What went right for this stock to give CAGR of more than 40%

Investing Strategies
60

Debt/Borrowing and it’s Impact on Share Price in Investing

Introduction

Debt or borrowed fund is used by companies for various purposes. It can be used either for expansion of business or repayment of higher rate debt or for working capital needs. Debt comes at a certain terms and condition and has implications on the business. It makes sense to borrow funds when company is capable to generate higher rate of return then the rate at which fund is borrowed. Eg. If Company generates return of 18% in it’s business then it makes sense to borrow funds at rate lower than 18% and deploy it in business. Debt creates leverage which fuels growth of the business. Debt if used properly in business can help it grow multi-fold. However, if a company has excess debt then it can affect the cash flow as well as profitability of the company. Many instances have been observed where companies have gone into liquidation/insolvency due to excessive debt.

Major Uses of Debt :

  1. Expansion of Business ( Capital Investment )
  2. Working Capital Needs (Funding Debtors +Inventory )
  3. Repayment of Existing Debt which has a High rate of Interest

Important Points related to Debt from Investment Perspective :

  • Investors must check credit rating performed by various rating agencies in respect of the debt of the company. For listed companies it is available online. It can give investor an idea in respect of credit profile of the company. If credit rating of the company is good it can borrow fund at lower rate of interest. Companies with bad credit rating should be avoided for investment because its cost of borrowing will be higher and also possibility of default is higher so shareholder risk is increased in such case

  • Debt to equity ratio upto 2 is considered to be safe for investing in a company. Many infrastructure companies in India borrow excess funds and when project gets halted due to any reason and there is cash-flow crunch it results in default and many other problems which ultimately and unfortunately erode share holder value

  • Purpose for which a company borrows fund is very important to understand from investor stand point. When fund is borrowed for expansion of business then for initial period when the new unit is being setup only costs are recorded and so profit goes down initially. Once the plant is ready and starts generating sales then higher profits become visible and share prices are likely to go up

  • When a company borrows fund for working capital one has to ensure that it does not have unusual high value of inventory(stock) or high debtor days than industry average. If it is so, it may indicate that inventory(stock) is not real and is being used to cover up some loss which is not being reported. Similarly high debtor days may indicate that some of debtors have turned bad debt but not being reported

  • If a company borrows fund regularly to repay the old debt it is not a sign of healthy company . It may indicate that company is not able to generate enough cash-flow from the business in the longer run to make the repayment of principal value of debt

  • Default in debt repayment is not a sign of healthy company. Due to extra-ordinary circumstances or one time event if such thing happens then it can be ignored. But if proper justification is not available then investor must exercise caution while investing in such companies and should be avoided to the extent possible

  • Investors must avoid companies with excessive debt . Companies which have debt to equity ratio in excess of 2 shall be totally avoided

  • In case debt is raised from outside the country , then investor must check the annual report to ensure that proper hedging has been done for the same so that currency fluctuation does not have impact on the profitability of the company

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61

@pratikchandak
I wonder what could have been the average PE of those companies during those hay days high performance …the 10 years period of the companies you listed? Was there any period in between or most of the time they felt like expensive just looking at their PE?

62

Operating profit margins and its importance in investing in shares

Introduction

Operating profit margin (OPM) is derived when direct expenses are reduced from total sales. OPM in excess of 10-12% is considered to be good. Higher the OPM the better . In business environment lot of factors keep on changing in real-time which affects the margin of the business. If a company has higher OPM it will be able to withstand and sustain adversity due to change in business environment. Regulatory changes, demand-supply changes , currency fluctuations, commodity cycles, change in rate of interest etc. are some of the changes that can affect a business.

Business with very low operating margins shall be altogether avoided . Because even a slight change in business environment can hamper the growth of business negatively impacting shareholders value. To improve operating profit margin companies can focus on cost reduction steps or increase sales of products which have high margins by changing the sales-mix of products.

