A Comparison of CAPM, French and Fama Model Returns with Market Return of Indian FMCG sector Ramanuj Sarda, Pursuing PGDM (International Business), Institute of Public Enterprise, Hyderabad, India. & Nilesh Poddaturi, Pursuing PGDM (International Business), Institute of Public Enterprise, Hyderabad, India. & Pawan Kumar Avadhanam, Asst. Professor (Finance), Institute of Public Enterprise, Hyderabad, India. Abstract: This paper is aimed at developing Capital Asset Pricing Model and French and Fama three factor model for the FMCG sector in India. CAPM uses market sensitivity Beta to describe the variation of stock returns whereas F&F model uses Size of the firm, Book to market equity and risk premium to explain the variation in returns. The models are developed for nine companies in the sector during the period 2007 to 2012 (yearly) and results are compared with the actual returns. It is found that the three factor model gives better results that are closer to the actual returns than those obtained by CAPM in most cases. Introduction: The Indian FMCG sector is the fourth largest in the Indian economy and has a market size of $13.1 billion. The sector is growing at rapid pace with well-established distribution networks and intense competition between the organized and unorganized segments. It has a strong and competitive MNC presence across the entire value chain. The CAGR of this sector is estimated at 17% since 2004. A sector with such high potential becomes one of the strongest market components for investment. The growth is reflected in the stock price movement of the sector’s constituent companies. Identifying the top1 players of the sector, this paper attempts to calculate yearly returns of these companies and also calculate the benchmark return against the market by two methods, CAPM and French and Fama Model. The method of calculating returns is discussed in the later part of this paper. An attempt has also been made to evaluate both the models against each other to arrive at a better model that could be applicable for further studies. Objectives: The major objective of this paper is to compare the CAPM and French and Fama model applicable to FMCG sector in India. French and Fama model is a three factor model unlike the single factor model CAPM; and hence F&F model is expected to be a better benchmark model for analyzing returns. Assumptions: Following assumptions have been taken in the study:  Market index SENSEX is taken as a proxy for market returns  Government Treasury Bill rates are taken as a proxy for risk free rates Review of Literature: The concept of wealth maximization focuses on enhancing the investor wealth by maximizing company’s value. Share prices are one of the major indicators of a company’s value; these prices are

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influenced by various factors which may have direct or indirect effect. Mahapatra and Biswaroy (2011) identify and quantify the impact of a wide range of fundamental and technical factors on the prices of equity shares in India. Shefali sharma and Singh (2006) determine the impact of company specific factors on equity share prices. The study establishes that share price changes are associated with changes in fundamental variables which are relevant for share valuation like payout ratio, dividend yield, capital structure, earnings, size of the firm and its growth [Wilcox (1984), Rappoport (1986), Downs (1991)]. Das and Pattanayak (2013) also identify the critical fundamental factors that have significant effect on stock price movements mirrored by indices Sensex and Nifty. Reinganum (1981) found that size and P/E ratios could explain variations in reurns; Banz (1981) discusses the size effect on stock returns. Fama and French (1992) suggest that stock risks can be proxied by size and book-to-market equity. Davis (1994) and Davis et al. (2000) confirmed the influence of B/M ratio and size. Pandey and Chee (2002) found that size, beta, E/P ratio, dividend yield and B/M ratio play a significant role in predicting expected stock returns in Malaysia. Connor and Sehgal (2001) studied the Fama and French three factor model and found that the proxies for market, size, and value factors could explain the cross-sectional dispersion of their mean returns. Rohinisingh (2009) relates stock returns to underlying behavior of beta and five company attributes, namely, size, earnings yield, cash earnings yield, dividend yield, and B/M ratio. Size and B/M were found to be significant in the individual regressions and only size was significant in the multivariate regression analysis. This study indicates that risk is multidimensional, and researchers should not depend on beta alone. Volatility in returns is a key issue in financial economics. The prices of stocks and other assets depend on expected volatility of returns. Singh and Babbar (2010) attempt to predict the volatility pattern in bank stock returns in India. Stock sensitivity to market (Beta) is correlated to market volatility. Modern capital theory, Capital Asset Pricing Model (CAPM), as developed by Sharpe (1964), Lintner (1965) and Black (1972) constitute a simplified model of asset pricing; the model incorporates sensitivity beta in analyzing the return. Fama and French (1992, 1993) find that three variables, market equity, ratio of market equity to book equity, and leverage variables capture much of the cross section of average stock returns. In the presence of these three variables, market beta does not have any explaining power. The empirical evidence against CAPM by Fama and French has generated a lot of debate and has called for major re-examination of the CAPM. Studies by Marisetty and Vedpuriswar (2002), Connor and Sehgal (2001), and Mohanti (2002) have supported the three factor model. Ansari (2000) has opined that the studies of CAPM in the Indian markets are scanty and no robust conclusions exist on this model. Dash and Sumanjeet (2008) support Fama and French hypothesis. The result suggests that in multivariate analysis, B/M equity and leverage have significant power; however, market beta has insignificant explanatory power. FMCG sector analysis of stock returns in India has not been extensively done earlier. This paper intends to analyze the said sector using French and Fama three factor model, considering B/M equity, size, and market volatility as major factors influencing stock prices. Sources of data:  Share prices of FMCG companies: BSE website  SENSEX closing prices: BSE website  Indian Govt. Treasury bill rates: RBI database  Financial statements: respective company websites  Industrial overview of FMCG sector: JStor, EBSCO, IBID www.theinternationaljournal.org > RJCBS: Volume: 02, Number: 10, August-2013

