(An old piece from Moneylife … Markets are markets- Amazon just ripped through the price barriers, while Eicher seems to have cooled off. I still maintain my views, but price prediction is not my cup of tea. Only thing I want to be sure about is that if I buy something, the upside potential in price has to exist. And some cushion for a downside too. )
Be mindful of your expectations when you buy really expensive shares
Old stamps, antiques, old watches, paintings, etc, are called ‘priceless’ for a reason. They do not follow any rules, or principles, of valuation. Their value could be from zero to infinity, depending on the eye of the beholder. And, unlike government securities or stocks, they do not generate any income. Still, there are experts for everything who can fix a value for things in their domain. Such valuation expertise defies rules applied to popular income-generating assets.
Of late, we are seeing most global markets flush with so much money that every asset class is getting an upward revision in valuation. Nothing is considered expensive. A promise, or a potential, is deemed far more valuable than actual profits. Someone aptly put up a forward on WhatsApp that read as under:
The company is Amazon, the online e-tailer. Yet to record profits; but hope springs eternal and, therefore, command sky-high valuation. We have companies in our country too that are as precious as antiques or stamps, even though they are profit-making. Only a collector can justify the valuations prevalent:
Market-capitalisation is the value attributed to a company with these financials. If we were to put the amount for its market-cap in a bank fixed deposit (FD), carrying interest at 8%pa, it would earn around Rs4,800 crore every year. This company is earning around Rs700 crore today. And will the earnings double every year? Even if they do, it will earn Rs1,400 crore in one year, Rs2,800 crore in two and Rs5,600 crore in three years. The company looks like it is grossly undervalued. What if the company were to grow only at 30%? Then, it would take nearly eight years for the profits to reach that level. In the meanwhile, the bank would have paid Rs4,800 crore in the first year itself, with every year, compounded. I would like to think that the market believes that the company will nearly double its earnings every year; in other words, a growth of 100%pa, or close to it.
What if the company stumbles? What if the company’s profits stagnate or fall? Or am I being stupid in even considering such a possibility? The company is Eicher Motors which has had a spectacular run. I do not know many people who bought its shares a few years ago, but there is a lot of talk about the stock now. Going by numbers, I see ‘great’ expectations riding behind the price. One small slip and the price will come crashing. If the market-cap rises at the same pace as the turnover, the stock is surely priced like a Kohinoor diamond. Definitely, not valued like a financial asset.
There are many such stocks. The problem with the markets is that they can be irrational—on both sides. What would I have done, if I had bought the share when the company’s market-cap was, say, Rs500 crore? Frankly, I would have started offloading my position long before the market-cap hit 30-40 times its rising profits. That itself would have been a spectacular return. Yes, I would always look back with ‘regret’; but that is my style. I do agree that, in the early stages, companies can keep doubling the revenue and the bottom-line every year. Where will it halt? It is a call that is hard to take; but I would take the call at some time. Eicher has doubled its top/bottom-line every two years. That is a near 40% (compound annual growth rate—CAGR). Even at this rate, it will take nearly five years or more for the profits to reach the level of the return on a bank fixed deposit on today’s principal.
Irrational: I do not understand these kinds of valuations that border on irrationality. I am happy to keep away from something that I cannot believe in—until I am comfortable with the price. A company may be great, its products great and prospects great. But price has to have a relation to the profits it makes. After all, money has alternate uses. We cannot impute a price simply because it is a price at which the last person bought.
One way to address this issue is to follow what Charlie Munger, partner of Warren Buffett, says: “Invert, always invert.” In this case, you might like to ask yourself, whether you would be willing to pay Rs60,000 crore to buy out the entire company that delivers profits of around Rs700 crore. The company’s highest (current) return on equity (RoE) is around 50%. HUL and Colgate deliver near, or more than, 100% RoE. Of course, I could be totally wrong. Maybe Eicher will sell two million motor cycles in a few years and earn Rs3,000 crore as profits. If you think it is going to happen, you should buy the share.
In all markets, we will always have prices that do not conform to normal valuation rules. They don’t trade on ‘Price to Earnings’ (P/E) basis but ‘Price to Expectations’ ratio. Of the two examples I discussed above, neither seems to fit in my buy list—at the current prices. I must say, that I like the company, Eicher, and have used it as an example to discuss and debate stock-market behaviour. It is just that I would like to own it, but at a considerably lower price.
The bigger game is in spotting such companies very early, if we have to make super returns from stocks. Page Industries is another great example of how companies can reward the investor, if spotted early. Here is where some deep thinking and knowledge of the product, the markets and the company helps. So we have to keep aside some of our investible money for such potential winners. We may choose three or four and, even if one pays off, it is worth the risk.
Potential Winner: For a potential winner, we must be sure when we are able to visualise the company a few years down the road. This would mean fulfilling the following conditions:
• It has a product that is easily understood and enjoys strong demand.
• There is some advantage over existing players that can give an edge.
• It has enough resources to keep growing, without coming to the capital markets.
• The company has very low debt or no debt.
• The product enjoys high profit margins.
• The product has a long life cycle and will survive for decades.
• The company can focus on building the product/brand and does not have to invest in logistics, distribution channels, etc.
• Company’s product/s has/have a mass market or cater to a growing and/or ‘aspiring’ population.
• The promoter owns at least 51% of the business.
It is important that one can understand what drives profits in the business without going into complicated Excel-sheet numbers. The simpler it is, the higher the chances of success. Also, look for global comparisons, wherever possible. Page Industries was harder for many to spot because its parent, Jockey International, is not a listed company. Information was not easy to access; one had to go on the premise that it was one of the top two or three brands in the world in ‘innerwear’ and that the Indian promoter is a trusted franchisee with the background, etc. The first-year numbers, the quarter-on-quarter numbers were all showing the way.