Friday, April 10, 2015

Time-tested principles of finding value based stocks offered by Graham & Buffett

The Graham-and-Buffettsville Smart Alpha Framework

First Criteria: Reduce Business Risk
Graham mentioned that when one buys a stock one is investing in the business. So one faces business risk, i.e the risk of the business losing customers and sales. Hence investing in fairly stable businesses with large revenue streams and a big customer base is crucial. This reduces the business risk. To sort through the more than 4000 companies available in the Indian stock markets we apply the first criteria: Select companies greater than INR 1000 crores in sales.
Second Criteria: Reduce Financial Risk
Graham was an investor in bonds, stocks as well as all forms of hybrids. So his eye for safety in stocks was very keen. The bonds of an over-leveraged company are risky. And if bonds are risky then the stock of that company is even more riskier! So the company could face financial risk and go bankrupt falling into the hands of the bondholders, leaving nothing for stockholders. To reduce the chances of bankruptcy, we apply the second criteria: Select companies with Debt/Equity < 30%.
Third Criteria: Focus on Value Creators
Buffett has mentioned that companies which earn below their cost of capital are value destroyers. He prefers to invest in companies with a Return on Equity of more than 15%, the value creators. This helps us stick to companies which are adding value to their equity holders: Select companies with ROE>15%
Fourth Criteria: Don’t Lose Capital
Buffett says there are only two rules to investing:
• Rule #1: Don’t lose capital
• Rule #2: Don’t forget Rule #1

Given that we don’t want to lose our investment capital, we should not overpay. Further, is there a criteria which can help us not only not overpay but in addition help reduce the chances of the portfolio value falling too much? One such criterion, in our opinion, is Dividend Yield. Dividend Yield is the inverse of Price-to-Dividend ratio. If Price to Dividend is low then we are probably not overpaying. This translates to the Dividend Yield being high. A high Dividend Yield also guards against a big fall. Assuming a company sports a 2% yield and the market falls by 50%, if the company falls with it, it will now be sporting 4% dividends and will become very attractive to income-oriented investors in high tax brackets. To reduce price risk and preserve your capital better: Select companies with Dividend Yield >2%
Now lets see how many companies pass these filters?
Start with 4000+ companies
• Apply First Criterion: Sales > INR 1000 crores
609 companies are left, more than 3000 removed
• Apply Second Criterion: Debt-to-Equity <30%
187 companies left, more than 400 removed
• Apply Third Criterion: ROE>15%
99 companies left, nearly half removed
• Apply Fourth Criterion: Dividend Yield >2%
25 companies left, more than 70 removed