Entry Valuation Matters

Please find below our key excerpts from a recent investor memo published by Congruence Advisors on "is it really necessary to ONLY buy quality businesses even though they are quoting at absurd valuations". Also case studies with respect to a few businesses have been covered which Valuations you pay in terms of P/E multiples actually matters a lot even if business is showing tremendous growth - especially to a majority of investors as they don't have patience to hold for 10 years. (Emphasis Ours)

1 - A popular narrative today is that entry valuation does not matter if you buy a proven high-quality business and are willing to hold the stock for 10 years or higher

2 - How many proven high-quality businesses exist in India where you can take a 10-year view?

-Maybe thirty at best. A behemoth like Reliance Industries did not make the cut till 3 years ago.

3- How many investors can hold stocks for 10 years and more?

- Very few if you actually take the time to go through hundreds of broking account statements, as I have.

4- For those who don’t fall into this bucket (holding a proven high-quality business for 10 years and higher), entry valuation matters a lot.

5- The reason we’ve chosen businesses from the consumer sector is that they have low cyclicality and secular growth prospects. If entry valuation matters in such businesses, it should matter even more for other businesses.

6- The trick is to track the valuation at which one buys and not just the stock price at which one buys.

Lux Industries:

7- If you had bought this once the trailing PE multiple crossed 30 in May 2017, you would have bought a business that generated PAT of 60 Cr in FY2017. It took almost 3 years for the stock price to come back to the same level but the more interesting chart here is the second one. The stock still hasn’t come back to the PE multiple range it was trading at from May 2017 till Sep 2018.

8- Between FY17 and FY19 the PAT for the business went up from 60 Cr to 101 Cr, that is a 66% increase in earnings but this was accompanied by a near stagnant stock price during the period.

Page Industries

9- For FY17 the PAT was 266 Cr.

For FY19 the PAT was 394 Cr.

Observe the stock price trend though there was very good growth in earnings. The reason for this underperformance was that valuation much higher than was warranted for the business even after accounting for the quality and growth visibility. The stock price is yet to get past its 2018 high, the current high PE is an anomaly due to the COVID situation that should correct itself in a couple of quarters.

10- You can always shove the Asian Paints stock chart in my face as a counterpoint to this. However, the odd exception to a rule does not make the rule irrelevant.

11- All principles have to be seen on a balance of probabilities. If something works more than 60% of the time, it is a very useful rule to follow.

Britannia Industries

12- FY18 PAT was 1,004 Cr

FY21 PAT was 1,864 Cr

13- How has the story panned out for investors who bought at elevated valuation in 2018? Here we go.

14- A few counter points can be made here as well. “Let us wait and watch how this does 5 years now, this will surely make you eat humble pie”.

15- Why can’t we accept the simple data backed thesis that when you buy at elevated valuation (compared to historical averages over the past 5 years), the return expectation should be lower than the historical average?

16- Why buy something at 60 PE when the 5-year average tells you that the business does trade at 40 PE sometimes?

17- Why can’t one be a good long-term investor who is also choosy about entry valuation? It is not an either-or scenario here.

18- I agree, I am big fan of doing a reverse DCF to decipher the expectations baked into stock prices for free cash flow businesses. But if most of the market tracks PE, does that not make it a relevant measure in a Keynesian beauty contest like investing?

19- What the “PE doesn’t matter” line of thinking fails to take into account is that looking at a stock price chart with the benefit of hindsight is different from experiencing price stagnation real time.

20- This year I have hit the 10-year holding mark for some businesses. While the journey does look fruitful when I look back, what transpired in real time for some of the stocks was this –

• Cera Sanitaryware made a peak of 2,700 in May 2015 and then fell to 1,600 over the next 12 months though PAT went from 101 Cr in FY15 to 130 Cr in FY16. PE multiple fell from 54 to 28 during this period.

• Kajaria Ceramics peaked out at 700+ in 2017 and then fell 50% over the next 8 months. The PE multiple fell from 50 to 26 in this period.

• APL Apollo fell from 2,400 in Jan 2018 to 1,200 by the mid of 2019. PE multiple went from 36 to 21 during this time accompanied by a stagnation in PAT for 4-5 Quarters.

21- A few businesses (Asian Paints, Pidilite etc) might always keep me waiting for a reasonable valuation but those are the exceptions to the rule.

22- You should not ignore a rule that works because of a few exceptions to the rule.

23- Investors who invest based on probabilities instead of possibilities have a higher chance of good outcomes over the long run.

Read Full: https://congruenceadvisers.com/business-analysis