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Count on the Margin 01

Count on the Margin 01

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Published by ekramcal

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Published by: ekramcal on Nov 21, 2008
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I
t cannot be denied that the GreatDepression of 1929 and the WallStreet crash that followed was per-haps the most humbling experi-ence for investors at the time. Life wastough and there was no hope to clutchon to. After crushing losses, moststocks were available at ridiculouslycheap prices over the next decade asthe markets remained trapped in abear grip.But as any stock expert will tell youtoday, behind every market disasterlurks opportunity – if you just lookhard enough. It was the same for Ben- jamin Graham, who, despite sufferingheavy financial losses himself, begana conscious campaign of snapping upstocks that suddenly became availableat bargain prices.Graham’ strategy was simple: buycompanies that he likened to cigarbutts – typically abandoned but stillgood for a puff or two. And you couldpick them up for virtually nothing.Stocks quoting below their liquida-tion values after keeping a ‘margin of safety’, allowing for any contraction inprices, were his key bets.His strategy soon started being talk-ed about in the investing community.One man, in particular, was highly in-fluenced by Graham’s strategy, andin tribute to his ‘idol’, bought sharesin about a hundred such cheap com-panies. His faith soon paid off: in fiveyears, John Templeton – whose nametoday is synonymous with valueinvesting – had multiplied hisoriginal investment several times,despite around 15 of those companiesgoing bankrupt.The value investing philosophy pro-pounded by Graham and practised vigorously by Sir John Templeton waseventually perfected into an investingtechnique that called on investors tobuy stocks cheap – so cheap that there was very little chance of the stock fall-ing any further (thus avoiding any lossof capital). After Graham articulated histhoughts on the subject in the book Se-curity Analysis in 1934, value investinggrabbed the attention of several pro-fessional investors, many of who haveadded their own perspectives over thefollowing decades. Nevertheless, thebasic essence of value investing hasremained the same: buy cheap.It was a philosophy that was bornin desperate times (the Depressionyears), and underwent a baptism byfire as it was tested time and again overthe next few years.So it wouldn’t be wrong to wonder just a little bit whether those princi-ples still work in today’s times, giventhat the past few years have been ex-ceptionally exuberant for the world’smajor stock markets.Cut to January 2008. In sharp con-trast to the crisis engulfing the stockmarkets when Graham started out, the world’s economies – India’s included– were exuding confidence like neverbefore. Many experts claimed that In-dian financial markets were experi-encing a secular bull run, not a cyclicalupswing that would die down anytimesoon.
Times have changed since Benjamin Graham wrote the Security Analysis buthis principles can hold investors in good stead even now
N Mahalakshmi & Mohammed Ekramul Haque
13 June 2008
Outlook PROFIT
41
Cover Story
COUNT ON THE
 
