IN SEARCH OF VALUE

With the markets continuing with their northward journey, investors should revisit Benjamin Graham’s value investing approach to emerge a winner in the long term, says Ramkrishna Kashelkar

THE MARKETS have always had a fancy for companies on a high-growth path, giving them a premium valuation over others. Most of the investors, too, tend to follow this rule — put your money where the growth is. After all, the logic of growth — as the profits grow, so will the stock value — is so easy to understand.
Although this popular strategy appears logical and successful, it is the contrasting investment approach of ‘value investing’ that continues to score over ‘growth investing’ consistently in the long run. Various empirical studies in different time periods and on various sets of companies have shown that value-investing — investing in companies with low P/E, low P/BV, high dividend yield — can give an investor sustained better returns over a period of time.
The primary reason investment researchers give for this phenomenon is related to the tendency of corporate earnings growth to move towards its mean or, in other words, the sustainable rate of growth. Although growth stocks initially experience higher growth rates than value stocks, the growth rates of both quickly revert towards the mean. Both these high-growth as well as low-growth phases are temporary. But overoptimism for high-growth stocks and over pessimism for others is a universal investor tendency. According to a collaborative research work of three experts, Lakonishok, Schleifer and Vishny, published in 1994, investors put excessive weight on the recent past in attempting to predict the future. This is a common judgement error in psychological experiments and explains investor preference for glamour stocks. In the process, one of the key principles of investing is violated — good companies are not always good investments. This common investor tendency practically ensures that value investing will continue to make superior returns in a longer timeframe.
To explain the concept in simple words, value investing is buying a stock before its growth cycle begins, while growth investing is when you enter a stock after the growth momentum becomes visible. As an investor goes on to invest in such ‘glamour stocks’, where the market has already discovered the growth prospects, she inevitably ends up paying a premium towards the higher future earnings. Obviously, unless you are very early to catch the trend, the growth investing approach can land you with high value stocks in which most of the upside potential is already built in the prices.
In this context, it would be interesting to look at auto component companies such as Munjal Showa and Ahmednagar Forgings. Both these companies posted higher profits in the December ‘09 quarter and are well-positioned to benefit from a sustained recovery in the automobile industry. Currently, both the companies are trading only slightly above their FY09 book values. Considering the profits made during the year so far, both scrips would be trading below their respective FY10 book values.
The key, therefore, lies in investing in companies that are trading significantly below their intrinsic value. For example, caustic soda manufacturer Aditya Birla Chemicals or the security solutions firm Micro Technologies are trading at a 30% discount to their respective FY09 book values. Both the companies were hit badly by the economic slowdown last year and are now on a recovery path. The chemical company is also expanding capacities eyeing capacity addition in the aluminium industry next year.
When working with a large number of companies, it makes sense to use price-to-book value (P/BV) as a proxy for intrinsic value to avoid the tedious and subjective calculations of earnings projection and cash flow discounting. In fact, the study published by Bauman, Conover, and Miller in 1998, which studied 2,800 stocks in 21 countries over a 10-year time period, concluded that price-tobook ratio is a better indicator of value than priceto-earnings, price-to-cash flows or dividend yields.
The value investing approach shuns the conventional wisdom that higher returns are associated with higher risk by focussing primarily on eliminating the risk. ‘Limit the downside and let the upside take care of itself’ is, in fact, one of the most fundamental principles of the value investing approach.
This approach has a number of key benefits. First, as mentioned above, it limits the downside risk — or the risk of a significant erosion in investment value if the market falls. At a low market price, these companies have high dividend yields, which adds to the margin of safety. For example, companies such as SRF, Nippo Batteries, Munjal Showa, Cosmo Films and Shipping Corporation of India are available at dividend yields of around 4-5%.
Many of these companies including GNFC, Shipping Corporation, India Cements and OCL India are investing significantly in their respective businesses. The expanded asset base is likely to bring in additional revenues and profits in the years to come. Most importantly, such companies can witness a quick run-up as soon as their present problems go away or sentiments improve.
With the benchmark Sensex within striking distance of 17,700 on Friday — a peak briefly touched in January after nearly two years — and not appearing inexpensive at a P/E of 21.4, we believe investors should take a break and look out whether any value buys are around. ET Intelligence Group brings you a list of such companies that can be the starting point for the search of value.
The primary criterion used for selecting the stocks was the price-to-book value, which was capped at 1.25. Further, the list was pruned to ensure companies with a track record of profits, positive cash flows from operations and dividends were included. Then the highly indebted companies and those earning too low a return on employed capital were excluded. Finally, companies in a perpetual downturn or with known dubious management record were eliminated.
All said and done, investors must do their homework before staking out money in the stock market. As Warren Buffett, the great Oracle of Omaha, who has played an instrumental role in popularising the value investing approach, puts it, “Never invest in a business you cannot understand.”