Saturday, October 9, 2010

Value investing: Significance and traps

Value investing is defined as an investment approach where an investor buys a stock which is undervalued as compared to its intrinsic price. Legendary investor, Benjamin Graham originated the concept of value investing. His follower, Warren Buffet, is also the greatest value investor known till date in the history of equity markets. According to Warren Buffet, value investing is the real form of investment, anything else is pure speculation.

The basic idea behind value investing is that many times market over reacts to negative news and rate good stocks below their fundamental values along with bad stocks. Value investing relies on fear psychology of market i.e. when there is fear in the market, everyone starts selling, be it a good stock or a bad stock. In this process, good stocks also come below their fundamental values. As and when the market sentiments improve, they finally reach their fundamental value.

Now, the million dollar question is how to identify a value stock. The answer is pretty simple.

A stock which satisfies following criteria can be classified as a value pick:

* Market cap is less than or equal to two-third of net current assets
* P/E of the stock is low as compared to the sector average
* PEG is less than 1
* Debt-to-equity ratio is less than 1
* Sales and EPS are rising year over year
* P/E is below its own past P/E (i.e. earnings rising but P/E declining)
* High returns on equity (RoE) as compared to industry average
* Price-to-book ratio less than or equal to 1
* Current ratio and quick ratio more than 1
* High dividend yield
* Low market-cap to sales ratio as compared to peers
* Company is generating enough cash
* Company has debt levels below its peers

Besides the above financial parameters, following criteria should also be met:

* Company brand name has strong reputation
* Company has strong market position
* Company has exceptional management
* Competitive advantages
* Product and market diversification

Points to be noted while doing value investing:

* A value investor should always look out for margin of safety. Buy a stock at 60-70% of its value price so that in case computation goes wrong and stock falls more, there are less chances of making loss. For example, if market cap of stock is already at two-third of its net current assets and stock is currently priced Rs 50, then buy the stock if it comes to Rs 30-35 (provided it satisfy other criteria too)

* Sell the stock when stock price reaches a point when the market-cap is equal to the net current assets of the company
* You should know how to differentiate a value stock and a cheap stock. Every stock which has been beaten down by the market is not a value pick. The company might be on the verge of bankruptcy or it might have been beaten down by the market for no fault of its own. Do proper research before investing. Investigate if there is any reason that justify the fall. If answer is no, it should be further looked into

* The risk is low in case of value investing as compared to growth investing provided you know the difference between a value stock and a cheap stock

* Value investing is not just finding the stocks hitting 52-week lows (even though they are mostly found from this list). It is about thoroughly understanding the business, carefully evaluating the company management and finally believing in the potential of the company

* As a value investor, you should have the courage to go against the crowd, staying focused on the long term goal and value, ignoring the short-term gains or losses. Value investing is a bottom up approach. A value investor ignores market sentiments and focus on business fundamentals and its intrinsic value.

* Understanding business story is crucial for value investing. Success cannot be achieved just by purely focusing on the fundamentals like Return on Equity or free cash flow. You should be good at understanding both the fundamentals, the story and how the two work together to define a great business

* You should have a long term focus to get real benefits of value investing. If you have done your homework right, you should not care what market is doing to the stock on a daily basis. Just look for a good price with respect to value and do not try to time the market

* Because of the wide popularity of this approach and the fact that all the information regarding companies is available so easily today through web, it is very difficult to find out companies that fulfill value investing criteria. Therefore, this strategy can be successfully applied only during extreme market panic situations. Value investing works best when stock market is at its historic lows like in current times. During bull period, it is difficult to find stocks below their intrinsic value. For example, during current bear markets, you can easily find out many value picks

* The basic problem with value investing is that new investors buy a weak stock which is in a strong downtrend thinking it a value pick. The stock then never picks up or makes further lows thereby increasing the losses multifold.

* As a value investor, you should have patience as many times market takes its own time to re-rate the stock.

When you go out for shopping, you look out for the best possible deals. You want a good quality product that will last for years at a fair price. Value investing is also about using the same approach while buying stocks i.e. buying a business that will create wealth for many years and that are available at fair prices.
Source: Stockmarketguide

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