Bubble In Quality?

Over the last couple of years, global economy and equity markets have seen enhanced volatility. A combination of global factors, protectionism, political uncertainty, record low bond yields, disruptions and new business models, massive Private Equity funding and the likes have led to polarised market behaviour. In India, another phenomenon experienced is the cleaning up of crony capitalism, liquidity related issues, corporate governance questions, increased banking non-performing assets, etc. The independence of auditors and rating agencies, apart from other fiduciaries have also been questioned, leading investors to become extra cautious.

All the above has led to a unique phenomenon: A bipolar market where the concepts of consistency, quality, stable earnings, low volatility and perceived safety have done disproportionately well while the other side of the markets languish due to investor apathy. A recent report by Goldman Sachs also highlights that an index of "stable earnings” US companies is now trading at all-time high 65% premium to 'volatile growth companies. Similarly, globally, outperformance of Growth vs Value Stocks has had the strongest and longest run in the last 10 years or so since 1970 (MSCI World).

Being an intrigued investor and always willing to learn, the current performance of some of the “quality" stocks had us thinking. Based on all traditional metrics, these stocks seem to be extra-ordinarily expensive and therefore logically, not in our investment shortlists nor in our portfolios. We, at Abakkus, were not convinced about their valuation a few months back, too, and with their recent up moves, they have become more expensive. We got together to introspect what we were missing that other smarter investors understood and we did not. And that is where a very detailed study, analysing most of these stocks started.

We made a list of the current high P/E stocks as a start. A very detailed analysis and number crunching followed. Yes, it is said that stock investing is an art. It can never be only numbers and financials and there must be some qualitative & future growth perspective to it. But ultimately, every valuation methodology has one underlying principle: the value paid today should justify future earnings potential of the company.

Our analysis:

We made a list of a few prominent perceived high-quality expensive listed Indian companies.

The Revenue, EBITDA and Net profit growth of each of the companies was tabulated from FY10-19. We also analysed the same growth over three & five years to clear the notion that near-term growth for such companies has been higher and therefore the high valuations.

We analysed the nominal GDP growth for India during this period, as logically superior companies should grow at a much higher rate than nominal GDP. Also analysed was the CPI inflation during the last nine years. Most of the companies selected are consumer-facing companies and sales growth for each one of them is a combination of inflation and volume growth. 

Natural deduction follows that given the much lower inflation now in India, nominal GDP growth for the next 9 years should average much lower than the last 9 years, even presuming a similar real GDP growth rate of 7%+. It is also natural to believe that the penetration levels today of most of these products is much higher than what it was 9-10 years back and hence the growth for the next few years should be lower than what it was over the last few years. Nonetheless, we are presuming that all the companies in our universe of study will grow at the same pace over the next 9 years as they have over the last 9 years.

Extrapolating it further, we have built scenario analysis of return expectations from these stocks.

E.g. HUL has grown its revenue at 9% CAGR and net profit at 12% CAGR in the last 9 years (See: Where is the superiority?). This also has to be seen in the light of a nominal GDP growth of 13% during the same period, implying a growth for Hindustan Lever of less than the GDP growth. Inflation during this period has been 7%, thus revenue growth net of inflation is only 2%.

Even if HUL's profits continue to grow at 12% CAGR till FY28, its P/E in FY28 will have to be 55x for mere 10% annual share price return and 82x for 15% annual share price return. Similar projections were done for all the other companies under the study (See: Point of no return).

Startling Insights

1. Out of 27 companies in the study, in the last 9 years

    • Average annual Profit, EBITDA and Revenue Growth has been 11%, 12% and 12% respectively

    • 6 companies have grown profits at less than 5% CAGR

    • 7 companies have grown revenue at less than 10% CAGR

2. 18 of the 27 companies need to trade at P/E more than 50x in FY28 for 12% annual return

3. 7 companies out of these need to trade at P/E of higher than 100x in FY28 for 12% annual return

The reason attributed by analysts and investors in favour of these high P/E companies has largely centred around stability of earnings and much superior growth. A few market participants whom we spoke to justified the high PES as they believed that these companies were growing at rates of 20-25% every year.

