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Why Are These Great Stocks Down 25%...36%...49%?

Nov 19, 2015

In this issue:
» Real estate players sitting on Rs 300,000,000,000 time bomb!
» Indian stock markets firm today
» ...and more!
0:00

In my early days on Equitymaster research team, I came across a headline in a business daily that seemed very odd to me. While I don't recollect the exact words, it read something like 'Bharti Airtel's quarterly profits rise by 100%; stock down 5%'.

I was puzzled. Why would a stock decline despite profits doubling? So I approached the analyst who covered the company to get his views. He smiled and said, 'Take a look at the valuations'.

I stared at him blankly, scratching my head.

'Market expectations were for much higher growth,' he said.

This little incident came to mind recently as I ran a screen for stocks that have declined the most from their peaks. Stocks of good quality businesses have declined sharply from their respective 52-highs. For instance:

One thing common between these stocks was that they were trading at above-average valuations not so long ago. Expectations for strong and sustainable earnings growth were high.

While it is true that businesses with strong tailwinds do have the ability to clock strong growth rates over long periods, the fact of the matter is that any signs of a 'slowdown' in the interim can cause the business to miss 'market expectations', and in the process, send the stock tumbling down.

Some apt lines from an article on valuewalk.com:

  • In your personal life, you may have realized that when people have high expectations they are very difficult to please. Everything has to go perfectly. If not, the person gets let down.
  • The price-to-earnings multiple is the same way. When it is high, a business is priced for perfection. Unfortunately the world is a messy place. Things don't always go according to plan. As a result, businesses priced for perfection will see their valuation multiple decrease when things don't go according to plan.

Is there a way to avoid such sharp declines? Well, no, not really...but investors can take measures to help them make better and more rational decisions. One such tool is what I like to call the 'Payoff Table'. It looks a little something like this:

Payoff Table
PE/G 15% 20% 25% 30% 35% 40%
20 -4% 0% 4% 8% 12% 17%
22.5 -2% 2% 7% 11% 15% 19%
25 0% 4% 9% 13% 18% 22%
27.5 2% 6% 11% 15% 20% 24%
30 4% 8% 13% 17% 22% 26%
32.5 6% 10% 15% 19% 24% 28%
35 7% 12% 16% 21% 26% 30%

Source: Equitymaster Research

Let me explain the table with the help of an example. Suppose a stock trades at Rs 100. Its trailing twelve month earnings per share (EPS) stands at Rs 2. Thus, the PE ratio is 50x.

Let's assume the company is a high quality business with strong return ratios. The icing on the cake is the strong growth. Else, why would investors be willing to pay up for it?

So, the key questions to ask here are - Is the price justified? And are growth rates sustainable?

Difficult questions to answer, no doubt. But the Payoff Table should help put things in perspective...

The table shows the expected per-year return on the investment (dividends not considered) if the company were to continue to grow at the corresponding growth rates for a five year period; the assumption here is also that, at the end of the five years, the stock would be trading at the corresponding P/E ratio.

Essentially, what investors are doing is making a call based on a probability. If the returns do not meet your expectations, it would make sense to revisit the stock idea some other time.

For instance, in the table above, I have highlighted the cells wherein the expected return is above 15% - an approximate long-term average level of returns investors should expect from equities.

I would like to reiterate that this method is not foolproof, but it can help investors make a better judgement call in situations of businesses garnering high valuations. Also, investors would do well to keep in mind that the EPS for base calculation should be adjusted for extraordinary items (and onetime gains and losses) to make the approach more meaningful.

Do you find the payoff table useful? Let us know your comments or share your views in the Equitymaster Club.

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3:00 Chart of the day

There are two asset classes that Indian loves the most. One is gold. And the other one is real estate. Many people prefer these asset classes because they are tangible. And because they strongly believe that, their prices can never fall.

For several months now Vivek Kaul, our India Editor of The Daily Reckoning has been busting real estate myths and unraveling the real estate Ponzi scheme in India. Vivek has maintained that real estate prices in India are set to fall as the real estate players struggle to survive the debt trap.

Real estate players in India are sitting on a huge pile of debt. As per rating agency CRISIL (as reported in Business Standard), India's top 25 real estate companies are confronted with the uphill task of refinancing aggregate debt worth Rs 300 billion in the medium term! These top 25 companies alone account for about 50% of the bank lending to the sector. For the past couple of years, these companies have been refinancing their loans. But things are getting worse lately. The construction cost is rising faster than customer advances. As a result, the real estate players are in a deadly debt spiral.

Take a look at today's chart of the day. It is clear that residential debt is rising at a brisk pace. The increasing ratio of residential debt to residential collections is an indication that construction costs are increasing at a faster pace than advances from customers.

The Rs 300,000,000,000 refinancing challenge!

What's the outlook for the real estate sector? Which way are property prices headed? To get an in-depth view of the sector, I would highly recommend you read Vivek's real estate guide. It's free!

4:40

After opening the day on a firm note, Indian stocks continued to steadily inch higher. At the time of writing, the Sensex was trading higher by around 355 points (1.39%). All sectoral indices except pharma are trading in the green with banking, auto, IT, and oil & gas leading the gainers' pack.

4:50 Today's Investing mantra

"When any guy offers you a chance to earn lots of money without risk, don't listen to the rest of his sentence. Follow this, and you'll save yourself a lot of misery." - Charlie Munger

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

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3 Responses to "Why Are These Great Stocks Down 25%...36%...49%?"

Damodar

Nov 27, 2015

Dear Devanshu,

Please elaborate on the table. It would have been better if you had picked up an example from the table itself and explained lucidly your point.

However, I am unable to find the logic in the table. To me it rather appears weird.
For example if a company quotes at PE of 20 and grows at 40%, the return as per Table will be just 17%. But if the same company quotes at PE of 35, the return I get is 30% p.a. This is exact opposite of what we learnt about pricing/valuations.

One more guest has asked for clarification. Would you kindly enlighten us.

Thanks in advance.

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Mukesh Tolani

Nov 20, 2015

Hello Devanshu,

Thanks for the nice article indicating the reason for decline in share prices of good quality stocks.

I completely agree with the fact, that high PE valuations should be given much more thought, before entering any scrip. A quarter or two, bad, will lead the share price spiralling down.

But, I would really appreciate if you explain, with 1 or 2 examples, the Pay-off chart.

For my investments, I normally use the PE/G ratio to gauge whether a particular share in adequately priced.
( Drawback : For G, I use the last 3 yrs or 5 yrs. CAGR., while in reality, it should be the forward looking % growth. I do this as I find myself not properly equipped to forecast the future earnings of the company )

Best Regards,

Mukesh Tolani
9823081484

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NITIN KHURANA

Nov 20, 2015

Dear Sir / Madam,

Earlier, 5Minute wrapup was said as not to read bundle of economic new-papers, and the crux of that was sum-up in this wrapup, though I understand all can't be wrapup in it.

But referring yesterdays 5Minute wrapup, Do you think, anything was related to events occurred for the day. This is an analytical research, though research was good but it can be dealt in any other series such as Profit Hunter or anywhere else.

The quality of wrapup has been downgrading from many months.


Though I may sound critical, but this is my personal opinion, you may have reasons for doing such things. But 5Minute wrapup to me is as shown earlier i.e. bundle of economic news-papers and top of it is 5Minute wrapup.

I would request you to introspect, as you are better than us, and come up with quality product.

With regards
NITIN KHURANA
9736002100

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