What is value investing? Here we attempt to explain the term in simple words
Fund managers keep talking about following value investing philosophies. Here are the definitions and how they are used by fund managers.
Every day we buy products which we think are of “good value”. But the definition for value differs from person to person. How?
Let’s take an example. You and your neighbour have bought a new smart LED television. Both of you say, “My TV is a better value buy than yours”. This is because you both have different definitions of value. Maybe you call your TV a good deal because you got it on sale at 20% off. Your neighbour, meanwhile, says his TV is a value buy because it has all the latest features when compared to another brand, for the same price.
Similarly, fund managers have different definitions for value. All ‘value’ managers buy stocks that they think are worth significantly more than the present price, but they’ll very rarely agree about what is ‘good value’. How a manager defines value affects his/her portfolio choices and ultimately the performance of the fund.
Let us take a simple example of two fund managers, Mr. X and Mr. Y. They manage large-cap equity diversified funds. Both the funds invest in blue-chip companies. The fund manager follow value investing for their funds. However, Mr. X’s fund has outperformed Mr. Y’s fund. How? This is because of the difference in each of their definitions of value.
While Mr. X follows a strategy where he picks stocks trading at a big discount to their intrinsic value, Mr. Y. picks stocks that are trading lower or at discounts to their peers. Both the managers seem to follow value investing but their opinions of ‘what is value’ are pretty diverse. So, there is very little similarity in the way they pick stocks. There are many different types of value investing. Read on to find out more.
Relative – One style in value investing is the relative value investing. Fund managers practicing relative-value strategies compare a stock’s price ratios (such as price/earnings, price/book, or price/sales) to some benchmark. In other words, value is relative.
These benchmarks can include one or more of the following:
The Stock’s Historical Price Ratios – Fund managers may look at companies selling for lower ratios than usual. Often, these companies’ prices are lower due to some type of “bad news,” to which the market often overreacts. For example, the stocks of Infosys crashed by 14% in August 2017 after the then CEO Vishal Sikka put in his papers. Infosys was around Rs 454 then. Many fund managers saw this as an opportunity to enter the stock. Today the stock price is around Rs. 730. Even recently, the stock fell from Rs 840 after a whistle-blower alleged that there were corporate governance lapses.
The Company’s Industry or Sub sector – A manager may believe that a company is undeservedly cheap compared with its competitors. For example, Reliance Nippon Life Asset Management debuted at Rs 135 at the start of 2019. Some fund managers thought that the company is under-priced when compared to its peers. The stock has soared to Rs 362.
The Market – In this case, a solid company may be dragged down because it’s in an out-of-favor industry. This scenario is common with cyclical sectors, such as technology. Infosys, for instance, is one of the dominant IT companies, but when its industry is rejected by the market, it will be dragged down, too. Value managers will jump on this opportunity. For example, consumer durable company stocks fell heavily due to the economic slowdown and the fear that it may affect the margins. Fund managers saw this as a buying opportunity.
Absolute value – Another style in value investing is absolute-value strategy. They don’t compare a stock’s price ratios to something else. Rather, they try to figure out what a company is worth in absolute terms, and they want to pay less than that figure for the stock. Absolute-value managers determine a company’s worth using a variety of factors, including the company’s assets, balance sheet, and growth prospects. They also study what private buyers have paid for similar companies.
There are two main reasons value managers will sell a stock.
• When the stock stops being a value pick, the manager sells the stock. Stocks stop being good values when they become what managers’ call fairly valued. That means that the stock is no longer cheap by whatever value measure the manager uses. For relative-value mangers, that could mean the stock has gained so much that its price/book ratio is now in line with that of its industry. For an absolute value manager, that could mean the stock’s price currently reflects the absolute worth the manager has placed on the company.
• They realise that they just made a bad stock pick.
• A manager may also sell a stock because it looks less promising than it did initially. In particular, new developments may lead the manager to a less favourable evaluation of the company.
Value investing has been a popular strategy. Thanks to Benjamin Graham and Warren Buffet. Graham introduced the concept in the 1930s. Value investing has changed drastically since then but the concept is still in vogue.
Do consider mutual funds that follow value investing.
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