Value Investing

Though I would like to call myself as a value investors, but for sure I do not have the skill and mindset for value investing. But one thing I can say with confidence that in last 4/5 years, just by following value investing concepts, I made decent money from stock market and investing in totality. Value investing is far the most effective and easy to apply stock valuation methods of all. Value investing is not just about buying stocks whose price is trading at all time lows. We need to analyze why the stocks are trading so low before buying one. The best way to know this is by analyzing the financial statements of the companies. The idea of value investing is to buy ‘quality companies’ at undervalued price. We cannot buy stocks of any tom dick and harry and feel that we are value investors. If you can buy Google or Coca Cola at undervalued price, then this will be value investing. There are simple rules of value investing which ones applied to a stocks will tell you if this stocks is a ‘quality stock’ or not and whether is available at ‘undervalued prices’ or not.

Some quick tips of value investing are:

Always calculate the intrinsic value of stocks

Read this http://www.safalniveshak.com/intrinsic-value-the-holy-grail-of-value-investing/ and evaluate the below thory:

Market price of quality stocks are generally traded at most ambitious prices. One must have seen that some stocks are traded at P/E ratios of 5 and others at outrageous P/E ratios of 30. The question must be asked that why investors are ready to buy stocks at such exorbitant P/E ratios? Or to make the question more basic I will say all investors should ask, what is the right-price of this stock?When we go to the market to buy groceries, vegetables, clothes we all see the price tags. We know the right-price levels of sugar, potato, T-shirt and the likes. Before we buy them we compare the market price with our right-price and only then we buy. People who bargain are those people who think that their right-price levels are lower than the current market price. Of course the value of right-price differ form person to person but the difference is not huge and for sure it confirms a general understanding. If acceptable price levels of sugar are $1 per Kg and if a trader is selling it at $2 then he can be sure of loosing his business.But in stock investment people do not know the right-price levels of stocks. This right-price is technically called as intrinsic value of stock. If one can learn to calculate the intrinsic value of a stock they can compare it with current market price and decide to buy/sell or avoid.

Warren Buffett says that stock s must be bought by maintaining a margin of safety of at least 2/3rd of its intrinsic value. Suppose if a stock has intrinsic value of $300 and it is selling market price of $200 (2/3rd of intrinsic value) only then the stock can be considered as an ideal buy.

In his 1989 letter, Warren Buffett wrote:

"What counts, however, is intrinsic value - the ﬁgure indicating what all of our constituent businesses are rationally worth. With perfect foresight, this number can be calculated by taking all future cash ﬂows of a business - in and out - and discounting them at prevailing interest rates. So valued, all businesses, from manufacturers of buggy whips to operators of cellular phones, become

economic equals." (Emphasis mine)

So the steps involved to buy you ideal stock are:

Step1 – Calculate intrinsic value of stock

Let us take example of an investor who would like to buy stock of a company names XYZ and in interested to hold it for next five years (form 2010 to 2015) at least. His expected return form stock is 15% per annum including dividends earned.

Step A – Calculate average growth of earning per share for last 5 years

Rs.

2005/06 2006/07 2007/08 2008/09 2009/10

EPS 32.5 41.3 50.9 49.7 49.7

CAGR (EPS) 8.9%

Where CAGR is calculated as :

A = P * ( ( 1 + r ) ^ n )

Where

A = Final Amount

P = Principal amount

r = Rate of interest, expressed in %

n = Number of years

For this example the value will be 49.7= 32.5 *(( 1+r)^5)

We will assume that the same 8.9% CAGR will be maintained by the company for the next 5 years of investment horizon. Hence EPS will grow form present levels of Rs 49.7 @ 8.9% CAGR to appreciate to Rs 76.12

Step B – Assume Price Earning Ratio (P/E) in the fifth year of investment horizon

2005 2006 2007 2008 2009

EPS 32.5 41.3 50.9 49.7 49.7

Market Price 398 685 132 761.6 1088

P/E 12.2 16.6 22.2 15.3 21.9

Average P/E 17.65

We will assume that the same level of P/E ratio of 17.65 will be maintained by the company in 5th year of investment horizon.

Step C – Predict market price of stocks in the fifth year of investment horizon

Market price = EPS X P/E

Market price = 76.12 (EPS in the year 2015) x 17.65 (P/E ratio in the fifth year) = Rs 1343

Step D – Calculate present value of market price of stock

Market price of stock in the fifth year = Rs 1343

Rate of inflation assumed = 7% p.a.

Present value of Rs 1343 = Rs 960

Step 2 – Maintain margin of safety

Price maintaining margin of safety = Present Value X 2/3 = 960 x 2/3 = Rs. 640

Step 3 – Compare current market price with 2/3 of intrinsic value

2009/10

Current Market Price Rs 1000

2/3 x Intrinsic Value Rs 640

Conclusion

As market price is higher than calculated intrinsic value (with margin of safety) hence we can consider this stock as overvalued. Overvalued stocks are never purchased by the great value investor Warren Buffett

Buy only those stocks which is trading at 2/3rd of its intrinsic value (margin of safety)
Buy stocks which has P/E ratio of less than 10 or PEG ratio of less than one.
Market price of stock should not be more than 1.5 times its book value,
The company should have been able to increase its EPS (in last 5 years) and annual growth rate (CAGR) of more than rate of inflation prevailing in the country.
Earning Yield should be at least close to rate of inflation prevailing in the country
Company should have a consistent of dividend disbursement to its shareholders with current dividend yield close to interest (net of tax) offered by bank fixed deposits

Source

Big Risk in Value Investing

Source

Value investing is much more than buying cheap stocks. As Munger said, “You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.” So while investing is about buying cheap stocks, value investing is about knowing clearly what you are buying.