However, surprisingly most of the companies have grown in line or around the pace of nominal GDP growth. In fact, a few companies have not even kept pace with the nominal GDP growth. Colgate India for e.g., has grown revenues at a CAGR of 10% and Profit at a CAGR of 7% over FY 10-19. One important reason presented for the high P/E ratios for these companies is stable and higher growth This data of growth is not too different than nominal GDP growth, thus making the argument of 50x-75x P/E multiples based on higher growth untenable.

We can see the implied P/E ratios, which these companies should trade at in FY28 to generate 10%, 12% and 15% CAGR returns over the next 9 years. Thus, for Asian Paints to yield the investors a return of 10% CAGR over the next 9 years, it will have to trade at a P/E of 71x FY28 earnings and for a 15% CAGR return, the P/E will have to be only 106x FY28. Similar data is extrapolated for all the companies under study. We don't think anywhere in the world at any point of time, companies have traded at P/Es of 50-100 for 10-15 years at a stretch. 

Why have these companies traded at such expensive multiples and what is the reason for their continuing near-term outperformance?

The reason for continued overvaluation of these companies is skewed investment inflow to these large cap companies over the past 4-5 years. As can be seen in (See: Finding favour), incremental domestic flows that were invested into the top 100 listed companies used to be only 31% of total flows in 2013-14 that have now risen to a whopping 84% in the top 100 companies and 96% in the top 200 companies. On the Foreign Portfolio Investors (FPIs) front, till June 2014,48% of their investments were in top 100 companies and 77% were in top 200 companies. This has now risen to 88% in the top 100 companies and 96% in the top 200 companies.

The trends of institutional investments, both domestic and foreign clearly indicate that investors have focused only on the larger companies irrespective of valuations, while ignoring the broader markets even though there is a big valuation gap. Few of the reasons for the same might be:

1. Flight to Safety: In an environment of volatility, fear and uncertainty, these companies have presented some growth and no negative news flow. Thus, investors have been comfortable adding these stocks to their portfolio as allocation bets.

2. Inclusion in Index and Passive Funds: The outperformance of these stocks in absolute basis and significantly on relative basis has led to a surge in their market capitalisation. The increase in market cap has led these stocks to be included in multiple indices, both in India as well as global indices like FTSE EM and MSCI. In an era of passive investing gaining ground, more inflows in passive funds has led to more buying in these stocks irrespective of valuations.

3. Regulatory Classification: In India, the reclassification of funds initiated by regulator, SEBI, has led to most of the mutual fund inflows moving to the top 100 companies.

4. Self-fulfilling cycle of pyramiding: Since these stocks have done relatively very well, funds that own them have done well over the last 2-3 years. Near term performance attracts more money and then the funds buy the same stocks again. Thus, it's a self-fulfilling cycle of buying performance, flows and more buying in the same stocks.

Why we believe that these companies will give no, low or negative returns over the next 5-10 years?

All-time high valuation. To make even 10% CAGR returns, the companies will have to trade at P/E ratios of 50-75x in FY28.

There have hardly been companies in the global markets, which have traded at multiples of 50-75x for periods of 10-15 years. In fact, we found that very few companies in US have traded at P/E over 50x for even 5 years cumulatively since 1990 even though this period included dot-com bubble' and 'subprime crisis’.

Modern trade and e-commerce are making competition in a lot of these segments much easier and funded by risk-taking Private Equity funds.

Our view is very clear: unless the growth expectations of these companies over the next few years goes up significantly there is absolutely no fundamental justification for these valuations to sustain.

There have been many instances in India itself, where the same companies or similar companies have seen no or negative returns over long stretches of time e.g. HUL between 2000 and 2010 or recently even companies like ITC, Castrol and Page Industries.

While it is difficult to foresee what will cause these companies to underperform, history has shown that something happens that pricks the bubble balloon. 

What can cause our conclusion to go wrong:

• In the near term, risk aversion may lead to more flows being invested in the clean, safe, "quality" basket.

• A company or few of them may surprise on growth being much higher than that over the last few years.

This is an excerpt from Abakkus' report 'The Big Call - Bubble In Quality?' You can read the whole analysis here.