Want to make money in stock market? Adhere to these 5 principles of Value Investing
Published: April 13, 2019 12:04 PM The Financial Express
Value investing is an idea that has been followed by a plethora of star investors from Ben Graham to Warren Buffett.
If you look back at the performance of the stock markets over the last 20 years, you will find two anomalous features about value stocks. Firstly, value stocks are found in the most unlikely of places and sectors. Many value creators may look obvious in retrospect but would have been almost invisible at that point of time. Secondly, the tipping point for a value stock has no fixed time period as we have seen in the case of many stocks. But value investing is an idea that has been followed by a plethora of star investors from Ben Graham to Warren Buffett. Let us look at some of the key underlying principles of value investing.
1. Value investing is all about patience
Value Investing is all about belief in the conviction one is carrying, where the idea you have shortlisted is unexplored, not widely covered or followed but the potential of that ideation being a disruptive element vis-à-vis its peers/sector being uncovered over a period of time is to be observed. Value investing does not entail quick returns but there exists a possibility that the stock might not move for a few years, but once its value starts getting recognized by the markets the returns can be multifold. Hence patience is an ideal virtue for value investing. To cite an example, in the recent decade, as US demand for generics started expanding rapidly and the Indian pharma companies built scale, the sector was ripe for value investing. When it comes to value investing, you have to either be close to the tipping point or be willing to wait for the tipping point. This tipping point is normally triggered by the disruptive idea gaining popular acceptance.
2. Value comes from managing short-term and long-term debt smartly
Value investing lays a lot of emphasis on keeping your debt in check. Your capacity to manage your short-term and long-term debt without hiccups is the key to value creation. Value investing is based on the principle of low leverage. In fact, most of the value creators in India have been funded through internal cash flows. Look for companies where the current assets in liquid form can comfortably service the current liabilities. Then we come to the long-term debt. High debt stocks rarely create value in the markets. We saw that in infrastructure stocks, power stocks and steel stocks. Over the last 10 years either they have given negative returns or deeply negative returns. Low debt with steady growth in revenues and profits is one of the best indicators of an undervalued company. Adding debt to reduce cost of capital may be good corporate finance but it is bad value investing.
3. Value investing means consistent above-average growth
A utility stock with steady cash flows and a high dividend yield rarely creates value. Value investing is all about big growth in the future. If you grow at a very steady rate or around the industry average then it is hard to be a value stock. What is required is consistent and concerted growth above the industry average. But, what is the kind of growth that we are talking about here and on which parameters?
Benjamin Graham calls for an approach to investing that is focused on purchasing equities at prices less than their intrinsic values. In terms of picking or screening stocks, he recommended purchasing firms who have steady profits, are trading at low prices to book value, have low P/E ratios and who have relatively low debt. Albeit, there are other parameters like promoters pedigree, corporate governance, strategy followed by the management etc. that need to be monitored as every company having the attributes that Graham suggested might not be ‘Value Buys’ but ‘Value traps’ INSTEAD.
Revenue growth is a must because that is where value begins. You need to look at a stock that is either creating new markets (like ecommerce) or penetrating existing markets deeper. That is what gives the company consistent above growth in revenues. Improving the asset turnover can only give you a small boost but to sustain revenue growth you need to prise open the market. Value investing is also about doing things more profitably. That is the driver of valuations. Finally, the ROE and the ROCE of the company must also be growing at above the industry average. After all, it is the capital that needs to be serviced better.
4. To PEG or not to PEG
This point is in a way related to the previous point but we nevertheless focus on it separately considering its importance in value investing. One of the simplistic approaches to value investing is to look at low P/E Ratio. But in a country like India where many stocks have opaque business models or where risks are not exactly disclosed or where governance is an issue, P/E may not matter much. Can you say that steel at 12X P/E is better than FMCG at 50X P/E? The answer is clearly “No”.
That is where PEG comes in handy. The PEG ratio is nothing but the P/E divided by the growth in ROE. This is a better method of identifying value stocks compared to P/E ratio which does not factor the growth aspect. Also, PEG, indirectly distils the quantitative and qualitative valuation of the stock and enables smoother benchmarking. Look for a reasonable PEG rather than a reasonable P/E and let it be consistent.
5. Moat and margin of safety
Back in 2007, Forbes did a cover story on Nokia which had just sold its billionth mobile phone with the title “Can anyone stop Nokia”. Exactly 4 years later, Nokia was rapidly sliding into bankruptcy as Apple had created the smart phone market and disrupted Nokia’s model for ever. Value investing is all about sustainable moats; not the kind of moat that Nokia built. Moat can be in the form of entry barriers or brands. Basically, moat is a business advantage that is valuable and sustainable.
However, moat does not talk about the actual stock price and that is where the final aspect of margin of safety comes in. It is said that every stock can be value at some time and awfully overvalued at other times. The margin safety measures the gap between the intrinsic value of the stock and the market. This is the last and perhaps the most important actionable input for value investing.
(By Mayuresh Joshi, Fund Manager, Angel Broking Ltd)