Value Investing: A Simple But Rock Solid Way to Start

How the BSE Sensex has rewarded value investing since 1986.
The BSE Sensex since 1986. Source: Google

You face two stark realities in value investing.

The first, a pleasant one, is this: the stock market will reward you handsomely, if you know what you’re doing.

Want proof?

Well, just have a look at the chart above…

But then, there’s the second, slightly bitter reality:

Value investing can often be a difficult, and confusing activity.

Here’s why:

There are over 2,400 stocks traded each day on Dalal Street. Source: BSE

You see, you can choose from at least 2,400 actively traded stocks on the Bombay Stock Exchange.

And the number is over 1,800 on the NSE.

And what’s more, for each stock, you could possibly read hundreds of pages of financial reports and news stories.

Every. Single. Year…

Whoa!

So, where do you even start?

Isn’t value investing just too much work for you?

Well, here’s the surprise:

Not only can you manage this mountain load of work, but you can actually exploit it to your own benefit!

Let’s see how.

How Warren Buffett Tears Through 6,364 Stocks


Imagine for a second, you are Warren Buffett.

How many stocks would you be dealing with? The answer… around 3,200. In fact, it used to be higher at 6,364 shares in 1997.

And so, how’d you choose from so many options?

Well, here’s what the value investing legend himself 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. The size of that circle is not very important; knowing its boundaries, however, is vital.”

There they are.

The three golden words of value investing: Circle of Competence.

Well and truly, one of the billion dollar secrets behind the investment track record of the world’s greatest investor.

And in case you think, it was just a one-off, here’s the Oracle of Omaha, in his letter to shareholders in 1999, again stressing upon exactly how important the concept of circle of competence is in value investing:

“If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter…We just stick with what we understand.”

So, here’s the takeaway for you: the next time you feel overwhelmed from having to choose from more than 2,400 stocks — realize that you actually have to deeply study only a few of those.

That’s right – only a few selected stocks.

But here’s the rub: Once, you do select your shortlist of stocks, you must then devote your full time and attention to it.

Now, you might be thinking, “It all sounds good, but can you show me how I can apply all this right here, for value investing in India?”

Yes. Absolutely.

I’ll show you exactly how. Step by step.

But first, here are…

4 Key Things to Know About the Value Investing Method

First, please note you’re trying to arrive at the initial shortlist of stocks for further study. You’re not trying to find the final selection of which stocks to buy. No, you are not at all trying to find your final value investing portfolio at this stage…

…and in fact, it is this process of shortlisting or filtering that both saves you time and improves the accuracy of your investing decisions.

So, that’s the first thing.

Secondly, remember, you can create your shortlist on any reasonable basis that you feel like.

Why?

Because you’re not a professional investor. Those guys have all kinds of weird pressures. Do this. Do that. A lot of that pressure, frankly, is quite silly.

As a individual, independent investor, you can jolly well do as you please. You actually can practice a purer form of value investing than they can.

And this is exactly why, you give yourself a fighting chance to match up to beat the big boys at their own game.

Thirdly, keep in mind some of the following practical ideas on how you can use Warren Buffett’s secret (which by now, you know is your ‘circle of competence’) to filter stocks for further study:

FILTER # 1

Product and Business Model

Can you understand it? If it’s too complex, you reject the stock.

FILTER # 1
FILTER # 2

Financial Statements

Can you understand them? If the accounting is too complicated, you reject the stock.

FILTER # 2
FILTER # 3

Underlying Technology

Does it change too rapidly? If it does, you reject the stock.

FILTER # 3
FILTER # 4

Destructive Competition

Is the industry in which the business operates, subject to a lot of churn? You choose stocks only where you feel the industry conditions are relatively stable.

FILTER # 4


And finally, note that these value Investing filters are not sacrosanct. You may use them or if you feel like, you many use any other criteria for arriving at your value investing shortlist.

Just make sure it reflects your strengths, and your comfort zone. Not someone else’s.

Be true to yourself.

How To Make Value Investing Easy for Yourself

So, let’s say you start with the 30 stocks in the BSE Sensex. These stocks are:

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

Let us attempt a classification based on the four value investing filters that defined our circle of competence above. Here goes:

Rejected: The financial statements of these stocks can 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 Bank
  8. SBI
  9. Yes Bank

Rejected: The business suffers from rapidly changing technology and industry conditions. We’ll get stumped.

  1. Bharti Airtel
  2. Tata Steel

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

  1. ONGC
  2. Sun Pharma

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

  1. HCL Tech
  2. Infosys
  3. TCS

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. Coal India
  2. Reliance Industries, and
  3. Vedanta

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
  11. Tata Motors

So there you are.

19 stocks – which is 63% of the total – have been rejected, outright. That saves you 63% of the time you’d devote to researching and picking out value stocks.

(By the way, I did not decide in advance to shortlist any particular percentage of stocks. It just turned out to be 63%. It could be more or lesser, depending on the initial list.)

Now you can focus on the selected 37% 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 Should You Do Next?

So, now you know where to start, when you’re new to the world of value investing.

You can now try this exercise with a larger set of stocks like the BSE 100 or the BSE 500.

The process is the same.

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

So go ahead, download them here:

1. Value investing template for BSE 100

2. Value investing template for BSE 500

Disclosure: On the date of this update, I own Axis Bank out of the stocks mentioned above. Have held the shares since 2005. Also, please note, the key to your value investing success is YOUR own circle of competence. That’s exactly why I don’t give investment advice or equity research recommendations at all. It simply doesn’t work.

28 thoughts on “Value Investing: A Simple But Rock Solid Way to Start”

  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 television 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 5,000+ 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:

            Step 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 lift one of Buffett’s many phrases). And we will discuss the point about reading very soon. 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…

      I often talk about the 5-Value Activators. Value Activator 4 is about how you decide to spend the money – i.e. portfolio allocation. There are 2 key things to note here:

      1. It is entirely dependent on Value Activators 1 to 3: How you generate your investing ideas, and 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. It 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

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