Count on the Margin 01

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It cannot be denied that the GreatDepression of 1929 and the WallStreet crash that followed was per-haps the most humbling experi-

ence for investors at the time. Life wastough and there was no hope to clutchon to. After crushing losses, moststocks were available at ridiculouslycheap prices over the next decade asthe markets remained trapped in abear grip.

But as any stock expert will tell youtoday, behind every market disasterlurks opportunity if you just lookhard enough. It was the same for Ben-

jamin Graham, who, despite sufferingheavy nancial losses himself, begana conscious campaign of snapping upstocks that suddenly became availableat bargain prices.

Graham strategy was simple: buycompanies that he likened to cigarbutts typically abandoned but stillgood for a puff or two. And you could

pick them up for virtually nothing.Stocks quoting below their liquida-tion values after keeping a margin of

safety, allowing for any contraction inprices, were his key bets.

His strategy soon started being talk-ed about in the investing community.One man, in particular, was highly in-uenced by Grahams strategy, andin tribute to his idol, bought sharesin about a hundred such cheap com-panies. His faith soon paid off: in veyears, John Templeton whose nametoday is synonymous with valueinvesting had multiplied hisoriginal investment several times,despite around 15 of those companiesgoing bankrupt.

The value investing philosophy pro-pounded by Graham and practised

vigorously by Sir John Templeton waseventually perfected into an investingtechnique that called on investors tobuy stocks cheap so cheap that there

was very little chance of the stock fall-ing any further (thus avoiding any lossof capital).

After Graham articulated histhoughts on the subject in the book Se-curity Analysis in 1934, value investing

grabbed the attention of several pro-fessional investors, many of who haveadded their own perspectives over thefollowing decades. Nevertheless, thebasic essence of value investing hasremained the same: buy cheap.

It was a philosophy that was bornin desperate times (the Depressionyears), and underwent a baptism byre as it was tested time and again overthe next few years.

So it wouldnt be wrong to wonder just a little bit whether those princi-ples still work in todays times, giventhat the past few years have been ex-ceptionally exuberant for the worldsmajor stock markets.

Cut to January 2008. In sharp con-trast to the crisis engulng the stockmarkets when Graham started out, the

worlds economies Indias included were exuding condence like neverbefore. Many experts claimed that In-dian nancial markets were experi-

encing a secular bull run, not a cyclicalupswing that would die down anytimesoon.

Times have changed since Benjamin Graham wrote the Security Analysis buthis principles can hold investors in good stead even nowN Mahalakshmi & Mohammed Ekramul Haque

13 June 2008 Outlook PROFIT

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Cover Story

COUNT ON THE


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Besides, stock prices were catapult-ing and there was what seemed like anever-ending ood of foreign moneypouring in. For ve straight years tillJanuary this year, the Sensex provedthe sceptics wrong at every level as it

rapidly scaled new all-time highs, re-

covering almost immediately afterevery tumble. And investors continued to buy into

stocks, whatever the price.Then, the inevitable happened. Glob-

al markets nosedived and over the

next few months, continued to plunge

as bits of bad news kept leaking outat a steady pace. Investors who hadbought stocks at steep valuations now began to understand just how foolishtheir actions were, not to mention thespeculators who had joined in for the

free ride. Value investors had seen this coming

all along. At a lecture in India on Janu-ary 8, Bruce Greenwald, renowned -nance professor at Columbia BusinessSchool, referred to stocks markets asbeing expensive. At the time, stocks

were actually peaking out. Greenwaldteaches the Graham and Dodd styleof investing in the university Grahamgraduated from. Value investing is not about predict-

ing when markets will hit their peaks.Graham (and todays value investorsagree) emphasised the preservationof capital as the bedrock of investing.The beauty is, as Graham said, any-thing bought cheap will invariably goup in price, says Chetan Parikh, asuccessful Indian value investor andmanaging director of Mumbai-basedJeetay Investments.

There is one difference though. What Graham considered bargainsand what todays value investors con-sider as cheap (and we are not talkingabout growth-style investors who donot mind paying a high premium forstellar growth prospects) are separated

by time.

