Retail Investors: Learn with ETMarkets: Quality or Value Investing: Which is for Retail Investors?
Especially in difficult times, because it is there that the attachment to its principles and its methods is tested.
Value investing is an approach where one simply buys the companies that are available at a significant discount to their intrinsic value. Benjamin Graham developed the concept of value investing in the early 20th century.
With David Dodd, he co-authored a book called “Security Analysis” in which they discussed various value investing strategies.
By buying stocks that appear to be undervalued, value investors could bet that these companies will be rediscovered by other investors and then profit from the resulting price correction. In other words, buying low and selling high is the fundamental principle of value investing, which may seem simple but is difficult to execute.
Although “value” can be calculated quantitatively, it is quite subjective due to the many assumptions behind it.
Value investors typically use a company’s past performance as well as its expected future performance to determine its current value as well as its future value.
Value investing is conceptually good; no one can argue that buying with a “safety margin” is a mistake. However, when looking only at companies available at a discount, you can miss out on good companies that are growing fast and attracting lots of investors.
The reasons could be that they are at the forefront of innovations in the technological field (for example:
in India) or are expanding rapidly into new markets (e.g. D-Mart, which still has a long way to go).
Some of these companies are also run by highly competent management with a high level of integrity, which reassures the investor. Although these companies may seem expensive, their stock prices may rise for several years; a value investor might miss such returns.
Sticking to value investing at all costs (effectively “low prices”) could lead to hoarding failed companies that have low price-earnings ratios, but unfortunately for good reasons.
This is called a “value trap” because the investor is obsessed with a certain valuation and can miss the big picture.
This is where a “quality approach” to investing helps. One way to build a quality portfolio is to select companies with strong ROOTS (debt-free companies with consistently high return on equity and owned by aligned developers) and WINGS (companies with sales, operating profit and growing cash flow).
Using this criterion, we find that some sectors, such as utilities, airlines and telecommunications, may be less favored. Consumer staples, manufacturing, e-commerce, technology, financial services, and pharmaceuticals are examples of capital-efficient, consumer-driven industries that often have strong roots and strong wings.
Quality portfolios can often seem expensive compared to value portfolios. Indeed, the focus is not just on price, but on the overall health of the business and its demonstrated ability to scale.
Our experience with quality wallets using ROOTS & WINGS is that on a rolling 3 year basis they have consistently beaten the Nifty50 benchmark, both in backtests and in live results since launch.
When we removed companies with the highest PE ratios, i.e. above a threshold at the 90th percentile PE in their sector, we found that the long-term performance of the strategy dropped . This result did not vary much by lowering or raising the cutoff.
Another interesting number to ponder is that the Nifty Midcap 150 Quality 50 Index has outperformed the Nifty Midcap 150 Index for the past ten years.
This quality index selects companies based on their return on equity, leverage and earnings per share (EPS) growth over the past five years.
A quality approach reconciles both the growth (WINGS) and the structural solidity (ROOTS) of a company. In this way, it reduces the risk of other investment strategies like growth; the latter may look enticing during bull markets, but could see a huge correction when bear markets ensue, as seen in huge pullbacks from platform and tech companies: examples being
in India and Netflix, Freshworks, etc. in the USA.
In summary, a quality approach has the potential to outperform value strategies or growth strategies over time because they are able to pick the best companies that are primed for long-term earnings growth.
(Disclaimer: The stocks mentioned in the article above may form part of our recommendations at any given time. Investors should consult their SEBI Registered Investment Advisor before investing in any stocks. Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of the Economic Times.)