When wonderful companies become bad stocks...

Apr 20, 2015

In this issue:
» Has gold lost its allure?
» Rural consumption story looks subdued
» A 'new' catalyst required for Indian stock markets?
» ...and more!

Whenever you walk into any consumer electronics store to buy a product, there are two aspects that you will consider. Let us assume that you are in the store to buy an LCD TV. First, among the many models available, you will zero in on the one that has most of the features that you want. The second factor that will play a big role in your decision making is the price. So even if you have decided upon a model, the price may seem too high for you. You will enquire about possible discounts. If those do not entice you, you will probably defer your purchase till the festive season on the hopes that the product will go on sale.

In other words, the price is important. Just as in buying goods in our everyday lives, prices play an important role in stock investing as well. But what exactly is the right price?

Let us say that you have done your research and able to identify some wonderful companies; of the type that would certainly meet the approval of the legendary investor Warren Buffett. Now, it is a well known fact that Buffett always talked about buying companies that are trading at a sufficient discount to the intrinsic value. But he also knew that truly wonderful companies may not always be available at deep discounts. As he very rightly said, "It is far better to buy a wonderful company at a fair price, rather than buy a mediocre company at a very attractive price."

But it is dangerous to take the concept of 'fair' price too far. Indeed, when Buffett talked about 'fair' prices, he certainly did not mean that valuations should go out of the window. What he meant was that it was alright to pay slightly higher premium for really good companies.

But paying a higher price does not necessarily mean that paying any price at any point for that company is fine. Indeed, because if you pay an extremely high price, what you will end up having is a wonderful company but a bad stock. In other words, the returns that you will garner from such a stock may not be good even though there is fundamentally nothing wrong with the company.

The rally seen in the Indian stock market in the past one year has pushed up the prices of many stocks. So much so that while the fundamentals of good quality companies have remained intact, many of them are trading at price to earnings multiple of 50 times plus. Should you buy such stocks and justify it by referring to Buffett's statement on fair prices? Not really.

So, to conclude, it is obvious that paying a high price for a bad company will turn it into a loss making proposition. Now paying a very price for a good company may not necessarily give you losses, but it will not contribute to your wealth building goals in the long term either. Indeed, even for the two ValuePro portfolios , my team and I are careful that we do not pay a very high price for stocks even though the businesses are very good.

Do you think it is alright to pay very high prices for good quality stocks? Let us know your comments or share your views in the Equitymaster Club.

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The rural consumption story is not looking great right now. For instance, unseasonal rains have wreaked havoc on crop production. Non-farm agricultural income has also taken a hit as construction and mining activity has yet to take off in a big way. On top of that, subsidies have been rationalized as the government looks to spruce up its finances. All of this has resulted in rural demand taking a hit.

Thus, sectors that are a play on the rural consumption theme have also seen a correction in stock prices of companies. These in particular include FMCG, automobiles, cement and fertilizer segments among others. Just as we are not advocates of theme based buying, we do not believe in theme based selling either. In other words, just because rural demand has remained subdued, it does not mean that all stocks from these sectors need to be sold off. What matters are the valuations, and if these are no longer very favourable, then you can certainly consider selling these stocks. This is especially given the big rally in the past one year in not just stocks from the sectors mentioned above, but other industries as well.

  Chart of the day
With Akshaya Tritiya being celebrated tomorrow, discussions on gold as an investment opportunity have started making the rounds. As you know gold has been an out of favour commodity for a while now. With stocks and other asset classes doing well, it would be fair to assume that gold is amongst the least preferred asset classes amongst investors.

Has gold lost its sheen?
* - Indicative figures

This is quite evident from today's chart of the day which indicates both the demand for gold (in tonnes) as well as the annualized returns; please note that the returns are calculated with the assumption that money was put in gold on the auspicious day each year and held on till date. For the seven year period leading up to 2010, the average returns on gold investments stood at around 13% levels. However for the next four years, (till 2014) the returns turned sour, going as low as 11.4% at 2014.

Coming to the demand for gold, India and China are amongst the biggest consumers of gold globally. But, India's demand for the yellow metal seems to have peaked in 2010, after which it has been on a declining trend. For China, the story only reversed in 2014 as gold demand tanked from about 1,300 tonnes in 2013 to about 800 tonnes in 2014. For India on the other hand, demand has averaged to about 920 to 930 levels over the past four years.

So the key question is, should one continue to make investments in gold, especially considering the not so great short term outlook? Factors such as low inflation levels, the Fed hiking interest rates, the Indian central bank taking actions to curb gold consumption, amongst others, that are keeping investors away from gold.

While the picture may be jittery for short term investors, we continue to believe that investors should have a small portion of their capital invested in gold as insurance. For it is no coincidence that the increase of funny money supply across the world has led to the surge in prices across asset classes. Commodities in general and gold in particular tend to make good investments over long periods when they are purchased at times when they are least favoured; times such as now.

Jim O'Neill, the retiring Chairman of Goldman Sachs Asset Management was in the news recently as he gave his views on the Indian stock markets. And given the way the markets have moved over the past eighteen off months, Mr. Neill is of the view that he is finding value elsewhere.

So, which regions are those? Europe and China. The former is preferred due to the reforms taking place while the latter is being favoured due to the shift towards services as well as increased consumption.

Mr. Neill believes that the Indian markets will be in a pause mode as they lack evidence of growth, which is required to keep the market momentum sustained. As such, a new 'catalyst' is required for the markets. As for his reference on the overall scheme of things, he prefers China and Europe followed by regions such as Mexico and Indonesia. India would rank somewhere next in this pecking order.

All this essentially boils down to is that fact that Indian markets are not cheap and essentially have high expectations built up. Had it been any other time, market participants would have punished the stocks. However, with the investment cycle yet to pick up, and considering that the profitability cycle seems to be at its worst stage in many years, there could be a sharp pickup in earnings - something that could possibly surprise the markets over the long run - over time, we believe.

Persistent selling activity led the Indian markets to decline gradually as the day progressed. At the time of writing, the BSE-Sensex was trading lower by 630 points or 2.2%. Weakness was seen in stocks across the board with realty, capital goods and FMCG stocks leading the pack of losers. While Asian markets were trading weak, markets in Europe were trading firm.

 Today's investing mantra
"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent." - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Radhika Pandit and Devanshu Sampat.

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2 Responses to "When wonderful companies become bad stocks..."

Ravi shah

Apr 20, 2015

Ms Radhika,Even I m buying value pro stocks on your recommendation assuming ,you n yr team doing it considering enough margin of safty and at fair price.Pl dont include any stocks if it is trading at unfair price and with no moats.

Like (2)

satish bhosale

Apr 20, 2015

wonderful companies name

Like (1)
Equitymaster requests your view! Post a comment on "When wonderful companies become bad stocks...". Click here!
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