The Hindu Business Line : Deep-value investing takes root

Given the prevailing valuation levels, identifying a stock with potential demands considerable resourcefulness, though it is not impossible for the diligent investor. There are certain strategies that can be adopted that will considerably add value when pursued consistently over a long period.

THERE has always been something frightening about `deep-value' stocks — for instance, stocks that are trading at a considerable discount to the Price-Earnings Multiple of the market. The PEM may be ridiculously low but given the poor quality of disclosures, investors continue to harbour fears of the unknown. The risk of probable loss completely blinds retail investors to the possibility of handsome gains. The result is that such stocks nosedive to even lower valuation levels.

That is why even stocks such as BPCL, Bharat Electronics, Tata Power, Dredging Corporation and GE Shipping traded at a PEM of less than 5 at some point over the past five years. For instance, BPCL was trading at a P/E of less than 3 in October 2000.

The bull market, however, appears to be ushering in a change in mindset. The strategy of investing in deep-value stocks appears to have taken root.

Consequently, the number of stocks trading at extremely low PEMs has fallen sharply. Deep-value investing has also delivered value consistently over the past five years.

Deep-value delivers: Any stock that trades at a discount to its intrinsic value is considered a value stock.

Also, any stock whose future earnings account for a predominant proportion of its present value — that is, its price to book value is significantly higher than one — is considered a growth stock.

There is often a debate on whether a particular stock should be classified as value or growth. Even a growth stock may appear to be a value proposition.

At the height of the technology sector boom in 2000, Satyam Computer was one of the top picks in a fund practising value investing.

If the choice of Satyam as a value pick confounds you, don't worry. You will face no difficulties in identifying other deep value stocks. They are that bunch of stocks generally ignored by the market.

Trading volumes would often be much below normal in those counters. In addition, such stocks would be trading at such low PEMs that thay can never be classified as growth stocks.

For our analysis, we considered stocks that traded at a PEM of less than 5. Why 5? A PEM of less than five suggests an earnings yield (100 divided by PEM) of more than 20 per cent. That is almost twice the return that a debt product could give investors over a longer period.

A PEM of 5 indicates that even without any growth in earnings, returns for an investor could turn out to be about 20 per cent per annum.

That would, however, require the valuation anomaly to be corrected and the present level of earnings to be maintained.

Every year, since October 2000, the set of deep-value stocks has always outperformed the market. This outperformance is also not driven by small-cap stocks. For the analysis, only stocks with a market capitalisation of over Rs 50 crore was considered.

A number of standout performers among this set of stocks have even delivered returns of about 100 per cent or more each year.

Neyveli Lignite (2001), Kotak Mahindra (2002), GE Shipping (2003), Carborundum Universal (2004) and Karnataka Bank (2005) are examples.

Digging deeper: In recent times, investors too have not shied away away from such deep-value stocks.

Despite an increase in the number of traded stocks, those trading at a PEM of less than 5 number about 45 now. This was about 173 in October 2001 and 95 in October 2004.

Investors thus need to dig deeper and can even cast their net wider. For instance, considering that stocks are trading at a PEM of more than 20, stocks that trade at a PEM of less than 8, instead of 5, can be considered deep value.

A new parameter too can be used. S&P in the US compiles a list of deep-value stocks that are trading at a discount of 80 per cent to their average PEM over the past five years. This parameter too can be used to identify such stocks.

Still, given the prevailing valuation levels, identifying a stock with potential demands considerable resourcefulness on the part of investors.

It is, however, still not impossible for the diligent investor. It is also a strategy that will considerably add value when pursued consistently for a long period.

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

More Stories on : Insight | Stock Markets | Taking count