Operating Margin (%) = Operating Profit / Net Sales

Operating Margin Important points :

  • Businesses which are having high competition or which are approaching end of life cycle are likely to have lower operating profits and should be avoided . Eg. Wires Business or Computer hardware business

  • Businesses which have monopoly or very high market share in a sector or some form of competitive advantage which cannot be easily replicated will normally have higher operating margins and shall be good for investment objective Eg. Alcohol industry due to barriers on entry of new players or Any Government enterprise having monopoly in a sector

  • Operating margins of a sector can be altered substantially due to change in business environment which can make a new investment advisable or an old investment obsolete. Eg. Demand for Automobiles is slowing down due to rise of cab industry and also upcoming disruption by electric vehicle is likely to make sector unstable and lot of existing players may die out or may have to merge with another company. So investment in auto sector may not likely be advisable at this moment if one is looking for Multi-Baggers.

  • While evaluating an investment in shares, one has to ensure whether there is consistency in operating profit margins for a certain period of time to say like 3 or 5 years. Companies which have very volatile operating margins can have wild share price fluctuations regularly and is unlikely to delivery consistent returns to shareholders

  • To improve operating profit margins , company can eliminate or outsource products with low profit margins . Increasing proportion of products with higher margins or introducing newer products with higher margins can also help

  • Cost-reduction program can be undertaken to improve operating profit margins. Reduction of cost can be done in various domains like packaging, transportation, raw material procurement, automation to replace costly labor etc.

  • Operating profit margin of companies with similar size and similar business model can be compared to identify which one is efficient

6 Likes
63

Returns and it’s importance on Investing in Shares

Introduction

Average nominal GDP growth rate of India was around 12% for the past 5 years.

( Nominal GDP includes both prices and growth, while real GDP is pure growth. Real GDP is what nominal GDP would have been if there were no price changes from base year. As a result, nominal GDP is higher than real GDP )

A return on capital in excess of nominal GDP can be considered as a good return from investor perspective. Return on Capital Employed ( ROCE) helps an investor understand what is the level of profitability with respect to total capital employed in the business. Return on equity ( ROE ) and return on assets ( ROA ) are also important ratios to asses the efficiency of the business with respect to owners fund and assets deployed respectively. The higher these ratios the better. Again these ratios are measure of efficiency of business. We want to invest in companies/shares which are most efficient and thereby will yield investor maximum returns

Investing activity is normally undertaken with objective of capital appreciation. Returns which the underlying business generates has a substantial and direct impact on the share prices of the company . Higher the return a business generates with consistency the better share price appreciation will be reflected. Investing in equity (shares) comes with it’s inherent risks. When capital is invested in shares a return which is in excess of risk-free rate has to be generated otherwise there is no rationale of taking the risk.

Formula for calculating Return on Capital Employed (ROCE) :

Return on Capital Employed (%) = Earnings before Interest & Taxes / Capital Employed

Capital Employed = Total Assets - Current Liabilities

Formula for calculating Return on Asset (ROA) :

Return on Assets (%) = Profit After Tax / Average Total Assets

Average Total Assets = (Assets at beginning of year + Assets at End of Year) / 2

Important points in respect of Returns :

  • ROCE and ROA are two important return ratios for evaluating investment in shares of a company. Companies with lower ROCE and ROA must be altogether avoided . ROCE must be always greater than weighted average cost of capital employed.

  • Return on Capital Employed ( ROCE ) is a better assessment ratio for returns compared to Return on Equity (ROE) because it is possible to inflate Return on Equity (ROE) by taking high levels of debt which may not be sustainable for business

  • By using ROCE, investor can compare whether company is employing it’s capital efficiently in comparison to peers in the sector as well as on standalone basis

  • News and media normally talks about profit and turnover figures. However for an astute investor it is important to verify how much capital has been employed to generate the amount of profits. Eg. Business A and Business B both in same sector have generated profits of 40 crore for the year. But Business A has employed 250 crore of capital and Business B has employed 175 crore of Capital. With this data we can easily determine that investor will be willing to invest in Business B because it is more effective

  • Return on asset ( ROA ) is higher for companies with asset-light business model rather than capital intensive businesses. Eg. Sectors like Steel, telecom, defense etc. have low ROA while consumption companies are likely to have higher ROA

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64

Diversification : Don’t Put all your Eggs in One Basket !

