The merit of value investing

GUEST COLUMN

A portfolio of stocks designed on the basis of Benjamin Graham's principles has beaten the market over the past three years.

Benjamin Graham, the author of Security Analysis, is hailed as the dean of Wall Street. In another book titled Intelligent Investor, Graham outlined an analytical method for defensive investors who want to use only simple methods of analysis as they cannot spare much time for active investment effort.

To make Graham's method growth-oriented and more explicit, this author provided specific numerical estimates and the modified Graham-Rao method was described in A Nine-step Route to Picking Value Stocks published in the The Smart Investor dated August 25, 2003.

The key criteria
The analytical criteria of the Graham-Rao method contain quality criteria and valuation criteria. The quality criteria are:

The company must have an adequate size (Sales of Rs 100 crore may be taken as adequate size for Indian companies)

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

The company should have paid dividends and earned profits for the last 10 years

There should be a growth in earnings per share (EPS) of 10 per cent per annum over the last seven years

The two valuation criteria are:

1.The current share price should not exceed 20 times the average EPS in the last seven years for companies with a seven-year growth (GAGR) higher than 20 per cent. For companies with past growth rate between 10 and 20 per cent per annum, the multiplier has to be the growth rate itself. In other words fair value is the average EPS of the last seven years multiplied by the P/E ratio specified as above

2.The current price should also not be more than 1.5 times the latest book value.

The method requires 10-year data to analyse stocks. But the method is unambiguous and uses a limited number of ratios.

Investors may complain about the 10-year data requirement; but they have to keep in mind that their hard-earned money has to be protected by committing it to companies with a good past record. Graham actually recommended dividend payment for 20 years.

Even though Graham's method has been known to the investment community since 1960, descriptions of its successful application were not available in published literature in both scholarly as well as popular versions and hence the method did not get the attention that it deserved.

The method is value-oriented and hence is more suitable to use during periods when the share prices are stable or falling. During periods when share prices are appreciating at a fast pace like in the past few times, value methods fail to identify potential buys and momentum methods take centrestage.

As a person interested in this method from a scientific as well as practical perspective, I applied this method of analysis on BSE's 'A' group shares in December 2002 and January 2003. I found 38 shares to be potential buys under the main valuation criteria of using past seven-year growth rate in earnings per share (EPS) and past seven-year average EPS.

The fair value is obtained by multiplying the average EPS with the past growth rate with 20 being the maximum multiplier. The fair values thus calculated are shown in Table 1. 

PERFORMANCE OF VALUE SHARES IDENTIFIED ON THE BASIS OF EARNINGS VALUATION IN JANUARY 2003
	"7-Year Avg. " of EPS (Rs)	"7-year growth rate" in EPS (%)	"Fair Value" (Rs)	"Price on" 29/1/03 (Rs)	"Adjusted price on" 20/11/06 (Rs)	Appreciation  (%)
Abbott	25.36	29.50	507.26	303.25	540.45	78.22
Adani Exports	31.92	18.00	574.56	135.55	1511.50	1015.50
Aurobindo Pharma	21.77	50.00	435.32	240.80	1173.30	387.25
Bharat Electronics	11.23	50.00	224.68	188.15	1110.15	490.03
BHEL	19.96	11.00	219.60	188.60	2403.50	1174.39
BPCL	20.67	15.50	320.43	194.40	370.35	90.51
Container Corp	22.69	35.00	453.80	233.80	2121.75	807.51
E Merck	14.54	20.00	290.80	241.60	471.65	95.22
GAIL	10.58	18.00	190.48	69.90	256.15	266.45
GMDC	19.53	15.00	292.95	86.10	342.20	297.44
GSK Consumer	17.11	25.20	342.20	269.00	538.90	100.33
GTL	31.88	20.00	637.68	76.30	127.75	67.43
HCL Infosystems	12.24	39.00	244.80	90.80	807.25	789.04
Hindustan Zinc	1.82	19.50	35.49	17.90	843.95	4614.80
Hindalco	72.92	10.00	729.20	599.35	1712.00	185.64
IBP	25.92	27.80	518.40	225.20	523.90	132.64
ICI	13.68	15.00	205.20	119.95	335.90	180.03
IOC	26.41	16.00	422.56	244.30	778.65	218.73
JB Chemicals	16.13	13.80	222.53	178.35	446.75	150.49
Kochi Refineries*	11.94	12.90	154.03	45.50	164.60	261.76
LIC Housing Finance	12.77	20.00	255.40	65.00	169.60	160.92
Moser Baer	16.95	36.00	339.00	194.55	496.40	155.15
MRF	146.15	24.00	2923.00	874.10	4423.20	1444.68
MTNL	18.12	13.00	235.56	107.45	130.60	21.54
Neyveli Lignite	2.70	18.80	50.80	25.00	62.80	151.20
NIIT	25.27	24.50	505.40	133.15	374.10	180.96
Novartis	16.02	19.00	304.42	267.55	406.20	51.85
ONGC	24.06	18.50	445.11	376.75	842.95	123.74
Procter & Gamble	24.45	22.90	489.00	394.00	1355.85	244.12
Pentamedia Graphics	24.03	13.90	334.02	16.35	4.35	-73.39
Pidilite	13.75	25.00	274.92	241.55	1040.00	330.35
Punjab Tractors	13.36	36.00	267.16	144.65	225.20	55.69
Rolta	8.66	34.50	173.20	70.00	268.40	283.43
SBI	30.17	17.50	527.94	283.45	1209.25	326.62
Sonata Software	1.46	38.50	29.22	15.95	34.45	115.99
SSI	18.24	41.50	364.76	84.50	157.00	85.80
Tata Tea	16.72	18.50	309.32	160.45	702.10	337.58
VSNL	34.77	23.00	695.40	90.00	439.50	388.33

