Rethinking P/E

Fear of the High P/E

Most often,  we avoid buying quality stocks as we are scared of the high P/Es and end up regretting. Stalwarts like Sanjay Bakshi and Basant Maheshwari have made it abundantly clear that there is no harm in paying up for quality.

One way to get out of the fear of high P/E is look at  PEG ratio, as Peter Lynch suggests. However, PEG typically understates the value of a stock. For companies with strong economic moats, a high P/E might very well be justified and in many cases, is likely to be understating the value. Sanjay Bakshi explains it beautifully in this insightful note , especially the  section where he takes us on a time machine back to 2005 to get a “perfect foresight” to help us in the valuation of Asian Paints.

Can we take this time machine into the future to helps us get “sufficient foresight” to assess whether to buy a high P/E stock or not?

@ 50 P/E – to buy or not to buy

In the last week of June 2014, Page Industries broke out after a short pause (moving within 5700-6700 range for about 2 months) in its long upward journey. It presented me a huge dilemma –  despite its strong fundamentals, is Page a good buy at a P/E of 50 (based on trailing 12 months EPS)?   I did not buy.

Now, it trades at 15k, after peaking at 17k levels. Interestingly, I came to know later that Basant Maheshwari had added more of Page about 6k levels (Probably, it was he who caused the momentum burst).

So, how can one get the conviction to buy a stock at such an apparently high P/E? For that, we need to get a sense of what is the upside potential from the current levels. We can spend hours in building a detailed DCF model to calculate the target price. The key issue here is identifying how long should be the explicit forecast period and how to estimate the terminal price, which typically accounts for over two-thirds of the total company value estimate.

To start with, we can forecast how the company’s EPS can grow in the future and use a target P/E to arrive at a target price for the stock. One of the key assumptions behind this is that the company can sustain the ROE it generated in the recent past.  I have discussed below how we can get “reasonable confidence” that the company can sustain ROE at the recent levels and how can pick a target P/E multiple.

  • Calculate potential EPS growth rate as sustainable growth rate (g)
    • 3-year average ROE x (1-payout ratio)
  • Forecast EPS of the company 3 years further down
    • Current EPS compounded for 3 years at g %
  • Calculate target price based on EPS estimate and target P/E multiple

Page valuation

The idea of this exercise is to get a “reasonably right” price range and help us face our fear of high P/E. In order to gain conviction, we need to look at how realistically can the EPS growth be sustained and also what target P/E multiple should be used.

Dissecting The Sustainable Growth Rate 

We can do a DuPont analysis of ROE to understand how the key driving factors are trending. By understanding how profit margins, asset turnover and leverage have contributed to growth in the past, we should be able to assess how sustainable the current ROE levels would be. A look at the chart below shows that Page has been able to increase its ROE by using the right levers and we can be reasonably sure that the high levels are likely to sustain for a longer period.

  • Profit margins: Increasing / stable profit margins over 3-5 years bode well. Is the competition in the industry intensive? How does the firm’s margins compare with the industry?
  • Asset turnover: Higher the asset turns, the better it is
  • Equity multiplier: Higher ratio indicates higher leverage, which should be avoided

Page - Du Pont

Picking The “Correct” P/E

A useful way to think about P/E is in terms of payback period. How long does it take to recover each rupee I pay for a rupee of EPS? Not surprisingly, high growth companies give you back the money quickly than slow growers.

In the example below, I have used cumulative EPS to calculate the time required to recover for a stock with EPS growing at 10% and another one with 30% growth. Assuming I pay Rs.15 for each stock, it takes about 9-10 years for me to recover full price paid for the slow grower, while it is about 6-7 years for the fast grower. If I bought the stocks at Rs.32, the fast grower would pay it all back in 9 years, whereas the slower one will take about 15 years.

PE rethought

In the previous calculation for finding the target price for Page, I have used the 8 year average P/E. Page has witnessed a P/E expansion over the previous eight years, reflecting improving fundamentals. If we take the 3 year average P/E of 31x, we get a price target of 12,565. Going back to Peter Lynch, if we were to value Page using a fair PEG of 1, we would use P/E of 38 (based on 3 year average EPS growth) in the above calculation, resulting in a target price of 15,400 (using a 3rd year EPS estimate of Rs.405).

