ET Wealth
Stock Analysis, IPO, Mutual Funds, Bonds & More

7 high alpha generating stocks to invest in

The CAPM expected return is used as an input in most discounted valuation models that are used to estimate the fair value of a stock.

, ET Bureau|
Dec 31, 2018, 06.30 AM IST
Getty Images
Stocks that generate alpha and exceed their expected returns can be smart long-term bets.
Companies that exceed shareholders’ expectations consistently have the ability to become market leaders. These companies are fundamentally sound— strong sales, profits and free cash flows— are competitive and durable.

Their stock prices offers ample capital gains to the investors with increased dividend payouts. Capital asset pricing model or CAPM is used to estimate the expected return of a stock.

It is a risk-adjusted model that takes into account risk-free rate, risk premium and the stock’s beta to estimate its return.

Promising, high alpha generating stocks
Returns from these stocks have beaten their expected returns across time frames
Source: ACE Equity and Bloomberg. Current price as on 24 December 2018. Estimates, analysts recommendations and target prices from Bloomberg.

The risk-free rate is the rate of return on an investment with zero risk. Government bond yield is often used as a proxy for risk free rate.

The second component called risk premium is the difference between the market return and the risk-free rate. The return of any representative market index such as Nifty or BSE Sensex is used as a benchmark for market return.

The third component, beta, is a measure of systemic risk—risk that cannot be eradicated via diversification. The expected return of a stock is calculated by multiplying the risk premium with beta and then adding the risk-free rate. Since market risks cannot be eliminated through diversification, the model compensates for such risks by forecasting a higher return for stocks with higher beta compared to stocks with low beta values.

Stocks with beta value greater than one are said to be more volatile compared to stocks with beta value below one. For instance, expected return of a stock with a beta of 1.5, when the risk-free rate is 7% and the market return is 10%, will be 11.5%, while for a stock with beta of one the expected return will be 10%.

The CAPM expected return is used as an input in most discounted valuation models that are used to estimate the fair value of a stock. In a dividend discount model, the CAPM return is the discount rate that equates future dividend payments to their present day value. Similarly, in free cash flow valuation model, the expected return is the rate that estimates the present value of future cash flows.

The current value of a stock is compared with its fair value using such discounted valuation models to determine whether a stock is over or undervalued. The model can also be used to find stocks that are generating excess returns, technically termed as alpha. Alpha is calculated by subtracting the CAPM return from a stock’s actual return. Stocks with positive alpha are considered outperformers and those with negative alpha are considered underperformers.

We identified BSE500 stocks that have generated positive alpha in the past one, three, five and 10 years. Beta values of each of the 500 stocks were calculated with respect to the BSE Sensex over the defined time frames. The calculation of beta involves the statistical applications of variances and co-variances, but it can be easily calculated using the Slope function of MS Excel.

The average 10-year government bond yield for the respective time frames was determined to derive the riskfree rate. For market return, point-to-point BSE Sensex return was used. Additionally, point-to-point returns of each of the 500 stocks were calculated for each time period, ending 19 December 2018. We calculated CAPM returns for each of these 500 stocks in the defined time frames and subtracted them from their actual returns to arrive at their alpha values.

We found 50 stocks that have consistently generated positive alpha in the defined time frames. We then filtered companies whose alpha has risen consistently— 10-year alpha was greater than 5-year alpha which was more than 3-year alpha and so on. Another filter was that companies should have a minimum alpha of 10% across all four time frames.

Only 24 companies passed these filters. In the second quarter of 2018-19, the aggregate operating profit (including other income) and adjusted year-on-year (y-o-y) earnings per share (EPS) growth of these 24 companies was 22.4% and 26%, respectively. Comparatively, BSE500 companies reported an aggregate operating profit and adjusted y-o-y EPS growth of 9.7% and 6.4%, respectively.

Of these 24 companies, 22 are tracked by Bloomberg analysts and there are 522 recommendations on these stocks. Out of these 62% are buy, 28% are hold and 10% are sell recommendations.

Also Read

Stock market update: Metals stocks gain; Jindal Steel up 3%

Stock market update: Energy stocks advance; Tata Power gains 2%

Stock market update: IT stocks edge lower; NIIT Tech slides 2%

Stock market update: Auto stocks leap; Motherson Sumi climbs 3%

Stock market update: Bank stocks surge; YES Bank jumps 5%

Add Your Comments
Commenting feature is disabled in your country/region.

Other useful Links

Copyright © 2020 Bennett, Coleman & Co. Ltd. All rights reserved. For reprint rights: Times Syndication Service