How to be Warren Buffett in India

By SHEFALI ANAND

It's pilgrimage weekend for thousands of stock investors who follow veteran investor Warren Buffett.
This Saturday, thousands of fans will gather to hear the "Oracle of Omaha" (Mr. Buffett is based in Omaha, Nebraska) at the annual shareholder meeting of his company, Berkshire Hathaway Inc.

Shefali Anand

For the uninitiated, Mr. Buffett is considered one of the most successful investors of modern times. One class A-share of Bekshire costs $117,000 today, 1600% more than what it cost 20 years ago.
Mr. Buffett follows "value investing" which basically involves buying companies or stocks at a price lower than what he considers to be their intrinsic value.
In the simplest terms, value investing is like buying a T-shirt from, say, Bandra's Linking Road or Delhi's Sarojini Nagar market for 200 rupees, rather than paying 1,000 rupees for a T-shirt of similar quality from a big store. Value investors wouldn't go to a big brand store, unless it is giving heavy discounts!
The opposite of value investing is "growth" investing, which involves buying something that is expensive in the hope that it will become more expensive in the future. Consider apartments in Delhi's Shanti Niketan neighborhood or Mumbai's Worli, which cost an exorbitant $1 million or more. Still, a "growth investor" might buy them because he believes that in a few years time, the apartment would fetch an even higher price.
I decided to look at how investors practice value investing, and perhaps Mr. Buffett's principles, in India.
There are less than two dozen mutual funds in India which follow value investing. A large number of money managers lean towards growth investing, though there are shades of it. Indian stocks have risen so rapidly over the last decade that few are cheap. It's easier to find deals in a bear market, when lots of stocks have fallen significantly.

Associated Press

File photo of investor Warren Buffett gesturing during an interview prior to a special Berkshire Hathaway shareholders meeting in Omaha, Neb., Jan. 20, 2010.

