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Pairs trading and value investing strategies.

INTRODUCTION

It has been long time that the investors have entirely been seeking for the investment knowledge to create their wealth. The value investing method has been one of the extensive interesting methods and so many investors have successfully and significantly applied value investing method, and that has led to academic research extensions. The investment performance would often be measured by comparison between return on investment of value investing method and that of the market or other investment methods such as growth investment method. Most of the research studies referred to similar basic concept that the value investment always invested in the securities with low financial ratios such as low Price-to-earnings ratio (P/E) and Price-to-book ratio (P/B) in order to reflect the securities that had lower trading prices than intrinsic values. Most of the studies indicated that the value investment always yielded higher returns than other investment methods.

In the meantime, the pairs trading strategy has been initiated by Gerry Bamberger and Nunzio Tartaglia who were Morgan Stanley's quantity analysts. In the period of 1985 and later, this pairs trading had been extensively utilized among the institutional investors or different types of funds that had more investment alternatives than general investors. The related pairs of securities such as securities of similar natures of business operations or securities in the same industries were selected, the securities were bought at trading prices which were lower than the values and sold them at trading prices which were higher than the values. The beliefs from doing this transaction were the reduction of risk exposures from the variances of the stock exchange markets and generation of capital gains from the mispricing of trading prices and intrinsic values.

According to the previous study, it indicated that the valuing investment consisting of low P/E and P/B stocks yielded higher returns while the investment in high P/E and P/B stocks yielded in the opposite outcomes, leading to the hypothesis that if the investors invest in low P/E and P/B stocks together with doing the short selling of high P/E and P/B stocks, this will inevitably generate more returns, and be useful in another aspect on increase of stock quantities, and then help reducing portfolio fluctuations.

The objective of this study is to develop the combination of value investing method and pairs trading strategy by creating of the portfolio in buying low P/E and P/B security portfolio, and short selling high P/E and P/B security portfolio with the expectations that in long run, these created portfolios will generate higher returns than that of the markets and sole investment in low P/E and P/B security portfolios while there are low fluctuations of returns and risks.

LITERATURE REVIEW

The value investing concept had been initiated from Graham and Dodd (1934) and was published in Security Analysis identifying that the investors could evaluate the stock values from the figures in the corporate financial statements and the evaluated value might be called as Intrinsic Value, and then invested if the values found was higher than market price. Subsequently, the academic researchers of the stocks with value investing characteristic were conducted. For example, Basu (1977) studied the high price-to-earnings ratio stocks and low price-to-earnings ratio stocks, and found that the high price-to-earnings ratio stocks generated lower returns than the market while the low price-to-earnings ratio stocks generated higher returns. Chan and Lakonishok (2004) studied the information in Japan and found that the value investing strategy yielded higher returns than the markets. Lakonishok, Shleifer, and Vishny (1994) found that a portfolio of stocks with low book-to-market and earnings-to-price ratios can yield excess returns without additional risk.

Fama and French (1998) conducted a study on the returns yielded by high book-to-market ratios and low book-to-market ratios. They reported that shares with high book-to-market ratios provided higher returns than low book-to-market ratios in twelve of the thirteen countries studied. By studying various financial status in selecting stocks portfolios with high book-to-market ratios, Piotroski (2000) found that stock selection could increase portfolio returns. Panyagometh (2009) conducted the study by creating the stock portfolios of the most well-known companies in Thailand ranked by the Wall Street Journal Asia (WSJA). The studying portfolios were classified into three categories including equal proportion-based investment portfolio, market value proportion-based investment portfolio, and Portfolio Optimization Theory-based investment portfolio; and the study result showed that all three portfolios could significantly generate higher returns than the stock investments in the entire market.

