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What Is Value Investing And Why Invest In Value Funds - Outside View by PersonalFN
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What Is Value Investing And Why Invest In Value Funds
Oct 30, 2017

With new-age stocks surging across the global markets; there's a debate on whether should the proponents of value investing eat crow? This isn't happening for the first time that the theory of value investing is severely challenged. Yet it's important to clear the air and revisit the basics.

If you speak to a global investor; you would rarely find a person offering bearish views on India; but ask him about a small European country facing lots of headwind, you will get a much diverse response.

Why go that far...

Given a choice - without any knowledge on finance and investing - will you buy stocks of new-age companies such as Facebook, Netflix, Google, Amazon, Tesla; or prefer the "old economy" ones in mining and consumption?

While it's easy for you to be convinced with the growth potential of "new-age economy", the old economy ones cannot be ignored. When you decide to go ahead with stocks which are well-accepted to be in a high-growth phase; you run a risk of paying too much for too little.

And it's not even always about "new economy" or "old economy", but almost always about paying for what you "perceive" to be the true value, hoping wealth creation in the future.

To put it simply, when you invest in equity - directly or through the mutual fund route - you are usually concerned with capital appreciation. And to this objective, many investors prefer to stay with companies which are in the high-growth phase or with the mutual fund schemes investing in high growth companies. But contrary to this, legendary investors such as Benjamin Graham and Warren Buffet have multiplied their capital several thousand times by adopting value investing strategies.

Value investing is knowing exactly what you are paying for today rather than speculating over what you could possibly get in future. And value lies in something available currently at a discount or at a price lower than its actual worth.

You too can be a value investor, in effect, by following the tenets of value investing. Here are four simple steps to value investing:

Step 1: Identifying circle of competence

This comprises all the businesses that you are familiar with and thoroughly understand. For Value investors, it is important to invest only in businesses that they understand. Value investors must focus solely on areas of business where they believe they have an edge over the average investor.

Say, you're a doctor. Being an insider to the healthcare industry, you would most likely have a pretty good first-hand understanding of the sector. You may have knowledge of various drugs by pharma companies. An analyst, on the other hand, would not have access to this valuable information. This puts you in an advantageous position. Of course, this does not mean you are already an expert on pharma companies; however, you are at a great starting position.

Similarly, many products and services that you use in your daily lives are often listed companies. As a regular consumer and visitor to the mall, you may have a good starting knowledge about product quality, pricing, and competitors.

Likewise, staying away from what you don't understand is equally important.

Step 2: A 'moat' to protect your castle

If we look at the castles, there is one feature which is pretty much common across all of them. The feature is a deep moat all around the castle. In the old days, this moat was typically filled with water and crocodiles or other predatory reptiles. The purpose was to keep the attackers/enemies away from the walls of the castle, thereby acting as an important security measure. Since it provided security, the kings were obviously big advocates of moats. In value investing too, you should look to protect your castle.

In simple words, you should look for companies with a sustainable competitive advantage. Larger the advantage, wider is the moat. This moat would protect the business from competition. And if the company is able to use its competitive advantage to widen the moat over time, then it is the perfect business to be in.

Companies that have a wide moat are able to earn higher returns for its shareholders. And it is able to do so consistently year after year, every year. This in turn propels its projected stock value. The best part about such companies is that they are able to do well even when conditions are bad. Given the gloomy picture that the current macroeconomic scenario paints, won't such a stock be a good idea? But how do you identify a stock with a solid moat? For this you need to understand how a company can build a moat.

How to build a moat...

This safety moats can be built by the business in a lot of ways.

