Filtering the market

SMARTSHARE

Different people swear by different valuation methods. But a good business will tend to score high on several metrics simultaneously.

The most critical part is setting up the first filter that winnows a few potentially investment-worthy stocks out of several thousand. This initial search tends to be both very intensive as well as extremely hit-and-miss.

This is where the big financial outfits score. They can use brute force to identify hundreds of potential candidates and narrow these down to a handful. They also have access to managements in a manner individuals don't.

My first filter is technical. I query for unusual changes in price-volume patterns and then trawl for fundamental information or news that might provide reasons for such unusual changes. Other people start with a PE cut-off, a base EPS growth rate, a high RoI etc, as their filters.

Some evidence suggest that any rational filter seems to yield results that are at least, marginally better than purely random selections. But as a method becomes more popular since it's successful, more people start to use it and the edge erodes.

Filters can be broadly classified as conservative or aggressive. An aggressive filter depends on something like high earnings growth. This is likely to ignore or place a low weight on value and the strength of the balance sheet. High EPS growth may translate into stratospheric PEs as occurred during the IT boom.

A conservative filter focuses on value. Typically, these are low PEs, low Price-Book Value ratio, high interest cover, low gearing and consistent dividend payouts. Growth gets a much lower weight.

The two are not mutually exclusive. A high-value stock can be high growth. And, a high-growth stock may be high-value. Think of Infosys in 1998, for instance; it was an obvious buy on both aggressive and conservative metrics.

At different stages of the market cycle, different filters work better. During a boom cycle, the aggressive filters offer higher capital gains. But conservative filters work even during busts whereas aggressive filters don't. When we account for risk and "weather-proofing", conservative filters seem to work better than aggressive ones.

This is definitely a conservative investor's market. It doesn't take Nostradamus to make two predictions: 1) Global crude prices will stay for several years. 2) Indian reforms will stagnate or at best, maintain current momentum until 2009. If those two predictions turn out to be true, betting on high-growth is like going skydiving without a reliable chute.

A few conservative possibilities occur to me. One is the good old dividend play. If you find a stock offering better than 4 per cent dividend yield, there's a reasonable cushion of safety. The other is relatively low PEG ratios "" my cut off would be 0.75. You can find both but only in unfashionable businesses.

Tata Chemicals is an interesting possibility. Its dividend yield is over 3 per cent. It has a very comfortable PEG of much less than 0.5 based on Q1 results and FY 06-07 estimates.

The Gujarat floods could cause a sell-off that makes it a serious value proposition. Its off-take may be affected in 2006-07 but it's likely to recover quickly.

At the current price of Rs 215, the stock is down Rs 45 from its April 2006 highs. It would be a very tempting long-term buy if the price drops to the Rs 180-190 zone.