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Methodology: Capital assets pricing Model (CAPM) A. Obtain the daily closing prices of the selected companies for the assigned period B. Natural Log is applied to the values to normalize the data and the change on this is calculated as(P1-P0)/P0. C. At the end of every year,Average Annual daily Return, Risk, Holding Period Return (HPR) of BSE Sensex and the selected companies are calculated D. Beta (β) for every year is calculated by running a simple regression, wherein market returns are taken as the independent variable and company returns are taken as the dependent variable. E. STANDARD DEVIATION function gives the Risk and SUM function gives Holding Period Return (stastical). F. But in this case, Financial HPR is used by calculating the percentage change between first vale and last value of percentage daily change for the year. G. Then CAPM is calculated by using formula Ra=Rf+ (Rm-Rf)*β Where Rm is Market return, β is Slope and Rf value is Risk Free Return. Calculating Expected returns using Fama and French approach To calculate expected return with Fama and French Model, we need to calculate betas and values of three independent variables. The equation used for calculating expected return in in Fama and French is as under:

(Rm-Rf)* This is the annual risk premium on market portfolio. Simply add up all the monthly (RmRf) values and obtain the annual Rm-Rf. (SMB) ** This is the annual size premium which can be obtained by adding up all the SMB values in all of the 12 months. (HML) *** This is B/M ratio premium and can be obtained by adding up the HML values of all of the twelve months. Step1: Calculate Ri-Rf A.Obtain the closing share prices of the required companies on a daily basis for the period of study B. Calculate the return using Ri = (P1-Po)/Po, for the companies individually C. Calculate Ri-Rf, wherein Rf is the risk free rate for that particular period. Step2: Calculate Rm-Rf A.Obtain the closing Sensex prices on a daily basis B. Calculate the market return using Rm = (P1-Po)/Po, C. Calculate Rm-Rf,wherein Rf is the risk free rate for that particular period. Step3: Calculate SMB A.Obtain the total assets of the selectedcompanies for the assigned period B. Sort the companies based on size i.e. total assets C. Divide the companies into two groups i.e. Small and Big, based on the median of the assets values D.Obtain monthly (end-of-month) closing share prices for 12 months for the BIG companies E.Calculate monthly returns for each company in the BIG group F.Calculate monthly average return of the companies constituting the Big group. G.Repeat the same process for SMALL group to calculate average monthly return www.theinternationaljournal.org > RJCBS: Volume: 02, Number: 10, August-2013

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H. Subtract the average returns of BIG from the average returns of SMALL in each of the 12 months. These monthly differences are the SMB values. Step4: Calculate HML A. Calculate the Book value per share ofthe selected companies for the assigned period. B. Book per share = Total Equity / No. of Shares outstanding. C. Obtain the Market value per share of the selected Companies for the assigned period. D. Market value per share = Share price at the end of the given year E. Calculate B/M ratio = Book value / Share price F. Sort the companies based on B/M ratio from HIGH to LOW B/M ratio. G.Remove the companies with negative returns andfor the given period and retain only those companies that have positive returns H. Divide the companies into two groups i.e. High and Low , based on the median of B/M values I.Obtain monthly (end-of-month) closing share prices for 12 months for the HIGH companies J. Calculate monthly returns for each company in the HIGH group K. Calculate average return for the HIGH in each month by averaging the returns L. Repeat the same process for LOW group to calculate average monthly return M. Subtract the average returns of LOW from the average returns of HIGH in each of the 12 months These monthly differences are the HML values Step5: Running Regression We make use of multiple regressions. Run a multiple regression with (Rm-Rf), SMB, HML as independent variables and (Ri-Rf) as the dependent variable. Obtain corresponding coefficients for the independent variables and the intercept along with their significance coefficients (p-value). The model is valid if the significance coefficient (p-value) of the intercept is greater than 0.05, as the model is tested at a significance level of 0.05. In case any of the models is not valid for a given company, comparison of CAPM and F&F is not applicable and hence N/A is assigned in such case. Besides comparison of returns, the overvalued and undervalued stocks are identified. If the actual return is above benchmark return, the stock is overvalued; similarly the stock is undervalued if the actual return is below the benchmark return.

