Starting Valuations Matters !!!

Reasonable starting valuation - minimizes risk and maximizes potential returns

Like many retail investors, I began my investing journey by purchasing random stocks I found online. Some performed well, others performed poorly, and some did nothing at all. I made many mistakes and learned from them over the years. These mistakes always prompted me to analyze why some stocks perform well while others do not.

Over the years, I read books and watched many interviews of Indian share market veterans like Rakesh Jhunjhunwala, Parag Parikh, Sunil Singhania, Samir Arora, Manish Chokhani, Samit Vartak, Jiten Parmar, Madhusudan Kela, Basant Maheshwari, Raamdeo Agrawal, Vikas Khemani, Sandip Sabharwal and many more. I also followed some excellent stock pickers like Ishmohit Arora (SOIC), Kumar Saurabh (Scientific Investing), Kedar (Congruence Advisers), Lalit Rathi (LKR Advisors) and others.

One common thing across these books and interviews was - Starting Valuation Matters !!!

Everything has price & beyond a point, you can’t just keep paying any valuations to stocks.

From 2018 to 2021, we witnessed a very interesting bull market in large-cap stocks. These companies were good then and are still good now, but why are they not performing well in this ferocious bull market? We have seen many cases over the last 4-5 years where good quality businesses are going nowhere, and stocks are just consolidating in a range while the rest of the market did exceptionally well.

Answer lies in Starting Valuations.

Good Business + Bad Starting Price = Bad Investment

In one interview, Manish Chokhani sir gave the example of Infosys from the 2000 era, where it was trading at a PE ratio of 322. From its peak PE, the stock fell 85% over the next 18 months and took almost 6.5 years to reclaim its previous high.

A similar thing happened with HUL, which took 11 years to reclaim its previous high.

There are many examples where both the business and management are good, but if we pay unreasonable starting valuations, it's very difficult to make money.

We are seeing a ferocious bull market over the last 3-4 years, but some high-quality large-cap stocks have done nothing. These are some of India's best companies with the best management, but still, these stocks have generated no returns in the last few years.

• Kotak Bank: In October 2021, the stock was trading at 5 P/B and has since derated to 2.8 P/B, generating no returns in the last 4 years.

• Asian Paints: In January 2021, the stock was trading at 119 PE and has since derated to 50 PE, generating no returns in the last 4 years.

• Hindustan Unilever: In September 2021, the stock was trading at 80 PE and has since derated to 54 PE, generating no returns in the last 3 years.

• Bajaj Finance: In September 2021, the stock was trading at 12 P/B and has since derated to 5 P/B. Despite good earnings growth, the stock has generated no returns in the last 3 years.

"No doubt, these are very good companies with excellent management, but if we pay an unreasonable starting valuation, it becomes very difficult to make money."

There was an interesting article written by Abakkus PMS in 2019 titled 'Bubble In Quality.' The exact scenario described in the article has unfolded over the past few years with these high-quality stocks.
Link : https://blog.abakkusinvest.com/the-big-call-bubble-in-quality/

Let’s discuss my own investing mistakes now :)

1)Astral: I started buying it in February 2021 when it was trading around 1150 with a 100+ PE and 13 times price-to-sales. Over the last 3.5 years, the company has posted moderate growth and is now trading at 1850 with a 90 PE and 9 times price-to-sales. In this bull market, the stock has generated a 60% gain in 3.5 years and is trading in a range.

Good Business + Good Management + Overpaying + Medium Growth = Time Correction

2)Aarti Industries: I started buying around September 2020 when it was trading at 40 times PE with decent growth. However, growth slowed down due to factors like China dumping. Over the last 4 years, the stock has generated no returns and posted low or no growth.

Cyclical Business + Good Management + Overpaying + Low to No Growth = Price Correction

3)Sona BLW: I started buying around Aug 2021 when it was trading at 100+ times PE with 20-25% growth. Company keep on posting good numbers with strong orderbook and reached all time high in Dec 2021 with 200 PE and since then its been 3 years, the stock has generated no returns that too when company is posting good numbers. Because of good earnings, PE reduced from 200 to 60 times now and stock is trading in same range.

Newly listed IPO + Good Management + Overpaying + Medium to high Growth = Time Correction

Because of overpaying, I made many more mistakes over the years, but I hope these examples set the context for why valuation matters.

Basically,You can buy BEST quality business with BEST Quality of Management and still you can generate poor returns by paying unreasonable starting valuations.

Interesting case of sustaining overvaluation :

There are many examples where high valuations are sustained for some time. The common trend in such cases is:

Sector Tailwind + High Growth + Bull Market = High Valuation Can Sustain Until High Growth Comes

Examples: Dixon, Kaynes, Dmart, PGEL, Trent, Safari,Zomato etc.

If you are paying high valuation to any business then you need to ensure company is going to post very high growth in coming time. You can't keep paying high valuations to medium or low growth businesses because if you do, you open yourself to two possibilities: either market will hit you by price correction by bringing price back to mean OR market will hit you by time correction which will bring your euphoria down and test your patience levels to the core.

Both Price & Time correction are very difficult to digest and very few people able to go through this journey successfully.

Different Cases of Growth & Valuations :

A) Good Business + Good Management + Overpaying + Low or Medium Growth = Time Correction

B) Mediocre Business + Mediocre Management + Overpaying + Low or Medium Growth = Price Correction

C) Good Business + Good Management + Reasonable Starting Valuation + Low to No Growth = Time Correction, with potential rerating when growth comes

D) Good Business + Good Management + Reasonable Starting Valuation + Decent Growth = Price Appreciation

E) Good Business + Good Management + Reasonable Starting Valuation + High Growth = Earnings Growth + PE Rerating = Potential Multibagger

Building a Safety Net :

To make money from stocks, we need either earnings growth or PE rerating. If we get both, we could be sitting on a multibagger.

1. Earnings Growth: The company posts strong numbers with high growth.

2. PE Rerating: The perception of the company changes, and investors are willing to pay higher valuations for future growth.

Out of these two, we can try to roughly guess earnings trajectory. Beyond a point, no one can predict how much PE rerating/derating can happen. Since we can't predict how much PE rerating or derating will happen, better to focus on building safety net by buying stocks at reasonable starting valuations.

This way, we give the stock an opportunity to witness earnings growth and PE rerating. In the worst case, if growth doesn't come, we won't face drastic corrections and will likely witness time correction.

If you join the party very late and at extremely high valuations, it's very difficult to make money because the company needs to keep posting very high growth to justify those valuations. As soon as growth stops, the market will start derating the stock.

Room For Error :

The wisdom in having room for error is acknowledging that uncertainty, randomness, and chance—“unknowns”—are an ever-present part of life. The only way to deal with them is by increasing the gap between what you think will happen and what can happen while still leaving you capable of fighting another day.

In investing, PERFECTION is a MYTH. No strategy is foolproof, and you will fail sooner or later in different market conditions. We are playing a game of probabilities. You will win some, lose some, and miss some. Beyond a point, no one really knows how much any stock will go up or down.

As investors, our job is to maximize returns, minimize risk, and find the best possible companies with the probability of making money. In a game where we know we will make mistakes sooner or later, it's good to give yourself some room for error. If you're lucky, you'll make a lot of money, and if you're wrong, you won't lose much.

AND this is the reason most of experienced investors always focus on Buying stocks at Reasonable Starting Valuation.

Disclosure: I am not SEBI registered. The information provided here is for education purpose only. Hence, always check with your financial advisor before acting on any contents of this newsletter.