While selecting stocks, pay attention to companies with strong fundamentals that are trading at low valuations currently due to business mix and Covid-19 led disruptions
All investors should understand that the money they pay today to buy a share is not for its past performance but always for its future performance.
There are two values assigned to an equity share traded in a regulated stock market. One is the market value and the other is the intrinsic value. Intrinsic value is nothing but the expected cash flows from the security discounted at an appropriate discount rate.
Stock selection based on the intrinsic value is known as value investing. This concept was originally proposed by Benjamin Graham and later followed by many, including Warren Buffet and others. Let us discuss whether value stock picking strategy works in the current market trend.
Ideal time for value investing The Covid-19 pandemic followed by a series of lockdowns has disrupted many industries and a significant number of companies are suffering as both top line and bottom line are affected. However, investors should look beyond the current scenario and pick companies that will emerge stronger once when the pandemic is over. Thus, one should identify such kinds of companies that are currently undervalued compared to their fair value / intrinsic value. We saw BSE Sensex hit a three-year low on March 23, 2020, closing at 25,981. After about three months, it was at 38,435, up by almost 50%.
Are markets overbought? We often see reports stating that markets are overvalued. In such a situation, investors should approach the market with the ‘bottom-up’ stock selection strategy where one should look out for shares which are available at a fair valuation. In this case, investors should consider broader markets and consider sectors shares in sectors such as FMCG, power, auto, steel, etc. and compare the same with their historical P/E multiple and take a call. Many companies in the above sectors have their businesses across the globe. While doing stock selection, investors should pay attention to companies with strong fundamentals that are trading at low valuations currently due to business mix and Covid-19 led disruptions. Once the situation stabilises and demand picks up, these shares gain attention from the market and other investors. So, investors may start accumulating shares that have the above characteristics and fall within the segment as discussed above.
Always keep an eye on the future All investors should understand that the money they pay today to buy a share is not for its past performance but always for its future performance. However, today, most of the investors are looking for a higher but quick return in a volatile market. A large numbers of retail investors including millennials and people who have lost their jobs owing to this pandemic, have no patience to wait it out in the current market scenario. Thus, they tend to neglect basic valuation philosophies and end up losing their hard-earned money. Even if you follow value investing, look at the future of the companies wherein you are investing.
To conclude, in the current market built around weak economic fundamentals, it is essential for investors to adopt value stock selection strategy and avoid companies with huge debts on their balance sheet or high percentage of promoter shares pledged in spite of their low valuations and high volumes in the market.
FINDING VALUE In the current market built around weak economic fundamentals, investors must adopt value stock selection strategy
Identify companies that are currently undervalued compared to their fair value / intrinsic value
Avoid companies with huge debts or high percentage of promoter shares pledged in spite of their low valuations and high trading volumes
Consider sectors such as FMCG, power, auto and steel, and compare the stocks with their historical P/E multiple and then take a call
The writer is a professor of finance & accounting, IIM Tiruchirappalli