Count on the Margin of Safety

Cover Story COUNT ON THE

Times have changed since Benjamin Graham wrote the Security Analysis but his principles can hold investors in good stead even now N Mahalakshmi & Mohammed Ekramul Haque

t cannot be denied that the Great safety’, allowing for any contraction in grabbed the attention of several pro- Depression of 1929 and the Wall prices, were his key bets. fessional investors, many of who have Street crash that followed was per- His strategy soon started being talk- added their own perspectives over the Ihaps the most humbling experi- ed about in the investing community. following decades. Nevertheless, the ence for investors at the time. Life was One man, in particular, was highly in- basic essence of value investing has tough and there was no hope to clutch fl uenced by Graham’s strategy, and remained the same: buy cheap. on to. After crushing losses, most in tribute to his ‘idol’, bought shares It was a philosophy that was born stocks were available at ridiculously in about a hundred such cheap com- in desperate times (the Depression cheap prices over the next decade as panies. His faith soon paid off: in fi ve years), and underwent a baptism by the markets remained trapped in a years, John Templeton – whose name fi re as it was tested time and again over bear grip. today is synonymous with value the next few years. But as any stock expert will tell you investing – had multiplied his So it wouldn’t be wrong to wonder today, behind every market disaster original investment several times, just a little bit whether those princi- lurks opportunity – if you just look despite around 15 of those companies ples still work in today’s times, given hard enough. It was the same for Ben- going bankrupt. that the past few years have been ex- jamin Graham, who, despite suffering The value investing philosophy pro- ceptionally exuberant for the world’s heavy fi nancial losses himself, began pounded by Graham and practised major stock markets. a conscious campaign of snapping up vigorously by Sir John Templeton was Cut to January 2008. In sharp con- stocks that suddenly became available eventually perfected into an investing trast to the crisis engulfi ng the stock at bargain prices. technique that called on investors to markets when Graham started out, the Graham’ strategy was simple: buy buy stocks cheap – so cheap that there world’s economies – India’s included companies that he likened to cigar was very little chance of the stock fall- – were exuding confi dence like never butts – typically abandoned but still ing any further (thus avoiding any loss before. Many experts claimed that In- good for a puff or two. And you could of capital). dian fi nancial markets were experi- pick them up for virtually nothing. After Graham articulated his encing a secular bull run, not a cyclical Stocks quoting below their liquida- thoughts on the subject in the book Se- upswing that would die down anytime tion values after keeping a ‘margin of curity Analysis in 1934, value investing soon. 41 13 June 2008 Outlook PROFIT Cover Story

as bits of bad news kept leaking out The world has changed in many HOW WE DID THE BACK-TESTING at a steady pace. Investors who had ways. And the way business is done The universe bought stocks at steep valuations now has changed appreciably. In the past began to understand just how foolish century, while industrialisation was Earnings yield portfolio: A portfolio of 30 stocks with the highest earnings yields, the their actions were, not to mention the still underway, manufacturing was the minimum cut-off being double the bond rate for the respective year, from the BSE- speculators who had joined in for the mainstay of business and companies 500 universe, excluding fi nancials, with a debt-equity of less than 1. For years that free ride. were largely asset-heavy. threw up less that 30 stocks, we went with the available stocks. Value investors had seen this coming Today’s businesses are more ser- all along. At a lecture in India on Janu- vice-led and asset-light. Even the Net-nets & cash bargains: All listed companies with a trading history of more than 90 ary 8, Bruce Greenwald, renowned fi - landscapes for accounting practices, per cent excluding fi nancials was taken as the universe. We calculated net-nets by nance professor at Columbia