Do high growth high valuation stocks make sense? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Do high growth high valuation stocks make sense? 

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In this issue:
» World's elite have tucked away US$ 32 trln in tax havens
» A banker's thoughts on India's trade policy
» 12 firms receive undue favours in coal blocks
» China needs to deleverage to continue forward
» ...and more!

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Multi-baggers. The term invokes more interest in investors than any other investment related word. The chance of seeing your money double, triple or grow more than that is something you never want to miss. But the big question is how one identifies these elusive multi-baggers. Very often, investors think that they would find such investment opportunities in stocks of companies that are in high growth sectors. More often than not, investors go for stocks which are supposedly in a niche segment with high growth. But such stocks are often available at very high valuations. So what should one do?

Several investors and their advisors try to justify these high valuations with the high growth of the stock. Conversations like "PE of 30 is justified keeping in mind the 25% YoY growth the stock has given till now" are common. Things become even tougher when there is no other company with a comparable business against which the valuation could be compared. As a result, companies with unique business models tend to trade at sky high valuations under the pretext that their growth rates justify their valuations. But unfortunately this statement does not always hold true.

Most of the times the growth rates people refer to in these cases are either that of the immediate past or of the distant future. With regards to the immediate past, it is imprudent to assume that this can continue unless there has been a strong track record evidencing the same. With regards to the distant future, it is impossible to predict that accurately unless one is highly skilled at astrology or crystal ball gazing.

The point being that there it makes no sense to assign high valuations to a company unless its business fundamentals justify the same. And fundamentals have to be intact over a long period of time. Recent or sudden spurts of growth may be just one off events. Investors would do well to check these and dig deeper before investing in such stocks. Otherwise, they would end up getting trapped by the higher valuations and may end up seeing losses rather than gains over the long term.

Do you think that high growth justifies higher valuations? You can also share your comments with us or post your views on our Facebook page / Google+ page.

01:10  Chart of the day
India's fiscal deficit is not something to be proud of. Higher subsidy burden combined with lower than estimated revenues have led the fiscal gap to widen. After crossing the budgeted level in FY09, fiscal deficit (as a percentage of GDP) had been kept within the limits in FY10 and FY11. But during the tumultuous time of FY12, fiscal deficit again crossed the budgeted numbers. Unfortunately with things not really improving in the current fiscal, it does appear that the history of FY12 is all set to repeat itself. The government has already spent its available kitty on subsidies. And its only July. The subsidies for the rest of the year need to be met. At the same time, revenues have not really flowed in as planned. Disinvestment has not even started. Tax revenues have lagged in the first three months. The grand telecom spectrum auction plan is still in the draft stages and its execution is being postponed on a daily basis. So by the looks of it, fiscal deficit would exceed the target yet again in FY13.

Source: Economic Times
* Budgeted. Actual will be reported only by the end of the year

Ever since the middle-east uprising against corrupt regimes and talks of income inequality between rich and poor began in early 2011, the issue of black money has grabbed much needed attention. A far-reaching new study suggests that a staggering USD $21-32 trillion in assets of super rich individuals has been lost to global tax havens. If taxed, that could have been enough to put parts of Africa back on its feet. It could even solve the euro debt crisis. The total worth of these assets far exceeds the value of the overseas debts of the countries they came from. The amount is equivalent to the combined GDP of the US and Japan. The study was conducted by Tax Justice Network, which campaigns against tax havens. They used data from the Bank for International Settlements (BIS), the International Monetary Fund (IMF), World Bank, United Nations and central banks. Thus, if the tax authorities find a way to tax this offshore wealth or entice its owners to reinvest it back home, it could go a long way in reducing some of the world's problems and help in reducing income inequality around the globe.

We all know how a continuous current account deficit is draining our foreign exchange reserves and also making the rupee extremely volatile. Sadly, all efforts toward addressing the issue are not bringing in the desired result. Amidst such a scenario, Mr Aditya Puri, the CEO of one of India's most respected private bank, HDFC Bank, has offered some suggestions. This is no doubt a very good gesture we believe. But there seems to be nothing new in what he has said.

Mr Puri wants a review of our trade relationship with China. This, as he believes that the dragon nation is dumping a lot of goods into India. As a leading daily points out, India is already very active on this front and leads in terms of number of anti-dumping complaints against China in the WTO.

