The return of value investing and the best recovery plays By SAURABH MUKHERJEA, AMBIT CAPITAL Quality has become a key driver of outperformance of stocks over the past three years. Indeed, our own high-quality portfolios, the good & clean series, have outperformed the indices by 20 per cent points over the past 19 months. While this is still our preferred mode of long-term investing, in the impending economic recovery, this approach is unlikely to capture re-rating stories among the beaten-down value names. Over the past 10 years, value stocks in India have outperformed growth stocks and the broader markets alike. However, over the past three years, the story has been changed. During this period, growth has thumped value. In particular, higher RoE growth stocks have performed significantly better than their lower RoE counterparts. Arguably, growth victory over value in the past three years has been due to the tough macroeconomic climate in India - investors desperate pursuit of pockets of the economy that still deliver growth has come at the expense of valuations. Value, on the other hand, has been beaten down as most of these stocks have suffered in this weak economy and hence exhibited poorer results and weaker growth, which gets extrapolated into the foreseeable future years by the sell-side. To the extent that we see the Indian economy turning (our GDP growth estimates: 6.3 per cent in FY13, 7.1 per cent in FY14), with interest rates falling and with the QIP market re-opening, it becomes imperative to focus on select value stocks that are sensible turnaround recovery plays. To identify stressed stocks, we look for BSE200 firms (ex-BFSI) that have high financial leverage measured by debt-equity ratio and interest to operating profit ratio, and high operating leverage proxied by decline in asset turnovers and EBIT margins. To the stressed stocks identified, we apply the F-Score test. In essence, the F-Score test ensures that these distressed stocks still have relatively decent balance sheets. These stocks are then subjected to our accounting filter. We thus arrive at a list of a dozen sensible picks for the recovery. This list in conjunction with the high-quality cyclical stocks from our good & clean portfolio should give investors the optimal list of stocks for the economic recovery. A couple of stocks have been included in this list (Jain Irrigation and Sintex) in spite of low F Scores as they perform well in our ‘greatness’ framework. The list has names like Adani Power, Ashok Leyland, Bharat Forge, Bharti Airtel, CESC, DLF, GVK Power Infrastructure, Hindalco, Indian Hotels, Jain Irrigation, Sintex and Tata Steel. This list in conjunction with the high-quality cyclical stocks from good and clean portfolio should give investors the right list of stocks for the economic recovery. The good & clean portfolios have focused on cash-generative, fundamentally sound firms with relatively clean accounting and good corporate governance. Stocks for the portfolio are chosen using our “greatness” framework while being also subjected to forensic accounting and corporate governance filters.