Investors who have ignored the latter (chosen to “buy at any price” or become “value” investors) have had to pay a heavy price. Let me start with the chart below.
The chart above presents the growth in market capitalisation of Nifty members over the past two decades divided into (a) market cap growth due to growth in earnings and (b) market cap growth due to rerating in valuations.
For example, (HUL)’s EPS has grown at a CAGR of 8% over the past two decades. Had its market cap grown at the same rate, it would be Rs 2.4 trillion today. In comparison, ’s market cap today is Rs 5.4 trillion. Rerating in valuations is responsible for 56% of HUL’s market cap growth.
% of growth in market cap and the balance 40% is driven by re-rating of valuation multiples.
Change in the valuation multiples for individual companies generates an even more pronounced result. Let us take the case of two companies – Coca-Cola and Hindustan Unilever.
In Cycle 1, Coca-Cola’s net income grew three times, but its share price grew over 10 times. In Cycle 2, net income was still growing (up 64%), but its share price corrected by 37%. In Cycle 3, net income growth and share price growth are more in sync.
HUL is similar. In Cycle 1 (which lasted eight years), its EPS grew 58% but its share price growth was zero. Over the next 13 years ended 2020, its earnings grew a little over three times, but its share price grew over 10 times. In Cycle 3 that began two years ago, the stock returns have been close to zero again.
Both companies were always great, but share prices were exuberant in one cycle and delivered zero to negative returns for many years in another cycle. Valuations matter and, as consumers, we know it. For example, I believe that iOS offers better security than Android. Consequently, I am happy to pay a premium for an iPhone compared to a Samsung phone. But would I buy an iPhone if it were priced 10 times the cost of Samsung? No. But how much premium am I (or others who subscribe to my theory) willing to pay? It is subjective, and precisely that divergence in views creates the market.
And since subjectivity is hard to quantify, you can’t weave a story around it. But “narrative” sells. That forces many investors to err by choosing a camp.
Some fall in the camp that “a good company is a great investment at all points”. Colloquially, we call them BAAP (Buy At Any Price) investors. When you can create a narrative of it being a great company with huge moats, it is difficult to argue that 80 times PE is expensive, and 60 times was not.
Others decide to buy only companies that are cheaply available and have decent dividend yields (who we call value investors). As we see from the chart below (that compares Russel Value and Russel Growth indices), this approach also leads to years of underperformance.
What is the solution then? Let me propose a new method of approaching valuations — one that deals with common sense. I assume that an investor understands the business of the company that she is buying (if that doesn’t hold, then maybe you should reconsider direct equity investing).
Let us then apply the filter of “reasonableness” to the decision of whether to buy a business or not. Based on the current market price, what assumptions of growth in cash flows are you required to make to justify the desired upside? Once you have the answer, let us then see if these assumptions sound reasonable. If the penetration of a certain great quality business is 90% and it has grown its free cash flow (FCF) by 15% over the past decade, and the market prices imply 20% growth in FCF for the next decade, we label these valuations as “outlandish”. That way, we don’t have to decide if 150 times PE is too little for this beautiful business with huge moats.
This approach may not appear intuitive (“buy great companies at any price” is such an easier narrative), might not sound scientific (no PE ratio, EV to EBITDA that we can debate at parties), and is not easy to execute (when markets are running on steroids of a particular theme — like buy quality companies in 2019, or tech companies in late 2021, you will be unable to participate and will witness others make huge money before the bubble bursts).
But the approach works. It is like when a patient with a headache consults a doctor for a diagnosis and care. Brain surgery will reveal the most accurate reason. But the doctor, often, will just send the patient back with aspirin and advise a good night’s sleep. The investment community can benefit if all of us are a lot more reasonable, and a lot less reliant on “easy-to-understand” false narratives.