Assuming Page makes another breakout, now above 16k levels, would I buy?

I might. As Basant Maheshwari put it eloquently – you cannot buy today’s stock at yesterday’s price.

An important point to remember is that investors generally tend to underestimate the competitive advantage period (CAP) of a company, the time over which the company generates returns above its cost of capital. If we were to assume Page will sustain such high ROEs for 5 years and extend the above target price calculation to 5 year horizon, we would arrive a target of 25,400 (based on 5 year averages – ROE of 63%, payout of 41%, P/E of 38 and FY2014 EPS of Rs.137). This implies a 69% upside from current levels.

Will Page be able to sustain such stunning high growth beyond 3-5 years? That will require much more detailed analysis. Prima facie, it seems it might.

Disclaimer

I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”.

This article is not a recommendation and for educational purposes only. No holdings in Page Industries.

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Rethinking P/E

M.E.D of Investing

How can we minimize the effort required for investing? What is the Minimum Effective Dose (MED) for making money? MED is the smallest dose that will produce a desired outcome. The concept of MED was popularized by Time Ferriss, in the context of physical performance, through one of his best-sellers, Four Hour Body.

A note of caution – MED is not about searching for the holy grail. It is about applying 80/20 principle. It is about selecting the minimum essential aspects that improve the base rate of success. MED is largely about saying NO to a LOT of things. MED, in essence, is more about mind than mere formulas.

Bull’s eye vs. bulls@#t Picasso-The-Bull-Lithographs-1-10

In his tour de force, The Bull (1945), Picasso shows how to cut away the clutter to arrive at the essence of a bull. A commentary on the masterpiece goes “At this penultimate stage, the more complex areas of the line drawing are removed to leave only a few basic lines and shapes that characterise the fundamental forces and correlation of forms in the creature.

When it comes to making money from stocks, most of it comes from increase in prices or capital appreciation, even though dividends return some money. Price changes are driven by multiple factors and the impact of a specific factor on price depends on the time horizon.

Can we tease out the fundamental forces that drive prices, just like Picasso did with The Bull?

Looking for structural tendencies

The key is to find how the patterns, be it prices or fundamentals, that are often repeated in the past. Value investing purists might probably hate the very notion of tracking price behaviour, going by Buffett’s logic.

Games are won by players who focus on the playing field – not by 
those whose eyes are glued to the scoreboard. - Warren Buffett

However, we cannot simply ignore the scoreboard. While the class of a player determines his long term success, his current form also matters. Unless a player keeps the scoreboard ticking, he is not going to win the game. We can identify useful clues to the player’s form by looking at the scoreboard.

Sprint vs marathon

When we search for the essential minimum for making money, we need to be conscious of the time horizon and the context. What should be removed as unnecessary depends a lot on the time horizon we look at. What works in a day’s or week’s time frame is highly unlikely to work for a multi-year period.

We cannot train for sprints and expect to win a marathon. We might win but the odds are pretty low. On the other hand, we need to train differently for long distance running. Even before we start training, we need to be clear whether we want to run a sprint or a marathon.

Sprints: Stock prices seldom move smoothly – they move in momentum bursts. Some of  the structural tendencies of the market work well in the short to medium term. Breakouts (strong price moves on high volumes) after a consolidation tend to work well in few weeks time frame. For example, study the charts of Sun Pharma Advanced Research Company (last two weeks of Jan 2015) to understand how momentum bursts happen.

In one of his posts, Pradeep Bonde (stockbee) explains the importance of studying structural tendencies of markets, which are basically behavioral traits of the market that are enduring. He notes some of the structural tendencies are PEAD (post-earnings announcement drift), momentum bursts and mean reversion.