I spoke to three value managers in India, including a disciple of Mr. Buffett, to see how they look for value. The number one challenge for each of them is: how to determine the worth of a company? Only then you can know if it's selling at a bargain.
Over the years, Mr. Buffett has shared some of the investing metrics that he uses but he has not laid out a specific template that everyone can blindly follow. So, investors have spent years coming up with formulas that they believe will help them find hidden gems.
In India, typically value managers look for "relative value," meaning a stock which appears cheap compared to something else, such as its peers or the Bombay Stock Exchange's Sensitive Index. This is in contrast to "absolute value," in which the stock is cheap compared to its intrinsic value.
"It's very difficult to be style pure in an excessively growth market," says Anoop Bhaskar, manager of the UTI Master Value fund. One reason is that money managers are expected to beat a benchmark index like the Sensex. In the U.S., some veteran absolute value managers hold cash if they don't finds cheap enough stocks. But when the market goes up a lot, those cash holdings can make them fall behind the market significantly. "A pure value fund in India can underperform for such a long time that investors and distributors just might give up on it," says Mr. Bhaskar.
Here are key takeaways from my conversations with India's value managers:
Anoop Bhaskar, fund manager of the UTI Master Value fund
Mr. Bhaskar, who manages 4.5 billion rupees ($100 million) in this fund, typically starts by looking at various sectors and zeroes in on the ones which other investors seem to be ignoring. Then he finds companies within the sector which are cheaper than peers.
Last year, many investors were avoiding stocks of information technology companies because they rely on business from the U.S. which was in severe economic turmoil. Mr. Bhaskar found that several of these companies were trading at price-to-earnings ratios (stock price divided by earnings per share) lower than their price-to-earnings ratios in previous years. He bought.
Unlike many analysts in India, who estimate future profits of a company to determine a company's worth today, Mr. Bhaskar looks for stocks which are cheap based on past earnings and values, over three- to five-year periods at least.
Often he finds small company stocks that trade cheap on an absolute basis, say with a price-to-earning ratio of 8 or less. (For comparison, Sensex's price-to-earnings ratio is around 21 now.) Mr. Bhaskar ends up buying a lot of small stocks for this reason – nearly 40% of his fund is invested in them. These helped the fund earn a whopping 114% return last year. For the last five years through April 28, the fund returned 20% annualized as compared to a 22.5% annualized return of the Sensex, according to ICRA Online Ltd.
But small stocks can be very volatile and hard to sell during bad markets, so this fund could be hurt sharply during downturns.
Lately, as small stocks have gained in value, Mr. Bhaskar has been moving into more large company stocks which carry lower risk. Also, they are easier to sell in a downturn to raise cash. So, he's been buying Maruti Suzuki Ltd., which appears cheap to him compared to automobile stocks.
See his current holdings here.
Sankaran Naren, manager, ICICI Prudential Discovery Fund
Mr. Naren manages 8.75 billion rupees ($200 million) in the ICICI Prudential Discovery fund, using many the same investing principles as Mr. Bhaskar: relative value, looking for sectors and looking at past earnings to determine value.
"We don't know if people have the ability to predict long into the future," he says.
In 2007, he says the hottest theme was infrastructure stocks. In comparison, not too many people were buying pharmaceutical stocks. So, he bought. Today, he finds telecom to be a relatively cheap sector as these stocks have been beaten down due to mobile price wars. "The sector today is facing existential issues," he says, but adds that it won't be a problem for the leader. Bharti Airtel Ltd. is his fund's biggest holding.
Like other value investors, Mr. Naren lays emphasis on different financial metrics for different types of industries.
When analyzing so-called "cyclical industries," Mr. Narain pays more attention to price-to-book ratio. Book value of a company is the value of its net assets or shareholder equity (total assets minus total liabilities) and represents what a company is worth after it gets rid of all its debt.
Cyclical companies are those whose fortunes are tied to economic or business cycles. Examples would be automobile and airline companies which do well when the economy is booming and vice versa. In comparison, consumer goods and pharmaceutical companies are "non-cyclical" because people will continue to buy toothpaste and drugs no matter what the economy is doing.
Since the earnings of cyclical companies can be very volatile, Mr. Naren finds it better to judge them by their asset values, thus price-to-book. Ideally, a value stock would be trading at a price below book value, but if not, at least at a low ratio like 2 or less.
Another metric Mr. Naren looks for is a high "return on equity" or "return on net worth," which is the company's net income divided by shareholder equity, and healthy "free cash flow," which is calculated by adding depreciation to net income and subtracting changes in capital expenditure and working capital, according to Investopedia.com.
Mr. Naren looks for the inter-relationship of the various metrics above to make his investment. For instance, a stock would not be cheap if it had a high return on equity but also a high price-to-book ratio.
The Discovery fund has gained 26% annualized over the past five years, according to ICRA. See his fund holdings here.
Nitin Bajaj, co-manager, Fidelity Value Fund
Fidelity India Value fund is a relatively young fund with 1.9 billion rupees ($43 million) in assets, according to ICRA data. Manager Nitin Bajaj has been an assistant manager with Fidelity in Europe since 2007.
He dismisses the idea that it's tough to find absolute value stocks in India. To select his investments, Mr. Bajaj uses Mr. Buffett's tenets: first, understand the business and then the specific company's competitive advantage and how it can maintain this edge and grow in the future.
He prefers historical price-to-earnings ratios because he believes that the "future of an industry or business is very similar to its past," he says.
For companies whose earnings are regulated by the government, such as power, or refining or cement companies, Mr. Bajaj looks at "replacement cost," which is the cost of rebuilding plants. In India, he says it costs $100 per ton to build a cement plant, so if a cement company is selling for less than that, it could be a buy. He uses other metrics for other businesses.
To buy, Mr. Bajaj looks for a "margin of safety," a term made famous by Mr. Buffett's guru, Benjamin Graham. This is the gap between the stock price and its intrinsic worth. So, if a stock worth 100 rupees is trading at 70 rupees, the margin of safety is 30%. Mr. Bajaj says a 30% discount is the minimum he needs to buy a stock.
Like some value investors, Mr. Bajaj is attracted to companies which pay dividend yields of 6% or more annually and are likely to increase them. There aren't many such companies in India, so he buys such stocks in countries like Korea and Brazil. His fund can invest up to 10% abroad.
Not all of Mr. Bajaj's fund holdings are value buys: as of February 2010, at least one third of the Fidelity India Value Fund investments were present also in the Fidelity India Growth Fund. See his fund holdings here.
Mr. Bajaj says this is partly due to the pressure to beat a benchmark index – in this case the BSE 200 index -- something which is applicable to money managers around the world. Also, he prefers to have some large companies in his portfolio because they are the easiest to sell in case investors need to pull money out of the fund. His fund investments are here.
Since individual investors don't have these pressures, Mr. Bajaj says they "have a huge competitive advantage" to practice value investing.
Are you such an investor? If yes, share with us how you find value and let me know if you'd be open to sharing it with other readers to get a healthy discussion going. After all, don't we all love a good bargain?