VALUE INVESTING: BUY A BUSINESS NOT THE SHARES

VALUE INVESTING: BUY A BUSINESS NOT THE SHARES

Dr. Tejinder Singh Rawal

Chartered Accountant

tsrawal@tsrawal.com

A value investor should look upon share investment as buying a part of a business. Investors should take the same approach to buying shares as they would if they were buying a business. The only difference is that instead of buying the whole of the business, they are only buying a tiny share.

A first year student of accountancy can tell us that when you buy shares of a company, you become part owner of the business to the extent of your shareholding in the company. We know all too well that this principle is at best a theoretical reality, and a minority shareholder may not have much right in a company’s management. We thus tend to treat this piece of law as ineffective piece of legislation. However, the fact that a shareholder is a part owner of business should not be ignored when valuing a business, since what an investor gets in lieu of the money he pays to buy a share is essentially a proportionate piece of the corporate ownership cake. And if you treat a share as a security existing in isolation, and not a proportional piece of the corporate cake, you would be doing so at your peril.

I have seen many , with finance professionals and Chartered Accountants being no exception, falling in the trap of thinking of shares as a piece of investment to be looked at independently without any reference to the fundamental business of which the share is a miniscule representation. Individual investors assume the research is beyond their level of competence and the professional investor is more keen to ride on the momentum rather than probe into the fundamentals of the company.

Finance professionals hold this view because of a firm belief embedded in their minds that the share price at any point of time is a perfect representation of its actual net worth, and the price deviation is either because of ‘noise’ or is a mere short term price discovery mechanism. These investors subscribe to what is known as Efficient Market Hypothesis, and would believe that since the market is efficient, the combined wisdom of the market determines the true market price, hence fundamental analysis has no role to play in such a market. But empirical evidence proves otherwise. Market price need not hover around the true value, and one may discover the divergence between the two in respect of many securities. It is this divergence, where the market prices a share considerably below its value, which the value investor is keenly looking at. In order to discover the divergence, you must have an ability to value the business of the company. While it is not an easy job to value even the business that you understand, it is well nigh impossible to value something that you don’t understand at all.

A prudent investor never buys a business that he does not understand. Similarly, a prudent share investor should never buy shares in a company, whose business he does not understand. Before buying shares, think of yourself as a business and find out whether you would have paid the same price per share for buying the business lock, stock and barrel.

Warren Buffett explains this concept very aptly in the following words:

“We try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows. Incidentally that shortcoming doesn’t bother us.”

Keynes also realized the importance of the knowledge of the company you are investing in when he said the following, “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about …”

Knowing a company involves research as well as personal experience and successful investors approach share investment the way that they would the purchase of a business.

They buy a business in an industry area that they know or that they have learned about, they investigate the financials, they look at how the business operated in the past, they weigh up future potential, and they then make a reasoned decision to buy at the price offered or not buy.

One difficulty for the individual investor is getting this information. Investors can track through a series of company reports and financial and other announcements and do their own summaries and analysis. Other investors may choose to simplify their approach and get the summarised information from an investment advisory. Thanks to the Internet now information is not the prerogative of the select few, but now even an individual investor has load of information at his command by a mere click of the mouse. Most companies maintain a section in their web-sites where they keep details of the annual, half-yearly and quarterly results, and provide other information relevant for the investors. Websites such as www.capitalmarket.com , www.icicidirect.com , www.sharekhan.com www.myiris.com , www.kotakstreet.com and www.moneycontrol.com also contain summarised financial information of the listed companies. Websites of BSE and NSE also contain invaluable information for investors.

Anecdotal evidence and personal experience can also be useful to an investor. There are investors who would not buy shares in a company unless they have visited the company facilities, and are personally satisfied with the credentials of the company. Some would even meet the key management personnel to ascertain their outlook and decide upon the quality of management. While this method may be impractical for most of the investors, at least researching into the published information, and enquiring about the company credentials from people who know the industry should help.

Phil Fisher calls this ‘the scuttlebutt method”. He likes to interview the people who may have first hand information about the company. He thus likes to talk to the employees, vendors, customers, and even people living in the local community of a company’s manufacturing facilities.

Ben Graham disliked the idea of interviewing the management. He felt that most of the presentations made by the management would consist of nothing more than a sales talk. Graham preferred to rely more on the published information that the interaction with the management.

Peter Lynch advises the investors to develop a childlike inquisitiveness to enquire about the companies that you come across in your day to day life, and build a story around those companies. He says that he would pay a close attention to the shopping bag that his wife brings home from the supermarket to judge the changing consumer tastes and preferences. This way, his research is more relevant and faster than that being done by any other research organisation, because his starting point is the consumer loyalty and preferences, something that is not easy for professional research organisations to focus on with so much confidence.

Lynch goes a step further to advice investors to filter out such companies from their list, as the investor cannot relate to on hearing the name of the company. He says that if the theme of a company cannot be explained with crayons, it is not worth investing in.

Whatever method suits your attitude and professional expertise, the message of all the experts is clear: don’t invest in a company unless you know the business well.

In conclusion, it may be said that, since your area of competence is different from my area of competence, the confidence that I have about a particular business may not be at the same level as you. Hence, it is quite logical that I concentrate on businesses that I understand, and apply the ownership principle while evaluating and valuing it.

Dr. Tejinder Singh Rawal

M.Com, MA( Economics and Public Administration), LLB, FCA, ISA, CISA, CISM, PhD

Chartered Accountant

E 13, Anjuman Complex, Sadar,

Nagpur 440 001 India

Ph: +91 712 2582923 Fax +91 712 2583522

Email: tsrawal@tsrawal.com