Merits of Value Investing
Many see the distinction between growth and value investing as somewhat arbitrary, but it’s useful to lay out what might differ between the two approaches. Armaan Madhani explains the difference in detail and lays out the pros and cons of value investing as well as its efficacy in the current market scenario
As stock markets across the world take a breather in light of recent events that have transpired over the last month, value investing is making a strong comeback. Recent geo-political tensions between Russia and Ukraine along with sky-high crude oil prices have threatened to further boost inflation levels and buoy fears of supply shortages affecting commodities. This has, consequently, put a dampener on high growth forecasts for companies across the board. As investors cast around for safe harbours in these choppy waters, value stocks are gaining traction. Value investing and growth investing are two different investing styles.
Many see the distinction between growth and value as somewhat arbitrary, but it’s useful to lay out what might differ between the two approaches. Growth stocks are those that have the potential to outperform either the overall markets or a specific sub-segment for a time period. These companies are expected to show robust growth in revenues and profits and they usually outstrip their rivals with innovative products, services and price offerings. Value stocks are usually large-cap and well-established companies that are currently trading below their real worth (i.e. intrinsic value) and will thus provide superior returns.
Rotation from Growth to Value
The US 5-year and 30-year treasury yields recently inverted for the first time since 2006, raising fears of a possible recession. Soon after the US 2-year yield briefly exceeded the 10-year yield for the first time since 2019, it inverted yet another segment of the treasury curve and reinforced the commonly held view that forthcoming rate hikes by Federal Reserve may reduce consumer spending and business activity, thereby causing a recession. It is a widely acknowledged notion that short-term yields being higher than long-term yields is abnormal and they signal that high levels of short-term yields are unlikely to be sustained as growth slows.
According to the Federal Reserve’s preferred gauge, inflation in the US has reached a new 40-year peak in February. In the same month, inflation-adjusted consumer spending in the US declined, suggesting that the fastest pace of price increases in four decades is starting to temper demand. Christopher Wood, Global Head of Equity Strategy at Jefferies, in one of his recent newsletters titled ‘Greed and Fear’ said, “The change in equity market leadership looks ever more pronounced in terms of the shift from growth to value stocks as investors have discounted ever more rate hikes following last week’s 7.5 per cent year on year US CPI (Consumer Price Index) report for January.”
This change in equity market leadership and rotation to value has been well underway since the start of the year. Year to date, the MSCI World Value Index has outperformed the MSCI World Growth Index by a decent margin. As per a note from Bank of America published in February, value stocks reversed a years’ long trend last month and outperformed growth stocks by the widest margin since the dotcom bubble. The outperformance of value relative to growth can continue in the coming quarters based on historical relative valuations. In the quarter ended March 31, 2022, S & P 500 Growth Index has nosedived 8.77 per cent while S & P 500 Value Index lost merely 0.69 per cent.
This distinctly signifies investors’ pursuit for safe havens in value stocks and caution on growth stocks. A key trigger of this shift to value stocks is the conviction among many analysts and investors that inflation has gained enough momentum to keep rising, thereby encouraging central bankers globally to act swiftly and tighten their respective monetary policies. The bull run witnessed in high-growth US technology stocks as a result of the pandemic is losing steam. Pressure continues to build on high-growth stocks as the cash flows of majority of these companies are driven by expectations of substantial earnings in the future.
This phenomenon is evident in primary equity markets globally as well. Volatility stoked by the exacerbating unfavourable war-like conditions in Ukraine has put investors on the edge. Initial public offerings (IPOs) worldwide have plummeted in the first quarter after a record showing in 2021. According to data compiled by Bloomberg, about USD 65 billion has been raised via IPOs around the world in 2022, down 70 per cent from USD 219 billion in the first three months of last year. That puts the global market on track for the lowest quarterly proceeds since the onset of the corona virus pandemic in 2020.
