The concept of value investing is very simple to understand but quite difficult in practice. The simplicity of value investing comes from what a value investor is trying to achieve – trying to buy a stock or financial asset for less than it’s worth. In this article, we look at the meaning of value investing, how to identify value stocks, intrinsic value, value traps and how to beat the stock markets with value investing principles
What is Value Investing?
Value investing is a discipline of investing that looks at trying to buy a stock or financial asset for less than it’s worth or intrinsic value.
While this might sound obvious to most, a large majority of investors buy stocks under the greater fool theory principle. The greater fool theory says that you buy something in the hopes that someone else will come along and buy the stock or asset from you at a higher price.
Incidentally, the greater fool theory has been responsible for many bubbles through the years like tulipmania in the Netherlands and the South Sea bubble that you can read in “Extraordinary Popular Delusions and the Madness of Crowds”. I had recently written a book review of this Charles Mackay classic.
More recently we see the theory at work in cryptocurrencies like Bitcoins between 2016-2018 or technology stocks during the 2000 dot com bubble.
Value investing is far away from this.
Value investing is a highly analytical and logical exercise in determining the real value of the stock against the price that the market is asking for it.
What Value Investing is NOT?
There is a vast majority of investors around the world who are trying to make a quick buck.
This is done by speculating the quarterly earnings number in a company’s upcoming meeting. The idea for them is to make a quick 5-10% and it is very likely that the bet can go south aswell.
A value investor takes a view that a quarter is too small a horizon for a company to either mend its problems or show significant improvement & growth.
Hence, it is important for you to be patient for a couple of years (maybe more) for –
- demonstrable improvement in revenue and earnings performance and
- emergence of a catalyst
This way, you can mildly define value investing as passive investing.
You are not hopping from one company to the other, one quarter to the other .. trying to find the next fish to fry. Unfortunately, most diversified mutual funds with over a 100 stocks do just that which does not allow them to be as successful as a lot of successful value investors who chase 10-20 stocks with high conviction.
How to Identify Value Stocks?
It is not uncommon to see people suggest that value investing is the art of buying lousy businesses at throwaway prices. The truth is far from it.
“Value” in businesses can come in different forms.
Let’s examine a couple of techniques in identifying value stock.
1. Identifying hidden value
Value investing finds a lot of warmth with discovering hidden assets in a business which the seller is not evaluating.
A quick example. You go to a neighborhood gift shop to buy a wallet and you find one for ₹400. But since the shop was closing down, there was a fire sale and the seller was offering it to you for ₹100. That’s one type of value.
But let’s say while searching, you come across a ₹400 wallet which has no discount available on it. But to your surprise, the owner had mistakenly left a ₹500 note inside the wallet.
This means the price of the wallet has dropped dramatically from ₹400 to minus ₹100. This is deep value for you as you are getting the wallet free of cost and you are earning ₹100 on top of it.
Now you might say that’s just good luck.
That’s true and that’s what hidden value finding is all about. Here are some real-world examples –
I ran today’s stock screener and found that there are 30 companies in the NSE which have more cash in the company than the total value at which one can buy 100% of the company (market capitalization)
Here is a sample list.
|Name of Company||Market Capitalization (in ₹crs)||Cash and Equivalent (in ₹crs)|
|NBCC (India) Ltd||2,997||4,832|
|Garden Reach Shipbuilders & Engineers Ltd||1,780||2,428|
|DEN Networks Ltd||1,523||2,164|
|Indiabulls Integrated Services Ltd||344||886|
|Tejas Networks Ltd||306||370|
|Hindustan Media Ventures Ltd||301||583|
|HT Media Ltd||249||1,577|
Some of these companies will be known to you.
Notice that the cash in the company is higher than the market capitalization (i.e. value of all outstanding shares in the company or market price per share * number of shares).
In other words, if I had enough money, I could have bought NBCC (India) Ltd for ₹2,997 crores .. gone to the bank .. written a check for ₹4,832 crores in my name .. and come out with a profit of ₹1,835 crores.
That’s a return on investment of 61% !
Now you might be thinking that if I buy a company then I not only get all the shares in the business i.e. 100% ownership but I also have to take in 100% of the debt aswell.
This is a valid question.
