How to Start Value Investing

It was 21 October, 1993.

Warren Buffett was on a TV show called “Adam Smith’s Money World”.

The host asked:

“What investment advice would you give a money manager just starting out?”

The Oracle of Omaha replied:

“If he were coming in with small sums of capital, I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities.”

Smith said:

“But there’s 27,000 public companies!”

The legendary value investor replied:

“Well, start with the A’s”

Why Value Investing is Mighty Hard…

I first came across this interview sometime in 2002, in Robert Hagstrom’s Warren Buffett Way.

And all these years later, it still knocks the wind out of my sails.

Because, you see, it is 100% the cold, hard, brutal truth:

Value investing proper, requires a shit load of work.

No two ways about it.

I mean, if you’re picking Indian stocks, you have 1,900 stocks on the NSE in front of you. And around 4,100 stocks on the BSE.

And if you’re already a busy professional with precious little time to spare, it’s all the more difficult.

But, what if I told you, there IS a short-cut?

And, what’s more, it comes from Warren Buffett himself?

…And Yet, There is a Simple Key

Here’s what Warren Buffett wrote in his letter to shareholders in 1996:

“What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence.”

“Now, wait a minute,” you say.

“Didn’t you say one must learn about EVERY listed stock?

Why are you now saying SELECTED stock?

Tell me clearly, what should I focus on: EVERY stock, or SELECTED stocks?”

Let me explain.

Take a look at this again:

So, you see… if you’re just starting out, don’t get overwhelmed with the 4,000 stocks.

Begin small.

That’s right – focus only a few selected stocks.

Only later, should you increase your coverage of stocks.

But here’s the rub: You must then devote sufficient time and attention to the few stocks you do select.

Makes sense?

“Fine,” you say.

“But give me something more concrete. How do I actually apply all this right here, for value investing in India?”

Sure.

Here it is. In 5 simple steps…

1. First Ask Yourself These 2 Questions

Before you begin, you need to ask yourself two questions:

A. How Much Work Can You Handle?

If you’re really pressed for time and can’t handle much, then start with the BSE Sensex (30 stocks).

But, if you can handle a mild workload, pick the BSE 100 instead.

And, if you can go full steam, start with the BSE 500.

And so on…

And the second question is:

B. What is Your Hunger for Risk?

If you wish to stick only to the prominent Indian companies, begin with the BSE Sensex, or the BSE 100.

But, if you’re game for some adventure, and want to hunt for hidden bargains, then you can pick up the BSE mid cap index as your starting point.

Or, maybe the BSE small cap index.

Your choice.

2. Put Together Your Initial Shortlist

Now, let’s say you start with the BSE Sensex.

These are the stocks you’ll have:

  1. Asian Paints
  2. Axis Bank
  3. Bajaj Auto
  4. Bajaj Finance
  5. Bharti Airtel
  6. HCL Tech
  7. HDFC Bank
  8. Hero MotoCorp
  9. HUL
  10. HDFC
  11. ICICI Bank
  12. IndusInd Bank
  13. Infosys
  14. ITC
  15. Kotak Mahindra
  16. L&T
  17. M&M
  18. Maruti Suzuki
  19. NTPC
  20. ONGC
  21. Power Grid
  22. Reliance Industries
  23. SBI
  24. Sun Pharma
  25. TCS
  26. Tata Motors
  27. Tata Steel
  28. Tech Mahindra
  29. Vedanta
  30. Yes Bank

So, with this list of 30 stocks, here’s what to do next:

3. Identify Your Unique Set of Filters

You now have an initial pool of 30 stocks (BSE Sensex).

Here’s what you do next:

Create a set of filters or tests, on which you’ll judge each of these stocks. Here are some practical tips:

A. Do You Understand What Your Company Does?

I mean, can you clearly describe the products and services, it sells?

Also, can you explain, in simple terms, how the firm actually makes money? You know, what’s called the business model.

If you can’t – because it’s all too complex – you can go ahead and reject the stock.

B. Does the Underlying Technology Change Rapidly?

To judge that, you have to first think about the industry your company is in.

Does it have a bad name due to the sudden shifts in technology? If yes, you may find it difficult to predict the stock’s future with any certainty.

You can reject the stock.

C. Is the Competition Destructive?

Again, think about the industry.

Is there a lot of churn?

You know, mad players who do crazy things? And make life difficult for everyone else…

If you find such rivals making the entire industry unstable, you can give a thumbs down to the stock.

D. Can You Figure Out the Financial Statements?

For this test, you have to download your company’s annual report.

Yes, this takes a few minutes.

And yes, you need to know a little bit of accounting for this… Which makes this filter more technical than the previous three.

But if you do have some accounting skills, look at the firm’s balance sheet and profit & loss account. And above all, look at the notes that come immediately after them.

And when you do, ask yourself, “Do I see a lot of difficult entries, which I can’t make any sense of?”

If yes, you can reject the stock.

Agreed, this filter is slightly trickier than the earlier ones. But terribly useful.

4. Reject the Wrong Stocks One by One

So, now you have your initial set of 30 stocks in the BSE Sensex. And you now know, how to draw your comfort zone based on the four value investing filters.

It’s now time to apply the filters to your initial set and reject the stocks which are wrong for you.

Here goes:

Rejected:
We might find the financial statements of these stocks to be complex and difficult to understand.

  1. Axis Bank,
  2. Bajaj Finance,
  3. HDFC Bank,
  4. HDFC,
  5. ICICI Bank,
  6. IndusInd Bank,
  7. Kotak Mahindra,
  8. SBI, and
  9. Yes Bank

Rejected: The business of these companies suffer from rapidly changing technology and industry conditions. There is a chance, we’ll be caught unawares.

  1. Bharti Airtel, and
  2. Tata Steel

Rejected: The business model of these firms is highly technical and will go over our head.

  1. ONGC, and
  2. Sun Pharma

Rejected: The business model of these companies can perhaps be understood by others, but we just can’t seem to get a feel for it.

  1. HCL Tech,
  2. Infosys,
  3. TCS, and
  4. Tech Mahindra

Rejected: The corporate structure seems complicated. We will have to do a lot of analysis of government policies and political intrigue. We don’t want to struggle with it.

  1. Reliance Industries,
  2. Tata Motors, and
  3. Vedanta

5. Arrive at Your Final Shortlist

Selected: Looks like we can understand the business if we study the company’s documents thoroughly and research the sector. Financial statements will also perhaps be relatively simple.

  1. Asian Paints
  2. Bajaj Auto
  3. Hero MotoCorp
  4. HUL
  5. ITC
  6. L&T
  7. M&M
  8. Maruti Suzuki
  9. NTPC
  10. Power Grid

So there you are.

20 stocks – which is 67% of the total – have been rejected, outright.

That saves you 67% of the time you’d devote to researching and picking out value stocks.

Now you can focus on the selected 33% of the stocks and devote time to study them in detail.

Important: Please note that you need not necessarily agree with this classification. You may want to define your circle of competence using your own different filters.

And that’s fine.

In fact, that’s exactly what you should do.

Just make sure you are comfortable with the criteria you set.

What to Do Next?

If you want to expand the shortlist to a larger number of stocks, you can now try this exercise with the BSE 100 or the BSE 500.

The process is the same.

You can start working on them instantly using the two templates I have kept for you in the value investing library.

Disclaimer: All examples of Indian stocks here, are for your educational purpose only. Please, do not treat them as investment advice or as research recommendation. From the stocks mentioned above, I own Axis Bank. Have held it since 2005.