What is the most important ingredient for investing in the market?
Just one word is information. Getting information to understand the business of a firm and how that is going to transpire into its financial statements. Information is the goal. It reduces your uncertainty and risk. The key is to get the information. The target of the information and value investing is to discover, as Benjamin Graham would say “I want to discover where price is different from value”. Price is what you pay and value is what you get. You want to pull that information to get an understanding of where these opportunities are where price is different from value.
It is active investing. It is different from buying a passive index and where you are just buying a basket of curious stocks and you exposed to the risk in those stocks, it is saying let me go through that basket and work out those which I want to buy, which I do not want to buy based on the information. But the key is information.
A lot of times people get confused between value and low price and they fall into value traps. How can we evade that and still find high quality companies at attractive value?
Well again it is information. You find that by information and there are traps out there. These traps are you see good companies and you think I will buy good companies. Now you do not buy good companies because good companies can be bad buys. There are firms that trade in low multiples and low price to earnings ratio and price to book ratios. for example, which turn out to be not good investments.
You are buying risk and so you need to get to understand that pricing is a good price to earnings ratio. Price to earnings ratio is based on growth. You are buying growth.
One of the mentors of value investing, Benjamin Graham, said beware of buying growth because growth is risky. So, buying a price multiple is buying growth and you should be aware of the risk. It is a deep analysis of risk as well as what the earnings’ pay offs are going to be. That is the key to it.
What are the key differences in your view between the two approaches – value investing and growth investing?
Value investing and growth investing in my mind is a bit of a misnomer. It is fuzzy thinking. All investing in my sense is value investing. I can buy good value in growth. One of Benjamin Graham’s notion was I do not buy growth because it is risky. One of the complaints about Benjamin Graham’s approach was in his days — we are thinking about the 1940s and 1950s — you could find companies which were underpriced without building in growth.
The complaint was that he would have missed out on one of the growth companies of the last half of the 20th century. He would have never bought IBM because he is buying growth.
What modern value investing does is we bring the two together. We really think about buying value in growth and most new companies — technology companies, new service companies, many of the new economy Indian companies — are based on growth. It is a growth economy here. They are relying on growth in the world and having systematic ways of buying that growth. That the new edge to value investing. The distinction between value and growth goes away in that framework.
The three most important words in the field of finance they say are margin of safety. A lot of time, investors pay more emphasis on potential returns and compounding returns. They start giving lesser weightage to the risk which comes along. How, in your view, should investors approach their calls so that risk as well as return equally importantly is taken into accounting?
Yes, risk goes with the return. You got to understand the risk. Margin of safety is a very important concept and I can put it in another way. Very often in finance and investing, we talk about the business risk. We talk about bettor risk. We talk about the bettors of stocks. These are actually important concepts and things you have to deal with. But the primary risk of investing is the risk of paying too much.
So the idea that you pay too much for a stock, that is your biggest danger. Actually, finding stocks where value is less than price is very important. That’s is the first way to deal with risk and that is a margin of safety. I do not buy stocks that are maybe reasonably priced or may be delivery price. I try and find stocks with good returns. I buy them with a margin of safety. With some good conviction, I understand, that this actually is a pretty good risk.
Anything can happen of course in this uncertain world but I do that with a margin of safety. When I think about risk, I consider how I am going to apply discount rate. If in fact, it is a reasonable rate of return, say 8% is a reasonable rate of return in the US market in this environment. If I can find one that is going to give me 10%, then I have a margin of safety there because I cover my required return of 8%.
One of the most actively used tools for arriving at the right valuations world over is discounted cash flows. In India too, a lot of fund managers and analysts use that. You have been talking about why discounting cash flows and projecting them in future may not be a very accurate way of arriving at value. How do you analyse that?
Yes, that is a correct statement. I think, discounted cash flow analysis is a very common technology for valuation, is a very speckle technology. First of all, it forecasts free cash flows. In the terminology in the accounting of free cash flow, is the that cash come from your business minus the cash investment.
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Stephen Penman on how to avoid falling into value investing traps have 1172 words, post on economictimes.indiatimes.com at August 23, 2018. This is cached page on WP Discuss. If you want remove this page, please contact us.