Value Investing - The art of taking advantage of market inefficiencies (with few examples)

 In my earlier blog,I have talked about markets not being so efficient in pricing the intrinsic value(true value) of the businesses/ companies, especially from a long term perspective . Value investing is all about taking advantage of these efficency gaps, whenever they present themselves to us . Lets now talk about why markets are not so efficient many times...

Price volatility in the market is driven by multiple forces:-

1) Fundamentals volatility - Change in information regarding fundamentals of the business or company lead to change in prices
2) Sentimental volatility - Sentiments such as greed and fear play a big role leading to herd mentality among market participants
3) Momentum/ Liquidity volatility - Changes in momentum and liquidity driven by factors like hot FII funds, hedge funds,RBI monetary actions, US Fed actions etc
4) Trader volatility -  Gambling and speculation instincts of traders along with future/options trading lead to more volatility of prices
5) Macro-economic news - Noises/ forecasts  on inflation, interest rate changes, GDP output etc lead to changes in market prices

Markets would have been 100% efficient in capturing intrinsic/true value if the stock prices would been driven by the first force only(fundamentals volatility). However , due to so many complex and muliple forces , markets often become not so efficient in pricing the true value/ instrinsic value of the companies.

One of the big root causes behind these multiple forces which impact market prices is the fact that 90-95% of the market participants(including retail investors, mutual funds, hedge funds, FII etc) are very short term oriented who try to make a fast buck out of every news or event. Big mutual funds and other institutions are in the rat race of beating the competition every month and quarter and hence pay only lip service to tenets of  long term investing or value investing.This short term orientation of market participants make the markets very short sighted and over-reactive to short term  events.

Warren buffet discovered that because 95% of all participants try to beat each other out of the quick buck, markets are very efficient in the short term and hence its impossible to beat the market consistently from a short term perspective. However because of the same short term orientation, markets are not very efficient from a long term perspective - sometimes grossly inefficent. Thats why Benjaman Graham also used to call Market as "manic depressive" who is either too happy or depressed due to short sightedness and over-reactiveness.

Hence the only way to beat the markets consistently is through long term value investing(atleast 3-5 years investing duration or more)so that you can exploit the shortsightedness & long term inefficiencies of the market.

Show me a guy who became a billionare only through short term trading and speculating . But there are many many examples of billionares through long term  value investing - from  people like Warren, Graham, John Templeton to our own Rakesh Jhunjhunwala.

Let me quote some examples of great companies or stocks  in India where market has shown inefficiencies providing mouth watering opportunities  to investors like us to make a killing.

Warren calls such opportunities as " bad news phenomenon" . You basically identify great businesses/ companies and wait for a temporary bad news event either with the specific company or with the specific industry or sector in general.The market over-reacts because of its shortsightedness  as if there is no tomorrow and slams the stock or stocks badly,providing us with glaring opportunities to make money.

Example 1: LIC Housing Finance - This is one of the best examples of the recent past. The company was running at the levels of Rs 270-280 sometime back, when the "cash for loan" scandal hit some of the financial companies including it(CEO got arrested) . Investors over-reacted and hammered the price to 140-150 within few days. Fact of the matter was that the impacted loans was just Rs 1000 cr out of a loan book size of Rs 40,000 cr(2.5%) and those loans too were not bad loans as they had been extended to blue chip companies. Secondly , the event was a temporary blip which could not permanently impact the business of a robust company and brand like LIC. I went ahead and bought tons of the stock with all the cash I had . Today the stock is back at levels of 230-240 within 6-7 months(50% returns ). Even today, the stock could be bought with a horizon of 3-5 years,as its at P/E of 10-11 with a ROE(Return on equity) & earnings growth rate of >20%.Over long term, it should give annualized returns of 15-25%, provided there is no terrible market shock.

Example 2: Bank of Baroda - This bank has been awarded and rated as the Best bank and Best PSU bank many times including 2010. In 2010 , its business grew by 27-28% . Its ROE is at 22%  and net NPA is <0.5%(one of the best financial performance among banks) . Its vision and outlook has been very progressive in terms of substantial investments in HR capabilities, IT and customer service excellence.Yet , its valued at 8-9 P/E , just because markets over-reacted and painted it with the same brush as the entire banking industry because of rising inflation and interest rates.Over long term(atleast  3-5 years or more) should give annualized returns of 15-25%, provided there is no terrible market shock.

Will provide more examples of such Indian stocks soon where we can exploit market's shortsightedness to buy at a substantial " margin of safety" to the intrinsic/ true value of the stocks and then wait for markets to value them correctly. Markets get the valuation right in the long run.

Happy reading