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                                 COUNT ON THE




 Times have changed since Benjamin Graham wrote the Security Analysis but
          his principles can hold investors in good stead even now
                                    N Mahalakshmi & Mohammed Ekramul Haque



I
    t cannot be denied that the Great      safety’, allowing for any contraction in    grabbed the attention of several pro-
    Depression of 1929 and the Wall        prices, were his key bets.                  fessional investors, many of who have
    Street crash that followed was per-      His strategy soon started being talk-     added their own perspectives over the
    haps the most humbling experi-         ed about in the investing community.        following decades. Nevertheless, the
ence for investors at the time. Life was   One man, in particular, was highly in-      basic essence of value investing has
tough and there was no hope to clutch      fluenced by Graham’s strategy, and           remained the same: buy cheap.
on to. After crushing losses, most         in tribute to his ‘idol’, bought shares       It was a philosophy that was born
stocks were available at ridiculously      in about a hundred such cheap com-          in desperate times (the Depression
cheap prices over the next decade as       panies. His faith soon paid off: in five     years), and underwent a baptism by
the markets remained trapped in a          years, John Templeton – whose name          fire as it was tested time and again over
bear grip.                                 today is synonymous with value              the next few years.
  But as any stock expert will tell you    investing – had multiplied his                So it wouldn’t be wrong to wonder
today, behind every market disaster        original investment several times,          just a little bit whether those princi-
lurks opportunity – if you just look       despite around 15 of those companies        ples still work in today’s times, given
hard enough. It was the same for Ben-      going bankrupt.                             that the past few years have been ex-
jamin Graham, who, despite suffering         The value investing philosophy pro-       ceptionally exuberant for the world’s
heavy financial losses himself, began       pounded by Graham and practised             major stock markets.
a conscious campaign of snapping up        vigorously by Sir John Templeton was          Cut to January 2008. In sharp con-
stocks that suddenly became available      eventually perfected into an investing      trast to the crisis engulfing the stock
at bargain prices.                         technique that called on investors to       markets when Graham started out, the
  Graham’ strategy was simple: buy         buy stocks cheap – so cheap that there      world’s economies – India’s included
companies that he likened to cigar         was very little chance of the stock fall-   – were exuding confidence like never
butts – typically abandoned but still      ing any further (thus avoiding any loss     before. Many experts claimed that In-
good for a puff or two. And you could      of capital).                                dian financial markets were experi-
pick them up for virtually nothing.          After Graham articulated his              encing a secular bull run, not a cyclical
Stocks quoting below their liquida-        thoughts on the subject in the book Se-     upswing that would die down anytime
tion values after keeping a ‘margin of     curity Analysis in 1934, value investing    soon.

                                                                                                                                   41
                                                                                                    13 June 2008 Outlook PROFIT
        Cover Story
                                                                                                     as bits of bad news kept leaking out
                         HOW WE DID THE BACK-TESTING                                                 at a steady pace. Investors who had
                                                The universe                                         bought stocks at steep valuations now
                                                                                                     began to understand just how foolish
       Earnings yield portfolio: A portfolio of 30 stocks with the highest earnings yields, the
                                                                                                     their actions were, not to mention the
        minimum cut-off being double the bond rate for the respective year, from the BSE-            speculators who had joined in for the
         500 universe, excluding financials, with a debt-equity of less than 1. For years that       free ride.
                    threw up less that 30 stocks, we went with the available stocks.                   Value investors had seen this coming
                                                                                                     all along. At a lecture in India on Janu-
       Net-nets & cash bargains: All listed companies with a trading history of more than 90
                                                                                                     ary 8, Bruce Greenwald, renowned fi-
        per cent excluding financials was taken as the universe. We calculated net-nets by           nance professor at Columbia Business
       deducting debt and current liabilities from current assets. The 30 or available stocks        School, referred to stocks markets as
          for the respective years with market-cap less than net currents were considered            ‘being expensive’. At the time, stocks
                                                                                                     were actually peaking out. Greenwald
          for the portfolio each year. Companies with cash and marketable securities less            teaches the ‘Graham and Dodd’ style
           all external liabilities greater than the market-cap constituted the cash bargain         of investing in the university Graham
                                      portfolio for the respective years.                            graduated from.
         Dogs of the Nifty: Top 10 stocks based on dividend yield at the end of every year.            Value investing is not about predict-
                                                                                                     ing when markets will hit their peaks.
                                                 The returns                                         Graham (and today’s value investors
            We computed total returns (price appreciation plus dividend income) for the              agree) emphasised the preservation
           portfolio constituted every year and with a holding period of 1-10 years for the          of capital as the bedrock of investing.
       period 1998-2008. For dogs of the Nifty we tested results only for a two-year holding         “The beauty is, as Graham said, any-
                                                                                                     thing bought cheap will invariably go
       period. In the case of a stock getting delisted or stopped trading, we considered the         up in price,” says Chetan Parikh, a
        stock to have lost 100 per cent in the year in which the stock disappeared from the          successful Indian value investor and
                        portfolio. All data has been sourced from CMIE Prowess.                      managing director of Mumbai-based
                                                                                                     Jeetay Investments.
                                                                                                       There is one difference though.
       Besides, stock prices were catapult-          covering almost immediately after               What Graham considered bargains
     ing and there was what seemed like a            every tumble.                                   and what today’s value investors con-
     never-ending flood of foreign money                And investors continued to buy into           sider as cheap (and we are not talking
     pouring in. For five straight years till         stocks, whatever the price.                     about growth-style investors who do
     January this year, the Sensex proved              Then, the inevitable happened. Glob-          not mind paying a high premium for
     the sceptics wrong at every level as it         al markets nosedived and over the               stellar growth prospects) are separated
     rapidly scaled new all-time highs, re-          next few months, continued to plunge            by time.