Besides, stock prices were catapult-ing and there was what seemed like anever-ending flood of foreign moneypouring in. For five straight years tillJanuary this year, the Sensex provedthe sceptics wrong at every level as itrapidly scaled new all-time highs, re-covering almost immediately afterevery tumble. And investors continued to buy intostocks, whatever the price.Then, the inevitable happened. Glob-al markets nosedived and over thenext few months, continued to plungeas bits of bad news kept leaking outat a steady pace. Investors who hadbought stocks at steep valuations now began to understand just how foolishtheir actions were, not to mention thespeculators who had joined in for thefree ride. Value investors had seen this comingall along. At a lecture in India on Janu-ary 8, Bruce Greenwald, renowned fi-nance professor at Columbia BusinessSchool, referred to stocks markets as‘being expensive’. At the time, stocks were actually peaking out. Greenwaldteaches the ‘Graham and Dodd’ styleof investing in the university Grahamgraduated from. Value investing is not about predict-ing when markets will hit their peaks.Graham (and today’s value investorsagree) emphasised the preservationof capital as the bedrock of investing.“The beauty is, as Graham said, any-thing bought cheap will invariably goup in price,” says Chetan Parikh, asuccessful Indian value investor andmanaging director of Mumbai-basedJeetay Investments.There is one difference though. What Graham considered bargainsand what today’s value investors con-sider as cheap (and we are not talkingabout growth-style investors who donot mind paying a high premium forstellar growth prospects) are separatedby time.
42
Outlook PROFIT
13 June 2008
Cover Story
CASH BARGAINS PORTFOLIO
Portolio consists o stocks with cash and marketable securities greater than market cap
year1 yr2 yr 3 yr4 yr5 yr6 yr7 yr8 yr9 yr10 yrLatestPortolio 199856.3013.47-45.88-22.24-12.962.035.9815.4110.658.688.42Sensex1998-17.007.82-4.23-4.46-5.885.916.3214.7514.8015.7414.78Portolio1999196.20-25.04-15.97-14.894.0124.8225.8721.0325.3926.24Sensex199940.052.870.12-2.8711.2010.8020.1819.5520.1018.92Portolio2000-45.69-37.70-3.116.5519.2419.6518.0529.1428.81Sensex2000-24.44-15.34-14.034.975.7317.1516.8717.8116.56Portolio2001-13.43-3.3031.7553.6466.8263.8874.1977.32Sensex2001-5.14-8.2917.1315.0027.9025.6925.5323.83Portolio2002-2.9839.6773.5186.9876.9684.3584.91Sensex2002-11.3330.1622.6237.8232.9631.5329.30Portolio200366.00109.10105.9969.2255.70%57.67Sensex200391.0644.2059.6447.1442.3339.09Portolio2004169.39120.5392.6549.2251.58Sensex20048.8345.9334.8732.2328.88Portolio200576.2240.8661.4266.43Sensex200595.6750.1341.1035.96Portolio200658.5028.6256.86Sensex200615.1919.8114.92Portolio200753.6737.15Sensex200718.8218.82Returns or 2007 portolio until May 27, 2008
The universe
Earnings yield portolio: A portolio o 30 stocks with the highest earnings yields, theminimum cut-of being double the bond rate or the respective year, rom the BSE-500 universe, excluding nancials, with a debt-equity o less than 1. For years thatthrew up less that 30 stocks, we went with the available stocks.Net-nets & cash bargains: All listed companies with a trading history o more than 90per cent excluding nancials was taken as the universe. We calculated net-nets bydeducting debt and current liabilities rom current assets. The 30 or available stocksor the respective years with market-cap less than net currents were consideredor the portolio each year. Companies with cash and marketable securities lessall external liabilities greater than the market-cap constituted the cash bargainportolio or the respective years.Dogs o the Nity: Top 10 stocks based on dividend yield at the end o every year.
The returns
We computed total returns (price appreciation plus dividend income) or theportolio constituted every year and with a holding period o 1-10 years or theperiod 1998-2008. For dogs o the Nity we tested results only or a two-year holdingperiod. In the case o a stock getting delisted or stopped trading, we considered thestock to have lost 100 per cent in the year in which the stock disappeared rom theportolio. All data has been sourced rom CMIE Prowess.
HOW WE DID THE BACK-TESTING
 
The world has changed in many ways. And the way business is donehas changed appreciably. In the pastcentury, while industrialisation wasstill underway, manufacturing was themainstay of business and companies were largely asset-heavy.Today’s businesses are more ser- vice-led and asset-light. Even thelandscapes for accounting practices,securities regulations and sharehold-ing patterns are dramatically differ-ent. Graham’s success was also in partbecause he had the luxury of buyingbusinesses that were truly ‘cigar butts’because of the state of the economy atthe time.Is Graham’s philosophy still stay rel-evant in the changed times, (one of optimism, although recent data doespoint to a slowdown) compared withthe gloom that the Father of Financial Analysis was witness to? Outlook Prof-it sought answers for this by relyingtwo factors: data, because data doesnot lie; and people who have been un-adulterated value investors.Before we disclose the results(please wait patiently – being patientis the first rule in value investing!), wepresent a quick look at Graham’s various strategies.
THE PHILOSOPHY
Graham’s investment radar mainlyflashed stocks that could be classifiedas bargains based on earnings poten-tial or asset values.The key earnings-based strategy thatmost lay investors can easily adopt in- volves buying stocks that offer a sub-stantial earnings yield, typically, twicethe prevailing bond rate.The earnings yield is the reverse of the price-earnings multiple. The logicis simple: if you view stocks as bondsthat offer no growth but yield fixed re-turns (consider profits as a proxy for in-terest earned) then the asset should be valued like a bond. If the earnings yieldis twice the bond yield, it means thatthe asset actually promises to doublethe returns you could get from hold-ing the bond. Given that the businessis profitable and will continue to beso, returns could be impressive as theyield in excess of the bond rate wouldprovide an adequate margin of safe-ty in the event of any capital erosion. Another earnings-based strategy is beto buy stocks that offer substantialdividend yield. Asset-based strategies of Grahamrevolve around buying stocks thatare quoting either below their liquida-tion value (especially for businessesthat do not have a future) or at a sub-stantial discount to the company’s as-set value (for businesses that boastgood future prospects). Another set of bargains includesstocks of companies quoting below the value of marketable securitiesand cash on their books after deduct-ing outstanding debt. The logic here isthat the company can use its cash andsecurities to pay of its debt and otherliabilities and still the shareholders would have something in their hand. At the heart of Graham’s philosophylies the ability to favour what is out of favour. Embrace the ugly, not the beau-tiful. Lift the disgraced and disregard-ed. And it works!
43
Sanjay Bakshi , CEO,Tactica Capital is a deep-value investor
PHOTOS: SANJIT KUNDU

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