Bottomline: When in doubt, root for value

Stock markets globally have been prone to big, wild swings of late, leading to significant uncertainty about the future trend. There are also several moving parts, making any forecasts of the future difficult. The Ukraine war and the western allies’ response, the lockdowns in China, tensions in West Asia, surging inflation and the US Federal Reserves’ next move are all factors that can influence the direction of markets.

Given where we stand, while trading is tricky with high volatility making this a high-risk, high-return market, investing can be made more rationally, provided you focus on long-term value and are patient enough to hang in there to reap the likely rewards.

LOOKING FOR VALUE

There are several tools that analysts and investors use to seek out value. Some look at earnings per share, others at enterprise value expressed in proportion to operating profits, some consider book value, and for life insurers, you have the embedded value. To each his own.

For non-financials, my preferred metric is the cash flow yield. Think of it like this: When you put money in a fixed deposit, what return or yield do you get? Let’s say today you manage 6 percent. Now, that 6 percent is a fixed rate over the term of the deposit—your preferred investment period. Think similarly of a share in a company.

The cash flow generated is expressed in relation to the market price of the stock to compute its yield. And this yield at the current market price should keep rising if the company’s profit is going to see secular long-term growth. So in effect, you are investing in an asset that will deliver higher yields going forward on your purchase price. Hence, you might be willing to accept a slightly lower yield than 6 percent in year one for a share than a fixed deposit, provided of course that the yield you generate over your term of investment also covers the higher capital risk associated with equities.

With the above understanding, we sifted through the top 100 companies listed on the stock exchange of Mumbai (represented in the BSE-100 index) to see how they fared on an operating and free cash flow yield basis. We looked for a minimum 5 percent and 4 percent yield, respectively, for the above parameters. And this is what we found.

The oil refining companies come out on top, but given that these numbers are for the last concluded fiscal (FY21), it needs to be noted that they had a very good last fiscal and this year hasn’t been that good, even in the concluded nine months. There is also the cyclical factor in steel companies, but in their case, the current fiscal has been better than the previous one. Even at FY21 levels, Tata Steel, though, doesn’t look terribly expensive.

Then there are the cement players, who are facing input cost pressures now and may not be able to deliver strong profitability. Then there’s IT, where frontliners HCL Technologies and TechMahindra still don’t look too expensive given the growth tailwinds. The point, in a nutshell, is that using historical data is an indication only and should not be used as the basis for investing in a company, but it definitely can be a good starting point.

Similarly, very high valuations, on a historical basis, need to be studied closely. For instance, the commercial vehicle cycle could be about to turn, aviation might just be getting out of a difficult period and consumer durables players, especially those with high summer sales, might finally be looking at a good sales year this time. But here again, the valuations are a pointer to evaluate whether a lot of the expectations are already in the stock price.

THE INVESTMENT STRATEGY

Once you identify the companies offering value and having good growth potential, the next thing you need to work on is your portfolio allocation based on risk-reward. This done, the next step is to create a basket of these stocks in the fixed proportion and invest in them periodically over the next 6-7 months like in a systematic investment plan (SIP).

If you stick to a disciplined approach, you should be able to generate healthy returns from this market. So, if you are wondering what to do in these volatile times, I’d say start looking for value. There’s much work to be done, and the market is allowing you time to do it.

Happy investing!