In search of value

GUEST COLUMN

Are conservative value stocks available in the market at valuations that fit Benjamin Graham's criteria? A report.

Can we find Benjamin Graham's conservative value stocks now? This is a question asked by many investors who have studied Graham's methods of buying cheap stocks.

In an analysis of all the listed stocks based on their ten-year financial performance over the period 1996-97 to 2005-06, nine companies came out as value stocks.

Under the criteria specified by the Graham-Rao method, the quality criteria were:

Rs 100 crore sales in financial year 2005-06

Current assets should be at least twice that of current liabilities and the debt-equity ratio should not be greater than 1:1 at the end of FY06

The company should have paid dividends and earned profits for the last ten years

There should be annual growth (CAGR) in earnings per share (EPS) of at least 10 per cent a year over the last seven years

The fair value criteria are:

The multiplier applied to seven-year average earnings is equal to the seven-year growth rate in EPS subject to a maximum of 20

The multiplier applied to the book value is 1.5 The compound annual growth is calculated by using seven-year EPS data of financial year ended March 2000 to year ended March 2006 using the principle of sum of terms in the geometric progression. This will give a uniform compound annual growth rate from the uneven EPS data.

Though 44 companies satisfied all the quality criteria, nine companies (from Cheviot Co to City Union Bank) satisfied the two valuation criteria (fair value based on earnings and book value) based on the January 3 stock price.

Could conservative investors buy them now? The initial answer would be yes, with the condition that the full portfolio is to be acquired. But please heed Graham's word of caution--the price behaviour of conservative value stocks will be similar to that of the market. Hence if the market corrects, the price of these stocks may also go down.

Also there can be a possibility that the good earnings record of these companies may not continue if there was a sudden spurt in earnings in some of these companies in the last one or two years due to specific economic events. Hence, there are risks from the perspective of earnings as well as from market price behaviour.

Graham advises investors to do a type of dollar cost averaging by recommending decrease in allocation to equities as the prices move up and increase in allocation to equities as prices move down. The minimum allocation to equity is specified as 25 per cent and the maximum allocation is specified at 75 per cent of the total securities portfolio.

Every year, investors are advised to improve the quality and value of their portfolio. Thus, long-term investors could modify their portfolios by including these stocks.

The stocks that satisfied the quality criteria include companies like Infosys, Wipro, Hindustan Zinc, Kansai Nerolac, Aventis, Container Corporation and Dr Reddy's Laboratories, but their market price is higher than the earnings and book value based fair value.

The value estimates provided here are valid till new annual financial results are declared. Hence investors can use these value estimates to compare with market prices periodically.

The 52-week high and low prices are presented to provide a reference for comparison. It is interesting to see that when one compares the fair value based on both earnings valuation and book value criteria, in five cases the 52-week high is below the fair value, while for the rest, it is between the 52-week high and low.

Graham commented that market prices exceed the fair values determined using this valuation method whenever expectations regarding spectacular future performance of the company over a fairly long period are factored in by market participants.

Conclusion
Graham's conservative value analysis approach has selected nine scrips fit to be labelled as 'value' stocks, available at less than their fair value.

The fair value estimates were found to be either higher than the 52-week high of between the high and the low for these stocks.

The analysis also provides a reference point for detailed investigations of growth prospects of the companies by professional analysts, so that the case for acquiring the value stocks identified by this method can be further supported.

                          (Click here to see table)

(The writer is professor of investment management at National Institute of Industrial Engineering in Mumbai)