DEMOCRATIZING WEALTH CREATION

Module : 1 Chapter : 9

How To Find
A Value Stock
 DEMOCRATIZING WEALTH CREATION

Value Investing And

Value Stocks
“It is far better to buy a wonderful company at a fair price than a fair company at a
wonderful price.” -- Warren Buffett
Value investing is an investment strategy that focuses on stocks that are under-appreciated by investors and the market as a
whole. Value investors look for stocks that appear cheaper in comparison to their underlying revenue and earnings instead of
the popular growth stocks trading at higher price multiples. This is done in the belief that the stock price of these under-ap-
preciated companies will rise when the market realizes the true intrinsic value of the business. This style of investing has
been popularised by none other than Warren Buffett, the world famous hedge fund manager. Buffett argues that the merit of
purchasing stocks that sell for less than their intrinsic value is that these stocks will end up delivering consistent returns in the
future.

Value investing requires a lot of research by sifting through many out-of-favour stocks before you find a single one that is a
true value stock. So, why should you, as an investor, consider value investing instead of taking the easy way out and picking the
popular growth stocks? First and foremost, everyone likes a bargain, and since value investing is picking stocks at a discount
to their intrinsic value, this strategy appeals to every investor. Furthermore, many investors like a margin of safety provided
by value stocks as these are inherently purchased at price that is less than what they are actually worth. There is no guarantee
that the stock price will not fall further, but since the price of this stock is already trading at lower than it is worth, any further
decline in share price becomes less probable and less dramatic. Finally, if you see yourself as a defensive investor with a low-
risk tolerance, then a good value pick will provide both protection against losing money as well as the potential to make good
profit once the market recognizes the true value of the stock.

With that in mind, let us look at some of the key characteristics of a value stock:

Price-to-earnings ratio below than its peers in the industry. Strong balance sheets with little or no debt.
Low price-to-book ratio. Established history of dividend payments.
High dividend yield. High-interest coverage ratios.
Low price to sales multiple. High return on equity.
Real, tangible assets backing every shares such as factories, real
Discount valuation relative to industry peers.
estate, or cash.
Lower PEG ratio than comparable industry peers. High fixed charge coverage ratios.
Current market price trades at a substantial discount to
Share repurchase programmes in place causing the actual total
conservatively calculated net present value of all future
outstanding shares to decrease over time.
earnings.
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 DEMOCRATIZING WEALTH CREATION

Screening for value stocks

Now that we know the various characteristics of value stocks, we can put together some parameters to help us screen them
and narrow down our list of stocks. Only then we can dig deep into the annual and quarterly reports to fully analyze the
company’s business and its prospects. There are plenty of stock databases available on the internet that will allow you to screen
stocks on the basis of your set parameters. Using free online stock screeners is a good option for finding stock ideas because it
allows you to make an independent and rational selection that is not influenced by the opinions and emotions of others.

STEP 1 : Generate ideas :

RoE> 15 per cent This indicates high profitability and potential competitive advantage.
This implies that the company does not depend on debt to finance its operations and
Debt-to-equity < 0.5
will not be tied down with servicing its debt during business downturns.
Current ratio >2 Makes sure that the company is able to pay its short-term obligations.

Although a low PE is synonymous with value stocks, we have to be careful because PE ratios vary between industries. A
company’s PE ratio should be compared only with its peers and the appraisal of a high or low PE must be made within
this context. By including the PE ratio as a criterion at the start, we may exclude potentially sound investment ideas
because PE in itself will not tell you if a stock is undervalued or overvalued relative to its intrinsic value.

Another optional criteria that you can set is that the dividend yield should be at least less than one if you want steady
dividend income. This can be important for some investors because value investing requires you to hold the stock for a
long period of time (sometimes 2-3 years) as it can take a while for the company to turn around and for the market to
recognize that an unpopular stock is undervalued.

Once you have set the above criteria, you will likely bring down your list of companies from 6,000+ listed companies to
around 30-40 potential picks. These are the stocks on which we can look more closely.

STEP 2 : Shortlist the best stocks

Now, we will dig deeper and apply a more stringent set of parameters to identify the ones that have the makings of out-
performers. For this, you may need to look beyond just numbers and go through the annual and quarterly reports.
To keep it simple, we can apply the principles of Warren Buffett and look for stocks with qualities given below:

n Consistently high profitability – A business with a competitive advantage will be one that is more efficient than
its peers and is able to increase its prices, unlike its less efficient competitors. This, in turn, leads to steadily increasing
profitability over the years. We must also check the free cash flows of the company, because if a company is generating
low free cash flows but high net profit, it may be a sign of earning manipulation.

n Low debt levels – We have already looked at the debt-to-equity ratio in the previous step, but here we will go a step
further and look at the trend of this ratio over the years. Has the debt on the books been trending downwards because
the company wants to go debt-free? Or, are there any capital expenditure (capex) plans by the management that will use
heavy leverage? To find out these answers, we have to read the management comments in the annual report and listen
to con-calls. Debt-heavy companies get in trouble more easily when their sales witness a slowdown or interest rates start
fluctuating and this is something we want to avoid while value investing.