Margin of Safety in Value Investing
Benjamin Graham, the father of value investing and mentor of legendary investor Warren Buffett, pioneered the concept of margin of safety. In his book, ‘The Intelligent Investor’, first published in 1949, Graham wrote, “The margin of safety is always dependent on the price paid. It will be large at one price, small at some price, non-existent at some still higher price. The margin of safety (MOS) is referred to as one of the fundamental principles in value investing, where securities are bought only if their share price is trading below its approximated intrinsic value. While investing, if a sufficient margin of safety exists, an investor’s downside risk is more protected.”
Hence, the margin of safety acts as a ‘cushion’, permitting some degree of losses to be incurred except being hit by any major inference on returns. To rephrase it, purchasing assets at discount decreases the negative effects of any declines in value and also reduces the chance of overpaying. To elaborate, the margin of safety can be interpreted as the difference between the estimated intrinsic value and the current share price. In order to estimate the margin of safety in percentage form, the following formula can be used: Margin of safety (MOS) = 1 − (Current share price | intrinsic value).
To quote an example, let’s say that a company’s shares are trading at ₹10 but the estimated intrinsic value by an investor is ₹8. Calculating the margin of safety, it comes to be 25 per cent. This can be interpreted as follows: there can be a 25 per cent drop in share price before it reaches the estimated intrinsic value of ₹8. From a standpoint of assessing risk, the margin of safety can be considered as a safety cushion in the process of investment decisionmaking to protect investors from overpaying for an asset — i.e. if the share price indicates that it can decline substantially post-purchase.
In comparison with using techniques like shorting stocks or buying put options as a hedge against a portfolio, margin of safety is viewed as a key approach in minimising investment risk by a huge proportion of investors. This approach, bundled with a longer holding period, helps investors better withstand any volatility in market pricing. On a general basis, the majority of value investors will not prefer investing in security unless the margin of safety is calculated to be around 20-30 per cent. If the margin of safety hurdle is 20 per cent, the investor will only purchase a security if the current share price is 20 per cent below the intrinsic value, based on their valuation.
Value in Favour
Rising interest rates combined with sharp market swings have prompted investors to steer clear of companies with forecasts of high growth rates yet relatively little in the way of current profits – the kind of stocks that dominate the IPO market. The performances of growth and value styles of investing tend to rotate. In other words, value stocks typically exhibit strong performance after the stock market has peaked. Following the recent growth-led rally, the value theme seems to be catching up. Empirical data suggest that these style shifts usually last a few years. Traditionally, consumption and service businesses were considered growth stocks while manufacturing and utilities were gauged as value picks.
The recent revival in the manufacturing segment due to government initiatives such as the production linked incentive (PLI) scheme and a capex-heavy Union Budget could change this dynamic. In the past few years leading up to the pandemic, it is evident that value stocks have relatively underperformed growth and momentum stocks. Low interest rate environment, surplus liquidity, paradigm shift in consumer behaviour, new-age digital economy and rapid business disruption could be some of the reasons that elucidate the underperformance. However, the tide seems to be turning as value investors are making a strong comeback. Value indices across the world are outperforming.
Value versus Growth
Which is better – growth investing or value investing? This is a perennial question among investors. The answer to this question depends on many factors since each style can perform better in different economic conditions. Growth stocks may do better when interest rates are low and expected to stay low, but many investors prefer to park their funds in value stocks as rates rise. Growth stocks have had a stronger run recently, but value stocks have a good long-term record. From 1927 through 2019, over rolling 15-year time periods, value stocks have outperformed growth stocks 93 per cent of the time, according to the data compiled by Nobel Prize laureate Eugene Fama and famed finance professor Kenneth French. While growth stocks might win the short-term battle, value stocks are winning the long-term war. On the contrary, this doesn’t imply that value stocks as a whole will be winners when the market conditions change. 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 at reasonable intrinsic values with 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-priced stocks or Penny Stocks as value stocks also mean cheap stocks.
Also, it is critical for an investor to be able to distinguish between stocks trading at cheap valuations that are witnessing a downfall due to deteriorating fundamentals with those that may be suffering temporary setbacks or beaten down as they are
What do you prefer in the current market scenario - value stocks or growth stocks? Can you elucidate the same?
