Searching for value among cheap stocks

All investors - whether big, small, long term or short term are forever searching for a scrip, available at a bargain price and which the market has yet to identify and which would be means to riches. It is the Holy Grail of the investing community.

How often have we been confornted by stocks available at a throw-away price just a year back and which we had ignored only to find that it is set to be the next growth story in the market. By the time it comes to our notice it is too late and it has already appreciated nearly 100 per cent.

Uma Shashikant of PruICICI asset Management Company has set out some rules by which to identify such scrips and do some value investing.

According to him, "Very often we know of stocks that have climbed up significantly in price, and the arguments for spending time and energy to locate them, are so compelling."

On the other hand we are also keen to find out which are the ones people are buying and see which stocks fit the value parameters we have set. Let us start out by the gainers list. This gives us a fair idea of stocks in which the big investors are interested in - or least some people in the market are interested in.

Uma says, "This list almost always throws up unknown names, and cheap stocks, with low volumes, and in many cases, it is the promoter, insider or interested groups selling or buying the stocks. Just look at the list of top gainers on any given day, and see how many ring a bell. Not many. They are all invariably unknown, unheard of. Consider the list of top winning stocks for the year. You will notice that a stock that appreciated from Re 1 to Rs 6 could well be on the top, having appreciated 500 per cent."

Is this stock meant for us? Very likely that the company is not so well known, and numbers are tough to get.

"We then turn attention to analysis, where we want to check some fundamentals and confirm that there is a story behind the price performance," Uma says.

The most popular fundamental parameters are price to earnings ratio and price to book value ratio. So what is the big deal about these ratios? If the P/E is a single digit number, and lower than the level for the market or the industry, we are sure we have a bargain on hand.

So is the case with stocks that have a low P/BV. If the book value of the stock is higher than its price, its sure has to be a bargain, because the price does not even fully reflect the accounting numbers.

"Some like to see the dividend yield as well," Uma points out. If the market's dividend yield is at three, and there are stocks with yield above that, they sure are selling cheaper relative to the market.

"It is easy to shortlist stocks on the basis of these parameters with any of the databases that are now widely available," she says.

But in most cases what we end up with, is a list of companies we know little about, companies that have a earnings of Rs 0.50 per share, selling at Rs three, showing up as a bargain at a P/E of 6. Is that your stock? Not sure?

That is really the problem in bargain hunting.

Cautions a fund manager, "There are a set of stocks that are 'cheap' - the untouchables if you like."

These are stocks that are neglected by the market, for a variety of sound reasons - poor management quality, failing business, unscrupulous promoters, lack of performance numbers, manipulated accounting data and such reasons.

Buying them cheap is not worthwhile, because they will not show any appreciation in price and could end up being dud stocks in your portfolio. Would this then mean, that market is always right? And that a good stock may not sell cheap? That is what academics call as market efficiency.

They like to point out that markets have the ability to price stocks right, because a large number of people are simultaneously examining information, and little would be missed.

So is bargain hunting futile?

"The truth actually lies somewhere in the middle," says Uma. While the market could be right most of the time, it does provide some windows of opportunity. Markets tend to overreact to information.

They could beat down prices of good and bad stocks, on unfavourable news. There are also situations where a stock is out of favour, because the company is going through a rough patch.

Among a numerous cheap low P/E and low P/BV stocks, could be gems that are yet undiscovered. They would surely be a few out of the many we short listed, that could turn out to be multi baggers.

To be able to invest into such stocks, that are out of favour, beaten down in price but have the potential to bounce back, making sure we have a bargain on hand, is value investing.

Very tough to implement, because choosing good companies from the heap of cheap stocks, requires familiarity with the business, ability to assess the management, effort to cull out the numbers, and in some cases, work with the management to steer things around.

"Which is why it is best implemented through an institutional investor - like a value fund, a private equity fund, or a venture capital fund,"says the fund manager.

Right now the market is attractively valued at a P/E in the range of 12. There are stocks that are valued even more attractively.

Opportune time to look at a value fund that picks out the winners for you." Well, what are you waiting for? Go out and start operations at once.

How to pick a winner

• The most popular fundamental parameters are price to earnings ratio and price to book value ratio. If the P/E is a single digit number, and lower than the level for the market or the industry, one can be sure of a bargain on hand
• If the book value of a stock is higher than its price, it has to be a bargain because the price does not fully reflect the accounting numbers
• If market's dividend yield is at three, and there are stocks with yield above that, they are selling cheaper relative to the market
• Choosing good companies from heap of cheap stocks, requires familiarity with the business, ability to assess the management, effort to cull out the numbers, and in some cases, work with the management to steer things around
• The best investment vehicle would be an institutional investor such as a value fund or a private equity fund