Value-Investing-5

Welcome to the fifth issue on value investing. Hope you enjoyed the last piece. While continuing with this theme, I intend to write a separate piece on mutual funds since a lot of people are more conversant and interested in mutual funds.
To recapitulate: We have so far tried to understand the following:

Retirement Planning: We had a look at how to go about retirement planning and what all actions are required to ensure stable after-retirement income. Asset classes: Different kinds of assets or let’s say investment avenues available like fixed income FDs, Equities, Gold, Real estate etc and representative returns from these assets. 

Value-Investing-1: What is value investing, how it has evolved and who were the chief proponents of the concept.

Value-Investing-2: Annually compounded returns of different asset classes like equities, FDs, gold & real estate and how the magic of compounding works. We saw that over long-term, equities offer the best wealth-creating opportunities. We also looked at four broad steps involved in value investing viz. Stock selection on financial analysis, Valuation, risk analysis and finally investment and monitoring.

Value-Investing-3: Value investing is as much art as science due to the large number of data points available. It is important to identify the important ones and disregard the superfluous data (cut the noise). We looked at the large-cap, mid-cap and small-caps categorization by market capitalization and looked at their pros and cons. We listed the minimum financial parameters for carrying out financial analysis for each of the three steps involved in value investing.

Value-Investing-4: Some discussion on industrial sectors and how financial parameters have different values or importance for specific industries. We looked at some important financial parameters in detail that constitute the first set of filters for stock selection.

Hope you are all with me so far.
In this issue, we will look at the valuation-related parameters and risk analysis required to complete the process of stock selection.After the financial analysis and first screening of financially sound stocks, we have the list of potential investment recommendations. The next step is to evaluate them for their intrinsic value and to see if they are currently actionable or you need to wait till valuations turn favorable. Never ever buy a stock above its fair value however good it may look. Warren Buffet considers this as the single most important principle in value investing and states that capital must be protected at all times (in the long term). His two golden rules in value investing are

1) Never lose money

2) Never forget rule 1

Warren Buffet

Once we understand the valuation parameters, I will demonstrate the above principle (underligned) with a discussion on a business  we are all familiar with (Avenue Supermarts Ltd – Dmart)Let us now look at the valuation parameters and risk analysis in detail.

Valuation Related

P/E (Current, historical and industry) : This is the most widely used valuation parameter. It is the ratio of price to earnings. Earnings here is the earning per share (EPS that we have seen in the last issue) and the price is the quoted price of the stock. So this parameter tells us how many multiples of earnings is the stock price. Let us try to understand it through a simple example.Suppose you have a fixed deposit of Rs. 100 in the bank which earns you Rs. 8 per year by interest. So here the asset is your FD valued at Rs. 100 and its price at any given time remains Rs. 100. The earning from this asset is Rs.8. So the price to earnings ratio in this case works out to be 100/8=12.5. Putting it another way, your asset is valued at 12.5 times of your earnings. Similarly, when a stock is quoting at a P/E ratio of 12.5, it tells you that the quoted price is 12.5 times its earnings (profits per share).Let us now look at it from the returns point of view. The FD if you hold for 12.5 years, will return your original investment of Rs. 100 (8*12.5) through interest (earnings) at Rs. 8 per year. So in a way, any stock quoting at P/E of 12.5 is supposed to earn for you the equivalent of the price you are paying today in 12.5 years. This value accretion is accumulated with the company. Some of it you may get through dividend and bonus and some through capital appreciation. So as a general idea, when you buy a stock at say 10 P/E or 20 P/E, you are looking to get back your investment in 10 or 20 years. P/E is in a way number of years required to get back your original investment. This is conceptual. In practice, it doesn’t happen exactly this way but it gives you an idea of how fair the price of share currently is. Here again we must remember that while evaluating the stock, we must look at the industry it is in (Industry P/E) and it’s growth prospects. For example, FMCGs and IT companies command higher P/Es for their cash generation capacities and low requirement of capital whereas capital intensive manufacturing businesses quote at lower P/Es. Public sector companies also quote at lower P/Es. Higher the PE for a particular stock, we can say it is more favored by the market. Sometimes the PE looks high due to temporary reduction in earnings and no correction in price. Again Large-caps command more P/E than mid-caps and small-caps. The market is ready to pay more for established and less risky businesses. Another important aspect to note here is that the price of a stock changes daily whereas earnings figures change only quarterly. So the P/E fluctuates with price movements. A stock with same earnings and no change in fundamentals may be available at a 15 P/E today but at a 10 P/E after two months if the market falls and the stock falls too. There is also a general market P/E which is calculated by the addition of price of all major companies divided by the addition of EPSs of those companies. To give you an idea its historical range has been 27 (highly priced market-bull market) to 16 (crash-bear market)

P/E to earnings growth: This is one of the criteria advocated and used extensively by Peter Lynch. It is the ratio of average yearly earnings growth to P/E. Here the numerator is indicative of growth of the company which is reflected in the growth in profits or earnings. The denominator is indicative of price with respect to profits at any given time. Companies with high growth are favoured by market and quote at higher P/E.  Peter Lynch suggests if profit growth is 1.5 to 2 times of quoted P/E, the stock is a potential buy. Meaning if the profit growth for last three or five years is 20% and current P/E is 10 to 15, it is worth buying upon further evaluation.

