The hunt for value

Cricket and the stock market are hogging the headlines these days, the former for its highs and the latter for its lows. And both hold the promise of greater exhilaration for the average Indian. So, while the Indian cricket team looks like recording its biggest ever Test series win against the Aussies, the incessantly falling stock market is creating excellent buying opportunities for investors despite the gut-wrenching uncertainty.

Indeed, the carnage on Dalal Street has been unprecedented. Large-cap stocks have lost 57 per cent, mid-caps 69 per cent and small caps 73 per cent from their peak levels in January. Investors who took the plunge in the stock markets either directly or through mutual funds two years ago feel cheated as stock values are down to their two year-lows. The wealth created over the last two years has gone up in smoke. People are running for cover and taking shelter in other asset classes such as gold and fixed deposits. Nobody knows when all this will end.

But ironically, it’s the severity of the fall that has made stocks that much more alluring. They are nearly as cheap now as they were five years ago when markets were just entering the longest bull-run in the India stock market history. The price to book value—the basic valuation parameter that is obtained by dividing the book value of a company by its stock price—of the largecap stocks that make up the Sensex and the Nifty, has now fallen to its May 2003 levels. The mid-cap stocks and the Top-100 companies by market capitalisation are also trading at price to book values that are closer to their 2003 levels.

India’s top value investors see enormous opportunities at present for picking stocks at a huge discount. “It’s the uncertainty and panic that causes good prices to emerge as investors tend to overreact to every news flow. My sense is that unless there is a complete breakdown of the financial system, markets will soon bottom out,” says Chetan Parikh, Director of Jeetay Investments and an ardent follower of Warren Buffett and his investment principles. He believes that the prices at which stocks are available today are as good as buying a risky bond with a high but uncertain income stream. He has a word of caution, though: “Price by itself has no meaning. You have to look at the underlying value in the company vis-à-vis its market price.”

Bharat Shah, CEO & Managing Partner at ASK Investment Managers and a former mutual fund manager, echoes Parikh. He says: “It isn’t as if the fundamentals of companies have deteriorated. But when irrationality takes over, then finding the bottom becomes mere guess work.” It’s bizarre to see reasonable businesses of decent sizes, profits and reasonable track record being available at earnings multiple of two to four times, he adds.

But not all value investors are gung-ho about valuations. “I am staying away from this market. I have stayed away from it since 2004. I am keeping 70 per cent of my assets in cash and the balance in stocks. There is going to be a big change of the regime. Capitalism will not be the same again. The notion of having free markets may cease to exist,” says octogenarian Chandrakant Sampat, a well-known investor with a sizeable following in the investment fraternity. He believes that value can only emerge if there is capital formation across economies and they are able to earn more than the current cost of capital.

The value hunter’s guide
Five reasons why you should do a value check before jumping in.

• A depressed stock price doesn’t guarantee value. Price is what you pay and value is what you get

• A low price to earnings or price to book value ratio is just one of the indicators of hidden value

• Special situations or events can lead to one-time value unlocking, but financials of the company will tell you if there is a long-term value in store

• Historically, stock prices tend to hover nearer to the mean. At present, the market P/E is at undervalued levels

Look for true value
Value picking doesn’t mean buying stocks that have seen the steepest falls. Many stocks have suffered because foreign institutional investors, which held large stakes in them, resorted to distress selling that has pulled down their stock prices, but that doesn’t mean that their business prospects have worsened. However, many other stocks have fallen simply because they were genuinely overvalued.

According to Jeetay’s Parikh, 350 stocks are quoting below their book values, or at a price to book value ratio of less than one. The price to book value is a key parameter for identifying a stock’s inherent value. Value can also be determined by looking at whether the company is generating sufficient cash to help it sustain the downturn; whether its sales and profits are showing a consistent growth and whether it has a high dividend yield and a track record of paying regular dividends.

A company may have inherent value if it holds a significant investment in another unlisted company that may go public anytime and that could unlock value for the former; or if it owns large tracts of land whose market value is not reflected in the balance sheet. An indication of a possible exit by a large institutional investor who came in during the initial phase of growth could possibly increase the valuations for minority investors; or an indication of demerger of unprofitable business units could bring out the hidden value.

