We are in the third year of what has been one of the biggest bull markets in the history of the Indian stock markets. The rally, which started around April-May 2003, has been nothing short of exhilarating (though volatility has taken centrestage of late). Of course, this phenomenal jump in Indian equities has not come just about by fluke. India Inc.'s fundamentals have improved significantly, as sales growth has remained buoyant, driven by increasing demand, which in turn has been fuelled by increasing affluence and the rise of the 'Great Indian Middle Class'.
Margins have seen strong expansion in many cases, due to aggressive cost rationalisation, and the bottomline has been equally strong due to debt restructuring initiatives and lower depreciation costs, as new capacity addition was largely absent since companies ramped up capacity utilisation at existing plants.
However, going forward, we believe that earnings growth is not likely to sustain at the 20% plus rates that were seen over the past 2 to 3 years. We expect the Sensex earnings growth to be in the range of 15% to 20% going forward. In such an environment, what is the kind of strategy that an investor should use to earn decent returns on his or her investments? In this write-up, we take a look at the 2 major types of investment styles and how they could apply in this market.
This style of investing was pioneered by none other than the famous Benjamin Graham, who was the guru of investing legend, Warren Buffet. His book, 'Security Analysis', is widely read and used even today, and is considered as having laid the foundations for modern day stock analysis. In simple words, 'value investors' are those whose goal is to purchase companies at a significant discount to their 'intrinsic value' - what the business would be worth if it were sold tomorrow. The 'margin of safety' is an important criterion for value investors. Therefore, in a sense, all investors are 'value' investors - they want to buy a stock that is worth more than what they paid for.
Typically, investors who describe themselves as value investors are focused on the liquidation value of a company. However, it should be noted that 'value' could be a very confusing term, as the idea of intrinsic value is not limited to the notion of liquidation value. If we view this from a fund manager's point of view, in order to be 'value investors', such people would generally have very strict, absolute rules governing how they purchase a company's stock. These rules are usually based on relationships between the current market price of the company and certain business fundamentals. Such business fundamentals could include the stock's price to earnings ratio (P/E), dividend yield, book value, operating margins, price to sales and cash flows.
Therefore, in such a market, where value does exist, but also given the fact that there are pockets where prices are still out-of-sync with fundamentals, we believe that one needs to be very disciplined and stick to one's rules while taking a call on stocks. For example, certain stocks in the cement and industrials sectors are still valued at a premium to what should be accorded to them. In such stocks, even though numerous rounds are doing the market about the great Indian infrastructure story, we believe that fund managers who consider themselves as 'value investors' should take a call as to whether the stock price has gone beyond fundamentals. While we do not doubt the growth prospects of these companies, we believe that in the end, there is a certain price that an investor should pay to buy their stocks and no more.
Growth investing is the idea that an investor should buy stocks in companies whose potential for growth in sales and profits is very strong. Growth investors tend to focus more on the company's value as an ongoing concern. They look more at the underlying quality of the business and the rate at which it is growing in order to analyze whether to buy it. Excited by new companies, new industries and new markets, growth investors normally buy companies that they believe are capable of increasing sales, earnings, and other important business metrics by a minimum amount each year.
The stocks that are bought by growth investors often appear expensive at first glance. But such stocks must be looked at from a future perspective. For example, companies like Infosys will always appear to be expensive. The stock currently trades at a trailing P/E multiple of around 35 times, which may seem steep. But if we consider the company's expected 40% growth in revenues and profits in FY07, and a possible 30% growth in FY08 as well, plus the outstanding track record of the company, then this figure may not seem so expensive after all!
We believe that India is in a high growth phase as an economy. Factors such as favourable demographics, increasing affluence, the domestic construction growth and the outsourcing story are major drivers of this growth story. Undoubtedly, there are numerous 'growth stocks' available in the Indian stock markets. As a fund manager, the challenge is to narrow down the investment universe to those stocks that are likely to be consistent value creators over the long-term, and which have strong execution skills. Factors like the quality of the management, industry growth prospects, the company's positioning in the industry, operations in a niche area and so on must be duly considered.
We believe that as an investor, one must not pay more for a stock than what it is worth. In other words, you may like the business of a particular company and its future prospects, but if the final stage of the evaluation process, i.e., valuation, is not favourable, then we believe that it is not prudent for you to buy the stock. The 'margin of safety' is an important factor that any investor should have in mind before making a purchase. This is an effective method of minimising your losses.