VALUE INVESTING - BASICS

Value investing is an important tool in the arsenal of a fundamental investor. In simple terms it means buying a stock for much less than what an investor thinks it is worth. But how does a value investor decide the worth of the company under study? Given below is an explanation of some basic parameters to decide whether a business is undervalued or not. They are

1. PE ratio. This is the ratio of the market price of a stock to its earnings per share. It also the number of years the business will take to realise earnings equivalent to the current market price based on current earnings. For instance a business having a PE ratio of 10 would take 10 years before its earnings behind one share equals the market price of one share. This, of course, assumes that the company will keep on earning the same amount of profits every year. PE ratio, therefore indicates how expensive a company is based on current earnings. This is a useful indicator to compare companies in a similar line of business. Lower the PE ratio, cheaper is the stock. Naturally, PE comparisons cannot be carried out across industries, because some industries are given higher PE ratios due to their business dynamics.
2. Market Capitalisation. The market cap of a business is the number of shares outstanding multiplied by the price of each share. In short the market cap denotes the notional cost of buying the entire shares of the company. This parameter is useful in judging the relative attractiveness of a business as compared to other businesses in similar lines based on what value the market has assigned that business by way of market cap. For example a business in the consumer durable sector may be valued at significantly lower market cap than another consumer durable company. This would make it a value buy based on market capitalisation. For more on how to value a business based on market cap refer here.
3. Book Value. Book value is value of assets of the company behind every share. It represents the valuation of the stock based on its underlying assets rather than its earnings. If the market price of a stock is quoting at or below its book value, it means that the market does not think that the prospects of that company are bright and often indicates that the company that has become insolvent. However if the market price is below book value due to factors of a temporary nature, then this fact can be looked at by investors as a value proposition and can be used to buy into the stock with a holding perspective till the negative factors turn around.
4. Dividends. A value investor uses the dividend payouts as an important factor to determine undervaluation in a stock. If the dividend yield of a stock (i.e. the dividend per share divided by the market price) is high it indicates a higher degree of safety in times of adverse market conditions. Also important is to see what proportion of its earnings a company pays out in the form of dividends. For more on use of dividend yields referhere
5. Net current assets. Net current assets (NCA) are current assets minus current liabilities. If a business has high net current assets and the markets are assigning it a market cap near or below its NCA, it indicates a high degree of undervaluation. According to Benjamin Graham, the pioneer of value investing, investors cannot often go wrong in buying a business valued at or below NCA.

   The above are basic factors used by value investors in determining the relative underperformance of a stock. Of course, an investor also needs to go into the reasons as to why the market is giving a significantly lower valuation to a stock or an entire industry and whether it is justified in doing so before taking an investment decision.

   
   

TOP 10 DO’S FOR FUNDAMENTAL INVESTORS

1. Never invest in tips and rumours.
   
2. Look at the products which you use and like. The companies making these products could prove to be very good investments.
   
3. Be on the lookout for solid businesses which are presently out of favour. Check the 52 week lows columns of newspapers. They make for good contrarian bets.
   
4. If the market capitalisation of a company is near its net current assets, it could be a good value pick.
   
5. Keep the business cycle in mind. Some businesses are cyclical in nature. Aim to invest at the bottom of a business cycle.
   
6. The market may know something that you don't about a stock. Check this out when you buy at rock bottom valuations.
   
7. Keep an investment timeframe of at least 2 years.
   
8. Do not panic in a market downturn. Review your reasons for buying and see if they remain intact.
   
9. Conversely be aware of changing fundamentals. If basic reasons for buying no longer remain valid, sell.
   
10. Remember the old adage " Buy when others are fearful, sell when others are greedy".

FUNDAMENTAL VS. TECHNICAL ANALYSIS

The quandary facing an investor today is to decide what theory should he use in his process of stock selection. If he is taking professional advice, who should he turn to, fundamentalists or chartists?

Have you ever had the experience of completely researching a stock, looking into its ratios and the market potential of its products and then investing into it, only to find that after you have bought it, the stock simply stagnates or even goes down? In such cases do you have the conviction in your analysis to hold on to your stock through thick and thin, disregarding the market and the opinions of analysts to sell? If the answer is yes, then you have the most important attribute a fundamental analyst should have. Patience.

Then again who does not like an investment to appreciate right after one makes it? Technical analysis gives one an indication of the direction which a stock is poised to take and investment decisions are based solely on such indicators. Technical analysts do not give any weightage to the accounts of the company, its products or the quality of its management. The company might be bankrupt for all they care. Their decisions are based on what the charts tell them. However, should they go wrong they have stop losses to protect them. The argument for the chartists is 'cut your losses and let your profits run'.

