September 27, 2012

Value trading

I am going to discuss a new term –value trading in this post. It is a very interesting concept and it was first mentioned by my good friend – arpit ranka.  I cannot claim any originality on this concept, but once it was mentioned  by arpit, I started thinking about it and found a lot of validity and relevance to my style of investing.

What is value trading? (my definition)
Value trading is best described as buying a stock with the expectation of selling the same (hopefully with a gain) in a short period of time based on the realization of a single or multiple triggers. This trigger can be fundamental in nature such as normalization of sales/ profit margins (from a temporary low), business event such as launch of a new product or new capacity or change in the business environment for the better such as moving from extreme  to moderate pessimism .

In addition to the fundamental issues, the trigger could be technical in nature such as short term overselling of a stock due to unexpectedly poor results or some temporary event such as elections which do not really impact the fundamentals of the business

In all these cases, one is expecting that the trigger will occur in the short term and the stock price will get a quick bounce (10%+) and one would be able to exit with a nice little profit

How does it differ from value investing
The above definition may sound a lot like value investing and I have been guilty of mixing the two for all these years. However as I think back, I have come to realize that they are not strictly the same and confusing the two can actually be harmful (as I will explain later in the post)

If one invests  with a long term horizon in mind, then it is critical to have a good idea of the intrinsic value of the company. In addition this intrinsic value should increase over time, if one is to make above average returns in the long run.

So in effect, one is playing a short term trigger in the case of value trading versus betting on the business in the case of value investing.

Examples of value trading
Lets look at some example I have posted in the past and look at which bucket these ideas fall into
  1. Patels airtemp
 I would call this ideas as a value trading idea as this company is in a highly cyclical industry. At the time of buying the stock, I was expecting that the downturn in the capital goods industry would not be deep and the fundamentals of the company and  its stock price would soon bounce back.
The trigger has yet to happen and as result the stock has slid further since the time I wrote about it.
  1. Ashok Leyland
I started looking closely at this company in mid 2008 and by the end of the year the bottom had fallen out of the commercial vehicle market (the company stopped production for a month in dec 2008 to reduce the inventory). I purchased the stock in early 2009 at highly depressed prices.

The trigger – normalization of commercial vehicle sales happened quite quickly towards the end of 2009 and the stock turned out to be a four bagger.
In both cases, I expected a normalization of  the fundamental performance and a bounce back in the stock price. In one case it happened faster than expected resulting in a large gain and in the other case the downturn has been deeper than expected and hence the stock price continues to languish
  1. Amara raja battery
The company is a no.2 player in the battery industry and operates in a close duopoly. The key insight in this idea is that the company is expanding its competitive advantage (brand and distribution) and also benefiting from  migration of demand from the un-organized to organized sector
I would tag this as a value investing idea as i don’t expect a specific trigger other than the fact that the company is improving its competitive position and hence should see an improvement in profitability and growth.

The first two examples I have discussed should bring out the following key point – In a value trading idea, the intrinsic value may not expanding or could be declining too. However the stock is undervalued and a set of triggers could close the gap with the intrinsic value. You can call this mode of investing as deep value investing or graham style investing too.

The last example of amara raja is more of a buffett style, high quality stock where although  one is expecting the gap with the intrinsic value to close, the bigger gains come from an increase in the value of the company itself.

The differentiating factors
The two modes of investing differ on several factors. The first factor is time – Time works against you in the case of value trading. If the trigger happens quickly,  the price rises quickly to the fair value and one can exit with a nice little profit. On the other hand if trigger gets delayed, then the overall returns may remain the same, but the annualized return is much lower.

In case of value investing, time works in your favor. As the company continues to grow its intrinsic value, the stock price should hopefully follow it (some times in spurts) and thus the idea becomes a buy and hold kind of idea.

The second factor where these two approaches differ is the nature of the business. The value trading approach works better in commodity  and cyclical industries. If one can catch the bottom of the cycle and bet on a tier 2 or tier 3 company in the sector, then the gains are very high when the cycle swings back to a normalized level. At the same time, one needs to also ensure that the stock is sold once the cycle has turned .