ASK’s Shah says he also looks at a company’s corporate governance norms and the ability of its management to allocate capital efficiently. “There have been instances when a company’s management has displayed poor capital allocation skills. It didn’t have an understanding of how to allocate across various businesses in an efficient way. As money was easily available, people became footloose about the way they allocated it,” he says. While screening stocks, he looks at a company’s sources of income rather than its assets, its earnings visibility, ability to sustain growth, and the size of its bottom line (it should be Rs 75 crore or above to qualify as a longterm contender in his portfolio). Jeetay’s Parikh says that in a tough market such as the current one, he also checks out the actions of the promoters—any dumping of their stakes in a bad market may not be a good sign.

Parag Parikh, Chairman of Parag Parikh Financial Services, a Mumbai-based broking and portfolio management firm, believes that cash-rich companies and those that are consumers of commodities will be favoured in this market. He also recommends stocks with high dividend yield. “It helps in overcoming investors’ bias towards a fixed deposit as they can substitute the high fixed deposit rates with the high dividend yields,” he says.

Brokerage firms, too, are recommending stocks based on their “value proposition”, instead of their earnings estimates as they did earlier. On October 15, ICICI Securities released a report titled The Sale Is On, which recommends seven deep value stocks across media, pharma, cement, oil and gas, real estate, banking and metals sectors. A CLSA report of October 6 talked about “bedrock analysis”, which considers the worst-case scenario for earnings and stock valuations and arrives at a bedrock value of top stocks under its coverage.

Guru speak Key takeaways from legendary investors.

Warren Buffett
CEO, Berkshire Hathaway

• A sound management
• The incentives of the promoters
• Focus on earnings capability
• Know the businesses you are investing in

Benjamin Graham
Buffett’s late mentor and author of Security Analysis and The Intelligent Investor

• Focus on today’s asset values and not unreliable earnings forecasts

• Think like a business owner and don’t overpay

• Special situation investing is not correlated with the market

Charlie Munger
Vice Chairman, Berkshire Hathaway

• Keep a checklist of what you are looking for in the company— for example, does it have a competitive advantage, and so on

• Use mental model to understand businesses and the price

Phil Fisher
Late author and stock investor

Scuttlebutt approach:
Listen to the business grapevine and get hooked into the company’s ecosystem to get an idea about its strengths. Check with suppliers, end-users of the company

Time to buy India’s top value investors evaluate the market and investing strategy.

Chetan Parikh
Director, Jeetay Investments
“Prices won’t collapse or touch ground zero except in the unlikely situation of financial system collapsing”

On the markets: Stocks are trading at a price that is like buying a risky bond at a high and uncertain income stream. But this price discount isn’t in isolation. It’s the price you pay for the underlying fundamental value of the company.

What now?
If you don’t buy stocks now, then it may be difficult to jump on the bandwagon when the sentiment changes for the better. If you can get a better value elsewhere, then why not sell at a loss and get into something which offers better potential?

Chandrakant Sampat
“Value can emerge only if there’s capital formation across the economies”

On the markets: I am staying away from this market. I have stayed away from it since 2004. I am keeping 70 per cent of my assets in cash and the balance in stocks. There is going to be a big change of regime. Capitalism will not be the same again. The notion of having free markets may cease to exist.

What now?
Value can emerge if economies are able to earn more than the current cost of capital, which is not happening now. Today, we are only seeing capital being transferred from one hand to another hand

Parag Parikh
Chairman, Parag Parikh Financial Advisory Services
“Opportunities don’t come everyday. But people are nursing their wounds”

On the markets: The markets were in (such) a state of frenzy that (they) couldn’t carry on for long. We did not allow clients to take risks that would wipe out their capital. This has a lot to do with behavioural finance.

What now?
The current market situation does offer better value. But the human mind only sees the present and goes with the herd, and tends to ignore the value on offer. The loss aversion in the market is huge simply because everybody else is doing the same.

Bharat Shah
CEO & Managing Partner, ASK Investment Managers
“Those who can see value aren’t participating because they cannot stomach a temporary downturn”

On the markets: The current state of the markets is much like what Warren Buffett described the US stock markets as in 1974—“Like an oversexed guy in a harem.” I can see value all around. It’s bizarre to see reasonable businesses now trading at P/E multiples of merely 2-4. Also, I can’t recollect the last time we saw a market-cap to GDP ratio of about 0.55 times.

What now?
Prices can still go down further because of a sentimental backlash. But look at it this way. In a situation where credit and asset markets were squeezed, only the equity markets provided liquidity. There is a real value lying around and if you don’t buy in these times, it means you don’t want to invest.

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