Construction of optimum equity portfolio with special reference to Pharmaceutical, Logistics and Telecommunication sectors in India

ABSTRACT The main objective of this research is to construct an optimum equity portfolio using Sharpe index model. A well-maintained portfolio is vital to any investors success. The optimal portfolio concept falls under the modern portfolio theory. The theory states that investors will act rationally, always making decisions aimed at maximizing their return for their acceptable level of risk. In this paper, construction of optimum portfolio is done for Pharmaceutical, Logistics and Telecommunication sectors. Fifteen companies (Five from each sector) were selected for the construction of optimum portfolio. They were ranked from largest to smallest based on excess return to beta ratio. The highest cut-off point was taken as base to calculate the proportion of money to be invested in each stock. This research would help investors to invest the right amount in the right stock. Keywords: risk, return, residual variance, Sharpe and market variance, etc.,

INTRODUCTION These global trends have far reaching implications for Indian pharmaceutical companies across the entire value chain, from generic players like Dr. Reddys to contract manufacturers like Piramal Healthcare. Indian companies need to re-look at their strategies carefully and see how best they can respond to the new scenario. Some of the ways the Indian players can take advantage of the emerging opportunities. With the growth in US and developed economies expected to taper off, emerging economies like India are expected to drive future growth. The key growth drivers in these countries are increasing per capita income, growing insurance penetration, better health awareness, higher government expenditure, adherence to IPR norms and shift in disease profiles. The Indian market was estimated at USD 8 billion in FY2008 and is expected to grow at 10-12% CAGR for the next five years. Life style related or chronic therapeutic segments are expected to grow at a much faster pace

than the more traditional acute segments. Crisil forecasts the Anti Diabetic segment to have a CAGR of 19% over the period 2008-13 compared to 14% for the Anti-Infective segment. This has led to MNCs such as Pfizer, GSK, Roche and Sanofi Aventis launching almost 15 on-patent products in India with an eye on high value life style related therapeutic segments. Indian companies are well positioned to partake of this huge domestic opportunity. Indian companies need to broaden their product portfolio to include growing therapeutic segments such as anti-diabetics, central nervous system and cardiovascular. Companies can now sell premium products to aspiring Indian middle and high class, while at the same time continue their focus on low value but high volume bottom of the pyramid class. India is today recognized as a global manufacturing hub, with nearly 40-50% lower production costs than the US and the largest number of FDA approved facilities outside the US. The growth in the Indian economy in coming decade is likely to be driven by the increased activity in the manufacturing and retail sectors. To enable these sectors to contribute effectively to Indias growth the logistics sector will have to step up to provide value-enabling solutions for these sectors. The future of the Indian Logistics Industry lies ultimately in value propositions for the customer. Value solutions can be engineered only if the complex strands of supply-chain mesh together seamlessly. These solutions are expected to command a premium but also come at a cost. The cost conscious Indian Market first has to be made to appreciate the value of premium services. In a supply driven market, supply chain solutions need to unlock the cost -saving aspect of efficient logistics services first. This would result a reduction in cost down the line, which can only happen when most of the deficiencies mentioned above are removed. Logistics companies can leverage further economies of scale when operations are expanded. This may require industries to collaborate with logistic service providers to nurture their businesses, possibly in a way the automobile industry in India nurtured the auto-component companies. The future is bright for the logistics industry in India- the expectation is that a tipping point for the industry will soon be reached which will propel it to greater heights. The various challenges faced by the logistics industry lead to high logistics cost incurred by the Indian Economy. This is despite the fact that the cost of labor, one of the most significant contributors to logistics cost in developed countries, is significantly cheaper in India. With regards to cost of spends on logistics, Indias logistics sector accounts for 13% of the GDP of India. This is much higher than that in the US (9%), Europe (10%) and Japan (11%) but lower