Sareewiwatthana (2011) studied on the returns of value stock portfolios in Thailand using the financial ratio criteria that P/E was 10 times below, P/B was 1 time below, and dividend yield was higher than 3%; and the study result indicated that the value stock portfolios significantly generated higher returns than stock market. Moreover, Sareewiwatthana (2013) tested the stock selection concept by using five financial ratios commonly used by value investors. The results show that the best performance is from using price to earnings ratio. It was also found that decreasing the number of stocks tends to yield better returns.

According to Pairs Trading strategy, there were several interesting researches. For example, Jacobs and Levy (1993) applied the theories of Arbitrage Pricing Theory (APT) or Capital Asset Pricing Model (CAPM) to identify the stocks having higher prices than intrinsic values or lower prices than intrinsic values as it was the opportunity to generate higher returns than Long (Buy) Only investment. Gatev, Goetzmann and Rouwenhorst (2006) utilized historical stock price data for matching with the stocks having the same directions of price relationships and then the occurring capital gains reflected the mispricing of stock market prices. Caldeira and Moura (2013) constructed the portfolios by using Pairs Trading strategy in the Stock Exchange of Sao Paulo (Brazil) and discovered that the constructed portfolios could generate high returns and Sharpe Ratio while there was low correlation with market returns. For an excellent review of the existing academic models could be found in Poterba and Summers (1988); Lo and MacKinlay (1990); Gatev, Goetzmann, and Rouwenhorst (2006) and Elliot, Hoek and Malcolm (2005).

STUDY OBJECTIVES AND HYPOTHESES

The stated objective of this study is to develop the combination of value investing method and pairs trading strategy by creating the portfolio in buying low P/E and P/B security portfolio, and short selling high P/E and P/B security portfolio with the expectations in long run. It is expected that these created portfolios will generate higher returns than those of the markets and sole investment in low P/E and P/B security portfolios while there are low fluctuations of returns and risks.

Based on the above objective, the following hypotheses have been developed and tested:

[H.sub.1a]: Based on the annual average daily return of Pairs Trading portfolio, Long Only portfolio, and SET Index, Pairs Trading portfolio could generate yearly returns higher than that of the Stock Exchange of Thailand (SET) index.

[H.sub.1b]: Based on the annual average daily return of Pairs Trading portfolio, Long Only portfolio, and SET Index, Pairs Trading portfolio and Long Only portfolio, Pairs Trading portfolio could yield higher returns every year.

[H.sub.2a]: Based on the holding period rates of return, the return of Pairs Trading portfolio will be higher than those of Long Only portfolio and SET Index in all investment horizons.

[H.sub.2b]: The longer the investment period is, the greater return margins will be among Pairs Trading portfolio, long only portfolio, and SET Index would be greater.

[H.sub.3]: Based on the daily mean return difference between Pairs Trading Portfolio and Long Only Portfolio, Pairs Trading Portfolio will yield higher returns than Long-only portfolios throughout the investment horizons.

[H.sub.4]: Based on the daily mean return difference between Pairs Trading Portfolio and SET Index, Pairs Trading portfolio will generate higher returns than SET index for all investment durations.

RESEARCH METHODOLOGY

Sample and Data Collection

This study uses the data on the Stock Exchange of Thailand comprising all stocks listed on the Stock Exchange of Thailand from 2002 to 2012. For each year, the Long Only and Pairs Trading portfolio are formed as below.

Procedure

* Long Only Portfolio

Step 1: Rank stocks from low to high price-to-earnings ratio (P/E). Then, assign score to each ranking.

Step 2: Rank stocks from low to high price to book ratio (P/B). Then, assign score to each ranking.

Step 3: For each stock, combine its scores from the P/E and P/B rankings. Then, pick 10 stocks with the lowest scores of the year to include in the Long Only portfolio. The weights are calculated by the following method:

[w.sub.i] = [1/n]

Where "n" is the number of stocks in the portfolio. Since we select 10 stocks to include in the value stock portfolio, then n equals to 10 in our study.

Step 4: In the beginning of each year starting from 2002, create the Long Only portfolio by buying 10 stocks qualified as in Steps 1-3.

