• Mayank Mehraa CFA, FRM

Practitioner's Take on Value Investing

Updated: Aug 15, 2020

What is Value Investing!

The term refers to a strategy of buying stocks that “appear” to be trading below fair value. In theory, the practice of investing in stocks that currently trade “cheap”  but have the potential to handsomely reward the investors in the future. The term, however, has been used to collectively represent the investing philosophy first taught by Benjamin Graham and David Dodd. 

The concept worked brilliantly back in a time and age when people did not understand Investing rather when they barely had funds to invest. For those who did, credible actionable information on stocks was not easily available. Investors would need to derive financial information from usually paid sources and then go through it with a fine-tooth comb. The idea of investing across economies as easily and swiftly as is done today might sound like a myth back then. Above all, the ability to buy stocks was restricted to a certain class of people who could afford all of the above risks.

What’s Changed?

Today, au contraire most investors have free access to parametric investing tools. Most investors and fund managers are very well versed in experiences and accounts of value investors. Accounts are standardized, regulated, uniform, and convenient to understand even for those with little or no commerce or business background. Most importantly today people are taught to analyze and understand financial statements. As compared to the effort and investment required to be a value investor back in the day while Warren Buffet made his fortune and today is not even comparable. I started my investing career at the inflection point in the investing industry. The first stock I analyzed, was majorly done via annual reports which were requested from the company through an email using an internet connection at 128kbps. While today I'm sure most investors have all their ‘Value Parameters’ nicely set on “free to use” websites which send you alerts as soon as stocks fit into them. Most people doing this usually mistake luck for logic.

The idea I'm trying to get across is, if you come across a stock which falls in all your ‘Value Pick screener’ s parameters there’s a high probability it's trading cheap for reasons you don't understand instead of it trading cheaply because you understand something most people do not, majorly since Price is supposed to be a leading indicator and often fundamentals (news/information) follow. Eventually such Value Stock would turn into a Value Trap and you may or may not be able to exit wisely from the stock, worst would be a failure to learn. Most such stocks would have scattered holdings since, if a wealthy investor sees value in a stock they usually buy such stocks all the way till these stocks become expensive. 

A few definitive characteristics of a value stock:

  1. Low PE - Usually a PE of close to 20x implies an earnings yield of 5%

  2. High Dividend Payout - Usually a high payout aims at putting money in the hands of the shareholders, which gives the stock a bond-like cashflow feature.

  3. A high long term average ROE

A Risk Premium Equation Perspective:

A formula to roughly understand the major components that impact the returns on a portfolio of value stocks.

Return=Rf+(Avg PE) + (MarketCap to GDP)-(R(TBonds)-)+

Past Returns

From the chart above it is evident how Value Investing did in fact succeed in making multi bagging returns for over a decade till 2010. Since then while the wealth index moved within a close range, for the same period the drawdowns became steeper. While I wouldn't attribute this solely to one reason, I feel technology has made information easily available at negligible cost while making it easier for capital to move. #interestinginsights- Internet users in India grew from 9.22Cr in 2010 (7.5% of the population) to 56.4Cr in 2020 (>41.7% of the population), while during the same the time the average cost of data declined drastically with a massive increase in speed and more online services distributing data.

Where does Value Investing still work?

Value investing has always worked across a long time horizon, so we always recommend a very strict stop loss on a value bet. Volatility has been at an all-time high recently, unlike how they did back in the day and hence investors preferred holding stocks for long and dividend yield worked as continued cash flow.

In the current setting, most investors are led to value investing via other people’s research. Most such investors are misguided with exactly what risk they are signing up for. I have noticed a pattern of how many investors use “Value Investing” as an excuse to cloak their mistakes hoping in the long term such investments may recover in value. More often than not these investments either result in meteoric losses or very nominal returns (in comparison to risks taken).

What we recommend

Stock Markets and investing have changed over the years since inception only getting more efficient in time. This is evident from how value investing has failed to consistently generate alpha as it once used to- majorly owing to better technology, higher participation of people (in multiple roles), and ease of flowing capital. These factors have not only made it difficult for a “Bargain” to remain available they have instead lead to the major problem of Value Traps- wherein, a visible probable value bargain actually turns out to have priced in future negative information- Information Asymmetry. That's a topic for another article.

However, there have been a series of patterns- anomalies- that have more often than not consistently performed. Anomalies- are outliers- something that does not stick in line with expectations. I was motivated to create a compilation of most anomalies with why I think they occur as I have noticed in my decade long experience. (Read More)

Investors who do not do their own research rather those who do not understand exactly how a company functions, most importantly what factors impact such companies should stay as far away as they can from “Value Investing”. Instead, investors should understand and integrate a major component of Momentum.

The above chart is taken from:

Agarwalla, S. K., Jacob, J. and Varma, J. R. (2013), Four factor model in Indian equities market, Working Paper W.P. No. 2013-09-05, Indian Institute of Management, Ahmedabad.


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