than in China (18%)). Major elements of logistics costs typically include transportation, warehousing, inventory management and other value added services such as packaging. What is worrying about the logistics costs in India is the distribution of costs across various heads. As can be seen from the accompanying chart, in India, as much as 31% of the logistics cost is attributable to the others category, which primarily includes various types of losses. If looked at from the perspective of logistics cost as a percentage of the total product cost India again fares poorly. The logistics cost as a percentage of total product cost in India is in the range of 4-5 times that in developed countries, to the tune of 20% of product cost. This is at a time when the quality of logistics services provided is not of the highest standards. NEED FOR THE STUDY The portfolio should not be constructed based on the brand identity, current performance etc because that would not help investors in achieving the anticipated or expected return. The main aim of portfolio construction is diversification and to maintain perfect negative correlation between the securities. Also, holding two or three stocks is always better than holding one. The optimum portfolio gives the investors a better clarity to invest the right proportion of money in the right stock and it helps the investors to get maximum returns with minimal risk. OBJECTIVES To study the relative market performance of 15 companies belonging to Pharmaceutical, Logistics and Telecommunication sectors listed in National Stock Exchange (NSE). The primary objective is to construct an optimum portfolio and to analyze the risk and return and to help the investors to invest the right proportion of money in the right stock. To guide the investors to get optimal portfolio i.e., maximum return with minimum risk. The secondary objective is to find the excess return to beta ratio, cutoff point etc.

LIMITATIONS

Only 15 companies in 3 sectors were taken into consideration for constructing optimum portfolio. If more companies from different sectors were taken, it would have given an accurate optimum portfolio. Stock prices considered were restricted to only five years data. When considering many years data, it would have given an accurate optimum portfolio. So time constraint is there.

REVIEW OF LITERATURE Klement Joachim, Greenrod James, O'Neil Jay in their paper described how strong preference for domesticequities can erode the wealth of Australian private investors over the long term and proposed an optimalallocation to domestic equities for Australian investors. Private investors around the world tend to have an excessive preference for shares of companies based in their home country. This home bias may be further strengthened if domestic equities receive preferential treatment by local tax laws. Australia's franking credit system is one example of preferential treatment for domestic equities. Franking credits reduce investors' tax liability on the dividends received from domestic companies but not on those from foreign companies. This tax advantage, and the solid performance of the Australian equity market over years, has led to very high, even excessive, allocations to domestic equities in the portfolios of Australian investors. Madura and Abernathy (1985) also examined the performance of global stock portfolios prescribed by ex post models. Using weekly stock market index returns for eight countries for the period, January 1978 to January 1981 the authors segmented the data into five sub-periods of equal length and for each period; a mean variance algorithm was used to generate ex post efficient portfolios. The ex post optimal portfolio weights then formed the basis for investment in the subsequent ex ante period. Thus all information for the ex ante strategy was developed from the previous period. Madura and Abernathy (1985) considered the performance of three mean-variance efficient portfolios. A low-risk portfolio which exhibited the least variance in an ex post basis, a high risk-portfolio produce which showed the highest expected return, and an intermediate risk portfolio which displayed the highest ex post return per unit risk Sharpe Ratio (Sharpe, 1966, 1994). For the ex ante strategy to be described as effective, it was expected to outperform a naive portfolio of the international stocks and the US index. In constructing these ex post optimal portfolios Madura and Abernathy (1985) observed that the returns and standard deviations in each country

performed differently in the various sub-periods. In other words the data was not stationary. Consequently performance of the ex post based efficient portfolios behaved poorly in subsequent periods. In particular on an ex ante basis the analysis showed that neither the naive nor the mean-variance international portfolios produced consistently higher returns relative to the US index. While in terms of risk, the mean-variance low risk portfolio was the only strategy, which consistently exhibited a lower standard deviation than the US index. Also no single strategy could be distinguished as superior when the risk-adjusted performance of the various strategies was compared. The authors concluding that the difference between "potential gains from an ex post analysis" and "realised gains from an ex ante analysis" may be substantial. Firstenberg conducted the earliest study, examining the role of hotels in a multi-asset real estateportfolio. Their study showed how modern portfolio analysis can be used to diversify optimally a real estate portfolio. By using NCREIF returns from 1978 to 1985, they showed that efficient frontier portfolios with the highest risk-return combination included hotels and offices. Their study was constrained, however, due to the short time span and serious under-representation of hotels in the early years of the NCREIF dataset. DeRoos and Corgel conducted some preliminary analysis which compared total hotel returns to the NCREIF. This comparison used various proprietary hotel indexes such as the Hospitality Valuation Index (HVI), the Pannell Kerr Forster Index (PKF), the American Council of Life Insurance Companies (ACLI) and the Cornell Index. This elementary analysis used total (income and capital) hotel return data from each of these indexes from 1984 to 1993 and compared it to the NCREIF index. They reported that the average hotel returns were higher than NCREIF returns and in general were more volatile Robichek Alexander A, Cohn Richard A, Pringle John J (1972) computes ex post rates of return and correlation coefficients for twelve alternative investment media for the period 1949-69 inclusive and analyzes the implications of the results for portfolio construction. Most of the prior work in the area of portfolio construction has focused exclusively on common stocks and the "riskless rate of return." Studies of rates of return on other investment media, such as bonds, real estate and commodities, generally have not included an investigation of covariances with other media.