n Sustainable competitive advantage – Here, the analysis goes beyond numbers as we look at reasons as to why a
company can hold on its own in a competitive environment. A highly profitable business will always attract competitors
and increased competition generally leads to lower profits, except when a company possesses a sustainable competitive
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 DEMOCRATIZING WEALTH CREATION

advantage. Hence, we have to be on the lookout for qualities and advantages that cannot be easily replicated. Such exam-
ples include patents, trademarks, lock-in effects, economies of scale, etc.

n Honest management – A good management can make a world of a difference in the company. It adds value be-
yond a company’s hard assets. However, a bad management can destroy company with even the most solid financials.
Warren Buffett advises that investors should look at three main qualities in management, namely, integrity, intelligence
and energy. He also adds, “if they don’t have the first, the other two will kill you”. You can look for these qualities by
going through the financials of the company for several years and look at whether the management has delivered on its
promises or has failed to deliver, and whether it takes responsibility for the failure or merely glosses over it.

STEP 3 : Finding a value stock

Scanning for the above parameters will take some work, but you will end up with a handful of quality companies. Now,
all we have to do is to pick a company that is available at the right price that gives a wide margin of safety. For example,
you should only consider buying when the current stock price is 25 per cent-50 per cent lower than the intrinsic value of
the stock. This way, much of the downside risk is mitigated because the stock is already very cheap. To find whether the
stock is trading at lower multiples, we can now look at valuation metrics. There are several ways to calculate the intrinsic
value of a company. Some of these are:
This method calculates the intrinsic value based on a reasonable, historical P/E
Price-earnings multiple valuation and then arrives at an intrinsic value estimate. One can also use the
industry PE or the PE of competitors for this calculation.
This is a powerful intrinsic value calculationbased on the discounted value of
Discounted cash flow (DCF) model
the cash that can be taken out of a business during its remaining life.
With the aid of these models, we can arrive at a company’s valuation. We can then compare this value with the price of
the stock.

It is rare to find a company that has all the great characteristics described above in steps 1 and 2 and is also trading at
low valuations. So, if the price is not right, you can simply add these stocks to your watchlist and buy when the opportu-
nity is right.

Performance of value stocks in India

To understand how value stocks have performed in India over the years, we can look at two indices: MSCI India Index and
MSCI India Value Index.

MSCI India Value Index (56 constituents) captures large-cap and mid-cap Indian stocks exhibiting overall value style charac-
teristics such as book value to price, 12-month forward earnings to price and dividend yield. If we compare this with MSCI
India Index (an index designed to measure the performance of large-caps and mid-caps in India with 101 constituents), we
will see that MSCI India Value has outperformed MSCI India during all periods. Over a longer time horizon such as 5 years,
value stocks have given returns of 14.75 per cent on an annualised basis, thereby outperforming MSCI India that gave returns
of 11.71 per cent.
Index performance — Price returns (per cent) (July 30, 2021)
Index 1-month 3-month 1-year YTD 3-year (annualised) 5-year (annualised)
MSCI India Value 1.27 10.35 43.71 20.36 16.64 14.75
MSCI India 0.86 8.96 40.8 14.79 11.5 11.71
Source: MSCI

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Registered Office Address: 419-A, 4th Floor, Arun Chambers, Tardeo, Next to AC Market, Mumbai - 400034

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 DEMOCRATIZING WEALTH CREATION

Avoiding value traps

While going about finding a value stock, you will time and again come across stocks trading at cheap valuations. There could
be a reason for such cheap valuation, which may not always be apparent. One must be careful to avoid these stocks that are
cheap for a reason. A couple of situations can produce value traps that an investor needs to look out for:

 If a company keeps losing market share to its competitors or is growing at a slower pace as compared to its historical
rate, then this might be a red flag for an investor. The income statement and the fundamentals may look strong; howev-
er, if the long-term prospects are weak, then the company should be better avoided.

 There are stocks in cyclical industries such as manufacturing and construction which see their earnings rise substan-
tially during boom times, only to see their earnings shrink when things cool off. When the market sees a possible bust
coming for a stock, the valuation may quickly appear to look inexpensive as compared to its earnings. You should avoid
purchasing a company’s stock that is approaching a time in the cycle of their business where sales and performance are
expected to drop off cyclically.

 It is hard to accurately predict assets of companies that buy a large number of patents. The value of this intangible asset
is very hard to measure and, thus, it becomes difficult to draw comparisons across companies or industries. Expiring
patents on key products can potentially make certain companies a value trap. For example, if a drug company has a
high-selling treatment but if it is losing patent protection in the near future, a major chunk of its profits can disappear
quickly. The same holds true for tech companies that are the first-movers in a new industry but lack the ability to protect
and retain their advantage.

DSIJ Pvt. Ltd. : Office no 211, Vascon Platinum Square, Next to Hyatt Regency, Vimannagar, Pune- 411014 I
Registered Office Address: 419-A, 4th Floor, Arun Chambers, Tardeo, Next to AC Market, Mumbai - 400034

SEBI Research Analyst - INH000006396​ Website : [Link]