»Profit Hunter by Equitymaster

On This Day - 23 JUNE 2021
Why I Haven't Recommended Any Adani Group Stock Yet

Rahul Shah, Editor, Profit Hunter

Adani group stocks have had a fantastic run over the last 12-15 months.

Just to put things in perspective, leave aside the current controversies for a minute and consider this...

Even the worst performing Adani group stock - Adani Ports - has done better than the BSE Small cap index, the best performing benchmark.

Adani Ports is up 180% since March 2020 lows as compared to 160% gains achieved by BSE Small Cap.

Also, the best performing group company - Adani Total Gas Ltd - has managed to do in 1 year what the Sensex can perhaps achieve in 20.

Even after the recent correction, the stock is up an incredible 14.6x since the lows of March 2020.

Other group companies have also done well. Adani Enterprises, Adani Power and Adani Transmission, have all seen their market values go up by 10.8x, 4.1x, and 6.5x, respectively.

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Little wonder, the Adanis are now among the richest people in the world.

I have chosen to stay out of this wealth creation opportunity though.

I haven't recommended a single Adani company to my clients since this big market rebound.

The reason for this is in the table below.

Adani Group: Is the Hype Justified?

Parameters Adani Enterprises Adani Ports Adani Power Adani Total Gas Adani Transmission
Earnings Trend (Rs/share)          
FY14EPS 20.2 8.4 -0.7 1.9 -
FY15EPS 17.7 11.2 -2.8 3.7 -0.1
FY16EPS 9.2 14.0 1.7 3.2 3.3
FY17EPS 9.0 18.9 -16.0 3.9 3.8
FY18EPS 6.9 17.7 -5.5 6.3 10.4
FY19EPS 6.5 19.3 -2.6 2.1 5.1
Valuation ratios          
Earnings Yield (%, based on avg EPS betn FY14 & FY19) 8.4% 5.9% n.a. 4.1% 2.0%
PBV ratio (x, 31 Mar 2020) 4.0 2.6 1.5 6.4 13.6
Business Quality          
Avg ROE (%, last 5 years) 4.1 20.1 -108.7 20.1 18.7
Avg D/E (x, last 5 years) 1.1 1.3 -27.4 0.7 3.7
Source: ACE Equity, Equitymaster

You see, just as a bond has a coupon and a fixed deposit has an interest rate, a stock has an earnings yield (inverse of the PE ratio).

An earnings yield of 6% means that the company has an EPS of Rs 6 per share and is trading at Rs 100 in the stock market.

Now, you want your earnings yield to be at least equal to that of fixed deposits or bonds if not more.

I normally prefer an earnings yield that's at least 50% higher than fixed deposits. So, if fixed deposits pay 6% interest, I want the earnings yield to be at least 9% if not more.

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It's important to base your earnings yield on average EPS over the last few years than a single year.

Average earnings over multiple years is a better representation of the true earnings potential of the company.

This way, I am protected with a margin of safety. So, even if a company records a 20%-25% fall in earnings, my earnings yield is still equal to or slightly greater than the yield on fixed deposits.

If you look at the table, only Adani Enterprises had earnings yield significantly greater than the 6% fixed deposits that banks are giving these days.

Its earnings yield stood at 8.4% based on the average EPS of the last 6 years.

All the other companies had yields significantly lower than the interest rate they were getting on competing asset class i.e. fixed deposits.

However, I wasn't quite happy with the business quality of Adani Enterprises.

Its average return on equity was a poor 4% for the last 5 years and it also had debt that was higher than equity on an average.

You see, I don't want my companies to earn a return on equity (ROE) of 35%-40% on a consistent basis. Very few companies are capable of doing that.

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For me, even a consistent ROE of 12%-15% just fine provided it's accompanied with low debt on the balance sheet. The debt to equity ratio should always be less than one.

Therefore, I go further with my analysis and try to dig deeper into the stock only if all the three conditions are met i.e. a good earnings yield, a reasonable return on equity and a conservative balance sheet.

None of the Adani group companies seem to meet all three of these conditions back in March 2020.

All the Adani group companies failed my valuation as well as business quality parameters back in March 2020.

So I decided against recommending them to my subscribers.

It can very well be argued that companies are valued based on the earnings they will generate in the future.

The reason the investors are so gung-ho about these companies is because all of them have a very bright future.

Well, that's a game that I don't prefer playing.

I like to recommend companies where I am getting enough bang for my buck right from day one. I want to see the companies maintain at least their historical earnings power if not exceed it.

However, these attributes seemed to be absent in the case of Adani group companies. I was being asked to shell out a hefty premium for earnings that these companies were likely to earn in the future.

And I wasn't comfortable with that.

These companies did not fit my circle of competence as Warren Buffett likes to call it. Therefore, I decided to give them a miss.

This doesn't mean I won't recommend these stocks at all. I certainly won't mind recommending them in the future provided they fulfil all the criteria I have laid out.

It's just that they don't seem to be doing so at the moment.

What do you think? Do you agree with me or do you believe there's a strong argument to be made in favour of investing in these stocks?

Let me know.

Warm regards,

Rahul Shah
Rahul Shah
Editor and Research Analyst, Profit Hunter

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