So we come back to the original question. Which process does one choose? It all depends on your nature and your frame of mind towards investing. If you cannot take a loss, stay away from technical analysis. Because, if your analysis should go wrong, the chosen investment has no fundamentals to protect your downside. The stock could well crash to zero (or rather near zero). If you make a trade and your stop losses are triggered, it is imperative that you book losses and not revise your stop losses downward.

If you are a fundamental investor, it does not matter what the stock price does in the short run, as long as you have done your research. The key here is patience and the capacity to mentally bear any notional losses in the conviction that your choice is backed by solid homework and that the market has to recognize its potential in the long term. This form is only suited to long term investors. If the stock appreciates after your purchase, well and good. But your timeframe should essentially be a long one right from the outset. It is an investment sin to convert short term trades to long term investments after they have fallen.

Therefore a good approach to stock selection might be to first research a stock on its fundamentals and then use technicals to time your purchase. The negative being that a stock price may already have broken out by the time your fundamental analysis is done. A method I personally like and follow is to allocate a certain percentage of your portfolio (say 75 %) to stocks based on fundamentals and deploy the remaining funds to technical picks. I generally do not tinker much with the first group, but whenever I make a profit on my investments in the technical basket, I remove my profits from the markets and redeploy the principal in other picks.

BASICS OF FUNDAMENTAL ANALYSIS

Investing based on fundamental analysis of stocks is considered by many to be the best form for the long term investor. There are two broad approaches in which fundamental analysis may be carried out.

Based on the present and future prospects

This approach consists of valuing a business based on various factors related to the products of a company, its markets, its competitors, its efficiency and service levels, its reputation in the minds of its customers.

An evaluation on the above parameters may be done by carrying out a market study of the company. One way to achieve this would be by talking to the company’ suppliers, customers, competitors, ex employees and dealers and distributors. Doing this would enable an investor to judge the strength of the company’ products in the market and its perception in the minds of its customers and competitors. An investor can thereby determine whether the company has strong customer loyalty for its brands, do its competitors have respect for its business acumen and does it treat its stakeholders fairly.

After a complete market study is carried out and the company has performed well on the initial checks, the management may be approached to discuss its future plans with regard to capacity expansion, launch of new products, fund raising plans etc.

Based on past performance

This approach consists of looking to the past to see how a business has performed so far, in order to give us a reasonable picture of how well it may be expected to do in future. This involves looking at published accounts and annual results of the company for the past 5 years and examining the following parameters:

a) Average rate at which the company is growing its sales.
b) Average rates at which the profits are growing.
c) Growth in per share earnings. This gives a clue as to whether the profits are keeping pace with dilutions in equity capital.
d) Market Capitalization (M Cap) of the company. (For more on this refer May 08 archives)
e) The dividend yield of the stock. (For more on this refer May 08 archives)
f) Price to Earnings (PE) ratio and Price Earnings to Growth (PEG) ratio.(I shall discuss this in depth in a future post)
g) The Net Profit Margins.
h) Return on Capital Employed (ROCE). This is the ratio of net profit to capital employed (Equity Capital + Reserves and surpluses)
i) Book value of each share. (Particularly applicable in case of Banking and Financials stocks)
j) Net Current Assets (NCA) of the company ( If the business is available at a M Cap near to its NCA, it may be further investigated as an attractive value buy)

After all these ratios are calculated they may be looked at in relation to the ratios of other companies in similar lines of business, to determine whether the company being investigated is undervalued or not. Ratios should never be used in isolation but as a benchmark against which other alternatives may be compared.

If both these approaches are combined, it cannot fail to reveal several undervalued stocks which may prove to be multi baggers once the market realizes their potential.

The above is only a brief summation of the principles underlying financial analysis and is intended to serve as an introduction to the subject. Investors are advised to further read up on the subject to broaden their understanding of the principles involved.

DIVIDEND YIELD STOCKS FOR CONSERVATIVE INVESTORS

Investors who prefer stability in their portfolios and are not comfortable with stock market volatility can look at dividend yield stocks as an alternative to debt based instruments.

Suppose a stock with a face value of Rs.10 is quoting at Rs.100 and giving a dividend of 50% currently i.e. Rs.5 per share of face value Rs.10, then its dividend yield is 5 %. An investor in this stock receives Rs.5 by way of dividend, on every Rs.100 invested. At present dividends are tax free in India which makes it all the more attractive.