     CASH BARGAINS PORTFOLIO
     Portfolio consists of stocks with cash and marketable securities greater than market cap
                         year          1 yr       2 yr     3 yr       4 yr       5 yr    6 yr      7 yr     8 yr     9 yr    10 yr     Latest
     Portfolio          1998          56.30      13.47   -45.88     -22.24    -12.96     2.03      5.98    15.41    10.65     8.68       8.42
     Sensex             1998         -17.00       7.82    -4.23      -4.46     -5.88     5.91      6.32    14.75    14.80    15.74      14.78
     Portfolio          1999        196.20      -25.04   -15.97     -14.89      4.01    24.82     25.87    21.03    25.39               26.24
     Sensex             1999          40.05       2.87     0.12      -2.87     11.20    10.80     20.18    19.55    20.10               18.92
     Portfolio          2000         -45.69     -37.70    -3.11       6.55     19.24    19.65     18.05    29.14                        28.81
     Sensex             2000         -24.44     -15.34   -14.03       4.97      5.73    17.15     16.87    17.81                        16.56
     Portfolio          2001         -13.43      -3.30    31.75      53.64     66.82    63.88     74.19                                 77.32
     Sensex             2001          -5.14      -8.29    17.13      15.00     27.90    25.69     25.53                                 23.83
     Portfolio          2002          -2.98      39.67    73.51      86.98     76.96    84.35                                           84.91
     Sensex             2002         -11.33      30.16    22.62      37.82     32.96    31.53                                           29.30
     Portfolio          2003          66.00    109.10    105.99      69.22   55.70%                                                     57.67
     Sensex             2003          91.06      44.20    59.64      47.14     42.33                                                    39.09
     Portfolio          2004        169.39     120.53     92.65      49.22                                                              51.58
     Sensex             2004           8.83      45.93    34.87      32.23                                                              28.88
     Portfolio          2005          76.22      40.86    61.42                                                                         66.43
     Sensex             2005          95.67      50.13    41.10                                                                         35.96
     Portfolio          2006          58.50      28.62                                                                                  56.86
     Sensex             2006          15.19      19.81                                                                                  14.92
     Portfolio          2007          53.67                                                                                             37.15
     Sensex             2007          18.82                                                                                             18.82
     Returns for 2007 portfolio until May 27, 2008

42
     Outlook PROFIT 13 June 2008
  The world has changed in many
ways. And the way business is done
has changed appreciably. In the past
century, while industrialisation was
still underway, manufacturing was the
mainstay of business and companies
were largely asset-heavy.
  Today’s businesses are more ser-
vice-led and asset-light. Even the
landscapes for accounting practices,
securities regulations and sharehold-
ing patterns are dramatically differ-
ent. Graham’s success was also in part
because he had the luxury of buying
businesses that were truly ‘cigar butts’
because of the state of the economy at
the time.
  Is Graham’s philosophy still stay rel-
evant in the changed times, (one of
optimism, although recent data does
point to a slowdown) compared with
the gloom that the Father of Financial
Analysis was witness to? Outlook Prof-
it sought answers for this by relying
two factors: data, because data does
not lie; and people who have been un-
adulterated value investors.
  Before we disclose the results
(please wait patiently – being patient
is the first rule in value investing!), we
present a quick look at Graham’s
various strategies.

