Can a Layman Apply Value Investing Techniques?
What is value investing? In simple terms its about buying a business (or a stock) significantly below its True Value (or fair value). But this is a simplistic way to understand and there is more to it which we will try to discover. Why should you follow value investing?
It is one of the most successful styles of investing, which has made millionaires and billionaires in the past several decades. To answer the question above, I would say “Yes, a layman can apply value investing, if he/she can understand the broad guidelines and start implementing it in a gradual and consistent fashion.”
Value Investing – Guidelines
From the basic idea above value investing seems to be a way to pick low-priced stocks or cheap businesses to investing. However, as it developed and several gurus such as Ben Graham, Warren Buffet, Seth Klarman and others had contributed by adding further refinements and improvements and this discipline has become more popular today among sophisticated investors.
Most gurus including Warren Buffet would prescribe the following three guidelines to get started.
- Look at investing in stocks/securities like investing in a piece of a business having a strong durable competitive advantage (moat)
- Make an assessment of the true value or Intrinsic Value of a company
- Purchase the security with a significant Margin of Safety (or significant discount to Intrinsic Value)
Becoming a pure value investor may not be feasible for a common man, but overtime one can become a successful investor.
However, the starting point is to use the guidelines above. In future we will explore various other criteria or variables that influence the value of a stock.
In case you are familiar with the above 3 aspects, you can also check out this article – Warren Buffett Investing Style
Look at investing in Stocks like investing in a piece of business with a strong moat.
Most people think of stocks like pieces of paper, which is far from the truth. A stock represents ownership in a company and its business. Hence investing in a stock should be based on your own understanding of the business.
When you select a stock make sure you understand the company, its business and what they are in to.
You can also read about this at Know the Business You are Investing In
Let me summarize it for you. You have know the business or industry the company is into, some idea about the products/services, how the company generates revenues, its management, etc.
For example Hindustan Unilever is a market leader in the fast moving consumer goods industry and has a wide range of products ranging from food, consumer products, personal care products, etc. Its leading brands such as Ponds, Dove, Lux, Lifebuoy, Fair & Lovely, Kissan are household brands that are worth atleast a thousand crore each.
Does it mean Hindustan Unilever is a value stock? Not yet. This is only a starting point. Value investors who also follow Buffet chose to invest in business that also possess a strong/durable competitive advantage.
Moat or Competitive Advantage
This is one of the key attributes that Warren Buffet looks for and this has brought success to his investing ideas.
What is Moat?
In literal terms it refers to the water body that surrounds a fort to protect a kingdom from intruders. The water body also has crocodiles and other beasts to prevent intruders from attacking. In business world this is competitive advantage. We understand that some companies have a strong competitive edge compared to others.
For instance Hindustan Unilever is one of the most competitive in the FMCG space and enjoys tremendous distribution power, brand value and consumer trust. Another example is Coca Cola, which is one of the favorites of Buffett. If we look back to early 90’s Infosys Technologies was one of the pioneers of Information Technology services to get listed on NASDAQ as well as on NSE/BSE, and emerged as fast-growing IT behemoth.
Moat is quite intuitive, but can be identified by superior market share, higher pricing power, strong brand value, ability to withstand economic ups and downs, etc.
Having a moat itself doesn’t mean the business is suited for business. This is where we need to turn to Buffett to refine this further. The businesses which Buffett loves have to have
- A strong durable competitive advantage/moat
- Should not be in price competitive businesses (baring few exceptions)
For instance one of India’s largest passenger car manufacturer Maruti may be a favorite among investors. However, Warren would avoid auto, oil & gas companies, airlines, etc which are in price competitive business which are subject to cut-throat competition and cannot have pricing power. Ofcourse there can be few exceptions assuming that moat is durable and sustainable for a long period of time.
In simple terms the moat or competitive advantage becomes durable when the company has the flexibility to increase prices and maintain profit margins. This could be due to the virtue of the brand or repeated consumer need. For instance companies like Gillette, Cadbury, Nestle, etc have been making the same or similar products for several decades with slight variants. But the consumer demand is continuous, repeated and consistent, and hence the moat is strong.
Now that we have a grasp on understanding the business and its moat we will move to the next Step.
For more on understanding the business please read Know the Business You are Investing In
Make an assessment of the true value or Intrinsic Value of a company
Many people who know value investing in India may not reveal the exact method of calculating or finding the Intrinsic Value. There are various methods of doing this and one has to make a judgment based on different method before arriving at a reasonable Intrinsic Value.
In Buffett’s approach Intrinsic Value is the discounted value of free cash flows that a business can generate over a long term. Free Cash Flows in simple layman’s terms are the residual cash left in the business – i.e. all cash revenues minus all expenses, which gives us the gross cash flows, and when we further deduct capital expenses we are left with Free Cash Flows.
In simple terms, Intrinsic Value = Present Value of all future free cash flows of a business
If you think this sounds too complex, think of a property and how it is valued. Its value is based on the potential future rents and increase in prices dependent on various factors. Hence, this framework can be applied to any business, and stocks are small portions of a business we invest in.
Recently I did the valuation of AVT Natural Products, a company which is in to solvent extraction business, which has a moat though it is dependent on a commodity (price-sensitive). The Intrinsic Value of the company as per my estimate came to Rs.39 per share.
Disclaimer: The companies or stocks or examples are only for illustrations. The author may have direct or indirect interest in these securities. Readers are requested to use their own independent judgment and take professional advice. Please don’t rely on this article for making buy/sell decisions.
Purchase the security with a significant Margin of Safety (or significant discount to Intrinsic Value)
The concept of margin of safety is to have a conservative estimate for the purchase price of a share to account for any errors, wrong assumptions, and unforeseen consequences.
For instance when civil engineers need to build a bridge with 10,000 kg load bearing capacity they try to estimate and build a bridge with 13,000 kg load bearing capacity, which is 30% in excess of what is required so as to account for any miscalculation, judgmental errors, higher traffic/load, etc.
Similarly when we want to purchase a stock, we have to buy it at a discount to the Intrinsic Value. For instance if Intrinsic value of a stock in your estimate is Rs.100 you may want to buy at with a 30% margin of safety, which means you will buy it at Rs.70 ( Rs.100 – 30% of Rs.100 discount).
In the above example of AVT Natural Products we have the Intrinsic Value estimate of Rs.39 per share. Should I buy at the intrinsic value itself? No, instead I would be buying the share at Rs.27.31 (39 – 19 *30%). This means I need to wait patiently until the price drops to Rs.27.31 before I can purchase the stock. This last step is the crucial aspect of value investing.
Why Margin of Safety when we have done such a thorough analysis? In many cases we may not know the business from A to Z, or the management’s ability to execute projects might change in future, or our growth expectations may not suffice, etc.
Similarly external factors such as economic slowdown, interest rates, change in technology, changing tastes or preferences, etc may dramatically affect the business. Hence having some margin of safety is important. The level of margin of safety (20%, 30%, etc) is based on your own assessment.
Now that we have the three key steps or guidelines for getting started in value investing, its possible for small investors to get started. However, remember that value investing is one of the styles of investing. So try to start small with a small portion dedicated to this, while you keep other investments in safe avenues such as blue chips.
Value Investing is about finding a stock that is worth more than is reflected in the current price. Even you can make fortunes with a value-based approach to investing.
I hope this article would have provided you with a conceptual understanding of value investing, which you can implement in a small way and benefit from. Feel free to share your thoughts, comments and feedback.