How to be a value investor when market is at peak

Value investing is not jumping on to the bandwagon but being a contrarian who picks up unloved stocks and beaten down scrips. In 2022, the BSE mid-cap index rose 1.38%, while the BSE small-cap index fell 1.8%. For value investors, these were opportunities waiting to be grabbed. Adventurous investors reaped a bumper harvest the following year. The mid-cap index soared 45% and the small-cap index shot up 47% in 2023. As Nathan Rothschild, member of the Rothschild banking family, famously said, “Buy when there’s blood in the streets.” 

There can be ‘absolute value opportunities’ in the markets, when there is panic and sellers outnumber the buyers. The crash in March 2020 after the outbreak of Covid was one such opportunity. But there can also be relative ‘value periods’ where markets don’t exactly crash but remain range bound for extended periods. Value investors have to identify stocks that are trading below their intrinsic value and are less expensive than their peers. 

How does one do that? The price-to-earnings multiple (P/E) and price-to-book (P/B) are two useful metrics. But these should not be seen in isolation. A stock may have a low P/E multiple because its prospects are not very bright. Six months ago, agrochemical major UPL was trading at a low P/E of around 12x before global headwinds and high interest costs hit the company hard.

When looking at the P/E of a stock, one must also know about the source of its earnings. A company may have sold some assets or divested some business. This extraordinary income would boost the earnings per share but is not sustainable. The company should have a positive operating margin, which ensures that the net profit is from business operations and not from other incomes.

For value investors, the margin of safety, or the difference between the intrinsic value of a stock and its price, is an important benchmark. Needless to say, the higher the margin of safety, the better it is for the investor. Let us assume the intrinsic value of a stock is ₹400 and it is trading at ₹350. The margin of safety is then 12.5%. If the stock price falls to ₹320, the margin of safety rises to 20%. The lower the risk, the higher the chances of earning good returns.

During bull runs, valuations can run far ahead of fundamentals and it is easy to get carried away during such phases. Right now, many stocks are trading at three-digit P/Es. A stock with a P/E of 30-35x may appear like a value pick if its peers are trading at P/E of 60-70x or even more. But there is no justification for buying an overvalued stock just because other stocks are even more overvalued. The serious value investor needs look at metrics such as the return on equity (ROE) and return on capital employed (ROCE) to judge a stock. ROCE is used when assessing companies in capital intensive sectors such as construction, heavy engineering and manufacturing whereas ROE is suitable for companies that are not very capital intensive, such as FMCG (fast moving consumer goods) and IT. A healthy ROE and ROCE of more than 10% indicates that the company is being run efficiently. 

The dividend payout ratio of a company indicates how sound its finances are. If the dividend yield (dividend as a percentage of the prevailing share price) is high enough, it adds to the margin of safety of the stock. Companies that regularly pay dividends and maintain the payout ratio are less likely to witness a steep decline in their share price. A classic example is ITC, which has consistently paid a healthy dividend in the past 20 years. This ensured that ITC shares remained steady even when the rest of the market was facing stormy weather.

Raj Khosla is managing director of MyMoneyMantra.com