When S Naren saw the annual report of Laxmi Machine Works, a company involved in manufacturing of textile machinery, he noticed that its market capitalisation was equal to the cash available on the balance sheet. The company had an order book for five years. It made huge cash profits, but was somehow ignored by the market.
Naren bought the stock. The year was 1989, and according to him, it was the first equity stock he had purchased. The stock price was INR400 and the price-toearnings (P/E) ratio stood at 2.3x. In the next five years, the stock went up 35 times to trade at INR14,000. Naren is the executive director and chief investment officer at ICICI Prudential AMC. This incident has been described in detail in the book, How Fund Managers Are Making You Rich.
This is an example of classic value investing. That’s how fund managers across the world invested — they looked at bargains in the stock market. India was no different. In fact, almost all fund managers here have considered themselves as value investors and revered Warren Buffett as their guru. While value investing has worked largely for most long-term investors, the style got a drubbing after 2008.
The new-age investors
By the virtue of being an emerging economy, India has been a growth market and value investing as a term has been used interchangeably with fundamental discretionary investing, long-term investing, and quality investing. If any stock can be sold or fitted among certain parameters, it becomes a ‘buy’ and ‘hold’ stock. However, even for the most successful investor in the world, there is nothing like ‘buy’ and ‘hold’ forever. The ‘forever’ implies if one is into discretionary investing.
However, the post-2008 world has seen the emergence of BAAP (buy at any price) investors. Some investors have quietly changed the definition of buying value or below a certain valuation threshold to buying quality at a reasonable price (QARP). Some are willing to buy quality at any price.
Consider the P/E multiples of the following stocks:
- Hindustan Unilever — 80x
- Asian Paints — 100x
- Titan — 191x
- Avenue Supermart — 250x
Conventional wisdom suggests these are highly valued stocks and investors should ideally avoid them. If you are a value investor (one who looks at bargains in the market for stocks available at a discount to their intrinsic values), you are going to take your pillow and hide under the bed as you expect these stocks to crash in near future.
But then the classic value investor, who was into cigar-butt investing, has changed his ways. Partly because there are no bargains in the market or because buying bargains also means high risk. An example is the cigar-butt investors who bought Yes Bank as it fell from its high. In this case, no institutional investors touched the stock and retail investors thought they were buying value. The stock went down from INR393 in August 2018 to INR60 — a fall of 85% in one year.
Institutional investors are now aware that markets are becoming good at pricing risk. Today, fund managers are ready to buy stocks with good fundamentals at any price. They call themselves quality investors. This transition happened after the 2008 financial crisis when the US market decided to cut interest rates, which reduced the cost of capital for some companies and they were able to become monopolies.
These companies started to trade at high valuations. No matter what your call was, their P/E kept expanding. Quality investors argued that there is nothing wrong in it. They felt that cash flows of these companies are growing and thus they deserved high a P/E.
The quality pick
Consider the below conversation:
Noob: Sir, can we buy HUL, Asian Paints, and Nestle at 80-90 P/E?
Furu (FinTwit Guru): P/E is passé, bro. Just look at FCF (free cash flow) compounding. They are compounding at 20% per annum. These are one-decision stocks. You just buy them.
Noob: But sir, what if multiple contracts in the next five years?
Furu: FCF compounding, bro. These are stocks for generations. Is anyone going to stop having a bath or eating Maggi or painting their home? Nothing will change in these industries and these are going to be forever. Diamonds, bro
Noob: Sir, for almost a decade in the 2000s these stocks didn’t go anywhere.
Furu: Too many questions. We want to give everyone a chance to ask their questions.
Noob2: Sir, can we buy HUL, Asian Paints, and Nestle at 80-90 P/E?
Let’s look at this from the point of view of a die-hard quality investor.
Businesses such as Pidilite, Asian Paints, HDFC Bank, et al. have three things going for them:
- FCF
- Ability to redeploy FCF
- Ability to enter adjacent areas and sustain growth momentum
Unlike what Bob Kirby outlines in his Coffee Can paper, in practice no one can manage money or invest the way Kirby’s client did. I don’t think even his ardent followers and practitioners do that. They weed out stocks that are notable to grow in a rapidly changing environment. They keep a concentrated portfolio and a close eye on the eggs in the basket. The value-add here, maybe, is if they are able to identify when a company is moving from a quality compounder to a quality trap. An example of that is ITC.
The Quality Furus are betting on a portfolio of 10-15 stocks with low turnover. They assume that about half the portfolio will be able to do all three of the above — generate healthy cash flow, redeploy it at attractive returns, and enter adjacent areas successfully and continue to grow. The other half may deliver market returns or lower. And the portfolio, as a whole, delivers above-market returns with low volatility and turnover.
Sounds good. But if starting valuations are nose-bleeding high, not just on P/E basis but also on a price/cash flow, then what does it take to make it an attractive proposition? Already, the original metrics of the quality portfolio are not working too well currently. If those metrics are run, they would throw up only two names. Hence, one needs to go back and tinker with the original algorithm and admit that it had been curve-fitted or narrative-fitted. So, why has quality captured the imagination of value investors over the last decade? Why have value investors segued into becoming quality investors? Most don’t have the Warren Buffett problem of size. They don’t need elephant guns. It’s simple — value hasn’t performed as well as it did before 2008.
Value erosion in the post-2008 world
Investors buy growth businesses at a high P/E (or low profits) as they believe they can make money in the future. Value investors buy value businesses at a low P/E with the idea of making money in the near future. However, in inflation, money today is more important than that in future due to higher interest rates. It also means prices are going up and companies that have the pricing power will be able to rule.
