I received this excellent question from prabhakar via email and have taken the liberty of posting the reply on the blog.

Hi rohit,
I have a query that’s bothering me a lot for quite some time now. Let me clarify at the outset that i believe in value investing(Buy something good way below its intrinsic value),no doubts about it.
Now i am stuck between two schools of thought here.
1) The Warren Buffett way — Buy a “great company” that is stable, when there is temporary trouble and it is selling below its intrinsic worth. Your returns will be decent(no multibaggers here) and compounded long term it work out well for you.
2) The Rakesh Jhunjhunwala way -Buy companies that are selling below intrinsic worth but that have a huge potential to scale big. You possibly get a multibagger here or you dont get anywhere.Example would be Titan & Pantaloon retail that he bought when they were relatively unknown.
Now the question is should we sacrifice multibagger potential for something that is stable?Or should we have both types of stocks in our portfolio.Whats your opinion?Which of the two philosophies is better?

Let me know your views if you find time.

I have thought along the lines of this question for quite some time and can reply from my personal perspective. Let me caution you – The answer to this question is very personal and depends on your own skills and beliefs.

I believe both the styles are equally good and can provide good returns. I would actually extend the question to RJ or WB or Benjamin graham (BG) style or a combination of each.

Key points of each approach
There are some key elements to each of these approaches. Benjamin graham’s (BG) approach is a very quantitative approach to value investing. The selection of an undervalued company is done based on various quantitative criteria such as low PE ratio, Market cap less than net current asset etc. There is a low to almost non-existent focus on the nature and quality of business. This approach is easy to follow, low risk and requires ample diversification.

WB’s approach takes elements of Graham’s approach such as margin of safety etc. However this approach relies less on the quantitative elements of the company and more on the qualitative elements of the business such as sustainable competitive advantage. The undervaluation is due to temporary factors such as losing a customer or some scandal, which has caused the earnings to drop in the short term. However the long-term prospects are still intact and hence the company is a good bet. WB’s approach focuses on the certainty of the long-term prospects of the company.

RJ’s approach builds further on WB’s approach. Here you are looking at companies, which are not undervalued by the traditional measures such as PE, DCF etc. The value lies in the business model and what the company will develop into.

Some Indian examples
A typical graham style company would be Denso or Cheviot Company. Here the company is selling for less than cash on the books or close to it. These companies are cheap by the traditional valuation measures.

A WB type investment could be GSK consumer or Concor or maybe Asian paints. These companies have a long operating history. They have a predictable business model and some competitive advantage. It is easy to look at the long term history of the business and project it to arrive at some measure of value. This investment approach is more difficult than the Graham style investing as it depends on the qualitative aspects of the business too. However it is possible to follow this style as it has quantitative elements to it and does not require a very deep understanding of business models.

An RJ type investment could be pantaloon or titan. This approach to investing requires a very deep understanding of business models and an appreciation of the qualitative aspects of business such as management quality, addressable opportunity etc. The current numbers of the company will not help you make a decision. If you get it right, the rewards are huge.

In addition RJ is moving deeper into this style by investing in smaller and smaller companies at an early stage (VC style) where the risk-rewards are higher.

So which is it ?
For me it is the BG or WB style. My skills have not matured enough for the RJ style of investing. I have looked at titan in the past and could not see the value. The reason I could not see value was due to my own shortcomings.

You may notice that my core portfolio is based on the WB style of investing, where as the other portfolio is based on the BG style of investing. I don’t have an RJ style investment at all and it is possible that I may never reach that level to make that type of an investment.

A common mistake
Don’t get me wrong on these examples. Yes bank, ICSA, Pyramid saimira and Dish TV are some examples, which fall under the RJ style of investing. The current numbers do not show an obvious undervaluation. The value lies in the future prospects of the business. Some of these companies have a new business model and if you can figure it out correctly, then you will make it big on these stocks.

I have however stayed away from these stocks as they are outside my competency.

I have seen a lot of new investors look at RJ’s philosophy and apply it to their picks. There is nothing wrong with it if you have it figured out and have the results and confidence to follow it. However I personally would not recommend following this approach till you have the knowledge, skill and temperament to follow it.

RJ’s approach is not for the faint hearted who is not ready to do his homework. RJ’s approach is easy to understand, but quite diffcult to execute and that where his genius lies.

I wrote in the previous post that I have changed my portfolio design and split it into two categories. The first group is the core portfolio which contains the long term ideas where the intrinsic value is increasing and I feel strongly about the long term prospects.

The second group called the graham portfolio, named after the dean of value investing – benjamin graham, will contain the statistically cheap stocks. These stocks are cheap by various measures such as PE ratio, Mcap less than net current assets etc.

