Relevance Of Value Investing
Looking at the current mood in the market and the way new investors think about stock valuation, it looks like the concept of value investing is outdated. Yogesh Supekar discusses why value investing is not something one should say goodbye to and that it matters even today when everyone is chasing growth
With the markets touching fresh all-time highs and stocks delivering unbelievable returns in a matter of months if not weeks, the classic debate of value investing versus growth investing has gathered steam. For those chasing stock prices without knowing the value of stocks, the fun ride is too good to spend time on identifying the value. Why spend time identifying value when by chasing prices one can become rich, and quickly! Besides, who wants to wait for years to bag multi-bagger returns when by investing in trending stocks you can quickly double your money? Once again in the past year or so we have seen the growth investing style becoming highly popular and fabulously rewarding the high-risk takers.
What one is not sure though is whether a similar high risktaking strategy will be rewarded in same magnitude in the coming quarters and years. In other words, will growth investing once again work in the coming 1-3 years or is it the time to focus on the merits of value investing? Investors better find an answer to this question and that too quickly before it’s too late. It looks like we are in that kind of a liquidity-driven rally where even a 5 per cent market correction is going to damage the portfolio structure and returns in a grave manner. The stocks have been in an upward trajectory a lot and higher the stock prices jump in quick time the shakier they become.
History has taught us that as the market gets shaky, the risk reward become unfavourable for the investors. With risk reward becoming unfavourable, money starts getting withdrawn from the equity markets and then that leads to a further slump in the equity prices. By the time individual investors realise that market correction is gathering steam, it often is too late and the damage to the portfolio returns is already done. One regular argument that several investors are making this time is to let the stock prices come down. “I have entered the market early and at lower prices and so I can weather the market correction,” is the common refrain.
These investors are failing to understand that the portfolio returns will be severely impacted in case of market correction and that would mean the averaging of the portfolio returns which in the past couple of years has been abnormally high. Does this mean that investors should take money off the table and exit the markets completely? No, that would not be advisable. In such times when the market can get volatile or when the probability of market correction, immaterial of its magnitude, is high, the investing style and philosophy needs to be adjusted. Exiting the market could be the worst mistake an investor can make as equity prices will eventually triumph and overcome correction before we realise.
A tweak in the investment strategy from more aggressive to a bit conservative is what may do the trick for equity investors. But then how does one become conservative and yet does not compromise on returns since ultimately isn’t it all about returns? For more returns shouldn’t we take more risks for after all higher the risks higher the returns? The market situation at its current level is suggesting that one may not get the expected returns for higher risks that one may undertake. That is what we mean by risk reward being unfavourable. However, one solution to solve this problem where we want a better risk reward ratio and very little compromise on returns is to adopt value investing style in the current market situation.
A switch from growth investing to value investing is not easy and it takes a complete change in style when it comes to stock-picking. In cricket terminology, imagine the captain asking Virendra Sehwag to bat like Rahul Dravid! More than technique, it’s the temperament that plays a crucial role. Value investing is a game of patience, persistence, conviction and to an extent it’s contrarian investing at its best. Deep knowledge is required and so also hard work when you adopt a value investing approach to your portfolio. A mix of high-quality growth stocks and value stocks may also not be a bad idea to start with. However, a shift in strategy could be wise under the current market situation.
Understanding Value Investing
Value investing, even though it is a scientific process, has an element of judgement involved. Hence, it is not easily comprehended by everyone. Some people just don’t understand it no matter how hard they try while for some it is highly intuitive. To understand value investing we need to refer to the most revered investment minds of all time – Benjamin Graham. He has made it pretty clear what value investing ought to be and in his mind, he was clear that value investing will outperform any other investing styles.
In one of the interviews given by him to New York Times on May 24, 1974, when he was almost 80 years of age and retired, he mentioned seven criteria for successful stock selection using value investing principles:
• The current assets are at least two times the current liabilities n Debt is not more than 110 per cent of the current assets
• The company has paid a cash dividend for at least past 20 consecutive years
• There has been no deficit in the last five years
• The price or earnings multiple is a maximum of 8
• The stock is selling at no more than half of the previous high
• The stock is selling at no more than two-thirds of net tangible book value per share.