Maller Ross A, Durand Robert B, Jafarpour Hediah (2010) an approach that enables us to assess ex ante how close a given portfolio is to this ideal. It illustrates applications of the theory by analyzing a large sample of US companies, comparing constant-correlation and momentum strategies with the optimal strategy. Simulations based on this data are also given for illustration. Choosing a portfolio from among the enormous range of assets now available to an investor would be facilitated if we could locate the return-risk ratio of a particular allocation along a spectrum of possibilities. A comparison between portfolio choices can tell us, for example, whether it is better to select a sub-optimal portfolio from a large class of assets or to perform a Markowitz optimal procedure on a subset of the assets. A common criterion for this assessment is the expected return-to-risk trade-off as measured by the Sharpe ratio. Given that the ideal, maximized Sharpe ratio must be estimated. Varadharajan P (2011), saic that, the main focus of this research is to construct an optimal equity portfolio with help of the sharpe index model. Portfolio construction is an important process of the investors for investment in the equity market. A good combination of portfolio will give maximum return for a particular level of risk. In this research, Banking and Information Technology sectors have taken into consideration for construction of equity portfolio. Five companies were selected from each sector and ranked them based on excess return to beta ratio. The cut-off point was calculated and highest value is to be taken as a base for calculation of money to be invested in each stocks. This research findings and suggestions would be helpful to investors. Kallman James(2003) Since 1952, financial analysts have known that each risk must be understood relative to the entire portfolio of risks. The failure to take this holistic perspective can result in the misallocation of scarce resources including money, people and time. The beauty of portfolio theory like many other valuable management tools, is that it is surprisingly simple. Essentially, it states that adding non-correlated risks together decreases the portfolio's risk. Risk mapping and portfolio evaluation is taking risk management into a new dimension. It draws on well-understood financial principles and computer simulation to describe, both with mathematics and powerful graphics, an organization's portfolio of risks. When the portfolio is understood at this level, it empowers risk managers to provide advice on the optimal combination of risks and the optimal control of risks. The yield is more confidence in attaining the organization's financial and qualitative goals.

A-Petersen Gabriel, Singh Arjun(2012) in this paper reviews the performance of five real estate subsectors (office, retail, industrial, apartment and hotel) covering a 20-year (historical) period in order to assess the impact the hotel subsector would have when constructing a multi-property investment portfolio. The research was built on the foundation of modernportfolio theory, and the data were analysed using several statistical and investment analysis tools such as correlation analysis, Sharpe ratio and a portfolio optimiser. The results suggest that hotels can play a valuable role in a multi-property commercial real estate portfolio. This might encourage the industry to develop adequate databases such that performance and investment statistics' benchmarks can be offered for investors, to thus position the hotel subsector as a viable asset alongside the other real estate subsectors in a property investment portfolio. Weilin Zhao, Chihiro Watanabe (2010), investigated that, India, famous for its software outsourcing service, has achieved high growth rates in software exports in recent ten years. The figure of Indian software export destination shows that the US has been the dominant destination for more than a decade. From the perspective of risk management, this paper provides to give some suggestions for software outsourcing service vendors by means of the portfolio analysis of India's software export market constitution. Though it is a simple two-market portfolio analysis model, the implications are significant for raising outsourcing service vendors' awareness in risk management, future market strategy and industrial development. RESEARCH METHODOLOGY This is a descriptive study on the construction of optimum portfolio using sharpe index model. The data for this research was collected from various websites such as National stock Exchange (NSE), Reserve Bank of India(RBI) and from the database Proquest. Therefore, secondary research has been done. Random sampling is done and ten companies were selected from each sector namely Metals and Banking. Therefore, the sample size of the study is 20. For the construction of optimum portfolio, four years data (June 2007 to May 2012) has been considered. STATISTICAL TOOLS USED:Return It is the total gain or loss of a security in a given period. It is calculated by difference between the todays market price and yesterdays market price to yesterdays market price.

