How to find value in an ever-expanding market

As Indian equity markets touch new highs everyday, Rahul Shah, co-head of research at Equitymaster, explains how investors can evaluate when to buy and sell stocks by following the principles of value investing.

Edited excerpts from his interview with Mint:

What are the fundamental factors an investor should consider before investing in the equity market?

There are two ways to invest in stocks – first to find the best stocks and second to avoid bad stocks. If you ask me, as a value investor, I would prefer approach number two because it is simple and easy. To be successful in investing, you should keep two things in mind – don’t overpay for good stocks and don’t invest in poor quality stocks. So if you avoid these two mistakes, 80% of your problems as an investor are solved.

Value investing helps to find a middle ground — stocks that aren’t too expensive but aren’t of low quality. Factors such as price to earnings ratio, price to book value ratio, debt to equity ratio and interest coverage ratio must be analyzed to ascertain the quality of a company and whether it can withstand different market cycles.

Some investors believe that they should rely on fundamentals when buying and technical factors when selling. What are your views on this?

I think there are some lessons that fundamental investors should learn from traders and technical investors. The most important discipline technical investors have when executing trades. A good trader will have simple and clear rules for exiting a particular investment. I believe that your rules for entering or exiting an investment should be so simple and simple that even a 10 year old child can follow them. Such objectives and specific rules exist as far as technical trading is concerned. However, fundamental investors often lack such clarity when it comes to regulations. One of the biggest mistakes a fundamental investor can make when selling is having vague rules. By simplifying the rules of sale and specifying limits, fundamental investors can benefit greatly. There should be simple rules based on time frame, profit limit or return percentage that can help investors decide when to sell a particular investment.

It explains how investors can decide when to sell. But, how can an investor decide when is the right time to invest in an ever-expanding market?

Value investors believe in finding the intrinsic value of the company and then buying the stock at a discount to the intrinsic value. One of the rules I follow is to invest in companies that are trading at a single digit or low double digit value to earnings multiplier. I am attracted to the price of earnings multiplier (P/E) of 9 to 15 times. Coming to the Price to Book (P/B) value, I would invest in that company if it is trading at 20% discount to the book value. So if the book value of a stock is ₹100, I would be comfortable buying it here ₹80 or less.

If you had followed this when the market crashed during March 2020 you would have found many good companies at good valuations. Having an upper limit for the P/E or P/B multiple will also help you avoid investing in fear and greed.

Investors who do not understand such ratios or how to read the balance sheet; Evaluate when to invest in stocks?

Warren Buffett often used to say that investing is not complicated and it is actually very easy to follow. I totally agree to that. I think you should start by following investing greats like Warren Buffet, Peter Lynch and Benjamin Graham. These great men have laid down many principles for investing and these principles will be valid even after 100 years from now. My suggestion for beginners would be to read and understand the thoughts and principles of these great people. Then start investing by following the investment principles that matter most to you. Along the way, adapt these principles to your temperament and risk appetite.

You can listen to the full interview Here.