Is there a deep value in low PE stocks? Things to keep in mind before investing.

Mohnish Pabrai is a value investor known for looking at stocks with PE (price to earnings) close to 1 that can turn out to be future multibaggers. These are usually small companies and the chances of them emerging from the ashes are thin. Yet Pabrai has done this with Fiat Chrysler in the past -- when he purchased them at a forward PE of 6.2x -- and is now doing it with Micron Technology – a semiconductor stock. But that is Pabrai. It is a strategy meant for highly focused investors who dive deep and take extremely concentrated positions. Pabrai in many ways is a deep-value investor. However, the twist is he buys these stocks for the long term. Deep value investing is all about buying stocks dirt cheap and in most cases once an investor achieves a certain price, he/she sells the stock immediately. These are rarely multi-baggers.ET Prime looked at the data to understand the ‘sweet PE number’ (extremely low), which can give the highest return – especially if one is holding on to an investment for over 5 years. It turns out that Pabrai is right. There is a way to buy stocks that are closer to the PE of 1 and see them bloom over a period of time. 95893311Dud or a stunner? There is a general assumption that stocks below the PE of 1 are mostly dud. While Pabrai’s strategy has worked in the past, it doesn’t work now. But then out of the 100 low-PE stocks between 1x and 5x, there will be atleast 10 stocks that will give super-normal returns. It is indeed a high-risk strategy. We did the data work.After listening to experts, we ran some numbers in our database. We took 2011 as the base year and separated stocks based on their PEs. For example, between the range of 0-5x, there were 24 stocks, while there were 85 of them in the PE range of 5x-10x. We then looked at their 5-year and 11-year returns respectively; we found that the 0-5x PE stock basket has delivered a return of 26% CAGR for the next 11 years. There is a survival bias to this list. We filtered companies that survived through the decade and made it to the Nifty 500. Had we added the microcap, unlisted and dead stocks, then the total number of stocks in the 0-5x PE bucket would have been 188. But this bucket would still be giving the highest returns at an 11-year CAGR of 20%.Out of 188 companies, only 24 were investible (hit rate of 13%) in the 0-5x PE bucket. Similarly, out of 278 stocks, only 85 of them were investible in the 5x-10x PE basket (hit rate of 31%).We also found that stocks like NavinFlourine, Garware Technical Fibres, KRBL and Polyplex Corporation were all small companies in 2011 with an average market capitalisation of INR350 crore. These companies have returned well over the next 5-10 years. 95893321Deep value investingAt the PMS Bazaar conference this year, Jigar Mistry, co-founder at Buoyant Capital, made an interesting remark. He said that fund managers in the 1990s operated at a time of quantitative tightening (QT) whereas the newer fund managers started their journey during the quantitative easing (QE) phase. “Since 1994, the Federal Reserve balance sheet has not come off. So you identified a great company and more money was flowing to those assets and you were bullish. You made a mistake, there was a time correction. Now I think that cycles will be even more pronounced and that is where the fundamental difference would lie in,” he said.Ramdev Aggarwal of Motilal Oswal, also a panel member, agreeing to it said, “A high quality, high growth company, you buy at a right price with a margin of safety. You do that and then it works brilliantly well. Then you are so happy with your success that you fall in love with that stock and over-estimate that company. That remains a mistake.”Aggarwal believes markets have moved ahead of the earnings potential of the company so much so that one has to harvest his/her bargains, move on and buy some other good bargains.“To expect that great companies are going to remain great for a very long time… that is going to be fewer and fewer companies,” he added.He cited the example of Eicher Motors, which he bought at INR6,000 crore market cap and saw the stock go up to INR85,000 crore market cap. He admitted to having held on to the stock and having to witness the high PE of 80x eroding.“On the whole, I made a lot of money. It did not go below 4x or 5x. But I had 10x and that got destroyed,” he said.Savi Jain of 2Point2 Capital, a value investor, believes that valuations alone cannot be the determining factor for making an investment. The primary driver is always the business strength. “ICICI Securities and Sun TV both are trading at a low PE multiple of approximately 10x. But that does not necessarily make them compelling buys. ICICI Securities is seeing a structural decline both in its market share and its yields, thanks to discount brokers. Sun TV, on the other hand, is losing both subscription and advertising revenues to digital players,” he said.Jain believes that one must constantly evaluate if their investment thesis is still valid in the face of structural changes in the industry. “Muthoot Finance was one of our most profitable investments and we held it since the inception of our fund six years back. However, we recently completely exited the stock, despite a low PE multiple, after seeing many quarters of market share loss to banks and new NBFCs.”Jain is a fund manager with a very good track record. He is a classic fundamental investor who can spot fraudulent balance sheets or tainted promoters. So, when Jain looks at the valuation, he considers many things that will or not work for the company in the future. But in many ways, Jain is also a value investor. However, he doesn’t want to call himself a long-term investor. Once he gets his return, he moves out. That is what a deep-value investor is also supposed to do. High risk, high gainWhy do extremely low PE or deep value stocks give high returns? The simple answer is that they are highly risky and thus give higher returns. But that is a very linear way of looking at things. We realised there is much more to this phenomenon and for that, we will have to start with John Templeton.In 1939, Templeton purchased all stocks in the US markets that were trading below USD 1 - USD104 in total with borrowed money. The sentiments were negative. Hitler wanted to take over the world and many thought that to be the end. Templeton knew he was taking a high risk. Only a few of these stocks would give him good returns. He also knew that 37 stocks were already in bankruptcy. Over the next four years (average holding period) his investment went up to USD40,000. Later, Warren Buffett also used a style called ‘cigar butt investing’ where he picked up companies that had some hiccups and were trading at a low valuation. These were ideally not long-term ideas. While he made money on the strategy, in his 1989 annual letter to shareholders, he termed this kind of approach as foolish. “In a difficult business, no sooner is one problem solved, another surfaces – never is there just one cockroach in the kitchen,” he wrote.But the fact is, Buffett made his first million using this strategy. Even Templeton made a lot of money on a risky strategy because during World War II the profitable companies were taxed more while many of his low-valued companies were not taxed at all. Here are two basic value investing strategies. They are risky and there is at least a 45% chance of losing money. That is why Templeton preferred to diversify. The quality biasAll Indian retail investors are deep value investors who mostly get their bets wrong, while professional investors are value investors with a quality bias and mostly get their bets right. Quality bias almost guarantees that one can invest in a stock for the long term because the company has shown a consistent return on equity, has given regular dividends and is growing at a steady pace. A case in point is Asian Paints and many FMCG companies that have been around for a very long term. Deep value investing is almost an out-of-fashion strategy, which is now slowly putting its head up as small companies are going through big changes. It is a time for high-interest rates and those small companies that can do a great job in capital allocation will do well in the future. But here is a twist. Indian markets are at an all-time high. Should we look for deep value in this market amongst small companies? That is a big question we will try to answer during this month sometime.(Graphics by Mohammad Arshad)