Stop Worrying About Market Valuations. Use This Investing Strategy - The 5 Minute WrapUp by Equitymaster
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Stop Worrying About Market Valuations. Use This Investing Strategy

Apr 25, 2016
In this issue:
» The volatility in FMCG sector's valuations
» The Equitymaster iOS App is finally here...
» Today's market roundup
» ...and more!
00.00
Devanshu Sampat, Research analyst

I'm about to tell you something that goes against common sense...

It is possible to make good money investing in expensive stocks.

How?

Let's get straight to it.

First of all, what is an expensive stock?

In simple terms, it would be a stock trading at a high PE ratio. Let's say, 40 times its current annual profits. Common sense says you should buy stocks when they are cheap. And sell them when they are expensive.

But investing is not so simple.

So here's the scenario. You are a long-term investor. You want to invest for your retirement. Unfortunately, valuations are not cheap. You want to buy only the best quality stocks. This is your retirement portfolio after all. But they are all trading at high PE ratios.

What should you do?

Let's say you buy a bunch of these expensive but high quality stocks. And hold on to them for many years. Will you do well?

You might say, 'That depends on which stocks we buy.' Yes, you would be correct. But only up to a point. Even the best stocks can be risky if you pay too much for them.

But...

What if you are comfortable with this risk? What if you want to invest a big amount right now? And forget about it till your retirement. If you buy great stocks at sky-high valuations, how much money could you hope to make?

To answer this question, I dug into some history of the 'Nifty Fifty' stocks.

I'm not talking about the NSE Nifty index. The 'Nifty Fifty' was a group of fifty bluechip stocks during the 1960s and 1970s in the US market.

They were the best of the best. Coca-Cola, McDonald's, GE, PepsiCo, Pfizer, American Express, Xerox, Dow Chemical, Johnson & Johnson, Merck, Disney, P&G, AT&T, Gillette, Lubrizol, Kodak... Well, you get the idea right? How could you go wrong with these stocks in your retirement portfolio?

Besides, it was a bull market. They were called 'one direction stocks'. Wall Street thought they could only go up!

Investors, big and small, loaded up on them. The PE ratios reached insane levels. One of them traded at a PE of 94 times at the peak!

Then, the bubble burst...just like all bubbles before and since. In the bear market of 1973-74, these stocks got hammered. Some fell up to 75%. Kodak went bankrupt in January 2012.

The story of the 'Nifty Fifty' warns investors about buying high PE stocks. But the story is incomplete.

A lot of water has flown under the bridge since the 1970s. What if you had bought these stocks at the peak and held on for all these years?

Jeremy Siegel, author of Stocks for the Long Run, found that this group matched the returns of the S&P 500 index from December 1972 until August 1998. Even if you had bought them at the peak, you would have still earned market returns!

And if the returns are counted till today, the expensive 'Nifty Fifty' portfolio has won the race.

Why?

Because the underlying earning power of great businesses will always win in the long run.

This got me thinking. Is there an example like this in India?

There is. It's Hindustan Unilever Ltd (HUL).

On 24 February 2000, the stock of HUL closed at Rs 310 (adjusted for a 10:1 split). The Sensex closed at 5,810 on that day. HUL's PE was high then, about 41 times.

Our condolences go out to any unfortunate soul who bought the stock that day. He would have had to wait a long time before he made any money. Eleven and a half years to be exact. Similar to investors in the 'Nifty Fifty' stocks.

On 16 August 2011 HUL closed at - you guessed it - Rs 310. Zero return on investment. HUL investors were not a happy lot a few years ago.

What about the Sensex? At 16,731 on 16 August 2011, the benchmark index had delivered 9.6% CAGR since February 2000.

Now, fast forward to today. Have things changed? You bet it has. At Rs 884 (Friday's close), HUL has delivered 6.7% CAGR since February 2000. The Sensex at 25,838 has delivered 9.7% CAGR. The gap has narrowed dramatically.

They say a picture speaks a thousand words. Take a look at this chart.

HUL is closing the gap with the Sensex

How much longer before the red line overtakes the blue line? Certainly not many more years, in our opinion.

The underlying earning power of great businesses will always win in the long run. Besides, I've excluded dividends in this scenario. HUL pays out a lot of its profits to investors.

So, what's the big takeaway here?

Stocks with moats, long-term growth visibility, high profitability, strong cash flows, and capable managements can be bought at PE ratios higher than the market... But only up to a point.

So, how can you use this while picking stocks? It's not difficult.

  1. Pick the best quality stocks (see criteria in bold above).
  2. Practice GARP investing (Growth at Reasonable Price) and not GAAP investing (Growth at Any Price).
  3. Buy them over time and not in one go.
  4. Hold for a long time (and collect those dividends along the way)!

We practice what we preach. This is the investment philosophy of The India Letter. We believe long-term investors in this service will be a happy lot.

Do you agree that GARP investing will provide good long-term returns? Let us know your comments or share your views in the Equitymaster Club.

03.20 Chart of the day

The FMCG sector has had quite a volatile run over the past year. This can be gauged from the kind of valuation changes the sector has seen in recent times. A year ago, expectations were that the lower input costs - led by the sharp falling inflation and crude prices - would lead to margin expansions, and thus higher profits. FMCG companies took advantage of this and increased spending on advertising & promotions.

But with rural consumption slowing down, volume growth declined closer to single digit levels. Not to mention that the intensifying competition took a toll on the market leaders' volumes as well. All of these factors have led to a major shift in valuations over time - Today's chart of the day shows the change in valuations of the FMCG majors over the past three years.

FMCG: Valuations Have Tamed From a Year Ago

As you can see, valuations for most of the companies still continue to be on the higher side; especially when compared to the other sectors. No doubt, the HUL example above proves, the quality of earnings for FMCG companies is on the higher side.

However, what will be the make or break situation for companies will be the earnings growth going forward. From the way we see it, it would become imperative to take a call on the margins and their sustainability - especially at a time when they hovering at their highest levels.

04:20

After a long wait, it's finally here... the Equitymaster iOS App! We already have a hugely successful Android app. The iOS app makes it possible for even more of our readers to access our honest views and opinions on investing in India. Download it right away and let us know what you think.

04:40

At the time of writing, the Indian markets were trading weak. The BSE-Sensex was trading lower by about 170 points or 0.7%. While telecom stocks were in demand, those from the metal and power sectors were trading weak. Stocks from the mid and smallcap spaces were trading weak as well, with their representative indices trading lower by about 0.2% and 0.3% respectively.

4:50 Today's Investing Mantra

"When stocks are attractive, you buy them. Sure, they can go lower. I've bought stocks at $12 that went to $2, but then they later went to $30. You just don't know when you can find the bottom." - Peter Lynch

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat (Research Analyst).

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1 Responses to "Stop Worrying About Market Valuations. Use This Investing Strategy"

RAJKUMAR S D

Apr 25, 2016

Sir, I agree with viewpoints so explained in this article. I remember the scrips like JP Associate, ONGC, SCI, JSPL, Suzlon etc who were yesterday's heroes now commanding astonishing valuation with higher PE ratios. But at the same time majority of multinationals like ABB Siemens Abbot etc even though commanding higher valuations then and today have given great returns to investors. Hence PE is not the only criteria for selection of retirement stock, the other factors are like business model, market strategy, management and liberal dividend policy and buy back policy which depends on their cash flow etc.
Thanks with regards

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