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Outlook PROFIT 13 June 2008

Cover Story

CASH BARGAINS PORTFOLIO

Port olio consists o stocks with cash and marketable securities greater than market capyear 1 yr 2 yr 3 yr 4 yr 5 yr 6 yr 7 yr 8 yr 9 yr 10 yr Latest

Port olio 1998 56.30 13.47 -45.88 -22.24 -12.96 2.03 5.98 15.41 10.65 8.68 8.42Sensex 1998 -17.00 7.82 -4.23 -4.46 -5.88 5.91 6.32 14.75 14.80 15.74 14.78Port olio 1999 196.20 -25.04 -15.97 -14.89 4.01 24.82 25.87 21.03 25.39 26.24Sensex 1999 40.05 2.87 0.12 -2.87 11.20 10.80 20.18 19.55 20.10 18.92Port olio 2000 -45.69 -37.70 -3.11 6.55 19.24 19.65 18.05 29.14 28.81Sensex 2000 -24.44 -15.34 -14.03 4.97 5.73 17.15 16.87 17.81 16.56Port olio 2001 -13.43 -3.30 31.75 53.64 66.82 63.88 74.19 77.32

Sensex 2001 -5.14 -8.29 17.13 15.00 27.90 25.69 25.53 23.83Port olio 2002 -2.98 39.67 73.51 86.98 76.96 84.35 84.91Sensex 2002 -11.33 30.16 22.62 37.82 32.96 31.53 29.30Port olio 2003 66.00 109.10 105.99 69.22 55.70% 57.67Sensex 2003 91.06 44.20 59.64 47.14 42.33 39.09Port olio 2004 169.39 120.53 92.65 49.22 51.58Sensex 2004 8.83 45.93 34.87 32.23 28.88Port olio 2005 76.22 40.86 61.42 66.43Sensex 2005 95.67 50.13 41.10 35.96Port olio 2006 58.50 28.62 56.86Sensex 2006 15.19 19.81 14.92Port olio 2007 53.67 37.15

Sensex 2007 18.82 18.82Returns or 2007 port olio until May 27, 2008

The universe

Earnings yield port olio: A port olio o 30 stocks with the highest earnings yields, theminimum cut-of being double the bond rate or the respective year, rom the BSE-

500 universe, excluding nancials, with a debt-equity o less than 1. For years thatthrew up less that 30 stocks, we went with the available stocks.

Net-nets & cash bargains: All listed companies with a trading history o more than 90per cent excluding nancials was taken as the universe. We calculated net-nets by

deducting debt and current liabilities rom current assets. The 30 or available stocksor the respective years with market-cap less than net currents were consideredor the port olio each year. Companies with cash and marketable securities less

all external liabilities greater than the market-cap constituted the cash bargainport olio or the respective years.

Dogs o the Ni ty: Top 10 stocks based on dividend yield at the end o every year.The returns

We computed total returns (price appreciation plus dividend income) or theport olio constituted every year and with a holding period o 1-10 years or the

period 1998-2008. For dogs o the Ni ty we tested results only or a two-year holdingperiod. In the case o a stock getting delisted or stopped trading, we considered thestock to have lost 100 per cent in the year in which the stock disappeared rom the

port olio. All data has been sourced rom CMIE Prowess.

HOW WE DID THE BACK-TESTING


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The world has changed in many ways. And the way business is donehas changed appreciably. In the pastcentury, while industrialisation wasstill underway, manufacturing was themainstay of business and companies

were largely asset-heavy.Todays businesses are more ser-

vice-led and asset-light. Even thelandscapes for accounting practices,securities regulations and sharehold-ing patterns are dramatically differ-ent. Grahams success was also in partbecause he had the luxury of buyingbusinesses that were truly cigar buttsbecause of the state of the economy atthe time.

Is Grahams philosophy still stay rel-evant in the changed times, (one of optimism, although recent data doespoint to a slowdown) compared withthe gloom that the Father of Financial

Analysis was witness to? Outlook Prof-it sought answers for this by relyingtwo factors: data, because data doesnot lie; and people who have been un-adulterated value investors.

