IEX: Can it Make a New High in FY24?

Investing is a peculiar field.

Here, you can have two different views on the same subject and yet, both can be correct.

Take the subject of investing in growth stocks for example.

Value investing legend Ben Graham did not like investing in growth stocks.

Here's what he had said about growth stocks in an interview back in 1976.

• To my mind the so-called growth-stock investor - or the average security analyst for that matter - has no idea of how much to pay for a growth stock, how many stocks to buy to obtain the desired return, or how their prices will behave.
  
  Yet these are basic questions. That's why I feel the growth-stock philosophy can't be applied with reasonably dependable results.

According to Graham, a stock with a PE of 10x should be preferred over a PE of 20x even if the latter is expected to grow its earnings at a higher rate going forward.

This wasn't a way that was shared by Peter Lynch, however. Lynch, the legendary fund manager at Fidelity, owed a fair bit of his success to investing in growth stocks.

In other words, he was a big believer in investing in growth stocks.

According to him, a stock with a PE of 20x and that's compounding its earnings at 20% per annum is a better buy than a 10x PE stock that's growing at just 10%.

In fact, after few years, even if the multiple of the high PE stock compresses to 15x and the multiple of the low PE stock expands to 15x, you will still end up with better returns from the high PE stock.

This is a dilemma, doesn't it? Should you listen to Graham or should you listen to Peter Lynch?

Well, as I said earlier, both the approaches can work in the stock market.

You can certainly invest like Graham and pay a PE multiple of around 10-12x and still end up with good long-term results.

However, you must ensure that you stay away from junk and poor-quality stocks.

Likewise, you can also invest like Peter Lynch and pay a high PE multiple provided you are convinced of the company's growth prospects.

So, if you want to pay a PE of 20x for a stock where you are convinced the company can grow at 15-20% for a good number of years, I think it is perfectly fine.

You will certainly get good returns from your investments by going down this path also.

But Peter Lynch also has a warning for you.

He has argued that it is very difficult for a company to grow profits consistently above 25% per annum. This is why a PE multiple of 25-30x is the maximum you should pay for any stock.

If you are paying more than 25-30x PE on a regular basis, you can land yourself into trouble and your long-term returns could take a beating.

So, here's the summary of what we've learnt so far.

• A PE multiple of 10-12x or even 15x is what you should pay, if you are not paying for growth.
• On the other hand, if you are investing in a growth stock, then a PE of 25-30x is the maximum you should pay for any stock.

Now, this brings me to the company that we are discussing today, Indian Energy Exchange Ltd or IEX as it is popularly known.

As I write this, IEX trades at a lofty PE multiple of close to 48x its trailing twelve-month earnings.

The stock is in a bit of a comeback mode lately having gone up 20% from its 52-week lows.

This has made investors wonder whether the worst is really behind for one of India's most favourite multibaggers stocks of the past few years.

For perspective, the stock was up a cool 7x between March 2020 and December 2021.

One big reason for the jump in share price was the sharp expansion in the PE multiple from around 23x in March 2020 to a whopping 90x in December 2021.

Yes, that's right. The stock's PE multiple had jumped to a massive 90x on the back of strong growth in earnings.

If a PE multiple of 90x was crazy and unsustainable, I don't think the current PE of 48x is quite attractive either.

As we just saw, the stock is neither a Ben Graham type of stock nor it is a Peter Lynch stock where the maximum PE should not be more than 30x.

Now, a deep value investor who idolises Ben Graham or a growth investor in the Peter Lynch style, may not be willing to invest in the stock at current valuations.

However, there is a group of investors out there that believe that the stock is not expensive even at the current PE of 48x.

They argue that given the growth runway ahead, the company's strong competitive advantage, and its impressive financials, the stock is a great long term bet even at current valuations.

Now, there is no doubt that IEX has a fantastic business model.

It provides a platform for both buyers as well as sellers of power and gives them the best deal possible in exchange for a small fee.

In fact, in developed nations like UK and Germany, almost 50% of the total power consumed is traded on an exchange like the IEX whereas in India, the number is just 3%.

So, imagine the potential even if this number goes up to say 30%. That's a straight 10x growth we are talking about.

Besides, I have not even considered the growth in per capita consumption in electricity in a growing economy like India.

Therefore, it goes without saying that the growth runway for the company is really huge.

Of course, there will be competition as more exchanges start offering the same services as IEX.

However, the company has a first mover advantage and could still end up commanding a lion's share of the market.

Therefore, its moat or its competitive advantage is pretty much like a platform company like say Amazon where more buyers prefer to buy power from IEX because they will get the maximum number of sellers there.

And more sellers prefer to sell their power on IEX because of the presence of large number of buyers. It is a gift that will keep on giving.

And this is just power I am talking about. The company has already set up a gas exchange. A carbon credits exchange and coal exchange are next in line.

Therefore, if successful, these present other growth levers for the company.

Last but not the least, the asset light nature of the business is another huge positive.

The platform the company provides is essentially a software which once developed, requires very little incremental investment.

This is reflected in the operating margins and the return on equity with the former in the range of 70-80% while the latter hovering at around 40-50%.

There is no doubt in my mind that IEX is indeed a good quality business with strong growth prospects.

But should you be willing to pay a PE multiple of close to 50x for such a business?

Quality and growth certainly do not come cheap. Just look at stocks like Titan, Page Industries, and Nestle.

These stocks are much more expensive than even IEX. Yet, there are investors who would be willing to buy them at their current valuations.

Therefore, in conclusion, IEX is a great quality business no doubt.

The growth potential is also huge given India's low per capita consumption and also how little the power consumed in India trades on exchanges.

But there are things like competition and frequent government intervention that can cause a dent in the long-term story of IEX.

Hence, after taking into account both the pros and the cons, I think I will be a lot more comfortable if a stock like IEX is bought at a lower PE multiple than what it is trading at right now.

I believe that investing is all about margin of safety and protecting your downside first and only then thinking about the upside. This margin of safety seems to be absent at current valuations.

Staggered exposure is another option in front of investors who want to invest in good quality companies but are not comfortable with the valuations.

They can say take 25% exposure right now and then steadily increase the exposure as the PE multiple falls back to more attractive levels.

Please note that we started this piece by asking whether IEX is ready to make a grand comeback. And we provided you with the most detailed answer possible.

I think it will be fair to say that unless the company manages to grow really well on the earnings front, the comeback may not last long enough.

But even if it does i.e. even if the stock keeps going higher from here, I won't mind it much.

I'd rather follow my own process of stock picking and not break it for a stock where I'm not too convinced with the valuations.

Happy Investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter