Value investing strategy is more like bargain hunting that reflects a practical and down-to-earth attitude. With a good eye and some luck, investors may enjoy the same success as the world’s most successful investor, Warren Buffett
The unpredictable movements of the stock markets leave the investors unsure as to whether they would end up making money in these choppy markets. Although it is a known fact that one needs to be invested for long to achieve better than market returns, investors are seldom aware of strategies to achieve such returns in such a risky market.
One benchmark for any investor is to follow the strategy of value investing. After all, this is the strategy used by the world’s most successful investor, Warren Buffett, who created an empire of $93 billion dollars through his investment style over a longer period of time.
Buffett was influenced by other value investors like, Benjamin Graham, David Dodd and Phil Fisher who helped him develop his investment prowess. Benjamin Graham is known as the “godfather of value investing”, who propagated the philosophy of value investing that is focused on purchasing equities at prices less than their intrinsic values by picking or screening stocks, which have steady profits, are trading at low prices to book value, have low price-earnings ratio (P/E) and which have a relatively low debt.
Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. There isn’t a universally accepted way to determine intrinsic worth, but it’s most often estimated by analysing a company’s fundamentals. Like bargain hunters, the value investor searches for stocks that they believe are undervalued by the market, or stocks that are valuable but not recognised by the majority of buyers.
Buffett, however, takes this value investing approach to another level and chooses stocks solely based on their overall potential as a company. By seeking not just capital gain, but taking ownership in quality companies capable of profit making, the Buffett strategy is a holistic approach.
But finding a low-priced value stock is not easy and there are no standard formulae to find one. However, there are certain markers that can guide us in our pursuit of achieving success in value investing.
Quality: Invest in companies upward of average quality having ratings of B or better. The famous credit rating agencies in India are CRISIL, ICRA, CARE, Brickwork Ratings, India Rating and Research and SME Rating Agency of India for small and medium enterprises.
According to the Securities and Exchange Board of India (SEBI), the long-term debt instruments can have the highest rating of AAA and the lowest of D, where instruments are already in default or are expected to be in default. Similarly, the ratings for short-term debt instruments can range from A1 to D.
Lower debt burden: Having high debt in capital structure puts undue pressure on companies for servicing fixed financial obligations which can lead to financial distress and in worst situations, bankruptcy. It is recommended to avoid companies with higher debt load. A debt-equity ratio is a good benchmark to identify the proportion of equity and debt being used to finance any company’s assets, and higher ratio suggests that more debt — rather than equity — is financing the company. Additionally, as a reference point, buying companies that have total debt to current assets ratio of less than 1.10 is advisable.
Higher liquidity: Liquidity in companies is very important to meet its short-term obligations and companies with a current ratio of over 1.50 should be chosen.
Consistent performance and high earnings growth: Identify companies that have performed better than other companies in the same industry. It can be done by calculating the Return on Equity (ROE) which reveals the rate at which shareholders are earning income on their shares. However, looking at the ROE just at the last year isn’t good enough and investors should view the ROE from the past five to 10 years to analyse historical performance.
In addition, earnings per share growth during the past five years should be positive with no earnings deficits. Earnings need to be higher in the most recent year than five years ago. Avoiding companies with earnings deficits during the past five years will help investors stay clear of high-risk companies.
P/E ratio: Look for companies that are selling at bargain prices by identifying companies with price to earnings per share (P/E) ratios of 9.0 or less.
Price-to-book value ratio (P/BV ratio): Since P/E ratios can sometimes be misleading, book value provides a good indication of the underlying value of a company and investing in stocks selling near or below their book value is a good strategy. P/BV ratios are calculated by dividing the current price by the most recent book value per share for a company, and investors should invest in companies with price to book value (P/BV) ratios less than 1.20.
Dividend paying stocks: Since investing in undervalued companies requires waiting for other investors to discover the bargains, and sometimes the investment horizon is long and tedious, it makes much sense to invest in companies that are currently paying dividends and investors can enjoy dividends while they wait patiently for your stock to go from undervalued to overvalued.
High profit margins and increasing: Consistency in performance is the most important thing for any company. A company’s profitability depends not only on having a good profit margin, but also whether it is consistently increasing. Profit margin can be calculated by dividing net income by net sales. For a good indication of historical profit margins, investors should look back to at least five years.
A high profit margin indicates the company is executing its business well, but increasing margins mean management has been extremely successful at controlling expenses.
For how long the company is listed on the stock market?: Typically, only consider companies that have been listed on the stock market for at least 10 years. Value investing requires identifying companies that have stood the test of time but are currently undervalued.
An investor should never underestimate the value of historical performance, which demonstrates the company’s ability or inability to increase shareholder value.
However, this has to be taken with a pinch of salt as a stock’s past performance does not guarantee future performance. The value investor’s job is to determine how well the company can perform in future as it did in the past, and that is often the tricky part.
Product mix: It is important that identified companies have products which are unique from their competitors and it is not advisable to invest in companies whose products are indistinguishable from those of the competitors, and those that rely solely on a commodity such as oil and gas. Any characteristic that is hard to replicate is the company’s economic moat, or competitive advantage. The wider the moat, the tougher it is for a competitor to gain market share.
Selling at 25 per cent discount: In real terms, determining whether a company is undervalued, is the most difficult part of value investing and investor must determine a company’s intrinsic value by analysing a number of business fundamentals including earnings, revenues and assets.
And a company’s intrinsic value is usually more complicated than its liquidation value, which is what a company would be worth if it were broken up and sold today. The liquidation value doesn’t include intangibles such as the value of a brand name, which is not directly stated on the financial statements.
Once an investor determines the intrinsic value of the company as a whole, he can compare it to its current market capitalisation — the current total worth or the market price of outstanding shares. If the intrinsic value measurement is at least 25 per cent higher than the company’s market capitalisation, the company can be considered valuable. The success of an investor will depend on his unmatched skill in accurately determining this intrinsic value.
However, whenever we get a stock at bargain price, some pertinent points should examined and checked to find the reason for the lower prices — if the company is competing in a dying industry or whether the company is suffering a setback from an unexpected problem. It is very important to understand if the setback is short-term or long-term and whether the company’s management is aware of the problem and if it is determined to take a corrective action. If the problem is short-term in nature and the management has a plan in place to tackle it, it is considered a good undervalued purchase.
Value investing strategy is more like bargain hunting that reflects a practical, down-to-earth attitude. Although the value-investing style is not without its critics, but some of the richest people in the world have used this technique successfully. Investors can follow the above mentioned value investing principles, and with a good eye and with a bit of luck, of course, they may enjoy same type of success as Warren Buffet.
(The writer is Assistant Professor, Amity University)