November 14, 2008

Some questions on value investing

I recently received a few questions on value investing via comments. I thought these questions would be best covered via a post

1. If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying, how does the undervaluation go away ?
2. If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
3. Ashok leyland had a 50% drop in sales last month? What are your views on it ?

In addition let me add a few questions and answers of my own

1. If value investing is so obvious, why do so few investors follow it ?
2. You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?
3. Is a macro view point inconsistent with value investing ?

If you buy a stock at 50% or less of instrinsic value, what makes the stock reach its intrinsic value ? if the traders are not buying how does the undervaluation go away ?

This question has been asked of several value investors and frankly there is no scientific explaination (yet!). The best explaination for this question comes from the dean of value investing – Benjamin graham who said ‘The market in the short term is a voting machine based on the emotions of investors. However in the long run, it is a wieghing machine driven by the underlying value of the company’

If you are new to value investing you have believe the above on faith, as I did initially, that the market eventually corrects the undervaluation,. However over a couple of years, you will see for yourself that the market does recognize the undervaluation and corrects it. However don’t expect the correction to be in a uniform straight line.

For ex: I invested in companies like concor or blue star in 2002-2003 time frame. The undervaluation in these companies was corrected by 2005-2006. This correction did not happen in a uniform fashion. On the contrary I have seen the correction happens very quickly with the major gains spread over a few weeks.

Ofcourse after the correction happens, the traders get excited as they can see volume strength and momentum and all that. They jump into the stock if the correction was swift and the stock is appearing in their filters. The stock gains further and now the analysts latch on it and start recommending it. Finally when everyone and his uncle is onto the stock, CNBC and our smart talking heads start recommending it. That’s the time to sell !! ..just joking, but you get the point.

If everyone practised value investing, will the market not become efficient and will value investors not be out of business?
If value investing is so obvious, why do so few investors follow it ?

Value investing is not new. The bible of value investing - security analysis by benjamin graham was published in 1934 ( I would recommend you to read it, multiple times). Most of us practise value investing in real life. If a TV is on sale, we go ahead and buy it.

However, very few do it in stocks. The reason is two fold. First, most of the investors cannot or do not want to evaluate the intrinsic value of a stock. So they really cannot be sure if a stock is a bargain or not. As a result they ‘outsource’ their thinking to others such as analysts, CNBC etc.

The second reason is temprament. It is difficult to stand away from the crowd. Think of it – how many investors out there think that this is a good time to buy. Most of them are ready to to accept the notion that now is not good time to buy and one should wait till the future is clear.

When is the future clear ? Was it clear in Jan 2008 when everyone thought the sky was the limit? If in hindsight it was not clear then, it is not clear now and it is never going to be completely clear ever. Investing is all about probabilities and of putting your money into situations where the odds (valuation) favor you.

So value investing is intellectually easy to understand, but emotionally diffcult to practise. You have train yourself to get excited when the stock prices drop and not get too thrilled when they shoot up.

You always mention about a long term view. What is long term ? 1,2 or 5 years ? should one wait indefinitely for the market to recognize the stock ?

I do not have a fixed holding period. As a long as the current stock price is less than the intrinsic value and I don’t need the cash to buy something cheaper, I will hold the stock. However if after 2-3 years, the stock price remains at the same level , I will analyse my thesis again to see if I am missing something. One has to be patient, but not stubborn and stupid.

Is a macro view inconsistent with value investing ?

I cannot speak for others, but I am not good at macro forecasting. I would never invest in a cement company based on the total expected cement volumes in Q3 of 2009. My approach is to look at a good company, with sustainable competitive advantage and available at an attractive price. If I find one, I will buy it irrespective of the macro forecast.

If the macro situation worsens, a strong company will do better than competition and would be available cheap (time to buy more). When the macro situation improves, this company will do well too and the investment will work out.

So I do not worry about what the exact macro, GDP etc numbers are. If one can find a good company at good valuation, good things will happen over time for the investor.

Ashok leyland had a 50% drop in sales last month? What are your views on it ?

This is an example of the macro situation worsening more than expected. However there has been no damage to the business model. Both tata motors and ALL have suffered steep drops in sales due to the macro situation. Unless one believes that Ashok leyland will go out of business due to this drop, I do not see any reason to change the
investment thesis.

That said, I have underestimated the cyclicality of this business and hence have reworked to the intrinsic value from around 60-65 to around 55-60.

Side note : I must be writing interesting stuff if some of my friends come up to my wife and tell her that they enjoy reading my blog and ofcourse her reaction to it, is that this blog is a nice excuse to avoid helping her :)


Vidyanshu said...

