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.
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.