Mr Puri's other major suggestion has to do with lifting export curbs, particularly in agriculture. We are whole heartedly with him on this too. But given how sticky the issue of food inflation has become, liberalising exports may be an issue. It is something the Government may not want to touch even with a 10-feet pole. Thus, Mr Puri may have to use a bit more of his ingenuity to come up with some really out of the box solutions to India's current account deficit woes.

The coal industry continues to be mired by one issue after another. As per a news report in, the Central Bureau of Investigation (CBI) has identified 12 private companies that may have been shown undue favours in coal mine allocation. About 64 companies were allotted coal blocks between 2006 and 2009. As per a certain CBI official, 12 out of these 64 companies did not meet the requisite criteria to get coal. Despite that, they were given undue favours. All these 64 companies are from Chhattisgarh and Jharkhand. It is alleged that the government had taken up a first-come-first-served basis policy to benefit some private companies. The names of the 12 companies have not been disclosed yet. The reason for this is that the CBI is yet to press charges against them. In its final report, the Comptroller and Auditor General (CAG) had pegged the notional loss due to allocation of coal blocks to private firms at Rs 1.8 trillion. This is likely to be another setback for Prime Minister Manmohan Singh-led government.

If rate hikes are a sign of higher inflation, rate cuts are a definitive sign of a slowdown in a country. Take the case of China. On 5 July, the People's Bank of China cut benchmark interest rates for the second time in less than a month. To top this off, since the end of 2011, there have been three successive cuts in the reserve requirement ratio. Plus, off late, the central bank has been injecting funds into the money market. But can these monetary measures fix the economy? Well, maybe not. China's banks are starved for cash and strict capital requirements have made things worse. Plus the economy is so leveraged that the only solution is deleverage. According to Fitch, the ratio of total financing/GDP in China rose from 124% in end-2007 to 179% in 2011. In a situation where economic growth is slowing, heavy debt in the system can snowball into a big problem. Forget Europe, but if China self implodes, the world is in for a massive economic crisis, with no end in sight.

The 21% duty on imported power equipment - imposed by the government recently - would benefit domestic power equipment manufacturers. This is because these duties would make imports more expensive. However, with the same happening, the final consumers would feel the impact as well. This is considering that electricity generation costs would increase as well. As per rating agency ICRA, the increase in capital costs for future generation projects would up the power generation costs by about 2% (or about Rs 0.06 to Rs 0.08 per unit) . It also pointed out that imported equipment contributed to nearly one-third of the power capacity addition during the eleventh five year plan- with a large portion of this being imported from the dragon nation. ICRA has also pointed out that the cost competitiveness of the domestic manufacturers had increased as the Indian Rupee has depreciated by about 25% against the Chinese Yuan over the last year.

While one may expect demand to significantly shift to the domestic equipment suppliers, it must be noted that supply constraints have been a major issue in the past. This is especially the case for bulk orders. We will however only be able to see the real impact of these developments once the overall investment environment takes a turn for the better.

In the meanwhile, after opening the day in the red, the Indian equity markets continued to trade below the dotted line. At the time of writing, Sensex was down by 222 points (1.3%). Among the stocks leading the losses was Maruti Suzuki which continues to face headwinds at its Manesar plant. Other major Asian stock markets have closed the day on a negative note with Hong Kong and Taiwan leading the losses in the region.

04:55  Today's investing mantra
"Understanding how to be a good investor makes you a better business manager and vice versa" - Charlie Munger

Click here to read our series on 'Lessons from Charlie Munger'
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2 Responses to "Do high growth high valuation stocks make sense?"


Jul 24, 2012

Higher growth companies definitely command a higher price,no doubt -- maybe growth at a reasonable price would be the answer, but the issue is how to identify the relation between growth and price. regards


sunilkumar tejwani

Jul 23, 2012

take the case of certain consumption oriented stocks like hosiery, home & kitchen appliances, baggage, paints, and fancy food chain restaurants. These stocks are trading at sky high valuations. P/E ranging from 30 to 40. Such stocks shouldn't even be touched with a barge pole. Moral of the story, how so ever super normal profits these companies might have earned in the recent past, it's impossible to repeat them in the next five years. Market operators are demanding next five year's earnings discounted today. When there isn't guarantee for tomorrow then why to pay next five year's earnings today. Remember the dot com fad when crazy valuations of all software companies, regardless of future sustainability of profits were ruling sky high.
Therefore one must be cautious what value one is paying for.

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