Business securities regulations and sharehold- deducting debt and current liabilities from current assets. The 30 or available stocks School, referred to stocks markets as ing patterns are dramatically differ- for the respective years with market-cap less than net currents were considered ‘being expensive’. At the time, stocks ent. Graham’s success was also in part were actually peaking out. Greenwald because he had the luxury of buying for the portfolio each year. Companies with cash and marketable securities less teaches the ‘Graham and Dodd’ style businesses that were truly ‘cigar butts’ all external liabilities greater than the market-cap constituted the cash bargain of investing in the university Graham because of the state of the economy at portfolio for the respective years. graduated from. the time. Dogs of the Nifty: Top 10 stocks based on dividend yield at the end of every year. Value investing is not about predict- Is Graham’s philosophy still stay rel- ing when markets will hit their peaks. evant in the changed times, (one of The returns Graham (and today’s value investors optimism, although recent data does We computed total returns (price appreciation plus dividend income) for the agree) emphasised the preservation point to a slowdown) compared with portfolio constituted every year and with a holding period of 1-10 years for the of capital as the bedrock of investing. the gloom that the Father of Financial period 1998-2008. For dogs of the Nifty we tested results only for a two-year holding “The beauty is, as Graham said, any- Analysis was witness to? Outlook Prof- thing bought cheap will invariably go it sought answers for this by relying period. In the case of a stock getting delisted or stopped trading, we considered the up in price,” says Chetan Parikh, a two factors: data, because data does stock to have lost 100 per cent in the year in which the stock disappeared from the successful Indian value investor and not lie; and people who have been un- portfolio. All data has been sourced from CMIE Prowess. managing director of Mumbai-based adulterated value investors. Jeetay Investments. Before we disclose the results There is one difference though. (please wait patiently – being patient Besides, stock prices were catapult- covering almost immediately after What Graham considered bargains is the fi rst rule in value investing!), we ing and there was what seemed like a every tumble. and what today’s value investors con- present a quick look at Graham’s never-ending fl ood of foreign money And investors continued to buy into sider as cheap (and we are not talking various strategies. pouring in. For fi ve straight years till stocks, whatever the price. about growth-style investors who do January this year, the Sensex proved Then, the inevitable happened. Glob- not mind paying a high premium for THE PHILOSOPHY the sceptics wrong at every level as it al markets nosedived and over the stellar growth prospects) are separated Graham’s investment radar mainly rapidly scaled new all-time highs, re- next few months, continued to plunge by time. fl ashed stocks that could be classifi ed as bargains based on earnings poten- CASH BARGAINS PORTFOLIO tial or asset values. The key earnings-based strategy that Portfolio consists of stocks with cash and marketable securities greater than market cap most lay investors can easily adopt in- year 1 yr 2 yr 3 yr 4 yr 5 yr 6 yr 7 yr 8 yr 9 yr 10 yr Latest volves buying stocks that offer a sub- Portfolio 1998 56.30 13.47 -45.88 -22.24 -12.96 2.03 5.98 15.41 10.65 8.68 8.42 stantial earnings yield, typically, twice the prevailing bond rate. Sensex 1998 -17.00 7.82 -4.23 -4.46 -5.88 5.91 6.32 14.75 14.80 15.74 14.78 The earnings yield is the reverse of Portfolio 1999 196.20 -25.04 -15.97 -14.89 4.01 24.82 25.87 21.03 25.39 26.24 the price-earnings multiple. The logic Sensex 1999 40.05 2.87 0.12 -2.87 11.20 10.80 20.18 19.55 20.10 18.92 is simple: if you view stocks as bonds Sanjay Bakshi , CEO, Tactica Capital is a deep-value investor Portfolio 2000 -45.69 -37.70 -3.11 6.55 19.24 19.65 18.05 29.14 28.81 that offer no growth but yield fi xed returns (consider profi ts as a proxy for in- Sensex 2000 -24.44 -15.34 -14.03 4.97 5.73 17.15 16.87 17.81 16.56 terest earned) then the asset should be Portfolio 2001 -13.43 -3.30 31.75 53.64 66.82 