Where value lies in this market

Value investing is back in vogue, as most large-caps are trading at lofty valuations. However, keep an eye on traps

For most of this past year, investors were chasing companies with high price earnings, the most commonly used valuation yardstick. They still made some good returns, as the price-to-earnings (PEs) of many of these stocks expanded along with earnings.

Take Tata Consultancy Services. Last year, its PE ratio was around 21, much higher than the market's 12-14 times. Yet, investors who bought into the company at the time have seen solid gains the past year, even as its PE has expanded to 25 times the trailing earnings.

But now there is a huge divide. One part of the market comprising of information technology (IT), pharma and fast-moving consumer goods (FMCG) is trading at high valuations. On the other hand, scores of companies in the old economy, mid-cap space trade at much lower valuations. Says S Naren, chief investment officer, ICICI Prudential MF: "A few sectors of the market such as IT and FMCG have done very well but their valuations are high. Other sectors, such as many good mid-cap companies, have not done so well. The relative under-performance here is more than 100 per cent."

In recent times, the value theme has not been playing out very well in the market. The performance of the value fund category in the past three years has been rather low. Average performance in those years has been at around one per cent, shows data from Value Research Online.

Now value could be back, as investors seek to go beyond the defensives. ICICI Prudential's Value Fund Series-I, a three-year closed-end fund, garnered Rs 643 crore recently. As some of the growth sectors such as pharma, IT and FMCG are already at very high valuations, investors are increasingly scouting for the kicker in equity returns.

How do you know if investors are currently looking at stocks? To find value, investors mustn't look at relative valuations between sectors but at the intrinsic value of the company, meaning, valuing a company by future growth and cash generating prospects, net of debt. For example, investors are comparing valuations of the tech sector, quoting at lofty PEs, to those of the power sector, which have slipped. This has magnified the difference in PEs between the IT and infrastructure sectors. But this does not make infrastructure a value segment in this market.

FMCG companies and IT companies have a proven record on earnings and so, they quote at high PEs. In infrastructure, which does not have a proven earnings record and where future earnings are not so predictable, valuations are rather low. The PEs of most FMCG companies are in excess of 35 times the trailing earnings, while those of oil and gas companies are in the lower single digits. Yet, saying that infra holds value is misleading.

On the other hand, investors are looking only at growth prospects, rather than allowing a company to grow over the years and expand its balance sheet. Says Akshay Mansukhani, partner, Malabar Investments, a boutique investment management firm: "In a volatile market, if you have one or two quarters of a slowdown, the high PE could see a significant downslide. So, buying a stock for expectations of earnings and not for earnings themselves does not constitute value investing."

Experts say value investing is about doing due-diligence on three pillars - the business, the management and the price of the stock in relation to future growth. When looking at a business, investors should keep an eye for the specific competitive advantage a company enjoys, such as a brand, special non-replicable skill sets or economies of scale, etc. This would ensure growth in revenue is sustainable. Second, investors should look at the quality of the management which invests in sustainable business growth. Says Mansukhani: "In India, there's a tremendous capital mis-allocation. If the company management is good, it will invest in the right segments. Value investing is a combination of structural advantages and management ethics."

Sometimes, value investing can take a long time to play out and a stock price might meander for some time. If a stock is not moving, investors should focus on earnings. If the earnings are growing fine and the stock has moved down, experts say you should buy more. Investors should give about eight to 12 quarters for earnings growth in these businesses, to gain scale and, more important, for the market to recognise the potential of these companies - and reward them with higher valuations.

As always, the cash flows a company is able to generate is what should be used as the benchmark to value a company. Says Vikas Gupta, assistant vice-president, Arthveda Fund Management: "If you can't see where a company's cash flows are coming from, then it's not investing but speculation. In a bear market, generally, most stocks are at good values. Even in a peak, if you look hard enough, most of the times you will find enough stocks to make a portfolio. Will that give amazing returns? No. But it will give you good returns over the long term."

But where can investors find value in this market? Experts note the tendency among institutional investors to chase large-cap stocks because their liquidity steeply drives up their valuations. Even among the large-caps, especially index stocks, those that have run up are in consumer, pharma and FMCG sectors. Hence, investors are more likely to find value plays in the mid- and small-cap arenas.

Says Naren: "IT and FMCG have run up. Most of pharma has run up. It's not that there's no value in the large-cap space. In terms of number of stocks, about 70 per cent is still in the value space. Having said that, one still has to avoid companies that are excessively leveraged or do not have such good future prospects."

Experts reckon that if investors stick to companies that have high returns on equity (of more than 20 per cent) and a valuation of around 15 times, with a reasonable surety of earnings growth in the future, such stocks should be able to perform reasonably well. Experts say some areas where there are deep discounts available in this market are public sector mining companies, going at a reasonable yield, and some select automobile companies, beside select bank stocks.