Marathons: If we are looking for stocks for the long run, we should search for compounding machines. These are companies that can keep generating cash as long as possible. Here again, it is very important to understand the difference between protecting the downside and increasing the  potential upside. This will help us in avoiding value traps. In his presentation on checklists, Mohnish Pabrai crisply summarizes what he learnt from Buffett.

A good investment needs two facets to be in place:

  • Downside protection – Margin of Safety
  • Upside earnings engine – Moat

I’ve often been mesmerized by the strong downside protection and overlooked the all-important moat.

Checklists: A great way to distill wisdom and impose discipline

Once we are clear about the investing time frame, we need to ensure we do not lose the signal as it gets drowned in ever increasing noise. Structurally, the amount of noise is high in the shorter time-frame, making us miss the signal too often. Studying history helps us in fading out the noise and finding the signal. History provides us with keys to assessing the base rates of certain patterns and hence, our probability of success. This would help us in creating checklists to codify the patterns and also disciplining ourselves.

M.E.D of Investing

Getting greedy when others are scared

How can we keep calm, let alone get greedy, when others are fearful, as Buffett asks us to?

Start by questioning our beliefs – about the markets specifically, and the sweet little world, at large, is coming to an end. In order to confront our fears, we need to understand what we believe will happen given a particular scenario. Our beliefs are shaped by our experiences. In the absence of similar experience to guide us, we are likely to join the crowd of chickens running around headless.

Anthony Robbins “What is a belief? It’s a feeling of certainty about what something means. Think of an idea like a tabletop with no legs. Without any legs, the tabletop won’t even stand up by itself. Belief, on the other hand, has legs. To believe something, you have references to support the idea—specific experiences that back up the belief. These are the legs that make your tabletop solid and that make you certain about your beliefs.”

Read history. History gives us stories and people for us to relate to and to remember. Unlike the Mungers and Buffetts of the world, it is far easier for normal people to remember stories rather than just abstractions.  We can easily recall a person that fumbled into or climbed out of a hole that we might be in right now.

Mark Twain History does not repeat itself, but it often rhymes

However, the flip side of such stories  is that boundary between fact and fiction often disappears quickly, resulting in distortion of the morals of the stories. In order to avoid this, it is of utmost importance that we read and build a library of many different stories – some teach you what to do and some, what not to do. It is not enough to read just Buffett and Peter Lynch but also Jesse Livermore. Depending on the situation, we should pick our stories correctly from our library, just like we pick our clothes from our wardrobe depending on the weather. Now, a short case study of my often-encountered situation that I mostly failed.

Fear of the 52-week high

What do you do when a stock that you are watching hits 52-week high or new high? Most often, I refrained from buying as I told myself that its chances of going up are low as it was already at 52-week high or new high. As irrational as it sounds, this has stopped me from getting into potentially profitable opportunities so many times that I lost count. The logic is simple – a stock cannot become a multi-bagger unless it keeps making new highs. A quick question from William O’Neil’s “How to make money in stocks” (yes, as cheesy a title can get! But, IMHO, this book is a must read.)

how does a stock go from $50 to $100?

Ask yourself: What does a stock that traded between $40 and $50 a share over many months, and is now selling at $50, have to do to double in price? Doesn’t it first have to go through $51, then $52, and $53, $54, $55, and so on – all new price highs – before it can reach $100?

(This is related to the concept of “Averaging up” – will most likely post something on this later)

To stand apart from, let alone go against, the crowd, we need conviction. Another wonderful tool to help us avoid biases, including herd mentality, is a checklist. It will help us in asking the right questions. However, remember this.

Conviction will not come from just checklists but rather from the beliefs and stories you associate with the items in your checklist.

To end, another gem from Mark Twain once again.

Whenever you find yourself on the side of the majority, it is time to pause and reflect.

Getting greedy when others are scared

“Boring” businesses = Better Bets?

Investing is essentially about finding asymmetrical risk / returns and compounding them over again and again. As mentioned in the previous post, it helps to think in terms of compounding cycles. How can we ensure such compounding cycles are repeated and remain positive?