63.88 74.19 77.32 valued like a bond. If the earnings yield Sensex 2001 -5.14 -8.29 17.13 15.00 27.90 25.69 25.53 23.83 is twice the bond yield, it means that stantial discount to the company’s as- Portfolio 2002 -2.98 39.67 73.51 86.98 76.96 84.35 84.91 the asset actually promises to double set value (for businesses that boast Sensex 2002 -11.33 30.16 22.62 37.82 32.96 31.53 29.30 the returns you could get from hold- good future prospects). ing the bond. Given that the business Another set of bargains includes Portfolio 2003 66.00 109.10 105.99 69.22 55.70% 57.67 is profi table and will continue to be stocks of companies quoting below Sensex 2003 91.06 44.20 59.64 47.14 42.33 39.09 so, returns could be impressive as the the value of marketable securities Portfolio 2004 169.39 120.53 92.65 49.22 51.58 yield in excess of the bond rate would and cash on their books after deduct- Sensex 2004 8.83 45.93 34.87 32.23 28.88 provide an adequate margin of safe- ing outstanding debt. The logic here is ty in the event of any capital erosion. that the company can use its cash and Portfolio 2005 76.22 40.86 61.42 66.43 Another earnings-based strategy is be securities to pay of its debt and other Sensex 2005 95.67 50.13 41.10 35.96 to buy stocks that offer substantial liabilities and still the shareholders Portfolio 2006 58.50 28.62 56.86 dividend yield. would have something in their hand. Sensex 2006 15.19 19.81 14.92 Asset-based strategies of Graham At the heart of Graham’s philosophy revolve around buying stocks that lies the ability to favour what is out of Portfolio 2007 53.67 37.15 are quoting either below their liquida- favour. Embrace the ugly, not the beau- Sensex 2007 18.82 18.82 tion value (especially for businesses tiful. Lift the disgraced and disregard- Returns for 2007 portfolio until May 27, 2008 that do not have a future) or at a sub- ed. And it works! 42 43 Outlook PROFIT 13 June 2008 PHOTOS: SANJIT KUNDU Cover Story

ing the market temperature works tors with handsome dividends and cap- an investment fi rm called Tactica would have liked.” beautifully as well. The proof of the ital appreciation. Capital, which specialises in deep- If wishes were horses, that would have pudding is in our study of stocks that Most of these names were ignored a value-investing . been true! In today’s circumstances, it were ultra-cheap in the past decade. few years ago either because business Other experts echo the sentiment. is not easy to fi nd stock that offer great Out of the 5,000-odd traded stocks at conditions were bad or the market sim- Managing director of Motilal Oswal Se- growth prospects with the margin of the peak of the IT bull run in 1999, 22 ply shrugged them off because there curities Ramdeo Agarwal safety embedded the stocks were trading below their liq- were alternative opportunities that says an attractive purchase way Graham liked it. uidation values (current assets mi- were more alluring. price is key to making mon- Graham’ strategy Most experts, however, nus current liabilities and debt). By “The market periodically gets into a ey. “The moment you pay was simple: believe trying to com- contrast, when the markets plunged phase of madness when there is a fas- a price for growth, where bine a growth style and to their nadir in 2003, 132 stocks met cination for a few sectors and the oth- is the outperformance?” buy companies the rather contrarian these criteria. ers are completely forgotten,” says E A he asks. “You are not deal- that he likened value-style technique Nevertheless, some of the most suc- Sundaram, a fomer fund manager with ing only with the company to cigar butts don’t mix very well. cessful value investors in the coun- HDFC Mutual Fund who now manages here, you are dealing with – typically Still, the perception try believe that some changes to funds for the Bilakhias. And it’s true: the price of the stock. Peo- of value lies in the eyes Graham’s strategies may be required during the dot-com boom, remember ple do not understand what abandoned but of the investor. “The to make it more effective (although how the old economy was forgotten? A role the price plays.” still good for biggest contribution of given that the back testing showed year ago, software service companies The sceptics argue the a puff or two. Graham to the world such good results, we wonder