And so I added the long-term debt in each of these companies to see if the cash in the company still remains higher than the enterprise value.
|Name of Company||Market Cap (in ₹crs)||Long Term Debt (in ₹crs)||Cash and Equivalent (in ₹crs)|
|NBCC (India) Ltd||2,997||0||4,832|
|Garden Reach Shipbuilders & Engineers Ltd||1,780||0||2,428|
|DEN Networks Ltd||1,523||266||2,164|
|Indiabulls Integrated Services Ltd||344||288||886|
|Tejas Networks Ltd||306||0||370|
|Hindustan Media Ventures Ltd||301||60||583|
|HT Media Ltd||249||293||1,577|
Surprisingly we see that, still, all seven companies have more cash in their balance sheet as compared to their market capitalization and debt put together.
This is just one example of hidden assets.
A word of caution – value investing and investing in general is not a simple thumb-rule based selection set. Cash in the balance sheet is one of hundreds of various parameters one has to see to identify the right stock to invest in.
Sticking to statistics, I further examined that 5 of the 7 companies displayed positive earnings (profits) in the last year. However when I apply a favourite parameter of mine, free cash flow, only 1 out of the 7 companies was free cash flow positive.
However on a broader basis, I hope you can see the importance of looking at hidden assets.
Bombay Burmah and Britannia Industries
Another interesting hidden asset analysis that you might want to do yourself is comparing the price movement of Bombay Burmah Trading Corporation Limited with Britannia Industries Limited. Here’s a useful chart.
Most important, it is important to note that Britannia Industries has 240,318,294 equity shares of ₹1 each. Of these 121,732,190 equity shares is held by The Bombay Burmah Trading Corporation Limited. That’s a little of 50% shareholding of Britannia Industries Limited.
This means, if you see a big gap between Britannia stock prices and that of Bombay Burmah Trading then it might be time to understand the cause of such gap and be ready to go long or short the stock.
2. Value Investing and Growth
Often investors look at growth and value as two different styles of investing.
This is a case of stereotyping an approach. I have learned over the years that value can come in many forms including growth.
Let me explain this with an example.
Suppose a country consists of two islands and the only connection between them is a narrow bridge. The bridge charges a toll of ₹100 whenever a vehicle wants to pass through it. The two island cities are flourishing and the number of cars is expected to grow by 20% over the next 10 years. The toll operator has no expenses so the entire ₹100 is the profit per vehicle that crosses.
Now we can clearly see growth in this operation as the number of vehicles are increasing by 20% every year. So if 1,000 vehicles passed in the first year then over 5,000 vehicles will be passing through in the tenth year.
But a true value investor looks at something more.
The bridge is a scarce commodity i.e. it is the only connection between the island cities. This means it controls all of the supply and also has pricing power. So instead of charging ₹100 for all ten years, the toll operator can charge an increase of 5% each year. See how the revenue graph will change over these ten years.
Growth is an important part of finding value in companies.
This growth should be qualitative and quantitative in nature as explained in the illustration earlier.
Value investors use multiple growth parameters such as EPS (earnings per share), dividend payout, revenue, EBITDA (earnings before interest, taxes, depreciation & amortization), net profits, free cash flow etc.
A growing company offers a higher margin of safety to our value calculations. We shall learn more about the margin of safety in coming sections.
What is Intrinsic Value?
Value investing is an analytical exercise and not just a mathematical one.
It should not be construed as a screening of statistically cheap price earning multiples. The value investing exercise aims to broadly estimate the intrinsic value of the company or business.
Note, I did not use the word price of stock. Price comes much later, the idea is firstly to find the real value of the underlying business. As explained earlier this is done as a mix of tangible and intangible factors.
Speaking about quantitative factors, one of the key tenets of value investing is to project the future cash flows of the business and then discounting them to the present value i.e. today’s prices.
Why is this done?
We do this because revenue of ₹1,000 earned today is more valuable than ₹1,000 earned after 5 years. That’s because you can use today’s money to good advantage and more so because you want to buy the business (or a stake in it) today rather than 5 years from now.
The math in a DCF calculation is very easy. What is hard here is the predicting of the future which requires us to see multiple variables including industry growth, price of supplies, macro trends, competitive advantage and many more parameters.
