Wednesday, April 1, 2015

Alpha of a Stock Demystified!

·         What alpha of a stock means to investors? Simply put, Alpha is a measure of an investment's performance compared to a benchmark, such as the S&P BSE 30. It's a mathematical estimate of the return, based usually on the growth of earnings per share.Alpha is one of five technical risk ratios; the others are beta, standard deviation, R-squared, and the Sharpe ratio. These are all statistical measurements used in modern portfolio theory (MPT). All of these indicators are intended to help investors determine the risk-reward profile of a mutual fund. Simply stated, alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund's return.

·         Can you explain with the help of an example how an investor can calculate alpha of a stock? A positive alpha of 1.0 means the stock has outperformed its benchmark index by 1 percent. A similar negative alpha of 1.0 would indicate an underperformance of 1 percent.

Let’s assume company XYZ’s stock has a return on investment of 12% for the year and a beta of + 1.5; our benchmark is the S&P BSE30 which was up 10% during the period. Is this a good investment?

A beta of 1.5 implies volatility 50% greater than the benchmark; therefore the stock should have had a return of 15% to compensate for the additional risk taken by owning a higher risk investment. The stock only had a return of 12%; three percent lower than the rate of return needed to compensate for the additional risk. The Alpha for this stock was -3 and tells us it was not a good investment even though the return was higher than the benchmark.

·         What negative or positive alpha signify to investors? How good is it to invest in high alpha stocks  A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.

·         What are the qualities of high alpha stocks? High-return stocks tend to have strong sales growth, strong earnings growth and realize high returns on invested capital. there are typically three ways stocks might achieve multi -fold gains. "The first is that it is truly a growth company and consistently puts up high-growth numbers. The second is a company that may be near bankruptcy or is really deep value and it comes back from the dead. The third is a little of both: A company that may be under the radar screen, perhaps with a checkered history, and it's really cheap, but not because it's a horrible company. It's just been neglected and hasn't performed very well, but maybe new management comes in and the company starts doing better."

·         What are the advantages and shortcomings of alpha?  Positive alpha is achieved with asset allocation, diversification, risk management, valuation strategies, and choosing individual investments with strategic advantages.

·         Can you suggest two stocks from the CNX Alpha index which can give positive return to investors in the next 24 months? Please give reasons. CNX Alpha Index aims to measure the performance of securities listed on NSE with high alphas. It is a well-diversified 50 stock index accounting for 12 sectors of the economy, in order to make the 50 stock index investible and replicable, criteria’s such as turnover, liquidity and market capitalization are applied while selection of securities. Weights of securities in the index are assigned based on the alpha values i.e. security with highest alpha in the index gets highest weight
Our company policy prohibits individual stock suggestions but going by the fact that Automobiles & Industrial Manufacturing have the highest weight in the Index, companies from these sectors can be a good bet.

(As narrated to MoneyToday)

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