Now one might argue that 5 % is low as compared to 8 to 9 % returns available on debt instruments. But one needs to take into account the potential for capital appreciation, that is most likely to accrue over the long run, if the stock has been carefully selected to begin with.

Consider a business with a dividend yield of 5 %. Now take a simplistic scenario where this company is growing its profits at a steady 15 % per annum, year after year. It also keeps on increasing its dividend at the same rate. Now also assume that the market discounts the earnings of the company also at the same rate as on the date of investment. What would happen after 5 years? Growing at 15 % per annum, the profits of the company would double and its dividend will be now raised to twice the original. The initial investors who had got in at 5 % dividend yield would now find themselves earning dividends at 10 % of their principal invested.

Not only that, since the earnings have doubled, the market would now value his company at twice the original price. Therefore our investor stands to gain both ways. One, he is now getting dividends at more than the market rate for debt instruments and two, his original investment has appreciated by 100 %.

An added advantage of such stocks is that their dividend yield protects their market price from falling very much. For instance if the market price of a company with an initial dividend yield of 5 % fall by half, the new dividend yield now becomes 10% based on the current market price. This makes the stock attractive for many investors to buy, thus pushing the price upwards.

A caveat in this strategy being, that companies are not obliged to pay dividends. This entirely depends upon the business environment. If the company encounters a business slump, this strategy might fail. But the strategy is not designed to protect against adverse business conditions in the first place. It is designed to give stability to a portfolio in periods of stock market gyrations, with the basic fundamental attributes of the business staying intact.

Even this risk might be mitigated to an extent by selecting companies which have a consistent history of steadily increasing dividends over long periods of time. Several multinationals and PSU banks fit into this category. Another plus in selecting such companies is that, the very nature of their being profitable over many business cycles gives the investor added conviction in their business models.

This strategy can be used to invest a portion of their assets into equity by conservative investors while investing the balance into debt instruments. It may not give mind blowing returns but will impart a solidity to the investor’s portfolio with returns that at least beat inflation, while ensuring a good nights sleep.

USE OF MARKET CAPITALISATION IN VALUING STOCKS

Market Capitalisation (M Cap) of a company is defined as “ the number of outstanding shares multiplied by the market price of each share”. For instance a company having an issued capital consisting of 1,00,000 shares with each share valued at Rs.100 will have a M Cap of Rs.1 Crore. M Cap of a company changes every day with the change in its market price.

Companies in India are classified into three broad categories on basis of their M Cap.

Large cap companies having M Cap of more than 5000 crore.
Mid cap companies having M Cap between 500 to 5000 crore.
Small cap companies having M Cap of less than 500 crore.

Market cap gives the relative size and stability of a company as compared toother companies in the same industry. An investor can give due weightage to the M Cap of a company before judging its potential as an investment candidate. FII’ and other large investors usually favour large cap companies because of the liquidity they provide and their ability to invest large amounts in these companies without causing wide fluctuations in the price.

Another useful indicator in evaluating a company is its M Cap to sales ratio. This ratio indicates what value the market gives a company as a multiple of its sales. Generally 2.5 to 3 times of sales is considered to be fair valuation for a business, depending on what industry it is in and what is its growth rate.

If a company is being valued by the market at extremely low multiples to sales, an investor can use this as a starting point to investigate why. This can be an important clue to discover undervalued companies. If further investigations into the fundamentals do not reveal any significant problems, it can be inferred that the market has not recognized the value of that particular business and it can be considered as an investment candidate. Like all other ratios, M Cap to sales cannot be used in isolation but should be viewed in conjunction with other fundamental parameters and business attributes.

Another useful hint which the M Cap gives us is that it points us towards the untapped potential of a business model which is in the nascent stage in a country and therefore is not making any profits yet, but the same business model has performed well in other countries where it has had time to flourish and realize its potential.

A case in point is DTH services in India, where companies cannot be valued on basis of existing matrices like earnings, cash flow etc. because they are not generating any profits due to huge upfront investments in infrastructure. M Cap can be a useful parameter to value such companies, by taking into account their number of subscribers and checking what capitalization the market has given to companies with similar number of subscribers in developed nations. If there is a significant variation in M caps, such companies can be considered worthy of further investigation.

Serious fundamental investors should therefore look at the M Cap not only from the viewpoint as an indicator of business soundness, but also as a starting point to spot businesses which are being ignored by the market in spite of being strong investment candidates based on other parameters.