Beta Coefficient. A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole

Where, r = Correlation Co-efficient between individual stock and Market. = Standard Deviation of Individual Stock = Standard Deviation of Market Risk-free Rate of Return (RF) Risk-free rate of return is the return on a risk free asset i.e. Government securities like 91 days T-Bill rate, 182 days T-Bill rate, 364 days T-Bill rate, 10 year bond rates, etc. Here 10 year bond rate has taken into consideration for risk free rate of return. Excess return to Beta ratio. It is the returns in excess of the risk-free rate.

Where,

= the expected return on stock i = the return on a riskless asset = the expected change in the rate of return on stock associated with

one unit change in the market return. Cut-Off Point This is the point at which an investor decides whether or not a particular security is worth purchasing. The formula is given by sharpe model as follows:

Where,

= variance of the market index = Residual variance i.e. variance of a stocks movement that is not

associated with the movement of market index.

Where, , is the proportion of investment of each stock And

` Where, ANALYSIS & DISCUSSIONS The first step is to calculate the return for each stock which indicates the total gain or loss experienced on an investment over a given period of time. Then, standard deviation and beta are calculated to measure the risk. The expected return on each stock (Ri) is also calculated. Table 1.1 Return, Beta and Variance of each stock Scrip Name Ranbaxy Biocon Beta 0.2605 0.3590 Return Ri 42.6959 42.2804 Variance ( ei)^2 8.4916 8.2761 = the cut-off point.

Cipla Dr Reddy Sun Pharma Aegischem Allcargo Concor Jet Airways TCI Airtel Idea MTNL Reliance Tata Docoma

0.2814 0.2449 0.2382 0.4342 0.1909 0.0806 0.6271 0.1973 0.1942 0.5189 0.4054 0.6170 0.4125

77.9879 154.8051 17.8961 51.9482 -122.6493 34.1789 44.7893 -2.3012 -43.9233 114.4812 -178.3790 -26.8537 -55.8334

3.2972 3.4613 11.1748 13.9017 11.3462 3.3108 16.1118 9.2043 8.2876 7.8870 7.9948 13.7119 6.8383

From Table 1.1 The companies which has beta value less than 1 shows it is less risky when compared to market risk.

Table 2. Excess return to Beta ratio Scrip Name Ranbaxy Biocon Cipla Dr Reddy Sun Pharma Aegischem Allcargo (Ri-Rf/) 137.4 98.54394 252.6641 603.9885 46.16026 103.7448 -678.527 After Ranking Dr Reddy Concor Cipla Idea Ranbaxy Aegischem Biocon

Concor Jet Airways TCI Airtel Idea MTNL Reliance Tata Docoma

338.3258 60.41915 -46.6395 -261.7 207.3169 -457.03 -54.7057 -152.074

Jet airways Sun Pharma TCI Reliance Tata Docoma Airtel MTNL Allcargo

From Table 1. 2: The excess return to beta ratio is found and it is ranked from largest to smallest (i.e. 1 to 15). Dr Reddy stands in the 1 st rank whereas Allcargo stands in the 15th rank. The excess return of any stock is directly related to its excess return to beta ratio. The ratio provides a relationship between potential risk and reward. The Risk free rate of return (Rf) which is taken from RBI website which is 6.9% is used to calculate the excess return to beta ratio. Table 1.3. Cut-off point calculation of 20 companies New Scrip Name Dr Reddy Concor Cipla IDEA RANBAXY (RiRf)*/ ei^2 10.4640 0.6643 6.0660 7.0782 1.0982 (RiRf)* /ei^2 10.4640 11.1283 17.1942 24.2725 25.3707 m^2*(RiRf) /ei^2 28.3461 30.1456 46.5778 65.7522 68.7272 1+m^2* ^2/ ei^2 1.0469 1.0523 1.1173 1.2098 1.2314

