.
All the nine fundamental indicators were calculated for all these companies using financial
statements for the financial year 2003 and 2004 and the composite F__SCORE was arrived at.
Table 1 shows the distribution of F_SCORE among these companies.
Table 1: Distribution of F_SCORE among the Selected High Book-to-Market Companies

F_SCORE 0 1 2 3 4 5 6 7 8 9
No. of Companies 0 1 5 16 16 26 16 14 9 1
It can very well be seen that most of the companies are clustered around the middle. 88
companies out of 104 (84%) are in the range of 3 to 7. That is, they have nearly 50-70 per cent
positive fundamental signals (in other words conflicting signals). A relatively much smaller
number of companies has large or small F_SCORE, that is, very low or very high percentage
of positive signals. Appendix 1 summarizes the percentage of companies with positive signal
for each of the fundamental indicators.
5
This approach could be criticized on the basis that it employs an ad hoc aggregate performance metric
(F_SCORE) to categorize companies into good or bad performers; especially when two accepted measures
of firm health and performance namely, financial distress (as measured by Altman’s z-score) and historical
change in profitability (as measured by the change in return on assets) are available. Evidence however, has
been established that after controlling for financial distress and historical changes in profitability, F_Score
still has additional explanatory power in discriminating between stronger and weaker firms (Lopes and
Galdi, 2007; Piotroski, 2000). Also, the ability to discriminate winners from losers is not driven by a single,
specific metric. Instead, future returns are predictable by conditioning on the past performance of the firm.
The combined use of appropriate performance metrics through measures such as F_SCORE or a DuPont
analysis, simply improves the ability of an investor to distinguish strong companies from weak companies.
Above all, this approach is simple and very easy to impliment.

Out of these 104 companies with different F_SCORES, we developed three portfolios. These
portfolios, hereafter called as Portfolio1, Portfolio 2, and Portfolio 3 consisted of companies
having F_SCORE in the range of 0-3, 4-6, and 7-9 respectively6. Each portfolio consisted of
equally weighted 20 companies7 randomly selected from the respective F_SCORE groups (an
effort however, was made to have maximum diversification8).
Return Calculations and Performance Analysis
To calculate returns from each of the portfolios, annualized stock-specific yields were calculated
on a buy-and-hold basis for a period of one year and two years following portfolio formation.
As the portfolios were equally-weighted, stock-specific returns were added to arrive at portfolio
returns. As suggested by Piotroski (2000) portfolios were formed after three months of financial
year-end so that all the information required was available. Thus, the period under study for
portfolio returns was from July 2004 to June 2006.
To study the performance of the portfolios both absolute and market adjusted returns were
calculated. Market adjusted returns were calculated in two ways, viz. by calculating absolute
excess returns over the market returns (Lopes and Galdi, 2007; Piotroski, 2000) and by
calculating required returns as driven by risk9 of the portfolio. Further, for market adjustment,
returns on three market indices namely, S&P CNX Nifty, CNX Mid Cap, and S&P CNX 500
were utilized10.
Empirical Findings
Descriptive Statistics for High Book-to-Market Companies
Table 2 provides descriptive statistics for all the high book-to-market companies with respect
to the fundamental signals taken up in the study. The average company in this quintile of
highest book-to-market companies had a mean (median) BM ratio of 4.96 (3.51). In line with
the findings of Fama and French (1995), these high book-to-market companies were poor in
6
Early researches have focused only on buying high F_SCORE portfolio, that is, portfolio of companies
with F_SCORE in the range of 7 to 9 (Piotroski, 2000) or buying high F_SCORE portfolio while
simultaneously shorting low F_SCORE portfolio as low F_SCORE company stocks are expected to perform
negatively (Lopes and Galdi, 2007). However, to see the relative impact of F_SCORE on stock performance,
we created three portfolios and go long on all of them.
7
Researchers have traditionally included all high book-to-market firms in their studies. However, having
hundreds of stocks in a portfolio is possible only in academic research. For this study to have practical
implications, we limited the size of portfolios to 20 stocks each. This is also supported by the fact that
diversification beyond 18 to 20 stocks only leads to additional transaction costs.
8
The criterion for selecting companies into respective portfolios was that a company should belong to a
particular F_SCORE group. No such consideration as industry growth or others were utilized. In case two
companies from the same industry got included in the first instance, one of them was replaced with another
company having the same F_SCORE but from a different industry.
9
Risk-adjusted required returns were calculated by computing â-adjusted returns for each portfolio.
10
â-coefficients with respect to three market indices were calculated using monthly returns for the period
under study.

