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Subprime chaos: Plan your investement strategy for better returns

22 Aug, 2007, 1042 hrs IST,Prerna Katiyar, TNN

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While the world equity market was reeling under the subprime chaos, there was a small news item,

which probably slipped attention of many. Investment guru Warren Buffett was quoted as sayingworsening credit and housing markets may provide some real investment opportunities. Generally

speaking, when theres a certain amount of chaos in certain sections, it is unpredictable where thefallout will be, but the fallout offers some real opportunity. It may surprise many but investing in the

end seems all about conviction and lateral thinking.

Mr Buffett with his successful investment track record has created a cult of investment followers. In

fact, some days back S&Ps came with finding that Infosys , Wipro and Satyam would have fulfiled hisinvestment criteria. His investing picking style is unique, in that he uses a blend of value and growth

investment philosophies. He once said

I am half Benjamin Graham and half Philip Fischer . While the former is a thorough value based

stock picker, the latter has dabbled with growth strategies . Worldwide equity investors seem to bedivided into these two distinct styles of stock picking - Value and Growth. Both are quite popular

stockpicking strategies so lets first understand whos who.

Value Investing Offer till stocks last

Dont we rush to pick things on sale thinking that its real worth is more than the offer price. This iswhat value investing simplistically put means. Investors that follow this style specifically target

companies with strong fundamentals in terms of earnings, dividends, cash flow, etc but are trading

below their actual worth (technically its called intrinsic value). Investors believe that a value stock iscreated due to over reaction to particular news affecting the industry only in the short term. BenjaminGraham pioneered this method of investment. His investing style was invented from his bad experience

in the 1929 stock market crash in US and therefore one could see that his investment principles aremore defensive in nature.

He insists on margin of safety , which is nothing but the discount to the intrinsic value that the stockprice is currently quoting at. Wider the discount , more is the margin of safety. The parameters he uses

to pick stocks are low price-to-earnings ratio, price-to-book ratio or price-to-sales ratio. Some of thesestocks may no longer be the flavour of current investors but again, the fundamentals make a strong case

that the stock will bounce back and show its true colour . Value stocks are not sector-specific as anattractive bargain can almost be found anywhere, but the probability of locating them today is more in

energy, financial service or healthcare sectors.

A word of caution here - a value stock available at a bargain does not mean that any stock that has

taken a plunge will qualify as a candidate in this category. A company that has hit 12-month low maynot necessarily be a value stock. A stocks sudden fall may be the markets reaction to some

fundamental problem of the company and thus refuting the basic criteria for categorising a stock as avalue stock.

Before qualifying a stock as value pick one must ensure that the debt of company does not exceed itsequity and it has shown a healthy earnings growth over the past few years. One might also get into

value trap in which the low stock price never recovers in ones holding period and hence may not get

expected returns.

Growth Investing Mining Diamonds

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Unlike a value investor, a growth investor is concerned with the future potential of a company, and lessinterested in its current trading price - quite like mining diamonds knowing that it will give good

returns once it is cut and polished . Growth investing is based on figuring out companies that have thecompetitive edge to become the next Reliance, Infosys, ITC or Hero Honda. A typical growth company

has expanding business model and reinvests its profit for extending operations.

They are represented by high price-to-earnings ratio and price-to-book ratio. As a thumb rule, they

generally show considerably high return on net worth/ equity (RONW or ROE). This indicates that itsshareholders are current enjoying its growth story in the form of higher ROE. A company that has

shown robust growth in profits and is expected to do even better in future is a good candidate forclassification as growth stock. Investors are ready to pay a premium for such stocks factoring in the

future growth potential which leads to its high P/E ratio. They believe that increasing top line andbottom lines will automatically translate into higher stock price and hence will take care of the return.

At current juncture, companies in the infrastructure and IT sector would be good examples of growthstocks.

The risk involved here is actual growth falling short of expectations, for which you have already paid a

premium. This may be due to poor revenues and earnings and may lead to a slump in the stock price.

To pick or to mix

Now this is an on going debate. It is difficult to predict which strategy will outperform the other. If

there are cases showing that value investors have outperformed growth over a period of time, thesupport on the growth investor side may be no less.

In fact, both these stock-picking strategies compliment each other well. So, instead of sticking to onestrategy , an investor may strive for decent returns with low risk by combining growth and value

investing - quite like diversifying ones portfolio across sectors to minimise risk and add up returns.

Common parameters used by fund managers

P/E below 16 or P/B value below 1

Debt to equity ratio below 1

Dividend yield of 5% or more

Companies showing consistent growth in sales and profits

High return on equity (16% plus)

Firms with higher earnings margin