Warren Buffett is a great role model for value investors everywhere. I, however, have been asked to write on just one lesson from Buffett that would particularly apply to investors — both local as well as foreign — in Indian stocks. Having practised value investing in India for the last 19 years, and taught it for the last 12, I came up with this. 

Pay up for quality

Flashback to March 1992. Harshad Mehta has lifted Indian markets to stratospheric levels and a company called Nestlé India is selling at a P/E multiple of 68 and 9 times book value. Crazy expensive, no? Now, imagine you had bought it at that crazy price level and held it till now. How much money you would have made? My workings show that you’d have earned 20% a year. Indeed, you would have done very well over the long term by buying that stock at virtually any price level and then never selling a share (see: Nestlé India: Buy and hold returns).

The reason for this astonishing performance is not hard to work out. The stock currently sells at a P/E of 45; so for the investor who bought it in 1992 at P/E of 68, the return did not come from multiple expansion. Instead, it must have come from earnings growth and indeed it did. In FY92, Nestlé India had revenues of about ₹500 crore and profit after tax of ₹23 crore. For FY11, the revenues had soared to ₹7,500 crore and profit after tax to ₹961 crore.

Did the fellow who paid 68 times earnings for Nestlé India in 1992 overpay? If he had, his long-term return should have been poor, right? But that didn’t happen. It didn’t happen because even at a P/E of 68, the growing earnings stream the company would deliver over the next two decades was not being fully factored in that “crazy” price. So, perhaps the fellow who bought it at that price was not that crazy after all.

It seems to me that Indian stock markets have systematically undervalued Nestlé India by ignoring its long-term growth potential. But, you ask, how much more can Nestlé India grow? I will let you dwell on this by providing you with a few data points.