Also remember that intrinsic value is never a precise number. Assumptions and predictions can never lead to a precise number. Even the greatest investors can only arrive at a range of value for any business, say this business is worth $1.2 to $1.5 billion.
Now if the business is available to you at $1.8 billion, then you have enough evidence to reject the offer because the price asked is way more than what your analytical estimates are saying.
But if the same business is available to you at $0.7 billion, then it is truly a case of it being traded at well below its intrinsic value.
The point here is that most companies in the stock market do not trade at its intrinsic value at most times. And this is the entire premise of value investing – identify discrepancies between a business’s intrinsic value and the market value.
Benjamin Graham – The Father of Value Investing
The birth of value investing is credit to Benjamin Graham. Benjamin Graham excelled at making money in the stocks markets. Most noteworthy was his ability to do stock without taking big risks.
Graham graduated from Columbia University and went on to work on Wall Street.
Over the next 15 years, he accumulated a sizeable corpus only to lose most of it in the stock market crash of 1929 and the Great Depression that lasted until 1933. This experience taught Graham the importance of minimising risk by investing in companies which traded at far below their actual intrinsic value.
These ideals inspired him to write the book Security Analysis (published in 1934), which chronicled his methods of analyzing securities. In this epic book, Graham proposed a clear distinction between investing and speculating.
Benjamin Graham’s approach to investment was contrary to the general public’s perception towards investing. Graham advocated the use of numbers and investing rules when everyone else viewed investing in stocks as a speculative activity. In other words, no one understood why stocks went up or down or how to value a company.
Mr. Market and Value Investing
Benjamin Graham introduced the concept of Mr. Market in Chapter 8 of The Intelligent Investor. Now Mr. Market is an imaginary figure who would come every day and yell out a price for a stock. Like all humans, Mr. Market will have good days and bad days. When he is in a very buoyant and optimistic mood, he’ll offer you a stock at a very high price. And on other days when he is depressed, Mr. Market will quote a very low price.
As an investor, you can pick any price that Mr. Market is offering or you can choose to ignore Mr. Market all-together.
Patience is a key virtue for any value investor. This is embedded in the principle tenet of value investing which says that the purpose of intelligent investing is not to invest with price as the anchor but finding the intrinsic value. Mr. Market is there to serve you with prices.
Unfortunately, many people think exactly the opposite and become servants of Mr. Market’s daily changing prices.
Any investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizeable declines nor become excited by sizeable advances. He should always remember that market quotations are there for his convenience either to be taken advantage of or to be ignored.Benjamin Graham
Margin of Safety and Value Investing
In Chapter 20 of the Intelligent Investor, Benjamin Graham introduced the concept of Margin of Safety.
Benjamin Graham uses the concept of the weight of a bridge. If you had trucks weighing 5,000 kilograms to go over a bridge, you would not make a bridge that supports only 5,000 kilograms. The idea will be to give extra support to the structure to make it more reliable.
When a value investor calculates the intrinsic value, it is based on many estimations about the future. The future is not certain hence we need more reliability in our calculations. The Margin of Safety does just that.
More specifically, Graham suggests buying stocks at 50% lower than what you have calculated as the intrinsic value. The larger the margin of safety, higher is the chance of making profits on your investments.
Explaining Margin of Safety with Net Current Asset Value Rule
Here’s one safety rule that Benjamin Graham has given.
Buy only if the price of stock is 66% or lower of the net current asset value per share.
Net current asset value is the difference between current assets minus current liabilities.
Now this is a very strict rule.
I thought I would have not found any company that fits this rule. To my surprise I found 5 companies that fit the bill with each of these companies having a market capitalisation of over ₹1,000 crores
|Name of Company||Total Current Assets (in ₹crs)||Total Current Liabilities (in ₹crs)||Net Current Assets (in ₹crs)||Market Cap (in ₹crs)||MCap / NCA|
|Bharat Heavy Electricals Ltd||38,349||23,081||15,268||7,556||49%|
|Tata Steel BSL Ltd||7,981||4,178||3,803||1,963||52%|
|Indiabulls Real Estate Ltd||12,172||8,469||3,703||2,257||61%|
|Bombay Dyeing and Mfg Co Ltd||3,475||1,599||1,876||1,150||61%|
Remember, you cannot blindly go with this rule.
