Price is what you pay, value is what you get, said Warren Buffett. A simple definition of value investing would be to buy companies at a price that is available at a discount to its intrinsic value or fair value. But in today’s market environment the term value investing is often used loosely to mean many things. We look at value investing as the conjunction of a series of processes that can lead to super normal returns and enormous wealth creation over the years. Here are a few aspects one needs to be mindful of while looking for value:
Low PE ratio is not always value
A common mistake made by investors is believing that all stocks trading at a low price-to-earnings (PE) ratio have value and are good investments. Value investing doesn’t mean buying companies that have cheap valuations due to their poor fundaments. Instead, it means buying companies that are trading at cheap valuations in spite of their rich fundamentals. This could happen either due to a company being undiscovered, an information arbitrage or even just market sentiments at times.
Often companies that trade at ‘cheap valuations’ are the ones which are beaten down due to corporate governance issues, poor growth, weak balance sheets, sombre outlooks, etc. The retail investors looking to make quick money get stuck in these valuation traps.
Look for PEG – High PE can also be value
Price Earnings Growth (PEG) is a barometer to assess how fast the growth of the company is, compared to its market value. A company with PEG of less than 1 i.e. where the underlying growth in profits is faster than the growth in market cap can also be a value investment. For example, a company trading at a PE of 30x, growing at 50%—resultantly with PEG of 0.6—is a better investment than one with a PE of 5x without any growth. The markets reward consistent growth with re-rating. Thus, it becomes pertinent to track the PEG ratio along with the PE ratio as it is a better indicator of value taking into consideration growth.
Look for value ‘now’ and not future
Lofty assumptions and aggressive price targets are classic characteristics of a buoyant market. One often hears so called ‘value’ plays based on 3-4 years forward estimates resulting in an attractive valuation on such futuristic profits. In doing so, execution risk is grossly undermined more often than not. Investors need to be wary of such value traps based on futuristic promises and rather look at buying stocks below their long-term valuation average at the time of making the investment.
Wealth creation over the long term
Generally, value investment opportunities are available because the market has not discovered them as yet and hence it often takes time for the market to discover these ideas and unlock the value. One needs to have the patience to see through the waiting period before such value unlocking can happen. In our experience returns are usually more back-ended. Serious wealth creation requires a fair amount of patience.
Understand the underlying business first
Understanding a company’s business model and method of valuation lends investors the comfort to hold on to the company during bad times. In this era of new-age businesses, it is prudent to understand what one is investing in and where it derives its value from.
Buying a company lower than its value is just the tip of value investing. We strongly believe investing is a function of discipline, value, conviction, and patience.
Pawan Bharaddia is managing director at Equitree Capital Advisors Pvt Ltd
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