why?) had joined the ranks of fallen angels. A other side. “The Gra- And you could of fi nance was three true Graham follower would, however, ham model is geared to words – margin of safe- MISSING OUT ON GROWTH? buy stocks precisely when there are no fi nding cheap cigar butts, pick them up ty – and if you keep that Focusing on the cheap stocks often takers for them. but many such compa- for virtually in mind while invest- means missing out on other opportuni- And what about growth? Graham nies may have issues with nothing. Stocks ing you will seldom go ties. Why? Because the market is usu- never believed in relying on the future, their character itself,” quoting below awfully wrong,” says ally instantly enamoured by anything so he would not pay a penny for growth. says Bharat Shah of ASK fund manager Sunda- new that turns up in business until The difference between Graham fol- Raymond James who their liquidation ram. they fi nd reason to think otherwise lowers and the growth seekers is pri- started out as a value inves- values after Remember the dot-com boom? Com- marily that the former are risk averse tor but later changed track. keeping a THE CHALLENGES panies were awarded sky-high valu- (you can even call them miserly) and “Cheapness can be an il- Nevertheless, some ations before it dawned on investors don’t seek to pay a price for growth. lusion. Just being cheap is ‘margin of safety’ strategies that were that many business models were sim- “Value investors want growth not good enough for me, it largely a product of ply unsustainable. for free,” says Sanjay Bakshi, profes- has to be supported by cap- circumstances that However, the notion that you sor at Gurgaon’s Management Devel- ital effi ciency and confi dence about prevailed during Graham’s time are could be left behind if you don’t pay opment Institute. “And by doing so, growth. While I like the cheapness that becoming less effective and riskier the price for growth is not entirely they could well make errors of omission Graham would have liked, I would also propositions. It’s easy to see the con- baseless. “If you buy stocks based but not of commission.” He also runs like quality of business that Fisher tentions. strictly on traditional value investment principles, you will only play the EARNINGS YIELD PORTFOLIO arbitrage opportunity (the differential between the fair price and the market Portfolios with earnings yield more than double the bond rate with a maximum of 30 stocks price) but the bigger opportunity in a year 1 yr 2 yr 3 yr 4 yr 5 yr 6 yr 7 yr 8 yr 9 yr 10 yr Latest country like ours lies in the future as Portfolio 1998 80.16 87.27 14.34 19.78 9.57 27.44 36.53 48.24 42.40 42.47 43.82 the business grows,” says K N Siva Sensex 1998 -17.00 7.82 -4.23 -4.46 -5.88 5.91 6.32 14.75 14.80 15.74 14.78 Subramanian, vice president at Frank- lin Templeton Mutual Fund. He’s con- Portfolio 1999 45.50 43.48 35.46 28.85 55.97 69.76 74.15 65.24 64.93 67.84 sidered one of the best fund managers Sensex 1999 40.05 2.87 0.12 -2.87 11.20 10.80 20.18 19.55 20.10 18.92 Chetan Parikh, of the past decade or so. Portfolio 2000 39.06 49.09 36.37 70.69 82.05 91.31 79.16 75.19 78.79 MD, Jeetay Investments has been a For sure, adopting a Graham approach Sensex 2000 -24.44 -15.34 -14.03 4.97 5.73 17.15 16.87 17.81 16.56 committed value investor would have encouraged investors to pass over new, emerging businesses Portfolio 2001 88.92 46.61 89.10 109.55 112.85 95.99 95.21 100.3 that have given outstanding returns Sensex 2001 -5.14 -8.29 17.13 15.00 27.90 25.69 25.53 23.83 on the bourses: Infosys Technologies, Portfolio 2002 27.32 105.81 141.89 139.39 110.76 105.14 109.9 8 Back-testing key Graham strate- HDFC Bank, Pantaloon Retail; and Su- Sensex 2002 -11.33 30.16 22.62 37.82 32.96 31.53 29.30 gies reveal a stunning performance. zlon Energy to name just a few. None Portfolio 2003 268.56 217.40 173.73 127.78 112.65 118.7 The strategy of picking up stocks of these stocks would have qualifi ed as that have earnings yields that value stocks in the Graham sense ever. Sensex 2003 91.06 44.20 59.64 47.14 42.33 39.09 are twice as high as the bond But you would have built an equally Portfolio 2004 289.12 220.77 134.53 118.07 125.5 yield proved to be spot-on stellar portfolio of stocks consisting of Sensex 2004 8.83 45.93 34.87 32.23 28.88 for