How to pick up value stocks, Buffett style

Even though this was Warren Buffett's first trip to India, investors here have been watching him closely, as they try to figure out his value investment strategy. Undoubtedly , Buffett has been one of the most successful investors globally.

Investors who put their money in Berkshire Hathaway, the company he runs, have reasons to be happy. After all $10,000 invested in Berkshire Hathaway in 1991 is worth $188,903, a return of 16% per annum, (excluding the dividend income). Compared to this $10,000 invested in the S&P 500 is worth $39, 846, a return of 7% per annum.

What is value investing?

 

Value investing is an investment paradigm that Benjamin Graham & David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 book 'Security Analysis' . "In a very simple sense, value investing is buying something that is less than its worth," says Nitin Bajaj, fund manager, Fidelity Mutual Fund. The stocks may quote below the intrinsic value either due to overall pessimism in the market or due to prevailing poor sentiment about the business or the company.

Buffett improvised his teacher - Benjamin Graham - and delivered astonishing performance for his shareholders. His key to success is buying a business that comes with high entry barriers. He looks out to own the pricing power for the products and services of a business that offers high incremental return ratios, is managed by a good management with rational capital allocation capability and still quotes at a reasonable price. He is a value shopper.

How to make value picks?

There are broadly three ways a value investor goes about investing . First is by following the old school of thought which focuses extensively on numbers. Some of the popular filters include low price-to-earnings ratio, companies quoting below cash balances , low market cap-to-sales ratio . This is where cigar butt investing comes in. Investors buy into a company purely because it is cheap, hoping that the market in due course of time will correct the 'valuation mistake' and reward the investor for spotting it early.

The second, and more polished version, is buying growth at a reasonable price. This method not only relies on the existing state of business and undervaluation but also factors in the possible future growth. "Investors will not only look at under-valued securities but also consider qualitative factors such as balance sheet strength, management quality and corporate governance , before investing," says Atul Kumar, fund manager, Quantum Mutual Fund. Seasoned investors also look at special situations such as merger arbitrage and open offers announced buy companies to earn profits with a pre-determined risk-reward ratio.

Walking the tight rope

 While the value approach to investing appears the easiest to preach, it is difficult to put into practice. Investors who opt for value investing must have patience to reap the rewards. At times, the businesses may be available cheap, because there are problems in the short term. Hence,you should have a longer time frame of at least 2-3 years, when you opt for this style of investing . There may be times, when the company's situation could deteriorate further from where you bought it.

"In such times, investors must have the ability to stand alone," adds Fidelity's Nitin Bajaj. "A fair degree of scepticism, a non-conformist stand and ability to search for value are essential ingredients for a successful value investor," explains Chetan Parikh , director, Jeetay Investments . The investor must have a lot of humility and should develop the ability to think about many scenarios with probabilities attached to it, he adds. Such a mindset is just the ticket to enter the value investors' club.

Risk factors

 Underperformance vis-??-vis the market for a long period of time is a big risk. Many people cannot stick to the strategy for very long period time and switch over to momentum chasing, which can be harmful. It is important for investors to have patience when buying value stocks, and should not be discouraged by stocks not doing well in the short term. The strategy must be judged over a very long period of time. Landing in a value trap is a risk where an investor ends up buying into a bad business trading at a cheap price.

??Before committing your money you have to take some extra efforts to understand the business to avoid getting into a value trap. Those who run a portfolio of multiple value ideas simultaneously can ensure that the impact of value trap on the portfolio remains minimal,? says Parikh of Jeetay Investments. Walking the tight rope while analysing the opportunities on the one hand and maintaining a value investors? mindset is not possible for most retail investors. Be it the inability to get into the value investing mode or lack of time to devote to the discipline forces to seek professional help.

Can mutual funds help?

There are very few pure value funds in India. But still there are some options in the market that look at buying growth at reasonable prices. If you can take a longterm view on Indian equities, say three to five years, such funds can be good wealth creators for you. "A lot of fund managers follow a blended approach rather than following pure value investing," adds Vishal Dhawan, who advises investors to have 15% of their portfolio in such funds. Of course, it is difficult for fund managers to emulate Warren Buffett's style, since fund managers have to walk the tight rope of value investing and at the same time have to be ready for redemption pressure arising out of short term underperformance.

It is the daily NAV pressure that makes many stay away from value investing. In addition, investors are always comparing returns from mutual funds with benchmark indices, and fund managers constantly have to invest in sync with the index. So, if investors wish to use the value investing style, they should have a different temperament. To start with take a long-term view of at least three years and have lot of patience. There are financial planners who feel that it is not necessary to go with any particular style.

"In an economy growing at 8-9 %, it would make more sense to chase growth than value," says Sumeet Vaid, founder, Ffreedom Financial Planners. Based on a client's profile, he recommends a mix of large-cap , mid-cap or small-cap funds. Some others feel value investing is for conservative investors with a low-risk profile. "We recommend value funds to clients who are conservative and want low volatility and standard deviation in their portfolio," adds AV Srikanth, executive director , Wealth Management, Anand Rathi Wealth Managers.