If one looks at the criteria suggested by Graham, one may find it difficult to implement it in today’s world. However, it is not impossible to find stocks fitting the described criteria when the markets are depressed. Market correction will lead to deep discount opportunities and that is where value is seen across the board. However, when the markets are trending and close to all-time highs then one has to really put in extra effort to identify value. An attempt can be made to select stocks that fit the criteria mentioned as closely as possible even if it is not possible to find stocks matching all the criteria point by point.
Stocks that have better than average long-term growth prospects are called growth stocks.
Value investing may sound absurd in today’s market condition; however, it will be unwise to assume it is obsolete. We are in a bull market and what a bull market does is that it dulls people’s senses. Investors find value investing senseless in bull markets as the gold rush mentality takes hold and returns that would take decades are generated in a matter of months. One of the important reasons why value investing needs careful consideration even in bull markets is because in spite of rampant optimism there is a sense of impermanence. There is no way that high flyers will stay afloat even when they are not making profits. When there is frenzy going on, one needs grounding of reality and value investing helps you focus on reality when the mirror shows you a much better picture than it actually is.
If one asks why people are chasing stock prices or up-trending stocks, it is easy to understand – they all want to make money. What the investing public needs to understand is that value investing can make you truly prosperous. In the past we have seen that market correction surprises investors and traders because the public is not emotionally and financially equipped to deal with it. Benjamin Graham, who came to be known as the god of value investing, asserted in his various communications that value investing will equip you to face market correction as the undervalued stocks may not correct that much when the overall market corrects. On top of it, value stocks have a tendency to outperform in the real long-term period. By real we mean more than five years. There are various studies that point to outperformance of value stocks over the long term. Yes, there are studies that point to outperformance of growth stocks as well but risk-adjusted value investing triumphs. Also, one aspect that need not be missed here is that growth stocks that tend to consistently outperform do have some intrinsic value and the stock prices trade below the intrinsic value so that the stocks tend to do well over a period of time.
Even in growth investing one should not buy stocks simply because they are going up. Stock prices need to be tied to value. There has to be value in growth stocks or else there is less likelihood of outperformance. One of the frustrating aspects of dealing with the markets is that it’s not very objective. Undervalued stocks may continue to remain undervalued for an inconveniently long time and at the same time stock prices can remain inflated for more than the required time, thus frustrating value investors. That is why an active investor always has to monitor the portfolio. It takes a matter of days to reverse the market situation or condition which leads to a drastic change in market sentiment.
Stock-picking has become a hobby these days and literally everything is going up. A cautious investor knows that one must approach stock-picking with a certain amount of humility. More so when you are value investing. A random pick will never create wealth and may in fact prove detrimental to the portfolio returns. It is worth remembering that the market in the short run is a voting machine and not a weighing machine, as was famously quoted by Graham. Trend following is great in trending bullish markets where majority of stocks are touching their 52-week highs. It works in the short run.
Carefully curated value stock is for all seasons and works best in the long run. One of the most difficult aspects of value investing is that you get to be consistent with your discipline. Market conditions will test your determination, your investment style, your conviction, your concepts of investing and your temperament. Says Prasad Goregaonkar, who has been an active investor for more than two decades now: “The market is complicated and value investing is not everybody’s cup of tea. Experts say one needs to be flexible in the market and at the same time some experts say you got to be disciplined and stick to your principle of investing. Trust me when I say that both are correct. However, no expert will teach you when to be flexible and when exactly to be disciplined to stick to your guns.”
“It comes with experience of having spent several years in the market. Investors look for objective answers all the time. However, the market is too fluid to provide such an easy answer to investors. Value investing can be indulged in if you have the qualities of logic, arithmetic, temperament, concept, consistent style, contrarian approach, staying power and a strong appetite for crunching numbers. The combination of all this can help you successfully dabble in the market with some serious money-making as an end result. However, I agree that growth investing is something easier and appealing as the results are seen relatively quickly,” he adds.