investors. Returns on Bharti Televentures and State Bank Portfolio 2005 434.52 172.21 110.90 110.9 such a portfolio beat the of India (at one time available signifi - Sensex every time! Cash cantly below book value); public-sec- Sensex 2005 95.67 50.13 41.10 35.96 bargains and net-nets have tor companies such as Bharat Earth Portfolio 2006 119.92 79.41 95.68 worked with 70 per cent Movers and BHEL and private-sector Sensex 2006 15.19 19.81 14.92 accuracy. (See table: Cash companies such as Areva T&D, Penin- Portfolio 2007 33.56 33.56 Bargains Portfolio) sular land, Gujarat NRE Coke, Merca- Sensex 2007 14.69 14.69 tor Lines, Aban Offshore and even Jai 8 Graham’s way of gaug- Corp. All of them have rewarded inves- CAGR Returns Note: 2007 based on latest sensex closing May 26, 2008 44 45 Outlook PROFIT 13 June 2008 13 June 2008 Outlook PROFIT Cover Story

8 The concept of book value and in and out of the company gate ev- tions. Indeed, some of the best-run of management and steer course whether it refl ects the true worth ery day; they’re not mentioned in the companies in the world have a neg- differently, it may not be the same of a company have undergone fun- balance-sheet though. ative working capital -- consumer for regular stock investors who damental changes over time. Book Similarly, the real value of consum- companies like Hindustan Unilever, may not be in any position to value was one of the prime pa- er companies lies in their brands Procter & Gamble and several oth- infl uence managements. rameters Graham relied on since and distribution network, again not ers actually have been operated with An Indian example comes from the he preferred judging what was on quantifi ed in the statement of ac- negative working capital for quite mid-cap segment of pharmaceutical the balance-sheet to looking at un- counts. “The balance-sheet does some time now. stocks. Take the Indian subsidiary quantifi able parameters. In his time, not capture the value of intangibles of Merck. Despite the fact that it has companies were asset-heavy and it like brands, but they also have cash 8 Some Graham strategies like cash the equivalent of 30-40 per cent of made sense to look at asset values. fl ows attached to them,” points out bargains work well in mature mar- its market capitalisation in cash, the Not anymore. Today, the real value Sundaram. kets like the US because the share- stock price has shrivelled. of several business lies not in the holding pattern is diffused, so a In hindsight, it’s easy to fi gure out plant and machinery they own, but 8 Similarly, Graham’s idea of looking fi nancial investor could identify situ- why the stock has underperformed: in more unquantifi able factors. Take at net working capital requires re- ations and act in a fashion that com- revenues haven’t grown as much software services, for instance. In thinking as well. The whole idea of pels management to unlock value. and the balance-sheet has shrunk. this industry, the real assets are the net-nets was to buy a company be- But in India, since promoters usual- So even as the company continues technically skilled people who walk low its working capital because if the ly hold fairly large stakes and corpo- to add to its cash pile every year, market did not give the company the rate raids are not that common, the the stock remains trapped in valuation it deserved, the promoter probability of liquidation is rather the doldrums. NET NET DROPOUTS could easily liquidate the company slim and dilutes the case for unlock- Companies that disappeared from the by realising the receivables and cash, ing value in such stocks. 8 Again, fi nding the right margin of net-nets portfolio midway pay off payables and debt – and still Besides, another risk with Graham’s safety itself is a diffi cult proposi- year 1 2 3 4 5 6 7 8 9 10 take home some cash (by the way, cheap stocks is that while you can tion for strategies like cash bargains. we’re not even accounting for fi xed buy a business at a lower price than Since these could involve long wait- 1998 1 3 1 1 1 assets here). Obviously, Graham was what it’s worth, you can never tell ing periods, unless there is a trigger 1999 1 3 looking at what was truly dirt cheap whether it will add or subtract value. in sight, the opportunity cost of cap- 2000 2 3 (cigar butts). Templeton’s Subramanian