Morningstar.com's Contrarian Approach to Equity Research

If you have spent any amount of time reading equity research reports from the various brokerage houses (including those that are supplied by your online broker - ICICI Direct, HDFC Sec, etc), you would have come across their stock target prices, and their buy/ sell calls based on those target prices.

Invariably these target prices are calculated based on some variation of Discounted Cash flow, or relative valuation methodologies like P/E, P/B etc. In a shift from the 'target price' model of equity research, Morningstar.com (U.S. site), has inverted this methodology and instead publishes its estimate of intrinsic value and provides its views on stocks based on how much lower or higher than intrinsic value the stocks are trading. The website refrains from publishing target prices.

For value investors, I believe that this is a very sensible approach. Given that the markets are highly unpredictable, it is quite clear that the 'Target Price' based approach might be more suitable for Growth investors as well as investors with shorter time horizons. Typically equity research reports have target horizons of 1 year.

The Morningstar approach works by providing an appraisal of the Intrinsic Value. Investors can then choose to enter or avoid the stock depending on their preference for margin of safety. i.e. Those who would like to invest in deep value situations, might prefer to invest in stocks which are trading at 50% discount to intrinsic value, and so on.

In India, we know Morningstar as a provider of research on Mutual Funds. In the US, the company has progressed and is now actively involved in equity research. I believe that as and when they bring their Intrinsic Value approach to India, it would be a valuable tool for Indian investors.

Performance of Value Investing in India

Outlook Profit magazine has a wonderful story on the long term results of investors practicing value investing in India. The article features interviews with well known Indian value investors, as well as results of hypothetical value investing portfolios back-tested for their performance since the year 1998.

It is available at: http://www.manualofideas.com/files/content/2008_mahalakshmi.pdf

The article covers several Benjamin Graham strategies to examine their performance over this 10 year period. These include - Cash Bargains, Low P/E (or high earnings yield), etc. Another important contribution of this article is to shine the spotlight on many under-the-radar investors like Prof. Sanjay Bakshi, Chetan Parikh, etc who donot receive much coverage in the business media, but have been generating market beating returns for years and years.

Kudos to the magazine for bringing out such a well researched piece on value investing in India. The article has also accepted into the archive of the Heilbrunn Centre for Value Investing at Columbia Graduate School of Business, the birthplace of Value Investing.

More wonderful value investment related material available at: http://www4.gsb.columbia.edu/valueinvesting/schlossarchives/public

Behavioural Investing: Anchoring

A building needs to be be built on a solid foundation, a theory must be built on solid arguments, and an investment decision must be built on solid analysis. However, investors often make investment decisions which are built not on solid analysis, but "anchored" on reference point. How does this impact returns enjoyed by investors? In the following paragraphs, we investigate.

Imagine that Mr. A purchased stock in company 'A' for Rs 100 per share. The stock steadily rises to Rs 150 over a period of a year. Unfortunately, as it turns out, the company derives 50% of its sales from its license of a fast-selling software product. Suddenly, the licensor decides to withdraw the license and enter the market on its own. The stock tanks as soon as the news breaks and hits 110. However, Mr. A sees that the stock is off its high of 150 and hence erroneously assumes it is undervalued, and purchases more stocks.

However, the company's fundamentals have clearly deteriorated, with no immediate hope of maintaining its earnings, unless it is able to take some radical steps. Thus, by falling victim to 'Anchoring Bias', Mr. A has compounded his loss.

Anchoring also works in another way. Since, even at Rs 110, the stock is above Mr. A's purchase price, he still has an illusory feeling that he is in the money. Hence, he continues to hold/ or even increases his position in the stock. Thus, instead of redeploying his money in a company with better fundamentals, he is continues to suffer from the consequences of his behavioural biases.