VALUE INVESTING – WHAT GOT BUFFETT HIS WEALTH

The investing strategy has stood the test of time and counts the loving investing wizard as among its champions

Source: Tavaga Research

The world of financial blogging in India has recently seen a debate on how overpriced some stock market favorites have become. Their PE ratios are trading at seemingly unsustainable multiples of anywhere between 50-100. But there is another way of picking equity stocks that is at odds with following such market trends — value investing. Value investing can unearth underpriced gems that could beat a strategy focused on stocks that are already favorites in the market.

Anyone advocating value investing does not have to look too hard for inspiration. One of the best known fonts of investing wisdom, Berkshire Hathaway Chairman Warren Buffet is an ardent proponent of value investing. According to Bank of America Merrill Lynch (BAML), value investing is, in fact, outperforming other strategies at the moment. Not just in the US, value investing is relevant as ever to India as well, especially retail investors. 

What is value investing

Value investing refers to an approach to investing in equity stocks. The strategy of value investing requires the investor to buy stocks that are selling at a price which is lower than its intrinsic price (and by extension, sell stocks when they reach their intrinsic value). The stocks picked for value investing in India and elsewhere need not be market favourites, despite their underlying potential.

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The intrinsic value or the true worth of the stock is the crux of value investing and what an investor should investigate and identify. To calculate the true value, we have to look at the fundamentals of the company whose stock we are considering to trade in. Buffett, with his legendary knack for deducing intrinsic value, has built his $88-billion empire by making value investing his second nature.

Economist and charismatic investor Benjamin Graham coined the term ‘value investing’ in 1934 when he co-authored the book, “Security Analysis”. Graham is said to have mentored Buffett, but even 85 years later, it is value investing’s benefits which have made Buffett follow its principles to this day.

Key to value investing

Value investing hinges on the undervalued stock which the investor has bought reaching its true worth either as the company grows and profits, or because of a catalyst event. Once the price equals the intrinsic price, the investor is expected to sell.

But the key to cracking value investing is the methodology of deriving the intrinsic value of a stock. To find the intrinsic value is where all the energy goes, no matter who the investor is, from large investment banks with a big team of research analysts and sophisticated tools to individual retail investors analysing a company. The true worth of a company’s stock, after all, is a hypothetical value and not standardised by the market.

A lot has been written about deciphering the key to value investing since Graham’s days, of course. Academic research, books and publications on value investing have tried to demystify it for everyone.

But the pointers to guide value investing, as laid down by Graham himself, are as follows:-

·         P/E ratio — Companies with a low PE ratio are better suited for a value investor as compared to companies with a high PE ratio. PE ratio tells at what multiples of the stock’s earning per ratio is the stock priced. The investor may determine the P/E ratio from the annual reports of the company.

·         P/B ratio — Companies with a low PB ratio are better suited for a value investor as compared to companies with a high PB ratio. PB ratio tells at what multiples of the stock’s book value per share is the stock priced,  again determined from the annual reports of the company.

·         Positive earnings per share (EPS) growth — This criterion asks the investor to pick up companies with growing (hence, positive) earnings per share and to avoid those companies which have negative earnings or which are in the red.

·         Healthy current ratio — Current ratio is an indicator of the liquidity measures of a company, and  measures its ability to meet its short-term financial obligations. Graham was of the view that companies should have a healthy current ratio. 

·         Regular Dividends —  Companies which pay regular dividends are considered more stable in value investing. It should be noted, however, that the dividend payout should not be high, as a high dividend payout suggests the company does not have enough projects in the offing to deploy the profits. Less future projects point to a potential stalling of growth, hence, it should ring alarm bells.

Value investor needs behavioural finance

Given that value investing banks on ascertaining a hypothetical value to earn returns, it may help if the investor is aware of the kinds of errors that a person may make in taking a call on which stock to buy. That is where behavioral finance and its lessons come in. 

Traditionally, financial theories on decision-making assume the investor is a rational being and hence, will naturally take the optimal call when it comes to picking their investment product. However, behavioral finance, a more modern thinking, puts the focus on human psychology and prejudices which may cloud a rational person’s thinking. And, value investing, which needs an error-free call on which stock to buy to work (as opposed to buying stocks based on popular feedback or market trends), benefits from behavioral approach to financial decisions. 