THE PHILOSOPHY
Graham’s investment radar mainly
flashed stocks that could be classified
as bargains based on earnings poten-
tial or asset values.
  The key earnings-based strategy that
most lay investors can easily adopt in-
volves buying stocks that offer a sub-
stantial earnings yield, typically, twice
the prevailing bond rate.
  The earnings yield is the reverse of
the price-earnings multiple. The logic
is simple: if you view stocks as bonds      Sanjay Bakshi , CEO,
that offer no growth but yield fixed re-     Tactica Capital is a deep-value investor
turns (consider profits as a proxy for in-
terest earned) then the asset should be
valued like a bond. If the earnings yield
is twice the bond yield, it means that      stantial discount to the company’s as-
the asset actually promises to double       set value (for businesses that boast
the returns you could get from hold-        good future prospects).
ing the bond. Given that the business         Another set of bargains includes
is profitable and will continue to be        stocks of companies quoting below
so, returns could be impressive as the      the value of marketable securities
yield in excess of the bond rate would      and cash on their books after deduct-
provide an adequate margin of safe-         ing outstanding debt. The logic here is
ty in the event of any capital erosion.     that the company can use its cash and
Another earnings-based strategy is be       securities to pay of its debt and other
to buy stocks that offer substantial        liabilities and still the shareholders
dividend yield.                             would have something in their hand.
  Asset-based strategies of Graham          At the heart of Graham’s philosophy
revolve around buying stocks that           lies the ability to favour what is out of
are quoting either below their liquida-     favour. Embrace the ugly, not the beau-
tion value (especially for businesses       tiful. Lift the disgraced and disregard-
that do not have a future) or at a sub-     ed. And it works!

                                                                                                      43
                                                                               PHOTOS: SANJIT KUNDU
        Cover Story
                                                                               ing the market temperature works
                                                                               beautifully as well. The proof of the
                                                                               pudding is in our study of stocks that
                                                                               were ultra-cheap in the past decade.
                                                                               Out of the 5,000-odd traded stocks at
                                                                               the peak of the IT bull run in 1999, 22
                                                                               stocks were trading below their liq-
                                                                               uidation values (current assets mi-
                                                                               nus current liabilities and debt). By
                                                                               contrast, when the markets plunged
                                                                               to their nadir in 2003, 132 stocks met
                                                                               these criteria.
                                                                               Nevertheless, some of the most suc-
                                                                               cessful value investors in the coun-
                                                                               try believe that some changes to
                                                                               Graham’s strategies may be required
                                                                               to make it more effective (although
                                                                               given that the back testing showed
                                                                               such good results, we wonder why?)

                                                                             MISSING OUT ON GROWTH?
                                                                             Focusing on the cheap stocks often
                                                                             means missing out on other opportuni-
                                                                             ties. Why? Because the market is usu-
                                                                             ally instantly enamoured by anything
                                                                             new that turns up in business until
                                                                             they find reason to think otherwise
                                                                             Remember the dot-com boom? Com-
                                                                             panies were awarded sky-high valu-
                                                                             ations before it dawned on investors
                                                                             that many business models were sim-
                                                                             ply unsustainable.
                                                                               However, the notion that you
                                                                             could be left behind if you don’t pay
                                                                             the price for growth is not entirely
                                                                             baseless. “If you buy stocks based
                                                                             strictly on traditional value invest-
                                                                             ment principles, you will only play the
                                                                             arbitrage opportunity (the differential
                                                                             between the fair price and the market
                                                                             price) but the bigger opportunity in a
                                                                             country like ours lies in the future as
                                                                             the business grows,” says K N Siva
                                                                             Subramanian, vice president at Frank-
                                                                             lin Templeton Mutual Fund. He’s con-
                                                                             sidered one of the best fund managers
                                                          Chetan Parikh,     of the past decade or so.
                                       MD, Jeetay Investments has been a       For sure, adopting a Graham approach
                                                committed value investor     would have encouraged investors to
                                                                             pass over new, emerging businesses
                                                                             that have given outstanding returns
                                                                             on the bourses: Infosys Technologies,
                                   8 Back-testing key Graham strate-         HDFC Bank, Pantaloon Retail; and Su-
                                     gies reveal a stunning performance.     zlon Energy to name just a few. None
                                     The strategy of picking up stocks       of these stocks would have qualified as
                                          that have earnings yields that     value stocks in the Graham sense ever.
                                            are twice as high as the bond      But you would have built an equally
                                             yield proved to be spot-on      stellar portfolio of stocks consisting of
                                              for investors. Returns on      Bharti Televentures and State Bank
                                               such a portfolio beat the     of India (at one time available signifi-
                                               Sensex every time! Cash       cantly below book value); public-sec-
                                               bargains and net-nets have    tor companies such as Bharat Earth
                                               worked with 70 per cent       Movers and BHEL and private-sector
                                                accuracy. (See table: Cash   companies such as Areva T&D, Penin-
                                                Bargains Portfolio)          sular land, Gujarat NRE Coke, Merca-
                                                                             tor Lines, Aban Offshore and even Jai
                                               8 Graham’s way of gaug-       Corp. All of them have rewarded inves-

