Jun 22, 2009|
Investors make mistakes. Here's one...
It wouldn't be wrong to call Suzlon a baby of the bull market. The stock, subsequent to listing(October 2005), enjoyed some pretty euphoric valuations for the next two years. As can be seen from the chart, with an average P/E of about 40, Suzlon was a darling of the stock market during those two years of 2006 and 2007.
The reason? The company was growing, and growing fast. For the five years from FY02 to FY07, the company managed to grow its sales and profits at a scorching CAGR of 72% and 50% respectively. That was enough for Suzlon to garner a very strong fan following. With such a strong upward trend of earnings, people happily paid an average P/E of 40 for the stock during that period.
This 'upward trend of earnings' has been the nemesis of many a stock market investor. A good showing on this front for a period 5, 4 or even 3 years are many a times regarded as an assurance of uninterrupted future growth and a warrant for projecting the curve of profits indefinitely upward. Especially when the general stock market sentiment is positive. This rising trend of earnings is used as a reason to draw many positive conclusions about the company, thus fueling some very optimistic future projections.
But like Benjamin Graham has pointed out in the past, there lie some hidden but very real dangers in projecting such trends into the future. More specifically, there are several reasons why we cannot be sure that a trend of profits shown in the past will continue in the future. In the broad economic sense, there is the law of diminishing returns and of increasing competition which must finally flatten out any sharply upward curve of growth.
There is also the flow and ebb of the business cycle, from which the particular danger arises that the earnings curve will look most impressive on the very eve of a serious setback. And that was the exact case with Suzlon. The world was awash with liquidity during that time. Thus Suzlon, who's products (wind turbines) require heavy capital investments, found no dearth of ready customers. Similarly, due to the upturn of the business cycle, debt was easily available, and that too at attractive rates. This further, made it easy for the company to leverage itself to achieve even higher rates growth and returns.
This extremely favorable environment was perfect for Suzlon's aggressive decision making, and thus showed up very impressively on the company's numbers. As mentioned above, the
earnings curve can look most impressive on the very eve of a serious setback. That's exactly what happened, and the subsequent crash in the stock's price was a very painful reminder of that very fact.
The above mentioned dangers in projecting trends into the future always exists. But it is just that during bull markets which extend for a number of years, the 'trend-of-earnings' phenomenon tends to become only a pretext to excuse mass speculation under the guise of 'investment'. Indeed, the profit-mad public becomes quite willing to accept the flimsiest evidence of the existence of a favorable trend, and project it indefinitely into the future. And as we all know, happy projections can lead to some very silly prices.
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