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Results and Interpretations: Fig. 1: Comparison of F&F and CAPM returns with actual returns

The above results show annual returns of respective companies, benchmark return calculated by CAPM and F&F model, absolute difference of actual return and CAPM return, absolute difference of actual return and F&F return. The validity of model is specified as per the significance of intercept obtained by regression analysis. During 2007-2008, F&F model is proved to be better for seven out of nine companies and in the rest two cases the F&F model is not valid. Thus for these cases, comparison of CAPM and F&F is not made. The status of the stock specifies if the stock is overvalued or undervalued during the period. These stocks get auto corrected in due course to an equilibrium return that is the market return. www.theinternationaljournal.org > RJCBS: Volume: 02, Number: 10, August-2013

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During 2008-2009, F&F is a better model in six cases; CAPM in one and in the reset two cases, either of the models is not valid. For the next two years, i.e. 2009-2010 and 2010-2011, F&F is better in five cases, CAPM in two and in the rest two cases, comparison is not applicable. During 2011-2012, F&F is proved to be better model in six cases, CAPM in two cases. Conclusion: On the whole, comparison of the model can be done in 36 cases out of which 80 percent of the cases show F&F model to be better than CAPM in analyzing returns. Thus it is evident that French and Fama three factor model is a better model than CAPM in analyzing stock returns. References: Ansari Valee A (2000): “Capital Asset Pricing Model: Should We Stop Using It”, Vikalpa, Vol. 25, pp. 55-64 Banz R W (1981): “The Relationship between Return and Market Value of Common Stocks”, Journal of Financial Economics, Vol. 9 (1), pp. 3-18 Black F, Jensen M.C., and M. Scholes (1972): “Capital Asset Pricing Model: Some Empirical Tests”, Studies in the Theory of Capital Markets, Praeger, New York, pp. 79-121 Connor G and Sehgal S (2001): “Tests of the Fama and French Model in India”, available at www.lse.ac.uk/collection/accountingandfinance/staff/connor/filesfama&frenchindia.pdf Davis J L (1994): “The Cross-Section of Realised Stock Returns: The Pre-Compustat Evidence”, Journal of Finance, Vol.49 (5), pp. 1579-1593 Davis J L, FAMA E F and French K R (2000): “Characteristics, Covariances, and Average Returns:1929-1997”, Journal of Finance, Vol. 55 (1), pp. 389-406 Downs T W (1991): “An Alternative Approach to Fundamental Analysis: The Asset Side of the Equation”, Journal of Portfolio Management, Vol. 17 (2), pp. 6-17 Fama E F and French K R (1993), “Common Risk Factors in the Returns on Stocks and Bonds”, Journal of Financial Economics, Vol. 33 (1), pp. 3-56 Fama E F and Macbeth J (1973): “Risk Return and Equilibrium: Empirical Tests”, Journal of Political Economy, Vol. 81 (3), pp. 607-636 Fama F. and R. Kenneth French (1992): “The Cross Section of Expected Stock Returns”, Journal of Finance, Vol. 47, pp. 427-466 Lintner John (1965): “The Valuation of Risk Assets and Selection of Risky Investments in Stock Portfolios and Capital Budgets”, Review of Economics and Statistics, Vol. 47, pp. 13-37 Marisetty V B and Vedpuriswar A (2002): “Small Firm Effect in Indian Stock Market”, The ICFAI Journal of Applied Finance, Vol. 8, pp. 51-66 Mohanty P (2002): “Evidence of Size Effect on Stock Returns in India”, Vikalpa: Journal for Decision Makers, Vol. 27 (3), pp. 27-37 Niladri Das and Pattanayak J K (2013): “The Effect of Fundamental Factors on Indian Stock Market: A Case Study of Sensex and Nifty”, The ICFAI Journal of Finance, Vol. 19 (2), pp.84-99 Pandey I M and Chee H K (2002): “Predictors of Variation in Stock Returns: Evidence from Malaysian Company Panel Data”, Global Business and Finance Review, Vol. 7 (1), pp. 61-67 Ranjan Kumar Dash and Sumanjeet (2008): “Explaining the Cross Section of Expected Stock Returns: An Application of Fama and French Model for India”, Finance India, Vol. XXII (3), pp. 923-935 Rappoport (1986): “The Affordable Dividend Approach to Equity Valuation”, Journal of Financial Analysis, Vol. 42 (4), pp. 52-58 Reinganum and Marc R. (1981), “A New Empirical Perspective on the CAPM”, Journal of Quantitative Analysis, Vol. 16, pp. 439-462 Rohini Singh (2009): “Company Attributes and Stock Returns in India”, The ICFAI Journal of Applied Finance, Vol. 15 (2), pp. 46-57

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Rudra P. Mahapatra, Prasanna K. Biswaroy (2011): “Impact of Fundamental and Technical Factors on the Prices of Equity Shares in India: An Econometric Analysis”, Finance India, Vol. XXV (4), pp. 1259-1272 Sharpe William F. (1964): “Capital Asset Prices: a Theory of Market Equilibrium under Condition of Risk”, Journal of Finance, Vol. 19, pp. 425-442 Shefali Sharma, Balwinder Singh (2006): “Determinants of Equity Share Prices in the Indian Corporate Sector: An Empirical Study”, The ICFAI Journal of Applied Finance, Vol. 12 (4), pp. 21-38 Singh Y P and Babbar S K (2010): “Volatility Patterns in Bank Stock Returns in India”, The Indian Journal of Commerce, Vol. 63 (1), pp. 1-20 Wilcox J W (1984): “The P/B-ROE Valuation Model”, Journal of Financial Analysis, JanuaryFebruary, pp. 58-66

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