That’s because it’s possible that some of these companies can be loss making while others might be simply value traps.
Infact, Graham shares some important value investing rules in the Intelligent Investor aimed at defensive investors. These include :
- Achieve a portfolio diversification of between 10 to 30 stocks
- Choose stocks in companies which have large sales numbers of atleast $1 billion
- Prefer companies which manage conservatively. Such as having a current ratio of 2 i.e. the current assets in the company’s books are twice the current liabilities which indicates that the company can pay its short term liabilities with no trouble.
- The company must have paid dividends for at least 20 years without having missed a single dividend payment
- No single year of decreasing earnings over the past 10 years
- The earnings must have grown by atleast 3% annually during those same 10 years
- The price earnings ratio should be 15 or lower
- The difference between assets and liabilities in the business should be atleast 1.5 times of the market capitalization of the company
Seems a little strict, doesn’t it?
Benjamin Graham lived in a different time to what we live in now. So it is OK to disagree with some of these tenets. I too don’t agree with some points here but we can’t help appreciate the author’s sincere plea to investors to start looking at investing as an analytical exercise and not a speculative one.
Graham, in the book, also created a checklist for the more enterprising investors where some of these criteria have been relaxed. However, he asks of the common investor to stick to the defensive style. That’s because most investors are likely to not have the necessary experience nor the time to research and follow the guidelines.
How to beat the stock market?
It’s sort of a tautology to say that there are 3 possible ways using which an investor can try to beat the stock market
- You can be a good stock picker & pick better stocks than the average investor
- You can be a good market timer & cleverly get in and get out of the market at low and high points
- Use leverage (debt) so if the market is up 10%, then on a lever of 2-to-1 you are up by 20%
Over time, I have seen that being focussed on point 1 (stock picker) has led to far better and consistent results as compared to point 2 (market timer). Ofcourse, it does not mean that some people are not good at timing the market. It is just that I have had more success in learning the ropes at identifying which stocks to buy, at what price and how long I need to hold onto it.
As far as leverage goes, taking on debt is great (and profitable) when things are going well. But it will put you out of business if things go south. Consequently, I avoid using leverage either in the form of borrowing or using options.
The idea for me is to focus on what is a good stock and I continue to advocate that approach to one and all.
For investors who cannot put in the time to figure out which stocks are likely to be potentially strong bets, I have two advices here –
- Buy an index fund. In my opinion, this remains the best option for anyone who cannot spare a couple of hours a week to understand stocks. An index fund is not a compromise option but a very intelligent option if you cannot spare the time.
- Find a talented fund manager. Opt for someone whose ideologies you truly believe in. Every fund manager has different styles of operations and after watching a few interviews on youtube, you can get a pretty good idea on where this fund manager’s style is congruent with how you would like your money to be handled.
An early lesson with stock picking is that a stock price reflects the consensus view of the marketplace. As it says in the book by Michael Steinhardt, one of the early hedge fund managers –
If you are buying a stock, you must have a variant perception i.e. you must believe in something different than the general consensus view.
It is important for you to know what you are expecting from the company that supports your view (positive or negative) about it from the consensus viewpoint.
Remember – to do well, you only have to do two things:
- Have a variant perception
- You have to be right (the hardest part)
To be right, let’s boil it down to a 4 step process that will ensure that you have picked up stock market winners who have the ability to be multibaggers in the future.
- Have a circle of competence
- Do an industry evaluation
- Evaluate the management
- Value the business
Circle of Competence
A circle of competence is your expertise about a company or an industry.
It is foolhardy to convince oneself that you know about every industry. Even great investors like Warren Buffett and Rakesh Jhunjhunwala know that they don’t understand technology stocks as much as they understand consumer companies, transportation firms or banks. The idea is for you to always work within your circle of competence and keep on expanding that circle.
Having said this, you really don’t need a big circle of competence.
People have built entire careers doing nothing else but investing in specific sectors like biotech or banking. The depth is far more important than the size of your competence. You have to set your boundaries and have to be humble about these boundaries.
In other words, don’t get sucked up into some emerging tech company or bank in Yemen that you have no idea about just because the PE ratio of this stock is super low or if the company is posting a 300% annual growth. Stay within what you know.
