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Are cheap stocks good investments?

Are cheap stocks good investments?

Not always. A stock could be available at a price lower than its peers for a variety of reasons. Don't be tempted by this. It's more important to know about the growth prospects of the company.

When Baron Rothschild was asked how he had amassed an enormous fortune from the stock market, he replied, "I buy sheep (cheap) and sell deer (dear)."

Rothschild aptly describes the basic tenet of value investing. To identify a value stock, you should compare its price with its fundamental factors and buy when you believe you are getting value for money.

The most commonly used yardsticks to determine this are price/book value (PBV) and price/earnings per share (PE). If these multiples are low, buy the stock. However, this principle may not always work to your advantage. Often, a stock can appear more reasonable and attractive than its peers because these ratios are low.

Rama Krishna, 33

Investing for: Eight years
Portfolio value: Rs 1.2 lakh
Present stock holdings: IRB Infrastructure
Value trap: Krishna bought 60,000 shares of Cals Refineries at 48 paise each, in November 2009. He thought the price was cheap and was bound to go up. He sold the shares at 33 paise in October 2010.
Loss due to value trap: Rs 9,000 in one year

"I bought the stock on a tip from a friend, but while the market is rising, the stock is going down. I had to sell low to cut my losses. Never buy penny stocks on tips."
For instance, a stock may be trading at a single digit PE multiple, while the market trades at over 20 times on a trailing basis, or it could be quoting below its book value. However, this is not always a good reason to invest in the stock. You need to examine various other aspects to determine whether it offers good value.

Firstly, you need to study the PBV and PE over a long period, say, three years. This is because one year's performance can be accidental or stage-managed. Also, it's not enough for the price-based parameters to be low. It's essential that the building blocks which make these ratios are improving.

So, the sales, operating profit, EBIDTA margin, net profit and return on net worth should be on the rise. If it has no growth or low-growth prospects, it will quote at a discount to its peers or the market.

A company can register a low growth for many reasons. The industry itself could be stagnating or the product can be in the process of being phased out. For instance, Network, a typewriter manufacturing company, went down as the product became obsolete with the advent of personal computers in 1990s.

Another important reason for the discounted price can be the quality of management. This is a broad term, which covers all management styles, from a dishonest one to one that is honest but lacks the vision and drive to grow. In high-growth industries, if the management quality is not good, the stock's valuations will be below that of its peers.

A company that encapsulates all these points is MTNL. In 2000, the telecom firm's stock was available at a high of Rs 390 and investors bought it because they considered the price cheap. However, MTNL's prospects have been declining, and 10 years on, the stock price has dropped to about Rs 65. Over the same period, the Sensex has moved from 6,000 to 21,000.

MTNL was licensed to operate in two of the most dense landline markets-Mumbai and Delhi. However, the growth in industry in these two cities was primarily spurred by mobile phones. The company was operating in a segment and market where the growth prospects were very low.

Some investors still hold on to the stock for the dividends it pays, prompted by the government, which is a majority shareholder. So, value investment does not only mean buying cheap. It also involves the ability to pick a stock that has the potential to become dear.

Manish Shah
Associate Director, Equities, Motilal Oswal

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