"Don’t put all eggs in one basket" is very well-known quote in the investing community. Objective of the statement is to distribute the risk so that failure of any single investment does not have material impact on overall return of the investor. Technical term for distributing risk is called “Diversification”.

Diversification can be done across asset-class like equity, debt, commodity, real estate etc. If you invest in assets that do not move in the same direction at same time and same pace then one can get benefits of diversification. Eg. In 2008 when the stock markets crashed big time, equity portfolios delivered high percentage of negative returns but at the same time debt(bonds) delivered positive returns which mitigated negative return to a certain extent for an investor who held equity and debt both in his portfolio at the same time. In this post we will deal majorly with diversification in respect to equity.

Diversification from Equity Perspective :

Why is there a need for Diversification ? Investment in shares is done after performing the necessary analysis. Analysis may be either technical analysis or fundamental analysis. How much ever detailed analysis is done it is never possible to determine and understand each and every variable out there in the universe impacting share prices. There is always a possibility of analysis turning out to be wrong due to change in known variables, or unknown variables may have adverse impact on the share prices and thus create risk of loss for investor. To reduce the impact of such risk , diversification is done.

Investment in shares provide opportunity for higher growth in long term. However the return from investment in shares is very volatile in nature due to drastic fluctuations in the share prices.

Important Points in respect of Diversification :

  • What type of shares to chose in portfolio of stocks for diversification will depend upon the risk appetite of the investor (Aggressive/Moderate/Conservative) . However, stocks from same sector can be avoided in single portfolio from diversification perspective

  • As per our understanding not more than 10% of equity portfolio must be invested in a single stock . Maximum of 15 stocks may be held in any equity portfolio. Holding very few stocks will increase the risk whereas holding stocks in excess of 15 is likely to dilute the returns along with the risk

  • Warren buffet once said that " Wide(Over) diversification is only required when investors do not understand what they are doing". Wide (Over)- Diversification is time consuming, inefficient and also leads to increase in transaction costs of investor, reducing the returns

  • Total Risk in Investment = Systematic Risk + Unsystematic Risk

  • Systematic risk is the risk which can impact adversely the entire stock market or financial system as a whole . Eg. Political Instability, Natural Disasters, Change in Tax laws, Economic crashes, Recession Etc. It is difficult to manage or mitigate systematic risk due to it’s inherent nature

  • Unsystematic Risk is the risk which can impact adversely shares of a specific company or a specific sector. Eg. Change in regulations impacting one industry, Financial Fraud in a company, strike by employees of an airline company etc. Unsystematic risk can be mitigated to an extent with the help of diversification

  • Diversification is very important tool available to all the investors which helps them survive in the financial markets and maintain a balanced growth in the long term

3 Likes
65

Yes, you are right. This financial year - valuation didn’t seem to matter as most prices in the short term are driven by flows of buy vs sell (demand vs supply) rather than what should be the right price for an asset. It is only in the long run that valuations began to matter a lot more. Also, in a year when most businesses and especially small businesses are stung by the slowdown, money flows to the strongest of the lot, and so the blue chips outperform. I think midcap to large caps valuations ratios is at a 10 yr low precisely because of this factor. The same is true for the top quality stocks vs one which is a level below to blue chips in quality. Surely most of the money in search of better short term performance is chasing a very narrow set of opportunities. While this money has outperformed this year, it will not be true over the long run from current levels. And this will be completely negated in a strong bull market year, whenever it comes.

Also, the important distinction to be made is whether one is a) momentum seeking trader or b) business-like investor. If you are the former, it doesn’t matter what valuations you are buying, just keep buying till performance is looking good and sell when the trend stops. But if you are buying a stock just like you are buying the business - you will look at cash return on your capital every year, you will think about the long term prospects, you will think whether the problems are structural or temporary. And you will definitely think about the price you are paying.

Its like buying a mercedes vs Skoda - is mercedes a better car - absolutely yes. Should mercedes be worth 50% more than equivalent Skoda - absolutely yes. But should you pay 5 times more for the Mercedes vs equivalent Skoda - absolutely NO. Because once paid you will have to live through it against the price you paid. Unlike a trader - who is only looking to buy and sell.