quotes a ital; the potential casualties in the 2001 2 1 He would have rejected companies classic example: when Warren Buf- portfolio (because Graham believed with low net current assets outright. fet bought Berkshire Hathaway, it in diversifi cation with less due dili- 2002 1 But, in today’s world, high working was still a textiles company. And in- gence as opposed to the strategy of 2003 4 1 capital is taken as a sign of a deterio- stead of continuing like that, Buffett concentration with utmost due dili- 2004 1 rating competitive position. Higher used the cash to build a business that gence that Buffett follows); and the 2005 1 receivables being built up; large dis- offered growth. fact that Graham never looked be- counts to customers; larger collec- While buying cash bargains may a yond fair-value situ- 2006 tion periods – all these are actually rewarding proposition for an activ- ations (not letting 2007 signs of worsening business condi- ist investor who can take the reins ‘profi ts run’); the mar- “Value gin of safety’s has to investors are be considerably high. GRAHAM’S NET NETS PORTFOLIO Finding such stocks balance-sheet Portfolio of top 30 stocks trading below their net current asset values in current circum- analysts and Year 1 yr 2 yr 3 yr 4 yr 5 yr 6 yr 7 yr 8 yr 9 yr 10 yr Latest stances poses a seri- regular market Portfolio 1998 43.46 89.16 4.77 12.22 7.40 15.22 24.51 28.30 24.41 22.24 23.64 ous challenge. analysts are Sensex 1998 -17.00 7.82 -4.23 -4.46 -5.88 5.91 6.32 14.75 14.80 15.74 14.78 8 While Graham’s strat- P&L analysts. “ Portfolio 1999 220.43 -1.32 10.57 5.55 20.07 28.07 38.66 31.08 27.44 28.29 egy is great in terms Sensex 1999 40.05 2.87 0.12 -2.87 11.20 10.80 20.18 19.55 20.10 18.92 of capital protection, Portfolio 2000 -30.22 -17.11 0.05 28.42 39.62 51.37 49.52 49.91 52.94 it focuses only on the arbitrage val- Sensex 2000 -24.44 -15.34 -14.03 4.97 5.73 17.15 16.87 17.81 16.56 ue between the margin of safety Ramdeo Agarwal, and the fair value of the stock (in Portfolio 2001 29.67 17.11 56.62 70.75 88.79 67.24 57.87 58.26 MD, Motilal Oswal Securities believes fact, Graham would invariably sell in getting the purchase price right Sensex 2001 -5.14 -8.29 17.13 15.00 27.90 25.69 25.53 23.83 the stock even before the fair value Portfolio 2002 1.86 44.03 70.12 85.30 70.52 72.13 74.76 was achieved). By doing so, some Sensex 2002 -11.33 30.16 22.62 37.82 32.96 31.53 29.30 present-day value investors say, you would lose out on the bigger value ham framework to work is a purely Portfolio 2003 91.19 102.59 84.42 66.92 68.32 68.78 that is usually built into the growth capitalistic society with little con- Sensex 2003 91.06 44.20 59.64 47.14 42.33 39.09 of the company. Templeton’s Sub- trols. But some companies that are Portfolio 2004 151.46 136.97 93.67 85.38 89.21 ramanian says that it makes a lot of going cheap in the Indian markets Sensex 2004 8.83 45.93 34.87 32.23 28.88 sense to look at metrics such as divi- today namely those in the oil, fer- dend yields because growth oppor- tilisers and sugar business are Portfolio 2005 54.25 67.26 81.85 93.37 tunities in some segments may have those that have been hit because Sensex 2005 95.67 50.13 41.10 35.96 exhausted but the situation may be of government controls. These Portfolio 2006 16.94 18.28 28.83 entirely different for India, where stocks look cheap, but it’s unlike- Sensex 2006 15.19 19.81 14.92 growth in those segments may be ly the situation will correct itself Portfolio 2007 31.938 34.809 just picking up. unless the government steps in. Sensex 2007 18.82 14.69 8 The ideal environment for the Gra- 8 Again, one of the gripes against 468 47 Outlook PROFIT 13 June 2008 Cover Story