Before we disclose the results(please wait patiently being patientis the rst rule in value investing!), wepresent a quick look at Grahams

various strategies.

THE PHILOSOPHYGrahams investment radar mainly

ashed stocks that could be classiedas bargains based on earnings poten-tial or asset values.

The key earnings-based strategy thatmost lay investors can easily adopt in-

volves buying stocks that offer a sub-stantial earnings yield, typically, twicethe prevailing bond rate.

The earnings yield is the reverse of the price-earnings multiple. The logicis simple: if you view stocks as bondsthat offer no growth but yield xed re-turns (consider prots as a proxy for in-terest earned) then the asset should be

valued like a bond. If the earnings yieldis twice the bond yield, it means thatthe asset actually promises to doublethe returns you could get from hold-ing the bond. Given that the businessis protable and will continue to beso, returns could be impressive as theyield in excess of the bond rate wouldprovide an adequate margin of safe-ty in the event of any capital erosion.

Another earnings-based strategy is beto buy stocks that offer substantialdividend yield. Asset-based strategies of Graham

revolve around buying stocks that

are quoting either below their liquida-tion value (especially for businessesthat do not have a future) or at a sub-

stantial discount to the companys as-set value (for businesses that boastgood future prospects). Another set of bargains includes

stocks of companies quoting below the value of marketable securitiesand cash on their books after deduct-ing outstanding debt. The logic here isthat the company can use its cash andsecurities to pay of its debt and otherliabilities and still the shareholders

would have something in their hand. At the heart of Grahams philosophylies the ability to favour what is out of

favour. Embrace the ugly, not the beau-tiful. Lift the disgraced and disregard-ed. And it works!

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Sanjay Bakshi , CEO,Tactica Capital is a deep-value investor

PHOTOS: SANJIT KUNDU


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8 Back-testing key Graham strate-gies reveal a stunning performance.The strategy of picking up stocks

that have earnings yields thatare twice as high as the bondyield proved to be spot-onfor investors. Returns onsuch a portfolio beat theSensex every time! Cashbargains and net-nets have

worked with 70 per centaccuracy. ( See table: CashBargains Portfolio )

8 Grahams way of gaug-

ing the market temperature worksbeautifully as well. The proof of thepudding is in our study of stocks that

were ultra-cheap in the past decade.Out of the 5,000-odd traded stocks atthe peak of the IT bull run in 1999, 22

stocks were trading below their liq-uidation values (current assets mi-nus current liabilities and debt). Bycontrast, when the markets plungedto their nadir in 2003, 132 stocks metthese criteria.Nevertheless, some of the most suc-cessful value investors in the coun-try believe that some changes toGrahams strategies may be requiredto make it more effective (althoughgiven that the back testing showedsuch good results, we wonder why?)

MISSING OUT ON GROWTH?Focusing on the cheap stocks oftenmeans missing out on other opportuni-ties. Why? Because the market is usu-ally instantly enamoured by anythingnew that turns up in business untilthey nd reason to think otherwiseRemember the dot-com boom? Com-panies were awarded sky-high valu-ations before it dawned on investorsthat many business models were sim-ply unsustainable.

However, the notion that youcould be left behind if you dont paythe price for growth is not entirely

baseless. If you buy stocks basedstrictly on traditional value invest-ment principles, you will only play thearbitrage opportunity (the differentialbetween the fair price and the marketprice) but the bigger opportunity in acountry like ours lies in the future asthe business grows, says K N SivaSubramanian, vice president at Frank-lin Templeton Mutual Fund. Hes con-sidered one of the best fund managersof the past decade or so.

For sure, adopting a Graham approach would have encouraged investors topass over new, emerging businesses

that have given outstanding returnson the bourses: Infosys Technologies,HDFC Bank, Pantaloon Retail; and Su-zlon Energy to name just a few. Noneof these stocks would have qualied as

value stocks in the Graham sense ever.But you would have built an equally

stellar portfolio of stocks consisting of Bharti Televentures and State Bankof India (at one time available signi-cantly below book value); public-sec-tor companies such as Bharat EarthMovers and BHEL and private-sectorcompanies such as Areva T&D, Penin-sular land, Gujarat NRE Coke, Merca-tor Lines, Aban Offshore and even JaiCorp. All of them have rewarded inves-

Chetan Parikh,MD, Jeetay Investments has been a

committed value investor

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tors with handsome dividends and cap-ital appreciation.