Value investing approach works where the economics of the business is good and the company has a competitive advantage. In such cases, if one buys the stock at reasonable valuations, then returns are good over a long period of time

Do not mix the drinks !
I would say that value investing or long term investing should occupy a larger portion of the portfolio. If however you have the time and energy to look for  value trading kind of ideas and can play them well,  the portfolio can get an extra boost from time to time

The danger is really from mixing the two approaches as I have done in the past. I have bought  trading kind of ideas and held on to it for a long time (assuming it was a long term investment). In such the cases the absolute returns came through, though the annualized returns were mediocre due to a delay in the key triggers.

The correct approach would be to keep in mind the nature of the idea (trading v/s investing), identify the triggers and the time it would take for the same to play out. If the triggers change or get delayed , then one should exit a value trading kind of idea. In contrast in a value investing idea, time is working in your favor and temporary hiccups are sometimes a good time to add to the position. In all such cases, one should just sit tight with the position.


Anonymous said...

I would like to add SREI as another trade. Interest rate will start falling and rs will appreciating resulting into forex gain(at least no forex loss) and decreasing interest and increasing profit and EPS

Joseph said...

Rohit – In the Value Investing book authored by Prof Greenwald, he talks about buying companies at a discount to NAV whenever NAV < EPV. Now if you think about it, NAV will be less than EPV whenever return on capital < cost of capital. And if return on capital is less than cost of capital, the intrinsic value of such a company will be on the decline. At first it boggled my mind as to why anyone would buy a company (even if it be with a margin of safety) where the intrinsic value is on the decline. And the more I thought about it, I realized that the only way to play such a situation is to identify the triggers that will help close the gap between the current market price and the NAV and hope that the trigger plays out quickly. This is also a bit of an odd situation, because the longer you hold such a company, you have to revise your intrinsic value downwards every year....a very funny situation where intrinsic value goes down to meet market price. Just thought I’d mention this....your blog post on value trading bears some resemblance to this idea (in my mind).


Joseph said...

I should have added (in my previous post) that the intrinsic value will be on the decline if such a company (where NAV<EPV) is still focused on growth (a common curse for many such companies).


Pradeep Raghunathan said...

This is a great post. I actually have been thinking hard on this and trying to marry "the buy and hold" with this "catching the cycle" thing. I was unable to reconcile between the two. This post gives some kind of clarity on how to think about it.

Anonymous said...

Hi Rohit,

Long time, hope you are doing well. In this context, I had read a good book -

I find this somewhat akin to an arbitrage, which is what deep value investing themes are at the end of the day. I think Prof. Bakshi's thoughts on combining deep value investing with a catalyst, along with using technical indicators like moving averages and stochastics probably a better approach if one wants to do this kind of trading. Again, I know you are not very keen on the use of technical indicators, but in a Bayesian sense they can be used as an additional conditional probability step towards buying or least I am exploring these kind of thoughts.

Do let me know if you have any insights.

Best, Vidyanshu.

Anil Kumar Tulsiram said...

Hi Rohit
Thanks for another good post. I realised the importance of short term investment (I prefer this term over value trading) after missing stocks like Manappuram Finance even when it was trading at P/BV multiple of 0.8x. The only thing which was stopping me was my belief that gold prices currently are in bubble stage. But I failed to realise that entire de-rating of stock was because of overblown concerns of RBI regulation and loan growth slowing down materially and secondly I do not like to invest in banks/NBFCs because of inherent leverage.
I agree with the overall theme of the post but disagree on one point that even stocks where intrinsic value is declining are fit for short term investment. I think any investment where one feels value is going to decline in future rather than rising, is not fit for investment at any price. In such cases one may get stuck in times of market crash. A better approach might be to invest in stocks 1) Which are not suited for long term investment as per one’s philosophy (for me it’s Commodity stocks, Banks, Pharma, Regulated sectors like power, fertilisers, etc) 2) Share price has currently taken huge beating because of overblown concerns 3)and stock is available is ultra-cheap valuation.
In summary I think it’s better to stick to value investing principles every time irrespective of tenure except in the case of special situations.