Ci 27.075 4 28.648 7 41.688 4 54.350 8 55.811 1

Aegischem Biocon Jet airways Sun Pharma TCI Reliance Tata Docoma AIRTEL Mtnl Allcargo

1.4071 1.5349 1.4747 0.2344 -0.1972 -1.5188 -3.7843 -1.1909 -9.3950 -2.1800

26.7778 28.3126 29.7874 30.0218 29.8245 28.3057 24.5214 23.3305 13.9355 11.7555

72.5389 76.6967 80.6917 81.3267 80.7924 76.6780 66.4266 63.2004 37.7501 31.8447

1.2682 1.3104 1.3765 1.3902 1.4017 1.4769 1.5443 1.5566 1.6123 1.6210

57.199 8 58.531 0 58.621 7 58.498 4 57.639 2 51.918 2 43.013 7 40.600 6 23.413 5 19.644 8

From Table 1.3: The highest value is taken as the cut-off point (C*).From the table 3,it is evident that Jet Airways has the highest cut-off rate C*=58.6217. All the stocks above the C* value can be included in the portfolio. Table 1.4. Selection of stocks among 20 companies Script Name Dr Reddy Concor Cipla Idea Ranbaxy Ci 27.0754 28.6487 41.6884 54.3508 55.8111

Aegischem Biocon Jet airways

57.1998 58.5310 58.6217

From table 1.4: These are the 8 stocks which are selected for the optimum portfolio. The proportion of amount to be invested is calculated for these 8 stocks. Table 1.5. Proportion of Investment in each stock Script Name Dr Reddy Concor Cipla IDEA RANBAXY Aegischem Biocon Jet airways Proportion of investment 49.87 8.80 21.40 12.65 3.12 1.82 2.24 0.09

From Table 5: The proportion of money to be invested in each stock is clear. The highest proportion of money (49.87%) is to be invested in DR REDDY and the lowest proportion of money (0.09%) is to be invested in JET AIRWAYS. Figure 1.1: Proportion of Investment using Pie chart

From figure 1.1 It is evident that 49.87% of the money is to be invested in RANBAXY followed by Cipla, Idea, Concor, Ranbaxy, Biocon, Aegischem and Jet Airways. The lowest proportion of money is to be invested in State Bank of India (SBIN). FINDINGS When considering the three sectors, the performance of Pharmaceuticals sector is higher than that of Logistics and Telecommunication sector. Out of the 8 stocks in the optimum portfolio, four stocks are to be selected from Pharmaceuticals sector, 3 from Logistics sector and one from Telecommunication sector. The stock which has the highest return will definitely have high risk. The optimum portfolio which is constructed using Sharpe index model will help the investors for their investment decisions. RECOMMENDATIONS Three sectors namely Pharmaceuticals, Logistics and Telecommunication sectors are considered for the construction of optimum portfolio. Using Sharpe index model, the top 8 companies out of 15 companies are selected for the portfolio. Of which, highest proportion of money (49.87%) has to be invested in DR REDDY, 21.4% in CIPLA, 12.65% in IDEA, 8.8% in CONCOR, 3.12% in RANBAXY, 2.24% in BIOCON, 1.82% in AEGISCHEM and 0.09% in JET AIRWAYS . Thus the investors are advised that the stocks of Dr Reddy, Cipla, Idea, Ranbaxy, Aegischem, Biocon, Concor, Cipla and Jet Airways should be held long.