Most of these names were ignored afew years ago either because businessconditions were bad or the market sim-ply shrugged them off because there

were alternative opportunities that were more alluring.

The market periodically gets into aphase of madness when there is a fas-cination for a few sectors and the oth-ers are completely forgotten, says E A Sundaram, a fomer fund manager withHDFC Mutual Fund who now managesfunds for the Bilakhias. And its true:during the dot-com boom, rememberhow the old economy was forgotten? A year ago, software service companieshad joined the ranks of fallen angels. A true Graham follower would, however,buy stocks precisely when there are notakers for them. And what about growth? Graham

never believed in relying on the future,so he would not pay a penny for growth.The difference between Graham fol-lowers and the growth seekers is pri-marily that the former are risk averse(you can even call them miserly) anddont seek to pay a price for growth.

Value investors want growthfor free, says Sanjay Bakshi, profes-sor at Gurgaons Management Devel-opment Institute. And by doing so,they could well make errors of omission

but not of commission. He also runs

an investment rm called TacticaCapital, which specialises in deep-

value-investing .Other experts echo the sentiment.

Managing director of Motilal Oswal Se-curities Ramdeo Agarwal

says an attractive purchaseprice is key to making mon-ey. The moment you paya price for growth, whereis the outperformance?he asks. You are not deal-ing only with the companyhere, you are dealing withthe price of the stock. Peo-ple do not understand whatrole the price plays.

The sceptics argue theother side. The Gra-ham model is geared tonding cheap cigar butts,but many such compa-nies may have issues withtheir character itself,says Bharat Shah of ASK Raymond James whostarted out as a value inves-tor but later changed track.

Cheapness can be an il-lusion. Just being cheap isnot good enough for me, ithas to be supported by cap-ital efciency and condence aboutgrowth. While I like the cheapness thatGraham would have liked, I would also

like quality of business that Fisher

would have liked.If wishes were horses, that would have

been true! In todays circumstances, itis not easy to nd stock that offer greatgrowth prospects with the margin of

safety embedded the

way Graham liked it.Most experts, however,believe trying to com-bine a growth style andthe rather contrarian

value-style techniquedont mix very well.

Still, the perceptionof value lies in the eyesof the investor. Thebiggest contribution of Graham to the worldof nance was three

words margin of safe-ty and if you keep thatin mind while invest-ing you will seldom goawfully wrong, saysfund manager Sunda-ram.

THE CHALLENGESNevertheless, some

strategies that werelargely a product of circumstances that

prevailed during Grahams time arebecoming less effective and riskierpropositions. Its easy to see the con-

tentions.

EARNINGS YIELD PORTFOLIO

Port olios with earnings yield more than double the bond rate with a maximum o 30 stocksyear 1 yr 2 yr 3 yr 4 yr 5 yr 6 yr 7 yr 8 yr 9 yr 10 yr Latest

Port olio 1998 80.16 87.27 14.34 19.78 9.57 27.44 36.53 48.24 42.40 42.47 43.82Sensex 1998 -17.00 7.82 -4.23 -4.46 -5.88 5.91 6.32 14.75 14.80 15.74 14.78Port olio 1999 45.50 43.48 35.46 28.85 55.97 69.76 74.15 65.24 64.93 67.84Sensex 1999 40.05 2.87 0.12 -2.87 11.20 10.80 20.18 19.55 20.10 18.92Port olio 2000 39.06 49.09 36.37 70.69 82.05 91.31 79.16 75.19 78.79Sensex 2000 -24.44 -15.34 -14.03 4.97 5.73 17.15 16.87 17.81 16.56Port olio 2001 88.92 46.61 89.10 109.55 112.85 95.99 95.21 100.3

