Value Investing

 Value Investing

Terry Smith describes himself as a quality investor rather than a value investor or growth investor.

Question is.. what is value investing and growth investing?

Value stocks trade on low valuation multiples −price-earnings (P/E) ratio, price-to book ratio and price-to-sales ratio

Growth stocks trade on high valuation multiples.

 

The trouble is that the value and growth labels are potentially misleading. Lowly-rated value stocks can be expensive and highly rated growth stocks can be inexpensive.

The value and growth labels are, however, unlikely to go out of fashion. They are used by academics for research and by investors to categorize stocks.

 

What matters is the intrinsic value of a company.

This alone determines if a share is expensive or good value. Intrinsic value is the present value of the free cash flow available to investors. This makes sense.

 

Investments should be valued in line with the cash they can return to investors. High-quality companies are good at generating free cash flow. The quality style of investing focuses on what matters: the ability of a company to return cash to investors.

 

To quote Buffett again:

"Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with managers of the highest integrity and ability."

 

ROCE

ROCE is the annual profit (before interest and tax) divided by the total capital invested. It is independent of the capital structure of a business and therefore puts companies on an equal footing.

One way of thinking about ROCE is as the lump sum return. It is the return a business generates if it had been given a single lump sum of capital. ROCE is the product of the operating profit (or EBIT) margin and the capital-turnover ratio (sales/capital employed). An increase in the profit margin and/or the capital-turnover ratio will increase the ROCE.

Attempt to Study Banking Stocks

 Attempt to Study Banking Stocks

Key feature of how bank’s work:

·         Give loans, earn interest (revenue).

·         Accept deposits, pay interest (cost).

·         Earned interest minus paid interest is profit.

Interest earned on loans should be more than interest paid on deposits. This income is called “Interest Income”

Banks also make money from the other sources like:

·         Distribution of mutual funds.

·         Distribution if insurance schemes.

·         Offering wealth management services.

·         Treasury operations (buying/selling debt securities).

By providing these services, banks charge a nominal fees. Income earned from other source is called “Other Income”

Banks pay “lower” interest rate on deposits and charge “higher” interest on loans. This difference in interest rates between loans and deposits is called as “Interest Spread”.

What is CRR?

Minimum reserves that a bank must keep with RBI. On CRR, RBI pays nothing to bank (no interest). The purpose of CRR is to ensure some liquidity. At present, RBI has keep the minimum CRR limit of 4%.

What is SLR?

Minimum amount that a bank must invest in government bonds. On SLR, banks also earn a return in form of interest. This way, the banks are forced to invest their funds. These funds remain safe always.

The interest earned (@7.7% approx.) on these investments is an added benefit. At present, RBI has keep the minimum SLR limit of 19.5%.

What happens if bank’s runs out of cash?

RBI comes into play. RBI acts as banker to banks. RBI gives loan to banks and charge an interest. This interest is called Repo Rate. Banks must maintain CRR+SLR, and on top of this, if banks need money, take loan.

Depositors perspective, CRR and SLR are beneficial, because 23.5% [CRR (4%) + SLR (19.5%) ] of their deposits are always safe.

Investors point of view, CRR and SLR are not as useful, because 23.5% of bank’s funds yields very low returns. CRR yields 0% returns. SLR yields only 7.7%.

Final Words:

When CRR/SLR goes down, means bank’s margin will improve.

When CRR/SLR goes up, means bank’s margin will fall.

FINANCIAL RATIOS FOR BANKS:

·         Net Profit

·         Advance-Deposit Ratio (ADR) & Their Growth Rates - A bank which maintains a low ADR (Advance To Deposit Ratio) is considered safe.

·         Equity Multiplier (EM) – (EM = Total Capital / Net Worth = 15 (max)). EM is a ratio between total capital and net worth. It is a sum of bank’s Net Worth plus External Debt; i.e. deposits accepted from public.

·         Return on Asset (ROA) – (ROA = Net Profit / Total Assets). For Banks, ROA of 1% or more is considered good.

WHY?

Unlike other business sector, banking business typically show lower ROA, because banking business is based on taking deposits from public. Deposits for banks are what “debt” is for other companies. Other business can survive without debt. But banks needs debt to survive.

·         Return on Equity (ROE) – (ROE = Net Profit / Net Worth). ROE >15% for banks is considered acceptable.

·         Net Interest Margin (NIM) – (NIM = (Interest Earned – Interest Expended) / Total Assets). The higher is the NIM the better, because higher NIM means, more “interest profit (IP)” per unit asset. NIM (max) – 4%.

·         CASA Ratio - Ratio of deposits in current and savings account/total deposits. A higher CASA ratio is desired because banks give low rate of interest in savings account (3-4%) deposits and no interest in current account deposits. High CASA ratio indicates lower cost of funds.

·         Gross NPAs - Higher NPAs is adverse for the banks. This should be checked to determine the asset quality of the banks.

·         Provision Coverage Ratio (PCR) - Total provision balances of the bank to gross NPAs. PCR ratio indicates the extent to which the bank has provided for the weaker part of its loan portfolio.

·         Capital Adequacy Ratio (CAR) – (CAR = (Tier-I capital + Tier-II capital)/ Risk-weighted Assets). It is the ratio of bank’s capital to aggregated risk-weighted assets.