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High-Growth Stocks: Are You Paying for Sprinters or Marathoners?

Aug 12, 2016

In this issue:
» E Commerce companies see weakening interest
» Dishonest promoters continue to thrive
» ....and more!
00:00
Tanushree Banerjee, Co-Head of Research

Olympians like Michael Phelps and Usain Bolt truly stand out from the rest. It's not just the number of medals they've won. Or the consistency with which they've won. But their distinct advantages over their competitors. Experts believe the physical structure of certain Olympians allows them to use their skill at speeds that are otherwise unrealistic to the rest of us. So it's not just a matter of 'practice makes perfect' for them. No, their dominance also depends on their ability to maximise their advantage.

If businesses were to compete in the Olympics, they would be of two kinds - sprinters and marathoners.

Sprinters would be businesses with temporary inflection points. The ones with sharp earnings recovery times. And the competitors that see a spurt in earnings thanks to new products or technical advantage.

The marathoners would be the businesses with long-term moats. Despite above-average growth rates, these businesses show no signs of slowing down.

The problem is that most investors fail to distinguish between the two. In fact, over the shorter duration of their outperformance, the sprinters attract more limelight than marathoners. Which is why they can even attract valuations as steep as the marathoners'.

Sometimes investors even speculate the sprinters will become marathoners. With this, they justify obscene valuations for the temporary but extraordinary growth rates.

The problem with paying unrealistic prices for such sprinters and marathoners is that it leaves very little for the investor.

There are plenty of old and new businesses today fetching valuations upwards of 30 times earnings. Rationally, one should not be paying more than 15 to 18 times forward earnings for even the strongest businesses. The growth assumption then becomes critical.

Say one is invested in the stock for five years. The business will have to consistently grow at 20-35% each year to fetch multiples that are between 45 and 75 times. It's not impossible, but it is very rare for any business, however strong. And the higher the multiple paid, the more difficult it is for the investors to fetch any returns. Plus, we are only considering growth rate to bring PEs to normalized levels. Imagine the growth required to make them give returns of at least 15%.

Growth Rate to get an Expensive Stock at 15-18x Five year forward P/E
Current PE Multiple Earnings CAGR Tenure
75 35% Five years
55 30% Five years
45 20% Five years
35 15% Five years
25 10% Five years
Source: Equitymaster

It pays to classify high-growth businesses into sprinters and marathoners. Then, as far as possible, only buy the marathoners at valuations that suit realistic growth rates.

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02:40 Chart of the day

The words tech bubble burst remind us of 2001 crash. And talking about the present days, e-commerce boom has caught the frenzy. India's fast-growing internet sector and smart phone boom over the past few years have huge investments in the Indian tech ventures. Many of these ventures were still hugely loss making. A mind boggling amount of money was invested, particularly during 2015. This funding rush has led to widespread overvaluation of such companies.

Burst of Yet Another Tech Bubble?


These venture investors seem to be working with the belief that they will always be able selloff their stakes to retail investors and move on. But the tide has changed. Going by the chart, investments in Indian tech startups during 2016, have not been encouraging so far.

As per Financial Times, investors have turned more cautious about the scale of losses at some of the companies and stiff competition from foreign rivals. So the mark down on valuation of the tech startups too hint at apparent cooling of sentiments.

03:40

A couple days back, my colleague Richa Agarwal wrote in an edition of The 5 Minute WrapUp, about - CEO salaries: A disturbing Trend for Minority Shareholders.

And here is one more such worrying fact. An article in Business Standard has compiled list of around 11 companies which are suspended. Incidentally, their promoters have continued to be part of boards in other companies or have floated new entities.

For various reasons, these promoters stopped filling results and other mandatory declarations for the listed companies. Eventually they simply ended their association with such companies. However, they have managed to get onto boards of other companies and earn compensation from them too. Many of these promoters currently occupy board seats in other companies ranging from two to fifteen.

But, what about the minority shareholders of the defunct companies? They got stuck without an exit.

The capital markets regulator, Security Board of India (SEBI) has reworked a policy and is contemplating stringent actions against promoters where small investors were not provided enough opportunity to exit. The earlier it brings such defaulting promoters to books the better.

04:45

In the meanwhile, after opening the day on a positive note, the Indian indices have continued to trade in the green. Sectoral indices are trading on a mixed note with stocks from the metal, FMCG, and capital goods stocks leading the gains. The BSE Sensex is trading up 192 points (up 0.7%) and the NSE Nifty is trading up 51 points (up 0.6%). The BSE Mid Cap index is trading up by 0.6%, while the BSE Small Cap index is trading up by 0.4%.

04:50 Investing mantra

"The difference between a good business and a bad business is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time" - Warren Buffett

There will be no issue of The 5 Minute WrapUp on 13th and 15th August 2016. We wish our readers a very happy Independence Day!

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst) and Bhavita Nagrani (Research Analyst).

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