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, step by step:

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.

Disclaimer: All examples of Indian stocks are for your educational purpose only. Kindly, do not treat them as investment advice or as research recommendation.

Disclosure: From the stocks mentioned above, I own Axis Bank. My SEBI research analyst registration no. is: INH300005130.

30 thoughts on “How to Start Value Investing”

  1. Good article sir. I want to do this exercise with a larger set of stocks like small cap 100 shares. So can u help me do this?

  2. Amit Singh Rahul

    Thanks for your very easy and illustrated example. It will be help me for sorting Companies name for Investment purpose.

  3. I think WB used to go through each and every company in the Moody’s or S&P manual and start from A down to Z. When asked how a normal person would do this, he said start with the companies with names beginning from A. I think he build his circle of competence by reading and filtering out…

    1. “I went through the Moody’s Manuals page by page. Ten thousand pages in the Moody’s Industrial, Transportation, Banks and Finance Manuals—twice. I actually looked at every business—although I didn’t look very hard at some.”

      1. Hi Bhaskar,

        Very valid observation.

        Correct me if I’m wrong – the ‘A-to-Z’ quote is from a TV program Warren Buffett did with the author ‘Adam Smith’, in 1993.

        At first glance, there seems to be a contradiction between the Adam Smith quote and the quote from the Berkshire letters. A deeper analysis shows otherwise.

        The context in which Buffett has said them holds the key.

        Warren Buffett began his value investing career as a quantitative (Grahamite) type of investor, chasing cigar butt stocks. He later developed more qualitative leanings, and now waits for economic franchises.

        The former requires that you intensely turn over every little rock to find the undervalued cigar butt. The latter requires that you be selective and patient for the easy-to-understand franchise to hit you on the head.

        Does Warren Buffett’s years of hard work with cigar butts inform his selections today?

        Of course.

        But, if you are new to value investing, do you necessarily have to exhaust all the 4,000+ stocks available on the BSE & NSE?

        Nope.

        Your circle of competence comes to your rescue.

        Does a truly dedicated value investor have to pick one approach over the other?

        Nope.

        He should use both the ‘circle of competence’ approach as well as the ‘A-to-Z’ approach. Though, the latter will require time and much intensity.

        1. Good points sir. I was just adding my thoughts that for a lay investor knowing his circle of competence itself is a blindspot. So reading broadly and widely is the way to go. If you already have a well defined circle of competence then having laser like focus makes more sense. There is no right or wrong approach in investing as we all know. For me reading widely has helped.

          On sidenote, you are doing a awesome work here. Please continue publishing more thought provoking articles on value investing. All the best !!

          1. Excellent point about circle of competence being a blind spot. :-)

            The thing about this exercise, Bhaskar, is that it is iterative. A beginner to value investing can take the following steps:

            1. Start with your present state of knowledge. Be very honest (bravado proves to be costly here) and stick to an extremely narrow circle, if need be.

            Step 2. Gain experience and build upon your knowledge base.

            Step 3. Revisit your circle of competence often and see if it has expanded.

            After all, Warren Buffett himself has expanded his circle of competence over the years – his purchase of IBM being a great case in point.

            Thus, the blind spot can be managed if we are completely honest to ourselves.

            Should a beginner to value investing focus on reading instead? Is reading a great idea for value investors?

            As you know, in value investing, we are big fans of reading ‘everything in sight’ (to use one many Buffettisms). The only issue is, studying will take time. So, it is a long term solution. Albeit a mighty effective solution!

            Thus, the realistic approach is to think of our tiny little circle of competence as a starting place. And to keep expanding on it by diligent study.

  4. K Praveen Kumar

    Hi Satyajeet,

    Amazing article, very useful for starters like me.

    Filters/areas of selection i believe could start from circle of competence, but can include few beliefs/metrics like zero debt stock, honest management, ethical business areas. This to an extent will reduce the workable universe.

    I would like to point out that the downloadable material is very nice. Thanks for this initiative, and I hope you continue doing this going forward.

    All the best!

    1. Hi Praveen,

      Always nice to hear from you! You’ve been highly supportive from the start – despite my many bumbling efforts.

      Hope you’re doing good. :-)

      Honest management, ethical business etc. can definitely be included as criteria in ‘circle of competence’.

      Debt-equity ratio (or zero debt for that matter), however, belongs to an entirely separately topic – ‘stock screening’.

      While both are closely related, ‘circle of competence’ is a Warren Buffett invention with a slightly more qualitative flavor to it. It embraces our limitations, foibles and idiosyncrasies and takes it from there. Behavioral finance guys would approve!

      ‘Stock screening’ is a more quantitative thing and its spirit can be traced back to the great Benjamin Graham. Of course, Warren Buffett did a lot of that in the 1950s and 1960s, when he began his value investing career.

      I’ll devote a separate article to the topic.

      Many thanks again!

  5. Hi,

    I chanced upon your blog and must say that it struck to me as a very sincere effort in educating the novice investor, myself included. Thanks very much.

    I think it would help to include a “share this” option in your articles and website to make it more popular and widen its reach through FB, Twitter etc.

