Identifying value in stocks

The stock market is dancing to the value tune these days. But what is it really?

For the better part of 2013, investors were ignoring traditional valuation indicators and going for companies with a great revenue potential or where the market opportunity seemed huge. However, in the fourth quarter of 2013, stocks that were beaten down and slow-growing started making a splashing comeback.

Take Bharat Heavy Electricals Ltd (BHEL), for instance. Since the beginning of 2103, the stock lost 55 per cent till August as investors sought out other growth opportunities. While ITC and Hindustan Unilever were expanding their price-to-earnings (PE) ratio, BHEL's PE began sliding and at one point, dipped below five times earnings in August 2013, when its stock hit a low of Rs 100. That was a nine-year low for the engineering giant.

Value seekers soon began spotting an opportunity in BHEL and started buying the stock. Its PE has gradually expanded and investors who bought at that price are now sitting on gains of nearly 83 per cent, as this debt-free company is currently quoting Rs 183.70. Why did investors suddenly spot an opportunity here?

Engineering, construction, mining and metal companies were seriously out of favour last year. However, most are bouncing back as investors and fund managers seek more value from the market. A slowing economy and sluggish order books has seen most of these stocks tumble to a lower single-digit PE ratio.

Real value or relative value
At the same time, there are stocks quoting at a very high PE ratio. While some people see value in BHEL, others see it in Just Dial. The Just Dial stock, quoting at Rs 1,603, is surging forward, even at a trailing PE of 103. That seems a sky-high price to pay by traditional valuation yardsticks. So, what are they seeing in the stock?

Experts say valuation parameters depend on the type of sector and the outlook for growth. "When people have higher expectations of growth, if that materialises, then some high PE stocks will appear at normal valuations after a few years," says Rikesh Parikh, vice-president (equities) at Motilal Oswal. "Valuation is relative and depends on the industry in which they operate."

Experts also say one should not confuse a value stock with a growth one. Among the most crucial yardsticks used by investors such as Warren Buffett are discounting of future cash flows and assessing its price relative to earnings potential.

Value seekers argue that even if for some reason the earnings potential remains sluggish, one should not be paying too high a price for a stock. Even as the stock market has hit an all-time high, value stocks continue to remain among the ones sought. Experts still find value in this market. Says S Naren, chief investment officer at ICICI Prudential Mutual Fund, "Despite the rising market, there is a lot of value still available in the broader market away from information technology, fast-moving consumer goods and pharmacheuticals."

Spotting deep value
Another question to ask - what is the cash flow a business is expected to generate? If that is significantly higher than the market's expectations, investors could justify paying a higher price for the stock. The only problem is if the flows don't materialise, the stock crash might be severe for high PE companies.

Going by the book and the traditional definition of value, it's all about buying stocks at a low PE and steady earnings growth. While a growth stock with be available at a higher PE, a value stock is usually available at lower PE. With steady earnings that can compound over time, value investing usually provides material gains over long periods of time, with relative safety and lower risk in the short term.

Usually, stocks at the value end of the spectrum have a lower PE and, therefore, the risks associated with these are lower. Investors also consider other things such as price-to-book value and dividend yield when looking for value stock. For instance, if the dividend yield is high, say five to six per cent, the stocks usually fall in the value basket.

Says Sumeet Nagar, managing director, Malabar Investments: "Price-to-book value can be misleading sometimes. For example, if a company has bought real estate years ago, its value is usually at low levels in its books."

Experts also say investors should watch for dividend yields. A fairly consistent and high dividend paying company can be available at low prices. Another indicator to watch is debt. Experts say if a company has too much leverage, it effects its ability to grow. Cash generated goes into paying interest. Says Nagar: "Some companies are going at very low prices because of heavy debt. Investors should watch the debt levels."

Falling share prices and valuations make it easier for investors to select value stocks. Fund managers like to buy these companies when they are abandoned and neglected by the markets. At present, the capital goods space and public-sector banks are among those in the value space.

One caveat: Experts say value investing requires patience. Sometimes, stocks could take a long time to be discovered by the markets but once discovered, can run up to fair value pretty quickly.

Why a particular stock value?

There must be a reason why a particular stock is so valued. A fund manager should be able to tell why a stock price has fallen and why earnings potential remains intact. And why the value has not been discovered by the market

Whether a fund manager had the stock three years earlier?

Value stocks can outgrow and become growth stocks or their price-earnings multiple could expand. If a fund was value three years ago, it must have a compelling reason why it is still value. It will also show how the stock revenues has fared the past three years.

What could make you change your views?

Fund managers should hold a view at what price a stock could cease to be value, when the value of a stock gets unlocked, or its fair price or when the market conditions have changed.