“My current portfolio is skewed towards value stocks which are my portfolio stocks that I intend to hold for an ultra-long term, and my tactical portfolio is dominated by growth stocks where I keep churning and booking profits,” he further states. With investors what usually happens is that there is performance pressure. In a bull phase the stock prices fly and hence the opportunity cost of holding an underperforming stock is very high even if it is fundamentally superior to other stocks which are outperforming. Hence, holding on to your conviction of value investing becomes difficult.
Value Investing and IPO
The ongoing IPO frenzy has been one of the biggest highlights of the market rally in the past 18 odd months. Getting rich in 2020 and 2021 has meant holding IPOs. The performance of the BSE IPO index goes to suggest that recently listed companies have been able to outperform BSE Sensex by a good margin. BSE IPO index is up by over 96 per cent while BSE Sensex has gained about 40 per cent in the past one year. If you go by the tenets of value investing, IPO investing can be a violation of rules. IPOs are rarely offered at below intrinsic value. In fact, the investment banker is mandated to extract maximum prices for its shares and the whole game is about selling equities so hard that maximum prices are quoted to investors.
The funny part is that the whole process is known to investors and is transparent and yet the public chase such opportunities. Again, FOMO and herd mentality is at its best when we see IPO after another hitting the market with stellar listing gains and outperformance. What IPO investors need to understand is that the greater the premium over book value, the more the value will depend upon the changing moods, sentiments and measurements of the stock market. Higher the stock price, more speculative the stock becomes and hence such stocks that have risen rapidly are considered risky. The question is why should you rattle your future on narrow bets when value stocks with established credentials offer better risk-adjusted returns?
To be fair to the IPO investors, in investment theory there is no reason why carefully estimated futures earnings should be a less reliable guide than the bare record of the past. But then the risk component is significantly high in IPO investing even if the returns are higher. On a risk-adjusted basis the equation is not always healthy with IPO investing. Value investing contradicts with IPO investing. For a pure value investor, IPO investing is very difficult. However, careful study and applying value investing principles to an extent can help IPO investors from getting trapped in the IPO frenzy. It is always better to be cautious than sorry!
INTERVIEW
Jitendra Upadhyay
Senior Equity Research Analyst, Bonanza Portfolio
What is value investing?
Value investing is the process to find the potential of growing sales and bottom-line for particular companies and businesses and buying them at a discount compared to how the market values them. In return for buying and holding these value companies and businesses for the long term, investors may be rewarded good returns.
Where do you see value in the current market situation?
PSU companies, metal and mining companies, automotive and ancillaries’ companies, consumer durable companies, housing finance companies, multiplexes still offer value due to improvement in their balance-sheet, order book, further reopening of the economy, secured lending business in nature and interest rates, all of which is leading to a revival in residential sale so that value unlocking is expected from them.
INTERVIEW
Roop Bhootra
CEO (Investment Services), Anand Rathi Shares and Stock Brokers
Does value investing work in a market environment like today?
Value investing is one of the most popular strategies in the markets and many investors and large funds follow not only this but many different strategies as per requirement. In simple terms, value investing is to buy a stock at lower than its intrinsic value. In my view, value investing is still relevant and working. In recent decades, value investing has come to mean buying stocks with low valuation multiples and selling them with high multiples. However, simply buying stocks with low multiples should not be confused with value investing. Many investors conflate value investing with the value factor. The value factor is an approximate measure of gaps between price and value.
What is the true definition of value investing and how best to apply it in the real world?
The true definition of value investing is buying a stock which is trading for less than its intrinsic value. Now intrinsic value is something which is critical in the application of value investing and there are many ways of arriving at it. Historically, investors have used earnings and book value multiples like PE or PB to arrive at the fair value which is increasingly becoming difficult nowadays as we see companies are trading at significantly higher multiples. One primary reason for this anomaly is that new-age companies have more intangible investments unlike that of their predecessors where tangible investments like land, factories and machines had larger share. With increase in intangible investments by new-age companies which by nature flow through profit and loss and not balance-sheet, lowering both earnings and book value has made ratios like PE or PB susceptible to error and are losing their ability to represent economic value. Value investors should focus on gaps between price and value for individual securities represented by value of future cash flows than using multiples.
