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Adapting value investing to the Indian environment

Conviction and patience have to be inbuilt in value investing, be it in India or anywhere else

Value investing is catching up in the investment community. Well, to be fair, it has been officially around for almost 90 years, since Benjamin Graham and David Dodd (professors at Columbia Business School) wrote about ‘margin of safety’ in the context of buying shares. In comparison, the development of the Indian equity market is much more recent and the application of value investing to the universe of stocks here can sometimes get tricky. A panel of four portfolio managers, who in their own ways rely on the tenets of value investing, was present at the Morningstar Investment Conference 2014 held on 11 November in Mumbai. They highlighted that the basic value investing goal is to buy a stock at a price below its intrinsic value or at a discount.

So, here is what you need to know if you want to pick stocks based on value.

Portfolio managers view

Value investing relies on the fact that at any point in time there are companies listed whose stock market prices are lower than the intrinsic value or expected value based on fundamentals. This difference is the margin of safety and comes about thanks to assessment of profitability and scalability of businesses.

This, in turn, comes due to unique competitive advantages that a business has. Warren Buffett called this a moat. A moat can essentially be looked at as a competitive barrier that a company has which sets it apart from others in the same space. This leads to a long business cycle where capital is growing at a high but sustainable rate.

According to Kenneth Andrade, chief investment officer, IDFC Asset Management Co. Ltd, “Once you identify a good company, you need to sit tight for long periods of time. The key is to identify scalability and the execution capability of the business." He doesn’t like to bucket himself into a value style, rather Andrade says that you can own high-growth companies but what is important is what you pay to acquire the stock.

Another panelist, Bharat Shah, executive director, ASK Group, said, “The debate on whether a particular investment style is value or growth is artificial. The distinction doesn’t matter. If a business is not going to grow, there is no value, and to buy a high-growth business, you will look for a margin, which is value."

Shah went on to emphasize that value can’t be measured only in terms of a low valuation that shows up as a low price-to-earnings (P-E) multiple or a low price-to-book (PB) value. That is an arithmetic exercise, and has to be combined with the ability of a business to grow and have quality management backing that growth.

In the Indian market, having a contrarian value strategy works best, said S. Naren, chief investment officer, ICICI Prudential Asset Management Co. Ltd. This means, you should buy when others are fearful and sell when they are too positive. He extended this argument to not just equity but all asset classes and said that investors need to be aware of cycles. Though the turn of a cycle can only be identified in retrospect, one has to be aware that asset prices move in cycles and it doesn’t remain in a one-way trend. This cyclical trend then needs to be superimposed on basics of investing, which are identifying strong growth companies backed by good quality managements and compounding return on equity (for a company). The panelists agreed that value investing requires the discipline to hold a stock over long periods.

Putting theory to practice

Discipline in selecting good quality companies without getting swayed by cheap valuations requires experience.

Parag Parikh, chief executive officer, PPFAS Asset Management Co. Ltd, said, “Ultimately, it’s about buying businesses. It’s not a piece of paper that moves up one day and down the other. Value investing requires you to wait, which is very difficult."

Shah said most people make the mistake of pursuing a strategy that relies on a theory which propagates higher risk for higher return. While this may work for asset classes in the big picture, he said it didn’t really apply to selecting individual shares or companies. In case of the latter, he said, the choice is based on the probability of high returns through lowest risk.

This is also the way to avoid a value trap. A value trap is a common mistake that value investors make when they buy a stock that has been trading at a low valuation for a long period expecting things to turn. However, due to poor intrinsic fundamentals, the turnaround doesn’t happen and the investor is stuck.

“The predominant strategy is to buy good businesses. It’s not always important to buy cheap, but predictability of the environment the business operates in is critical," said Andrade.

Mint Money take

Be it value or growth, an underlying tenet of successful investing is being able to pick a good quality business. This means identifying businesses with good growth capability; ability to use capital efficiently; scalability of operations and a competitive advantage that gives it a pricing power.

Then comes the job of buying the stock. Here it’s important to see whether you are able to buy with a margin of safety. This means judging that the current market price isn’t fully reflecting the future potential of its earnings growth.

Lastly, you have to hold on. You won’t find an expert who defines how long you need to hold, but it’s clear that the holding period has to be more than 3, 6 or 9 months. Hold on till the business continues to produce at a rate higher than the stock price reflects; now, that could be 2, 3, or 10 years. Conviction and patience have to be inbuilt in value investing, be it in India or anywhere else in the world.

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