The question we are asking here is that – Is this a good business?
- Does it have sustainable competitive advantages?
- Does it give high returns on capital?
- What are the growth prospects? Is it balanced?
- Is it generating a lot of cash flow?
While this is a company level analysis, we also are doing an industry level analysis in terms of seeing into areas like :
- Are the trends in the industry favorable?
- Are there any headwinds or tailwinds?
- What are the industry dynamics? (like a Michael Porter Five Forces analysis)
The idea here is to look for some sort of informational edge which is possible by interviewing present and past employees, maybe visit some stores, talking to management, listening to earnings calls, understanding the company culture etc.
We are trying to establish if this is a good company in a good industry.
Having said this, I have invested in a number of lousy companies in lousy industries at the right price. But this is more risk than what I should have ideally taken.
Because if the price was not right, then I could have been in big trouble. Infact, the best value investors come to appreciate that a “great business at a good price” is better than a “good business at a great price”.
Over time, I have started to subscribe to this philosophy. I now give more credence to companies which are currently available for $10, are earning $1 but have the ability to earn $5 at some point in time. Believe me this is far better than a company which is available for $5, is earning $5 and whose earnings are likely to go down to $1 in the future.
Recently, I wrote a piece on Axis Focused 25 fund where the fund manager seems to follow this principle of opting for high growth & high return on equity companies even if these are available at high valuations currently. The fund manager is OK with that because five years from now, these same companies will look really cheap for the money that was paid today.
The third element to evaluate is the competence of the management.
Here, there are three questions that need to be asked –
- Are they good operators? (execution)
- How good are they with capital allocation? (resourcing decisions)
- Are they trustworthy and shareholder friendly? (governance & return to shareholders)
Most people become CEOs because they operate the business well. Along with execution prowess, a large part of long-term value is created based on capital allocation.
History is full of instances where companies have been ruined due to big dumb acquisitions where the buyer company took on a lot of debt to acquire something which did not live up their excel-based assumptions. Overall value was destroyed.
Here are some expensive mistakes
GE’s acquisition of Alstom
GE had acquired this business for $10.1 billion and it was GE’s keeness to get the deal done fast that led it to pay too much. Such was the case, that after taking control of Alstom, GE spent about another year working out exactly what it had bought.
And the numbers were startling as the Alstom business had gross assets of $21.3 billion and liabilities of $ 23.2 billion in its books. This means the business that GE had acquired had a negative book value of $ 7.2 billion (i.e. $10.1 + $21.3 – $23.2)
Microsoft’s acquisition of Nokia
In 2015, Microsoft announced that it was cutting 7,800 jobs and writing off $7.6 billion related to its acquisition of the Nokia phone business. That was more than the $7.2 billion that was paid by Microsoft to acquire that business in 2014.
Even today, a number of companies destroy value by buying back large amounts of shares through share buyback programs when the shares are trading at all-time highs. These are probably times when the stock prices are overvalued and when the stock turns south, they stop the share buyback at a time when they should actually be buying these back.
Now that we have gone through our three filters or selection criteria, the final step is to identify a value to our company or companies we are tracking.
This does not mean just buying low multiple but declining companies. This process involves the buying of stocks like Google, Facebook, Amazon, Exxon Mobil etc. You want to be asking yourself if the stock of these wonderful businesses is really cheap to warrant an investment by you.
Remember – you would want to have a margin of safety in your calculations.
I have written a well-received article on the valuation of shares where we looked at five different methods of doing so. These have been used by the top investors from around the world and as a beginner investors, these should serve you in over 95% of investments you make.
What is a value trap?
One of the biggest danger to a value investor is getting caught up in a stock that looks cheap when you buy it and then just stays cheap. Over time the business deteriorates, the earnings deteriorate and the multiple stays low. This is a value trap.
I have myself been guilty of having invested in such value traps and kept sitting on it for years with no action on the stock.
Let’s take a look at HT Media
Value Traps and the Curious Case of HT Media
I used to own shares in HT Media a few years back but liquidated all holdings in this company in 2016.