44
     Outlook PROFIT 13 June 2008
tors with handsome dividends and cap-        an investment firm called Tactica would have liked.”
ital appreciation.                           Capital, which specialises in deep-         If wishes were horses, that would have
  Most of these names were ignored a         value-investing .                         been true! In today’s circumstances, it
few years ago either because business          Other experts echo the sentiment. is not easy to find stock that offer great
conditions were bad or the market sim-       Managing director of Motilal Oswal Se- growth prospects with the margin of
ply shrugged them off because there          curities Ramdeo Agarwal                                   safety embedded the
were alternative opportunities that          says an attractive purchase                               way Graham liked it.
were more alluring.                          price is key to making mon-     Graham’ strategy Most experts, however,
  “The market periodically gets into a       ey. “The moment you pay             was simple:           believe trying to com-
phase of madness when there is a fas-        a price for growth, where                                 bine a growth style and
cination for a few sectors and the oth-      is the outperformance?”
                                                                              buy companies            the rather contrarian
ers are completely forgotten,” says E A      he asks. “You are not deal-       that he likened         value-style technique
Sundaram, a fomer fund manager with          ing only with the company          to cigar butts         don’t mix very well.
HDFC Mutual Fund who now manages             here, you are dealing with           – typically            Still, the perception
funds for the Bilakhias. And it’s true:      the price of the stock. Peo-                              of value lies in the eyes
during the dot-com boom, remember            ple do not understand what       abandoned but of the investor. “The
how the old economy was forgotten? A         role the price plays.”             still good for         biggest contribution of
year ago, software service companies           The sceptics argue the           a puff or two.         Graham to the world
had joined the ranks of fallen angels. A     other side. “The Gra-             And you could           of finance was three
true Graham follower would, however,         ham model is geared to                                    words – margin of safe-
buy stocks precisely when there are no       finding cheap cigar butts,          pick them up           ty – and if you keep that
takers for them.                             but many such compa-                for virtually         in mind while invest-
  And what about growth? Graham              nies may have issues with        nothing. Stocks          ing you will seldom go
never believed in relying on the future,     their character itself,”          quoting below           awfully wrong,” says
so he would not pay a penny for growth.      says Bharat Shah of ASK                                   fund manager Sunda-
The difference between Graham fol-           Raymond        James     who     their liquidation ram.
lowers and the growth seekers is pri-        started out as a value inves-       values after
marily that the former are risk averse       tor but later changed track.         keeping a            THE CHALLENGES
(you can even call them miserly) and           “Cheapness can be an il-
don’t seek to pay a price for growth.        lusion. Just being cheap is
                                                                                                         Nevertheless,
                                                                             ‘margin of safety’ strategies that some       were
  “Value investors want growth               not good enough for me, it                                largely a product of
for free,” says Sanjay Bakshi, profes-       has to be supported by cap-                               circumstances        that
sor at Gurgaon’s Management Devel-           ital efficiency and confidence about prevailed during Graham’s time are
opment Institute. “And by doing so,          growth. While I like the cheapness that becoming less effective and riskier
they could well make errors of omission      Graham would have liked, I would also propositions. It’s easy to see the con-
but not of commission.” He also runs         like quality of business that Fisher tentions.

EARNINGS YIELD PORTFOLIO
Portfolios with earnings yield more than double the bond rate with a maximum of 30 stocks
                    year       1 yr       2 yr       3 yr      4 yr       5 yr     6 yr    7 yr    8 yr       9 yr    10 yr   Latest
Portfolio          1998       80.16      87.27     14.34     19.78        9.57    27.44   36.53   48.24      42.40    42.47    43.82
Sensex             1998      -17.00       7.82     -4.23     -4.46       -5.88     5.91    6.32   14.75      14.80    15.74    14.78
Portfolio          1999       45.50      43.48     35.46     28.85      55.97     69.76   74.15   65.24      64.93             67.84
Sensex             1999       40.05       2.87      0.12     -2.87      11.20     10.80   20.18   19.55      20.10             18.92
Portfolio          2000       39.06      49.09     36.37     70.69      82.05     91.31   79.16   75.19                        78.79
Sensex             2000      -24.44     -15.34    -14.03      4.97        5.73    17.15   16.87   17.81                        16.56
Portfolio          2001       88.92      46.61     89.10    109.55     112.85     95.99   95.21                                100.3
Sensex             2001       -5.14      -8.29     17.13     15.00      27.90     25.69   25.53                                23.83
Portfolio          2002       27.32    105.81     141.89    139.39     110.76    105.14                                        109.9
Sensex             2002      -11.33      30.16     22.62     37.82      32.96     31.53                                        29.30
Portfolio          2003     268.56     217.40     173.73    127.78     112.65                                                  118.7
Sensex             2003       91.06      44.20     59.64     47.14      42.33                                                  39.09
Portfolio          2004     289.12     220.77     134.53    118.07                                                             125.5
Sensex             2004        8.83      45.93     34.87     32.23                                                             28.88
Portfolio          2005     434.52     172.21     110.90                                                                       110.9
Sensex             2005       95.67      50.13     41.10                                                                       35.96
Portfolio          2006     119.92       79.41                                                                                 95.68
Sensex             2006       15.19      19.81                                                                                 14.92
Portfolio          2007       33.56                                                                                            33.56
Sensex             2007       14.69                                                                                            14.69
CAGR Returns      Note: 2007 based on latest sensex closing May 26, 2008

