Value Stocks : 2021

Market participants are focusing on 2021 and there is a huge level of enthusiasm and high expectation on the part of investors as far as the forthcoming year goes after an unbelievable 2020. It was not easy to pick pharmaceutical and IT as probable winners at the start of 2020 and similarly it will not be easy to pick the set of stocks that may dominate in 2021. Geyatee Deshpande puts forth a case for value stocks to do well in 2021 while Yogesh Supekar highlights how to identify value stocks 

An unbelievable 2020 is coming to an end and investors have already started focusing on what may lie ahead in 2021. The problem of entering a new year after a stellar market performance is always the high level of optimism and a hint of overconfidence on the ability of the markets to deliver positive returns. By all means the market structure is simply looking great and there are no major signals of a reversal in trend. However, investors are increasingly realising that the stock prices cannot jump in a unidirectional manner. The year 2021 may welcome us with additional volatility which may surprise investors.

Beginning of any fresh year there is always an attempt made by market participants to speculate which sectors will outperform and where the Sensex is headed towards. As of now, investors want to know:

• Whether the outperformers of 2020 will continue to outperform in 2021?
• Will the Sensex deliver double-digit returns in 2021?
• Will small-caps and mid-caps rally in 2021?
• Whether value stocks will outperform growth stocks in terms of value investing versus growth investing?

While the questions are pretty objective in nature, the answers to these questions are definitely not straightforward and subjective in nature.

Will Outperformers of 2020 do Good in 2021?

It is expected that the IT and pharmaceutical companies will continue to do well in 2021. There is earnings’ visibility in both the sectors and there is a good amount of traction in stocks from both the sectors as we enter 2021. Investors however have to be cautious on the valuation front. The outperformers of 2020 are expected to do well but it will be difficult for the stocks from these two dominant sectors to outperform in 2021.

It is common for investors to chase returns and invest in those stocks that in the past have given excellent returns. The specialty chemical stocks and the API-based pharmaceutical stocks did exceedingly well in 2020. It is expected that the stocks from these similar sectors will continue to do well in 2021 as well as the momentum in IT stocks may continue. It is expected that stocks with some intrinsic value and margin of safety will do some catching up in 2021. 

Says Prasad Gore, a banker by profession and a long-term investor, “I have never been this confused in my over two decades of equity investments’ experience. I am not able to decide whether I should continue banking on similar stocks that did well in 2020 or should I switch to some other counters. My broker is advising me to buy quality value stocks such as ITC, Marico, etc. and the reason he is giving me is that these stocks are cheap in terms of valuations. However, when I look at the stock prices, the cyclical and high-beta stocks which I perceive as risky are jumping high almost on a daily basis. I think I agree with what my broker says about value stocks but how does one identify value stocks and are they available in the current buoyant market scenario?” 

Given such a common sentiment, it is important that investors understand what value stocks are and whether value stocks really outperform in the long run. 

Do Value Stocks Really Outperform in the Long Run? 

When it comes to formulating a market-beating strategy there is a raging debate amongst the puritanical investors on whether value stocks tend to outperform growth stocks or is it viceversa? According to a study by Bank of America, since 1926 someone who has adopted value investing style has been able to garnet 13,44,600 per cent returns while someone who has adopted growth investing strategy has been able to garner just 6,26,600 per cent returns. It looks like value investing methodology is superior to the growth investing methodology looking at the above statistics.

However, when one considers the fact that over the past decade the Russell 1000 Growth index has returned 17 per cent annually while the Russell 1000 Value index has managed to generate just 10 per cent, the exuberance for value investing can subside drastically. When we consider both the data sets, the question is about which one is more important. Is it the past returns over the 10-year period or the past returns over the 90-year period? The important aspect to understand here could be that both value investing and growth investing can outperform in different time periods and what matters most is the investment horizon that an investor has in mind.

Assume that an investor has a time horizon of about one to two years and he ends up buying value stocks instead of momentum stock. There are chances that the returns may be compromised for this investor as most value stocks will take their own sweet time to start performing while the investor has only one or two years at his disposal. The thing with value investing is that it needs a lot of patience on the part of the investors, not to forget the opportunity one has to deal with by locking funds in value stocks.