Also, tax rates matter a lot. Reduction of taxes gives a direct benefit to valuations. Just like interest rates in the economy.

Finally, my advice to all momemtum chasers - have strict stop loss.

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66

All the points you have made are absolutely in line with market wisdom, proved again and again over time by many great investors. I do not dis-agree with them at all.

I am trying to answer question “what prompted market to value a certain stock higher than what it was in the previous year (CAGR > 40% or any other number)”. The answer to that question is “the stock delivered on market expectations for that year”.
For a minute forget fundamentals and technicals. Think of it as an appraisal process, even if a highly paid executive delivers on his KRAs, he is rewarded as handsomely or even better than any other employee (lower in rank and salary) who also has delivered on his KRAs. The base salary paid to both hardly matters in this reward calculations. If the overall company (market) does well, the bonus (reward to the expectation beater) is even better (like in 2014). If the company (market) does badly (read 2008), the expectations beaters also do bad, but still better than the rest.

As long as companies like Page, Eicher kept on delivering on market expectations, markets kept on rewarding them. The year their performance did not meet the expectations, their value dropped.

Buying an expensive item while a similar item at lower rate is available is a different ball game. Nothing to do with valuation in my view.

Eventually, the trader and the investor have the same goal, to make money as fast as possible. The key to both is understanding market behavior, because only the market can reward you. I have tested this hypothesis over historical data and found some value in this, hence my answer.

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67

  1. Trying to beat the market by looking at what is currently working in the market is what momentum trading or speculation is and is different from investing which is based on fundamentals. Some of the best traders all over the world including Rakesh Jhunjhunwala has said repeatedly that 99% of the traders end up losing money. If one thinks one belongs to the other 1% - good for that person. But I am pretty sure that 99% are not going to fare well trying to second guess market moves. The reason is almost the entire institutional market and most young but greedy investors are trying to do this only. Most so-called investors and traders are focussed on short term only. They want instant gratification. Very few children win the marshmallow experiment and hence very few can go for delayed gratification by going through a period when gains are not visible. Of the other lot, few have much better information on what is going to happen and how to react and they win over the others.

  2. The Indian economy has not delivered as per expectations and there has been a corporate governance and liquidity crisis so all these highest-quality stocks have got re-rated not because of any particular reason but because of flows coming to them. The whole point of fundamental investing is to take advantage of the market where value is being ascribed due to non-fundamental reasons. If I owned it, I would sell the kind of stocks I am guessing quality worshippers are holding right now because the valuations of the same are due to non-fundamental reasons. I just can’t keep the fundamentals and valuations aside while looking at any stock.

  3. To make money as fast as possible is not the goal of an investor - the goal of an investor is to take calculated risks and indulge only in stocks where the risk-reward is in your favor from a long term point of view (say 5+ years). Too many people have lost everything that they had in the markets by trying to earn fast. The goal is to make big money but slowly, sustainably and without commensurate risks. The stock that you have which is valued at 80 times earnings has a real risk of being de-rated to 40 times and to 20 times in few quarters if earnings growth decreases by even 5-10% - something which no human can calculate with precision in a real-world - nothing is a cinch in the market - that is an understanding which comes only by long enough experience.

  4. Coming to the anecdote here: So will you pay your CEO a salary of 50 cr when you company just earns 100 cr in a year because he fulfilled or done much better his KRA’s. Any sane BoD will, first of all, make a rule that the salary of any executive can’t go beyond a certain % of the company’s earnings no matter what the performance is. Similarly, the price paid to buy the stock of a company should not exceed a certain % of the company’s earnings, no matter what the performance is in a particular year.

The bottom line is while investing, yes earnings matter, yes operating earnings growth matters but yes, valuation also matters equally. Treating Stock price as a singular function of operating earnings performance is wrong. A lot of worshippers of Quality at any price will have to undergo a catharsis in the coming years, the catalyst being none other than their God (markets) itself. I suspect many of the highest quality companies that will continue to show expected operating performance trends will undergo de-rating while this happens, purely as irrational valuations bring them down like Gravity. Speculators who have interest in them better apply stop-loss and trade.

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68

Appreciate your response. Your clarity of thought is very evident and helps new investors like us immensely. Thank you!

