Growth Stocks: Here's How Much to Pay for Quality 

Dear Viewers

Hello and a warm welcome to all of you.

With interest rates rising up, both in india and globally, a good number of stocks have seen their PE multiples compress. PE multiple, as I have shared in my previous videos, is simply a ratio of stock price to earnings per share, and is a measure of how much the market is willing to pay per unit of earnings.

In some cases, such as in case of loss making new age companies, this was long due.

However, Im here to talk of quality and growth businesses. When multiples correct, it is a good time for investors to lap up wonderful businesses at a fair, if not wonderful price.

So that's exactly what Im going to speak of today. I.e, how to assess growth quality and if its okay to pay up. Ill also talk of a few stocks where growth potential and growth quality seem good.

I know a lot has been written and said on the matter. And yet, margin of safety remains a well understood concept only in theory, and not so much in practice.

There are extreme conservationists who would not look at a stock if it trades above a price to book value of one.

There are cautious growth investors who would be okay entering at a PE of 25, but not beyond that. Then there are ones who would be okay with entering at high multiples as long as peg , that is, pe ratio to growth rate is close to or less than one.

Some are fine taking staggered positions as long as the PE multiple there are not too far from long term median average multiples. For instance, if a stock has been trading at a 5 year median multiple of 40 times, they will take solace in historical multiples and would be okay paying that much.

Before we dive into it, to set the context right, allow me to start with some extreme examples.

A safe stock like HUL was available at a PE of 45 times in FY16. Had you invested then at the seeminlgly high multiple, your return would still have been at a CAGR of 17%.

If you bought Tata Elxsi at a multiple of 41 times six years ago in March 2016, your gains would have been 572% over seven years , a neat 31 CAGR.

Over a period of time, there are two variables to gains in the stock price. The first is earnings growth, the other is multiple expansion /rerating. For instance, in case of Tata Elxsi, earnings have grown nearly 5 times in last seven years, while the multiple itself has expanded from 40 x to 54x.

In case of HUL, the earning multiple has grown from 45 times to nearly 60 times, while the earnings have grown 2.4 times.

Now I understand the merit in the warnings to not overpay. But the truth is - a lot of high quality businesses such as Tata Elxsi will always be out of bounds for over conservative investors, never giving them a chance to have 10 or 100 baggers in their portfolio.

Yes, I have cherry picked to drive home the point.

For every Tata Elxsi and HUL that can be quoted, there are stocks were once synonymous with quality but have gone no where in a 5 year interval and have even lost money.

For instance Lupin, where PE multiple, return ratios and earnings have all gone for a toss...

I know there is no crystal ball to gaze the future.

But here are a few simple parameters you must consider to minimize the chance of seeing your stocks getting derated, i.e, where the PE comes down overtime.

I would recommend you to start with stocks that have a respectable return on capital employed or ROCE of 15% or above. The next thing you have to check is if there are enough triggers for sustainable growth, or reinvestment. I don't mean just the revenue growth, but visibility on sustainable margins or value addition prospects that could improve margins as well. That is, you must look for businesses where the profits that are reinvested back in the business are able to generate a higher or at least similar ROCE than what the business is generating.

This obviously rules out the commoditized and cyclical businesses and limits your universe to companies with structural tailwinds.

In case of acquisitions also, you should be very cautious. Statistically, most of them fail to give the desired results and turn out to be case studies on good money turned into bad. A classic case is Ranbaxy deal for Sun Pharma.

If a company is diversifying into other segments that are unrelated or have nothing to do with forward or backward integration, you should be mindful on whether these diversions will contribute to higher or lower margins.

When it comes to decisions like above, you are basically counting on the management quality.

So, to summarize, to look for candidates with rerating potential or to avoid candidates that could be derated, there are three factors you should focus on:

1. A respectable ROCE of 15 pc to begin with
2. Reinvestment prospects there should be avenues for growth for the company. And these opportunities should be such that incremental capital when invested should allow either similar or higher returns than the existing business.
3. Management Quality.

A lot of growth investors justify high multiples citing the topline. However, more than the numbers, it is the quality of growth that matters. And only for good quality growth you should consider paying up.

Let me share an excellent example of good growth versus bad growth in the universe for listed companies in India. I came across this example in the book : The Biography of a Failed Venture by Prashant Desai. Here, the author shares the story of his failed venture KAN D:FY, an Indian sports brand (apparels and footwear) that was launched with much fanfare and with ambassadors like Hardik Pandya, Farhan Akhtar, and Anil Kumble.

As obvious from the book title, the venture failed. But the learnings that have been shared are big that I would recommend you to read the book for.

As per author, one of the biggest reasons for the venture's failure was lack of patience to grow, or chasing growth at any cost- beyond budget, beyond means and beyond bandwidth. And this was rooted in misplaced confidence and insensitivity to risks.

He differentiated virtuous from virtuous growth by sharing a more familiar example of D-Mart (Avenue Supermarts) and Big Bazaar (Future Retail), two listed businesses in the similar industry (retail), that met two completely different destinies. Before D:FY, Mr Desai was associated with Future Group, and was responsible for driving investor engagement for Pantaloons. So this is as good as an objective view from the insider.

