Good company, bad stock

I look at long term trends in the market and try to understand what I am missing. For example, amazon has always sold for an astronomical PE and I thought it was over-valued. However, the continued over-valuation, had me puzzled and I started reading up more on it.

I cannot get into the specifics here, but amazon is a case where the company is investing via its P&L (expensing the investments) due to which its current profits are suppressed. Think of it as a collection of businesses where one group is making above average profits and those profits are being re-invested in other loss-making new businesses. When you add the two together, the consolidated profit appears to be low. As a result, PE for the company appears to be optically high

I have used this learning to look closely at some of my ideas and tried to back out the investments which are being expensed in the P&L account. This ensures that I look past the optically high valuations and arrive at the steady state valuation, which may be lower.

Every company is not an Amazon

I wrote a post on this topic – The value of overvalued stocks, which is one of the most read posts on the blog. Since then quality and durability of growth has become near religion in the markets. Any one challenging or questioning this belief is seen as touch of step with the market. It is similar to the religion in mid & small caps in 2017 when I published this note – The Indian bitcoins

We have some companies in India, which continue to sell at high valuations and have done so for a long period of time. Are they similar to amazon?

For starters some of these companies are not growing at high rates. Some of them have grown at a low double digit CAGR in the last 10 years. In addition to that, these companies are not suppressing their cash flows to invest in new businesses like amazon. So, their PE is not optically high.

There is an element of truth behind this phenomenon. These companies enjoy a dominant position in their industry and have shown steady growth for a long period of time. The problem is that this growth is now being projected to last in excess of 20+ years. Can it last that long? Sure, it can – but a lot can change in that period too.

Nothing new under the sun

The interesting bit is that this is not a new phenomenon. If you looked at Infosys or WIPRO in 2000, you could have easily made a case for quality along with a large opportunity space for them. Both the companies did not disappoint – Infosys grew its revenue from around 900 crs to 87000 Crs over a 19-year period.

How did the stock do from its peak in March 2000 (PE of around 100) till date (before the recent drama)? It has given a return of 7% CAGR which is less than an FD return.

The company did its job and did not disappoint (26% topline growth for 19 years). It’s the investors who overpaid for it. There are more such examples from the recent past where the company has done well, but the returns were sub-par as investors overpaid for the stock.

Quality is a means, not an end

Quality is an input in the valuation and analysis of the company. It gives you the ability to project the cash flows of the company with higher certainty into the future. However, there is always a limit to this certainty.

If a company sells at 50 times earnings and is growing at 13% CAGR (1-2% above nominal GDP growth rate), it will require one to be sure of the cash flow for the next 23 years. That is a hell lot of certainty! and by the way in this scenario, the company has to perform better than this assumption for an investor to make higher than risk free returns (remember the Infosys example?)

Now some investors would like to argue that this is such a fantastic company, that the PE will keep rising. Welcome to the greater fool theory. You are in effect betting that the person buying from you expects the cash flow growth to extend beyond 23 years with certainty. Good luck with that

The end game

Some companies selling at high multiples are growing rapidly and if they can sustain this growth, will grow into this valuation. However, that is not the case with all the companies. Some companies have a very high market share in their industries and are unlikely to grow at super high growth rates.

A lot of these low growth, high valuation names face the risk of market moods. If the mood changes, valuations and stock price will drop. Unfortunately, the growth rates will not be high enough to bail out the investors over the long term.

These companies will continue to do well, and their sales and earnings will keep rising. Once the market fancy shift, investors will have to endure a long period of sub-par returns. This period can often stretch to years at a time.

In an age of instant gratification, how many investors have the patience to hold onto such ideas for years waiting for the earnings to catch up with the valuation? In case of fund managers, if they lag the markets for a year or two, they will lose investors and will be forced to move to something else.

Why no names?

I have not provided any quantitative analysis in the post. I could provide stats and numbers to make my point – but that will be useless. If you hold such a company, you will come up with reasons on why your specific case is unique or different (I have done the same in the past too).

I will resist naming these companies as I have no interest in getting trolled on social media. Calling them out is the equivalent of calling someone’s child ugly. It is better to keep such opinions private.

It is near impossible to accept something against the companies you hold. On top of that these are high quality, universally admired companies which have given good returns in the past. Most investors would never entertain the idea that these are good companies, but bad stocks