What is value investing?
Imagine if I sell you a ten rupee note for five rupees, would you be interested in buying? Of course you will be, why wouldn’t you buy something that is worth way more than the price you are paying for it?
Value investing is exactly this, buying a business which is trading at a lower price than its actual business value. While it sounds very simple and interesting, spotting a value stock is not an easy task. To understand how to spot an undervalued stock, it is important to understand what value in a stock means.
What is a value stock?
A value stock is a stock that trades below its intrinsic value, the intrinsic of the company may be determined by comparing company’s business value (such as company’s profit, sales, cash flow etc) to the value that the market offers.
Value stocks are a result of inefficiency of the market in assessing the true value of a stock.
Sometimes value stocks may be popularly known but still trade below their intrinsic value because people have a negative view about the stock or sector, which leads to heavy selling, and the stock starts trading below its intrinsic value.
Why a stock becomes undervalued?
There are many reasons why a stock may become undervalued, from a widespread pessimism about the stock or sector, to low popularity in a stock. Here are some of the most common reasons listed below:
Poor financial performance with a possibility to turn around:
When a company posts financial results that are below people’s expectations, it results in widespread pessimism which leads to heavy selling, bringing the price down.
Because of this, the price of stock gets so depressed that they start trading below the company’s business value, making it a value stock for a long term investors.
When the financial performance improves, the price start rising to a fair value, giving value investors a good return on their investment.
Example of a turnaround company:
A perfect example of such pessimism is Ashok Leyland. In the year 2013, due to slump in infrastructure development in the country, and slowdown in European economy, company had to cut back production in its European subsidiary Avia.
Domestically, company was not performing well due to low truck rentals, consequently, sale of new trucks was down. Company’s revenue fell to 21.4%, rising raw material costs added to the woes of the company and shot up to 75% of the sales. During this period, Ashok leyland was trading at around Rs. 15 per share, lowest in the last 4 years.
If you look back at Ashok Leyland’s valuation, during 2013, Ashok Leyland was trading at less than half its net operating revenue, a great bargain at the price paid for a company that hold 35% market share in commercial vehicles segment.
As the years went by, economic condition of the sector improved and Ashok Leyland’s shares started to climb. Today, Ashok Leyland is trading at Rs. 119 per share giving a return of 793% in 5 years, a return of 51% CAGR.
Despite strong financial performance, some companies trade below their intrinsic value because their business is too boring and uninteresting.
A fancy tech startup may get everyone’s attention because of its cool factor, but who would be interested in a company that makes boring auto parts for an automobile brand.
The fact is boring companies like these also make good investments as their revenues are stable and cash flows are strong.
Example of a low popularity company:
A great example of such a company that recently got investor’s attention is Minda Industries(I have written a detailed analysis of the company, you can read it here).
Minda Industries is an auto ancillary company (it manufactures auto parts for various automobile companies, also known as OEM (Original Equipment Manufacturers). In 2013, company was trading at one fifth its net operating revenues (Price/ Net Operating Revenues=0.23) while it price to book value was 0.79.
While the company was trading at such cheap valuations, the business was posting strong financial performance every year. In 2008, company’s Net Operating Revenue was Rs. 403 crores by 2012, company’s Net operating Revenues reached Rs. 1,177 crores, a growth of 197% a CAGR growth of 23.91%.
During the same period, Minda Industries’ Net Profit increased from Rs. 15.72 crores in 2008 to Rs. 33.41 crores in 2012, a growth of 112%, and a CAGR growth of 16.27%.
From 2013 to 2017, company’s Net operating Revenues grew from Rs. 1,044 crores to Rs. 1,617 crores in 2017, a growth of 52%, and a CAGR growth of 9.14%, while its net profits grew from Rs. 30 crores in 2013 to Rs. 94 crores in 2017, a growth of 2013%, and a CAGR growth of 25.66%.
In 2013, Minda Industries was trading at a price range between Rs. 30 per share to Rs. 40 per share, on 20 Sept 2017, price of Minda Industries share is Rs. 863 per share, a return of 2,057%, a CAGR return of 84.84%.
Minda Industries was clearly a value investment which was undervalued even when it was posting great growth results, simply because market was unaware of such a hidden gem.
Characteristics of a value stock:
So how would you know if a stock is undervalued? Well, There are some common inherent characteristics in a company that make a company undervalued, and a great investment opportunity for value investors.
Steady growth in sales and profitability:
The first prerequisite for a company to be a value investment is to be profitable. A company with cheap valuation is of no use if its financial condition is deteriorating, such a company will ultimately turn into a garbage. Therefore, it is important for a company to be profitable and financially healthy.
Look at past 5 years sales figures of the company, if the company’s sales are rising every year, it is the first positive sign of a healthy company.
However, this is not the only factor you should consider. Every company must make profits in order to keep the business running.
If a company is making huge sales but is bleeding losses for the past many years, there is a good chance of that company will turn into garbage rather than a goldmine.
An investor must analyze company’s past Net Profit of at least 5 years, if company is making frequent losses, due to high operating expenses, rise in cost of raw material etc. it is better to be vigilant or stay away.
