Value Investing: The Road To Undervalued Stocks

What Is Value Investing?

Value investing is a strategy of investment in which the stocks are chosen with the benchmark of finding the intrinsic value of the stock. The stocks which trade below its intrinsic value are called undervalued stocks or value stocks. The value investors are those who actively look out for stocks they believe are in the undervalued state. Investors who use this strategy have the fundamental belief that the market overreacts to good and bad news, which as a result, move the stock price. In the case of undervalued stocks, these movements do not agree with a company's long-term fundamentals, providing an occasion to profit when the price is deflated.

Undervalued Stocks - The Bedrock Of Value Investing

The entire philosophy of value investing is based on identifying undervalued stocks. In a way, we can say that, value investing strategy is nothing but a pursuit of undervalued stocks. Stocks whose market values is way below its intrinsic value or it has gone below because of some news of market overreaction. In theory, the idea sounds simple but the process of finding undervalued stocks is quite complex.

How To Find Undervalued Stocks?

The first thing that should be figured out is the health of the economy and whether you should be investing at that time. Analysts often refer to this as a macroeconomic picture. Many economic activities are linked to each other. You will have to monitor policy changes by the government, central bank, statistical data like inflation numbers, employment data, import-export data, currency rates, etc. for Indian as well as global markets and especially countries which have a significant impact on Indian market like United States, European Union, etc. If your market analysis has determined that the market is in an uptrend and likely to continue for some time, you want to buy stocks in those sectors and industries that are showing the best potential to be big winners in the uptrend. Also, always remember that a market which is climbing higher will not ensure that all stocks will perform well.

Dont Look For Stocks, Look For Businesses (Preferably Those You Understand)

It is hard to determine whether a company's stock would be a good buy if you don't actually understand what that business does or how it makes money. On the other hand, if you understand the business, you can use that knowledge to your advantage. For example, if you like smart-phones and if you like to read about them, you're probably in a good position to compare companies that make them. Remember, a strong company doesn't mean it is a buy; it can be expensive and would not deliver good returns. A bad company will rarely be a good buy especially for the long-term even if it is trading at a cheaper price.
Warren Buffett is a famous example of this creed. He never invests in any business which he doesn't understand. Over the years, Information Technology (IT) companies have made plenty of money for the investors, however, Buffett stays clear of investing in IT companies because he doesn't understand how it functions. If he is not able to understand the business operations he will never be able to assess its performance and understand its growth potential.

Analysis Of Intrinsic Value Of The Stock

There are dozens of metrics you can use to evaluate a stock, but the following are some of the best for locating undervalued stocks:

Price to earnings (P/E) ratio: To calculate the P/E ratio you have to divide the stock's current market price by its annual earnings. To compare companies in the sector, the P/E ratio is useful. The rule of thumb is that a lower P/E means a stock is "cheaper," however, this does not mean you can buy the stock as there are various other variables to consider.

Price-to-book (P/B) ratio: This ratio is determined by dividing a stock's price by its equity per share. A book value of less than one indicates that the stock is trading for less than the cost of a business's assets. Value investors stress on P/B multiples to find companies with a margin of safety.

Price-to-earnings to growth (PEG): Looking at just P/E may not do the trick. For better insight value investors never fail to check PEG. It is found by dividing a stock's P/E ratio by its estimated earnings growth rate over a specified time period -- usually the next 5 years. This can be useful for evaluating the valuation of a company which have high P/E, but whose earnings are also rising swiftly.

Return on equity (ROE): This is one of the most popular ratios which is used not just by value investors but by all the retail investors. Return on equity is a measure of how competently a company is utilising invested capital to produce profits.

Debt-to-equity ratio: As the name suggests, this is determined by dividing a company's total debt by its shareholders' equity.

Current ratio: Current ratio gives a distinct idea to the investors of how quickly a company can pay its short-term debts. This ratio gives a clear insight into the company's liquidity. The liquidity metric is calculated by dividing a company's current assets by its current liabilities.

