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Of Pricey Market Darlings, Rahul's Love Affair with Hated Stocks, and Uncle Sam's Expensive Gift

May 14, 2018

Ankit Shah, Research analyst

Recently, we had a very interesting debate in the Equitymaster research team.

It started when my colleague Tanushree Banerjee showed the team how some stocks, which were 'market darlings', had performed over the last 5-10 years despite their expensive valuations.

Our research had clearly shown that these were sound businesses to own.

We knew they would do well for years to come.

But we weren't blind to valuations. It has always been a critical consideration for us.

Of course, we understand 'market darlings' are seldom available at a bargain. So, it makes sense to pay a reasonable premium for these businesses.

And we've done that successfully with many of our recommendations.

But, we've had our fair share of 'errors of omission' too. Or missed opportunities. Like the ones Tanushree pointed out.

Last Monday, I'd shown you how legendary investor Warren Buffett's investing career is filled with mistakes, stupid decisions, and missed opportunities. And yet, he has been so incredibly successful.

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The important thing, as I'd explained, is what you learn from your past experiences.

And this is the reason why Tanushree initiated this discussion.

Had we been terribly wrong in being conservative and not recommending those 'market darlings' at lofty valuations? Should we have simply forgotten about valuations aside and given a thumbs-up to those stocks?

These stocks seemed to suggest so.

At this point, I must let you know that Rahul Shah was quietly following the conversation. He didn't say much. From the look on his face, I could tell he didn't care much about the 'market darlings'. Because he's found an incredibly successful way to beat the Sensex buying hated stocks. (You can see Rahul's winning losers here...)

The discussion took an interesting turn when my other colleague Radhika Pandit put forth this question:

  • It's quite possible that some of these businesses (if not all), will do brilliantly for the next decade too.

    Would we be willing to go lax on valuations and recommend them now?

Radhika, indeed, had a very valid question.

If paying no heed to valuations of 'market darlings' had been rewarding in the past decade, should we simply shed our conservatism now and embrace the new reality of sky-high price to earnings (P/E) multiples.

Mind you, some of the stocks that we discussed are currently trading between 60 and 90 times their earnings.

This got me thinking. What did we really miss out?

If you deconstruct the capital appreciation in a stock, it boils down to two key factors: earnings growth and P/E expansion.

The first one is fairly simple. If the earnings of a company grow, the stock price will appreciate as well.

However, the expansion of the P/E multiple can be a result of multiple factors. Companies get re-rated because of improvement in business fundamentals. Or higher growth expectations.

But there's one more factor that causes P/E multiples to expand.

The answer is liquidity.

If there's a flood of liquidity pouring into the stock markets chasing a limited number of high-quality stocks, what's going to happen?

These stocks start commanding a scarcity premium. And it creates a virtuous cycle - higher stock prices driving more investors to buy those stocks in anticipation of even higher stock prices.

This goes on till the liquidity tap keeps pouring. And investors who don't join the fray can look foolish for an extended period.

But then, how could you have predicted the flood of liquidity?

The answer is: You should have known someone at the US Fed, the American central bank, who could have told you, "Dear investor, buy whatever you like... We're going to suppress interest rates and flood the system with so much liquidity over the next decade that everything that appears expensive now will appear like a bargain in retrospect."

I hope you get the joke. The truth is that it was practically impossible to anticipate such level of market manipulation and intervention by a central bank. Even the US Fed had no clue how this unprecedented monetary experiment was going to unfold.

But what this experiment did was that it sloshed the global financial system with liquidity. And a lot of this liquidity found its way into the stock markets.

Now, should we assume this will continue through the next decade as well? Should you buy expensive stocks and expect P/E multiples to remain in expansion mode?

The Chart of the Day offers some hint...

Chart of the Day

One of the key determinants of liquidity flows in the stock markets is interest rates. The 10-year US Treasury bond is a global interest rate benchmark.

This Chart Has the Key to Your Future Stock Market Returns

The prolonged artificial suppression of interest rates and money printing by the US Fed, flooded the global financial markets with cheap liquidity and lifted stock prices to frothy levels.

In fact, at the recent shareholder meeting of Berkshire Hathaway, Charlie Munger did make a reference to this condition:

  • Low-interest rates are unfair to old savers, but favourable to Berkshire Hathaway's shareholders sitting here. We are all a bunch of undeserving people and hope we continue to be so.

Now, just the way lower interest rates can fuel stock market rallies, the vice-versa is also true. If interest rates start firming higher, it can play spoilsport to the unbridled global stock market bull run.

In fact, the market correction we witnessed in February-March this year can be attributed to the rising yield on the 10-year US Treasury bond.

In a note to my Insider readers at the end of January 2018, I'd raised a warning flag about the rising yields on the benchmark 10-year US Treasury bonds.

With bond yields now breaching the 3% mark, and the Fed in the process of shrinking its balance sheet, you cannot expect the flood the liquidity to keep lapping up stock prices.

If interest rates go up further, foreign investors will either go slow on India or exit all together.

So, be careful. Don't take the abnormally high valuation multiples as the new normal. At the same time, don't exit the markets out of panic.

Stay invested.

Happy Investing,

Ankit Shah
Ankit Shah (Research Analyst)
Editor, Equitymaster Insider

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