Sensex 2001 -5.14 -8.29 17.13 15.00 27.90 25.69 25.53 23.83Port olio 2002 27.32 105.81 141.89 139.39 110.76 105.14 109.9Sensex 2002 -11.33 30.16 22.62 37.82 32.96 31.53 29.30Port olio 2003 268.56 217.40 173.73 127.78 112.65 118.7Sensex 2003 91.06 44.20 59.64 47.14 42.33 39.09Port olio 2004 289.12 220.77 134.53 118.07 125.5Sensex 2004 8.83 45.93 34.87 32.23 28.88Port olio 2005 434.52 172.21 110.90 110.9Sensex 2005 95.67 50.13 41.10 35.96Port olio 2006 119.92 79.41 95.68Sensex 2006 15.19 19.81 14.92Port olio 2007 33.56 33.56

Sensex 2007 14.69 14.69CAGR Returns Note: 2007 based on latest sensex closing May 26, 2008


45

Graham strategywas simple:

buy companiesthat he likenedto cigar butts

typicallyabandoned but

still good ora puf or two.

And you couldpick them up

or virtuallynothing. Stocksquoting below

their liquidationvalues a terkeeping a

margin o sa ety


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8


6

8 The concept of book value and whether it reects the true worthof a company have undergone fun-damental changes over time. Book

value was one of the prime pa-rameters Graham relied on since

he preferred judging what was onthe balance-sheet to looking at un-quantiable parameters. In his time,companies were asset-heavy and itmade sense to look at asset values.Not anymore. Today, the real valueof several business lies not in theplant and machinery they own, butin more unquantiable factors. Takesoftware services, for instance. Inthis industry, the real assets are thetechnically skilled people who walk

in and out of the company gate ev-ery day; theyre not mentioned in thebalance-sheet though.Similarly, the real value of consum-er companies lies in their brandsand distribution network, again not

quantied in the statement of ac-counts. The balance-sheet doesnot capture the value of intangibleslike brands, but they also have cashows attached to them, points outSundaram.

8 Similarly, Grahams idea of lookingat net working capital requires re-thinking as well. The whole idea of net-nets was to buy a company be-low its working capital because if themarket did not give the company the

valuation it deserved, the promotercould easily liquidate the companyby realising the receivables and cash,pay off payables and debt and stilltake home some cash (by the way,

were not even accounting for xedassets here). Obviously, Graham waslooking at what was truly dirt cheap(cigar butts).He would have rejected companies

with low net current assets outright.But, in todays world, high workingcapital is taken as a sign of a deterio-rating competitive position. Higherreceivables being built up; large dis-counts to customers; larger collec-tion periods all these are actuallysigns of worsening business condi-

tions. Indeed, some of the best-runcompanies in the world have a neg-ative working capital -- consumercompanies like Hindustan Unilever,Procter & Gamble and several oth-ers actually have been operated with

negative working capital for quitesome time now.

8 Some Graham strategies like cashbargains work well in mature mar-kets like the US because the share-holding pattern is diffused, so anancial investor could identify situ-ations and act in a fashion that com-pels management to unlock value.But in India, since promoters usual-ly hold fairly large stakes and corpo-rate raids are not that common, theprobability of liquidation is ratherslim and dilutes the case for unlock-ing value in such stocks.Besides, another risk with Grahamscheap stocks is that while you canbuy a business at a lower price than

what its worth, you can never tell whether it will add or subtract value.Templetons Subramanian quotes aclassic example: when Warren Buf-fet bought Berkshire Hathaway, it

was still a textiles company. And in-stead of continuing like that, Buffettused the cash to build a business thatoffered growth. While buying cash bargains may arewarding proposition for an activ-ist investor who can take the reins

Cover Story

GRAHAMS NET NETS PORTFOLIO

Portfolio of top 30 stocks trading below their net current asset valuesYear 1 yr 2 yr 3 yr 4 yr 5 yr 6 yr 7 yr 8 yr 9 yr 10 yr Latest