                                                                                                                                        45
                                                                                                          13 June 2008 Outlook PROFIT
        Cover Story
     8 The concept of book value and                    in and out of the company gate ev-                 tions. Indeed, some of the best-run
       whether it reflects the true worth                ery day; they’re not mentioned in the              companies in the world have a neg-
       of a company have undergone fun-                 balance-sheet though.                              ative working capital -- consumer
       damental changes over time. Book                 Similarly, the real value of consum-               companies like Hindustan Unilever,
       value was one of the prime pa-                   er companies lies in their brands                  Procter & Gamble and several oth-
       rameters Graham relied on since                  and distribution network, again not                ers actually have been operated with
       he preferred judging what was on                 quantified in the statement of ac-                  negative working capital for quite
       the balance-sheet to looking at un-              counts. “The balance-sheet does                    some time now.
       quantifiable parameters. In his time,             not capture the value of intangibles
       companies were asset-heavy and it                like brands, but they also have cash          8 Some Graham strategies like cash
       made sense to look at asset values.              flows attached to them,” points out                 bargains work well in mature mar-
       Not anymore. Today, the real value               Sundaram.                                          kets like the US because the share-
       of several business lies not in the                                                                 holding pattern is diffused, so a
       plant and machinery they own, but            8 Similarly, Graham’s idea of looking                  financial investor could identify situ-
       in more unquantifiable factors. Take              at net working capital requires re-                ations and act in a fashion that com-
       software services, for instance. In              thinking as well. The whole idea of                pels management to unlock value.
       this industry, the real assets are the           net-nets was to buy a company be-                  But in India, since promoters usual-
       technically skilled people who walk              low its working capital because if the             ly hold fairly large stakes and corpo-
                                                        market did not give the company the                rate raids are not that common, the
                                                        valuation it deserved, the promoter                probability of liquidation is rather
       NET NET DROPOUTS                                 could easily liquidate the company                 slim and dilutes the case for unlock-
       Companies that disappeared from the              by realising the receivables and cash,             ing value in such stocks.
       net-nets portfolio midway                        pay off payables and debt – and still              Besides, another risk with Graham’s
       year      1   2 3 4 5 6 7       8     9 10       take home some cash (by the way,                   cheap stocks is that while you can
                                                        we’re not even accounting for fixed                 buy a business at a lower price than
       1998            1   3 1 1             1          assets here). Obviously, Graham was                what it’s worth, you can never tell
       1999          1   3                              looking at what was truly dirt cheap               whether it will add or subtract value.
       2000            2   3                            (cigar butts).                                     Templeton’s Subramanian quotes a
       2001          2   1                              He would have rejected companies                   classic example: when Warren Buf-
                                                        with low net current assets outright.              fet bought Berkshire Hathaway, it
       2002            1
                                                        But, in today’s world, high working                was still a textiles company. And in-
       2003          4     1                            capital is taken as a sign of a deterio-           stead of continuing like that, Buffett
       2004              1                              rating competitive position. Higher                used the cash to build a business that
       2005            1                                receivables being built up; large dis-             offered growth.
       2006                                             counts to customers; larger collec-                 While buying cash bargains may a
                                                        tion periods – all these are actually              rewarding proposition for an activ-
       2007                                             signs of worsening business condi-                 ist investor who can take the reins