In this study, the P/E and P/BV ratios of all of the stocks listed in the Stock Exchange of Thailand at year's end are used.

* Pairs Trading Portfolio

Step 1: Rank stocks from low to high price-to-earnings ratio (P/E). Then, assign score to each ranking.

Step 2: Rank stocks from low to high price to book ratio (P/B). Then, assign score to each ranking.

Step 3: For each stock, combine its scores from the P/E and P/B rankings. Then, pick 10 stocks with the lowest scores and 10 stocks with the highest scores of the year to include in the Pairs Trading portfolio. The weights are calculated as in the Long Only portfolio.

Step 4: In the beginning of each year starting from 2002, create the Pairs Trading portfolio by buying 10 stocks with lowest scores, simultaneously, short-selling 10 stocks with highest scores qualified as in Steps 1- 3.

RESULTS OF THIS STUDY

Hypotheses Testing

The annual portfolio efficiency measurement of both types of portfolios by comparing the average daily return between each other and comparing with SET Index as shown in Table .1

Table 1 reported annual average daily return of Pairs Trading portfolio, Long Only portfolio, and SET Index. According to the results, Pairs Trading portfolio could yearly generate returns above SET index and if comparing the return of Pairs Trading portfolio and Long Only portfolio, Pairs Trading portfolio could yield higher returns than every year except only in 2003. The results supported hypotheses 1a and 2a

Table 2 presented the returns of both types of portfolios and SET Index. Having supported hypotheses 2a and 2b, the return of Pairs Trading portfolio was significantly higher than Long Only portfolio and SET Index in all investment horizons, and the longer was the investment period, the return margins between Pairs Trading portfolio and Long Only portfolio, and SET Index would be greater. When completing 10 years of investment duration, Pairs Trading portfolio yielded high annual average return up to 110.75% while Long Only portfolio yielded 41.48% of annual average return, and SET Index yielded only 12.93% of annual average return.

Figure 1 presented the values of Pairs Trading portfolio, Long Only portfolio and SET Index. When starting the investment in 2002, each portfolio value was assumed to be equal to one unit and when ending at year 10th, it would find that Pairs Trading portfolio had very much higher values than Long Only portfolio and SET Index by 1,728 times of initial investment values for Pairs Trading portfolio values, 32 times of initial investment values for Long Only portfolio, and 3 times of initial investment values for SET Index values.

In addition, we also performed matched-pair tests to the daily mean return difference between Pairs Trading portfolio and Long Only portfolio as well as between the Pairs Trading portfolio and the SET index.

Figure 1 presented the values of Pairs Trading portfolio, Long Only portfolio and SET Index. When starting the investment in 2002, each portfolio value was assumed to be equal to one unit and when ending at year 10th, it would find that Pairs Trading portfolio had very much higher values than Long Only portfolio and SET Index by 1,728 times of initial investment values for Pairs Trading portfolio values, 32 times of initial investment values for Long Only portfolio, and 3 times of initial investment values for SET Index values.

In addition, the author also performed matched-pair tests to the daily mean return difference between Pairs Trading portfolio and Long Only portfolio as well as between the Pairs Trading portfolio and the SET index.

The hypothesis testing results were shown in Tables 3 and 4 for matched-pairs tests to the daily mean return difference between Pairs Trading portfolio and Long Only portfolio, and between Pairs Trading portfolio and SET index, respectively. Table 3 indicated that at 99% of statistically significant confidence level, Pairs Trading portfolio yielded higher returns than Long-only portfolios throughout the investment horizons except only for one and two year investment horizons. Table 4 reported that Pairs Trading portfolio generated higher returns than SET index for all investment durations at 99% of statistically significant confidence level. These results are consistent with hypotheses 3 and 4.

The researcher did the comparison on risk adjusted return by using Sharpe ratio. Table 5 reported Sharpe ratio of Pairs Trading portfolio, Long-Only portfolio and SET index. The results in Table 5 indicated that even if considering on risks, Pairs Trading portfolio provided higher Sharpe ratio compared to those of Long-Only portfolio and SET index in all investment horizons.