Dear Rohit,

A nice summary of what Value investing is and what it is not. I think the temperament part cannot be overemphasized. One needs to be able to think and wait in terms of years and not days or months. Secondly, value investor will be delighted at the prospect of making 20-30% per annum..most others want to do that much in days! Lastly, risk averseness is paramount. As Graham had taught Buffett - you should be able to say no to more than 90% of the stock picks betting on not more than 10% and then too doing a thorough due diligence. In sum because of the temperament/patience needs, need to be happy with smaller but more guaranteed returns this form of investing does not find much favor with the broader trader/"investor" community. Hope I rephrased your post above succinctly.


Vic said...

Hi Rohit,

Great post again. Good to know your wife is getting compliments for your blog, now you can justify all the time you spend on it. :-) Hey..after all you use this research for your investments too.

Anyway, I have a question on the exit strategy as it relates to your post. I recall that you mentioned that you might sell Graham type stocks if it reaches 90% of its intrinsic value.

For Core Portfolio, I assume one would sell if the stock becomes overvalued. What percentage of overvaluation is considered a good exit point? e.g. is it when the price reaches over 10% of intrinsic value?



patrick ho said...

chanced upon your blog while surfing around. I personally feel that undervaluation of companies is largely because of a lack of catalysts.

Let's look at GEICO, the company with the famous gecko for its brand. Warren Buffett saw to it that the business had the potential but was not realising it. What next? Take over the company and attempt to change some operations within while keeping key personnel. This was the catalyst that companies need for the divergence in intrinsic value and actual price to converge.

Even if there are no apparent catalysts, the quarterly profits and reports should eventually bring the market to awareness of such a company. What's needed on our part, like you have mentioned, is patience, and truckloads of it.

As for an exit strategy, as long as the business fundamentals have not detoriated, one might want to hold on to the stock even if it is temporarily overvalued, unless of course there are better positions to initiate where valuations are even more depressed.

Just some personal opinions;)

Anonymous said...

Hi Rohit,

Very good post, and nice comments here too.
Yes, I have read Ben Graham's perspective on this in Intelligent Investor. But, one needs to reinforce that virtue again and again. You did a great job in that regard.
The turn of events over this year has created a problem of plenty. I've seen some mouth-watering opportunities have emerged. Again, I'm waiting for your proposed next post on these opportunites.

Regards, Prashanth

Rohit Chauhan said...

hi vidyanshu
yes , you have summarized my post fairly well.

vikas - i generally consider 10-20% over intrinsic value as a good start point to sell. however as with my buying, i dont do the selling in one shot. i will sell small % at a time and see if the company is doing well on the upside. intrinsic value as you know is not static and needs to reworked at least on a regular basis


Rohit Chauhan said...

hi patrick
welcome to the blog. i agree with your thinking. warren buffett said regarding GIECO that the franchise was intact only the business was suffering from a temprorary issue.
however if you read snowball - his biography, you will that it required a skilled manager to turn it around.


Rohit Chauhan said...

hi prashant
have been a bit busy these days. but i will post on some ideas soon.

acutally in this market, you can pick whatever you like and it is quite likely to be undervalued as long as you avoid bad businesses


Vic said...

Thank Rohit,

I read the same strategy in Pabrai's book. It makes sense, I think it is similar to building a position i.e. do it in small chunks over a period of time.



TP said...

Off late I started visiting your blog. I love reading your comments. I believe in value investing too and I agree with you its difficult to practice. I have a fundamental question regarding stock buying. As you mentioned in your reply to one of the questions above that you sell some % at a time. Do you adopt the same strategy for buying as well? To me the pros of investing full amount when it reaches MOS price is we are fully invested. But the downside is in such a market situation (as we face today) its quite possible that the price drops further and can present an even better buying opportunity. Wanted to know your views on what the best approach would be.

Vic said...


I was reviewing the analysis of some of the stocks that you posted.

Will you be posting the analysis of remaining ones that are part of your portfolio (Core and Graham style)?



Rohit Chauhan said...

Hi tp
i will be answering your question via a post

vikas - i will be posting the analysis of rest of the stocks soon


Admin said...

In my opinion, the best investing method is understanding the competitive advantage of the company product, management and vision. In India, I can see some companies in this group that is, ITC (cigarette monopoly), Marico (Parachute oil monopoly), United Spirits (beverages monpopoly), Pantaloon Retail (retail monopoly). understanding the company products and its ability to raise or low the price along with inflation, choosing the same by customers again and again, product innovation and managerial quality should be considered... above companies are best in there respective areas and good consideration for long term investors who follow Warren Buffett or Graham theories. What is your opinion?