In our previous post on this topic, Is Value investing the right investment style for you: Part 1, we discussed how different investment styles relate to our investment needs and risk attitudes. We also discussed in the previous post that, investment style is not just relevant for investors who directly invest in stocks through their brokers, but also for mutual fund investors because mutual fund manager’s usually have preference for one investment style relative to others. Knowing the fund manager’s investment style will help the investors understand the investment strategy of the fund.
From an investor’s perspective there can be different investment styles, but there are broadly three themes – active versus passive investing, large cap versus midcap investing and growth versus value investing. In this two part series, our focus is primarily on the growth versus value stock picking style. In our post, Is Value investing the right investment style for you: Part 1, we discussed the basic differences between these two investment styles.
To recap, in the growth style, investors or fund managers, invest in stocks which showed high earnings growth in the past and more importantly, can deliver high earnings growth in the near term (over the next few quarters or years). In the value style, investors or fund managers, invest in underpriced stocks, in other words, stocks trading a lower valuation compared to its fair price. In our earlier post, we discussed that over the last 10 to 15 years, the overall performances of growth and value stocks were not very different. However, growth and value stocks outperformed each other in different market conditions. In this post, we will discuss the different characteristics of value investing.
In Value Investing style, investors or fund managers try to identify stocks which are trading at prices which are significantly below their fair price. Why would shares trade at price above or below its fair value? Share prices on a day to day basis are determined by demand and supply of shares in the market (stock exchange). As per Eugene Fama’s Efficient Market Hypothesis, the market discounts all information about companies in the share prices. If Fama’s Efficient Market Hypothesis was true then, it will not be possible for fund managers to beat the market. Yet, as many of our readers probably know, Warren Buffett, the foremost practitioner of value investing, has consistently beaten index funds for a long period of time.
In reality, the market is often not able to discount all information correctly in share prices. This may be because not all market participants have access to all the information and even when they have, they may not be able to factor them correctly in share prices. Even in a highly matured market like the US stock market, Warren Buffet believes that, “there is much inefficiency in the market”. A discussion on various factors leading to mispricing in the market is outside the scope of this post, but for our purpose, it suffices to say that some stocks can be over-valued in the market while others can be under-valued. Over a period of time, the market price of the shares will converge with the fair value in the process of price discovery by the market. Value investors and fund managers have successfully exploited gaps between price and value to get good returns. Investors may need to be patient with value because the fair (intrinsic) value price discovery process in the market may sometimes take a fairly long time depending to industry specific or company specific factors. However, historical data has shown that quality value stocks, which were bought at deep discounts to fair value, gave fantastic returns to investors.
While EPS growth is the primary focus for growth investors, valuation metrics is of a lot of importance in value investing. Price Earnings Ratio (P/E) and Price to Book (P/B) Ratio are two important valuation metrics used in the value investing. Dividend Yield is another important ratio which value investors look at. Many of our regular readers know about these metrics, but we will briefly recap these ratios for the sake of all our readers.
The chart below shows that the Price to Earnings ratios (both trailing twelve months and forward) and Price to Book ratio of MSCI India Value Index (index of value stocks) is lower those of MSCI India Index (index of both growth and value stocks), while the dividend yield of MSCI India Value Index is higher than that of MSCI India Index.
Margin of safety is one of the most important concepts in value investing. Margin of Safety is the strategy to buy stocks which are trading at a significant discount to their intrinsic value or fair price. One of the biggest challenges of value investing is estimating the fair price (intrinsic value) of a stock. Fair price is usually determined by estimating future free cash-flows and discounting them. In value investing, you may not simply want to buy stocks which are trading below their fair price – you may want to buy stocks which are trading at least 10 – 30% below their fair price. This discount to the fair price is the margin of safety.
One of the most important tenets of value investing espouses the importance of preservation of capital. Margin of safety ensures that, you are buying stocks at deep discounts and this limits your downside risks even in market crashes. Margin of safety also protects the investor from mistakes. Estimating the intrinsic value of a stock is highly subjective; different analysts, brokerage houses and fund houses use different valuation models, which can produce different results. Further forecasting future earnings or cash flows is quite difficult, because a lot of assumptions go into the forecast of future cash flows or earnings. By using a margin of safety, you have a cushion if you overestimated the intrinsic value of the stock.
Using a margin of safety, you can not only limit your downside risks, but you can get extraordinary returns in the future, provided you bought fundamentally good quality stocks. Legendary investor, Warren Buffett, is known to have applied 50% discount on fair price or even more to set his target price for some shares. The financial crisis of 2008 gave him an opportunity to buy shares at such deep discounts and make extraordinary returns over the next 5 – 6 years. Buffet’s investment in Goldman Sachs shares in the wake of Lehman Brothers collapse is part of investment folklore on Wall Street. He bought Goldman shares at very deep discount and made several billion dollars of profit within a few years of his investment.
It takes a lot of skill and opportunism to identify high quality stocks trading at very deep discounts, which give investors high margin of safety. Retail investors may not be equipped with these skills and we think that, retail investors are best served by mutual funds for long term equity investments. We have discussed the concept of margin of safety in much greater details in our post, Margin of Safety: Importance in Equity Investing; we urge investors, who are interested in value investing to read that post.
Warren Buffett once said that, success in investing does not correlate to high IQ (intelligence). Buffett says, “What you need is the temperament to control the urges that get other people into trouble in investing.” Value investing requires a patience if you want to get the best results. Patience does not come naturally to many Indian equity investors, but it is essential in value investing - value funds may underperform for a period of time, even a few years, but if you are patient, you are likely to get rewarded handsomely.
Value investors need to have an absolute return mindset. What you ultimately want from your investment is the absolute return, which meets your investment goals. However, investors often compare how their funds are doing versus the market and relative to their peers. Relative return versus benchmark or peers is useful for comparison, but it may lead to you make reactive and often wrong investment decisions because there inevitably be periods when growth funds will outperform value funds. However, this should not lead you to switch from a value to growth fund, because you may find the growth fund under performing in the subsequent period. As a value investor, you should primarily care about, how much return your value fund has given over sufficiently long investment tenure (at least 3 to 5 years). If it meets your expectation, you should remain invested.
In this two part blog post series, we discussed about different investment styles, with emphasis on value investing. Depending on investment needs and attitude, you should determine if value investing is the suitable investment strategy for. Then you can work with your financial advisor to select good value funds.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
Dwaipayan leads content production and mutual fund research in Advisorkhoj.com. He is actively involved in business development strategy, driving revenue growth and profitability, delivering superior customer satisfaction and talent development in Advisorkhoj. An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with nearly 17 years of management and consulting experience in financial services domain across several geographies. In his previous corporate role, Dwaipayan was the Chief Financial Officer of American Express Global Business Services in India. He also co-founded a boutique consulting start-up to advice companies on business restructuring initiatives like private equity funding, mergers & acquisitions, divestitures, outsourcing and organizational restructuring. Dwaipayan has a strong track record of driving superior financial performance and developing talent in the organizations he has been involved with. He can be followed on his Twitter handle @DBadvisorkhoj.
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