VALUE INVESTING

Equity markets around the world continue to be driven by the two powerful emotions of greed and fear, leading many an investor to chase the most talked-about ideas without perhaps as much consideration for the underlying fundamentals and therefore overlooking some great investment opportunities just because these do not find favour with the market. At the same time, far away from the day-to-day clamour of the stock markets, there is a school of investors who quietly work on a disciplined approach to stock picking, making sure that they are buying into low expectations and keeping valuations on their side. Investing to them is not just buying stocks, but using stocks as a conduit for buying into businesses. This is the essence of
Value Investing. This edition of the Perspective takes a look at the concept of Value Investing, its usefulness as an investment style and addresses some of the common misconceptions associated with it.

AT A GLANCE􀂃 The basics of Value Investing
􀂃 Value Investing has worked in markets across the world over the long term
􀂃 Common misconceptions on Value Investing ZOOMING IN WHERE MARKETS REFUSE TO TREAD
"The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities...The market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion,” said Benjamin Graham and David Dodd, professors of finance at the Columbia University in
the USA, who in the 1930s, laid out what is considered to be the framework for value investing. Their concept was actually very simple: identify and invest in companies trading below their inherent worth or intrinsic value.

THE QUEST FOR INTRINSIC VALUE

The value investor looks for stocks with inherently strong fundamentals - including earnings, dividends,book value, and cash flow - that are selling at a lower price, given their quality. The value investor tries to actively identify companies that seem to be incorrectly valued (undervalued) by the market and therefore whose share price has the potential to increase when the market corrects its anomalies in valuation. While a company’s market capitalisation reflects the value of its stock based on what investors are willing to pay for its shares, the intrinsic value seeks to identify what the company is really worth, based on the value of the underlying business. Value investment professionals use different techniques to calculate intrinsic value and there is no universally accepted measure. But, for the most part, they use criteria based on a company’s assets and earnings to evaluate its past performance and estimate its future prospects. Understanding the management, competition and the business model and fundamentals of the company, is also important
in determining the intrinsic value of a company. Then there are other variables such as brand name, trademark, and copyrights that are often difficult to calculate and sometimes not accurately reflected in the market price. Value investors would only be interested to invest in companies that are available at significant discounts
to their intrinsic values. Value investing combines the conservative analysis of determining intrinsic value with the requisite discipline and patience to buy stocks only when a sufficient discount from that value is available in the market.
Because value investing is as much an art as a science, value investors feel the need for a margin of safety to arrive at a decision to invest. A margin of safety is achieved when securities are purchased at prices sufficiently below their intrinsic values to allow for human error, bad luck, or extreme volatility in a
complex, unpredictable, and rapidly changing world.


According to Graham, "The margin of safety is always dependent on the price paid. For any security, it will be large at one price, small at some higher price, nonexistent at some still higher price."
Conventionally speaking, many of the value investors begin their search by looking for investing in stocks with low price-earnings (P/E) or low price-book value (P/BV) ratios in the tradition of Benjamin Graham. The other ratios used by Graham were Dividend Yield, Return on Equity (RoE), Return on Capital Employed (RoCE), Enterprise Value to Earnings before interest, taxes, depreciation and amortisation (EBITDA), Enterprise Value to Sales and Price to Cash Flow etc. Over time, these ratios have been used in the primary screening criteria by many value investors.

BENJAMIN GRAHAM’S VALUE INVESTING TOOLKIT

Based on years of empirical evidence, Graham developed a screening toolkit which he used extensively to identify value picks.

1. P/E of the stock has to be less than the inverse of the yield on AAA Corporate Bonds
2. P/E of the stock has to less than 40% of the average PE over the last 5 years
3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield
4. Price < Two-thirds of Book Value
5. Price < Two-thirds of Net Current Assets
6. Debt-Equity Ratio has to be less than 1.
7. Current Assets > Twice Current Liabilities
8. Debt < Twice Net Current Assets
9. Historical Growth in EPS (over last 10 years) > 7%
10. No more than two years of negative earnings over the previous 10 years.

VALUE INVESTING – THE WARREN BUFFETT WAY
Graham's most famous student, Warren Buffett, has taken value investing to another level. He chooses stocks on the basis of their overall potential as companies or businesses. Holding these stocks as longterm plays, Buffett seeks not capital gain but ownership in quality companies extremely capable of generating earnings.

WARREN BUFFETT’S TENETS FOR VALUE INVESTINGBusiness
􀂃 The business the company is in should be simple and easy to understand.
􀂃 The firm should have a consistent operating history, manifested in operating earnings that are stable and predictable.
􀂃 The firm should be in a business with favourable long term prospects.

Management

􀂃 The managers of the company should be candid. As evidenced by the way he
treated his own stockholders, Buffett put a premium on managers he trusted.
􀂃 The managers of the company should be leaders and not followers.

Financial
􀂃 The company should have a high return on equity. Buffett used a modified version
of what he called owner earnings:
􀂃 Owner Earnings = Net income + Depreciation & Amortization – Capital Expenditures
􀂃 The company should have high and stable profit margins.

Market
􀂃 Use conservative estimates of earnings and appropriate discount rate.
􀂃 Valuable companies can be bought at attractive prices when investors turn away
from them.

SOME OTHER SCREENERS

Here is a list of a few more thumb-rules that some value investors use as rough guides for picking stocks. Do remember that these are guidelines, not hard-and-fast rules:
1. Look at companies with P/E ratios at the lowest decile of all equity securities.
2. PEG (Price to Earnings Growth) should be less than 1.
3. Stock price should be no more than the tangible book value.

