A beginner's guide to value investing

What is value investing?

Value investing is a strategy employed by investors to buy stocks at a price below their intrinsic value and sell them when the market price is equal to the intrinsic value. Intrinsic value is calculated on the basis of a fundamental analysis that takes into account qualitative factors (market conditions, regulatory environment) and quantitative factors (financial ratios). This medium of investing, however, contravenes the established tenets of security analysis. Studies have found that value investing fares much better than growth investing in volatile markets. Value stocks without a higher degree of risk have been found to perform better than growth stocks. This adds substance to the claim that value investing is a departure from customary security analysis.

Finding undervalued stocks

There is no guarantee of success in the realm of stock investing as the dynamics flanking the market (such as poor information) can knock your portfolio strategy off-course. But there is always an avenue for effective estimation and guesswork.

Finding undervalued stocks is one such exercise. Looking at the price to earnings ratio (P/E) and its growth is a good start. A growth rate of less than 1 may indicate a potentially undervalued stock. Such stocks tend to have a lower P/E compared to the industry average. Stocks with low P/E are eligible candidates, but low P/E may also signal that growth trajectory of stocks is going downward; therefore it is advisable to investigate further. High dividend yields and a high book to market value ratio may also indicate undervaluation.

It is also important to complement your quantitative analysis with a qualitative analysis. A thorough qualitative analysis will entail the consideration of the firm's competitive advantage, its target market, its ability to influence prices, its products and its market share.

Reazuddin Ahmed, Executive, Institutions and Foreign Trade, LankaBangla Securities says, “The most important thing to assess is the industry growth rate; it is also important that investors take into account the goodwill of the company, the transparency of its financial reporting, the quality of corporate governance and the industry growth rate.” These factors should then be used to calculate future cash flows of a particular stock, the sum of which will decide the intrinsic value.

If the intrinsic value exceeds the current market price of the stock by a certain percentage (margin of safety) then the stock is deemed to be undervalued. Also, one can calculate expected earnings per share (eps), which if higher than the current eps, that also indicates a potentially undervalued stock. Again if expected P/E is higher than current P/E, the stock can also be considered undervalued.

Now an average investor may not be able to compute such tedious calculations but then again some basic knowledge of finance, understanding of the industries and a little bit of intuition can go a long way.

Value investing requires patience

It takes time for stocks to reach their intrinsic value. In the short term, stocks may be undervalued due to a plethora of factors – the company is performing poorly but is operating in a very lucrative market; insiders can drive down prices via selling; external forces such as political instability may also bog down share prices. Reazuddin Ahmed adds, “The market itself may be in a bearish mode, i.e. selling pressure is high hence prices fall.” Gradually over time, stocks of companies with strong governance, a coherent strategy and robust goodwill will prevail in the long run and attract the attention of investors, forging a wave of demand for the stocks.

The scenario in Bangladesh

Reazuddin explains since investors in Bangladesh are hungry for short term profit, value investing does not have a strong foothold. Value Investing requires a lot of analysis in which retail investors in our country are not well versed. In Bangladesh, mostly institutional investors engage in short term investing. The stocks of banks in Bangladesh are largely undervalued. Naivety on part of the investors is major reason behind this undervaluation.

Value investing can reduce volatility in the market as value investors won't be fazed by short term profits. In the long run, investors can earn a handsome sum. Reazuddin adds, “If value investing gains traction, it will attract innovative local companies to launch IPOs.” He goes on to say, “Market asymmetries will be reduced hence undervalued stocks will be priced properly and the increased stability will lead to augmented trading growth. This in turn will infuse liquidity in the market.” A dose of innovation in the economy can create employment opportunities and turn Bangladesh into a cradle of creativity.