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The Trap Laid For Value Investors These Days

Aug 31, 2016

In this issue:
» Defence sector to benefit from indigenization thrust
» India Inc unfazed by not so cheap bank loans
» Market update
» ...and more!
00:00
Tanushree Banerjee, Co-Head of Research

Festival season is around the corner. It's time to dispose of old worn-out clothes and accessories. It's time to refurbish homes. Shops and markets are usually crowded this time of the year. In fact, when I was a kid, this was the only time of the year I remember seeing the signboards announcing 'SALE'.

Over the years, though, SALE has become a round-the-year phenomena. Retailers look for excuses in every season to offer their wares at a discount. And ecommerce companies thrive on the discount model. Yes, customers are spoilt for choice these days.

But perhaps ironically, I find the discount stores less crowded than the ones not offering a SALE. And the reason is obvious: Customers do not find the products on SALE of the desired quality. They would rather buy a better product at a reasonable price.

Now, this consumer mindset is a good model for a value investing mindset. However, we rarely relate the two.

Most investors relate value investing to stocks on sale. But they seem to forget that stocks cannot be on sale throughout the year. And if they do find stocks on sale throughout the year, they may not get the best quality. Instead, they will find themselves in what is called a value trap in the investing parlance.

Now, there's nothing wrong with looking for great value in the markets. But expecting to find it in quality stocks at all times is unrealistic. Even the best value investors in the world, Buffett and Munger, have had their share of value traps.

Here is Buffett on one of his mistakes...

  • Even with Charlie's blueprint, I have made plenty of mistakes. The most gruesome was Dexter Shoes. When we purchased the company in 1993, it had a terrific record and in no way looked to me like a cigar butt. Its competitive strengths, however, were soon to evaporate because of foreign competition. And I simply didn't see that coming.

    Consequently, Berkshire paid $433 million for Dexter and, rather promptly, its value went to zero. GAAP accounting, however, doesn't come close to recording the magnitude of my error. The fact is that I gave Berkshire stock to the sellers of Dexter rather than cash, and the shares I used for the purchase are now worth about $5.7 billion. As a financial disaster, this one deserves a spot in the Guinness Book of World Records.

So if you find low-PE stocks in the current market, don't be overjoyed. There may be more than meets the eye.

Some of our subscribers complain because we don't recommend stocks in overheated markets. They wonder why we can't find a cheap stock among the thousands listed.

Our explanation is always the same: Overriding the core principles of value investing in the search of actionable stocks does not yield positive results. The opportunities to buy the best stocks at the most reasonable prices are, in fact, few and far between.

As Buffett says...

  • Successful Investing takes time, discipline, and patience.

We would rather recommend our subscribers stay patient than land them in a value trap.

If this approach to picking stocks interests you, and I believe it should, I have a surprise for you. You can now try my publication, StockSelect, which follows this exact same approach to picking stocks, for a full 30 days! Full details are given here...

02:45 Chart of the day

The country's defence landscape is dominated by Defence Public Sector Units (DPSUs) and Ordnance Factories that account for nearly half of the overall market. There are nine DPSUs and 41 ordnance factories in the country. Among them Hindustan Aeronautics Ltd (HAL) and Bharat Electronics Ltd are the largest players. These two along with the ordnance factories produced more than half of the total defence equipment in FY16 (upto Dec 2015). But the overall production by the public sector has stagnated. Defence production grew at an average rate of 5.3% in the past two years. Although a number of private companies are engaged in the production of defence equipment, but their participation has been limited owing to the sensitive nature of some projects. Therefore, the country continues to rely on imports of military equipment.

To reduce dependence on imports, the government has increased thrust on indigenisation and greater private sector participation under the Make in India policy. In its defence procurement for 2016, highest preference has been accorded to equipment domestically designed, developed and manufactured. This requires capital inflows as well as technological inputs. For this purpose, the FDI limit in Defence has been increased to 49% under the automatic route and above 49% on a case-to-case basis under the approval route by the government. So far, 36 FDI/joint venture proposals in defence with both public and private sector companies have been approved. Apart from this, budgetary allocation for defence in FY17 has been raised by 11% to Rs 2.5 trillion. These initiatives will not only equip India's security systems with the latest, modern technologies but will also help in boosting the country's manufacturing share.

Defence Production by Public Sector in Doldrums


03:51

Fingers have been frequently pointed at the Reserve Bank of India for not being very generous in cutting interest rates to boost the investment climate. However, in a bid to protect their earnings banks themselves have been miserly transmitting the rates. In response to 1.5% cut in repo rates since January 2015, banks lowered their lending rates by a mere 60 basis points (0.6%), as per RBI's annual report for FY16.

Moreover, this has hit the retail consumer rather than the corporate borrower. According to RBI, home loan rates fell by 0.26% since 2015 even as the borrowing cost for corporates declined by 1.44% over the same period. India Inc has been able to access cheaper borrowings thanks to the easing of the yields on corporate bonds in line with that on government securities. Taking advantage of low yields, there was a surge in the public issuance of corporate bonds in FY16 which in turn has helped India Inc to pare down its borrowing costs.

04:45

After opening the day flat, Indian equity markets have recovered smartly. At the time of writing, BSE Sensex was trading higher by 94 points and NSE-Nifty was trading up by 46 points. Both mid cap and small cap stocks are trading higher by 0.7% and 0.4%, respectively.

04:56

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst) and Madhu Gupta (Research Analyst).

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2 Responses to "The Trap Laid For Value Investors These Days"

UDAYA SHANKER PRASAD

Sep 10, 2016

Kindly elaborate the sentence five years down the road you will be laughing all the way to bank. What I could understand that since we are purchasing great businesses at unreasonable price and after five years down the line our return is not as per expectation and we go back to bank.
If I am wrong please clarify.

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Vivek Shivdasani

Sep 4, 2016

As far as value traps go I have two observations to make. First that over the years countless investors have been mislead by Ben Graham's doctrine of cigar butt investing. It is only after a decade of buying low pe, high dividend yield stocks of third rate businesses did I learn my lesson.
Warren Buffet says to buy into franchises at reasonable prices. Well in India you never get to buy into great businesses at reasonable prices. When did Asian Paints sell at reasonable prices or for that matter Procter and Gamble. In India you can buy great businesses with wide moat at very unreasonable prices and five years down the road you will be laughing all the way to the bank.

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