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How to Know if it's the Right Time to Sell

May 26, 2022

'BUY on rumours and SELL on news'.

Indian investors saw this well-known phenomenon play out a couple of days ago.

The gold standard of the pharma industry Divis Laboratories reported good March quarter results.

The stock fell 15% in 2 days!

The reason?

The management didn't give guidance. There was fear of the company having seen peak margins.

A lot of people use the phrase, 'time in the market being much more important than timing the market'.

Well, in my opinion, timing the market is equally important as time in the market.

Also, when I say, 'timing the market', I don't mean forecasting market levels or stock levels on a daily or weekly basis. That is akin to gambling at Las Vegas.

By 'timing the market', I mean identifying peak margins/peak growth for companies and sectors.

I also think it's important to understand the concept of 'peak metrics' to protect the downside.

While the last 2 years have been no less than a fairy tale, reality has started to sink in as the world gets used to inflation.

The era of free money is behind us. If you thought any and every stock will make you money, you are in for a rude shock. The year 2022 is going to separate the men from the boys in the Indian stock market.

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So let me tell you the concept of 'peak metrics' in investing and why identifying the trend is extremely important.

Let's rewind to the latter part of the last decade.

During 2006-07, India was getting introduced to the world in the pharma sector. The Indian pharma sector exported barely Rs 290 bn worth of products in 2008.

It was back then during those days when India was getting introduced to the world with its low-cost manufacturing in generics in the US and European markets.

Companies like Sun Pharma, Lupin, Dr Reddys, erstwhile Ranbaxy, and Cipla were at an inflection point when it came to exporting generic drugs to the US market. A natural tailwind in the form of currency depreciation too aided the growing sector.

The superior performance of the pharma sector can be seen from the table below.

In US$ bn FY09 FY10 FY11 FY12 FY13 FY14 FY15
Exports to USA 1.5 1.9 2.3 3 3.4 3.9 4.1
Growth (%)   27% 21% 30% 13% 15% 5%
Data source: Ace equity, Equitymaster

Sales of top 5 pharm companies grew at 18% CAGR over 6 years from FY09-FY15. Pharma exports to USA were booming during at that time.

The effect of strong growth in sales tricked down to other operating parameters such as return on equity. This resulted in a valuation re-rating for the sector and almost all pharma companies.

In my view, it was nothing less than the Y2K moment for the software industry.

Return Ratios FY09 FY10 FY11 FY12 FY13 FY14 FY15
ROE of pharma stocks 9% 12% 13% 14% 16% 19% 22%
Data source: Ace equity, Equitymaster

Valuation ratios FY09 FY10 FY11 FY12 FY13 FY14 FY15
Price to Book of Pharma stocks 2.5 4.5 4.9 3.5 4.1 4.7 6.5
Data source: Ace equity, Equitymaster

Now I'm sure it's extremely difficult to identify a trend at the bottom and play the entire upside.

But even if you invested in the pharma sector in 2010 or 2011 (which is 2 years after the trend), I'm sure you would have made at least 2x returns in 3 years.

As the story started playing out, the noise started gravitating towards the pharma sector and the stock multiples started re-rating.

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Now the problem is people get attracted to noise and price action.

In 2014 when the re-rating had happened, everyone you met was talking about the pharma sector and how they had made money. It was difficult not to invest when everyone around you was making money.

But at 6-7 times price to book, what upside did we have? The valuations were at peak and so were the margins.

What people fail to understand is that in a bull market and especially when a particular sector is in a bull market, analysts go overboard with their estimates.

They extrapolate financials to justify their target prices, without giving any importance to the concept of peak margins.

If margins just go up linearly wouldn't that attract more competition?

Anyways, lets look at the other half of the previous decade and what happened to pharma stocks.

In US$ bn FY15 FY16 FY17 FY18 FY19
Exports to USA 4.1 5.4 5.5 5.1 5.7
Growth (%)   32% 2% -7% 12%
Data source: Ace equity, Equitymaster

Now at 6.5 times price to book imagine what will happen if the growth slows down from double digits to high single digit?

Its quite foolish to assume that margins will also keep on expanding. As growth slows down due to pricing pressure, margins suffer, ROE gets hit, and valuation de-rates.

This is exactly what happened to the pharma sector.

Return Ratios FY15 FY16 FY17 FY18 FY19
ROE of pharma stocks 22% 18% 16% 11% 11%
Data source: Ace equity, Equitymaster

Valuation ratios FY15 FY16 FY17 FY18 FY19
Price to Book of Pharma stocks 6.5 4.5 3.8 3.7 3.1
Data source: Ace equity, Equitymaster

A double whammy. Valuation multiples de-rated and price erosion and competition led to earnings downgrades too.

Coming back to the present day, it's the same story playing out in midcap IT stocks. A 30-50% correction in the past 6 months.

Again, peak valuations, peak margins, and peak growth. If IT companies start getting consumer multiples with the narrative of tech being the consumption story, my only reaction would be God Bless the people who buy IT stocks at 50-60 PE ratio.

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I'm sure you must have noticed the 50% price correction in all the diagnostic stocks.

To sustain an 80 PE multiple; earnings of diagnostic stocks have to double every 2 years for at least the next 3-5 years.

So, the point is...

Pharma in 2019. IT and diagnostics in 2022...all are classic cases of investing at peak multiples, peak margins, and peak growth.

Stocks like Dr Lal, Mindtree, Metropolis, L&T Infotech, Thyrocare, Persistent to name a few have been battered down as their sectors has achieved peak metrics for now. They are likely to have meaningful headwinds in the near term.

So, what should investors do to identify peak metrics and sell before it's too late?

Use these pointers...

  • Always use the concept of mean valuations i.e. mean PE or mean PB. If the valuations are far higher than the mean, it's prudent to sell.
  • Promoter selling: The promoter of a company always knows more than investors. If there is promoter selling it's prudent to relook your position. On the contrary use Equitymaster's Stock Screener to find stocks in which promoters are increasing their stakes.
  • One rule which I follow to identify peak margins is to see how fast the margins have grown over the past 2 years or to look at the margins in the previous up cycle.

Also use Equitymaster's Stock Screener to find the most overvalued stocks and most undervalued stocks in India.

I would end this piece on a cautious note. This is not the time to do bottom fishing. I believe the worst for the market is still ahead of us.

Stay safe and happy investing!

Warm regards,

Aditya Vora
Research Analyst, Hidden Treasure

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