Active Value Investment Frameworks

Q&A: Questions & Answers
1

Hi everyone,

I’ve been thinking about stock investment a lot. It appears to me like there are largely 4 types of companies in the stock Market:

  1. The great ones which everyone agrees are great companies. Eg: Hindustan Unilever, Britannia, nestle, Bajaj Finance, Abott India. These are typically overpriced (they might be momentarily underpriced towards the bottom of market downturns (like the 2000, 2008, 2020 market crashes).
  2. The bad ones where the market anticipates that the companies are not going to grow, or possibly even go bankrupt or out of business. Eg: yes bank, DHFL, manpasand beverages, satyam.
  3. The average/okayish ones which probably won’t grow a ton, but would possibly still be there after 5-10 years: eg: ongc, oil india
  4. The ones which are probably great but the market does not trust the numbers (or their longetivity). And hence these are possibly underpriced.

Active (long only) investors generally try to find companies from that last bucket. A great investment of time and patience is required to consume all the financial artifacts related to the candidate companies (annual reports, research reports, analyses, management commentary in the media, similar artifacts related to the competitors). One would possibly also employ one or many valuation methods such as discounted cash flows, relative valuation methods (p/e ratios, peg ratios), other heuristics such as “magic formula” by Joel Greenblatt.

These methods often throw up stocks which are might ‘appear’ to be cheap but are probably cheap for a very good reason (eg: see tata metallicks from https://smallcase.zerodha.com/smallcase/SCMO_0006/stocks).

Of course, it requires an investor’s insight to be able to understand when such stocks can be trusted and when they cannot be.

My question to the good people of this forum is this: what qualitative factors do you look for in undervalued smallcap/midcap companies?

Note: In some sense, all investors (except dividend investors) are speculators since capital growth is simply the hope to sell the piece of share at a higher price to someone else in the future. To that extent, it is also important to think about what kinds of companies are under-valued right now which are bound to be re-rated in the future.

To start off this thread, I’d like to provide one such soft variable I look for. The example is “Parag Milk Products”. The company makes the famous “Go” cheese and paneer brand. I believe they are severely undervalued. They have a medium but reducing debt and high interest coverage ratio. I believe this company is being valued as a “commodity producer” (milk producer) right now and not as an FMCG (fast moving consumer goods) company that they are. For this reason, I believe it will eventually get re-rated. The TL;DR soft factor: Rerating due to transformation of the industry in which it operates.

Thoughts?

1 Like
3

Hi @kartiks thanks for replying.

I was thinking more about the qualitative factors which cannot be screened for on screener.in. One would certainly apply filters for Sales growth, debt levels (trends, comparison to equity base) and so forth, but i also find that part of the equation relatively easy.

If i understand correctly, you prefer direct customer facing brands, the reason I find it hard to follow, or invest in such companies is that they’re always trading at ridiculously high valuations (factoring in half a century of double digit growth if not more).

Is “no holding by mutual funds” a positive for you, or a negative?

“Not paying dividend while keeping debt high” - How are debt and dividend connected in your opinion? I always thought debt is just an alternative to raising capital via equity dilution whereas dividends are more a function of profitability and growth prospects of the company. Also, would you prefer such companies, or not prefer them?

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Market does not believe in the promoter. He talks much and does not deliver.

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Sectoral preference

  1. Defensive preferably.
  2. Cyclical for tactical allocation.
  3. Avoiding unfamiliar industry.
  4. B2C over B2B.
  5. Wide to narrow moat.

Management check

  1. Check for corporate governance issue.
  2. Promoter background check.
  3. Minority shareholder treatment in the past.
  4. Any unlisted company by promoter in the same business.
  5. Unpledged promoter holding.
  6. No change or increase in promoter holding.
  7. No frequent equity dilution.
  8. Capital allocation history.
  9. Execution history.
  10. No defaults.
  11. Credit rating check.

Valuation adjustments

  1. High allocation in moat businesses at fair price.
  2. Wide diversification in non moat businesses at undervalued price.
  3. Higher valuation for sustainability.
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8

For me some key qualitative pieces are:

  1. Presence of a succession plan (Promoter kids/ relatives already involved in running the business at fair compensations - have seen good examples where promoter kids earn 20k monthly salaries)

  2. No corporate governance issues (money being siphoned by promoters through related party transactions, foreign subsidiaries being set-up without the purpose being clear and lack of reporting on their operations etc.)

  3. Presence of a moat/ strategic advantage (can be evaluated by looking at operating margin vs. peers, ability to pass on input cost variations to customers i.e. stable or reducing COGS % Revenue)

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9

Detailed study of a company happens if and only if it passes these first filters:

  1. Promoter quality - No frauds or any corporate governance issue in the past.

  2. Companies not dependant anyway on Government as a customer (companies like Titagarh Wagons or pipe companies or companies like A2Z) or support from Govt in terms of environment clearances or licenses etc. (companies in mining sector)

  3. Skin in the game - Promoter having at least 50% of the total shareholding and trend should be steady holding or increase in their holdings

  4. Focus mainly on B2C companies

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