The more aware we are of biases, the easier it is to avoid or rectify them. Observed financial behavior would be a better guide to value investing than idealised financial decision-making which assumes investors are rational, acting after considering all the available information, and that the markets are efficient. In reality, neither exist.

Behavioral finance biases may stem from two kinds of errors people are prone to commit. Cognitive errors arise from wrong statistics, faulty calculations or the tendency to cling to faulty beliefs which can be either illogical or irrational. Emotional errors arise out of impulses, intuitions and emotions dictate our actions.

Some of the behavioural biases an investor may face:-

1. Framing bias People with this bias (or a tendency to think this way) tend to get caught in the way a fact is framed. This may lead to wrongful identification of an equity as being a good fit for value investing. 

Say, portfolio A is presented as having a 10-percent chance of falling short of investment goal, while another portfolio, portfolio B has a 90-percent chance of meeting the same investment goal. Someone with a framing bias would opt for the second portfolio, with its overtly positive positioning, even though both portfolios have the same risk profile.

Framing bias
Source: Tavaga Reseach

Equity investors should keep this bias in mind and should try to focus on the future potential of an investment. We should check from time to time if the factors that led us to acquire an asset have meaningfully changed since acquisition to tackle a framing bias.

2. Herding bias — Herding is a commonly observed bias in financial markets. Herding sees otherwise rational people start behaving irrationally by imitating the actions and choices of others, while making their own financial decisions. 

Herding takes place when collective actions carry seemingly better and more useful information compared to private knowledge. Value investors particularly should refrain from falling prey to these herding and do their own research before buying a stock. Herding based on others’ opinions, even if it is the larger market’s opinion, can jeopardise true value investing.   

3. Illusion of control — Holding equity stocks with this bias can create a problem. People with this bias tend to think they can influence or control outcomes when, in fact, they cannot. 

The misplaced confidence in being able to control results may lead a stock-holder to trade unnecessarily rather than hold on to a stock. Frequent trading may lead to lower returns than holding equity stocks for longer.

Another classic example of the bias is a person  investing in a company they work in, thinking that they have some control over its fortunes. Should the company perform poorly, such a bias may lead to loss of both their investment and employment.

4. Loss aversion – The bias explains how investors are often more loss averse rather than be risk averse (calculate the risk involved). They are more attuned to losing money rather than gaining money, and the shock of losing is more indelible than the joy from profiting. 

Hence, investors take excessive risk when their investments are in loss, and turn conservative in with risk-taking when their investments are going well. A value picker should understand this bias and cut off loss-making stocks when required, rather than hope for their investment to rebound. 

Value vs growth investing

Value and growth are two styles of investing, with both aiming to track down different characteristics of a stock. 

Value investors seek out stocks which are undervalued in the market, whereas growth investors go for stocks that offer strong growth prospects in the earnings, and are often already popular.

Categorisation helps investors understand the nature of the stocks. So, value stocks can be referred to as those stocks which generally have low PE and PB ratios, pay consistent dividends and are in cyclical downturn.

While growth stocks refers to those stocks which have high PE and PB ratios. Being high-performing companies they have above-average net income growth, and are already on the radar of most investors. 

The debate on whether value or growth stocks perform better is an unending one. But as BAML recently pointed out, value investing is doing better in the current scenario.

How does Warren buffett value stocks

Billionaire investor Buffett has always been a champion of value investing. He is known to eschew market trends and instead,  deep-dive into the valuation of companies with the aim of finding out the ones with good fundamentals trading cheaper than their worth. His value-investing formula, anecdotally can be summarised as “Buying quality businesses at reasonable prices”.

 For a retail investor, no matter how simple, value investing is best done through fundamental research without any shortcuts.

Sound fundamental research will reveal the companies which remain undervalued but have promising potential. 

Even if the intrinsic price arrived at is not as accurate as say, what Buffett would calculate, we would still have ownership of a good company with regular dividends and scope for growth.

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