always cheap – and they deserve to DOGS OF THE NIFTY could run the risk of deterioration in folio requires going after little-known be so – there are others that deserve Portfolio of top 10 dividend yield stocks business. Candidates in the out-of-fa- or desired stocks. We all know what superior valuations. A classic exam- vour category now include commod- kinds of stocks are thrown up on these ple, says Subramanian, is Infosys YEAR 1 yr 2 yr ity companies which look incredibly screens, but it requires nerves of steel Technologies. “Earlier on we made Portfolio 1998 -14.68 27.71 cheap but may be vulnerable to an and guts to buy these stocks. Why? this mistake of trading Infosys for Sensex 1998 -17.00 7.82 earnings decline if the cycle turns for For one thing, you may not have heard cheaper software companies. Only Portfolio 1999 145.80 40.83 the worse. One way to assess these about most of them. For another, most later did we realise that in some companies may be to look at average of these stocks will be drenched in pes- Sensex 1999 40.05 2.87 companies, the premium was be- earnings for the past fi ve years or more simism, so most investors will be re- cause of the difference the manage- Portfolio 2000 10.53 26.90 to remove the effect of cyclicality. luctant to invest in them. ment can make. It is not captured in Sensex 2000 -24.44 -15.34 Professor Bakshi says one way to look Indeed, the reason value investing current earnings but it can make a Portfolio 2001 65.29 33.08 at cash bargains is to identify compa- is so diffi cult is because it may feel difference in the long haul.” Sensex 2001 -5.14 -8.29 nies with fairly certain cash fl ows and completely foolish for a while. “But not focus as much on ab- true value investors PICKING WINNERS Portfolio 2002 4.64 90.51 solute cash levels. Since are not worried about Finding the catalyst: Buying cheap is Sensex 2002 -11.33 30.16 companies with regular “If you buy stocks looking foolish as long a great idea but the biggest challenge Portfolio 2003 198.09 77.03 cash fl ows will soon turn based strictly as they’re certain they in Graham-style investing is fi guring Sensex 2003 91.06 44.20 into a treasure-chest of haven’t acted foolishly,” out the trigger that will unlock value cash, they could be viewed on traditional remarks Bakshi. in the stock. While a margin of safety Portfolio 2004 11.64 41.06 as cash bargains, he says. value investment Yet impressions mat- is important, it is essential to look at Sensex 2004 8.83 45.93 The problem with look- principles, you ter to a large swathe the probability of getting that trans- Portfolio 2005 83.05 33.90 ing at future cash fl ows, will only play of investors. So even lated into returns. “Sometimes, the Sensex 2005 95.67 50.13 as Graham also explained, if back-testing comes catalysts could be growth itself,” says is that it requires a judge- the arbitrage up with sparkling re- Portfolio 2006 -4.25 11.70 professor Bakshi. If the stock trades ment of the future and opportunity, sults, it’s still diffi cult at a multiple of four times or so, and Sensex 2006 15.19 19.81 those projections can dif- but the bigger for many to go ahead earnings are still growing, your total Portfolio 2007 32.65 NA fer from person to person. opportunity in a and take the plunge. returns could be very attractive since Sensex 2007 18.82 Nevertheless, since stocks “The reason value in- you can pocket a dividend yield, a price are now no longer avail- country like ours vesting is not popular is appreciation equal to the earnings able at high discounts as in lies in the future because people do not growth and see a potential re-rating of prises. There are risks to such a strat- Graham’s time, “we can’t as the business have the patience to go the stock as well. In addition, a poten- egy though. The lack of transparency ignore the value of future through these dull and tial buy-back by a proactive manage- in dealings between group companies cash fl ows while looking at grows.” boring ideas,” says Mo- ment, special dividends, or open offers and the vested interests of promoters valuations,” says Bakshi. tilal’s Agarwal. arising from potential take-over bids can sometimes erode value in such While Graham’s solution Another reason why act as catalysts as well. stocks. for minimising the risk of bankrupt- most investors get bludgeoned with Despite the deep value some hold- “Unless you know that the inter- cies and frauds was diversifi cation, their stock picks is that they don’t al- ing companies harbour, there are ests of the promoters are aligned with looking at divergences in cash fl ows ways follow the rules and resort to gut few takers for such stocks simply be- those of minority shareholders, there is and earnings in recent years (not just feel or judgement, which frequently cause there are no obvious triggers no point in touching such stocks,” says quarters) can also be effective in spot- goes wrong. “As humans, we do get in sight. But Bakshi says