Schroders, an investment manager, gives a good example. “If you were to spend GBP100 buying into a value business on a P/E ratio of 5x, say, that multiple suggests your shares should make GBP20 a year in profits, and so you will ‘get’ your money back after five years. In contrast, a growth business is likely to have a high P/E ratio, which means low profits today, but growth investors pay up in the hope of making their money in, say, years 16 to 20 rather than the first five. In financialspeak, that makes the value business a ‘short-duration’ asset and the growth business a ‘long-duration’ one.”
Companies in the business of infrastructure, real estate, and commodities tend to make big profits because they can price their products high in an inflationary environment. During deflation, growth companies like software and technology do well as they can afford to keep prices reduced and grab market share faster. Markets are pricing fundamentally strong stocks with monopolistic pricing power and good cash flows at high P/E or high price/cash flow multiples. Here, the distinction between quality and value fades.
We looked at the value and quality indices over the last 15 years to understand this better.
Value has been thoroughly beaten by growth/quality in the post-2008 era. We looked at the base rates of three-year rolling returns for three periods — 2008- 2012, 2013-2016, and 2017-2021. The numbers tell the story.
Over the entire period of 2008-2021, quality beats value on a three-year rolling return basis 64% of the time. However, look at the numbers when we break it down. In the first four-year period, quality beats value only 37% of the time. In 2013 (which would have returns of 2013 over 2010), quality beats value 70% of the time and during 2018-21, it beats value 83% of the time.
What is driving this?
Investors were still suffering from the 2008 trauma. The mantra in the new era was to go for quality, avoid companies that have debt, have stable cash flows, and the belief that not much of the industry will change in the event of a “one in a hundred years” crash. No surprises that HUL woke up from a 10-year slumber. Defensive sectors like FMCG and pharma took off along with other consumer quality names like Astral and Relaxo. Today, investors are hoping that ITC does that.
But why didn’t this phenomenon correct after five years or so post the 2008 crisis? Well, it did. If you look at the rolling-returns graph. Value made a comeback after 2016. But quality did not correct as much. Then, there was demonetisation, Donald Trump’s victory, GST, and the 2018-end mini crash. Finally, the pandemic hit. Value stocks, which are usually economy-sensitive, were hit more than defensives. However, after the vaccine roll-out, value has caught up with quality. The spread between three-year rolling returns is now a mere 4% as against 31% in the past. But that is a 2021 phenomenon as we will see later.
Abakkus studied the performance of quality stocks in its research paper called The Big Call – A Bubble in Quality. It looked at 27 prominent stocks with high P/E ratios. The conclusion was that most of these companies would have to trade at 50x-75x P/E to earn 12% return over the next nine years. And a reverse discounted cash flow (DCF) showed that 30-40 years of consistent growth would be needed to affirm current valuations.
What it didn’t go into though was the FCF compounding and reinvestment part, which the Quality Furus swear by. However, what one cannot deny is that investors are paying an extraordinary premium for growth and quality companies today — not just in India but globally, too.
Chasing valuation
The mean valuation for the current decade in Indian markets has been in the region of 23x trailing returns, against 17x for the previous pre-quantitative easing decade.
Incidentally, 17x is what we have seen at the bottom end of the range after 2008. Valuation-driven investors, who were looking for bargains and anchored to the previous decade, were left waiting for a long time and perhaps are still waiting for valuations to revert to their levels in 2000s.
This was also the time many discretionary valuation-driven investors like Seth Klarman were waiting for a reversion to mean valuations and expected that when the US Fed unwound its massive quantitative easing (QE) programmes, the tide would turn. It has not happened yet, and I wouldn’t hold my breath hoping for it to happen anytime soon. Buffett, meanwhile, made his big bet on Apple and it has turned out to be a monster winner for him.
Have financial markets adapted to excess liquidity? Have we bought into Modern Monetary Theory (or monetary sovereignty) as the new normal? The laws of economics cannot be suspended forever is what someone said about China. And this seems true for the world too post-QE. However, whether cryptocurrencies disrupt this and bring down the dollar as reserve currency remains to be seen.
The bottom line
Value investing still exists. It exists in the private markets where investors are betting on loss-making companies, expecting them to grow bigger over time. But the private-equity manager has a low probability or success ratio. He will have to take more bets to be successful. Value investing will also exist in small-cap businesses where some investors will bet on companies that they expect to become big. In both cases, investors will be betting on the quality of promoters and their stories.
Meanwhile, there is another style that has gathered ground wherein investors are simply betting big on things that keep going up and getting out of stocks that keep going down. That is basically the momentum style of investing where only the movement of the stock price matters. Investing styles change, but as the saying goes “bhav bhagwan che” (price is God), which leads us to say, “momentum, quality no baap che” (momentum is the father of quality and a number of other factors). Think about it, ultimately every long-only investor, irrespective of their style of investing, makes money when stock prices go up.
In 2010, an elite group of economists along with investors and political strategists wrote an open letter to the US Federal Reserve chairman Ben Bernanke. Notable among the names were Seth Klarman (Baupost Group), Cliff Asness (AQR), Jim Chanos, (Kynikos Associates), Niall Ferguson (Harvard University), James Grant, Paul E Singer (Elliott Associates).
They wrote, “We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalise monetary policy”. Eleven years later, the US is still searching for inflation. Yes, we have some this year but it’s being labelled “transitory”. However, have the rest of the concerns been proven to be valid? Have financial markets been distorted? It seems valuations no longer matter.
(The author is the managing partner and principal officer at QED Capital Advisors.)
(Graphics by Manali Ghosh)