To a layman, when you mention the word ‘finance’ most of the times one thinks of stock markets. One may not know how to go about making money in the markets but one certainly finds it thrilling to see the ups and downs of Sensex and Nifty. So, what is so fascinating about the stock markets? Let’s understand the basic purpose of stock markets first. For a company that wants to grow, they find it cheaper to list themselves and go public than borrow money through debentures and bonds where they have to pay a certain amount as fixed interest every year. If they want to expand and their future cash flows from a certain project will take time to yield, they go public and raise money from the capital markets wherein the decision to pay or not to pay dividend to the equity holders is in their hands. While the equity holders do enjoy voting rights, how many of them actually attend AGMs these days? Very few.
Whereas for the investors, they generally look to invest to earn a little extra money apart from their steady income. They look for a return higher than what term deposits or fixed deposits have to offer, over and above the current inflation levels in the country too. Currently in India, a term deposit of over a year gives 6-6.75% per annum as returns and Sensex and Nifty gave a return of approximately 28% in 2017. Hence, investment in capital markets seem attractive. One must also remember though, that higher returns are also riskier. This is where value investing as a strategy is helpful.
Before diving into value investing, it is essential to understand the difference between an investor and trader. A trader is a person who makes money but investing for short term with a goal to buy at a lower price and sell at a higher price. He is only concerned about his short-term profit. An investor on the other hand looks for wealth creation. An Investor uses the Value Investing strategy, wherein he or she spots a company which is trading at a price lower than its intrinsic value. A value investor looks optimistically at these companies and hopes to make money when eventually the price surges to match the actual potential of the company. The father of value investing Benjamin Graham rightly said “Price is what you pay, value is what you get”.
So, how do investors go about value investing? Investors study and analyse the company well. They use the method of fundamental analysis wherein they learn more about the intentions of the management, business model of the company, look at previous years financial statements and then value the company. They also consider the industry scenario and macro-economic conditions of the country.
Intentions of the management can be found out by simply learning more about the promoters, company history, reading the management discussion in the annual report. Business model can be studied by doing extensive research and even speaking to some of the employees of the company if need be. Financial statements of listed companies are available on their websites for one to analyse and fathom the financial health of the company. Lastly, for valuations different methods are used such as Discounted Cash Flow Analysis (DCF), Relative Pricing, Net Asset Value method to name a few.
The downside of value investing is that it is a time-consuming process. The price of the company may take years to catch up to its true potential. An investor must have patience and conviction for the same. One must also understand that markets are not always rational. Its main participants are people and a lot of them make decisions based on emotions. Certain behavioural biases one must look out for are herd mentality-where some investors follow choices of other investors, Loss-aversion bias-wherein we prefer to avoid losses to making gains and this fear may lead to inaction, Anchoring-where we stick to the first piece of information we got while making the decision which may no longer be relevant. As Warren Buffett aptly said, “It is only when you combine sound intellect with emotional discipline that you get rational behaviour.” One must keep that in mind and not get influenced.
As for value investing, keeping the goal of wealth creation in mind, it is a sound approach compared to short term trading. “Thousands of people have tried, and the evidence is clear: The more you trade, the less you keep.” – Benjamin Graham.