I won’t overpay for stocks!!!


One should not overpay for stocks.

There is no question that sometimes markets get it spectacularly wrong. While broad market performance is often sentiment and liquidity driven, individual stocks are sometimes completely misunderstood, and the market simply does not give them their due.

Within the broad market today, there are a number of stocks available at PE ratios of 30-50. There are several others available below 10. The large majority of midcap and large cap stocks are available with PE ratios between 10 and 30. Why this wide divergence between PE ratios of different businesses?

As I have understood it over the last year and a half or so, markets currently like companies which

a) Have Good Corporate Governance

b) Have steady growth, notwithstanding economic conditions. Usually, a necessary condition of this is economic pricing power through some kind of moat – brand power, distribution power, unique location or asset.

c) Are present in sectors markets like for the moment, because of the market’s reading of macro or microeconomic themes.

d) Have high Return of Equity and High Return on Incremental Capital Employed

e) Have Low Levels of Debt, which again allows them to come through economic cycles unscathed.

As a result of this, companies which are currently available at “high” prices (in my parlance, high ¬†PE ratios) are typically multinationals across the board (though especially those which own consumer brands, like Colgate), Pharmaceutical Stocks (like Sun Pharma), Indian Consumer Goods Stocks (like Marico and Emami) or Consumer Discretionary Goods Stocks (like Asian Paints). All these stocks share many of the above characteristics. The darling sectors of the markets are FMCG, Consumer Discretionary, and Pharmaceuticals. Autos and Auto Ancilliaries and Private Sector Banks are raring to join the party.

But it wasn’t always so. Rewind back to 2006. I wasn’t an active market participant at that time, but what I do remember is that HUL(which meets all the above criteria) ¬†languished for a long time in the first decade of the new millenium. And what was going at crazy valuations- DLF. DLF did have unique assets (Land) and did have good growth, and was present in a market sector which agreed with the market theme of the moment.

But on all the other parameters, Debt Levels, Corporate Governance, Return on Incremental Capital, DLF actually scored very low.

While DLF and HUL are probably only two examples, I think it is hard to argue on the broad thesis that stock prices run up first, and then broad thematic explanations are fashioned later to explain the stock run up.

One enduring theme is the notion of Economic Moats. Popularized by Buffett-Munger, and then expanded by Pat Dorsey, Economic Moats seem to deliver enduring returns over long periods of time. But even here, there can be a slow decay of moats over time, (witness Coco-Cola and Microsoft, as vivid recent examples), and thus for investing over the long run, investors need to focus on more than just economic moats-they need to be careful about the price they pay for stocks. If one pays too much for a stock, no matter how great the structural and human characteristics of the business, then you cannot expect that over the long term, you can make great returns on your investment.

This is particularly true when one confronts the kind of bull run we are in, and which may, hopefully, translate to being a multi year bull run. In September 2013, all stocks, save for some FMCG stocks, were available at prices which would have given great multi year returns, One did not need to be a stock market genius to acquire stocks at the prices they were available at then and then just wait till they would give you great returns over time. But as the bull run proceeds, I am quickly becoming sad. While I still have capital to deploy, I do not find prices very attractive any more. But the uncertainty is killing: On the one hand, if this is a multi year bull run, then it is best to purchase today, otherwise one might miss out on all the great gains that are likely to accrue. In the next post, where I discuss contrarian investing, I will also discuss how a great stock price itself propels companies forward. On the other hand, if it turns out to be a chimera, then one needs to be very careful about the price one is paying, and the kind of business one is paying a high price for. Otherwise, one needs to start worrying about capital preservation, rather than return on capital.

The time has not come yet, but I do see a time in the near future, where I just keep enjoying the run up in stock prices while doing absolutely nothing in the market other than staying invested. As far as I am concerned, I will not overpay for stocks beyond what their earning capacity is, plus a small speculative element where they may find avenues for growth in earnings beyond the obvious. So the only alternative is to wait for others to do so. Gauging value of stocks, and then sticking to that notion of value, is my investment style.

 

Update:

Here is a nice article by Dr. Vijay Malik, which talks about the same principle of not overpaying for stocks, but in a much more analytical way.

Investment Performance October 2014



The last 2 months were not happy, from a relative performance point of view. The reasons for this are not difficult to see. I went on purchasing IDFC, Oberoi Realty and IL&FS Investment Managers, despite poor market performance. This general underperformance of some of my largest holdings was a prime reason for the underperformance. Other stocks which significantly underperformed also included Selan Exploration and Sesa Sterlite, partly driven by the Oil price fall. NMDC was another underperforming, based on low global iron ore prices, though NMDC’s own financial performance should continue to be robust.

Here is my graph of relative performance:

Here is a table of rolling returns:

Column1 Nifty Midcap Nifty SBI Midcap Fund Kotak Classic Fund My Porfolio
Last Month 3.3 4.3 3.6 4.4 3.8
Last 3 Months 5.6 7.6 13.0 7.5 8.3
Last 6 Months 22.0 32.7 41.0 24.0 47.3
Last Year 32.3 53.4 76.1 38.5 89.4
Since Inception 32.3 53.4 76.1 38.5 89.4

Portfolio Composition at the end of October 2014



Here is a new edition of my portfolio composition. The last two months have not been particularly kind to my portfolio performance, as can be seen in the next post. In fact, partly due to the fact that I was travelling, and partly due to procrastination due to my relative poor performance in September, I missed putting up my portfolio at the end of September.

