Buying rupee notes for 50 paise

Okay, you can substitute any currency in the phrase, but in its essence, value investing really is buying rupee notes for 50 paise. That sounds easy enough and if you are a reader of investment books and follow the economic news, you will be amazed that this simple principle has made Buffett, Munger, Graham, Miller, Klarman, Pabrai and many many more billions of dollars. That would be too good to be true and hence a warning is in order – as simple as it sounds, it is perhaps one of the toughest strategies to adhere to and will require discipline and a level of sophistication with subjects like corporate finance, accounting, strategy, corporate law, etc.

It started for me with a book called “Intelligent Investor” by the legendary Benjamin Graham. I read the book slowly (this was a new subject for me) and about a month and 300 pages later, I reached the section on valuing a company. I was puzzled at how Graham was referring to the value of a company as something “known”. How do you know whether the rupee note is really worth a rupee? I had read in my MBA classes of discounted cash flow as one of the methodologies, but that assumes prior knowledge of future cash flows. You may have that knowledge with some degree of certainty for a high quality bond, but stocks are a different matter. They are subject to the valuers experience more than anything else. I have been at it for 3 years now, and have never met (and will never meet) two people whose assessment of the “value” of a company is the same! Graham had distilled it into a simple formula and though I must admit that I have not found much use for that formula, a new value investor can perhaps use it to estimate the value of a company.

Even though the value of a company cannot be known for sure as each will have a different number, it can be estimated and can be compared with the current market price for its cheapness or dearness. The value of a company has to be a function of management quality, free cash flows, balance sheet, income statement, growth projections of the industry, growth projections of the company, shareholding, etc. Put your experience in the mix and each will be able to come up a weighted average of these factors. Let’s assume that for a company X, your valuation comes out to be V and you ask yourself how confident are you that the valuation is V? That’s a tough question, and the likely answer is that you don’t know. Really, no-one is sure what the correct value is and that is why a good value investor always keeps a margin of safety! If you value a company at (say) Rs. 100/share and its available at Rs. 50/share, well that’s a 50% margin of safety and in this case, you really are buying rupee notes for 50 paise!

So in its essence, value investing really is about

• Finding these rupee notes
• Finding these rupee notes which are selling for 50 paise or less
• Buying them and hoping that the values converge over time giving you a reasonable rate of return

It may sound simple, but does open a Pandoras Box of very pertinent questions. I will try and shed some light on these in my future posts, but as points to ponder, these are

• Finding the rupee notes: what is this about? As it turns out, many of the rupee notes (read stocks) circulating in the market today are fake or are 50 paise dressed up as rupee notes.
• If you can value a company selling at half or less of your valuation, so can others. And if it is correct, they may drive down the price down where the valuation gap disappears. In finance parlance, this phenomenon is known as the efficient market hypothesis. Take it from me, value investors believe in their heart of hearts that the efficient market hypothesis does not hold all the time, and there are lapses in the market which create a temporary valuation gap and the value investors exploit this. Your objective is to hunt for these gaps and profit from them.
• How do you know whether the valuation gap will close over time? Even the legendary Graham had trouble explaining why it closes, but take it from the masters that it does. Over time, it always does. Value is reflected in the earnings which drive up prices to its mean valuation.

Over the subsequent posts, I will delve deeper into these topics and suggest books and supporting material which the readers may find useful. This is a vast subject, and I will over time try and introduce readers to its breadth and depth.