According to Porter and McGahan, the key factors that determine whether a company can achieve abnormal profits and how long can it keep generating such returns are

  • Industry effect – How the structure of the industry affects the company’s performance
  • Firm effect  How the company’s unique characteristics drive its performance compared to rivals within the same industry

Further, cash flow return on investment (CFROI) data from Credit Suisse show that mundane businesses indeed have sticky high returns.

abnormal returns Boring is beautiful

Back home in Indian markets, if we cared to look away from the Pharma, Banking and Auto stocks that were hogging the limelight over last year, we would have found several multi-baggers out of companies in boring businesses such as selling plywoods (Century Ply – 8x since April 2014), egg products (SKM Egg Products – 20x) and white goods (IFB Industries – 7x). In fact, businesses that are seemingly “dull” – selling bricks, funeral services, furniture, carpet etc., are favorites of legends including Peter Lynch and Warren Buffett. What makes the dull so special?

#1. Dull = Slow changes = Lower uncertainty = Higher hit rate

The odds of getting our predictions wrong for a dull industry are pretty low. In other words, we are less likely to lose our bet with boring businesses than exciting ones. While innovation is beneficial for society at large, the accompanying uncertainty for individual firms is not good for investors. Slow changing industries typically extend the period that money works for us – increasing the number of compounding cycles.

Warren Buffett Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s the lack of change that appeals to me. 

#2. Not just boring, but better base rates

Just boring is not enough. In order to improve our odds, we should picking an industry which has a higher base rate of success i.e. higher probability of superior returns on average historically. For instance, returns from FMCG companies have been historically much better than that from airline companies. Hence, the chances of picking winners from FMCG space is much better than airline sector, as FMCG companies are, on average, healthier than airline firms.

Prof. Sanjay Bakshi If you want to catch a lot of fish, then you must go to a pond where there’s a lot of fish. You may be a great fisherman, but unless you go to a pond where there’s a lot of fish, you are not going to find a lot of fish. 

When it comes to making money, “boring” is better. 

“Boring” businesses = Better Bets?

Compounding Machine – How to build one?

Berkshire Hathaway (BRK), the widely popular Warren Buffett’s compounding machine, delivered a mind boggling performance over the past 50 years. Average annual increase in BRK’s market value over 1964-2014 was 21.6%, vs. 9.9% for S&P 500 – an out-performance of about 12%. And the increase in market value of BRK was 163 times that of S&P 500.

The greatest shortcoming of the human race is our inability to understand the exponential function. Prof. Al Bartlett

We are naturally inclined to think linearly and have a real hard time estimating the impact of exponential changes. We woefully fail in answering simple puzzles such as guessing the impact of folding a paper in half multiple times over and over again – 42x takes you to the moon, 51x to the sun and at 103x, it will be as thick as the universe. No wonder, Einstein called it the eighth wonder of the world.

The key here is the number of years that BRK had outperformed S&P 500. While both had roughly 40 years with positive yoy growth over this period, BRK bested S&P 500 on 34 occasions, with an average out-performance of 29%. On the other hand, S&P 500 won over BRK in 16 instances, but at an average difference of 15%. Among the bad years, BRK had a deeper decline vs. S&P 500 only on two occasions.

Buffett perf

Breaking it down

#1. Number of compounding cycles   Time is money. The more time we have to make our money work, the better it is. I believe it helps to think in terms of compounding cycles instead of years.  Eight cycles with 30% return each multiplies money by 10x, whereas additional eight cycles would make it more than 60x.

Compounding#2. Increasing the size of growth cycles   According to Bartlett’s Rule of 70, one can calculate the time to double by dividing 70 by the growth rate. To double our money, we need 14 growth cycles of 5% each, but just 7 cycles if our growth rate is 10%.

#3. Limiting the decline cycles   Cutting one’s losses early, be it for traders or investors, is key to building wealth. Reducing risk i.e. capital loss is of utmost importance.

Compounding – DIY or Outsourced?

When a typical value investor looks for a company with wide and durable moat (i.e. above average returns sustained over a long period), he is essentially outsourcing the compounding process to the management of the company. The more the number of such durable moats he can find, he would require fewer number of compounding cycles.