     GRAHAM’S NET NETS PORTFOLIO
     Portfolio of top 30 stocks trading below their net current asset values
                          Year        1 yr       2 yr      3 yr     4 yr     5 yr      6 yr         7 yr       8 yr     9 yr     10 yr     Latest
     Portfolio           1998       43.46       89.16      4.77    12.22     7.40     15.22        24.51      28.30    24.41     22.24      23.64
     Sensex              1998      -17.00        7.82     -4.23    -4.46    -5.88      5.91         6.32      14.75    14.80     15.74      14.78
     Portfolio           1999      220.43       -1.32     10.57     5.55    20.07     28.07        38.66      31.08    27.44                28.29
     Sensex              1999       40.05        2.87      0.12    -2.87    11.20     10.80        20.18      19.55    20.10                18.92
     Portfolio           2000      -30.22      -17.11      0.05    28.42    39.62     51.37        49.52      49.91                         52.94
     Sensex              2000      -24.44      -15.34    -14.03     4.97     5.73     17.15        16.87      17.81                         16.56
     Portfolio           2001       29.67       17.11     56.62    70.75    88.79     67.24        57.87                                    58.26
     Sensex              2001       -5.14       -8.29     17.13    15.00    27.90     25.69        25.53                                    23.83
     Portfolio           2002        1.86       44.03     70.12    85.30    70.52     72.13                                                 74.76
     Sensex              2002      -11.33       30.16     22.62    37.82    32.96     31.53                                                 29.30
     Portfolio           2003       91.19      102.59     84.42    66.92    68.32                                                           68.78
     Sensex              2003       91.06       44.20     59.64    47.14    42.33                                                           39.09
     Portfolio           2004      151.46      136.97     93.67    85.38                                                                    89.21
     Sensex              2004        8.83       45.93     34.87    32.23                                                                    28.88
     Portfolio           2005       54.25       67.26     81.85                                                                             93.37
     Sensex              2005       95.67       50.13     41.10                                                                             35.96
     Portfolio           2006       16.94       18.28                                                                                       28.83
     Sensex              2006       15.19       19.81                                                                                       14.92
     Portfolio           2007      31.938                                                                                                 34.809
     Sensex              2007       18.82                                                                                                   14.69

 8
46
     Outlook PROFIT 13 June 2008
  of management and steer course
  differently, it may not be the same
  for regular stock investors who
  may not be in any position to
  influence managements.
  An Indian example comes from the
  mid-cap segment of pharmaceutical
  stocks. Take the Indian subsidiary
  of Merck. Despite the fact that it has
  the equivalent of 30-40 per cent of
  its market capitalisation in cash, the
  stock price has shrivelled.
  In hindsight, it’s easy to figure out
  why the stock has underperformed:
  revenues haven’t grown as much
  and the balance-sheet has shrunk.
  So even as the company continues
  to add to its cash pile every year,
  the stock remains trapped in
  the doldrums.

8 Again, finding the right margin of
  safety itself is a difficult proposi-
  tion for strategies like cash bargains.
  Since these could involve long wait-
  ing periods, unless there is a trigger
  in sight, the opportunity cost of cap-
  ital; the potential casualties in the
  portfolio (because Graham believed
  in diversification with less due dili-
  gence as opposed to the strategy of
  concentration with utmost due dili-
  gence that Buffett follows); and the
  fact that Graham never looked be-
  yond fair-value situ-
  ations (not letting
  ‘profits run’); the mar-           “Value
  gin of safety’s has to         investors are
  be considerably high.
  Finding such stocks
                                balance-sheet
  in current circum-             analysts and
  stances poses a seri-        regular market
  ous challenge.                  analysts are
8 While Graham’s strat-       P&L analysts. “
  egy is great in terms
  of capital protection,
  it focuses only on the arbitrage val-
  ue between the margin of safety            Ramdeo Agarwal,
  and the fair value of the stock (in        MD, Motilal Oswal Securities believes
  fact, Graham would invariably sell         in getting the purchase price right
  the stock even before the fair value
  was achieved). By doing so, some
  present-day value investors say, you
  would lose out on the bigger value         ham framework to work is a purely
  that is usually built into the growth      capitalistic society with little con-
  of the company. Templeton’s Sub-           trols. But some companies that are
  ramanian says that it makes a lot of       going cheap in the Indian markets
  sense to look at metrics such as divi-     today namely those in the oil, fer-
  dend yields because growth oppor-          tilisers and sugar business are
  tunities in some segments may have         those that have been hit because
  exhausted but the situation may be         of government controls. These
  entirely different for India, where        stocks look cheap, but it’s unlike-
  growth in those segments may be            ly the situation will correct itself
  just picking up.                           unless the government steps in.

8 The ideal environment for the Gra-       8 Again, one of the gripes against

                                                                                     47
        Cover Story
                                                                                       always cheap – and they deserve to
                                                                                       be so – there are others that deserve
                                                                                       superior valuations. A classic exam-
                                                                                       ple, says Subramanian, is Infosys
                                                                                       Technologies. “Earlier on we made
                                                                                       this mistake of trading Infosys for
                                                                                       cheaper software companies. Only
                                                                                       later did we realise that in some
                                                                                       companies, the premium was be-
                                                                                       cause of the difference the manage-
                                                                                       ment can make. It is not captured in
                                                                                       current earnings but it can make a
                                                                                       difference in the long haul.”