  1. Brand: A good way for a business to build its competitive advantage is by building a brand. A brand that has consumer recall. It would take years and lot of investment for another company to challenge the authority of a good brand. Take the example of Coca cola. It is one of the most well-known brands in the world. This brand gives it the pricing power. Despite the number of soft drink manufacturers who have been in existence, none have been able to dethrone Coke as a leading soft drink brand.
  2. Economies of scale: A good way to look at economies of scale is to think of a company that can increase its operations without increasing its costs at the same pace. Such companies tend to have a massive size of operations. They have already incurred huge fixed expenses. Additional costs that are more variable in nature are not very high. So as sales increases, these companies are able to expand their operating margins. The economies of scale help the company makes a moat because for any competitor to enter the market, it would need to make a huge investment. Something that is only possible if it has very deep pockets. And even if it is able to make such an investment, it would still take time for it to become a low-cost producer, something that economies of scale can help in. As a result, the dominant company could cut prices to retain its competitive advantage. A fine example would be Walmart. The company has been able to reach the size it is today simply due to the economies of scale.
  3. Switching costs: When you buy a laptop or a computer, more often than not it comes loaded with the Microsoft operating system. Have you even thought about changing the operating system? The answer would most probably be no. Why not? Because there is a cost involved. This is what called a switching cost. High switching costs make it costly for a customer to switch from one product to another, or from one company to another. If a company is able to create this moat, then it ends up having a customer following without the threat of competition. Switching costs create a barrier of entry in a way that it deters competition.
  4. Patents: A great way to build a moat is to simply patent the product. If competition wants to enter the market place, it has to wait till the patent expires. Or, it will have to buy the patent from the company. Typically, pharma companies have been able to build such moats.
  5. Monopoly: Being in a unique or niche business makes for a good way to create a safety moat. Being the only company in the area means that there is literally no competition. But, there is something important to note here. The company should not have monopoly in a business that has demand. Because this advantage is something that is harder to sustain. The higher returns that a monopoly earns can and does end up attracting competition. Therefore, the test for the company is whether it can defend its competitive advantage over long-term.

These are just some ways in which a company can create a safety moat. Other ways include creating network effects, having cheaper access to raw materials, government regulations that favour one company over another are among others.

The bottom line is that the company should have a competitive advantage. The advantage should help it generate superior returns over time. And, the advantage should ideally be growing over time. If the moat is too tiny, competitors can easily cross over it in no time. So, safety moats need to be getting wider and/or deeper as the years go by. And if you find such a company, then make sure you invest in it when it is available at cheap valuations. Such a stock can help you earn superior returns in the long term.

Step 3: A word about management

Perhaps among various factors that need to be looked at before investing in a company, the management is the most important. And, this is also where the difficulty lies. After all, how do you assess management? Unlike company financials, ratios and valuation methods which can be quantified and expressed in numbers, management quality is more subjective. No number can be assigned to it. And yet, it is one of the most crucial elements in value investing.

There are three main factors in assessing management:

  1. The results of the company
  2. The treatment of the company's shareholders
  3. How well it allocates capital

Let us consider these separately.

  1. Results: Past performance is highly indicative of how well the management has been able to steer the growth of the company. This is through both good times and bad. Indeed, a good management needs to be proactive and have the ability to respond to changes, competition, opportunities, and threats. Having said that, what must be noted is that, the management track record has to be evaluated in context of the sector dynamics in which companies operate.
  2. Treatment of shareholders: Shareholders obviously stand to benefit if the management has been able to provide healthy returns on capital and dividends consistently. Return on invested capital and dividend yield are some of the important parameters to be looked at while determining whether or not a shareholder is getting the most of what he has put into the company.
  3. Allocation of capital: How effectively the management is able to allocate capital is a very good indicator of its quality. For instance, one needs to evaluate whether this capital is being invested in projects or activities in line with the company's overall growth strategy. Moreover, are these investments generating good returns? If the capital is not being invested in, the question of whether it is being distributed to the shareholders.

There have been instances in the past where the management of cash-rich companies has made ill-suited acquisitions, which have been a drag on the company's overall performance. Instances such as these are examples of misallocation of capital by the management.

Management strength at the end of the day is a qualitative factor. But investors need to have a grasp on the people at the helm of affairs before they decide to invest in the stock of a particular company. This would mean reading annual reports, analysing company performance, and keeping check on the management's communication with the shareholders. This may not be as concrete as numbers, but it certainly helps in forming a reasonable judgment on what the management's objectives are and what it intends to do to drive company performance going forward.

Step 4: Valuations

The last step pertains to valuations. It is most important of all the steps since valuations decide the action points (buy or sell) of investors.

How to estimate intrinsic value?

Determining value is a tough task. That's because it involves forecasting future cash flows which in itself is a challenge. Discounting those cash flows at an appropriate rate gives us an estimate of value. However, forecasting cash flows for a business is not easy because of the uncertainty involved with the future, unlike coupon bonds. Valuing coupon bonds is relatively easier since you know the coupon payments of future. But that is not the case with businesses.

So, basically the mantra is to look out for businesses that resemble coupon bonds. This would make the valuation exercise easier. In other words, businesses where forecasting future cash flows is relatively easier are the ones that should be on the radar. Once you have the estimate of cash flows, discount it with the appropriate interest rate and compare it with your purchase price. The decision then needs to be taken accordingly.