In reality one can prove that value investing generates better returns than growth investing and vice-versa depending on the time period one takes into consideration. Value investing is all about investing in companies that are undervalued and whether a stock is undervalued or not can be measured in multiple ways such as price to earnings and price to book value. Growth investing focuses on those stocks that are showing rapid growth in earnings, cash flows and revenues. Growth stocks are almost always trading at exorbitantly high price to earnings’ multiple.

Value trap is an illusion for investors and hence one has to stay away from it. A value trap generally happens when investors look at the fundamentals and the market price of a stock which seems to show that the stock is valued at a discount, also known as cheap stock in simple terms. But in reality this is not the case as the stocks are not as cheap as they appear and actually offer little hope for growth. The illusion causes investors who are looking for a bargain to bet on such stocks, thereby taking a very risky stance wherein they believe that the stock will beat the market. However, it ends up providing either negative or unattractive returns.

Are Value Stocks Available Right Now?

Value stocks are available in the markets at any given point of time. It is just that one has to adopt the right process to identify stocks that are trading with some intrinsic value and showing adequate margin of safety. The concept of value investing, even though popular, can be confusing for an average investor. Often enough, value stocks are confused with low-price stocks or penny stocks as value stocks also means cheap stocks. Beaten down stocks are also at times confused for being value stocks even though there is a good chance to identify value in beaten down stocks.

In other words, all beaten down stocks are not value stocks and similarly not all low-price stocks or penny stocks are value stocks. Value is determined by comparing the stocks under perusal with its peers. Let’s say, for example, that other things being equal, SAIL is trading at a PE ratio of 17 while JSW Steel is trading at a PE of 72. One can easily, and rather superficially, state that SAIL is much cheaper than JSW Steel and hence has more value than JSW Steel. But in reality, the other things are never equal and hence deeper analysis is required post which an investor has to assess the pros and cons of investing in a particular stock.

Just looking at the PE ratio may not help and PEG is a better parameter to judge between two stocks. To understand whether a stock has value, a deeper study needs to be done before including it in the basket of value stocks. One of the practical ways to find value stocks is to first ascertain if the stocks are financially sound and that the fundamentals are attractive. Once the stocks with attractive fundamentals are identified, it will be interesting to note if the TTM PE for the company is less than the industry PE or more than the industry average. 

How To Decide Which Are The Best Value Stocks To Buy?

Understanding the company before analyzing the stock plays a crucial role in this process of selection of the value stock. Listing down some parameters which you should keenly observe would include the company's runway which includes long term plans, its business principles, financial stability having a healthy and sustainable capital structure and also an efficient management to manage the organization. Payment of consistent dividends by the companies also should be considered as an important parameter by the investors. Meanwhile, analyzing the company's performance and competitiveness among the peers in the same industry using some valuation techniques would give investors an idea whether the stock is undervalued or overvalued as compared to its peers .Some of the popular relative valuation techniques are analyzing the Price-to-earnings ratio(P/E) or Price to Earnings growth ratio(PEG),Price-to-book ratio(P/B),Enterprise value to Earnings before interest, depreciation and tax ratio(EV/EBITDA) and other wellknown valuation technique is Discounted Cash Flow (DCF).

This valuation style incorporates number of parameters of the company starting from free cash flows of the company to cost of capital in order to arrive at the final true value of the company and compare it with the current market price of the stock and to know if the stock is trading expensive or cheap. Usage of all the multiples will not necessarily give the investors same value hence in some cases it is advisable to use the blend of these valuation necessarily directs the investors to weighted average of various intrinsic values using different methodologies. Too choose the best valuation technique the company's business model should be examined and then decide which technique can be applied best to the model. For eg. EV/EBITDA technique can be best suited for the companies which run on a capital-intensive model. Taking on moderate risk while investing in this bunch of stocks investors can look upon immediate and market beating returns along with consistency of performance. As these stocks are advised to be held over a long period of time the growth eventually averages out and the returns tend to become consistent.