Competitive Business Advantage - The Thing That Makes The Difference

The second stage is to choose the businesses which you can fully comprehend. While the ones you choose might reflect your personal objectives, your appetite for risk, or interests, in general, there are certain key components that make companies successful. One such key characteristic is having a competitive advantage. A competitive advantage is essentially a leg up over similar businesses, and the more sustainable a company's competitive advantage, the more likely it is to remain profitable in the long run.

For example, one well-known company with a sustainable competitive advantage is Bharat Forge. Bharat Forge is a part Kalyani Group which is USD 2.5 billion worth.It is a market leader in Indian forging business with a strategic global footprint across Germany, France, and Sweden.Owing to its strong capabilities in the domain of engineering, R&D and manufacturing process, it has transformed itself from being a supplier of the component to a preferred development partner. It is one of the best players in terms of operating efficiency among peers thanks to its strong business model. It enjoys operating profit margin and net profit margin of 28%/14% respectively which is higher than peer range of 10-22%/ 2-10%. Strong business model, market leader position, and operational efficiency makes it value added pick among peers.

Look For Companies That Have High Corporate Governance

One of the most important aspects of stock analysis is to understand the company and its management. Management teams are responsible for making strategic decisions that impact the value of their companies over time. That's why it's important to find companies with strong leadership teams. As you do your research into who's running the companies you should check for the manager's track record, experience, and if he/she has any specific talents. You might also find yourself drawn to managers with certain characteristics.

RBL Bank Ltd. is the best example of a successful business story under great leadership. After 2010, the company witnessed growth in topline and bottomline as well under the new leadership of Vishwavir Ahuja. Vishwavir Ahuja is a successful banker with rich experience in banking and has earlier headed Bank of Americas India operation. In last seven years, he has built a strong team with rich banking experience. During this period, net profit of the bank has risen to Rs 446 cr in FY17 from Rs 12 cr in FY11 with the growth rate of ~70% vs de-growth rate of ~27% over FY06-11.

Growth is the driver of future stock price

If your stock investment strategy involves identifying stocks you can hold over a long period of time, you will need to identify stocks of companies which offer the best growth opportunities. In such cases, focus on businesses that are expected to accelerate at a faster rate than their competitors, thereby generating, or having the ability to generate above-average earnings. Identifying growth drivers and coming up with financial projections is probably the hardest part of picking right and safe investments.

To explain this point in detail, let's continue with the same example of Bharat Forge. There are many growth drivers like - replacement demand pull up, pick up in infrastructure activity, low fuel prices, lower interest rate, healthy economic growth supporting company fundamental. The company is placed well with a sustainable business model, sound financials and competitive advantage in a positive industry scenario. In the case of Bharat Forge, it will be safe to say that the company has robust fundamentals and good growth drivers which will ensure that there will be sustainable growth in the future.

Reading The Management Commentary Every Quarter Is A Must

A good way to learn more about the companies you are interested in is by tuning in to the earnings conference calls. Typically, businesses conduct conference calls on a quarterly basis, usually following the release of financial information. During these conference calls, management will discuss the latest financials, major factors that impacted performance, and projections for the upcoming quarter or year. Tuning in to a conference call can give you a good sense not just of how a company is doing financially, but how management responds to changes in performance, for better or worse. This is important because it's possible for a company to have strong earnings in one quarter and poor earnings the next, but the way management addresses hiccups can have a huge impact on a company's long-term value and viability. Most companies post their conference call schedules on their websites and allow investors to listen online.

Value Picks - The Final Destination Of Value Investing

One goes through the trouble of research and analysis of companies on such a micro level only to find the stocks worth investing in for a long period of time. Though there may be a chance that you may miss some of the basics while chasing these micro-level factors. So its highly advised to get your pick passed on through every aspect of becoming value pick. There are 5 things which you cant afford to miss while picking the exact value pick from the basket of undervalued stocks you identified. To be honest, we dont want you to face difficulties in your stock market investment, so we have briefed 5 pointer checklist in our scholarly article Value Picks: 5 Things You Must Do, To Shortlist Them. Read it before investing in a undervalued stock because its not necessary that every undervalued stock is a value pick.

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