performance. The average ROA of these companies was a meager 0.01. At the same time,
compared to the previous year both average and median company saw a decline in ROA (-0.02
and -0.01 respectively). The change in margin and turnover over the previous year also
showcased similar behavior (-0.12 and -0.01 respectively) and (-0.14 and -0.04 respectively).
Lastly, an increase in leverage and a drop in liquidity were observed for an average high boo-
to-market company.
However, a vast range and non-normal distribution (see skewness and kurtosis) was observed
across all the measures. Seeing this, selected descriptive statistics along with the percentage
of companies with positive signals were also computed for the three portfolios (Appendix 2).
As expected, the number of positive signals was highest in portfolio 3 (F_SCORE in range 7
to 9) and lowest in portfolio 1 (F_SCORE in range 0 to 3). Therefore, it indicates that investing
in high book-to-market companies with high F_SCORE could be profitable and one needs to
avoid companies with low F_SCORE, however high is the BM ratio.
Table 2: Descriptive Statistics Regarding Nine Fundamental Signals (All Companies)

Signal BM ROA CFO ∆ ROA ACCRUAL ∆LEVER ∆ LIQUID ∆ MARGIN ∆ TURN
Mean 4.96 0.01 0.05 -0.02 -0.04 -0.01 -0.03 -0.12 -0.14
Median 3.51 0.02 0.04 -0.01 -0.04 -0.01 -0.03 -0.01 -0.04
Stdev 3.67 0.06 0.08 0.08 0.10 0.05 2.53 1.54 0.47
Skew 2.95 -1.00 -1.01 2.71 1.26 -1.57 0.73 8.10 -2.41
Kurt 10.99 2.58 7.32 15.71 7.85 13.08 11.86 75.22 12.14
Max 25.00 0.15 0.31 0.51 0.50 0.16 13.37 14.36 1.43
Min 2.50 -0.22 -0.40 -0.25 -0.34 -0.32 -9.24 -3.44 -2.60
To investigate this point further, correlations between individual fundamental signal indicator
variables, overall F_SCORE and one year and two years market adjusted returns (both excess
market returns and â-adjusted returns) were computed. The same are presented in Table 3.
As expected, a high correlation was observed between the F_SCORE and one year and two
years market adjusted returns (0.14 and 0.29 respectively). Apart from this, the three strongest
explanatory variables that emerged were CFO, ∆ROA, and ∆MARGIN (correlation of 0.20,
0.22, and 0.26 with one year return).11
11
Piotroski (2000) found ROA and CFO as the strongest explanatory variables. Lopes and Galdi (2007)
found ∆ROA and ∆LEVER

Table 3: Correlation Analysis Between Fundamental Signals, Overall F_SCORE and One Year and Two Year Market Adjusted
Returns
ACC ∆LIQ EQ_O ∆MA F_SC 1 year 2 Years

ROA CFO ∆ ROA RUAL ∆LEVER UID FFER RGIN ∆TURN ORE return return
ROA —
CFO 0.01 —
∆ROA 0.01 0.18 —
ACCRUAL 0.55 -0.83 -0.14 —

∆LEVER -0.01 -0.30 -0.45 0.25 —
∆LIQUID 0.00 0.04 -0.07 -0.03 0.07 —
EQ_OFFER -0.12 -0.15 -0.10 0.06 0.03 -0.03 —
∆MARGIN 0.06 0.22 0.62 -0.15 -0.58 0.00 -0.04 —
∆TURN 0.15 -0.19 0.17 0.24 0.04 -0.07 0.04 0.07 —
F_SCORE 0.42 0.47 0.50 -0.12 -0.51 0.12 -0.21 0.19 0.43 —
1 year 0.11 0.20 0.22 0.09 -0.05 -0.45 -0.10 0.26 0.15 0.14
return (0.10) (0.10) (0.19) (0.07) (-0.06) (-0.40) (0.25) (0.17) (0.15) — —
2 Years 0.18 0.24 0.13.