                                                                                     PICKING WINNERS
                                                                                     Finding the catalyst: Buying cheap is
                                                                                     a great idea but the biggest challenge
                                                                                     in Graham-style investing is figuring
                                                                                     out the trigger that will unlock value
                                                                                     in the stock. While a margin of safety
                                                                                     is important, it is essential to look at
                                                                                     the probability of getting that trans-
                                                                                     lated into returns. “Sometimes, the
                                                                                     catalysts could be growth itself,” says
                                                                                     professor Bakshi. If the stock trades
                                                                                     at a multiple of four times or so, and
                                                                                     earnings are still growing, your total
                                                                                     returns could be very attractive since
                                                                                     you can pocket a dividend yield, a price
                                                                                     appreciation equal to the earnings
                                                                                     growth and see a potential re-rating of
                                                                                     the stock as well. In addition, a poten-
                                                                                     tial buy-back by a proactive manage-
                                                                                     ment, special dividends, or open offers
                                                                                     arising from potential take-over bids
                                                                                     act as catalysts as well.
                                                                                       Despite the deep value some hold-
                                                                                     ing companies harbour, there are
                                                                                     few takers for such stocks simply be-
                                                                                     cause there are no obvious triggers
                                                                                     in sight. But Bakshi says there is one
                                                                                     way to play these stocks. The cata-
                                                                                     lyst, he says, could potentially come
                                                                                     in the form of a turn in the business
                                                                                     of an underlying subsidiary. Usually,
                                                                                     when business turns, the perceived
                                                             K N Siva Subramanian    value of the holding company im-
                                      VP, Franklin Templeton Mutual Fund, has an     proves and results in a fall in its dis-
                                                   enviable long-term track record   count to intrinsic worth. The perceived
                                                                                     value in the company improves as
                                                                                     a consequence.
                                                                                       A case in point is Nalwa Sons.
                                            Graham’s strategy is that frequently     The stock was available at a 75 per
                                            the list of worthy buys is made up of    cent discount to its intrinsic value
                                            obscure stocks on which there is lit-    but as group company JSW Steel
                                            tle public information. The reported     (Nalwa holds 45 lakh shares) got re-
                                            earnings are thus suspect and the        rated for the better, the discount
                                            chance of being duped, quite high.       contracted to 16 per cent of Nalwa’s
                                            So following the rule always is never    intrinsic value.
                                            easy.                                      Experts say the way to view such
                                                                                     companies is by taking a call on how
                                                          8And finally, there is      the operating business of the subsid-
                                                          an anti-thesis to Gra-     iary will fare in the long haul. For in-
                                                            ham’s    philosophy.     stance, if cement is expected to do
                                                              Pretty much like       well over the next five years, it would
                                                              the fact that some     make a lot of sense to put money in
                                                               companies      are    holding companies of cement enter-