Portfolio 1998 43.46 89.16 4.77 12.22 7.40 15.22 24.51 28.30 24.41 22.24 23.64Sensex 1998 -17.00 7.82 -4.23 -4.46 -5.88 5.91 6.32 14.75 14.80 15.74 14.78Portfolio 1999 220.43 -1.32 10.57 5.55 20.07 28.07 38.66 31.08 27.44 28.29Sensex 1999 40.05 2.87 0.12 -2.87 11.20 10.80 20.18 19.55 20.10 18.92Portfolio 2000 -30.22 -17.11 0.05 28.42 39.62 51.37 49.52 49.91 52.94Sensex 2000 -24.44 -15.34 -14.03 4.97 5.73 17.15 16.87 17.81 16.56Portfolio 2001 29.67 17.11 56.62 70.75 88.79 67.24 57.87 58.26Sensex 2001 -5.14 -8.29 17.13 15.00 27.90 25.69 25.53 23.83Portfolio 2002 1.86 44.03 70.12 85.30 70.52 72.13 74.76Sensex 2002 -11.33 30.16 22.62 37.82 32.96 31.53 29.30Portfolio 2003 91.19 102.59 84.42 66.92 68.32 68.78Sensex 2003 91.06 44.20 59.64 47.14 42.33 39.09Portfolio 2004 151.46 136.97 93.67 85.38 89.21Sensex 2004 8.83 45.93 34.87 32.23 28.88Portfolio 2005 54.25 67.26 81.85 93.37Sensex 2005 95.67 50.13 41.10 35.96Portfolio 2006 16.94 18.28 28.83Sensex 2006 15.19 19.81 14.92Portfolio 2007 31.938 34.809Sensex 2007 18.82 14.69

NET NET DROPOUTS

Companies that disappeared from thenet-nets portfolio midwayyear 1 2 3 4 5 6 7 8 9 101998 1 3 1 1 11999 1 32000 2 32001 2 12002 12003 4 12004 12005 12006

2007


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of management and steer coursedifferently, it may not be the samefor regular stock investors whomay not be in any position toinuence managements.An Indian example comes from themid-cap segment of pharmaceuticalstocks. Take the Indian subsidiaryof Merck. Despite the fact that it hasthe equivalent of 30-40 per cent of its market capitalisation in cash, thestock price has shrivelled.In hindsight, its easy to gure out

why the stock has underperformed:revenues havent grown as muchand the balance-sheet has shrunk.So even as the company continuesto add to its cash pile every year,the stock remains trapped inthe doldrums.

8 Again, nding the right margin of safety itself is a difcult proposi-tion for strategies like cash bargains.Since these could involve long wait-ing periods, unless there is a triggerin sight, the opportunity cost of cap-ital; the potential casualties in theportfolio (because Graham believedin diversication with less due dili-gence as opposed to the strategy of concentration with utmost due dili-gence that Buffett follows); and thefact that Graham never looked be-yond fair-value situ-ations (not lettingprots run); the mar-gin of safetys has tobe considerably high.Finding such stocksin current circum-stances poses a seri-ous challenge.

8 While Grahams strat-egy is great in termsof capital protection,it focuses only on the arbitrage val-ue between the margin of safety

and the fair value of the stock (infact, Graham would invariably sellthe stock even before the fair value

was achieved). By doing so, somepresent-day value investors say, you

would lose out on the bigger valuethat is usually built into the growthof the company. Templetons Sub-ramanian says that it makes a lot of sense to look at metrics such as divi-dend yields because growth oppor-tunities in some segments may haveexhausted but the situation may beentirely different for India, wheregrowth in those segments may be

just picking up.

8 The ideal environment for the Gra-

ham framework to work is a purelycapitalistic society with little con-trols. But some companies that aregoing cheap in the Indian marketstoday namely those in the oil, fer-tilisers and sugar business arethose that have been hit becauseof government controls. Thesestocks look cheap, but its unlike-ly the situation will correct itself

unless the government steps in.

8 Again, one of the gripes against

47

Ramdeo Agarwal,

MD, Motilal Oswal Securities believ esin getting the purchase price right

Valueinvestors are

balance-sheetanalysts and

regular marketanalysts are

P&L analysts.


