How do I pick value stocks?

It is in the nature of things that many hard problems are best solved only when they are addressed backward.

How do I pick value stocks?

“Invert, always invert” – Albert Einstein

Time is a constraining factor for everyone and you can’t expect to perform analysis on all the companies. Therefore, it is important to filter out companies that are relevant for the analysis.

How to screen relevant companies?

There are three pillars of equity investing: profit, cost and growth.

No one knows the future, therefore considering past growth and then assigning a value may defeat the purpose of investing.

Criteria no. 1: Profit

A company that is not profitable is not worth spending time on. I focus on companies that are profitable and have a long history of delivering profits.

Companies that have a history of Return on Investments of more than 20% every year have a potential of creating shareholder value.

Last 10 years Return on Invested Capital > 20% per year

Criteria no. 2: Cost

A company can be funded by equity and debt. A loan requires contractual payment just like you pay EMIs for your car, home etc. Therefore, a company has to make payment for the loans irrespective of the profitability.

Debt to equity measures the relationship between the capital that has been borrowed and the amount that has been contributed by the shareholders.

This can be identified by using a ratio ‘debt to equity’. It simply means total borrowing divided by total equity.

Debt to Equity < 1

I do not prefer investing in commodity or government owned companies.

When we apply all these criteria, we will have around 30 companies from the top 100 companies by market capitalization. Now the task is to focus on those 30 companies and identify 12-15 companies available at a reasonable price.

How to analyze a company?

There are three parts to the analysis:

1. Historical analysis

2. Industry analysis

3. Valuation

Historical analysis

I break down P&L and Balance Sheet in two parts, core and non-core. This helps in assigning the value only to the core business. Return on Invested Capital (ROIC) helps in performing this analysis.

Return on Invested Capital (ROIC) refers to a measure which is used to calculate a company’s efficiency in allocating capital towards the most profitable investments. Simply put, it shows how well a company’s using its funds to create returns.

The return on invested capital is a fundamental metric which shows a company’s ability to grow from what was invested into it. I also do forensic checks to ensure that the company’s management is not manipulating the earnings.

Industry analysis

“When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” – Warren Buffet

A company that has consistent record of a long profitability and growth usually have a competitive advantage.

Performing a detailed historical analysis can help investor understand if a company has sustainable business advantage.

Valuation analysis

Break-up the value of a company as ‘no-growth’ and ‘growth’.

No-growth value

We always want to look into the future and identify investment opportunities. However, there is no way anyone can look into the future and be 100% sure that the forecast will become reality. Another way to look at a company is to assume that the company will not grow. The company continues to exist but the growth is zero (I ignore few months of negative growth, if any).

Growth value

This is the most unpredictable element of value for a company. Growth in any company comes when new investments earn a return higher than the cost it spends. Unfortunately, only those companies that have competitive edge can earn return higher than the cost over a long period of time.

Benjamin Graham's Mr. Market:

"...Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. "

Ideally, a company's price that is close to its 'no-growth' value is a good price. The final decision depends upon a combination of many qualitative and quantitative factors.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

How does an economy work?

An economy is usually seen as a complex machine made up of millions of moving parts and mechanisms working together to serve all people and institutions within that ecosystem.

Economic Cycle

However, if we view the economic system from a broader and more simplistic perspective, we can improve our understanding of how the economy functions.

Transactions are the foundational stone of the economy.

These transactions are exchanges of money or credit between buyers and sellers for goods, services or assets. All participants in an economy (people, business, institutions and the government) engage in transactions. It is clear that since transactions are the way to participate in an economy, they are the drivers of all economic forces.

A market is a platform where transactions for the same things are repeated continuously. For example, the gold market, the bond market, the stock market, etc.

The two major institutions which exercise control over the markets, and the economy in general, are the Central Government and the Central Bank. The government collects and manages taxes and does public expenditure. This is known as fiscal policy. The Central Bank controls the volume of money in an economy and manages the interest rates. This is called monetary policy.

Credit and debt are a critical concept to understand as it is through credit that lenders make their money and borrowers get the money to buy things, or to invest, which they couldn’t afford to beforehand. The amount of credit directly affects spending in an economy. If borrowings are increased, they will lead to increased consumption, which will lead to a rise in incomes (because spending for one person is an income to another), which will, in turn, result in more borrowings. Overall, this process leads to economic growth

As people get more and more credit, they have the ability to consume more than they produce. However, in the future, they have to repay this debt, and they will have to produce more than they consume in order to do that.

Thus, an economy with credit expands (due to more spending and increased incomes) in the short run, and then it recedes when the debt is repaid, and the central bank increases the interest rates to control inflation (inflation increases due to increased spending and demand for goods). Higher interest rates lead to lesser borrowings, which results in reduced spending, a dip in income levels and then recession.