Cash flow and intrinsic Value Calculation (by discounted cash flow, Ben Graham formula, Dhandho formula) :Cash flow or the net cash flow is the amount of cash or cash equivalents a company is generating from the business. It is also a measure of the Company’s liquidity and overall financial performance. Strong and positive cash flows are favoured by the market for obvious reasons. Such a company is better equipped to tide over financial stress in difficult times. Intrinsic value is the valuation of the company based on its cash flows, financial health and growth as compared to market capitalization. For example, if current market capitalization (Share price * number of shares issued) for a company is 20,000 crores and the intrinsic value calculated is in the range of 15,000, we can say the company is overvalued. If the intrinsic value is 30,000 crores, the company is undervalued and a potential buy. We will talk about this in detail as we get acquanted with financial analysis.
The above three indicators give us sufficient information to decide if the stocks shortlisted through value investing step one (Business understandability, management quality, promoter holding, ROE, ROCE, debt to equity etc) are valued fairly or overvalued or undervalued. Let us now see a few examples to better understand. I have tabulated the results below. (Source: Screener.in). I have included only P/E for valuation in the table. Profit growth is given to calculate second parameter (P/E to earnings growth)

You can see that I have clubbed a small/midcap company with a large-cap in each sector to compare how the market looks at large-caps (Safe) and small-caps (Risky) in terms of P/E. The market is ready to pay a higher price (high P/E) to large-caps compared to small-caps. I have all these stocks in my portfolio except for Dmart and TCS. I sold TCS last year at 60% gain in two years and I will not touch Dmart even with a 100-foot pole at these valuations. Let’s discuss these scrips in detail. I suggest you keep a printout of my last mail handy to refer to financial parameter definitions and desired values (or open it on other device).
Let me put in a few words about dividend yield. This percentage is what you get on your investment. The dividend declared by companies ranges anything between 10% to 1000% or more. It is based on face value of the stock which can be Re 1 or 2 or 5 or 10 (Used to be 100 also earlier but obsolete now). Companies pay dividend twice or thrice a year out of profits they earn. This percentage of profits is called dividend payout. Dividend payouts are typically 30-40% of profits for investor friendly companies. Higher the number, better for investors. Now if a company declares 100% dividend on shares of face value of Rs. 10, it works out to be Rs. 10 per share. If you have bought shares at Rs. 100, your dividend yield is 10/100 = 10%. If you bought shares at Rs 200, your yield is 10/200=5%. So you see, dividend yield changes with daily price. Dividend income up to Rs. 10 lacs is tax-free so it makes sense to buy high dividend yield companies (mostly public sector because Govt as promotor forces them to pay high dividends)
1) REC & Cochin Shipyard: Public sector companies. Always low PE given by the market. High dividend. In fact at price of Rs. 90 (in December 18, just three months before), REC dividend yield was 10% – Tax-free. As of now,  REC stock price is up 67% up from its low and the company recently paid Rs 11 per share (110%) interim dividend. Profit margins are good, PE is moderate. There is still upside but limited. Cochin Shipyard has good parameters, no debt, good dividend. Only shipyard in India making profits despite being public sector. Very well managed.
2) Himatsingka Seide and Dmart: As I referred earlier, this company is a market leader in some typical technologies and has just completed capacity expansion. It has taken a lot of debt (debt/equity ratio 1.8) for expansion but now is the time to sweat its assets and grow top line and bottom line. If all goes well, it may grow fast to graduate to midcap level. A little risky though. Dmart (avenue supermarkets) has an exciting business. Asset light model (They take premises on lease and don’t invest in buildings), negligible debt, good ROE/ROCE, good profit growth. But look at PE of 102 at profit margins at under 5%. EPS is moderate at 12. Theoretically, it will take 100 years to get back your investment. There is no way it can grow its profit margins much, given the kind of business it is in. Market is giving insane valuations to this scrip which can’t be supported for long and many unwary investors holding this scrip are likely to burn their fingers in coming years.
3) Biocon and Glenmark: Both good companies but down due to overall problems in the pharma sector. USFDA inspections and observations is a hanging sword all the time. However, sometime in the future, as happens usually, the market will favour pharma and then these will fetch good valuations. 
4) Persistent & TCS: TCS is a marvel. Despite its colossal size, it achieves a 20% net profit margin. A cash cow. Persistent is good too and at 14.5 PE, is fairly valued. Was a screaming buy at Rs 540 a couple of months ago. All IT companies are good margin, debt free and dividend-paying companies. There are other IT small-caps like Sonata, Cyient, Eclerx etc. All doing well though currently not as cheap as they were before.
5) GHCL & UPL: For similar ROE/ROCE/Debt-Equity, net profit margins and better dividend, GHCL fetches only one-third valuation as compared to UPL (P/E 7 versus 22 for UPL). By all rules of the game, GHCL should double in a couple of years if it is able to maintain its performance at current level.
6) Indostar Capital and LIC housing finance: Both these stocks have recovered substantially along with others such as Repco home, canfin homes and bank stocks from their lows. Indostar entered the market through IPO a couple of years before at a price of Rs. 650 or so. The stock performance is good ar 26% profit margin at much less capital (Debt/equity 2.26 only for a finance company). This is a stock with high potential.
7) Hero Motocorp & TVS Srichakra: Both these stocks have excellent financial parameters and look at the EPS. Currently available at very favourable valuations due to auto sector being down. As soon as the sector picks up, these stocks will see at least 30% upside.
In the next issue, we will look at the risk analysis and also industry categorization in a different way. Not sectorwise.
Hope you like the discussion. Please revert with your comments, suggestions and queries.

Happy investing

bhushan