"Don’t be afraid to be a loner but be sure that you are correct in your judgment."
-Walter J. Schloss

Smart investors always look for stocks with high earnings’ growth rates at inexpensive valuations within a particular industry. It is important to note that the essential quality is the visibility of earnings’ growth and availability at reasonable valuations. When both these qualities merge, we have a value stock in front of us. The list of stocks given below is an example of high earnings’ growth stocks available at inexpensive valuations. Stocks with TTM PE less than the industry average PE are considered inexpensive in this case.

It is possible to identify several stocks where the TTM PE is less than the industry average PE. However, not all stocks that fall in this list can be good value propositions. Fundamentals need to be strong and the financials of the stocks under consideration should be healthy. The list below can be used as a reference point for those stocks where the TTM PE is less than the industry average PE. But stocks that are not fundamentally robust are compared to the list shared in the above table.

Conclusion

There were three Vs that dominated the headlines in 2020 – virus, vaccine and volatility. Come 2021, don’t be surprised if ‘V’ for ‘value’ dominates the headlines along with the other laggards with better fundamentals can be expected to catch up in 2021 as things come back to normalcy. Investors have to be smart to identify value stocks though and refrain from investing in any stocks that have underperformed. Just because the stock has underperformed and not risen in 2020 does not mean it will rise in 2021. One has to identify the value trap and yes there are several such stocks available in the markets as of now.

It is widely perceived that PSU stocks are offering a lot of value and are actually trading at a deep discount. However, not all PSU stocks are value buys right now and several could be value traps. The ability to identify value stocks followed by right action by investors will determine success in 2021 for longterm investors. There are a huge number of stocks available at discounts and are trading at lower valuation than the growth stocks or so-called high-flying stocks. Buying value stocks does not mean we ignore growth investing. There could be growth stocks offering value and trading at discounts to its peers.

One simply has to identify the valuation gap and bank on the right kind of stocks for outperformance. Globally the equity markets are flushed with liquidity and there are no signs of the liquidity drying up. The foreign equity money is expected to flow in 2021 as well. We have never seen a more forceful monetary policy before as a reaction to the pandemic. It looks like the stance by the US Fed is to keep interest rates closer to zero as long as inflation stays within the central bank’s comfort zone. As former European Central Bank President Mario Draghi famously said, policy-makers will do whatever it takes to avoid the crisis and the year 2021 may not see any negative surprises on the interest rate front.

We enter 2021 with lot of optimism because we have positive developments on the vaccine front as well as on the Brexit deal which has long been impacting the market sentiment. The global stage is all set to recover from the pandemic shock in 2021 and that augurs well for global equities. The recovery phase, even though expected to be V-shaped in several economies like China and India, may be uneven in several large economies, thus leading to heightened volatility and scepticism about the durability of the recovery cure. The patchy recovery leading to non-synchronised growth will also mean that those economies that will recover the fastest will attract sizeable amount of capital in the form of investments.

Such skewed capital flows can lead to higher stock prices in certain markets. In all likelihood, the Asia Pacific region and emerging markets can be expected to benefit from such global liquidity flow. All in all, the momentum is positive and we are entering into 2021 with lot of good cheer which will keep stock prices upbeat. As we speak, the Japanese Nikkei 225 has touched levels not seen since early 1990s. Dow Jones Industrial Average is at record highs, thus supporting the Sensex to gain further ground.

"Value investing is at its core the marriage of a contrarian streak and a calculator." -
Seth Klarman

The positive momentum will continue in 2021 as well and the economy will stage a recovery better than most expect it to. And as the economy gains further ground, all kinds of cyclical stocks can be expected to outperform.

Value stocks may do well as there is a limit to how much money can be parked in the growth stocks and the so-called momentum stocks. With rich valuations and sharp run up, there is little margin of safety left in the growth stocks , thus making a strong case for value stocks. Also, value stocks will tend to fall less in case we see a market correction happening. Value buying will naturally push the value stocks higher even as the growth stocks may see some retracement from overbought zones.

While value stocks have a track record of outperforming markets in the long run for all practical purposes, investors are advised to adopt a blended approach of investing where a mix of growth and value stocks are included in the portfolio. This blended approach will ensure capturing holistically the opportunities that are offered by the markets in 2021.