Saturday, 31 December 2011

Wealth Creation Through Elementry Mental Constructs of Value Investing

As we all are about to enter into a new year, I thought it appropriate to share my views/understanding on how one can enhance his/her chances of creating long term prosperity by applying or understanding certain fundamental constructs of value investing. I will try to present these basic ideas with least jargon. What really astonishes me is the fact that, in spite of general sense amongst people that investing is a fairly involved and complex subject, the underlying ideas for successful investing is fairly simple!

Power of Compounding: Even though, most of us are aware about the power of compounding, we rarely are able to appreciate the enormity of the whole idea. Two important variable in the compounding is time and rate of return.

Let us first look at what impact time horizon can have on your returns! If I were to invest Rs. 1,00,000 in 2012 in indexed mutual fund for 10 years with expected rate of return of 12% (average return from market), at the end of 10 years, I will end up with roughly 3.1 lakhs. However, if I increase my time horizon to 20 years, initial investment of 1,00,000 will turn into 9.65 lakhs, multiplying wealth by power of 2! Similarly, if I were wise enough to invest the money for 30 years, I will end up with bountiful of 30 lakhs. So what's the message? Start making investment early in life and you will be able to reap maximum benefit of compounding

Another important factor in compounding equation is rate of interest/return. Let's see how it impacts wealth creation. Let us assume that as in earlier example, I have made investment of 1,00,000 in 2012 in index fund for 30 years, I will end up with 30 lakhs at the end of 30th year. Instead of being a passive investor, I decide to manage my own portfolio of stocks, selected on the basis of value investing principles. Let me assume, hypothetically, that my portfolio outperforms the average market returns by just 1%, i.e. my portfolio yields 13% average return instead of 12%. This slight out performance will increase my corpus from 30 lakhs to 40 lakhs, increase of whooping 33% over investing period. Many value investors, by sticking to value investing principles, have outperformed the average market returns by 5-7% over 25-30 years! This results into astonishing number of multiplying original amount by 100-200 times. On the other hand, if the same amount is invested in a long term FD yielding average 8% return, I will end up with 10 lakhs (only 1/3 of index fund returns) at the end of 30 years. This leads me to conclude that it is worth the time and effort in researching and creating sound portfolio of companies as even moderate out performance can be a significant wealth creator.

Concept of Risk: Risk is an abstract concept.
What is amusing is that risk is defined differently for different disciplines. In stock market, risk is measured through volatility of the stock prices compared to market movement, called beta! This definition of risk is counter intuitive. Let's take an example, in year 2011, market went down by 25% while BHEL corrected by 50% from price level of 4x to 2x, resulting into beta of 2. Now had BHEL fallen only 25%, price would have come down from 4x to 3x, resulting into beta of 1. Now if one were to buy BHEL stock, based on definition of risk in stock market, we shall have to conclude that buying BHEL at 2x (lower price) is riskier than buying it at 3x (higher price), an absolutely illogical conclusion to draw!

Instead of taking volatility as measure of risk for stocks, value investing suggest that risk should be defined  as per dictionary definition i.e. a probability or threat of damage, injury, liability, loss or other negative occurrence that is caused by external or internal vulnerabilities. Now if one apply this definition to measure risk in investment decision, it is the probability of loss of capital! Hence value investing is all bout deploying capital in businesses/stock in a manner whereby the risks (of loss of capital) are lowest! This indeed is a very powerful construct, as not losing money is half the battle won in wealth creation.

Price is what you pay, value is what you get: This famous quote from warren buffet, very effectively summarizes the disconnect between price and value. As an investor, one should always focus on value of underlying business instead of price quoted in the stock market. If the investor is getting a chance to get into business at a price substantially lower than the intrinsic value of the business, he should buy stock. If the price quoted in the market is substantially higher than the intrinsic value of underlying business, investor should avoid/sell the stock. Even though price may be substantially higher/lower than value in the short term, in long run price will undoubtedly approximate the value! However, one can not predict the time frame in which price will approximate value and hence one should make investment decision with long term horizon (10 years or beyond)

Valuation and Margin of Safety: This is one of the most powerful conceptual framework created by father of value investing Ben Graham. As discussed earlier, investor should focus on underlying value of business. however the question is how to determine intrinsic value of a business?

Typically valuation of a company can be done in two ways.

Liquidation Value: Liquidation value of business is the value that an enterprise can expect if it were to close down its business, liquidate its assets and clears off its liabilities. This value is reflected in (fixed assets+ investments + net current assets-liabilities). This is the most pessimistic valuation of a company and hence if a profitable enterprise is trading below its liquidation value, there is a distinct possibility that enterprise is undervalued.

Going Concern Value:In this type of valuation, the basic assumption is that company is a going concern and will keep on generating cash flows from business for foreseeable future. In this case, one has to factor in future cash flow that a company may generate, based on certain assumptions about growth rate in revenue, margin, tax rates, capital expenditure etc and discount future cash flows by applying appropriate discounting factor. However, it is important to recognize that future cash flow of a company is culmination of so many variables and their interplay that it is impossible to predict them with any certainty! Hence, Ben Graham suggests that we should always keep margin that provides us safety in terms of loss of capital. To put it simply, if I value a company XYZ based on going concern basis and arrive at value of 100, I should consider the value of company as only 50. Now if the stock is valued in the market at less than 50, and I buy it, chances of my losing capital is very less unless in case of catastrophe!

this  approach of being risk averse correlate with the concept of "risk" in investment where primary objective of any investor shall be to preserve capital and earn reasonable return on the capital.

So based on above discussions, some important takeaways that can be very useful in wealth creation

  • Start investing early in your life time to take maximum advantage of compounding as wealth grows exponentially to time literally!
  • At the early stages of life, allocate more capital to high yielding asset class compared to low yielding asset class. Additional 1% return over 30 years can increase your wealth by 33%
  • Risk in investment shall not measured through beta, but through probability of loss of capital. Sometimes, volatility creates excellent opportunity for investment.
  • stock price is not same as the value of enterprise. stock price may be less or more than enterprise value. Focus on understanding inherent value of the business.
  • In the long run, stock price approximates value of a business hence invest when stock price is substantially (margin of safety) less than enterprise value.
  • Invest for long term only as one can not predict the exact time frame in which stock price will approximate value of a business.
  • If a profitable company with reasonably good business is trading below its liquidation value, chances of undervaluation are high.
  • It is extremely difficult to determine value of a company based on future cash flows due to interplay of number of variables. Hence while valuing, make conservative assumptions and apply 40-50% margin of safety. If the stock is trading below the discounted value, go load up!

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