You see, both Big Bazaar and D-Mart started their journeys around the same time. The former opened its first store in 2001. D-Mart followed closely in 2002.While Bigbazaar was focused on general merchandise, fashion and food, DMart focused on grocery and general merchandise only. Over the next decade, while Big Bazaar sprinted to 250 stores, D-Mart moved at snail pace to just 10 stores.

Big Bazaar was in a hurry to grow the store network. It opted for rented model , used debt to grow a business that was relatively working capital intensive due to non FMCG and fashion related products. It focused on store ambience. And on ad spends to drive footfalls. The model worked for Bigbazaar to grow aggressively in the initial years.

D-Mart, had a starkly different approach. It focused on perfecting the store economics first. It invested in its own stores. The high capital intensity was offset by faster moving inventory and rent saving, as it avoided slower moving consumption categories. The model catered to basic consumer needs, who did not care much about store ambience.

D-Mart avoided the expense on store frills , with just basic air conditioning. The savings it made were invested into catering to the deepest consumer need - value, through discounts on the MRP. This led to more business per store. And the profits generated were reinvested back in the business, in opening more stores.

DMart's patient approach avoided the debt trap and lure of unsustainable growth.

A few years after their first stores - the results were vastly different. In the next seven years after first decade, while D-Mart opened 190 stores, Bigbazaar expansion was limited to 50. As the years progressed, even that became unsustainable for Bigbazaar. It crumbled under its own pace.

Without hindsight benefit, a superficial growth investor would have indeed swung towards Big Bazaar, had both been listed then.

And we all know how that would have turned out for him.

Today, D-Mart enjoys a market cap of over Rs 2200 bn, with a clean balance sheet. Future Retail has languished at less than Rs 2 bn and is now confined to books on business case studies. Its flagship chain Bigbazaar is now taken over by Reliance Industries.

Now as promised, let us take a look at businesses where growth has come along with increasing returns. As such, these companies seem to be doing something right when it comes to expansion strategies. I would like to preface this by saying to not consider these as stock recommendations and do your own due diligence while making any such decision.

1. The first is Infobeans Tech, a smallcap IT firm that boasts of clients in the Fortune 500 list and operates in the areas of product engineering and digital transformation. In the last 3 years, the company has grown the topline by 2.3x, its operating profit over the same period have grown 3.4x. And its ROCE over this time has expanded from 16 times to 27 times. The company aims to double in every two to three years through both organic and inorganic ways , and is available at a TTM PE of 25 times and 5 year average return on capital 23%.
2. The second is PDS. The company acts as a service platform in the textile segment that links the customers i.e., global brands and retailers such as Walmart, Target, JC Penny etc with designers and factory network across cost effective manufacturing hubs, while managing supply chains and ensuring quality and ESG compliance. As a platform, the more business it does, the stronger it gets from networking effects. With this model, the global brands and retailers can focus on the front end part of value chain that matters the most to them - being customer centric and can cut down their go to market lead times. The backend part can be outsourced to financially robust, ESG and process compliant, multiproduct and multi geography players such as PDS. The business model allows PDS to operate in asset light way with low margins but very high growth potential and healthy returns. The company is available at a PE of 15 times with 5 year average return on capital of 15%.
3. The third is Narayan Hrudayala that owns and operates healthcare multispecialty, tertiary & primary healthcare facilities that initially focused on cardiac & renal but expanded to cancer, neurology, neurosurgery, orthopaedics and gastroenterology facilities. The company has aggressive capex plan for over 2 to 3 years estimated at Rs 20 bn. The return ratios , i.e Return on equity and capital employed were above 25% each, and debt to equity ratio remains well below 1. The stock is trading at a PE of 32 times and at a PEG of 0.7 times.

If we have to go more quantitative about it, here's illustration for you.

In the example, the stock has an EPS of 20 times. Let's say you have a fair idea that the stock will be able to compound at 25% CAGR over next 5 years. And because it is focused on self sustainable growth, it is not paying any dividend. How much will you be willing to pay for a minimum IRR or CAGR gain of 15%.

Well, I have assumed that over next 5 years, given high returns on capital, more competition will come in and PE will moderate to 15 times.

This is what earning profile is expected to look like as per basic calculations. Where entire net profit is reinvested back at 25% rate of return.

The 5th year earning of 61 Rs with multiple of 15 times implies a price of Rs 916, over 5 years. For me to get an IRR of 15% over this stock, the levels I could enter the stock today comes at Rs 455 , implying a current PE of 23 times. You could use some hit and trial and goal seek function in the excel as such to arrive at a PE that could give you a CAGR of 15%. So basically, with these basic and back of the envelope way, you should avoid paying a PE of more than 23 times for a stock of a company that is likely to offer an incremental return of 25% on the capital invested back in the business.

Needless to say, you should have a decent understanding of management quality, business and industry prospects to get a fair sense of incremental ROCE in the business.

Btw, if you do not have enough insights or understanding to assess the business on these parameters, growth investing or paying up is not for you. You would be much better at following a disciplined quantitative way of investing with clear entry and exit parameters.

So with this, I have come to the end of the video. I hope it adds some value in your investment journey. I would love your feedback. Don't forget to press the like button and share the video for more such content. And do subscribe to Equitymaster channel to get future alerts for my videos.

Thank you for watching. Goodbye.