Value Investing

Should you buy Growth? Or should you buy Value?
You should buy what makes you money said the wise guy.

Growth vs. Value investing is one of those debates that have been around for ages now and you can be sure that in the year 2050 the inheritors of your portfolio will still be at it, hammer and tongs. Because, they are two diametrically opposite schools of thought on the way to make money in the stock market. But why re-invent the wheel? Let us first turn to the Gurus who wrote the book on what both these schools of investing stand for.

 

For Value stocks we turn to Sir John Templeton:

These are stocks selling at substantial discounts to our appraisal of their longer term, intrinsic value. Generally, we choose solid companies whose stock is trading at prices that are unduly low in relation to their value and potential.

 

And for growth stocks here's the word from the doyen of growth investing, Mr. Thomas Rowe Price, a pioneer of this approach in the late 1930s:

Growth stock investing focuses on well-managed companies whose earnings and dividends are expected to grow faster than both inflation and the overall economy. The real test for a growth company is its ability to sustain earnings momentum even during economic slowdowns. Such companies will provide long-term growth of capital, preserving the investor's purchasing power against erosion from rising prices, he predicted.

Now that we have the words of the masters let's delve into the Value school today and next time we'll dig deeper into growth.

 

Buying a Dollar for 50 cents

Value investing is a very simple concept. As Warren Buffett, the legendary investor and disciple of Benjamin Graham put it, its all about "...buying a Dollar for 50 cents...". So if you find a cement company which is trading at Rs120 a share, (like say ACC is) and you believe that the intrinsic value of the company is actually Rs200 per share because that is what your analysis of its business, assets and prospects justify, then you would jump to buy it because it would clearly be a bargain buy.

Value investing is a lot like buying an Arrow shirt at their Annual sale. Or Buying a TV during the festival season when every manufacturer is trying to woo you with a 'value for money' offer - 20 DVD's worth Rs9000 free with a 14' TV priced at Rs14,000. As you can see, in both instances there is an element of waiting for the best bargain and buying at that opportune time.

Just like the shopper who scours the market for the best bargain before making his purchase, the Value Investor hunts for stocks that are ' trading at prices that are unduly low in relation to their value and potential.'

Price Earnings ratios, Price /Book ratio, Enterprise Value/Replacement value, Dividend yield, Liquidation value. These are the metrics by which Value investors typically place great store.

Low P/E & P/B ratios, a discount to replacement value, a high dividend value and a discount to liquidation value can get a value-oriented Investor highly excited.

 

What does the value investor hope for?

That sooner or later the asset will trade at a price more reflective of its Intrinsic value and then he, who bought it at a bargain will be sitting on neat little pile of money (profit).

One of the most popular delusions about value investing is that it is all about liquidation value and does not look at an enterprise on a going basis. Some harsh critics would have us believe that Value investing is the equivalent of investing by looking in the rear view mirror. However, the words of the masters indicates otherwise.

Let us go back to the words of Sir Templeton and focus on his choice of 2 phrases - '...longer term, intrinsic value...' and '...prices that are unduly low in relation to their value and potential...'.

It should be quite obvious that 'Longer term Intrinsic value' is not and cannot be a function of the past. And mark the use of the word Potential in the second phrase - that again implies a peep into the future.

Here's Ben Graham, the author of Security Analysis & Intelligent Investor, and the father of Value investing on the same subject.

While it is true that it is the expected future earnings and not the past that determines value, it is also true that there tends to be a rough relationship or continuing connection between past earnings and future earnings. In the typical case, therefore, it is worthwhile for the analyst to pay a great deal of attention to the past earnings, as the beginning of his work, and to go on from those past earnings to such adjustments for the future as are indicated by his further study.

What we are driving at is that 'Value' investing does not ignore the future. It merely attributes a lower probability of being able to successfully predict the future.

 

The attributes of a Value Investor

Value investing places a great premium on a virtue called Patience. If you are the kind of shopper who rushes into a shop to buy what you came for and rush promptly out, then value investing is not for you.

On the other hand, if you are the type to walk into 10 shops, compare prices and work out the arithmetic of the special offers before making up your mind, then value investing might be just what the doctor orderd. The value investor does not mind waiting for a bargain to come along - the annual Arrow sale, the festival season...

But that is not the only reason why Patience is a key virtue for a wannabe Value investor. It's one thing to possess the tools and the knowledge to figure out that something is trading below its intrinsic value. But you make money from an undervalued stock only when the price finds it correct levels. That happens when more people recognize the fact that the stock is undervalued. And that can be a long, long wait.

The fact that value investing places a premium on patience in a round about way again reinforces our belief that Value investing is not a backward looking tool. Think about the cement company in question. As per your estimate its intrinsic value is Rs200 per share today. But remember, its not what it is worth today, but what it will be worth on the day that the market correctly prices it, that will determine the profits you make.

What if a new revolutionary technology reduces the cost of building a cement plant by 20% due to a change in the manufacturing process? What if Dupont or BP develops a new plastic that does away with the need for cement next year? Then what? It would be only fair then to presume that in those circumstances ACC's intrinsic value would follow suit and head lower.

The Intrinsic value as estimated today is based on our knowledge of the factors that impact the company and our ability to forecast them.

The moral of story is that you can ignore the future only at your own peril. And a Value investor must recognize that. The great Value investors knew that.

What the Value investors are looking for is Margin of safety. They are looking at buying a stock at as much of a discount to Intrinsic value as possible. This provides them with a margin of safety because the future is always difficult to predict!

Growth investors on the other hand have their eyes firmly focused on the future. Next time we'll dig into their side of the story.