Regards,
Ashish

69

While it is fairly obvious your dislike for quality at any price, and I agree with the broad thesis - there is one big difference of opinion I have which is not coming out from your viewpoint.

You’re pretty much implying that investors in high quality sky high valuation stocks can/will lose their shirt when earnings growth rate drops and stock subsequently derates.

That will not always be the case for these high business quality and management quality companies - stock prices can also move sidewards for years while the earnings gradually grow into the valuations. At the end of 5-10 years - there might be a big opportunity cost that such investors might have borne, but they would still pretty much get their capital back.

I just cannot understate the importance of low volatility low risk investments with very high probability of getting capital back which can allow investors to put big sums of money at play. This is what would let most people sleep easy at night.

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70

Not taking sides but this quote caught my attention.

Why not just park money in a fixed income instrument if low volatility and low risk are that important? Why stick to high quality stocks to achieve this objective? 10 year rolling return of a short term debt mutual fund is in the 8% range, not a bad deal given the low risk and low volatility.

When one invests in equity the objective is to beat fixed income returns by a good 5-6% in a country like India, that’s where the equity risk premium in the DCF comes into play over and above the risk free rate.

It is extremely painful to invest in a high quality business and then to sit and watch the price go nowhere for 3-4 years while the business keeps growing operating profits at a healthy 10-12%. It is like writing the answers that one was taught by his teacher at school and then discovering that he has failed in the mid term exam. He may still pass in the final exam but does he have the grit to hold on till then?

Which is why it is not a bad approach to sometimes say - I like the business but do not like the stock. There are 100+ decent listed companies to choose from, why chase after those 20 companies that are clearly the current favorites and are being priced that way? This is more behavioral finance than classical finance, not a bad way to view things once in a while.

That said, I agree that the average investor is better off investing in HUL, HDFC Bank, Asian Paints and sitting tight for 10 years rather than try his hands at discovering multibaggers. But the key point is this - most people cannot, and they do not know that they cannot.

Logically everyone understands this but behaviorally they just cannot execute well enough. There is history to prove this time and time again, the next time will likely be no different.

But then, we digress from the topic of the thread :slightly_smiling_face:

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71

As twain has said, “History doesn’t repeat but it does rhyme”

I recommend you read about 1970s market of US and what happened to NIFTY FIFTY stocks. Of course, this is a case of extreme but then many of the market darlings in India are trading at extreme valuations right now - at multiples never ever seen before. I am not saying we are going to see a crash or not - all I am saying that the smooth ride of just a time correction and no price correction is a luxury which we might not get to experience.

Here is what Forbes magazine wrote about NIFTY FIFTY stocks in 1970s:

"The Nifty Fifty appeared to rise up from the ocean; it was as though all of the
U.S. but Nebraska had sunk into the sea. The two-tier market really consisted of
one tier and a lot of rubble down below. What held the Nifty Fifty up? The same
thing that held up tulip-bulb prices long ago in Holland - popular delusions and
the madness of crowds. The delusion was that these companies were so good
that it didn’t matter what you paid for them; their inexorable growth would bail you
out."

Also, if you thinking about capital preservation, yes your capital will be preserved and even multiply if you hold for 20 years, I have no doubt about it. But before that you should also know that something like this can even happen to market darlings (sure we all know these names):

Blue Chip Performance: 1973-1974

Du Pont -58.4%
Eastman Kodak -62.1%
Exxon -46.9%
Ford Motor -64.8%
General Electric -60.5%
General Motors -71.2%
Goodyear -63.0%
IBM -58.8%
McDonalds -72.4%
Mobil -59.8%
Motorola -54.3%
PepsiCo -67.0%
Philip Morris -50.3%
Polaroid -90.2%
Sears -66.2%
Sony -80.9%
Westinghouse -83.1%

If you can hold it out and hold for another 10-15 years patiently and sleep peacefully through this, you will get a satisfactory return. The question is how many will be able to. The question is that without real valuation comfort (free cash flow to enterprise value yields) & income comfort (as a % of price paid, from dividend and buybacks) - how many of us are able to withstand even 50% of such drawdowns. And especially when the entire media around us will start singing just the opposite tunes then of what we are hearing now.