return (0.17) (0.22) (0.12) -0.09 -0.30 -0.40 -0.14 0.22 0.03 0.29 — —
Do High Book-to-Market Stocks Offer Returns to Fundamental Analysis in India?
(-0.09) (-0.27) (-0.36) (0.10) (0.15) (0.05) (0.31)
Figures in parenthesis show correlations with â-adjusted returns

165
Portfolio Performance
As discussed earlier, the basic emphasis of the study was to test the applicability of
fundamental analysis to high book-to-market stocks in a practical way, and that is why three
portfolios with different F_SCORE ranges were created. The following text focuses performance
of these portfolios. Table 4 provides the mean values of different fundamental signals for the
three portfolios separately. To check for significance of difference among the three portfolios,
Kruskal-Walis statistics and related significance levels have also been shown.12 It can be
observed that except for ACCRUAL and change in liquidity, the three portfolios differ
significantly on all other fundamental variables. Accordingly, it can be expected that these
fundamental signals and therefore, the F_SCORE should be useful in discriminating among
the future performances of the portfolios.
To evaluate this expectation, the performance of the three portfolios over the next one year
and two years from the date of portfolio formation was observed.
Table 4: Comparison of Portfolios on Different Fundamental Signals

Portfolio ROA CFO ∆ ROA ACCRUAL ∆LEVER ∆ LIQUID ∆ MARGIN ∆ TURN
Portfolio 1
(F-score 1-3) -0.02 0.00 -0.05 -0.02 0.02 -0.06 -0.26 -0.18
Portfolio 2
(F-score 4-6) 4.63 -0.04 0.01 -0.13 -0.25 0.05 -0.00 0.00
Portfolio 3
(F-score 7-9) 0.03 0.08 0.04 -0.05 -0.02 0.53 0.87 -0.11
KW 5.696 7.085 18.408 1.578 16.816 1.456 18.658 14.132
statistics (p<0.058) (p<0.029) (p<0.001) (p<0.458) (p<0.001) (p<0.795) (p<0.001) (p<0.001)
Table 5 provides information on absolute returns from the portfolios over one year and two
years. The most striking result is the fairly monotonic out-performance by portfolio 3 again
reinforcing the capability of the F_SCORE.
Table 5: Returns from the three portfolios
Annualised yield (%)
Portfolio 1 year holding period 2 years holding period
Portfolio 1
(F-score 1-3) 31.30 47.20
Portfolio 2
(F-score 4-6) 8.58 65.22
Portfolio 3
(F-score 7-9) 98.66 120.22
.12 As observed in Table 2, the distribution of fundamental signal values is non-normal. Also, literature has
evidenced concerns regarding the use of parametric tests (Kothari et al., 1997). Therefore, non-parametric
test statistics were applied.
Absolute returns are of no significance unless compared with a benchmark. Excess returns
over the market returns were therefore, computed. Table 6 shows the returns performance of
the portfolios vis-à-vis selected market indices.
Portfolio 1 and Portfolio 2 have shown mixed response in terms of excess returns over the
market indices. For both one year and two years holding periods, Portfolio 1 has underperformed
the CNX Mid Cap but outperformed the S&P CNX NIFTY and S&P CNX 500. Portfolio 2 on
the other hand, underperformed all indices for one year holding period but outperformed all
indices for two years holding. However, Portfolio 3 has been very consistent in its performance.
All the market indices have been outperformed for both one and two year’s holdings. The
amount of excess returns over the market returns too is substantially larger when compared
with portfolio 1 and 2. This again signifies the strength of F_SCORE in crafting out superior
high book-to-market portfolios.
Table 6: Comparison of Portfolio Returns with Selected Market Indices

