Value stocks for better returns in the long term
“When you practise value investing, you are not jumping on to the bandwagon. You stand alone,“ says Sankaran Naren, CIO of ICICI Prudential Mutual Fund.
“When you practise value investing, you are not jumping on to the bandwagon. You stand alone,“ says Sankaran Naren, CIO of ICICI Prudential Mutual Fund. But this contrarian approach can prove rewarding because you buy good stocks at beaten-down prices. “Since you buy at a low price, the probability of loss of capital is lower,“ says Atul Kumar, head of equities, Quantum Mutual Fund.
Borrowing from the combined wisdom of the gurus of value investing, we put the 200 stocks in S&P BSE 200 index through 10 filters to identify scrips trading below their intrinsic values. With each filter, some stocks dropped out so that in the end there were just 14. Of these, we have shortlisted the 10 stocks most recommended by analysts.
Bargain stocks or value traps
The price-to-earnings (PE) and price-to-book value (PBV) ratios are favourite tools of value investors. But a low PE or PBV alone does not make a value stock. “Many PSU banks, leveraged enterprises and real estate companies are trading below their book values. They are not value stocks but value traps,“ says Nilesh Shah, managing director of Kotak Mutual Fund. This is why no PSU bank made it to our list. On the other hand, a quality stock at a high price is also not a good investment. That is why we have eliminated all companies with a PE of more than 20 and a PBV of more than 5.
To avoid the value traps, we have included only those companies that have consistently generated profits in the past five years. Not only that, but these companies should have registered at least a 10% annualised growth in net profit during these years. We also selected only those companies with a positive operating margin to ensure the net profit came from business operations, not extraordinary income. We also took into account the return on capital employed (RoCE) ratio as well as the return on equity (RoE) to ensure only efficiently run businesses made the cut. Also, all companies with a debt-to-equity ratio of more than 2 were eliminated.
Margin of safetyOne abiding principle of value investing is to buy a stock with a margin of safety . This is the difference between the intrinsic value of the stock and the price you pay for it. The higher the margin of safety, the lower is the risk and higher the returns potential. A high dividend yield lends a margin of safety to a stock. We included companies that have consistently paid dividends for the past five years and the dividend payout was at least 10% of the profit in each of the five years.
Afew caveats for investors. Value investing is another name for patient investing. Don't expect fireworks from your value picks. “Value investing reduces the downside risk to some extent but value stocks also take time to appreciate. The stocks may remain at a discount for a prolonged time,“ warns Dinesh Thakkar, chairman and managing director, Angel Broking. Then again, you need to hold these stocks for the long term to be able to get the best returns. Warren Buffett, arguably the most successful value investor of all time, likes to hold his stocks “forever“.
Full story: Learn how to pick value stocks