Becoming a Value Investor using Nifty PE Ratio

First of all, I am overwhelmed with the responses I got for the financial concerns and issues survey conducted few days back. Thanks to you all, there are so many feedbacks that I am still reading through all of them.

And to be frank, I was surprised to see so many people being so honest and more importantly, aware of their financial issues. This awareness in itself is like a quarter (not half) battle won. I plan to regularly take up issues raised in the survey and do detailed posts around it. And here is the first one…

One of the readers had an interesting concern:

I am not a value investor. And nor can I become one as I don’t have the time to monitor or analyse stocks. But I still want to become a sensible investor who invests more when there is panic around. I have read that it’s wise to Buy Low and Sell High. I don’t want to think much about Selling-High right now, as I am pretty young. But I do want to invest more when everyone else is selling, i.e. I want to Buy-Low. But if I go for individual stocks, it can be risky. For someone like me, it makes sense to stick to mutual funds. But how can I know when to Buy More. Even if I invest regularly, shouldn’t I be buying more when markets are down and I have additional funds?

That’s a pretty reasonable concern of the reader. And I think that many among us do not really have the time to become real investors. We are better suited to piggyback on expertise of others.

So what I understand from this question is that he wants to become a Value Investor, without bothering too much about picking individual stocks.

Fair enough…I would say…

By the way, I don’t consider myself to be a value investor. At most, I am an opportunist who is interested in buying good companies, at relatively cheap prices and holding them for very long periods of time. And yes…every now and then, I do take up small short-term speculative positions as well. But these positions are small and generally not more than 5% of my overall portfolio size.

I know…the above paragraph is more like a disclaimer. So anything I say from here onwards should be considered as coming from the mouth of a self-confessed non-value investor and not an expert of any kind. 🙂

But jokes apart, it’s a fact that 95 out of 100 people who invest in stocks, would be much better off if they do not invest in stocks directly. They should rather stick with well-diversified mutual funds. And I am saying this not because I consider myself to be an expert or an authority in something (on the contrary, I am a pretty regular guy as detailed in 17 Unknown but Honest Facts about me). But because successful investing is more about our own personalities and discipline rather than just about picking the right stocks.

To explain this, lets take an example. Suppose your overall portfolio size is Rs 10 Lacs. Now you consider yourself to be a good investor and find a good stock selling cheaply. But you only invest Rs 5000 out of the Rs 10 lac in this stock. This stock goes on to become a multibagger (10X) – your Rs 5000 investment becomes Rs 50,000. But at an overall level, your portfolio of Rs 10 lacs only moves up by Rs 50,000 (or Rs 45,000 to be precise) ~ to Rs 10.5 lacs. Nothing much to boast of. Right?

So it is never just about picking the right stock. It’s also about position sizing and how convinced you are about the stock (and a thousand other factors).

Successful value investing is also about being prepared for the rare investment-worthy opportunities. This means that even if you have chosen the right stock, and are ready to allocate a significant part of your capital to this stock, you still need to have the cash to invest in the opportunity. Because if you don’t, you cannot become a value investor, of for that matter even a decently good investor.

So what should an individual who wants to do value investing, but not through specific stocks, do?

The answer is not very complicated. But there is a catch, which I will disclose after giving the solution.

Lets break down this problem statement into 2 parts:

• Identify situations when it makes sense to invest additional money.
• Identify investment options where one can invest

Here is the solution…

Part 1

If you go through these above tables you will realize a clear correlation between these indicators (P/E, P/BV and Dividend Yields) and Returns you can ‘expect’ to earn when you invest on basis of these indicators. And here, by investing I mean – investing in a large group of stocks and not in individual stocks.

So…

Lower the P/E Ratio when you invest, better your chances of getting higher returns. (Proof)

Lower the P/BV Ratio when you invest, better your chances of getting higher returns. (Proof)

Higher the Dividend Yield when you invest, better your chances of getting higher returns. (Proof)

It is as simple as that. And a few years back, I even found a range of P/E ratios, which seem to control Indian markets. You will be surprised to see how clear this PE Band is!! I was mightily surprised when I say it first. Here is another interesting analysis of how much time Indian markets spend at various PE levels.

Now you would want to know how to track these indicators regularly. The answer is that you can either track it using this link on NSE’s website. Or you can check out monthly updations, which I make to State of Indian Market page.

Part 2

Now comes the second part. Once you know that it’s a no-brainer to invest at a particular moment, and you have the cash power to do it, the question is where to invest.

I know you would love to invest in individual stocks, see them become out-of-the-world multibaggers and boast of being a great stock picker. But lets be honest. It’s not easy at all. Even expert investors are unable to find great stocks easily. So for all practical purposes, individual stock picking is best avoided by average investor. End of discussion.

So where does one invest?

The answer is… in a group of stocks. A well diversified selection of stocks belonging to various industries, which as a group help in mitigating the risk of getting it wrong by investing in individual stocks. Yes. I am talking about mutual funds.

When its time to invest more (identified in Part 1), you need to invest heavily in well diversified and proven mutual funds (Part 2). Done. Nothing else to do. You will be rich. 🙂

So the action plan for you is:

1. Invest regularly in a few good mutual funds through SIP.
2. If possible, increase SIP every year by 5% to 10%
3. Keep a regular track of P/E, P/BV and Dividend Ratio (DY) of overall market.
4. If markets go down and with it PE, PBV goes down and DY goes up, you would do well to invest additional money in these mutual funds.
5. If the thought of investing more when your portfolio is going down does not make sense to you, then you need to rethink whether stock markets are a place for you or not.

The above approach is like giving booster shots to your portfolio when markets are going down. I have done a comprehensive 4-part analysis on investing more when markets are down. Results of the analysis were surprising as it proved that just by keeping it simple, i.e. investing a constant amount regularly still made a lot of sense for majority of investors. But if you have additional money, which you can invest and forget for few years, don’t hesitate to put it in mutual funds.

I hope that with this post, I have been able to clarify on how to become a value investor by using just plain, simple mutual funds. Let me know if you all have any questions or suggestions for this post. It will help me improve future posts addressing financial concerns.

Note – Whenever you think about investing in stocks or mutual funds, make sure that you are doing it for atleast more than 5 years. There have been 5-year periods when stock markets did absolutely nothing.