MUMBAI: Value investing involves investing in companies and businesses that appear to be trading for less than their intrinsic or book value. Value investors believe that long-term wealth is created by focusing on business and fundamental factors of a company and not reacting to the ups and downs of a market. 

As Indian equity markets continue to touch new highs everyday, Rahul Shah, co-head of research at Equitymaster, explains how investors can evaluate when to buy and sell stocks following the principles of value investing. 

Edited excerpts of his interview with Mint:

What are the fundamental factors that an investor must consider before investing in the equity market?

There are two approaches to investing in stocks - first to find the best stock and second to avoid the bad stocks. If you ask me, as a value investor, I would prefer approach number two because that is simpler and easier. In order to be successful in investing you must keep in mind two things – don’t overpay for a good stock and don’t invest in bad quality stocks. So if you avoid these two mistakes, 80% of your problems as an investor are solved.

Value investing helps find a middle ground - stocks that are not too expensive but not of low quality. Factors like price to earnings ratio, price to book value ratio, debt to equity ratio and interest coverage ratio must be analysed to ascertain the quality of a company and whether it can withstand various market cycles.

Some investors believe they must rely on fundamentals when buying and focus on technical factors while selling. What are your thoughts on that?

I feel there are few lessons fundamental investors must learn from traders and technical investors. The most important being the discipline technical investors have when executing trades. A good trader will have simple and clear rules for exiting a particular investment. I believe your rules to enter or exit an investment must be so easy and simple that even a 10-year-old child can follow them. As far as technical trading is concerned such objective and specific rules exist. However, fundamental investors often lack such clarity when it comes to rules. One of the biggest mistakes a fundamental investor can make while selling is having vague rules. By bringing simplicity and specified limits to selling rules, fundamental investors can benefit greatly. There should be simple rules based on a time horizon, profit range or return percentage that can help investors make a decision on when to sell a particular investment.

That explains how investors can decide when to sell. But, in an ever- rising market how can an investor decide when is the right time to invest?

Value investors believe in finding the intrinsic value of the company and then buying the stock at a discount to the intrinsic value. One of the rules I follow is to invest in companies that are trading at a single digit or low double digit price to earnings multiple. A price to earnings multiple (P/E) of 9 to 15 times is what appeals to me. Coming to the price to book (P/B) value, I will invest in a company if it is trading at a 20% discount to book value. So if the book value of a stock is ₹100, I will be comfortable buying it at ₹80 or lower.

If you had followed this when the market crashed during March 2020 you would have found many good companies at good valuations. Having an upper limit for P/E or P/B multiple will also prevent you from investing out of fear and greed.

How can investors who do not understand such ratios or how to read a balance sheet; evaluate when to invest in a stock?

Warren Buffet often said investing is not complex and is in fact very simple to follow. I completely agree with that. I think you should start by following the greats of investing such as Warren Buffet, Peter Lynch and Benjamin Graham. These greats have laid down many principles for investing and even 100 years from now these principles will be valid. My suggestion to beginners would be to read and understand the views and principles followed by these greats. Then start investing by following the investment philosophies that make the most sense to you. On the way adapt these principles to your temperament and risk appetite.

You can listen to the entire interview here.