Learn with ETMarkets: Quality or value investing: Which one is for retail investors?

Investing is one endeavour in which there are many possible approaches to arrive at a desired financial goal. The approach one adopts to reach the goal must make one gain enough conviction to stay invested through the journey, through good and bad times.

Particularly in difficult times, since that is when one’s commitment to one’s principles and methods is put to the test.

Value investing is one approach where one simply buys those companies which are available at a significant discount compared to their intrinsic value. Benjamin Graham developed the concept of value investing in the early 20th century.

Together with David Dodd, he co-authored a book titled “Security Analysis” in which they discussed various value investing strategies.

By purchasing equities that appear to be underpriced, value investors might bet on those companies being re-discovered by other investors and then profit from the resulting price correction. In other words, buying low and selling high is the core principle of value investing, which may sound simple but is difficult to execute.

While ‘value’ can be quantitatively calculated, it is quite subjective because of numerous assumptions that go into it.

Value investors typically use a company’s previous performance as well as its predicted future performance to determine its current value as well as its future value.

Value investing is conceptually good; no one can argue that buying with a ‘margin of safety’ is wrong. However, when one restricts only to those companies which are available at a discount, then one may miss out on good companies which are growing rapidly and are attracting a whole lot of investors.

The reasons could be that they are leading innovations in the technology space (eg:

in India) or are expanding rapidly into new markets (eg: D-Mart, which still has a long runway to grow).

Some of these companies are also run by highly competent management with high levels of integrity which gives comfort to the investor. While these companies may seem expensive, their stock prices may run up for several years; a value investor might miss out on such returns.

Sticking to value investing at any cost (actually at ‘low prices’) might lead to hoarding dud companies that have low Price-to-Earning multiples, but unfortunately for good reasons.

This is termed a “value trap” because the investor is fixated on a certain valuation and might miss out on the bigger picture.

This is where a ‘quality approach’ to investing help. One way to build a quality portfolio is by selecting companies with strong ROOTS (debt-free companies with a consistently high return on equity and owned by aligned promoters) and WINGS (companies with growing sales, operating income, and cash flows).

By using this yardstick, one finds that some sectors, such as utilities, airlines, and telecom, may be less favoured. Consumer staples, manufacturing, e-commerce, technology, financial services, and pharma, are examples of capital-efficient and consumer-focused industries that frequently have strong roots and powerful wings.

Quality portfolios may often appear expensive compared to value portfolios. This is because the emphasis is not on just the price but on the holistic health of the company and its demonstrated ability to scale.

Our experience with quality portfolios using ROOTS & WINGS is that on a rolling 3-year basis they have beaten the Nifty50 benchmark consistently, both in backtests and in live results since launch.

When we removed companies having the highest PE ratios, i.e. above a cutoff at 90th percentile PE in their sector, we found that the long-term performance of the strategy dipped. This result did not vary much by lowering or increasing the cutoff.

Another interesting number to ponder is the Nifty Midcap 150 Quality 50 Index has outperformed the Nifty Midcap 150 index over the last ten years.

This quality index picks companies based on their return on equity, financial leverage, and earning per share (EPS) growth during the previous five financial years.

A quality approach balances both the growth (WINGS) and the structural soundness (ROOTS) of a company. In this way, it reduces the risk of other investing strategies like growth; the latter may look alluring during bull markets, but could see a huge correction when bear markets ensue, as seen in the huge drawdowns in the platform and technology companies: examples being

, in India and Netflix, Freshworks, etc in the USA.

To summarise, a quality approach has the potential to outperform value strategies or growth strategies over time, because they are able to select the best companies which are poised for long-term earnings growth.

(Disclaimer: Stocks mentioned in the above article may be part of our recommendations at some point in time. Investors ought to consult their SEBI Registered Investment Advisor before investing in any stocks. Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times.)

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