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Outlook PROFIT 31 January 2008

Grahams strategy is that frequentlythe list of worthy buys is made up of obscure stocks on which there is lit-tle public information. The reportedearnings are thus suspect and thechance of being duped, quite high.So following the rule always is nevereasy.

8 And nally, there isan anti-thesis to Gra-

hams philosophy.Pretty much likethe fact that somecompanies are

always cheap and they deserve tobe so there are others that deservesuperior valuations. A classic exam-ple, says Subramanian, is InfosysTechnologies. Earlier on we madethis mistake of trading Infosys for

cheaper software companies. Onlylater did we realise that in somecompanies, the premium was be-cause of the difference the manage-ment can make. It is not captured incurrent earnings but it can make adifference in the long haul.

PICKING WINNERSFinding the catalyst: Buying cheap isa great idea but the biggest challengein Graham-style investing is guringout the trigger that will unlock valuein the stock. While a margin of safetyis important, it is essential to look atthe probability of getting that trans-lated into returns. Sometimes, thecatalysts could be growth itself, saysprofessor Bakshi. If the stock tradesat a multiple of four times or so, andearnings are still growing, your totalreturns could be very attractive sinceyou can pocket a dividend yield, a priceappreciation equal to the earningsgrowth and see a potential re-rating of the stock as well. In addition, a poten-tial buy-back by a proactive manage-ment, special dividends, or open offersarising from potential take-over bids

act as catalysts as well.Despite the deep value some hold-ing companies harbour, there arefew takers for such stocks simply be-cause there are no obvious triggersin sight. But Bakshi says there is one

way to play these stocks. The cata-lyst, he says, could potentially comein the form of a turn in the businessof an underlying subsidiary. Usually,

when business turns, the perceived value of the holding company im-proves and results in a fall in its dis-count to intrinsic worth. The perceived

value in the company improves asa consequence. A case in point is Nalwa Sons.

The stock was available at a 75 percent discount to its intrinsic valuebut as group company JSW Steel(Nalwa holds 45 lakh shares) got re-rated for the better, the discountcontracted to 16 per cent of Nalwasintrinsic value.

Experts say the way to view suchcompanies is by taking a call on how the operating business of the subsid-iary will fare in the long haul. For in-stance, if cement is expected to do

well over the next ve years, it wouldmake a lot of sense to put money inholding companies of cement enter-

48

K N Siva SubramanianVP, Franklin Templeton Mutual Fund, has an

enviable long-term track record

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prises. There are risks to such a strat-egy though. The lack of transparencyin dealings between group companiesand the vested interests of promoterscan sometimes erode value in such

stocks.Unless you know that the inter-ests of the promoters are aligned withthose of minority shareholders, there isno point in touching such stocks, saysTempletons Subramanian.

Then again, the famous law of aver-ages or reversion to the mean couldhelp a stock run the distance. Instanc-es of over-reactions to one-off situa-tions could be good Graham picks.But investors really need to be able to

judge the situation correctly to makesure that what they think is a one-off really is just that.

Take the recent forex losses by somecompanies, for instance. Buying bankstocks just because forex losses camein much lower than expected is de-nitely not a wise call. At this point intime, its still uncertain if the prob-lem could strike again. It may not bea one-off situation as some experts areclaiming. After all, as professor Bakshirightly points out, there is never justone cockroach in the kitchen.

Talking of out-of favour stocks, investors need to careful when theyredealing with downturns.

Again, the problem with some com-panies whose names pop up as goodearnings yield candidates is that they

could run the risk of deterioration inbusiness. Candidates in the out-of-fa-

vour category now include commod-ity companies which look incrediblycheap but may be vulnerable to anearnings decline if the cycle turns for

the worse. One way to assess thesecompanies may be to look at averageearnings for the past ve years or moreto remove the effect of cyclicality.

Professor Bakshi says one way to lookat cash bargains is to identify compa-nies with fairly certain cash ows andnot focus as much on ab-solute cash levels. Sincecompanies with regularcash ows will soon turninto a treasure-chest of cash, they could be viewedas cash bargains, he says.

