The motivation behind this paper was to see if financial statement analysis could be employed by investors to design portfolios of low book-to-market stocks that could help them earn excess returns in the Indian context. Using a modified framework from Mohanram (2005), which employs a G_SCORE, capable of separating ex post winners from losers among low book-to-market companies, and portfolio formation on the basis of the G_SCORE, we find convincing evidence that financial statement analysis can help investors form profitable portfolios among low book-to-market stocks. We show that portfolios with high G_SCORE (6 to 7) provide outstanding returns both on absolute and riskadjusted basis and far outperform the markets. At the same time, portfolios with low G_SCORE (0 to 3) offer very poor returns and always underperform the markets on both absolute and risk-adjusted returns. Thus a growth investor could shift his distribution of returns rightwards by investing in portfolios of only high G_SCORE stocks; simultaneously shorting low G_SCORE portfolios would further amplify the returns.

Investment strategies that derive from signals interpretable through financial statement analysis have been quite popular in literature. Notable among them have been Ou and Penman (1989), Lev and Thiagarajan (1993). In addition, simple models using market-based signals have also been popular among investors and analysts (for example, see Lopes and Galdi, 2007). One of the most popular market-based signals has been the book-to-market ratio and it has been established that high book-to-market stocks/portfolios, popularly called value stocks/portfolios, outperform the markets.

On the other hand, the low book-to-market strategy has been equally popular and was probably motivated by professional investors’ herding on growth stocks (low book-to-market stocks) expecting that herding would lead to return continuation in growth stocks with strong appreciation in past. However, a practical problem that can potentially be faced by many investors is: “Are all low book-to-market stocks, growth stocks?” Certainly not; as Mohanram (2005) emphasized, less than 48% of all low book-to-market stocks1 earned positive returns in two years following the formation of the portfolio. Aspris et al. (2013) found similar performance in the Australian context (44% stocks) as also Athanassakos (2013) in the Canadian context (50% stocks). Clearly, there is something more than just the book-to-market ratio for a stock to be classified as growth stock and this ‘something’ could help investors discriminate, ex ante, between eventual strong and weak stocks (Aggarwal and Gupta, 2009).

Applied Finance Journal, Data, Signals Related, Profitability, Methodology, Returns, Financial Statement Analysis, Low Book-to-Market Stocks, Evidence, National Stock Exchange (NSE), India.