WHERE TO LOOK FOR VALUE?
Equity markets, from time to time, present situations which are called “Valuation Anomalies”, in which the market either overlooks or is ignorant of the value – either hidden or emerging out of a shift in business parameters. Value Investors wait for these situations to identify suitable investment opportunities.

There are basically three kinds of valuation anomalies that can be seen in the markets:
Over-pessimism – the entire market becomes pessimistic about something and the stocks start falling.Because the stocks are falling, no one wants to invest in them.
Under-estimated structural earnings potential – this structural change happens in an industry or a business which changes it from a fundamentally bad to a good business. And because the markets are so taken by what is happening currently, they miss the structural change.
Under-estimated change (the extent or pace) – this arises where the extent or pace of change is not properly estimated by the market.

The key point of note here is that market will always present such valuation anomalies. These anomalies in turn, are driven by risk-aversion of market players who would like to stay with the crowd and invest in stocks which are already going up no matter how expensive they are. Markets are going to be driven by greed and fear and this is what will create valuation anomalies.

THE VALUE – GROWTH CONUNDRUM

While Value Investing is focussed on valuation anomalies and buying stocks which trade at a price significantly lower than their intrinsic values, Growth Investing involves buying stocks which have a high earnings growth rate and are likely to be expensive as expectations are high. While both styles of investing have their merits as investment strategies and they come into prominence at different phases in the market cycle, empirical evidence is in favour of value investing over a sustainable period of time. This is mainly because in value investing, one buys into low expectations that are less likely to disappoint whereas investing for growth could lead to underperformance over a period of time as growth rate tends to revert to the mean in a capitalistic economic model. For instance, if there is a high growth opportunity in an industry within an economy, it will attract new players who would invest more capital to set up new capacities. As a result, over a period of time, the industry is likely to lose its competitive edge leading to a reversal to its mean growth rate. It is important to remember that any investment strategy that is based upon buying well-run, good companies and expecting the growth in earnings in these companies to carry prices higher is risky, since it ignores the reality that the current price of the company may reflect the quality of the management and
the firm. If the current price is right (and the market is paying a premium for quality), the biggest risk is that the firm loses its lustre over time, and that the premium paid will dissipate. If the market is exaggerating the value of the firm, this strategy can lead to poor returns even if the firm delivers its expected growth.


COMMON MISCONCEPTIONS ON VALUE INVESTING

1. Value investing is investing in “cheap” shares Value investing does not mean just buying any stock with falling prices and therefore one that seems cheap. Value investors generally do their homework to be certain that they are picking a company that is undervalued in spite of its high quality. It is important to distinguish the difference between a value company and a company that simply has a declining price. Say, for the past year Company A has been trading at about Rs. 25 per share but the price suddenly drops to Rs. 15 per share. This does not automatically mean that the company is selling at a bargain and hence is a value stock. All we know is
that the company is less expensive now than it was last year. The drop in price could be a result of the market responding to a fundamental problem in the company. To be a real bargain, this company must have fundamentals healthy enough to imply it is worth more than Rs. 15. Value investing always compares current share price to intrinsic value not to historic share prices. Picking “cheap” stocks without adhering to a valuation discipline could often lead to “Value traps” where prices go on declining further and the investor is never able to recover his investment.

2. A stock with a lower valuation ratio is a better value pick Contrary to popular belief, value investing is not simply about investing in stocks with lower valuation
ratio like a P/E or P/BV. It is just that stocks which are undervalued will often reflect this undervaluation through a low valuation ratio. A low valuation does not necessarily imply that the stock is a value pick. It could be in response to a fundamental issue or weakness in the company. A value investor would try to
establish the intrinsic value of the company and compare it with the market value. The higher the difference between the market value and intrinsic value, the better is the value pick.

3. Value stocks are difficult to find in a growth/emerging market Value investing has nothing to do with a Growth economy or market. Every market, irrespective of its
nature, is likely to throw up valuation anomalies. These anomalies are more to do with market sentiment than anything else. More often than not, there are situations where the market participants take investment decisions out of either greed or fear. As a result, there are some fundamentally strong stocks which suffer from market pessimism, or the market fails to understand the structural earnings potential in an industry or the pace or extent of change is not appreciated.

4. Value investment can not work in a growth market like India A simple study shows that a notional investment of Rs. 1 lakh in the MSCI India Value Index has given about twice the returns of the same investment in the corresponding Growth Index, over a period of the
last 10 years.

5. Value investing can outperform but with a higher risk
The following table shows the compounded annualised growth of the MSCI India Core, Growth and Value indices across various time periods. It can be clearly seen that the Value index has outperformed the others significantly across time periods. At the same time, the Value Index has not added significant risk as compared to the other two indices, when measured by volatility or annualised standard deviation of monthly returns.

CONCLUSION
Value investing has outperformed other investing styles across global markets over the long term. Irrespective of market cycles and regardless of the fact that it is a high or a slow growth market, there could be valuation anomalies which would provide stock picking opportunities for the focused and disciplined value investor.
For most individual investors, it would be well near impossible to replicate this strategy to build up their own stock portfolios. They would be well-advised to look at investing in value funds offered by mutual fund companies to reap the benefits of value investing and add style diversification to their investments.


Source: Fidelity