INTERVIEW
Kanika Agarrwal
Co-founder of Upside AI
How can an ML-based system identify value investing opportunities?
The promise of a good machine learning system is the ability to learn what has worked historically in different market conditions and then apply these learnings to the present scenario. As such a good machine learning system should ideally not be restricted to one philosophy of investing. Rather, it should be adaptive and move between philosophies as and when it sees fit, be it growth or value or any other classification. So, when the market is indeed ripe with good value-based opportunities, a good ML-based system should recognize these opportunities and present them to the investor.
Is value investing a good investment strategy in the current market situation- your thoughts?
In some sense, all of investing is value investing. We are all searching to invest in something that is available at a price less than its fundamental value. And we all hope that everybody else will recognize this discrepancy in due time and the price will appreciate matching the intrinsic value. The debate comes in when one needs to define fundamental values. The old school approach, expressed by Benjamin Graham and championed by his disciples, the most famous of which is Warren Buffett, was to be very conservative and decide a company’s fundamental value with its past performance. Only those companies that were stable and cash-generating for years were considered to be investable. But what really needs to be determined is the present value of future cash flows. And there is no reason to discard the so-called “growth” companies that, although might not be profitable so far, but have great potential for future growth. One should not restrict by the definition of value investing, to just look at valuation multiples. The principles of value investing can be applied in all market conditions. Why even Warren Buffett himself, despite being allergic to tech companies for the longest time, has now his biggest investment in Apple!
Conclusion
No other name has dominated the investing world as much as Benjamin Graham or Warren Buffet. Graham has been dubbed as the god of value investing and is often credited for turning speculation into equity. Many believe he professionalised investing. His philosophy was always to buy stocks at a deep discount from the book value. Needless to mention, this philosophy has had unparalleled success. There is no doubt that if you follow Graham’s advice and include value stocks in your portfolio, chances are that you will not be unsettled by market volatility in the short run. His proposition always was that investors pay too much for the trend in growth stocks and too little for the less fashionable stocks.
It is very difficult for new-age investors to grasp such a concept of deep discount and identify value stocks because recently the trending stocks or growth stocks have managed to deliver returns in a matter of months rather than decades. As the growth stocks and trending stocks continue to outperform, it is natural for some to ignore the merits of value investing. The market valuation is stretched right now and the way the stock prices refuse to come down, one question that comes to everybody’s mind is about whether fundamentals matter anymore? Clearly the stocks prices have run ahead of fundamentals and that is why even the foreign brokerages have raised concerns.
We have seen several foreign brokerages downgrade the India market from ‘outperform’ to ‘market perform’. BSE Sensex is up by about 29 per cent in USD terms while the MSCI Emerging Market index is trading in negative territory. Investors are aware about the stretched valuations; however the fear of missing out (FOMO) factor is at play here. Abundant liquidity in the system and the fact that the trend remains intact until it is reversed will ensure that investors participate on the long side in the current market even when it is looks unsustainable at new heights. Value investing could be boring and unfashionable for many. But one must remember that value investing does not matter until it does.
A market correction of anywhere between 5-10 per cent in the key benchmark indices and we will have value investing as one of the most trending key word searched by the so-called new-age investors. Time and again history has taught us that value in stocks matter in the long run and it is the ultimate factor that will determine both safety and quality returns for your equity investments. In the current market situation, the defensives are showing relative safety and value. There are select opportunities in certain sectors as pharmaceuticals, FMCG and IT where there is still value. Several opportunities are also visible in PSU banks and in select PSUs as well.
When you analyse the recent results of Tata Steel, the company announced quarterly PAT of close to Rs 12,500 crore and the market capitalisation of Tata Steel is about Rs 1.5 lakh crore. Value does exist in such metal companies. Because the markets have run up so high so fast, it is almost impossible to find deep discounts in the current market which may fit the descriptions shared by Graham or even Buffet. However, if efforts are made in the right direction one can identify stocks with good fundamentals available at low PE and high ROE ratio that also pay high dividends. Such stocks offer value and if included in the portfolio may outperform in the longer run.