High Return on Capital
Return on Capital shows how efficiently a company is utilizing its capital to generate profits.
Higher ratio shows company is using its capital intelligently by utilizing its resources in the best manner.
As a rule of thumb, companies that have debt on their books must have Return on Capital above prevailing interest rate, if that is not the case, then company runs a risk of defaulting as it will be hard for the company to cover interest expenses from its profits.
Debt is a good source of capital for a company, it is less costly, faster way of getting funded if there is an urgent need for capital.
However, too much debt could be a major cause of disaster for a company. When a company raises capital using debt, it has to pay the interest to the lender irrespective of whether the company is making profits or suffering losses.
If a company is unable to pay back its debt to lenders, it may have to shut down its business in order to pay back its dues.
It is thus important for an investor to check the debt levels of a company, even if it is making good profits, because if the profitability of the company falls in the future, paying debt will get difficult.
Low Price to Book value:
Book value is a total imaginary value of all the tangible assets left for shareholders of the company after paying all its obligation such as debts, payment to creditors, preference shareholders etc.
In other words, Book value can also be seen as the liquidation value of the company from a shareholder’s point of view.
Price to Book value is a ratio that tells you about the value of the assets held by the company and how market values them.
In other words, it’s a ratio that shows the ratio between the true value of assets held by the company versus the value market thinks is right.
Undervalued companies have low price to book value because market does not know about their true worth against the value of assets held by the company.
That is why stock price of such companies remains at lower levels, giving value investors a good bargain.
Steady dividend payouts:
Dividend is a part of company’s annual profit, that company distributes to its shareholders to keep them invested. undervalued companies that make good profits and have enough cash to fund their expansion usually pay generous dividends. For a value investor, dividends are like oxygen in a suffocating room.
Regular dividend payments provide steady cash flow to shareholders, an investor can also afford to remain patient if the stock takes longer to move from undervalued to overvalued.
Value investing has been one of the best ways of investing in stock market, it has stood the test of time and has been proven successful by many investors by some of the wealthiest investors and fund managers in the world such as Warren Buffett, Peter Lynch, John Templeton, Rakesh Jhunjhunwala, Parag Parikh, Ramkrishna Damani and Chandrakant Sampat.
However, it has its own advantages and disadvantages as well. Some of the pros and cons of value investing are mentioned below.
Advantages of value investing:
Better Growth Potential:
Most of the popular companies trade at high premium compared to their present value because they have a strong past performance record and their future is largely predictable.
Undervalued companies on the other hand usually trade below their intrinsic value providing a better growth potential.
Margin of Safety:
Margin of safety is a term coined by Benjamin Graham and David Dodd, it is the difference between the real value of the business and the price market quotes.
Since market price of undervalued companies is below its intrinsic value, it provides a good safety against errors in judgement and potential loss of capital.
Great investment opportunity even in an overvalued market:
When market sees a long bull rally, most of the popular companies trade at higher valuation, making it difficult for investors to find good investment opportunities. Since undervalued companies are unpopular, they provide great bargains even in a bull market.
Disadvantages of value investing:
Value may take longer to realize, or may not be realized at all
Undervalued companies that are lesser known to majority of investors, take time in achieving their fair value. That is why it may take longer than usual for a value investor to make multifold profits from value investing. In the worst case, a company’s true value may never be realized and it may remain ignored by the market.
To safeguard yourself against such risk, you should always keep track of traded volume of the stock, if the company has decent volumes, there is a good chance of it for the market to realize its true value.
Requires emotional discipline:
Finding an undervalued stock requires a lot of research and analysis, even if you do find one, an undervalued stock, unlike growth stocks take lot of time and investor’s patience to show meaningful returns.
To be a successful value investor you need to develop lot of patience and emotional discipline, which you will learn only with experience.
Wrong or faulty analysis may lead to huge loss of capital.
One of the biggest downside of value investing is the challenge of correctly estimating the intrinsic value of the company. There are multiple methods used by different investors to estimate the true value of a company.
Some investors use DCF (Discounted Cash Flow) method, while others use CAPM (Capital Asset Pricing Model).
While all these methods are widely used by institutional investors and Investment bankers, none of these methods can accurately calculate the true value of a company as all these methods are based on projected or estimated future earnings of a company.
The accuracy of your analysis depends on the accuracy of your future earnings estimate, if your estimated earnings are way below actual earnings, the value your model will arrive at will be too conservative, which the market may never offer and you will lose a an investment opportunity.
On the other hand, if your earnings estimate is too high, the price you pay for the company will be way above the actual intrinsic value, leading to low return on investment, or even loss.
It is thus always important to keep track of your future estimates and revise your analysis regularly.
Value investing is one of the best investment strategies that has stood the test of time. It has been practised by some of the wealthiest investors in the world and is still working for them.
Value investing, is not something which is not exclusive to the rich,no matter what is your income level, if practised in the right way, value investing can provide huge return on investment.
If you follow the right strategy, practice the discipline needed, and can avoid being carried away by the noise of business channels and herd mentality, a fortune is waiting for you to be taken.