One of the most challenging aspects of equity investment is identifying a good company at an attractive price. A company may have a strong business, healthy financials and good growth prospects, but its stock may not always be available at a reasonable valuation. On the other hand, a stock that appears cheap may have underlying issues that justify its lower price.
This is where fund managers rely on thorough research and analysis prior to making investment decisions. They do not simply base their opinion on the share price but comprehend the company, its financial performance and what the market may be saying. In this blog, let’s find out about the approaches of fund managers in finding worthy companies at lower prices.
What does “good company at a low price” actually mean?
A “low price” does not simply mean that a stock trades at ₹100 instead of ₹1,000. The key is whether the stock is fairly priced relative to the company’s earnings, growth prospects, assets and cash flows.
This is the difference between a low-priced stock and an undervalued stock. A company could have a low share price and still be expensive as per its financial performance. Fund managers seek investment opportunities in companies that have solid fundamentals but are undervalued in the market.
They start by understanding the business
Before looking at valuation, fund managers study how a company makes money, its products, customers, industry and competitive position. They also seek out benefits like brand strength, pricing, technology or a broad distribution system that will enable them to sustain growth.
This allows them to determine if the business can keep up with its competition and continue to expand in the long run.
They dig into the company’s financial performance
Fund managers analyse revenue, profit margins, earnings, cash flows and return ratios to assess the company’s financial performance. They can also see ROE, ROCE and debt levels, and they might analyse multiple years of figures to look for any long-term trends.
Looking at these factors together can help fund managers determine whether the company’s financial performance is strong and consistent.
Then they ask: Is the stock actually cheap?
Fund managers use valuation measures such as P/E, P/B and EV/EBITDA to assess whether a stock is reasonably priced. They compare these metrics with the historical valuations and industry peers, and expected growth, as a lower multiple does not always equate to a stock being undervalued.
This is why value mutual funds may look beyond stocks with simply low valuation multiples. The emphasis is on identifying companies which may be undervalued yet have great business prospects.
They look for what the market may be missing
A stock can be undervalued due to short-term factors like low demand or short-term margin pressures. The fund manager determines whether these are temporary issues, and whether the long-term prospects of the company remain favorable.
If a company’s future potential is underestimated in the market, the stock can become attractive from a valuation standpoint.
How fund managers bring all these factors together
When it comes to finding a good company at a low price, there’s no one particular formula. Fund managers combine business research, financial analysis and valuation to form an overall investment view.
They can also learn about industry trends, connect with company leadership and track businesses within their portfolios. Investors can also use an online investing app to research companies and view financial details, but convenience should not be a substitute for proper research.
Bottom line
Finding a good company at a low price involves much more than looking for a falling share price or a low P/E ratio. Fund managers analyse the company, its financial position, its future prospects and valuation before determining if the current price is appealing.
The concept is straightforward: a great investment opportunity can be found when a fundamentally strong business is offered at a price that doesn’t adequately reflect its underlying value. Valuation should always, however, be viewed in the context of the quality and sustainability of the underlying business.
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