The fair values were compared with prices on January 29, 2003, and the shares whose prices were less than the fair values were identified as the candidates for buy decision. These buy candidates were compared with the brokers' recommendation at that point of time. Eleven shares were found to be on the recommended buy list of brokers; and these are mentioned in Table 3. 

TABLE 3
Adani Exports	Moser Baer
Bharat Electronics	Neyveli Lignite
BHEL	Novartis
BPCL	ONGC
GSK Consumer	Procter & Gamble
Hindalco
This is a list of value shares selected on the basis of earnings valuation and price/book value criteria in January 2003

The performance record of the value portfolios specified in 2003 was reviewed recently based on the November 20, 2006 prices. The current market prices were adjusted for bonus issues and stock splits and the adjusted values are shown in tables.

Table 1 contains the details of shares that are undervalued on the basis of earnings valuation criteria. Table 2 contains the list of shares that passed both the earnings valuation criteria and book value valuation criteria. 

THE MERIT OF VALUE INVESTING
TABLE 2
Adani Exports	Hindalco	Neyveli Lignite
Aurobindo Pharma	IBP	NIIT
BHEL	ICI	Pentamedia Graphics
BPCL	IOC	Rolta
GAIL	Kochi Refineries*	SBI
GMDC	LIC Housing Finance	Sonata  Software
GTL	Moser Baer	SSI
HCL  Infosystems	MRF	Tata Tea
Hindustan Zinc	MTNL	VSNL
This is a list of value shares selected on the basis of earnings valuation and price/book value criteria in January 2003

Table 3 contains the list of shares that passed the earnings valuation criteria and also recommended for purchase by the brokers.

Portfolio performance
To compare the performance of the portfolios with the market's performance, the performance of the portfolio under two alternative strategies was calculated. Strategy one assumes an equal investment of Rs 4,000 in each of the scrips. Strategy two assumes an equal investment of 100 shares in each scrip.

The closing value of the Sensex on the day is 13,430.71. The value of Sensex at the initiation of the portfolio was 3,238. The current value of the portfolio where an equal amount of investment (Rs 4,000) was made in each scrip of Table 1 is Rs 7.84 lakh.

Investment in Sensex multiplied to 4.15 times during this period. In comparison the investment in the equal-amount portfolio went up to 5.15 times. In terms of annual growth rates, the Sensex growth rate is 46.89 per cent and the portfolio growth rate is 55.77 per cent.

The second portfolio strategy applied to shares in Table 1 required an investment of Rs 6.71 lakh and the amount would have grown to Rs 28.92 lakh. This would result in the portfolio going up 4.31 times giving an annual growth rate of 48.45 per cent.

Thus the portfolios under both strategies having all the shares have beaten the market performance at the current peak level.

Equal-amount investment portfolio in Table 2 shares would have grown to Rs 6.38 lakh. The portfolio value would have multiplied by 5.91 times giving an annual average return of 61.65 per cent.

For portfolio strategy two, the value would have grown to 19.82 lakh from the initial investment of Rs 3.87 lakh. The portfolio would have multiplied to 5.13 times giving an annual return of 55.54 per cent.

The portfolio of shares that satisfied both the valuation criteria also gave an above market performance in both the strategies. It is interesting to observe that performance of these portfolios is better than the portfolio of shares in Table 1.

During this period, the 11-share portfolio (shares identified by Graham-Rao Method and recommended by brokers) would have given an annual return of 49.60 per cent in equal-amount strategy and 43.61 per cent in equal-number strategy.

Conclusion
This analysis and its subsequent monitoring suggests evidence in favour of the method. Conservative and defensive investors can use this method to identify fairly valued and undervalued shares as and when they are available in the market and include them in their buy and hold portfolios.

But investors have to remember another Graham's statement that market risk exists along with promise of return in equity share investment.

There is no foolproof analytical method that will assure you only price increase in the stock market subsequent to your buying the share. You have to be prepared to tolerate a 50 per cent reduction in market quotation even after you buy at fair value or at a still lower price.

Also, every value share included in the portfolio may not turn out to be winner. Share investors have to be prepared for losses in some commitments and can expect profits only at the portfolio level.

(The author is the professor of investment management at National Institute of Industrial Engineering)