This article was published in Moneylife Magazine. Some thoughts about the valuations of large cap companies. Basic thoughts are that we have to study trends in them. What is happening to the profitability of dominating players. What happens is that trends in profitability can be good indicators over a period of time. Often when we find that old P/Es do not come back, the answer will often lie in a secular decline in ROCE/ROE.
I have always tried to segregate investment in equities into two categories. The first one is to buy into established companies with a long history. I know that I am unlikely to find spectacular returns; but I still hope to get better than index returns, provided I can buy the scrip at the ‘right time’. The second category is to buy young companies with the potential to grow exponentially from where they are when we get in. In a sense, it is akin to venture capital investing, because not every bet will pay off. The hope is to pick as judiciously as possible and hang on to them for many years. Let me talk about the first category. The old and the boring ones, so to say. I will start with a bunch of companies from the Nifty 50 and put down some numbers:
The table above needs some explanation. These are established companies with longish history and are very likely to continue to be in business for the next decade or more. Thus, the single important metric to evaluate them will be the amount of money they can make as profits each year. Their growth is not going to be spectacular and the 10-year averages are more likely to hold over the next 10 years or probably get weaker as the base effect takes its toll. Thus, RoE (return on equity) is an excellent tool to measure how good they are. The RoE could swing in a good year or a bad year; but is unlikely to shift to a different plane altogether. Generally, over time, RoE will tend to remain in a very narrow range for mature businesses.
I have done some slicing of the 10-year numbers. I have chosen four time periods to see what is happening to the key metrics. I start with the latest 10 years’ data. Then, I chose the latest five out of the 10, the latest three and then, finally, the latest 12-month period also known as trailing twelve months (TTM). These are large companies and, by and large, their top-lines would have some correlation to economic growth. The table below helps me to:
i) Find out the trend in sales, profits and RoE. If TTM is lower than the latest three which is lower than the latest five which is lower than the latest 10, then there is a declining trend and vice versa;
ii) Use the trend to figure out which companies in the Nifty 50 will outperform or underperform the index, by using the first two columns ( average P/E and P/BV) in conjunction with the findings above;
iii) Use the trend to add or reduce the portfolio.
To give an example, in the grid below, based solely on numbers, some of the oil companies look very attractively priced. They are trading below their historic averages in terms of P/E (price-to-earnings ratio) and P/BV (price-to-book-value ratio). The basic premise is that they will continue to maintain their historic RoE. There is a probable distortion here because oil price deregulation is a recent phenomenon and, hence, the future should look better as do the more recent numbers. Thus, if government policies do not get any more restrictive than they are today, it is very likely that this bunch of stocks will deliver better returns than the overall index, given their attractiveness. Of course, fundamentally, one could point out to a number of reasons why one should, or should not, invest in a stock. I am referring to a visible pattern in the numbers that make decision-making simpler. If I extend the same analysis to the entire Nifty basket, I get some very interesting observations. For the sake of curiosity, I will list a few:
I) Bosch Ltd has a 10-year average RoE of 17%, with progressively lower recent numbers, trades at nearly 50 times earnings, has an average top-line growth of 10.4%, with the recent five years’ being 5.6% and recent three years’ being 6%. What this means is that growth in real terms has probably not happened or the company has lost its pricing power (if volumes have grown);
II) Bajaj Auto Ltd has a 10-year average RoE of 38.2%; but, in the latest five years and three years, RoE is dramatically down to 28.7% and 25.3%, respectively. Clearly, there is increasing competition in the industry. The other auto companies have a similar trend; but Eicher Ltd has delivered increasing returns to its shareholders. Its 10-year average is 26.2%; but the RoE, over the latest five years, is over 32% and that over three years is 36%.
These are purely quantitative trends. At some point, market memories fade and prices catch up with performance. The numbers of the large software companies are a clear revelation. There is slowing growth, slowing profitability and worsening RoE. Thus, their ‘average’ valuations and current valuations reveal a story of deterioration. I am not advocating this approach for all companies. It is merely another tool to help make a decision when it comes to established companies. When you spot a statistical opportunity, do not jump in blindly. Use it as a starting point. Fundamental analysis cannot be replaced. Quantitative analysis can only be a decision support system rather than a stand-alone method for investing.