Value Trading

GST Impact

I am going todiscuss a new term value trading in this post. It is a very interesting
concept and it was first mentioned by my good friend arpit ranka. I cannot claim any originality on this
concept, but once it was mentioned by
arpit, I started thinking about it and found a lot of validity and relevance to
my style of investing.

What is valuetrading? (my definition)
Value tradingis best described as buying a stock with the expectation of selling the same
(hopefully with a gain) in a short period of time based on the realization of a
single or multiple triggers. This trigger can be fundamental in nature such as
normalization of sales/ profit margins (from a temporary low), business event
such as launch of a new product or new capacity or change in the business
environment for the better such as moving from extreme to moderate pessimism .

In additionto the fundamental issues, the trigger could be technical in nature such as
short term overselling of a stock due to unexpectedly poor results or some
temporary event such as elections which do not really impact the fundamentals
of the business

In all thesecases, one is expecting that the trigger will occur in the short term and the
stock price will get a quick bounce (10%+) and one would be able to exit with a
nice little profit

How does itdiffer from value investing
The abovedefinition may sound a lot like value investing and I have been guilty of
mixing the two for all these years. However as I think back, I have come to
realize that they are not strictly the same and confusing the two can actually
be harmful (as I will explain later in the post)

If oneinvests with a long term horizon in
mind, then it is critical to have a good idea of the intrinsic value of the
company. In addition this intrinsic value should increase over time, if one is
to make above average returns in the long run.

So ineffect, one is playing a short term trigger in the case of value trading versus
betting on the business in the case of value investing.
Examples ofvalue trading
Lets look atsome example
Patels Airtemp
I would call this ideas as a value tradingidea as this company is in a highly cyclical industry. At the time of buying
the stock, I was expecting that the downturn in the capital goods industry
would not be deep and the fundamentals of the company and its stock price would soon bounce back.

Thetrigger has yet to happen and as result the stock has slid further since the
time I wrote about it.

Ashok Leyland
Istarted looking closely at this company in mid 2008 and by the end of the year
the bottom had fallen out of the commercial vehicle market (the company stopped
production for a month in dec 2008 to reduce the inventory). I purchased the
stock in early 2009 at highly depressed prices.

Thetrigger normalization of commercial vehicle sales happened quite quickly
towards the end of 2009 and the stock turned out to be a four bagger.

Inboth cases, I expected a normalization of
the fundamental performance and a bounce back in the stock price. In one
case it happened faster than expected resulting in a large gain and in the
other case the downturn has been deeper than expected and hence the stock price
continues to languish

Amara Raja Battery
Thecompany is a no.2 player in the battery industry and operates in a close
duopoly. The key insight in this idea is that the company is expanding its
competitive advantage (brand and distribution) and also benefiting from migration of demand from the un-organized to
organized sector

Iwould tag this as a value investing idea as i dont expect a specific trigger
other than the fact that the company is improving its competitive position and
hence should see an improvement in profitability and growth.

The first twoexamples I have discussed should bring out the following key point In a value
trading idea, the intrinsic value may not expanding or could be declining too.
However the stock is undervalued and a set of triggers could close the gap with
the intrinsic value. You can call this mode of investing as deep value
investing or graham style investing too.

The lastexample of amara raja is more of a buffett style, high quality stock where although one is expecting the gap with the intrinsic
value to close, the bigger gains come from an increase in the value of the
company itself.

The differentiatingfactors
The two modesof investing differ on several factors. The first factor is time Time works
against you in the case of value trading. If the trigger happens quickly, the price rises quickly to the fair value and
one can exit with a nice little profit. On the other hand if trigger gets
delayed, then the overall returns may remain the same, but the annualized
return is much lower.

In case ofvalue investing, time works in your favor. As the company continues to grow its
intrinsic value, the stock price should hopefully follow it (some times in
spurts) and thus the idea becomes a buy and hold kind of idea.

The secondfactor where these two approaches differ is the nature of the business. The
value trading approach works better in commodity and cyclical industries. If one can catch the
bottom of the cycle and bet on a tier 2 or tier 3 company in the sector, then
the gains are very high when the cycle swings back to a normalized level. At
the same time, one needs to also ensure that the stock is sold once the cycle
has turned .

Valueinvesting approach works where the economics of the business is good and the
company has a competitive advantage. In such cases, if one buys the stock at
reasonable valuations, then returns are good over a long period of time

Do not mixthe drinks !
I would saythat value investing or long term investing should occupy a larger portion of the
portfolio. If however you have the time and energy to look for value trading kind of ideas and can play them
well, the portfolio can get an extraboost from time to time

The danger isreally from mixing the two approaches as I have done in the past. I have
bought trading kind of ideas and held on
to it for a long time (assuming it was a long term investment). In such the
cases the absolute returns came through, though the annualized returns were mediocre
due to a delay in the key triggers.

The correctapproach would be to keep in mind the nature of the idea (trading v/s
investing), identify the triggers and the time it would take for the same to
play out. If the triggers change or get delayed , then one should exit a value
trading kind of idea. In contrast in a value investing idea, time is working in
your favor and temporary hiccups are sometimes a good time to add to the
position. In all such cases, one should just sit tight with the position.