48
     Outlook PROFIT 31 January 2008
DOGS OF THE NIFTY                            could run the risk of deterioration in      folio requires going after little-known
Portfolio of top 10 dividend yield stocks    business. Candidates in the out-of-fa-      or desired stocks. We all know what
                                             vour category now include commod-           kinds of stocks are thrown up on these
                 YEAR       1 yr      2 yr
                                             ity companies which look incredibly         screens, but it requires nerves of steel
Portfolio         1998    -14.68     27.71   cheap but may be vulnerable to an           and guts to buy these stocks. Why?
Sensex            1998    -17.00      7.82   earnings decline if the cycle turns for     For one thing, you may not have heard
Portfolio         1999    145.80     40.83   the worse. One way to assess these          about most of them. For another, most
                                             companies may be to look at average         of these stocks will be drenched in pes-
Sensex            1999     40.05      2.87
                                             earnings for the past five years or more     simism, so most investors will be re-
Portfolio         2000     10.53     26.90   to remove the effect of cyclicality.        luctant to invest in them.
Sensex            2000    -24.44    -15.34     Professor Bakshi says one way to look       Indeed, the reason value investing
Portfolio         2001     65.29     33.08   at cash bargains is to identify compa-      is so difficult is because it may feel
Sensex            2001     -5.14     -8.29   nies with fairly certain cash flows and      completely foolish for a while. “But
                                             not focus as much on ab-                                    true value investors
Portfolio         2002      4.64     90.51   solute cash levels. Since                                   are not worried about
Sensex            2002    -11.33     30.16   companies with regular           “If you buy stocks looking foolish as long
Portfolio         2003    198.09     77.03   cash flows will soon turn            based strictly          as they’re certain they
Sensex            2003     91.06     44.20   into a treasure-chest of                                    haven’t acted foolishly,”
                                             cash, they could be viewed          on traditional          remarks Bakshi.
Portfolio         2004     11.64     41.06                                    value investment
                                             as cash bargains, he says.                                    Yet impressions mat-
Sensex            2004      8.83     45.93     The problem with look-           principles, you          ter to a large swathe
Portfolio         2005     83.05     33.90   ing at future cash flows,                                    of investors. So even
                                             as Graham also explained,
                                                                                 will only play          if back-testing comes
Sensex            2005     95.67     50.13
                                             is that it requires a judge-        the arbitrage           up with sparkling re-
Portfolio         2006     -4.25     11.70
                                             ment of the future and               opportunity,           sults, it’s still difficult
Sensex            2006     15.19     19.81   those projections can dif-                                  for many to go ahead
                                                                                but the bigger
Portfolio         2007     32.65       NA    fer from person to person.                                  and take the plunge.
Sensex            2007     18.82             Nevertheless, since stocks
                                                                               opportunity in a          “The reason value in-
                                             are now no longer avail-         country like ours          vesting is not popular is
                                             able at high discounts as in      lies in the future        because people do not
prises. There are risks to such a strat-     Graham’s time, “we can’t           as the business          have the patience to go
egy though. The lack of transparency         ignore the value of future                                  through these dull and
in dealings between group companies          cash flows while looking at              grows.”             boring ideas,” says Mo-
and the vested interests of promoters        valuations,” says Bakshi.                                   tilal’s Agarwal.
can sometimes erode value in such              While Graham’s solution                                     Another reason why
stocks.                                      for minimising the risk of bankrupt-        most investors get bludgeoned with
  “Unless you know that the inter-           cies and frauds was diversification,         their stock picks is that they don’t al-
ests of the promoters are aligned with       looking at divergences in cash flows         ways follow the rules and resort to gut
those of minority shareholders, there is     and earnings in recent years (not just      feel or judgement, which frequently
no point in touching such stocks,” says      quarters) can also be effective in spot-    goes wrong. “As humans, we do get
Templeton’s Subramanian.                     ting the warning signs. “Instead of         carried away. A strict Graham strat-
  Then again, the famous law of aver-        looking at accounts statements for just     egy would involve selling stocks pe-
ages or ‘reversion to the mean’ could        a year, we should look at the aggregate     riodically, in fact mechanically,” adds
help a stock run the distance. Instanc-      picture for five years, which will offer     Agrawal.
es of over-reactions to one-off situa-       clues to the true picture,” says Bakshi.      Another fact that Graham followers
tions could be good Graham picks.              Among companies that are capital in-      need to accept is that they will rarely
But investors really need to be able to      tensive, it is a worthwhile strategy to     make extraordinary returns. On the
judge the situation correctly to make        search for those that have a high return    other hand, they will rarely lose mon-
sure that what they think is a one-off       on equity and low price-to-book value.      ey. It’s important to be comfortable
really is just that.                         As Motilal’s Agarwal puts it: “Value in-    with the fact that sometimes, they will
  Take the recent forex losses by some       vestors are balance-sheet analysts and      miss new growth opportunities – but
companies, for instance. Buying bank         regular market analysts are P&L ana-        not giving in to such temptations can
stocks just because forex losses came        lysts. Value investors buy assets cheap     ensure a safer ride.
in much lower than expected is defi-          and ahead of the market recognising           True, there are those who have been
nitely not a wise call. At this point in     a turnaround.” Thus, instead of look-       enormously successful by follow-
time, it’s still uncertain if the prob-      ing only at operating and net margins,      ing growth investing techniques. But
lem could strike again. It may not be        it is perhaps smarter to look at long-      these investors, it has to be acknowl-
a one-off situation as some experts are      term returns ratios. With companies         edged, are extraordinarily smart and
claiming. After all, as professor Bakshi     operating in cyclical industries, stocks    have learnt to be at the right place
rightly points out, there is never just      should be picked up when the industry       at the right time. Very few ordinary
one cockroach in the kitchen.                is down in the dumps.                       investors can aspire to be successful
  Talking of out-of favour stocks, in-                                                   that way.
vestors need to careful when they’re         INTELLIGENT INVESTING                         The relentless pressure of keeping up
dealing with downturns.                      It cannot be denied that Graham’s           with the Joneses and the need to boast
  Again, the problem with some com-          strategy demands enormous psycho-           about the latest stock picks at a party is
panies whose names pop up as good            logical strength and will-power. That’s     what investors need to overcome to be-
earnings yield candidates is that they       because building a Graham-style port-       come really successful investors. p

                                                                                                                                      49
                                                                                                       13 June 2008 Outlook PROFIT

				
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