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  • Gain Warren Buffett's edge with value funds

    Article by Neil Parikh in DNA, May 31, 2017

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    Value Investing can mean different things to different people. Value is expressed and measured in the eyes of the beholder. What may provide value to one person may not provide necessarily the same value to another.

    In a nutshell, Value Investing is an investment style whereby the investor buys a stock, trading at a significant discount to its intrinsic value. Investors look for 'margin of safety' when buying these stocks. It is the difference between the intrinsic value of the stock and the market price.

    Markets fluctuate between extremes. For instance, the onset of an unsavoury development may result in a stock falling out of favour. However, given the manic-depressive nature of markets, the price may be beaten down far more than warranted. This opens up an opportunity for the value investor, as the intrinsic value could now exceed the stock price. This provides an opportunity to buy at a bargain.

    There are two predominant value investing related schools of thought. The first one is Benjamin Graham's 'cigar butt' approach where one buys statistically cheap companies even if the business themselves are not particularly good. The idea is that buying these stocks is akin to finding a mostly smoked, discarded cigar. There might be one or two puffs remaining, which would be free. So you are only looking at quantitative measures here and not paying too much attention to the quality of business.

    The second school of thought is Warren Buffett's, where the approach is to find extremely high quality businesses with durable competitive advantages at a reasonable valuation. I belong to this school of thought.

    Some of the characteristics to look at in a company when investing with this philosophy are : management quality, some type of moat or competitive advantage, low or no debt, high dividend yield, low capital intensity and high return on equity (ROE). Importantly, they should be available at reasonable valuations. Also, one's investment horizon should be long (ideally, more than five years).

    The process of identifying and finding such opportunities is a tedious one and requires adopting an investor's mindset. This means eliminating the emotions of fear and greed from the decision making process, and basing the actions on factual data rather than just gut feelings.

    If this sounds tough, confusing and intimidating, do not worry! The good news for investors in India is that there are a few really good value funds (with a reasonably long track record) available in the market and one can invest in these, leaving the investment decisions to professional managers.

    Value funds typically provide low volatility and low risk in the portfolio. As investing is done with a margin of safety, downside is protected and can help ride out the storm in case markets are depressed for extended periods.

    When markets are in an upswing and valuations are expensive, such value funds typically take some cash calls, as investment-worthy ideas are hard to come by. They will not chase the 'hot' sectors or the 'fancies' of the market as these will most likely be expensive and will not fit the value strategy. Of course, this may hamper returns in the short run in case the markets continue their momentum.

    Hence, patience, discipline, a long-term view and the 'capacity to suffer' are vital attributes, both, for fund managers and investors in such funds.

    The managers of such funds are usually seeking sectors which are out of favour or aiming to invest in good companies whose stock price has plummeted owing to temporary reasons, either intrinsic or extrinsic.

    As it may take time for the gap between the stock price and its intrinsic value to be bridged, it is always advisable to opt for such funds only if one can stay invested for a period of at least five years.

    A key objective of such funds is : Cap the downside during difficult times and generate higher alpha over the long-term. Consistency of returns with low fluctuation in the net asset value is the gold-standard that such schemes aspire to. They prefer to adopt a disciplined approach, rather than blindly chasing peers.

    The mindless chase for returns often entails a symmetric increase in risk profile. This can be profitable till the good times last. But when the markets turn, such funds will be prone to massive losses as they have invested in hot sectors whose valuations far exceed prudent levels. In contrast true-to-label value funds will not go down as much and consequently, protect your capital.

    These funds believe that the power of compounding will help create wealth over the long term and that this can be done by eschewing needless risk to one's capital. Crucially, they understand that not losing money is more than half the battle won.

    In conclusion, if an investor has the patience to remain invested for at least five years and wants long term wealth creation with low volatility and risk, then value funds should be the investment vehicle of choice.

    SAFE INVESTMENT

    Value funds typically provide low volatility and low risk in the portfolio and some even have long track records.

    Some value funds take cash calls when markets are on an upswing and valuations are high.

    The original article could be seen here.

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