CONCLUSIONS

This research studied Stock Exchange of Thailand for ten year period from 2002 to 2012. The objective of this study is to test whether the combination of value investing method and pairs trading strategy could enhance portfolio returns. Pairs Trading portfolio was created by buying low P/E and P/B stock portfolio, and short selling high P/E and P/B stock portfolio. The study results indicated that Pairs Trading portfolio could statistical significantly generate higher returns than Long-Only portfolio and SET index did either for short term or long term investment durations. The Pairs Trading portfolio investment was also found that when ending of 10 year investment duration, Pairs Trading portfolios had 50 times of higher values than Long-Only portfolio returns, and 500 times of higher returns than SET index returns. In addition, under the measurement by Sharpe Ratio, the study showed that short selling in high P/E and P/B stocks for matching in pairs with the investment in low P/E and P/B stocks could generate higher investment returns and the increased returns were still worthwhile even if already considering from the risks.

REFERENCES

Basu, S. (1977). Investment performance of common stocks in relation to their price-earnings ratios: A test of the efficient market hypothesis. Journal of Finance, 32(3), 663-682.

Caldeira, J., & Moura, G. V. (2013). Selection of a Portfolio of Pairs Based on Cointegration: A Statistical Arbitrage Strategy. Available at SSRN: http://ssrn.com/abstract=2196391 or http://dx.doi.org/10.2139/ssrn.2196391.

Chan, L. K., & Lakonishok, J. (2004). Value and growth investing: Review and update. Financial Analysts Journal, 60(1), 71-86.

Elliot, R. J., Hoek, J. V. D., & Malcolm, W. P. (2005). Pairs trading. Quantitative Finance, 5(3), 271-276.

Fama, E. F., & French, K. R. (1998). Value versus growth: the international evidence. Journal of Finance, 53, 1975-1979.

Gatev, E.G., Goetzmann, W.N., & Rouwenhorst, K.G. (2006). Pairs Trading: Performance of a Relative-Value Arbitrage Rule, Review of Financial Studies, 9, 797-827.

Graham and Dodd. (1934). Security Analysis: Principles and Technique. New York and London: McGraw-Hill Book Company, Inc.

Jacobs, B.I., & Levy, K.N. (1993). Long/Short Equity Investing, The Journal of Portfolio Management, 52-53.

Lakonishok, J., Shleifer, A., & Vishny, R.W. (1994). Contrarian investment, extrapolation, and risk, Journal of Finance, 49, 1541-1578.

Lo, A. W., & MacKinlay, A. C. (1990). When Are Contrarian Profits Due to Stock Market Overreaction? Review of Financial Studies, 3(2), 175-205.

Panyagometh, K. (2009). Can a great company be a great investment in Thailand? The International Journal of Business, Accounting, and Finance, 3(2).

Piotroski, J. D. (2000). Value investing: The use of historical financial statement information to separate winners from losers. Journal of Accounting Research, 38, 1-41.

Poterba, J. M., & Summers, L. H. (1988). Mean reversion in stock prices: Evidence and Implications. Journal of Financial Economics, 22(1), 27-59.

Sareewiwatthana, P. (2011). Value investing in Thailand: The test of basic screening rules. International Review of Business Research Paper, 7(4), 1-13.

Sareewiwatthana, P. (2013). Common Financial Ratios and Value Investing in Thailand. Journal of Finance and Investment Analysis, 2(3), 69-85.

Kamphol Panyagometh

NIDA Business School, Bangkok, Thailand

Kamphol Panyagometh received his PhD in Finance from Schulich School of Business, York University, Canada. Dr. Panyagometh is an Associate Professor in Finance at NIDA Business School. He has earned many important professional designations including Chartered Financial Analysts (CFA), Financial Risk Managers (FRM) and Certified Financial Planners (CFP). Furthermore, he has published research papers in academic journals such as Financial Management, Journal of Financial Planning, Research in Finance, Financial Services Review as well as Canadian Tax Journal.

