Investors and analysts often look at value investing in contradistinction to growth investing. Quite often, they converge; which means a growth stock may also be a value stock if appropriately priced. It is common for people to mistake low P/E stocks to be value stocks but that may be a slightly misleading approach to value investing. Normally value stocks are those that offer a substantial margin of safety. The margin of safety of a stock is defined by the extent to which the market price of the stock is below the intrinsic value of the stock. Wider the margin of safety, the better the value stock! Value stocks are also the ones with a moat that is not yet recognized by the market. A company may have a unique advantage like a vast distribution network, cash cow products and disruptive new ideas which may not be reflected in the price. These can also be value stocks.
Value stocks hold huge potential for appreciation because they are quoting at a deep discount to the value. In fact, value stocks are where you can actually make big investment money if you enter the stock at the right time. But the big question is how to identify such value stocks? Here are 7 approaches to value stocks and how you can go about it!
1. Focus on business models that are truly disruptive
Disruptive business is not only about finding products but also about a new market, a new market channel or even a new positioning. In India, the real value stocks have been the disruptive stocks. Infosys disrupted the IT model and Eicher disrupted the high end motorcycle market. Both created markets where none existed. In the process they got the first mover advantage and it showed in the market valuation. Then there are companies like Havells that bet heavily on the electrical goods segment turning more organized. Growth came as a logical progression. An investment of Rs. 1 lakh in Havells in 1997 would be worth Rs.30 crore today. That says it all!
2. Don’t miss out on the way the company manages working capital
The humble working capital may be where most of the real problems of the business are hidden. You may wonder; can current ratio really identify undervalued stocks? The answer is yes. Arvind Mills in the mid 1990s was a favoured stock but it was running a current ratio of 6:1. That was hardly sustainable as inventory was piling up and was a harbinger of oversupply. The stock lost 95% over the next 5 years. Amazon creates wealth despite making hardly any profits because of the positive debtor cycle that it enjoys.
3. It is difficult for high debt stocks to be value stocks except in euphoria
High debt and high cost debt have never been value creators. When you identify value stocks, always look for companies with low debt levels and also low equity base. Capital needs to be serviced and that is never accretive to shareholder value. Look at how high debt companies like RCOM, GVK, GMR and Suzlon destroyed value. Also consider how companies like TCS, Infosys, and Eicher with little debt created tremendous value for shareholders. Apart from the quantum of debt, the cost of debt is also a key consideration. Focus on stocks with low debt ratios and high interest coverage ratios.
4. Value is created when stocks jump into a high growth trajectory
This is normally the best signs of a stock that is turning around. The market is more than willing to pay a premium for a stock where the top-line and bottom-line are going to grow at a very rapid pace. Normally, a shift to a high growth plane entails a higher valuation in the form of P/E ratio. Value in the stock market is all about high growth. That is why high growth sectors like IT and FMCG have traditionally got higher valuations.
5. ROE and the ROCE must be growing above the industry mean
While ROE measures what you earn for equity shareholders, ROCE measures what you earn for all providers of capital. Both are important. Buffett has an interesting mantra. If ROCE and ROE are above 15% and the two are not too far from each other, then there is the potential to be a value stock. A stock with a high ROCE and lower ROE is rewarding its non-equity capital better than equity capital. Such stocks will find it hard to create value in the stock markets.
6. Not P/E ratio but PEG ratio can be a good barometer of value stocks
PEG ratio is an improvement over the PE ratio. When you adjust the P/E ratio by the sustainable growth rate of the business, you get the PEG. P/E is a lot more static compared to PEG and therefore PEG offers a better barometer of value. Rather than focus on companies with low P/E ratio, you must focus on companies with low PEG ratio. To grasp the concept of PEG better, here is a sampler. A stock may be undervalued at 20X P/E Ratio if the growth is 32% but a stock may be overvalued at 12X P/E Ratio if the growth rate is just 6%. That is what makes PEG more effective as a measure for value investing.
7. How often do you see companies with dividend yields of 8% really creating value to shareholders?
Ok, they do have a value base due to the dividend yield, but little else. Why is that so? Investors prefer companies that retain most of their earnings and reinvest in the company. Of course, that is subject to a high ROE, otherwise reinvesting in the business is pointless. A high dividend payout ratio indicates that the company has limited investment opportunities and hence is paying out dividends liberally. Some of the best value creators like Infosys, Havells, Eicher and even Berkshire Hathaway have been stingy on dividends. Focus more on plough back and the ROE at which it is ploughed back. That is value!