Rohit Chauhan said...

Hi anon
interest rate as a trigger is a very dicey variable to play. if you are confident of the interest rate drop long dated debt funds or directly 10 yr GSECs


Rohit Chauhan said...

Hi joseph
you hit the nail on the head. as my friend neeraj marathe has told me several times ...these are dirt cheap stocks you buy and wait till they become just about cheap, and then sell and move on

personally, after doing this over time i am tiring of it. too much work and headache for a few % extra returns


Rohit Chauhan said...

hi pradeep
well you can marry the two ..if you find a industry which is moderately cyclical capital goods industry. buy a very good company at bottom of the cycle and then hold it ...the inital return will from the bounce and long term return will be from the business itself


Rohit Chauhan said...

Hi vidyanshu

long time ....good to see you back :)

i have been exploring these kind of options and may be once i semi-retire and do this investment thingy full time will do it more

for the time i have dabbled a bit in this and now kind of pulling back as it is too much work and not enough upside. however will keep doing oportunistic stuff like the globus spirit play once in a while ....but unlikely to be a serious component


Rohit Chauhan said...

Hi anil

first ...i need to post your comment you sent via email ...let me try to do that

you have a point in focussing on the best ideas ..atleast for the core portfolio. however once in a while there are opportunistic investments which can be made...though part time investor should stay away as they dont have the time and energy to manage it

on companies in slow decline, there are cases where even that works out if the management is taking cash out and giving it back to the shareholder

in addition, in some cases, the price gets so cheap that the biz is almost for such cases, you can buy it and wait for the market to reprice it.

ofcourse all this is very time consuming ...a lot times just buy a good company and let it compound. less headache

Lucky said...

The biggest risk with 'value trading' is of taking the 'value' out of it. It requires so much effort and diligence that one might easily get into sub-par ideas, especially in range-bound fairly-valued markets like ours as of now.

I entered into stocks like IFCI, Reliance Capital early this year. Also made good profits but it was a pain nonetheless.

Tried to do the same with Indraprastha Gas and Gujrat Gas later this year. Did not make anything though they were much better picks.

Sold and feeling relieved that my portfolio is in better shape now. Though GGC going up 10% pained a lot, but that's another lesson - when you buy to make quick profit, you may also end up selling without making that profit (buy for non-value reason and sell for non-value reason).

So it's always a choice between continuous activity and almost hands-off approach. Quantum LTE Mutual Fund does the former very well and I feel it's justified mainly for such entities only. Definitely not for individuals with other full-time assignments.

Mokhtar said...

Hi Rohit,

U have a nice blog, I recently came across this and have enjoyed reading it.

Ur investment ideas have lot of depth.

Regarding Novartis, how do you see the recent Glivec court case coming? As far as I have been reading around it seems like a lot depends on this case result for Novartis future launches and investments in India. I have a lot of confidence in the Parent Novartis AG.Mega-pharmas like Novartis have the advantage of being able to afford some of the brightest scientists and the most cutting-edge oncology research money can buy. They are working on products of the future that will redefine the medical scenario.The race is who invents the future medicines first making these companies filthy rich. This is 1 of the most important factors giving me confidence about Novartis India. The de-listing buzz has also dettled down now in the price and the CMP will remain subdued until the court case is out I guess. How do u read about Novartis now, or have u found something else to replace novartis. Are you still holding it?

Anonymous said...


it reminds me of the post you shared back in oct-11 about tata steel's liabilities. From investing point of view one wouldnt/shouldnt be keen on buying into a company with such a big pension plan exposure. however, from trading perspective one could have entered it given the hole in pension pot "tends" to grow over a longer time period. plus how many people would firstly identify that risk and secondly, stay away from the script given all the market chatter pressuring them to trade? so "maybe" it could have been a value trading opprotunity give it takes a while for market to bring such things to the fore!!