Understanding Value Investing: A Guide to IPOs and More

Investors are often confused between “value investing” and value stocks … let’s clarify.

First let's understand the three categories of stocks - Growth, Value, and Core (AKA, growth at a reasonable price)

1. Growth Stocks

Growth stocks are generally stocks of those companies whose earnings are growing at a fast pace, typically faster than the market. These companies demonstrate the ability to grow at above-market rate for the foreseeable future, and typically reinvest earnings to generate further growth.

a. Naturally, everyone wants to own companies like these. But growth comes at a price. These companies don’t trade cheaply. Fast-growing companies tend to trade at higher price multiples. The P/E (Price to Earnings), P/B (Price to Book), P/S (Price to Sales) multiples of these companies are generally high vis-a-vis the market average.

b. A few examples of growth companies in today's environment are HDFC Bank, Bajaj Finance, Nestle, and D-mart.

c. Advantages of growth stocks - Stock prices typically follow earnings. If earnings are growing fast, stock prices should follow suit.

d. Disadvantages of growth stocks - These stocks are not cheap and they trade at a premium - at high valuations.

e. Risks with growth stocks - The market is paying a premium for higher future expected earnings growth. If these companies don’t live up to their growth expectations, stock prices can quickly correct.

2. Value Stocks

These stocks/companies have low prices which could be for many reasons - either sector-related or short-term hiccup-related.

a. Value stocks typically have low P/E (Price-to-Earning) and low P/B (Price-to-Book). The markets don't give these companies a premium because these companies are not expected to grow at or faster than the market in the foreseeable future.

b. A few examples of value companies in today's environment are ITC, ONGC, and SBI.

c. Advantages of value stocks - The biggest advantage is their low stock price. Anyone who is price sensitive may find these stocks attractive.

d. Disadvantages of value stocks - Caveat Emptor. Let the buyer beware that the price of a stock may not appreciate as expected. Stocks don’t trade cheap without a reason/rationale. The market does not have high expectations of the company’s earnings.

e. Risks to value style stocks - Stock price may not appreciate as expected.

3. Core Stocks

Also Known As “Growth at Reasonable Price” (GARP)

a. Growth stocks have the potential for high earnings growth and, generally, these companies trade at a premium. Value stocks trade low and these companies may have low immediate earnings growth. Core stocks, meantime, combine the basic premises of growth stocks and value stocks. Core stocks are stocks of companies that generally have consistent earnings growth but don't trade at a premium.

Now that we have explained ‘Value stocks’ as one among the three main categories of stocks: Value, Growth, and Core, let's get into the details.

Large, mid, and small-cap stocks have clear categorizations defined by SEBI based on market capitalization. The top 100 stocks are considered large-cap stocks. The next 150 stocks (101 to 150) are called mid-cap stocks and the next 250 stocks (251 to 500) are considered small-caps. However, when it comes to growth and value stocks, there is no clear demarcation or definition. This also lends to the air of confusion between value stocks and value investing.

What really is Value Investing?

As we know, “beauty lies in the eyes of the beholder”. Value often lies in the eyes (or the excel spreadsheet) of an investor!

Value Investing

Let's start with a simple problem.

Let’s say there is a machine available in the market for Rs 1 lakh. This machine will help you cut your overall cost by Rs 20,000 per year. The life of one machine is 3 years. Should you buy this machine?

Clearly, no. Simple math: In three years, you save Rs 60,000. Why on earth would you pay Rs 1 lakh?

Today, Google will tell you the price of a stock in a nanosecond. But is that it’s value? The price of a stock is easy to determine; value, not so easy to figure out.

One can determine the value of a company by deep-diving into the company’s business - it’s past, it’s present and extrapolating its future. Valuation is a science, and at the same time, it’s also an art because one has to imagine the future and make assumptions.

One way to value an asset is by discounting future cash flows to today. This is called intrinsic price. However, no two investors will arrive at the same intrinsic price as both investors will have different assumptions and different take on the company’s future prospects.

A Value Investor buys companies where: Intrinsic Price > Market Price of the stock. If there is a positive difference between intrinsic price and market price, then it’s a good buy for value investors.

One of the biggest advantages of investing in “VALUE” companies is high margin of safety. How?

1. The chances of permanent losses are slim as the current price of a stock is much lower than its intrinsic price.

2. There is enough scope for error. The future is uncertain; even if there are unforeseen events, there is enough safety in the purchase price.

A value investor doesn’t look at a consensus to determine value and focuses on the intrinsic price vs the market price. As long as the intrinsic price is significantly higher than the market price, the value investor is happy to hold the stock.

Apple stock might not fit in a definition of a value stock because of its high P/E ratio, but Warren Buffett, who is considered a doyen of value investing, has Apple as his top pick. Warren Buffett sees value in Apple, where he finds the intrinsic value of Apple to be far higher than its current market price.