But here I am, with my portfolio at the end of October 2014. As usual, this is not a complete disclosure of my portfolio. This list is only of those scripts which constitute more than 1% of my portfolio. Nevertheless, I am also disclosing in the text below if there were major changes in the rest of the portfolio.

Stock Latest Price Inv. Price Overall Gain % Portfolio %
IDFC (97) 148.25 133.3108609 11.21 10.55%
Oberoi Realty (64) 242.15 238.5116518 1.53 8.96%
eClerx Services (18) 1,347.80 1029.558952 30.91 2.82%
ILandFS (36) 20.2 15.32131761 31.84 2.39%
Larsen (22) 1,597.70 1096.596358 45.7 2.13%
Cummins (4) 720.05 411.2417355 75.09 2.12%
MPS (14) 712.4 128.6641026 453.69 2.12%
Indian Hotels (20) 104.8 73.70118644 42.2 1.88%
Selan Explore (28) 487.9 317.7249493 53.56 1.83%
IRB Infra (18) 254.5 90.26702128 181.94 1.82%
NMDC (28) 168.3 133.9162406 25.68 1.71%
Mayur Uniquoter (11) 430 111.0322327 287.27 1.67%
Balkrishna Ind (11) 756.3 232.4213927 225.4 1.61%
Kaveri Seed (13) 915.45 296.6391304 208.61 1.60%
HPCL (13) 522.15 470.71725 10.93 1.59%
Bharat Forge (9) 801.4 272.25 194.36 1.59%
Shilpa (11) 539.65 370.2180563 45.77 1.49%
Munjal Auto Ind (11) 117.45 33.99787765 245.46 1.43%
PTC India Fin (6) 50.1 14.68682894 241.12 1.36%
Oriental Carbon (9) 382.6 113.2114733 237.95 1.34%
Muthoot Cap (11) 253.2 97.38 160.01 1.33%
Ajanta Pharma (14) 1,887.60 1007.725543 87.31 1.32%
Sesa Sterlite (3) 253.05 150.9941003 67.59 1.31%
Sun Pharma Adv (19) 196.5 123.5597701 59.03 1.30%
EID Parry (13) 218.85 141.47 54.7 1.30%
Poly Medicure (7) 833.15 280.2228601 197.32 1.22%
PI Industries (11) 429.9 171.8891892 150.1 1.21%
Hind Zinc (18) 168.95 121.9935484 38.49 1.20%
RS Software (11) 630.9 204.2701613 208.86 1.19%
Grindwell Norto (7) 526.05 256.5177241 105.07 1.16%
TCS (9) 2,558.20 1953.9 30.93 1.13%
Reliance (7) 979.25 810.3029891 20.85 1.10%
Sobha Developer (14) 430.9 314.4363636 37.04 1.08%
Akzo Nobel (5) 1,299.05 1027.196154 26.47 1.03%
Tata Inv Corp (13) 556.5 404.9865 37.41 1.02%
ICICI Bank (9) 1,614.05 948.6365854 70.14 1.01%

The movement towards consolidation continues. However, this is also tempered by the fact that I have bought new scripts in the last two months. Nevertheless, the number of scripts which have at least a 1% contribution to my portfolio is 37 (compared with 33 at the beginning of September 2014), and together they constiture 71% of my portfolio. As before 32% of the portfolio was invested in the top 8 scripts.

What have I been buying in the last two months? And what did I sell?

Well, I continued to purchase IDFC, Oberoi Realty and IL&FS Investment Managers, averaging down as the stocks fell all of September, and most of October. It requires great guts or folly to keep buying in the face of negative outcomes from a stock price point of view, and sometime in November, I hope to have a post which will talk about these dilemnas.

I also purchased a significant quantity of L&T and TCS, again as they fell. In addition, I added a small quantity of Jaypee Infra, Sobha Developers and DLF, when they fell rather sharply because of a weak real estate environment and negative news flow.

In general, I have also resolved to improve the quality of my portfolio, from a cap goods, finance and realty bias to more quality names with better moats. To this end, I made significant purchases of Indian Hotels (Convertible Debentures) Akzo Nobel (which now is in the list of 1% stocks), United Spirits (which is almost there), and Dr Reddy’s Labs.

In terms of my older themes, I bought significant quantities of Reliance, Bayer CropScience, India Bulls Housing Finance, Gujarat Pipapav Port, and Vardhman Testiles.

What did I sell? Only RS Software at a time when the stock really shot up. At that price of 730 or so, the stock is more expensive than say EClerx, and EClerx has a superior track record of governance, disclosure, earnings, and dividends. I still own significant RS Software, and given my purchase price, I will evaluate my position only after a quarter or two.