Why Warren Buffett’s value investing model doesn’t work in Indian market

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Omaha's Oracle Warren Buffett (photo by Michael Prince for Forbes)

NEW DELHI: The concept of value investing has been advocated by legendary investors like Benjamin Graham and Warren Buffett, and is followed widely around the world. But it simply does not work in India.

In a threadbare analysis, Ambit Capital in a report said value investing does not always work in the context of the India market because while earnings yield of value stocks looks attractive, these stocks display limited potential to actually realise those earnings given their declining return ratios, excessive leverage and poor accounting practices.

Based on a comparative analysis of value investing in the US and in India over the past 20 years, Prashant Mittal, research analysts at Ambit Capital, said the cheapest firms in terms of price multiples in India have the lowest return on capital.

Ben Graham defined a value stock as one that trades at a discount to its intrinsic value. Most investors use low price-to-earnings multiple and low price-to-book value as measures to identify such stocks.

Why value investing does not work?

The strategy involves buying cheapest stock on the basis of such multiples as earnings yield, return ratio and then selling the most expensive ones is a strategy that repeatedly delivered returns to investors in the western world.

However, in India, to consistently generate healthy returns investors need to focus disproportionately on the quality of the franchise and worry less about the prevailing valuations.

After analysing companies with top and bottom quartiles based on highest PE multiples, Ambit Capital found that these companies enjoy the highest return on capital. Conversely, the cheapest firms on price multiples have the lowest return on capital.

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The brokerage said its concerns over value investing stem from three main issues.

Declining return ratios: Analysts at Ambit Capital found that the return on capital employed (RoCE) and return on equity (RoE) have been declining for value companies in India (companies in the lowest P/B quartile of the BSE200 index) compared with their US counterparts, which display a mean-reverting profile for these return ratios.

While poor accounting quality is a recurrent theme in Indian corporate life, any earnings growth might simply be a function of accounting shenanigans rather than an underlying change in earnings prospects, the Ambit report said.

 While investors in the cheapest companies in the USA would have reaped the benefits of any bounceback in returns after a period of economic stress, a similar investment strategy would have gravely disappointed investors in India.

Excessive leverage: Another factor that makes value investing a worthwhile exercise relates to the extent of leverage employed by these stocks. The leverage quotient for stocks of the BSE200 companies has been rising steadily while a decline in the interest coverage ratio.

This raises concerns over cash flows available for equity shareholders after servicing debt. Hence, these stocks might look cheap in terms of earnings, but the ability of these companies to generate cash flow to reward equity holders is questionable.

Poor accounting quality: Another factor that Ambit thinks hurts the value story is the fact that most companies that look attractive based on P/B multiples in India are also the ones that have lowest forensic accounting scores.

Our accounting framework penalises companies for shenanigans such as aggressive revenue recognition, aggressive provisioning practices and poor quality of auditors.

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