What is value investing and how do I pick under-valued stocks in the Indian market? In this post, we discuss the concepts, and then demonstrate with an example how you can find value picks yourself.
What is Value Investing?
The essence of value investing is quite simple and intuitive. Buy an asset (stocks in this case) at a price significantly less than its actual worth. Over time, market will re-rate the stock to its intrinsic value when you sell for a profit.
There is only one small problem though – how do we know what is the intrinsic value of a stock?
Well, there can be various ways to measure it, as we discuss below.
Liquidation value represents the proceeds that would be received by simply shutting down the company and selling off it’s assets.
After the 1929 stock-market crash and the great depression that followed, investors were very sceptical about investing in stock market. Consequently prices of stocks remained extremely depressed. Ben Graham, the legendary investor and father of value investing, would purchase stocks whose prices were less than the liquidation value and sell them back once they attain their intrinsic value for a profit.
According to Graham, if you buy 20-30 companies that meet this requirement without doing further analysis, and sell them when they eventually reach their true value, the results would be ‘quite satisfactory’. Graham used this method with success for over 30 years.
This method works well in extremely depressed markets. Unfortunately in normal market conditions it’s very difficult to find stocks of decent companies quoting below their liquidation value.
Present Value of Future Cash Flows
Graham disciple Warren Buffet defined intrinsic value of a business as present value of future cash-flows added together, based on works of Williams & Weise. There is a subtle difference though, Buffet used earnings to represent cash-flows in-place of dividends used by William & Weise.
American economist Myron J. Gordon came up with simplified equation popularly known as the Gordon model, to estimate value. Assuming stable dividend growth, price of a dividend paying stock can be represented as:
Price per share = D1/ (r – g)
- D1 = estimated value of next years’ dividend.
- g = constant growth rate of dividend till perpetuity.
- And r = expected rate of return on equity
Let’s say you want to buy an apartment for renting-out. Your expected rental income is 1L per year and you wish to increase rents by 5% every year.
Assuming you expect 10% RoI on real estate, fair price as estimated by Gordon’s model should be 1/(0.01–0.05) = 20L.
Now, let’s say, due to downturn in real estate sector you find the apartment selling at 15L. Your rate of return will improve to r = 1/15 + 0.05 = 11.67% nominal.
DCF or DDM lets you calculate the intrinsic value of an asset, be it stock or real estate. It also helps you estimate returns based on current price.
Limitations of DCF
Unfortunately DCF or DDM can be difficult to use in most industries as it requires estimating future cash-flows or dividends many years into future. Generally this is not very practical except for very few situations (such as rental type of businesses, etc). Additionally, the formula becomes meaningless in cases where growth rate in earnings is more than cost of equity.
Interestingly, while Buffett accepts the principle of discounting cash flows, Charlie Munger once said in public that he has never seen Buffett perform a formal DCF analysis himself (1, 2).
Munger: Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.
Buffett: It’s true. If [the value of a company] doesn’t just scream out at you, it’s too close.
Contemporary Value Techniques
With absolute measure of value of a business being hard to determine, except for academic purposes, contemporary fund managers tend to rely on relative valuation approach while practising value investing.
According to Institutional Investor Magazine, most pension fund consultants’ group value managers into 4 categories, based on the criteria they use to identify cheap stocks. These are:
- Low PE manager, normally looking for out-of-favour stocks
- High Dividend Yield Investor
- Low P/BV (often leading to depressed cyclicals)
- Low P/CF Manager (much the way takeover specialists work)
Research findings (3)
According to study performed by David Dreman and Eric Lufkin, contrarian value strategies beats the market consistently with lower draw downs. The study measured the Compustat 1500 – largest 1500 stocks publicly traded – for a 27 year period ending December 1996. 10K dollars invested in the bottom 20% of the above 4 value measures generated 708K for low P/E stocks, 572k for low P/CF, 685K for low P/V and 415K for high Dividend Yield stocks compared to 289K generated by the market.
Further, each of the strategies performed better than the market in the down period, with high dividend yield stocks declining the least (-3.8%), followed by low P/CF (-5.8%), P/E (-5.7%) and P/BV (-6.2%).
10 Potential Value-Picks
To apply value principles in the Indian stock market, we perform the following screen. We filter stocks trading at PE less than 10 (9.6 gives bottom 20% PE stocks as on date) and PSR less than 1.5, further, check for reasonable growth, profitability and earnings quality.
As on 27 Sep 2018, our screen returned the 10 stocks listed below:
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Disclaimer: This is not a recommendation of buy any of these stocks, please do your research or speak to financial advisor before investing
Value investing is intuitive. It tells us to buy business at prices significantly less than its intrinsic value and sell once prices reach their true worth. Challenge arises in accurately estimating value of a business. Absolute measures such as liquidation value or present value of future cash flow determined by DCF model tends to have practical limitations. Contemporary value investors therefore rely on relative valuation techniques such as low P/E, low P/BV, low P/CF and high dividend yield metrics to identify stocks. We ran a simple screen to demonstrate how value picks can be identified in the Indian market following this concept.
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- Discounting future cash flows – Buffett & Munger approach
- Contrarian Investment Strategies – The Next Generation, by David Dreman, 1988 Simon & Schuster, pp155