Jul 4, 2013|
Good time to buy stocks based on valuations?
As much as Warren Buffett was in awe of his mentor Benjamin Graham, he did not ape him blindly. It did not take Buffett too long to realize that Graham's Margin of Safety mantra does not work in isolation.
Graham backed his theory by the 'cigar butt' analogy. According to him, cigar butts that are thrown away are always good for a few puffs. Similarly investors should look for discarded companies that possessed good turnaround prospects. They idea here is to pick up companies that are trading dirt cheap or have a ridiculously large margin of safety.
Now whether or not a stock is cheap would depend on several factors. The sustainability of margins and free cash flows, leanness of balance sheet and valuation of its peers could be the key determinants.
But investors often take the short cut to select 'cheap stocks' Ones trading at 52 week lows are the favorites. It is a common perception that stocks trading at prices that are a fraction of what they were a couple of months back are cheap, and therefore attractive.
What 52 week low does and does not signify?
The 52 week low price of the stock is not at all indicative of 52 week valuations, as against popular perception. There could be a case where the performance of the company has deteriorated over the quarters. In such a case the trailing twelve month earnings may be lower now than what they were 12 months back. And even at 52 week low price the stock may be more expensive on year on year basis.
Thus the basic premise that stocks, even blue chip ones that are at 52 week low prices, are good buys goes out of the window. Investors who fail to recognize the risk in some of these stocks often fall into the 'value trap' as well.
Stocks that have witnessed considerable price erosion need not always be a victim of near term headwinds, speculation or liquidity issues as investors would like to believe. On the contrary the correction could be backed by a very genuine fundamental concern. And investors who not pay heed to such concerns suffer the most.
Big investors may not have the 'Midas touch'
Several Midcap and smallcap entities trading near their 52-week lows have seen spurts in their stock prices over last few sessions. That such stocks elicit a lot of interest from FIIs and market speculators is no secret. But it would be nothing short of foolishness for retail investors to assume that FIIs or domestic institutions and HNIs (high net worth individuals) investing in such stocks would lend them the 'Midas touch'. On the contrary, such investors exit the speculative positions before retail investors get a whiff of it.
So can valuations be your prime stock screener in current times?
Rest assured this is not a rhetorical question. We genuinely believe that earnings quality of Indian companies have rarely been as unpredictable as they are now. Hence, while a value investor cannot lose sight of valuations; these are not the best times to focus on that alone. For if one were to shortlist stocks primarily based on valuations, there is a high risk of being sucked into a value trap! We would rather recommend that investors screen stocks based on important risk parameters (ERMTM could be one of the tools used for this). Only the companies that comfortable filter through these should be evaluated on valuation metrics.
||Tanushree Banerjee (Research Analyst), is the editor of ValuePro, The India Letter, and Stock Select, Equitymaster's oldest recommendation service. She is also the editor of Equitymaster's most popular newsletter read by over 200,000 subscribers, The 5 Minute WrapUp. Tanushree started her career at Equitymaster covering the banking and financial sector stocks along with scrutinizing the RBI policies. And over the last decade, developed our research processes that have helped us pick out various multibaggers, across all sectors. A firm believer of "safety first" when it comes to investing, Tanushree closely follows the investing philosophies of Warren Buffett, Jeremy Grantham and Joel Greenblatt.
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