After all, everyone is looking to buy low and sell high. What is it that differentiates real value investors, who are actually quite rare, from all the others who trade in the stock market?

Value Investing is…difficult!

Identifying a cheap stock and buying it is a relatively easier proposition. But value investing is difficult. Difficult because:

You need to have patience, and a lot of it
You must be disciplined
You must leave out any emotion
You must know when to go against the crowd
You must read and study a lot (annual reports, investing books etc.)

So, in all, value investing requires hard work. This is probably the reason you won’t find many value investors out there.

But whoever has had the patience to practice value investing in its real form, has done wonders for his stock portfolio.

Value investors, so much consumed in finding ‘value’ in the stock market generally overlook some big risks that might lead them to incorrect judgments. So, what are those risks that value investors face day in and day out…and might easily ignore in their pursuit of value?

Here are three that I have personally encountered over the past five years of being a value freak (and many value investors out there might vouch for the same, plus add to the list):

Falling into ‘value traps’

The most widespread saying in stock investing is – “buy low, sell high”. But this is easier said than done. There are times when stocks that are beaten down unfairly can create some of the best opportunities if you have patience. But then, there are times that a stock, even after a drastic fall in its price, continues to slide despite cheap valuations.

This kind of stock is what is known as a “value trap”, whereby the stock appears to be cheap because of

low multiples of price-to-earnings (P/E),
price-to-book value (P/BV), or
even cash flow.

Investors looking for a bargain buy into such a company only to never see the stock price improve again.

Just because value investors are so focused on the ‘cheapness’ of the stock’s price, they ignore the ‘cheapness’ of the underlying business…

Rising competition that’s eating into profits due to reducing entry barriers for new players.
Declining overall sector growth that’s putting a cap on the future growth.
Volatile earnings that is set to hurt future growth and expansion.
Rising debt on the balance sheet that can create problems in case of a slowdown.
Poor management that’s destroying capital.
Management aggressively pursuing acquisitions that can put the entire business at risk of going down.

All these factors that value investors might ignore in their intoxication of having found a “great stock at a great price”, can set the bait for the perfect value trap. A classical argument before falling into a value trap is – “The stock has already fallen by 90%. How much more can it fall?”

Well, a stock that fell from Rs 100 to Rs 5, first fell 90%…and then another 50%. As simple as that!

Take a look at banking stocks as of now. When you are investing in a bank, you are actually investing in a leveraged, blind investment portfolio (of loans, advances, and treasury investments) and the investment portfolio is invested by bankers.

It’s just very hard to have an accurate value because they hold so many assets, and the assets they hold are not always clear. In case of PSU banking stocks specifically, while most of them appear “cheap” as of now (in fact, they have been cheap for quite some time now), I have a lurking doubt that most of these are value traps given that they are sitting on huge potential NPAs -Non Profit Assests (property and agriculture loans) that may create havoc anytime in the future.

P/E and value traps

Most investors I’ve seen falling into a value trap have been those who believe that a stock with a low P/E (price-to-earnings) presents ‘great value’. You see, P/E’s aren’t a perfect measure of value.

A company that is small and growing fast may have a very high P/E, because it may earn little but has a high stock price. If the company can maintain a strong growth rate and rapidly increase its earnings, a stock that looks expensive on a P/E basis can quickly seem like a bargain.

Conversely, a company may have a low P/E because the business is going downhill and there are signs of greater trouble in the future.In such a case, what looks like a “cheap” stock may be cheap because most people have decided that it’s a bad investment.

Such a temptingly low P/E related to a bad company is called a “value trap.”

Take a look at this P/E chart of Suzlon Energy (during the volatile phase of January 2008 and March 2009), and you’ll understand the concept better.

Avoiding value traps

The simple way to avoid a value trap is to not concentrate on its stock price or valuations much but do a strong due diligence…not just into financial metrics, but also in the operational aspects of the business…like its competition, management quality, and competitive moat.

Here are a few key questions you must ask yourself before attempting to catch a falling knife (a falling stock that appears cheap):

What are the odds that this company will not be around ten years from today?
What is the company’s sustainable competitive advantage that no competition can take away from it?
Is the management overly optimistic about the future?
Are the company’s products getting out-dated?
Is the company’s balance sheet getting messy (with rising debt and working capital)
Will I be happy to see the stock fall 50%? (This is the ultimate test for an investment. If you will be happy to buy a stock at half of today’s price regardless of the short-term noise, simply because you know that the company is intrinsically strong, that’s a good sign…and usually not a value trap.)

If getting answers to these questions worry you, don’t worry!

You will get the answers to all these questions when you study the company – its quarterly reports, the annual reports, and the management’s vision for the future.

Always remember, the (stock) price is what you pay, but it is the “value” that you get. So be clear of the value you are getting. Avoid falling into a trap.

Mis-assessing cash flows and margin of safety
Acting on frustration at not finding ‘value’

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