Excess
Annualized A n n u a l i z e d Portfolio
Holding Portfolio Market Market Yield Returns Portfolio
Portfolio Period Yield (%) Index (%) (%) Performance
S&P CNX
NIFTY 14.91 16.39 Out perform
Portfolio 1 31.3 CNX 35.17 (3.87) Under perform
1 year holding MIDCAP
S&P CNX 500 21.6 9.7 Out perform
S&P CNX
47.20 CNX MIDCAP 48.69 (1.49) Under perform
2 years holding S&P CNX 500 41.29 5.91 Out perform
S&P CNX
NIFTY 14.91 (6.33) Under perform
Portfolio 2 8.58 CNX MIDCAP 35.17 (26.59) Under perform
1 year holding
S&P CNX 500 21.6 (13.02) Under perform
S&P CNX
65.22 CNX MIDCAP 48.69 44.6 Out perform
2 years holding S&P CNX 500 41.29 52 Out perform

Table 6: Comparison of Portfolio Returns with Selected Market Indices

Excess
Annualized A n n u a l i z e d Portfolio
Holding Portfolio Market Market Yield Returns Portfolio
Portfolio Period Yield (%) Index (%) (%) Performance
S&P CNX
Portfolio 3 98.66 CNX MIDCAP 35.17 63.49 Out perform
1 year holding S&P CNX 500 21.6 77.06 Out perform
S&P CNX
2 years holding S&P CNX 500 41.29 78.93 Out perform
As a second step, â-adjusted portfolio returns were computed. Table 7 shows the comparison
of actual returns vis-à-vis â-adjusted returns with respect to three market indices (portfolio â
have been provided in Appendix 3). Returns for a holding period of two years have been
presented.
Table 7: Comparison of Actual Returns and â-Adjusted Returns

Excess
Yield
Over â-
Actual Required â- adjusted
Annualised Market adjusted Yield Yield Portfolio
Portfolio Yield (%) Index (%) (%) Performance
Portfolio 1 S&P CNX NIFTY 99.86 18.20 Out perform

118.06 CNX MIDCAP 176.52 (58.46) Under perform
S&P CNX 500 125.01 (6.95) Under perform

Outstanding performance by Portfolio 3 only becomes more visible in this case. Portfolio 1 is
not able to meet its risk-adjusted required returns in two (CNX MIDCAP and S&P CNX 500)
out of three cases when risk adjustment is done with respect to three market indices (loss of
58.46% and 6.95% respectively). While Portfolio 2 is able to meet the risk-adjusted return
requirements with respect to all the three indices, the degree of outperformance is insignificant
when compared to Portfolio 3. Portfolio 3 outperforms its risk-adjusted returns requirements
by huge margins (294.91%, 224.91% and 272.48% with respect to S&P CNX Nifty, CNX
MIDCAP, and S&P CNX 500 respectively). This proves beyond doubt that portfolio crafted
with companies having high F_SCORE should be eventual winners while those portfolios
with low F_SCORE should be eventual losers. Therefore, a value investor who focuses on
high book-to-market firms could actually shift his/her returns distributions rightwards using
a portfolio of value companies having high F_SCORE. The returns could further be improved
if he/she simultaneously shorts a low F_SCORE portfolio.
Conclusions
This paper investigates if an accounting-based fundamental analysis strategy can help
investors earn excess returns on a portfolio of high book-to-market companies in India. The
strategy we adopt is based on Piotroski (2000) who identified 9 fundamental signals to form a
composite score (F_SCORE) capable of separating out ex-post winners from losers among
high book-to-market companies in the US stock market. However, it is not clear whether the
results of such a strategy could be directly applied to Indian stock markets. This is so because
there is evidence that market efficiency in India is at the most weak form. Also, during the
1990s when the trading and investments were mostly domestic, the markets weathered scams
like the Harshad Mehta scam and Ketan Parekh scam. On the other hand, of late, India has
been among the most favoured investment destinations in the world. Amidst these conflicting
scenarios and scant evidence on the usefulness of fundamental analysis in India, the
environment represents an additional challenge to the usefulness of fundamental / financial
statement analysis; a test of investment strategy based on fundamental analysis is strongly
warranted.
Using the F_SCORE framework from Piotroski (2000) but a different approach to portfolio
formation (to make it practicable) we find convincing evidence that a fundamental analysis
based investment strategy for high book-to-market companies can separate winners from
eventual losers. We show that portfolios with high F_SCORE (7 to 9) provide outstanding
returns way above the market returns and risk-adjusted returns. At the same time, portfolios
with low F_SCORE (0 to 3) offer very poor returns and often under-perform the markets or
required risk-adjusted returns. Thus a value investor could shift his distribution of returns
rightwards by focusing on investing only in high F_SCORE companies. Shorting low F_SCORE
could further amplify his returns.
During the period under the study, Indian stock markets witnessed a strong bullish phase – a
plausible reason behind the strong performance of the investment strategy. However, had
that been the case, then all the portfolios should have performed well, which actually did not
happen. Apparently, the most convincing reason was proposed by Piotroski (2000) that these

