How to avoid investing in great businesses at untimely valuations

Analytical: A vast segment of the investing community believes that investing in quality businesses is the ultimate recipe for investing success. The belief is that valuations matter less since premium valuations ascribed to quality companies is justified. However, reality is more nuanced than that.

For example, if you consider Nestle India’s stock price movement over a 10-year period (January 2013 to December 2022), the stock quadrupled from ₹4,900 to over ₹20,000, with healthy compound annual growth rate (CAGR) returns of 15.1% (ex-dividends). The company’s earnings growth happened at high return on capital employed, or ROCE, (10-year average ROCE of 56%) and valuations expanded to 90x trailing PER.

However, if we look at the stock’s performance between March 2015 and March 2016, the stock fell approximately 31%; significantly higher than Sensex’s 10% fall in the same period. This underperformance was primarily led by a sharp decline in earnings. Prolonged underperformance has also been seen in other quality companies in the past, i.e. HUL (January 2001-March 2010; April 2020-December 2022), Hero Moto (November 2015 to December 2022), Sun Pharma (July 2014 to December 2022), Symphony (November 2014 to December 2022), etc. What is common in these phases for the referred companies is growth slowed down and ROCEs compressed.

Is it possible to forecast such phases of slowing growth and declining ROCEs? A stock’s price is the clearest and most reliable signal of the market’s expectations about a company’s future earnings per share (EPS) performance. If EPS growth expectations embedded in the stock price are too lofty then it is reasonable to avoid the stock. On the other hand, conservative EPS expectations could set up a stock for future success. Typically, when a segment of the market exhibits strong growth, expectations from the future rise. High expectations set-up a stock for disappointment, since growth tends to mean-revert for a variety of reasons. In such instances, the risk of missed opportunity must be preferred over the risk of lost capital.

Let us consider the recent example of Nifty IT Index*, a quality segment of the market. Between 2013 and 2019, the IT index traded at average PER of 20x, for average growth of 11% and return on equities (ROEs) of 21%. Come Covid, due to remote working requirements, IT stocks outperformed and PER rose to 38x in current year (CY)21. In CY20-CY21, EPS growth was 6.5% and 17.8%, respectively. Given that valuations expanded to nearly 2x of previous averages, it was safe to assume that growth expectations from future were lofty. The set-up was perfect for future disappointments. CY22 growth decelerated to 9.5% leading to the index correcting 26% in the year. With the benefit of hindsight, the index constituents were best avoided in CY22.

Behavioural: Staying disciplined and consistently positioning away from lofty expectations helps to avoid disappointments. This is easier said than done, since inherent biases in investor psychology nudge investors toward pockets of exuberance. For instance, tendency of social proof or Herd mentality pushes an investor to seek pockets where others have been investing. However, by virtue of others’ buying, these pockets may have already rallied and become over-valued.

Conversely, loss avoidance tendency makes an investor shun pockets which have corrected recently and where investor interest has waned. However, due to meagre expectations, these pockets may be positioned for future investing success. For instance, private corporate banks witnessed a prolonged period of NPA accretion and loss provisioning. This phenomenon depressed their earnings and hindered growth. However, toward the end of the last decade these banks had made sufficient loss provisions and buttressed balance sheets through capital raises. Investors continued to extrapolate recent weakness into the future, thus de-rating most of these banks. With strength of franchises, these banks overcame the headwinds and reverted to their growth path. Overcoming recency bias and loss avoidance tendency would have been highly profitable for investors in this instance.

A quick hack to fight own biases and clarify one’s thinking is to restate problems in inverse form, as suggested by the great algebraist Carl Jacobi. Inversion is a powerful thinking tool because it puts the spotlight on possible errors and roadblocks that are not obvious at first glance.

(Disclaimer: The portfolio manager may or may not take any position in the stocks taken as examples. This should not be construed as an indication of current or future positioning of a given stock in client portfolio.)

Anshul Saigal is portfolio manager & head- PMS, at Kotak Mahindra Asset Management Company.

*Source: Emkay Research and Bloomberg