The 'Seedhi Baat, No Bakwaas' View on ITC

Oct 12, 2020

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Rahul Shah, Editor, Profit Hunter

Here's how ITC, the cigarettes to hotels conglomerate, has performed over the last 10 years.

  • Topline CAGR of a moderate but acceptable 9.1%.
  • Bottomline CAGR of a decent 13.2%.
  • Average dividend payout of a highly impressive 61%.
  • Highly capital efficient ROE of an average 27%.
  • An almost debt-free balance sheet for each of the last 10 years.

If past performance is crucial to determine if a company is an investment or a speculation, then ITC qualifies as an investment, hands down.

There aren't many blue chips out there that are better investments than ITC.

The company is literally an A++ across all the parameters that we just saw.

However, stocks are bought based on the returns they would generate in the future. Not how they performed in the past.

And it is this crucial aspect that recently led to a lot of fireworks on social media.

A section of investors has accused the company of meaningless diversifications and expensive acquisitions.

They say investor patience is running out fast and the company better take some concrete steps to show it means business.

But another group is of the opinion that it is us who need to be patient and give the company some time.

In fact, this group believes the effort towards building new revenue and profitability streams is already bearing fruit.

Both these groups could be right on some of the points and wrong on others.

However, I have a much simpler way of finding out whether the stock deserves to be bought by a true- blue value investor or not.

Here it is...

What is the price to earnings ratio (PE) you would assign to ITC if its future performance is going to be similar to its past?

If you ask me, I will pay a multiple of 18-20x its trailing twelve month normalised earnings. May be, 25x tops.

However, any more than that and you are injecting some speculative element into the valuation. You are putting a lot of pressure on the company to log in higher growth rates than it did in the past.

I haven't come across a lot of investors that consistently paid more than 25x and have earned market beating returns over the long term.

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There could be a few exceptions where one may have paid 30x, 35x or even 40x for that matter, and still earned good returns.

However, unless you are insanely skilled in picking good quality, high growth stocks, paying very high multiples on a consistent basis is a recipe for below par long-term returns.

Now, here's the interesting part...

Three years ago, ITC was trading at price to earnings ratio of 30x-35x its trailing twelve-month earnings.

Put differently, investors were expecting the company to grow much faster than in the past.

I am not saying investors were wrong in making this assumption. But more often than not, such attempts have always ended with these investors having to swallow a bitter pill.

And this is exactly what an investor in ITC at those multiples ended up with. The stock price has nose-dived since then. ITC has crashed close to 50% from its 3-year ago levels.

Cut to the present and the scenario is totally different.

As I write this, ITC is trading at a price to earnings multiple of around 14x, a full 180-degree shift in expectations.

Investors are now expecting the stock to have a future that is worse than its past.

I wouldn't say such an outcome is impossible but I would also ask you to look at the bright side.

If the company indeed goes on to have a future worse than its past, I don't think the downside is going to be huge.

On the contrary, if the company performs the same way as it has done in the past, I see some good upside in the offing over the medium term.

And if it does better than the past, which cannot be ruled out, the gains could be even bigger.

It seems to be a classic 'Heads I win, Tails I don't lose much' scenario.

I can't pass a more definite judgement on ITC than this. However, I can certainly say something with a high degree of confidence.

If you invest in 25-30 stocks that have the same characteristics as ITC and trading at around the same valuations, you will probably make good money on your portfolio over the next 2-3 years.

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In fact, this is exactly how Warren Buffett and other value investors have made their billions. They minimised losses when they were wrong and maximised gains when they were right.

One last thing...

It's not healthy to fret too much over a single stock.

In a significantly diversified portfolio, it is how the group performs a whole that moves the needle of performance and not any individual stock.

So, stop worrying too much about any one stock. As long as you have the odds in your favour for the stocks in your portfolio, you would end up doing well even if few outcomes don't go your way.

By the way, do check out this video on another bluechip, HUL. It's about how investors made and lost money in it based on the same principles that I applied to ITC here.

Warm regards,

Rahul Shah
Rahul Shah
Editor and Research Analyst, Profit Hunter

PS: Tanushree Banerjee just published a guide to potentially enormous wealth: The Explosive Rs 4 Lakh Crore Opportunity. Get access to this new guide here...

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1 Responses to "The 'Seedhi Baat, No Bakwaas' View on ITC"

Ajit

Oct 13, 2020

Very sensible observations and reasoning. Thanks for the post.

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