The Hindu Business Line : Value stocks outperform funds

It is possible, using a formula-based approach, to identify a portfolio of ten or so stocks that could be winners. But, as such approaches sometimes tend to miss out on certain other factors that determine stock prices, it is good to watch out for specific market trends as well.

THE STOCK market's dalliance with value stocks has only grown stronger, continuing the trend that emerged in April 2003. Value stocks had been beaten down for many years before 2003, but for a brief recovery in 1999. They have since bounced back with a vengeance and continued their winning streak over the past 12 months too.

A portfolio of ten value stocks registered a gain of 105 per cent in the past 12 months. This was better than that of most actively managed diversified equity funds. Needless to add, the returns were significantly higher than that of indices.

Value portfolio: The ten stocks identified in October 2004 using a formula-based approach popularised by legendary US investor Benjamin Graham were: BPCL, Bank of India, Century Enka, Cholamandalam Investment, Karnataka Bank, Kochi Refineries, MRO-TEK, Munjal Showa, Sirpur Paper and Tata Investment Corporation. BPCL, Kochi Refineries and Sirpur Paper registered returns that were lower than that of the Sensex, while the others recorded 87-220 per cent.

The conditions used to identify these stocks were:

Low price-to-earnings multiple, meaning a PE that is below that of Sensex

Low price-to-book value; Price-to-book value lower than that of Sensex

Good solvency and low leverage

Growth in profits of at least 10 per cent compounded over the past five years

The record of the value portfolio in the last two years was also encouraging. Ten stocks chosen in October 2002 delivered average returns of more than 100 per cent over the next 12 months. This was then significantly better than what most mutual funds achieved. The performance of stocks chosen in October 2003 was considerably more mellowed. They did beat the Nifty and the Sensex but their returns were below what many equity funds notched up.

Trends over the past three years appear to indicate that the probability of outperforming equity funds is higher when stock prices are rising strongly. In a period characterised by volatility, as that between October 2003 and September 2004, the record of value stocks may not have been highly impressive. Having said that, identifying value stocks with a greater degree of research may prove rewarding. Formula-based approaches, on the contrary, tend to miss out on some factors that are determinants of stock price trends, which, in any case, keep changing. For example, this strategy relies heavily on a fund's record. The performance of formula-based approaches may suffer from the risk of inconsistent performance.

Portfolio for 2006: Fully cognisant of the pitfalls of adopting formula-based approaches, let us consider the portfolio for 2006: Andhra Sugars, Ashok Leyland, Bihar Caustic, GNFC, GAIL, GE Shipping, Hindalco Industries, Tata Steel, Tata Investment Corporation and Union Bank of India. But for Tata Investment, none of the other stocks figured in the 2005 portfolio. Hindalco had earlier figured in the portfolio for 2003.

The average dividend yield of the stocks in the portfolio is nearly 3 per cent. But for Bihar Caustic, the dividend yields of all the stocks are more than 2.5 per cent. The price to book value of all the stock is less than 3 and the average is about 2. The average PE multiple is about 8. All these multiples compare favourably with the average return on net worth of the portfolio of about 30 per cent. A notable point about the portfolio: Earnings of all companies are cyclical. The risk, therefore, may be considered high, normally.

Any reversal in global economic growth may thus hit the earnings of these companies hard. The low valuation of the stocks, however, promises that these stocks would weather the storm much better than others. If the economy keeps growing at a fast clip and commodity prices stay stable, returns to the investor will be attractive.

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page