You can see that the stock price hardly moved for four years from 2015 to 2018. And since 2018, the price has only dropped. 1 share of HT Media is today available at ₹13.55
The P&L of the last five years of HT Media is available below
As we can see here, the company has not grown its revenues in the last five years. Infact, the revenue has degrown for each of the last 3 years.
FY2019 was negative income for this company but that might have been due to some extraordinary expenses. The company had a pretty decent three quarters of FY20 which means on an as-if basis (i.e. business functions minus impact of coronavirus) would have been back to the regular EPS (earnings per share) of ₹7.
At a per share price of ₹13.55 and for a business earning ₹7.00, it might seem like an Alice in Wonderland situation.
But that is not the case.
In my mind, this is clearly a value trap and some of the data here does support that.
Look at the balance sheet of HT Media
The amount of cash in the company is staggering.
The cash in the company in March 2019 was ₹1,577 crores. And the current market capitalization of HT Media is ₹260 crores.
This means the cash in the company is over 6 times of the value of the company.
We also see that HT Media has debt on the balance sheet as on March 2019. This debt is ₹267 crores. If I add this debt to HT Media’s market capitalization, it totals ₹527 crores.
Even including debt, the cash in the company is 3 times the value of the company.
Then why does HT Media continue to be a value trap?
- Poor management – It is clearly the primary reason. Capital allocation is the most important function of good management. The job of the management is to produce a high return on equity for its shareholders. This is not being done by this management. If the management has no use for the cash in their balance sheet then they should have disbursed it back to the shareholders as special dividend
- No growth – No growth in revenue, no growth in operating cash flow and no growth in earnings.
- Use of debt when cash is available (absurd!) – One has to wonder why HT Media has taken long term debt in its books when there is so much cash available in the company
Bed, Bath & Beyond
In the United States, we can look at Bed, Bath & Beyond as a value trap.
The business has been clobbered by Amazon and other online competitors to the extent that their stock looks cheap.
To know more about Bed, Bath and Beyond .. do watch this video.
Other examples of value traps have been paging companies, telex machines, cheque printers and even some newspapers have become classic value traps.
Traits of Value Trap Stocks
Most value trap stocks have one or more of these traits –
- Diminishing competitive advantages
- No patents or unshakeable assets
- Lack of innovation
- High debt (though not necessary)
- Poor management
- Declining revenue growth
- Declining profitability
- Shift in technology in industry but these are not keeping with the times
Proper research is required while investing in these cheap stocks to understand the reason behind their low valuation. It pains every value investor to have been stuck in a value trap. I have been in this position about half-a-dozen times in my early investing days.
I wanted to touch upon this topic because many beginner investors go overboard by investing in too many stocks.
Believe me, this is an important trait of value investing.
In my early investing days, I too would invest in dozens of companies (sometimes as high as 50 stocks). This did not serve any purpose and I spent more time going through my list rather than meaningfully waiting for the stocks to flourish.
Remember. Investors like you and me are not mutual fund companies and need to have more conviction on the stocks that we own if we are going to beat the market.
Always focus on owning anywhere from 10 to 20 stocks with not more than 20% in any one stock.
This might be totally different than what you might have read. You might have read of instances where Warren Buffett had as much 50% of his assets invested in a single stock or some author saying one should be adequately diversified and suggesting you own 40 stocks at a time. I am suggesting a middle path here – 10 to 20 stocks with a max of 20% in any one stock.
Once in a while you can make a big bet if something pops up that is super cheap and super safe and add more units. I have done that myself and taken up my portfolio to that one stock having 30-35% of it for a brief period of time. I don’t recommend you doing that as I was taking unproportional risk in the portfolio.
The point here is that it helps to be focussed about investing and not all over the place.
Focus in investing comes from –
- Defining your circle of competence (do what you know)
- Clear investment rules
- Be patient and wait for the right price to come
- Get rid of investment biases
- High rejection and low selection funnel
Getting rid of investment biases is a very prerequisite to becoming a good investor.
This bias can be something as simple as – oh, this stock was available at ₹100 when I first saw it and now it is available at ₹300 so I won’t buy it.
This is not the right approach. Remember, you are in the business of making money now and emotions have to be kept aside. I did a book review of Big Mistakes recently where the author (Michael Batnick) had compiled a list of mistakes that great investors had made from time-to-time and the lessons we can draw from these.