In contrast, a trader takes the process of compounding in his own hands. He looks for smaller gains over shorter periods so that he can have multiple compounding cycles. The biggest problem with shorter cycles is the issue of leakages – in the form of short term capital gain taxes (15% in India) and frequent broker commission outflows.

Success with compounding, DIY or outsourced, depends a lot on our ability to differentiate signals from noise and act decisively on those signals.

Compounding Machine – How to build one?

How to miss a 6 bagger

Have you ever had the experience of selling a stock soon and only then watch it (with increasing frustration) to go up and up?

That has been my experience with Arrow Coated Products (ACP), which I came to know about from Valuepicks blog. Entered at 65, exited at 88 – roughly 33% within 45 days. Not a bad return. But, only if I waited for 7-8 more months! Well, only the consolation is that at least I have some splendid company. Even Prof. Sanjay Bakshi has had a similar experience with Eicher Motors.

The importance of mental clarity, be it for traders or investors, cannot be overstated. Identifying a stock to invest in would be most likely the easiest part of the whole process. Other key decisions, including position sizing and when to sell, can make or break a good investment.

My biggest lessons (or mistakes)

#1. Never confuse between trade and investment

ACP had strong fundamentals – 3 years ROE of 35%+, negligible debt and strong patent portfolio. I should have had the conviction and PATIENCE to stick on. Developing conviction definitely deserves another post.

#2. Most often, the best stock to buy is the stock you already own

I could have entered ACP again later at several price points and still tripled or doubled my money. But, I did not as I had mentally shut out myself to ACP and was looking for “next big winner”.

#3. Bet big

Wealth is not built by investing pennies. Even if I had held on to ACP till now, buying just 100 shares is not the way to improve wealth. Identifying stocks to invest is just a small portion of the story, a lot depends on how big your position is and how you decide to sell.

516064_Daily_28-01-2015

How to miss a 6 bagger

Not So Random Walk

Of late, the mainstream media has seen the worth (or rather lack of any) of elegant theories and models, particularly CAPM, EMH and BS model, proven by many including Mandelbrot and Nassim Taleb. However, these theories continue  to be taught in B-schools with not much of warnings regarding their efficacy. Probably, reducing the behaviour of a complex, dynamic system like stock market to a set of beautiful (?) equations might have a certain orgasmic appeal. In Misbehaviour of Markets, Mandelbrot systematically takes down the tenets of Brownian motion that underpin these models. It is a pity that fractal analysis of markets is not introduced in B-schools.

Market has memory

One of the key ideas he discusses is that the Market has memory and its movements are not independent,  a key assumption of Brownian motion and hence standard financial model. 

“…a key idea behind a fair coin is that it has no memory.

Of  course, well-behaved price changes are not the only assumption underlying the standard financial model. Another is that each flip of the coin, each quiver of the price, should be independent of the last.”

Market is not a dog chasing a ball, not knowing where it will be next moment. Rather, it is like a drunk who staggers in a direction for some time and then takes a different direction as he suddenly “remembers” that he has gone too far off the track. In effect, he walks, not in a random direction every moment, but in a direction that his momentum takes him. 

Normality is not so normal

The bell curve has been beaten to death by Taleb much more eloquently all through his Black Swan trilogy. Mandelbrot also attacks the “normality” assumption – price changes follow a normal curve, crowding around the mean with the thinner tails at extremes. With many a example, he clearly demonstrates that the tails are indeed fatter than the bell curve assumes i.e. extreme changes have higher probability than “normally” assumed. That said, another thing I found to be interesting was how Mandelbrot describes the measure of fatness of the tails – kurtosis  (a topic that I skipped knowing well that I can pass my statistics exam without that). 

Kurtosis – how closely real data fit the ideal bell curve… think of it as how much “spice” is in the statistical broth. A perfect, unseasoned bell curve has a kurtosis of three. A hot, fat-tailed curve would have a higher spice number, while a curve that had been boiled into a dull paste would have a lower number.

Not So Random Walk