Predicting cash flows for cyclical businesses

But, say you are looking at a business where forecasting free cash-flow is difficult. For example, a capital intensive business. How would cash flows be forecasted then? Also, what kind of discount rate should be used here considering the riskiness in cash flows?

The legendary investor, Warren Buffett states that for cyclical business, the estimates have to be conservative. Also, since his focus is long term investing, the discount rate used is constant across securities. And that figure is arrived at by using the Government bond rates. An appropriate premium over that and you are on the right track. No complicated financial models like risk premiums, sensitivity analysis, scenario frameworks and betas, just simple logic, mathematics.

Word on relative valuation

You might have known by now that Buffett is not a big fan of relative valuation because of his focus on cash flows. Nonetheless, if used, appropriate relative multiples need to take into account the return generating capability of the business like shareholder returns- return on equity, return on capital employed, etc.

How to estimate growth rates?

Forecasting future cash-flows involve an estimate of growth rate. The mantra here is to be conservative. If the growth rates are high, the estimate on intrinsic value will increase. And investment decisions are based on comparing intrinsic value with the market price. Thus, your estimate of intrinsic value has to be as accurate as possible. High growth rates make intrinsic value more susceptible to changes. Hence, being conservative pays off.

Margin of safety

The margin of safety is the essence of valuation. Since the estimates of intrinsic value involve subjective assessments, there is a possibility of being overly optimistic. Margin of safety provides cushion by adjusting the optimism from the forecast. Say, for example, your estimate of intrinsic value is Rs 100. Taking into consideration a margin of safety of 20%, you can adjust the value to Rs 80. This will ensure that you do not overpay for any asset.

Why consider investing in value funds?

By now, you may have recognised that 'value investing' isn't easy -- it is exhaustive, involving number crunching, reading, and thorough researching. Therefore, truly discovering value stocks can be a daunting task, but you can hold some wonderful value stocks in your investment portfolio.

How?

By simply investing in the value style equity mutual funds which enable you to take exposure to value picks by providing you the benefit of diversification.

Value style funds, too, by definition pick-up stocks for their portfolio that are under-priced and are likely to pay good dividends. A professional fund management team based on value investing principles and strategies discovers and picks stocks for the scheme's portfolio with the objective of creating value and wealth for investors in the long run. A fund manager may construe value in the line of business and the business model of the company, which enables it to earn attractive returns for its investors.

Further, while undertaking its stock picking activity the fund manager may discover value buying opportunities in various market capitalisations. So, you may find a value fund that has exposure to large caps, mid-caps, and/or small caps. Moreover, while taking sectoral bets, they have the latitude to discover value stocks within a promising sector, and at the same time be fairly diversified.

In the portfolio building exercise, value style funds look forward to the bear or corrective phases of capital markets and follow a bottom-up approach in stock picking. This is because a corrective phase of the equity markets enables them to buy companies/stocks at attractive valuations (thereby following the value investing principles) for their portfolio. They usually hold the stocks bought during the bear or corrective phase of the market until mis-pricing (in the stocks) gets corrected. Further, value funds do not indulge in aggressive portfolio churning, thereby exposing you, the investor, to less risk.

As far as investing in value oriented funds is concerned, certainly there are merits. However, managing a value fund is not cake walk. It requires the fund house to have a deeper understanding to ascertain whether the investment will be truly valuable or a dud in the long run. It also requires, at times, the courage to go against the market and take bold calls. Hence, careful selection matters a lot to have the best mutual funds schemes in the portfolio. Therefore, sound risk management strategies are of the utmost importance for a fund house offering value style funds. Value funds are suitable for investors with a moderate-to-high risk profile and whose investment horizon is at least five years. PersonalFN is of the view that investors may consider adding well-managed value funds to their portfolios, especially the ones with established track records.

At PersonalFN, we follow a rigorous research process to help you, investors, select the best mutual fund schemes for your investment portfolio. With over decades of experience, PersonalFN has put together a research report on potentially the best mutual fund SIPs for your long-term portfolio - The Super Investment Portfolio - For SIP Investors. Under this, we conduct a detailed analysis on how SIPs in the top shortlisted mutual fund schemes have performed, across multiple market conditions and timeframes. Only those funds that successfully pass this evaluation are chosen.

Don't miss out on early bird discounts. Subscribe to the report here. Remember, investing systematically in mutual funds can make your dreams come true.

This article first appeared on PersonalFN here.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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