    Looking forward to a rewarding relationship with your work/website. :)

  6. Thanks for the wonderful article as well as the PDF file illustrating WB guide to investing.

    However I have one question though. While WB rightly mentioned that we should look at Cigar Butt companies to diversify our investment in the initial period, don’t you think that we should look at the very definition of Cigar Butt companies with relation to the current times.

    As you rightly mentioned in the article – Buffetts First Million; during those times there were asset heavy companies however in the current times, the composition of asset heavy companies is shrinking and there are more business which are asset light.

    If you permit me, my opinion would be to look at the very definition of a Cigar Butt company ( a stock which has a last puff remaining – a puff for free). If we apply this definition then there are stocks in market which are asset light but also are under valued since they are hit by the broader issue of Capital outflow, Economy issues etc. I woud list a penny worth suggestion that we should look at stocks which has greater liquidity, stock which has leadership in the category – Number one or two and it’s current stock value is low because of broad issues affecting.

    One such stock I can point out is Sun Pharma (disclaimer : I own stocks of Sun pharma) which is a market leader in its category, has given stellar performance over a period of time, has done some strategic acquisitions but the value is beaten down due to broader issues affecting the stock market, economy as well as the major investor selling stock. However the future of the company is well placed and I think this stock qualifies as a Cigar Butt company although the stock price seems high.
    Other stocks would be software stocks e.g. TCS, Wipro (Disclaimer : I hold these stocks in my portfolio) which are asset light but they are available cheap today due to suspected lower income in the future.

    I believe we need to look at the very definition of Cigar Butt companies in light of the current times and availability. This of course is my opinion.

    Thanks

    Regards
    Waman

    1. Hi Waman,

      Thanks for writing in!

      I understand your concern.

      Buffett did indeed look at the definition again. But the definition that he looked at again was ‘good investment’ in general and not ‘cigar butt’ specifically.

      In other words, he moved beyond cigar butts and started looking at better quality companies with economic moats around them. They tend be light on tangible assets and have a lot of intangible assets/goodwill. This happened from the late 1960s onwards.

      So, your point is well taken. The definition of a good investment has indeed changed with time. And that is the genius of Warren Buffett!

      The definition of ‘cigar butt’, however, is what it always was. And there’s no harm done.

  7. Nice one !!!

    Rejecting stocks basis complexity may be good for people who do not have adequate time but still wish to do their own research. However the value is always found when the complexity gets simplified through restructuring.

  8. Snerhal Vankudre

    Dear Satyajeet.

    Discovered the blog today.

    Really fantastic effort put in by you. i went through your all articles in single day. Loved so much cant resist to continue reading. Thanks my vision of value investing has been polished.

  9. vaidy thirunavu

    Dear friend i am new to this blog, learnt about the art of value investing.

    Totally i failed in share investment. your article taught me to understand the mistake what i have done and what i should not do.

    I will buy the stock with the aim of value investing and i will not loose money further. I will get success.

    Thanks for giving essential information for the value investor.

  10. I came across your site through Google search yesterday. I appreciate your efforts to make novice people like us the fundamentals of value investing. I am enjoying the articles presented by your site.

  11. Great article. The concept of rejecting and focusing on few is well illustrated. I personally will try this as it’s very practical. Looking forward for more case studies.

  12. I prefer Techno Funda approach because all information can never be gathered but everything is in the price. Price and volume gives the first hand information as to what is playing out. Liked your approach as well but on a individual level it is very difficult to scuttle butt.

  13. Leslie Menezes

    Dear Sir,

    You have provided a very simple approach to a newbie value investor. I plan to apply this approach and in the worst downside I expect this approach should reward me by saving my capital.

    1. Thank you, Leslie!

      Indeed, downside protection is of utmost importance in value investing. In fact, that’s what this oft-mentioned Warren Buffett quote means:

      “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”

      Although, frankly, I’ve never been able to track back to where he actually said that! :)

  14. HEMANTHA KUMAR

    Dear Satya ji,

    Namaste. The article is very good. Warren buffett invested large sums in few companies. How can we allocate funds whatever we have. Requested for an article from you on this subject. I know that fans will always burden their stars.

    Thank you and best of luck.

    Hemanth

    1. Dear Hemanth,

      Namaste. And thank you for your kind words!

      Will definitely keep your suggestion in mind. But let me quickly share this for now:

      1. Portfolio allocation is entirely dependent on how you generate your investing ideas, what kind of research you do, and as a result, how much conviction you develop about the idea. That is to say, Hemanth, the work involved in value investing is front-loaded.

      2. Portfolio allocation is independent of portfolio size. You are absolutely right – we are obviously not in the league of Warren Buffett. Almost no one is! But that doesn’t mean we can’t emulate his “focused” style of portfolio allocation.

      In fact, the Oracle of Omaha himself is on record suggesting that we’d do well to stick to only 20 stock picks in an investing lifetime. Simply because it will ensure we think about each of them thoroughly and that will improve the quality of our decisions! :)

      Warm regards,
      Satya

  15. Very well explained the practical tenets of Value Investing without going into technicalities.

    An excellent starting point for the uninitiated, but even a good refresher for those who try to practise Value Investing, but at times lose the track.

    1. I’m so glad you liked it, Chirag!

      All of need to hark back to the basics from time to time. I certainly need to. :)

Leave a Comment

Your email address will not be published. Required fields are marked *