companies, which did not command large market price, were ignored by market participants
and were hardly followed by analysts. Moreover, our strategy, in contrast to early researchers,
focuses on portfolio performance and not the performance of individual stocks. Whether
market inefficiency or a rational pricing strategy or any thing else is a subject matter of further
investigation.
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Appendix 1
Percentage of Companies with Positive Signals for each of the Fundamental Indicators
(All Companies)
Fundamental BM ROA CFO ∆ROA ACCRUAL ∆LEVER ∆LIQUID ∆MARGIN ∆TURN

Signal
Percentage of N/A 5 8 36 34 71 44 54 31 69
Companies
Appendix 2
Selected Descriptive Statistics for Fundamental Indicators along with Percentage of
Companies with Positive Signal
Portfolio 1 (F=0-3)
Percentage of
companies
with positive
Variable Mean Median Stdev signal
BM 5.710 3.704 4.990 N/A
ROA -0.022 0.001 0.075 52
∆ROA -0.052 -0.021 0.063 00
∆MARGIN -0.262 -0.072 0.736 00
CFO 0.001 -0.004 0.053 47
∆LIQUID -0.059 -0.060 2.465 33
∆LEVER 0.018 0.014 0.029 14
∆TURN -0.185 -0.116 0.227 14
ACCRUAL -0.024 0.005 0.098 47
Portfolio 2 (F=4-6)
Percentage of
companies
with positive
BM 4.634 3.280 3.458 N/A
ROA 0.010 0.016 0.053 58
∆ROA -0.001 -0.010 0.072 29
∆MARGIN -0.042 -0.014 0.211 29
CFO 0.052 0.053 0.092 76
∆LIQUID -0.252 -0.030 2.351 45
∆LEVER -0.008 -0.008 0.046 66
∆TURN -0.131 -0.052 0.410 24
ACCRUAL -0.042 -0.045 0.112 77

Portfolio 3 (F=7-9)
Percentage of
companies
with positive
BM 5.097 3.571 2.713 N/A

ROA 0.029 0.030 0.032 83
∆ROA 0.036 0.014 0.105 92
∆MARGIN 0.870 0.027 3.072 91
CFO 0.082 0.086 0.067 96
∆LIQUID 0.536 -0.010 2.995 48
∆LEVER -0.025 -0.007 0.073 78
∆TURN -0.110 0.055 0.718 78
ACCRUAL -0.053 -0.025 0.072 83
Definition:
Note: All variables are measured as of the financial year-end prior to portfolio formation
(year t) BM equals the firm’s book value of equity at the end of financial year t, scaled by
market value of equity. ROA equals net income before extraordinary items for the financial
year preceding portfolio formation scaled by total assets at the beginning of year t.
ÄROA equals the change in annual ROA for the year preceding portfolio formation. ÄROA is
calculated as ROA for year t less the firm’s ROA for year t-1.
ÄMARGIN equals the firms gross margin (net sales less cost of goods sold) for the year
preceding portfolio formation, scaled by net sales for the year, less the firm’s gross margin
(scaled by net sales) from year t-1.
CFO equals cash flow from operations scaled by the beginning of year t total assets.
ÄLIQUID equals the change in the firm’s current ratio between the end of year t and year t-1.
Current ratio is defined as total current assets divided by total current liabilities.
ÄLEVERAGE equals the change in the firm’s debt-to-assets ratio between the end of year t
and year t-1. The debt-to-asset ratio is defined as the firm’s total long-term debt (including the
portion of long-term debt classified as current) scaled by average total assets.
ÄTURN equals the change in the firm’s asset turnover ratio between the end of year t and year
t-1. The asset turnover ratio is defined as net sales scaled by average total assets for the year.
ACCRUAL is defined as net income before extraordinary items less cash flow from operations,
scaled by beginning of the year total assets.

