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Buy low and sell high!

May 31, 2007

Mid-caps seem to be the flavor of the season on the street. With NSE-Nifty touching all time highs and BSE-Sensex itching to do so, investors seem to be wary of increasing their positions here as sizeable gains from a 2-3 year perspective except in select stocks looks like a distant reality. In stark contrast, the mid caps, which participated in the current rally to a lesser extent, seem ripe for the picking as not only do they have attractive valuations, but most of them also enjoy higher growth rates than their more illustrated heavyweight peers. But it is also here that investors tend to burn their fingers the most by resorting to some horrendous stock picks. Hence, it is here more than anywhere else that one needs to conduct an extremely honest assessment of the investment opportunity and not fall into traps of lofty promises.

Everyone loves security and more so financial security. Hence, in times of an eventuality, it is the mid caps that get ejected from one's portfolio, as large caps seem to provide greater protection from downside. Further, one very well knows what happens when panics set in. Rationality and prudence get thrown out of the window and a stock that should have fallen by only 10%-15% may go on to lose as much as 50% of its market cap in no time. While it is true that once the dark cloud of panic clear, good quality mid cap stocks can spring back to life, the poorer ones can remain there forever. It is investing in these types that we want to avoid.

The so-called herd mentality in us humans has given rise to certain themes in every bull market. Such was the love for tech and dotcom stocks in the US in the late nineties that companies with even the faintest of association with the sector saw their valuations soar manifold in no time, without of course, the concomitant rise in earnings. Closer home, parallels could be drawn with the reality stock mania and more recently, the media stocks to some extent. Such is the optimism surrounding this sector that certain companies that have not even turned profitable are being locked in upper circuits on a regular basis. This despite the fact that, memories of the reality sector collapse is still fresh in most of our minds.

No matter how good the fundamentals and how excellent the growth prospects are, we are not huge fans of investing in companies with lofty valuations. Even Peter Lynch, arguably one of the greatest stock pickers of our times, was averse to investing in companies with a P/E ratio of more than 20 for growth stocks. Compare this with the more than 50 times for some media companies in India currently and the dangers become apparent.

It does not take more than tenth grade math to find out that companies with such a high multiple in order to justify its current price will have to grow its earnings consistently at 13% CAGR well into perpetuity if one assumes a return of 15%. Now take out your spreadsheets and see how many companies have grown at such a rate even for 15 years at a trot in the past. Only a handful of them! Let us say the number is 20. So out of a mid cap universe of say 500 companies, the probability of you making good on your investment at such lofty valuations is a poor 4%. In other words, only one out of 25 companies will make a good investment at 50 times earnings multiples.

This leads us to one of the most basic tenet in investing, 'Buy Low and Sell High'. So next time, some one tries to lure you into investing in a mid cap with a P/E of 50, you know what to do. We will be back with more investing wisdom later.

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