»Profit Hunter by Equitymaster

On This Day - 26 JULY 2021
Asian Paints and the World of Irrational Exuberance

Rahul Shah, Editor, Profit Hunter

Last week, Tuesday to be precise, Asian Paints climbed 6% in a day.

The jump was significant considering the large size i.e. marketcap of the company. It also came on a day the Sensex closed negative. That made it even more noteworthy.

The buoyancy in the stock was due to the quarterly results announced the same day.

On a year on year basis, the company has put up a stellar show. It saw an impressive 160% growth in its profit. This was on the back of its revenues almost doubling.

For Mr Market, these two numbers were enough to conclude that the performance was stellar and the company's stock needs to be rewarded accordingly.

However, a closer look at the financials reveals something entirely different.

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The stellar show has come on a significantly lower base. It's largely a result of a below par performance during the same quarter last year due to the lockdowns. Thus, the performance this quarter was nothing but normalcy being restored.

In fact, what seems to have escaped attention are its low operating margins. Although it has taken price hikes to counter this drop, its ability to grow volumes in a tough environment will be thoroughly tested.

Ok, maybe I am reading too much into this.

But was this irrational exuberance justified? Especially when the stock is trading at a lofty PE multiple of 85?

I agree that it's one of India's best franchises. In fact, my research tells me that it's a part of the rarest of rare clubs in India.

The company has earned an ROE (Return on Equity) of at least 20% in each of the last 10 years. This makes it one of the only 100 companies in a universe of close to 4,000 to have achieved this feat.

Think of 20% ROE as a fixed deposit that consistently pays an interest of 20% or higher, year after year.

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But does this make the company a buy at any price? I don't think so.

Even Warren Buffett's favourite stock, Coke, was a buy at any price stock like Asian Paints back in 1998.

The stock market was going ga-ga over it and had valued the company close to 100 times earnings. What happened over the course of the next twenty years is a perfect case study on why it's always better to ask 'how much' when it comes to investing.

Coke never touched the same stock price again for the next 20 years. Yes, you read that right. Those who invested in Coke back in 1998 had to wait for a couple of decades just to break even.

Does a similar fate await India's largest paint company? Maybe not.

But I certainly think the investing in the stock at current valuations has perhaps a limited upside potential but a significant downside risk.

Of course, those who invested in the stock a few years back, when the valuations were attractive, can perhaps keep holding on to their positions. Their point-to-point returns few years from now may still look attractive.

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However, I can't say the same for those who are looking to buy the stock at the current valuations.

Even after we take into account the fact that we live in a low interest rate world and that India's best days are perhaps ahead of it.

What do you think, dear reader? Do you think Asian Paints is a 'buy at any price' stock?

Do let me know.

Warm regards,

Rahul Shah
Rahul Shah
Editor and Research Analyst, Profit Hunter

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