The current market scenario has lots of push and pulls in place. On the one side we are seeing the economy recovering from the severe shock of the pandemic, thus leading to normalisation in lot of sectors and on the other side we have global shock because of the Russian-Ukraine conflict, rising commodity prices and high inflation. In an environment when yields globally are rising, any company which derives lot of its value from future cash flows has a higher risk to its value than the company that can be justified with near-term cash flows.
Therefore, in such environments of rising yields and higher inflation expectations, value stocks are placed better than growth stocks. Historically also we have seen a high correlation between the performance of value stocks and inflation. Also, if you look at the earning delivery and fundamentals of companies
simply unable to meet investor expectations. Value investors will always run the risk of ploughing capital into stocks that are cheap for a reason and ultimately continue to underperform. Such stocks are called value traps, but the same phenomenon exists with growth stocks as well. Investors who buy into high-growth companies at premium valuations may get burned if these companies are unable to maintain the rapid pace of expansion that analysts and investors demand.
In other words, all beaten down stocks are not value stocks and similarly not all low-priced stocks or penny stocks are value stocks. Value is determined by comparing the stocks under perusal with its peers. However, just looking at the PE ratio in isolation may not help while PEG ratio provides a better parameter to judge between two stocks. To understand whether a stock has value yet to be unlocked, a deeper study needs to be undertaken before making an investment decision. A simple method to identify value stocks is to first ascertain if the company is financially sound and fundamentally attractive. Once these stocks are identified, it will be interesting to note if the TTM PE for the stock is higher or lower than the industry PE or the 10-year average PE of the stock.
Conclusion
Over the last six months, frontline benchmark indices Nifty 50 and Sensex have furnished close to nil returns. Indian stock markets witnessed a meaningful correction in the first half of March 2022 primarily on account of geopolitical tensions, heavy FII selling, inflation concerns and wild swings in crude oil prices. However, markets staged a decent recovery in the second half of the month. Year to date, overseas investors have pulled out a net `1.14 lakh crore from the Indian equity markets. For the sixth straight month in a row, foreign institutional investors have offloaded their equity holdings on a net basis.
While the Russia-Ukraine crises has had a relatively limited direct impact on the Indian economy given our lower import dependence on these countries, soaring commodity prices continue to pose a key risk both in terms inflation as well as corporate earnings’ estimates on account of higher input costs. As per a recent report by S & P Global Ratings, “Soaring commodity prices, further triggered by the Russia-Ukraine war, could moderate healthy recovery of the country’s economy and put pressure on the Reserve Bank of India (RBI) to normalise its monetary policy faster than anticipated.” Higher commodity prices could also undermine buoyant private consumption trends in India.
Currently, unceasing inflationary pressures and rising bond yields are the key variables to monitor in the near term for the markets. Elevated price levels have already started to weigh on demand and this can lead to tapering in growth and earnings estimates if operating and net profit margins take a hit. Also, the recent rise in bond yields can have serious implications for stock valuations. Smart investors should look for stocks with high earnings’ growth rates that are trading at inexpensive valuations within a particular industry. It is paramount to note that the ‘quality’ factor accrues from the visibility of earnings’ growth and reasonable valuations.
Value investing as a strategy has persistently come under question over the past few years due to its underperformance against growth stocks. Warren Buffett’s first rule of investing is – never lose money. The probability of losing money is relatively marginal if one buys great businesses at a significant discount to their intrinsic values (i.e. ample margin of safety). Ergo, even in case of a sharp correction, downside will be limited as compared to a growth stock. An investor should look for businesses with competitive advantages, healthy growth prospects, strong and clean balance-sheet, low leverage, consistent free cash flows, good capital allocation track record and outstanding management.
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 of returns for equity investments. Hence, a shift in strategy could be wise under the current market situation. Value investing is a game of patience, persistence and conviction. While value stocks have an unblemished track record of outperforming markets in the long run, investors are advised to adopt a blended approach of investing where a combination of high-quality growth stocks and value stocks are included in the portfolio.