The problem with look-ing at future cash ows,as Graham also explained,is that it requires a judge-ment of the future andthose projections can dif-fer from person to person.Nevertheless, since stocksare now no longer avail-able at high discounts as inGrahams time, we cantignore the value of futurecash ows while looking at

valuations, says Bakshi. While Grahams solution

for minimising the risk of bankrupt-cies and frauds was diversication,looking at divergences in cash owsand earnings in recent years (not justquarters) can also be effective in spot-ting the warning signs. Instead of looking at accounts statements for justa year, we should look at the aggregatepicture for ve years, which will offerclues to the true picture, says Bakshi. Among companies that are capital in-

tensive, it is a worthwhile strategy tosearch for those that have a high returnon equity and low price-to-book value.

As Motilals Agarwal puts it: Value investors are balance-sheet analysts andregular market analysts are P&L ana-lysts. Value investors buy assets cheapand ahead of the market recognisinga turnaround. Thus, instead of look-ing only at operating and net margins,it is perhaps smarter to look at long-term returns ratios. With companiesoperating in cyclical industries, stocksshould be picked up when the industryis down in the dumps.

INTELLIGENT INVESTINGIt cannot be denied that Grahams

strategy demands enormous psycho-logical strength and will-power. Thatsbecause building a Graham-style port-

folio requires going after little-knownor desired stocks. We all know whatkinds of stocks are thrown up on thesescreens, but it requires nerves of steeland guts to buy these stocks. Why?For one thing, you may not have heard

about most of them. For another, mostof these stocks will be drenched in pes-simism, so most investors will be re-luctant to invest in them.

Indeed, the reason value investingis so difcult is because it may feelcompletely foolish for a while. But

true value investorsare not worried aboutlooking foolish as longas theyre certain theyhavent acted foolishly,remarks Bakshi. Yet impressions mat-

ter to a large swatheof investors. So evenif back-testing comesup with sparkling re-sults, its still difcultfor many to go aheadand take the plunge.The reason value in-

vesting is not popular isbecause people do nothave the patience to gothrough these dull andboring ideas, says Mo-tilals Agarwal. Another reason why

most investors get bludgeoned withtheir stock picks is that they dont always follow the rules and resort to gutfeel or judgement, which frequentlygoes wrong. As humans, we do getcarried away. A strict Graham strat-egy would involve selling stocks pe-riodically, in fact mechanically, adds

Agrawal. Another fact that Graham followers

need to accept is that they will rarelymake extraordinary returns. On theother hand, they will rarely lose mon-ey. Its important to be comfortable

with the fact that sometimes, they willmiss new growth opportunities butnot giving in to such temptations canensure a safer ride.

True, there are those who have beenenormously successful by follow-ing growth investing techniques. Butthese investors, it has to be acknowl-edged, are extraordinarily smart andhave learnt to be at the right placeat the right time. Very few ordinaryinvestors can aspire to be successfulthat way.

The relentless pressure of keeping up with the Joneses and the need to boast

about the latest stock picks at a party is what investors need to overcome to be-come really successful investors. p

DOGS OF THE NIFTYPortfolio of top 10 dividend yield stocks

YEAR 1 yr 2 yr

Portfolio 1998 -14.68 27.71Sensex 1998 -17.00 7.82Portfolio 1999 145.80 40.83Sensex 1999 40.05 2.87Portfolio 2000 10.53 26.90Sensex 2000 -24.44 -15.34Portfolio 2001 65.29 33.08Sensex 2001 -5.14 -8.29Portfolio 2002 4.64 90.51Sensex 2002 -11.33 30.16Portfolio 2003 198.09 77.03Sensex 2003 91.06 44.20Portfolio 2004 11.64 41.06Sensex 2004 8.83 45.93Portfolio 2005 83.05 33.90Sensex 2005 95.67 50.13Portfolio 2006 -4.25 11.70Sensex 2006 15.19 19.81Portfolio 2007 32.65 NASensex 2007 18.82

If you buy stocksbased strictlyon traditional

value investment

principles, youwill only playthe arbitrageopportunity,

but the biggeropportunity in acountry like ourslies in the futureas the business

grows.


Count on the Margin 01

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