Table 1

Performance Comparisons Based on the Annual
Average Daily Rates of Return

Year   Pairs Trading   Long Only    SET
         Portfolio     Portfolio

2002       0.30%         0.24%      0.07%
2003       0.42%         0.47%      0.30%
2004       0.51%         0.02%     -0.04%
2005       0.29%         0.04%      0.03%
2006       0.31%         0.15%     -0.01%
2007       0.03%        -0.02%      0.10%
2008       0.47%        -0.06%     -0.23%
2009       0.42%         0.41%      0.20%
2010       0.18%         0.17%      0.14%
2011       0.08%         0.01%      0.01%

Table 2

Performance Comparisons Based on the Holding
Period Rates of Return

Investment     Pairs     Long Only    SET
Horizon       Trading    Portfolio
             Portfolio

1             113.37%     80.09%     17.32%
2             148.64%    141.80%     59.41%
3             178.10%     81.99%     30.04%
4             157.00%     60.86%     23.80%
5             148.77%     57.60%     17.48%
6             116.35%     44.33%     18.89%
7             127.50%     33.23%      5.77%
8             133.85%     45.95%     11.67%
9             124.01%     46.75%     14.56%
10            110.75%     41.48%     12.93%

Table 3

Matched-pairs Tests to the Daily Mean Return Difference
between Pairs Trading Portfolio and Long Only Portfolio

Investment   Daily Mean Return     Mean Difference
Horizon

              Pairs    Long Only   [Pairs Trading--
             Trading                  Long Only]

1            0.3017%    0.2367%      0.0650%
2            0.3613%    0.3520%      0.0093%
3            0.4112%    0.2398%      0.1714% ***
4            0.3812%    0.1911%      0.1901% ***
5            0.3680%    0.1855%      0.1824% ***
6            0.3122%    0.1509%      0.1613% ***
7            0.3346%    0.1214%      0.2132% ***
8            0.3447%    0.1570%      0.1876% ***
9            0.3269%    0.1587%      0.1682% ***
10           0.3269%    0.1442%      0.1827% ***

*** Statistically significance at 0.01 level based on the
paired sample t-test.

Table 4

Matched-pairs Tests to the Daily Mean Return Difference
between Pairs Trading Portfolio and SET Index

Investment   Pairs Trading vs      Mean Difference
Horizon      SET Index

              Pairs    SET Index   [Pairs Trading--
             Trading                  SET Index]

1            0.3017%    0.0693%      0.2324% ***
2            0.3613%    0.1871%      0.1742% ***
3            0.4112%    0.1097%      0.3015% ***
4            0.3812%    0.0897%      0.2915% ***
5            0.3680%    0.0704%      0.2976% ***
6            0.3122%    0.0748%      0.2374% ***
7            0.3346%    0.0316%      0.3029% ***
8            0.3447%    0.0527%      0.2919% ***
9            0.3269%    0.0621%      0.2648% ***
10           0.3269%    0.0566%      0.2703% ***

*** Statistically significance at 0.01 level based on
the paired sample t-test.

Table 5

Sharp Ratio of Pairs Trading Portfolio, Long-Only
Portfolio and SET Index

Investment    Pairs     Long     SET
Horizon      Trading    Only

1            0.2072    0.1580   0.0475
2            0.2437    0.2223   0.1449
3            0.2150    0.1680   0.0773
4            0.1982    0.1435   0.0667
5            0.1953    0.1367   0.0469
6            0.1738    0.1105   0.0494
7            0.1669    0.0787   0.0135
8            0.1754    0.1012   0.0284
9            0.1722    0.1044   0.0362
10           0.1648    0.0957   0.0323
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Author:Panyagometh, Kamphol
Publication:International Journal of Business and Economics Perspectives (IJBEP)
Geographic Code:9THAI
Date:Dec 22, 2013
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