At some point all valuations as they go high and high fall under their own weight, any random excuse becomes the reason for the fall in their prices but the real reason is that smart money has already left them or at best indulging in trading on them.,It is very tough to figure out the exact point at which trend reversal will happen but it is always better to be safe than sorry.

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72

What you’ve not highlighted is the performance of the Dow Jones Industrial Average (DJIA) - (which contained many of these Blue chips) during this crash.

First, for the uninitiated - what is the Dow Jones Industrial Average (DJIA)? As per Wikipedia, the Dow Jones Industrial Average, or simply the Dow, is a stock market index that measures the stock performance of 30 large companies listed on stock exchanges in the United States.

I assume DJIA = Sensex (caveat DJIA contains 18/30 largest companies in US market as of today)

Now coming to the performance of Dow Jones during this crash

Date Started: 1/11/1973
Date Ended: 12/06/1974

Total Days: 694
Starting DJIA: 1051.70
Ending DJIA: 577.60
Total Loss: -45.1%

Now let’s assume a similar crash of 45% happens over 2 years on the Sensex,

1 Jan 2022
Sensex - 22,621

Let me ask the following questions?
1. Can you confidently tell us any sector or company which will give you positive returns in such years of a market crash?
2. Isn’t it justified for the Asian Paints, HULs, Reliance, HDFCs of the world to fall 60-70% during that timeframe?

I’m also not a believer in quality at any price - but what I’ve learnt the hard way from Indian markets perspective is that there should never be any compromise on management quality.

There is a very very long list of names where retail investors have got burnt (me included) due to compromise in either business quality or management quality.

Management Quality - DHFL, Manpasand, Vakrangee, Yes Bank, Indiabulls (perceived? still nothing major proven but stock lost 80-90% and I’m down 35%)

Even if management quality is perceived to be good, market perceived business quality matters - Edelweiss, Piramal great examples.

Finding very good business quality and management quality almost always comes at a premium. If retail investors don’t have the patience to wait for long periods to actually pay very less premium, then it would almost always make sense to go pay the high premium demanded by the market at the time rather than compromise on quality.

6 Likes
73

Amongst all the explanations given for the valuations, i feel one should also look at the margin improvement that has taken place in some of these cos. The average FMCG co has significantly less margins a decade ago and there has been a remarkable improvement here. Shouldn’t the valuations then follow suit? The story has been of improving fundamentals over time. I think when comparing PE multiples or any other valuation metric one should factor in this improvement.

image

Here are the 2004 and the 2019 margins. The improvement is evident.

image

Best
Bheeshma

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74

From the data, it looks like bulk of the improvement in margin happened post 2015. I think we also need to consider the impact of crude price drop on FMCG margin. See this: https://www.google.com/amp/s/wap.business-standard.com/article-amp/economy-policy/crude-oil-spike-could-pinch-fmcgs-hard-operating-margins-likely-to-suffer-118041201412_1.html

Since all the major companies show improvement in margin, it could be mostly driven by crude price instead of company specific fundamentals.

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75

Partially correct but not applicable to Nestle and Britannia . Moreover the effect of crude cannot be this pronounced IMHO

76

Can this pivotal rule be used to part sell shares which have run up and thus resulted in excess of 10% weight.

Let’s say top 3 shares in my portfolio are at 8% wt each to start. After a year one of them as run up and is now 14%. Should I sell such that new wt comes to 9 to 10% again.

1 Like
77

Do not cut your flowers to water the weeds

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79

You have written it so well…My compliments and respect for your clear and mature thoughts :pray:

Rgds
RR

80

My 2 cents here -

An individual investor should practically never have a very high percentage allocation to any one particular stock - Ideally not more than 20% in any one particular stock even if your have an extremely high conviction - remember, you are not running the company and you don’t have insider information. Profit booking and trimming position doesn’t mean that you are exiting from the stock and i for one do not consider it a bad choice and remember, economic down turn and company specific black swan events are situations that not many people can predict accurately - and the ones who predict these are generally not stock market investors :slight_smile:

Thanks,
AJ