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Warren Buffett once described value investing in the simplest terms as "buying a business for less than its worth". Unfortunately, situations of clear under-valuation don't arise all that often. And, judging what a business is worth is not an easy task. Assets owned by the business are worth something. There are also the potential future profits. Valuation of the latter is difficult.
Value investing also requires patience. The investor has to identify businesses that are selling cheap, buy and wait for the price to correct upwards to fair valuation or beyond. Most value investors look at the net worth of a company first - this is a rough valuation of the assets. The net worth can also be usefully represented as the net worth per share, which is more often called the book value (BV).
The BV is usually an understatement. First of all, BV undervalues fully depreciated assets such as machinery which is still productive and it usually undervalues real estate. Second, BV ignores future cash flows from a running business.
A price-to-book value (PBV) of less than 1 shows that the company's market value is less than the value of its assets. If it is making any profits at all, this must be an under-valuation. So, a situation when a running business is trading below book value is always worth examination.
This kind of discount can occur at the nadir of a cycle for a deeply cyclical business. Or it may be due to some sort of temporary setback. Both these cases are tempting. However, a situation where an apparently decent business is trading below BV can also happen because the market has no faith in management. Such a situation, when the price is low because management has a dubious reputation, is usually worth avoiding.
On a market-wide basis, the value investor can also look at averaged book value across an entire index. This is interesting. It is reasonable to assume that a low index price to BV is unlikely to be caused by the market's distrust of the management of every company in the index. So, a low index to BV ratio is more likely to be a bargain than a low PBV for a single company. However, it is also unlikely that an index PBV will ever hit the "perfect bargain" levels of 1 or less, even at the bottom of a big bear market.
The PBV ratio is mean-reverting for the Nifty. It is positively skewed with a longer right tail (that is, there are more high values than low values). The lowest Nifty PBV ratio since January 2010 was 2.6, while the highest ratio was 3.97 and the average ratio was 3.25, with a standard deviation of 0.32. The current value is 3.4, which is just a little above the long-term average.
A value investor would settle for a ratio of below 2.9 ( the average minus a standard deviation) as "cheap". Such a low PBV occurs just 13 per cent of the time. On the obverse, valuations above average plus one standard deviation (above 3.65) occur 22.4 per cent of the time.
The historical characteristics suggest that the Nifty is not particularly over-valued at the moment. But nor is it undervalued in historical terms. There is no reason for a value investor to get excited or alarmed by current values.
As the statistics indicate, roughly 65 per cent of the time, a broad index like the Nifty stays in the fairly valued zone of average plus/minus one standard deviation. Anybody who bought when the Nifty was below the mark of average minus one standard deviation would have picked up decent returns on those investments. Somebody who bought at above the level of average plus one standard deviation would be carrying a higher risk of capital losses.
Note that the Nifty has moved from a low of 4,500-4,600 in 2011 to recent highs of 8,180 - roughly 80 per cent off the lows. But that huge range is normalised to some extent by the BV, which has moved between 2.6 and 3.97 - roughly 50 per cent from the lows.
Looking at the index over a five-year timeframe helps with perspective. The market may have zoomed up in the past five months. But over a five-year frame, the market still looks reasonably valued. For a long-term investor, it is business as usual rather than a situation dominated by abnormal values.