Appendix 3
Portfolio â Values with Respect to Selected Market Indices
S&P CNX NIFTY CNX MIDCAP S&P CNX 500

Portfolio 1(F-score 1-3) 1.09 1.48 1.27
Portfolio 2 (F-score 4-6) 1.40 1.42 1.47
Portfolio 3 (F-score 7-9) 0.98 1.34 1.14

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Decision, Vol. 36, No.2, August, 2009

Decision, Vol. 36, No.2, August, 2009

Decision, Vol. 36, No.2, August, 2009

Decision, Vol. 36, No.2, August, 2009

Decision, Vol. 36, No.2, August, 2009

Data and Methodology

Decision, Vol. 36, No.2, August, 2009

Decision, Vol. 36, No.2, August, 2009

Table 1: Distribution of F_SCORE among the Selected High Book-to-Market Companies

Decision, Vol. 36, No.2, August, 2009

Decision, Vol. 36, No.2, August, 2009

Table 2: Descriptive Statistics Regarding Nine Fundamental Signals (All Companies)

Decision, Vol. 36, No.2, August, 2009

ACC ∆LIQ EQ_O ∆MA F_SC 1 year 2 Years

∆ROA 0.01 0.18 —

ACCRUAL 0.55 -0.83 -0.14 —

Decision, Vol. 36, No.2, August, 2009

∆LIQUID 0.00 0.04 -0.07 -0.03 0.07 —

EQ_OFFER -0.12 -0.15 -0.10 0.06 0.03 -0.03 —

∆MARGIN 0.06 0.22 0.62 -0.15 -0.58 0.00 -0.04 —

∆TURN 0.15 -0.19 0.17 0.24 0.04 -0.07 0.04 0.07 —

2 Years 0.18 0.24 0.13.

(-0.09) (-0.27) (-0.36) (0.10) (0.15) (0.05) (0.31)

Figures in parenthesis show correlations with â-adjusted returns

Table 4: Comparison of Portfolios on Different Fundamental Signals

Table 6: Comparison of Portfolio Returns with Selected Market Indices

Decision, Vol. 36, No.2, August, 2009

Table 6: Comparison of Portfolio Returns with Selected Market Indices

Table 7: Comparison of Actual Returns and â-Adjusted Returns

Portfolio 1 S&P CNX NIFTY 99.86 18.20 Out perform

Decision, Vol. 36, No.2, August, 2009

Decision, Vol. 36, No.2, August, 2009

Decision, Vol. 36, No.2, August, 2009

Decision, Vol. 36, No.2, August, 2009

Lev, B. and Thiagarajan, R. 1993. Fundamental information analysis. Journal of Accounting

Decision, Vol. 36, No.2, August, 2009

Fundamental BM ROA CFO ∆ROA ACCRUAL ∆LEVER ∆LIQUID ∆MARGIN ∆TURN

Decision, Vol. 36, No.2, August, 2009

BM 5.097 3.571 2.713 N/A

Decision, Vol. 36, No.2, August, 2009

S&P CNX NIFTY CNX MIDCAP S&P CNX 500

Portfolio 3 (F-score 7-9) 0.98 1.34 1.14

Decision, Vol. 36, No.2, August, 2009

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