Short-term Debt Cycle (approx. 7 years)

As the economy grows, people continue to push the highs and lows of the cycle. In the upward curve, incomes are rising in tandem with the debt, so the debt burden continues to remain manageable. However, at its peak, the debt burden in comparison with the income increases and come to a boiling point. This is where the downward curve starts. Debt repayments rise faster than incomes. Since people are repaying their debts, overall spending in the economy is reduced. This leads to a decrease in income levels.

During this period, due to low spending and borrowings, the debt burden reduces. Businesses and organization face a cash crunch and they try to reduce their costs by laying off the workers. Unemployment rate skyrockets, and a lot of participants of the economy default on their debts. The government’s budget deficit also rises substantially as it tries to redistribute resources.

The government and the Central Bank cooperate to manage the economy in a time of crisis and facilitate its recovery. This may be in the form of lowering down taxes, increased infrastructure spending and/or reduced interest rate.

The economy works in cycles and understanding these cycles can be an important part of the investment process. Usually, if you can get a sense of the peak or trough of a cycle that can help avoid investment mistakes.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

Is this a good time to Invest? Are you kidding me!

There are many articles floating around on this topic. I can promise you that you will learn something new.

On 4th March 2020, as I was heading towards a self-imposed lockdown for the next 12 days, I messaged my family:

I went for a 10 days intense meditation program called Vipassana. When I came back on 15th March 2020, the world was indeed different, not sure better or worse.

As I switched on my mobile, messages started pouring in from the investors. Everyone wanted to talk to me.

I checked headline indices; the market was down by 25% in just 2 weeks. In the next few days, it further declined by 15%.

My Vipassana timings could not have been better. The world was crashing but 10 days meditation provided calmness. It was time to understand the issues in more detail. On one side, fear of Covid 19 and on the other hand moratorium on Yes Bank by RBI.

I started reading news related to Covid 19. Most of the newspapers were just one-sided i.e. the world is ending due to Coronavirus.

I read about historical pandemics, did some data analysis on Covid 19 cases, reflected on the asset allocation and stock selection.

A couple of US medical institutes also indicated that the virus activity may decline due to high temperature and humidity. Clearly, those factors favoured India and other South-East Asian countries. Data from Thailand, Singapore, Philippines, Vietnam and Hong Kong somehow indicated moderate growth in comparison with colder regions including Italy, France, NY etc.

Covid 19 week by week cases across region

India was in a better situation both from the number of infected cases and timings. We had the advantage to learn from other country's experiences. The government took necessary steps including junta curfew followed by the nationwide lockdown. So, the question is "what next"?

The market fell by 40% in just one month. Although it has recovered a little from its lowest point but do we expect the market to fall further?

I did some research and found a paper published by Wharton. The stock market likes predictability and any form of uncertainty makes the markets nervous.

History.com also shares a lot of information on Russian Flu (1889) and Spanish Influenza (1918). Clearly, the market has reacted to Coronavirus more than previous pandemics. But maybe the market was expensive and it corrected to reflect a fairer price. Let’s evaluate.

One of the indicators, I prefer to use is to compare broader market earning yield (NSE500) with government security yield. Earning yield represents what the market is expected to deliver. Government security represents a safe return. This is a method recommended by Benjamin Graham in his book, The Intelligent Investor.

NSE 500 Earning Yield vs G-Sec Yield

What we see here is that currently the government security yield is equal to earning yield. This level was last seen in 2008. Does that mean, the market will not fall further? The simple answer is - ‘I don’t know’ and probably no one knows. But we do know that the current levels are attractive enough and accumulation can start.

“Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” - Warren Buffet

Now, addressing concerns of specific groups:

1. Mutual Fund Investors: Market has fallen, exiting from mutual funds now may not be the best time. There is enough indication that the market might take some time to get back to its previous highs.

Fundamentals indicate that it is time to build the portfolio into equities. Do not stop your SIPs and continue to maintain your asset allocation.

In my opinion, there is a bigger concern in the debt mutual funds. In these situations, a lot of companies with debt may default, especially those that are not backed by cash flows. Even if they do not default, declining cash flows may cause credit downgrade, leading to mark to market losses in your debt mutual fund. It is advisable to move into government security-based mutual fund(s) (short term/liquid) or an arbitrage fund or a fixed deposit with a solid bank (SBI/HDFC bank etc).

2. Direct Equity Investors: The world is bound to change due to massive supply chain disruptions. Even after the lockdown is over, most of the countries may not open borders for regular travel due to the fear of new cases of Covid 19 that might get imported.

We must acknowledge that we are a highly populated country with high domestic demand. Therefore, a portfolio consisting of companies that have an Indian supply base as well as consumer base may do better.

The massive fall in the market provides opportunity to start building your equity portfolio.

Markets do not like uncertainty, once the outcome is certain, even a bad one, the market will stabilize and start reflecting fundamental values. If history can provide any clue, we have survived all catastrophic events.

This too shall pass.

In my opinion, it is a good time to start building your portfolio with a horizon of 3-5 years. Be prepared to see a lot of volatility in the coming weeks to months in both equities and corporate debt.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337