there is one Templeton’s Subramanian. ting the warning signs. “Instead of carried away. A strict Graham strat- way to play these stocks. The cata- Then again, the famous law of aver- looking at accounts statements for just egy would involve selling stocks pe- lyst, he says, could potentially come ages or ‘reversion to the mean’ could a year, we should look at the aggregate riodically, in fact mechanically,” adds in the form of a turn in the business help a stock run the distance. Instanc- picture for fi ve years, which will offer Agrawal. of an underlying subsidiary. Usually, es of over-reactions to one-off situa- clues to the true picture,” says Bakshi. Another fact that Graham followers when business turns, the perceived tions could be good Graham picks. Among companies that are capital in- need to accept is that they will rarely K N Siva Subramanian value of the holding company im- But investors really need to be able to tensive, it is a worthwhile strategy to make extraordinary returns. On the VP, Franklin Templeton Mutual Fund, has an proves and results in a fall in its dis- judge the situation correctly to make search for those that have a high return other hand, they will rarely lose mon- enviable long-term track record count to intrinsic worth. The perceived sure that what they think is a one-off on equity and low price-to-book value. ey. It’s important to be comfortable value in the company improves as really is just that. As Motilal’s Agarwal puts it: “Value in- with the fact that sometimes, they will a consequence. Take the recent forex losses by some vestors are balance-sheet analysts and miss new growth opportunities – but A case in point is Nalwa Sons. companies, for instance. Buying bank regular market analysts are P&L ana- not giving in to such temptations can Graham’s strategy is that frequently The stock was available at a 75 per stocks just because forex losses came lysts. Value investors buy assets cheap ensure a safer ride. the list of worthy buys is made up of cent discount to its intrinsic value in much lower than expected is defi - and ahead of the market recognising True, there are those who have been obscure stocks on which there is lit- but as group company JSW Steel nitely not a wise call. At this point in a turnaround.” Thus, instead of look- enormously successful by follow- tle public information. The reported (Nalwa holds 45 lakh shares) got re- time, it’s still uncertain if the prob- ing only at operating and net margins, ing growth investing techniques. But earnings are thus suspect and the rated for the better, the discount lem could strike again. It may not be it is perhaps smarter to look at long- these investors, it has to be acknowl- chance of being duped, quite high. contracted to 16 per cent of Nalwa’s a one-off situation as some experts are term returns ratios. With companies edged, are extraordinarily smart and So following the rule always is never intrinsic value. claiming. After all, as professor Bakshi operating in cyclical industries, stocks have learnt to be at the right place easy. Experts say the way to view such rightly points out, there is never just should be picked up when the industry at the right time. Very few ordinary companies is by taking a call on how one cockroach in the kitchen. is down in the dumps. investors can aspire to be successful 8And fi nally, there is the operating business of the subsid- Talking of out-of favour stocks, in- that way. an anti-thesis to Gra- iary will fare in the long haul. For investors need to careful when they’re INTELLIGENT INVESTING The relentless pressure of keeping up ham’s philosophy. stance, if cement is expected to do dealing with downturns. It cannot be denied that Graham’s with the Joneses and the need to boast Pretty much like well over the next fi ve years, it would Again, the problem with some com- strategy demands enormous psycho- about the latest stock picks at a party is the fact that some make a lot of sense to put money in panies whose names pop up as good logical strength and will-power. That’s what investors need to overcome to be- companies are holding companies of cement enter- earnings yield candidates is that they because building a Graham-style port- come really successful investors. p 48 49 Outlook PROFIT 31 January 2008 13 June 2008 Outlook PROFIT Cover Story