The ART of Valuation

[Donald]

@deep86

Now, my question is how should I value a stock which I already hold in the portfolio, for which I am hopeful that business will continue to do well but I am not sure how much of that is already priced in. Does it make sense for me to continue to own this business? Should my valuation of business for buy and hold not be different? How should I go about doing valuation for this and similar stocks.

@deep86 You are not alone in pondering/wondering on this aspect .
The SELL decision is certainly one of the most tricky. We keep learning with every experience. I find it also has much to do with temperament. We have seen in the Capital Allocation thread the typical sell decision for us is A. Is the business capable of growing at 20-25% CAGR for next 2-3 years? If not, the case is decided there itself (assuming there are many others who can; so far that has never been the problem in our markets). B. If the business can keep growing at 20-25% cagr for next 2-3 years or double, then can the stock price also double in the same timeframes?

So here, we are addressing mostly B - the overvaluation situation.

The first extreme over-valuation situation I faced was Astral Poly (quoting at 70x plus - or almost 3-year forward earnings) 3-4 years back. The most usual advise I got was “don’t try to fix what ain’t broken”; dont try to second guess markets; we don’t know how high Mr Market can take Astral. I coudn’t be satisfied with that as I kept asking so where would you draw the line? what if the Valuations reach 100x, will you still not book any profits?? I started booking profits in Astral in chunks as earnings failed to keep pace with the expectations built-in.

Although each individual sell decision merits its own specific industry/business cross-examination, let me share some generic comments/insights from our collective experience base - perhaps some of these may resonate with you.

The comments below should mostly be taken in the context of small to mid-size emerging businesses only (my experience base).

1. Markets are inherently forward looking - even in bear markets. So 1-year forward is the base rate. In bull markets like current, 2-year forwards become the optimistic norm - such as what we are experiencing now for most businesses. I have seen I don’t get too worried when valuations are within 2-year forwards. When valuations exceed 2-year forwards and start approaching 3-year forwards, I find myself uncomfortable and start selling in chunks.

2. For me it became important to SLOT a business in my mind (Art of Valuation) and assign a stable normalised PE for the specific business - depending on past track record, business quality, management quality, and future earnings visibility - (Industry and Competitive position). I found myself doing this in B+, A, A+, A++ slots. Astral was in A category or 20-25x earnings slot and was a sell at 70x earnings 3-4 years back.

3. I find Industry tailwinds and specific business growths practically swing the needle the most. A business consistently growing at 40-50% when valued at say 40x earnings, can within a year of holding come to more reasonable valuations like 27-30x earnings. It no more appears that expensive. And curiously, when half the financial year is past us (like now) such high-growth consistent businesses may no more be expensive!! (except in businesses with seasonal variation between quarters)

4. The key to persistent high-valuations is high-growth sustaining in the near to medium term.Therefore, it becomes extremely important for me to be focused on the Industry Tailwinds, Competitive Position of the business remaining stable (NOT deteriorating) - which means high visibility into near-term growth NOT faltering. Sustained high-growth becomes the panacea for most of our mistakes (including staying put in over-valued territory).

5. It therefore became extremely important for me to learn to become ruthless (get out of love with my money-spinners, imitating Hitesh Patel, at first) in the dissection of the industry and the business - when deciding to stay put in over-valued territory. Learn to be ruthless in distinguishing HOPE vs VISIBILITY. So the first thing I ask in such a over-valuation situation is a) Is the Runway still large enough - for the leading players in the industry to keep running at the same speeds b) What’s the near-term evidence - if there have been speed-bumps, how severe were these c) in case of speed-bumps where I decide to keep faith, what makes me so confident that high-growth would return in the near-term (few quarters, a year)

6. I have also learnt to respect the fact that reversion-to-the-mean is a rule of nature - especially true for high-growth, high-profitability businesses. 8 out of 10 cases, there is plateauing after 3-4 years of high-growth. Very very few businesses continue to defy this rule consistently beyond 3-4-5 years. So if I make the case for sustained high-profitability growth beyond 3-4 years (Or, high-growth returning quickly, say in less than 1-2 years of what may seem like a blip/pause after 2-3-4 quarters of low growth/de-growth) I want to make sure to double-check the facts; make sure to engage with the skeptics and be able to reasonably rebut all the objections with consistent data-points based defence, not my hope-based opinion.

7. I find myself holding a different perspective from another popular (and probably financially correct) edict - that if you can’t buy a business at current levels, you have no business holding it, either. So yes, even when I am pretty confident about sustainable high-growth in a specific business (say, Bajaj Finance) Buy and Hold decisions for the same business are different for me in a bull market situation like current from a practical standpoint - when valuations are over-stretched. I find much higher margin of safety (higher risk-adjusted returns decision-making) if I am holding from lower levels, than if I were to buy afresh. I want to ensure I don’t lose capital, rather than bet on only one scenario playing out, however probable. However, when valuations are reasonable (near stable normalised levels for category slots) I often find myself averaging-up with conviction (If I find Industry is stable and growing/ and competitive position is demonstratively getting stronger) in consonance with the edict :). Contradictory behaviour - in higher-risk situation?

8. Once comfort level on Valuations are breached as above, I find it useful to sell not all in one go, but in meaty chunks. If discomfort is quite high, it’s more like a 20% trim, else 10%ish. Instead of taking a call on how high Mr Market can take the business to, its nice to spread out the selling - giving us a chance to admit that we might have been wrong, and pause - if the trajectory of upward valuation is steep. Witnessed this with Can Fin homes, and paused for a long long time, eventually easing out

9. In this recent bull run, I have been compellled to trim/book profits mostly on account of position in portfolio becoming too large for comfort. I have learnt not to let individual position sizes get bigger than 20-25% for any extended periods. With larger portfolios, I find the need to preserve capital has taken center-stage, at the cost of sacrificing some growth for more assured risk-adjusted returns.

Re: your specific business - Kajaria has proven to be a quality business. However, I have not invested/tracked Kajaria ever, so not the best person to comment on the specific case. But if i see that growth has hardly kept pace or faltered, I would be wary of that. And examine if that is the same fate being met by most of industry. If certain competitors are able to grow significantly even in this environment (FY 2017 and 1HFY18) I would like to understand the reasons behind. In such a situation it would be a mistake to assume the over-hyped (in my opinion) notion that post-GST the most organised players are slated to gain the most. We are probably seeing far more the case that the semi-organised are getting better organised faster. One would also examine the housing industry segments that are growing and that are not, and which businesses might be able to take advantage of the growing segment better. One would also like to take into account the fact that Tiles segment probably has relatively low share of replacement demand; that tiles is relatively a late-cycle beneficiary of housing market rebound - while making the case for the industry/business for next 2-3 years.