The recent past has seen the stock markets experience volatility due to uncertainty about economic growth, the Coronavirus pandemic, and related headwinds. In this situation, stock picking becomes challenging with most investment strategies not playing out as expected. The two key investment strategies that most investors follow are - value investing and growth investing.
About value investing
When you invest in a stock that is quoting at lower than its intrinsic value (usually called quoting at a discount), it's termed as 'value investing'. Intrinsic value implies the 'true' value of a stock. This can be a subjective decision with different analysts computing intrinsic value in different ways. Well, known value investors include Warren Buffett, Benjamin Graham, Charlie Munger, etc. While value investing can be fruitful, there are some challenges that this strategy brings.
Pitfalls of value investing
- It is difficult to identify quality stocks that are under-priced. Stocks are usually available 'cheap' for good reason – the company could be in an industry with low/no growth prospects, the management may be suspect, the company's financials may be weak – high debt, low profitability or loss-making, etc.
- You will need to have a deep understanding of the industry, the business, and the company to assess whether it is a 'value' stock.
- You will also need to have knowledge and understanding of finance to assess the intrinsic value of the company. You will need to compare the intrinsic value to the market price of the stock to decide whether the stock is underpriced by the market. There are numerous methods used by financial analysts to compute an intrinsic value and you will need to decide which method works for you.
- Your investment tenure will be uncertain; you cannot predict when the company will recover/start on the growth path.
- There isn't sufficient information about these companies in the public domain. You may not have sufficient information about the company, its management, and business to assess the quality of the stock.
- You may believe the stock price has hit rock bottom; however, it may fall further after you have invested.
About growth investing
Growth investing implies investing in 'growth' stocks which represent companies that are expected to grow at an above-average rate as compared to the industry they belong to and/or the overall market. Growth investing carries a high risk as growth companies are usually those that are young and don't have a performance track record. This strategy has the following challenges:
Pitfalls of growth investing:
- Market prices of growth stocks tend to be highly volatile; investors who are uncomfortable with volatility should avoid growth investing. You also need to time your entry; if you invest when the stock has already moved up significantly, you may either make meagre gains or even incur losses.
- Just like timing your entry, you also need to closely monitor the movement of the stock's price so that you can correctly time your exit. When there is a slowdown in the growth of the company's revenues, the price tends to drop swiftly, which makes it difficult to exit. As a result, you may end up making meagre gains/incurring losses.
- Valuations of growth stocks are a combination of hype/market sentiment and the actual growth potential of the company. Separating the two may be difficult. You will need to have good knowledge of both the company and the market sentiment surrounding the stock. If the stock price falls, you will need to judge the reason – whether the company's growth potential has been adversely impacted or its market sentiment has turned negative – to decide whether to exit the stock or stay invested. This can be tricky.
- Most businesses are cyclical. If you enter at a time when the business cycle is heading downward, you will see a fall in the stock's value.
- Growth-oriented companies may not declare dividends so that they can reinvest the funds in the business. This deprives you of cash inflow.
While both these investment strategies work when there is some amount of certainty on how the stock markets are expected to move, going forward, during uncertain times, these strategies tend to become riskier.
Greater the uncertainty, the greater the risk. In this situation, investors should look for safety in quality. In other words, opt for QUALITY investing.
About quality investing
Quality investing, popularly called 'Coffee Can' investing was conceptualized by Robert Kirby, considered to be one of the greatest investors, in the 1980s. He used the concept of the coffee can which Americans used to store their valuables in and hide the can under their mattresses to be left untouched for decades. This concept implies looking for companies that are fundamentally strong with an established track record, quality products/services, leaders in their industry and run by management with outstanding credentials and experience. The idea is to invest in these companies and stay invested over a long period, through all the ups and downs that the market may experience. Investors stand to build serious wealth while taking on lower risk by investing in such quality stocks. However, the key to success in this investment strategy is to stay invested over long time periods.
Kirby talks about a wife, a client of his, who requested him to combine her deceased husband's investment portfolio with hers. Kirby was amused to find that the husband had invested in stocks recommended by Kirby. However, he had ignored Kirby's 'sell' recommendations and continued holding on to his investments. The result was astounding. The husband's portfolio had grown exponentially over the years. This incident gave Kirby the idea of 'coffee can' investing. As Kirby said, “The success of the program depended entirely on the wisdom and foresight used to select the objects to be placed in the coffee can, to begin with.”
Here are 10 key parameters to spot 'coffee can'/quality stocks:
- Look for stocks with a market capitalization of over Rs. 1,000 crores. Market capitalization is the multiple of the number of outstanding shares and the market price of the stock (Market capitalization = number of shares outstanding multiplied by the market price per share).
- The company should have been in existence for at least 10 years.
- Over its existence, the company should have delivered Revenue/Sales growth of at least 10% and Return on Capital Employed (ROCE) of at least 14% consistently over the last 10 years.
- The company's management should be visionary. They should have the ability to foresee expected shifts in the business scenario based on micro and macro factors and reposition the company accordingly in order to keep its products/services relevant. The company should be a leader or an emerging leader in its industry with other players following its lead. The company should be a frontrunner to adopting new technologies to make its business more efficient and improve its offerings to its customers.
- The industry/sector the company operates in should have strong growth prospects. It's preferable to opt for a sector that is on the threshold of sustained exponential growth.
- There are constant shifts in value based on progress made. For instance, with respect to commuting, moving from cycles to cars, and now, to driverless cars; similarly, in the home segment, moving from black and white TV sets to flat-screen TVs with not only colour but different resolutions. The company should have successfully moved through these value migration stages while maintaining its leadership.
- Look for quality companies in the B2C (Business to Consumer) market segment. The B2C segment is scalable and offers greater growth potential than the B2B segment. It facilitates building brands, customer loyalty, expanding across geographies and products, etc. All these aspects result in a rise in the company's equity valuations.
- Look for quality companies you are familiar with based on brands, quality, service, loyalty, etc. Let's say, you use a particular brand of toothpaste that you like and have been using for years. Check out the company manufacturing this toothpaste; study its business, growth prospects, management, financials, etc. Additionally, check out if it adheres to the parameters of 10% Revenue/Sales growth and 14% Return on Capital Employed (ROCE) consistently over the last 10 years. You may find a quality company worth investing in your analysis.
- Quality companies usually have tremendous pricing power. They have the ability to offer products across the price spectrum thereby increasing their consumer base. For instance, a company manufacturing brown goods (refrigerators, air conditioners, etc.) can cover the entire consumer spectrum by offering products at different price points. The key however would be maintaining quality even for products priced in the affordable range. To make products affordable for its customers, quality companies usually exercise their strength with attractive bargains with their vendors or suppliers. Since the company purchases its raw material in bulk, it can strike a good bargain with its suppliers and pass on the benefits to its customers through lower prices.
- It's best to avoid PSU stocks and cyclical such as commodity companies.
Selecting quality stocks and staying invested over the long term has the potential to result in significant wealth appreciation.
The writer is the Founder & Chief Financial Planner at MoNey MinTing ManTra, a Hubli based financial planning firm
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