CONCLUSION

In this paper, the sectors considered for the construction of optimum portfolio are Pharmaceuticals, Logistics and Telecommunication sectors. The number of stocks considered for the construction of optimum portfolio was 15 stocks (5 from each sector ). But, the optimum portfolio is constructed with the top 8 stocks with the help of Sharpe index model. The top 5 stocks which took place in the optimum portfolio are Dr Reddy, Cipla, Idea, Ranbaxy, Aegischem, Biocon, Concor, Cipla and Jet Airways. Out of the 8 stocks in the optimum portfolio, four stocks are to be selected from Pharmaceuticals sector, 3 from Logistics sector and one from Telecommunication sector. The optimum portfolio using Sharpe index model will be helpful for the investors to make proper investment decisions and to get the maximum return with the particular level of risk. REFERENCES Berenson, M. L. and Levine, L. M. (1993) Basic Business Statistics Concepts and Applications, Prentice Hall, Englewood Cliffs, NJ. Cower, T. M. (1991) Universal Portfolios, 1(1), 1-29. Cower, T. M. and Ordendich, E. (1996) 'Universal Portfolios with Side Information', IEEE Transactions on Information Theory, 42(2), 348-63. Hakansson, N. H. (1971) 'Multiperiod Mean-variance Analysis: Towards a General Theory of Portfolio Choice', Journal of Finance, 26, 857-84. Hunt, B. F (2002) 'Growth Optimal Portfolios: Their Structure and Nature', UTS mimeo. Judge, G. G., Carter HiU, R., Griffiths, W. E., Lutkepohl, H. and Lee, T. C. (1988) Introduction to the Theory and Practice of Econometrics, 2nd edn, Wiley, New York, NY. Luenberger, D. G. (1998) Investment Science, Oxford University Press, New York. Merton, R. C. and Samuelson, P. A. (1974) 'Fallacy of the Log-normal Approximation to Optimal PortfolioDecision-making Over Many Periods', Journal of Financial Economics, 1, 67-94. Karmin, Craig, (2004), Moving the Market -- Tracking the Numbers / What s Hot...and Not: Crude Held the Sweet Spot in May; Rising Oil

Prices Resonated With Stock, Bond Markets, Causing Most Assets to Fall, Wall Street Jounal , ISSN : 00999660, Pg C.3. Leahy, Joe, (2007), Indian market 'correction' looms, Leading banker warns of overvalued stocks Property prices 'overheating, Liquidity crunch in banking to accelerate trend, ISSN: 03071766, pg 17. Linebaugh, Kate, (2006), Moving the Market: Cnooc Buys 45% Stake in Oil Field After Indian Firm's Bid Is Blocked, Wall Street Journal, ISSN: 00999660, pg C.3. Admati, Anat R., and Stephen A. Ross, 1985. Measuring investment performance in a rational expectations equilibrium model, Journal of Business 58, 1-26. Avramov, Doron, and Russ Wermers, 2006, Investing in mutual funds when returns are predictable, Journal of Financial Economics 81, 339377. Axelson, Ulf, Per Stromberg, and Michael S. Weisbach, 2007, Why are buyouts levered? The financial structure of private equity funds, Journal of Finance forthcoming. Bansal, Ravi, and Amir Yaron, 2004, Risks for the long run: A potential resolution of asset pricing puzzles, Journal of Finance 59, 1481-1509. Barber, Brad, Terrance Odean, and Lu Zheng, 2005, Out of sight, out of mind: The effects of expenses on mutual fund flows, Journal of Business 78, 2095-2120. Barras, Laurent, O. Scaillet. and Russ Wermers, 2008, False discoveries in mutual fund performance: Measuring luck in estimated alphas, Working paper, University of Maryland. Basak, Suleyman, Anna Pavlova, and Alexander Shapiro, 2007, Optimal asset allocation and risk shifting in money management, Review of Financial Studies 20, 1-39. Bekaert, Geert, and Robert J. Hodrick, 1992, Characterizing predictable components in excess returns on equity and foreign exchange markets, Journal of Finance 47, 467-509.

Berk. Jonathan B., 1995, A critique of size-related anomalies, Review of Financial Studies 8, 275-286. Richard C. Green, 2004. Mutual fund flows and performance,in rational markets, Journal of Political Economy 112, 1269-1295. www.nseindia.com