Neha Katyal
IMT Nagpur

Value Investing relates to selecting stocks which are under-valued in the stock markets. This under-valuation necessarily means stocks which are selling at less than their estimated fair price and not just any stocks selling at low price.

History

Benjamin Graham is regarded by many to be the father of value investing. The concept of value investing was given by Benjamin Graham and David Dodd in 1934.

Analysis Done for Value Investing

The indicators used for value investing, as given in “Security Analysis” by Benjamin Graham and David Dodd, 1934, are:

1. Price to Earnings ratio (P-E Ratio) should be at least double the AAA bond yield

2. PE ratio of the stock should be less than 40 percent of the average PE ratio for all stocks over the past five years

3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield

4. Price is less than Two-thirds of Tangible Book Value, where tangible book value is calculated as difference between total book value and value of intangible assets such as goodwill

5. Price is less than Two-thirds of Net Current Asset Value (NCAV), where net current asset value is defined as liquid current assets including cash minus current liabilities

6. Debt-Equity Ratio (Book Value) has to be less than one

7. Current Assets > Twice Current Liabilities

8. Debt is less than Twice Net Current Assets

9. Historical Growth in EPS (over last 10 years) > 7%

10. No more than two years of declining earnings over the previous 10 years

Other investors may indulge in estimation of future growth and cash flows. All these indicators help to identify the under-valued stocks which may be used for value investing. These are the stocks defying the efficient market hypothesis, that is, their market prices do not reflect all the information, existing or new, about the stocks in their market price.

En-cashing Upon the Opportunity

People using the value investing technique make money by buying the stocks of these specific companies when the market price is deflated and selling in the better times. As the intrinsic value of these stocks is higher than the price at which there are trading, these are available at a discount, the discount which later translates into the profit.

People without much experience in investing in the stock markets can use the value investing technique to their advantage by observing the P-E ratios and other indicators. As the stocks are available at less than their fair value, the novice investors can use the value investing technique to their advantage as in this they are able to keep a higher margin of safety, for probable errors. This defensive investment in stocks trading below the fair value acts as a safeguard to adverse future developments common in the stock market.

Precautions while using Value Investing

The investor may wrongly consider an under priced stock as undervalued as well leading to loss of investment. In a bear market, the price of all stocks are low, but that does not have to mean that all of them are undervalued as well and have high earnings potential over the investment horizon.

Value Investing in Current Scenario

The financial sector crisis in the US has seen stocks around the world tumble to levels, which were unthinkable less than a couple of years ago. In a market when most people would agree that the best strategy to play the stock market right now is to stay away from it, value investors, have a different view. The value investing philosophy suggests that the current condition provides an excellent opportunity to pick up shares at very cheap prices. Talking in Graham’s language, this could be one of the times when the market is unjustifiably pessimistic on a large number of stocks. This however, does not imply that all stocks should be bought just because they are trading at way below the bull-run highs. In every bear run, although there are stocks which fall due to genuine falls in their values, there are many which decline simply because of the widespread pessimism among investors. Obviously, the intrinsic value of the company does not swing with the mood of the investors. A large number of stocks consequently end up taking a huge beating without any rational reason and hence trading at huge discounts to their intrinsic value. Thus, every bearish phase brings about some excellent opportunities for the value investor to capitalize upon. In the later part of this article, we will evaluate the performance of some such opportunities provided at the end of the dot-com bust, over the subsequent boom in the Indian stock markets.

Conclusion

In practice, value investing is similar to deriving gains through arbitrage pricing theory, in that, it involves finding stocks which are under priced in a certain market. Using the value investing technique for creating a portfolio of stocks is a better option than buying only a few stocks. The creation of a portfolio may be done by a novice investor as well to reap the benefit of having a higher margin of safety and the obvious benefit of diversification of risk.

For using the value investing technique, the investor must ensure that proper valuation techniques have been used and no extra optimism has been shown. The evaluation may be done using simple fundamental analysis techniques such as Economy-Industry-Company analysis (EIC), estimating future discounted cash flows or may be studied in relation to the market using techniques such as Capital Asset Pricing Model (CAPM).

An assumption made while using the value investing technique is of the marketability of the security. It is assumed that the stock would be easy to sell at the end of the desired investment holding period as the prices of the stock would have risen, making it easy to book profits.