Hunting for value

You could begin by applying Joel Greenblatt’s (US-based hedge fund manager) Magic Formula. This is done as follows. Pick up a universe of stocks,say the BSE 100. Then find out the PE and the ROE for all these stocks. On one Excel sheet,arrange these stocks in declining order of PE. Then give marks to these stocks (lower the PE,higher the marks that a stock gets). On another Excel sheet,arrange these stocks in ascending order of RoE. Again give marks to these stocks (higher the RoE,more the marks). Now add the marks that each stock gets on the two criteria. Arrange the cumulative marks in declining order. The stocks that get the highest marks will be those with the highest RoE and lowest valuation,and hence the most desirable.

Next,look up the current yield of 10-year government bonds. Divide 100 with this yield. What you get is a PE value for government bonds. What this PE value connotes is the number of rupees you are willing to pay to get Re 1 in risk-free return. It stands to reason that for riskier instruments such as stocks,you should demand a lower PE. Imagine that the current yield on 10-year government bonds is 6.6. Therefore,15.15 (100 divided by 6.6) becomes the PE for risk-free earnings. Any stock that you invest in should have a PE less than 15.15. Use this approach to reduce the number of stocks in the magic formula list.

Parsing further

You could look for stocks that show steady growth in earnings per share (remove those that show wild fluctuations). You could also reduce the number of stocks by applying a minimum criterion for five-year or ten-year compounded annual growth in earnings per share. Similarly,you could have a minimum return on equity criterion.

If by now you have reduced the number of stocks to,say,seven or 10,you will have to pick up one stock. Select one with a famous brand name. A famous brand name is an important source of competitive advantage.

Next,read up the annual report of the company (especially the Management Discussion and Analysis section). In particular,pay attention to whether the company possesses durable sources of competitive advantage (what Warren Buffett calls a ‘moat’). If possible,speak to experts about the prospects of the stock. Finally,stick to stocks where the management has an impeccable reputation.