I received the following question from manish and thought of replying to via a post

Also I will be curious to know your strategies for these two portfolios. Will you be looking for a certain percentage of gain (say 50%) for Graham Style stocks and exit. I believe you will keep holding Core Portfolio forever (until business is intact).

The graham portfolio would be at best 20-25% of my total portfolio. The percentage is not fixed and will depend on the number of attractive ideas I can find.

I will not looking at a percentage gain to exit these stocks. For me the sell decision would be based on two factors – If the stock is selling at or 90% of intrinsic value I will sell the stock. In addition if the fundamentals deteriorate considerably or if the valuation gap does not close in 2-3 years, I may decide to bail out.

The holding period for the core portfolio could be longer as the intrinsic value of the companies is also growing. So unless the stock is grossly overpriced, I may continue holding a stock for some time.

Lesser analysis
In terms of analysis, I spend a considerable amount of time on the stocks in my core portfolio. However for the graham ideas, I am looking at cheap, obviously undervalued stocks and hence the extent of analysis would be less. I would be balancing the risk by diversifying more in the graham portfolio. The graham portfolio is an opportunistic reaction to the market crash.

An idea: HTMT Global
HTMT global is an IT/BPO company. Hinduja TMT (now called Hinduja ventures) demerged their IT/BPO business in 2006 and merged that into HTMT Global from Oct 2006.

Financials
HTMT global had a revenue of around 673 Crs in 2008 and a net profit of around 87.4 Crs. The company had a net profit margin on a consolidated basis of around 13% and an ROE of around 26% on invested capital. The total capital is around 823 Crs and a net cash of around 430 crs on the balance sheet (held in the subsidiary)

HTMT global on standalone basis (excluding subsidiaries) earned 367 Crs and a net profit of around 58.8 Crs. The company had a net margin of around 16% on a standalone basis. The lower margins on a consolidated basis is due to the Subsidiary ‘Affina’, which was turned around during the year.

Growth numbers are not representative as the demerger happened in the middle of 2007, however the company has been growing in excess of 30%.

Positives
The company is doing quite well and has been expanding the scope of its operation in terms of headcount, new clients etc. Athough the numbers are not comparable, the company has shown almost 50% growth per annum for the last 7 years (although from a small base – see pg 6 of annual report). The company has a cash of almost 470 crs (Q1 09) which has been earmarked for accquisitions and should add value to the company
The financials are quite good, with good free cash flow and a good dividend payout of almost 100%.

Finally the valuation is amazing. The company is being priced for less than cash on the books which means that the company worth more dead than alive

Negatives
Hindujas control this company and are not know for corporate governance. In addition the credit crunch and recession could hurt the company’s growth. However in the long term this should increase the offshoring.

Conclusion
Unless you believe that the company is worth less than cash, you cannot justify the valuations. One likely reason for the crash in price is the sell-offs by FII’s.

I am still looking for more negatives on the company, but cannot find any. One has to keep in mind that the stock price is assuming worse than bankruptcy. Personally, I am looking at this stock for my Graham portfolio.

Over the past few months I have modified my portfolio structure a bit. I have now divided my portfolio into two portions. The core portfolio, consists of companies where the intrinsic value is increasing and i have a higher level of confidence about the company. The other portion is more of a graham style portfolio. This consists of companies which are extremely cheap based on the various measures such as market cap less than cash on book, ultra low PE or market cap less than net current assets.

The core portfolio is a larger portion of my total portfolio and has companies, for which I have done a deeper and detailed analysis. The ‘graham’ portfolio on the other hand consists of the ‘cheap’ ideas. These companies may not score high on corporate governance or may not be a great businesses, but they are insanely cheap.

The idea behind this ‘cheap’ stock portfolio is to take advantage of the large number of opportunities, which are coming up in the market now. Ofcourse the number of stocks I plan to hold in the ‘graham’ styled portfolio could be between 15-20 or even higher versus 10-12 in the core portfolio.

So why this disclosure?
I will post on such cheap companies as time permits. I am planning to add them under the category of ‘graham’ type stocks – cheap stocks, but not necessarily great companies.

This type of value investing is also called cigar butt investing and it was developed in 1920s by the dean of value investing – Benjamin graham. This type of investing is low risk, involves quite a bit of diversification and works best during bear markets.

So please don’t be surprised if I post on ‘not so great, but cheap’ companies. One can get decent returns from such a portfolio, provided you have adequate diversification.

Is the stock undervalued?
I am getting several comments and emails asking whether so and so stock looks cheap. The odds of a stock being cheap these days are very high. If you pick 10 stocks randomly, I bet 5 will be cheap. However the question most of us should be asking is not whether the stock is cheap, but whether one understands the company well enough and will have the emotional fortitude to withstand another 20% drop in the stock price.