Let alone expensive stocks, even good companies are not always good investments

The short seller in its report expected an 85% downside on a fundamental basis and accused Adani group companies of improper extensive use of entities set up in offshore tax havens as it expressed concern about high debt levels.

This led to a sharp decline in Adani group stocks.

While the timing of the report can be questioned, considering it was published just 2 days before the mega FPO, the point I am trying to make is different.

If you look at Adani group entities, barring may be an Adani Port and Adani Transmission, all of them have crazy valuations and extremely high debt levels.

There is no margin of safety in most of the Adani group stocks.

In the stock market, valuations and growth should be the starting point which should determine future returns as well as margin of safety.

In Adani’s case, as an analyst, no matter what future projections you take, the valuations will never make sense.

Adani group companies are trading at 100-300 times P/E multiple or since they are asset-heavy business even if we consider the valuation metric of price to book, most of them are trading at 20-100 times.

I mean how can any analyst justify a price to book value of more than 15-20 times?

So as an analyst who is modelling Adani stocks, let’s say you make future projections and project profits to double every 3 years (which is near impossible), you would still require 8-10 years to justify the current price.

While I personally agree the timing of the news of Hindenburg looks malicious, but the key take away is that such stocks with such astronomical valuations will always be at the mercy of such triggers.

While Adani is the hot topic for the week, let us talk about some BAAP (Buy At Any Price) stocks which came out with their results during the week.

I am referring to Pidilite and Asian Paints genre of stocks.

The common thing between both these companies are that they are both market leaders and enjoy a strong brand in the market.

In fact, Pidilite’s product Fevicol is synonymous with glue. Such is the brand pull.

However, the problem again is the fact that people don’t differentiate between a good company and a good investment.

A good company may not necessarily be a good investment.

Pidilite has a P/E ratio of 95 times with a ROCE and ROE of 26% and 21% respectively in FY22.

Its 5 year average P/E ratio is 61 times and currently the stock is trading at 2 standard deviations above its 10 year mean.

If you look at the last 10 year performance of Pidilite, the company has grown profits from FY14-FY17 at an average of 21% (decent in my view) while the next 5 years (FY18-FY22 period) average net profit growth rate was dismal at only 7%.

Why did the stock price jump 10 times in 10 years?

The magic of re rating of P/E multiples…

The PE multiple grew from 37 times in FY14 to 95 times in FY22.

This shows that major price movement over the past 5 years has come from multiple re rating and not earnings growth.

And mind you, there has been no material ROCE or ROE expansion over the past 5 years.

While Adani and Pidilite are two extremes, the point I am trying to make is that valuations are the king of the market.

For all the people who believe in buying stocks with high valuations, let me spell out 2 scenarios.

Scenario 1: Earnings catch up fast (I am talking about a 25% CAGR over the next 5 years) which will optically bring down the P/E multiples.

Scenario 2: Earnings grow slowly and as a result stock prices correct which leads to P/E multiple de rating.

While scenario 1 is less dangerous, tell me one company (apart from HDFC Bank) which can grow its earnings at 25% CAGR for a long period?

Scenario 2 spells out danger…

Most of the highly valued quality companies fall in that category and should be avoided in my view.

While the last decade was dominated by the Pidilites and Asian Paints of the stock market which reached astronomical valuations due to valuation multiple re rating, the next decade would be very difficult for these players as earnings will have to catch up really fast to those 80-100x multiples.

In my view, the real delta will be created with the following combination:

-Small Cap or Mid Cap stock

-ROE and ROCE above 12-15%

-Net Profit CAGR expectation of 15-20% over the next 2-3 years

-Valuation multiples say P/E below 30x (depending on industry to industry)

It’s time to be smart and not overpay and go the Coffee Can way...

Disclaimer:This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com