My experience with Page Industries is similar.It has been a multibagger for me at
whichever price I had entered.
Thanks for an insightful article.
Sorry to say but the examples look to be suffering from Hindsight Bias… All examples are from FMCG which are doing well currently, & its difficult to say when we are overpaying & when we are not.
Any pointers to decide on that Sir?
The key point I wanted to illustrate was that generally speaking, truly long-term wealth creating companies (in FMCG or other sectors – see for example MICO now called Bosch), have tended to be underpriced by the market, even at relatively higher P/E multiples. There is no speculation here. I used Nestle just as an example to illustrate my point.
Let’s do a thought experiment. The value of any financial asset is the present value of its future cash flows. While the future is uncertain, if one could go into the past in a time machine, with full knowledge of what will happen over the next few decades, one could figure out what the value should have been in the past – 20, 15, and 10 years ago. If you do that with Nestle (or for that matter most long-term wealth creators), you’d be surprised to find that even at multiples typical value investors shy away from, those stocks were underpriced by the market.
Why did this happen? It happened because the long-term value of moat-generated sustainable and growing earnings were only being partially reflected in past stock market valuations. If the DURATION of a GROWING earnings stream is going to be LONG, then double digit P/E multiples (which look expensive to most investors), are actually bargains. At least history shows that to be the case.
I read this fascinating article yesterday which sort of supports my thesis: “The Mysterious Factor ‘P’: Charlie Munger, Robert Novy-Marx And The Profitability Factor” at:
Here is an except which agrees with my research.
“More profitable companies today tend to be more profitable companies tomorrow. Although it gets reflected in their future stock prices, the market systematically underestimates this today, making their shares a relative bargain – diamonds in the rough.”
As value investors trained under the Graham and Dodd framework, investors get tied down by anchors like “book value” and “P/E multiples” based on past earnings. This kind of anchoring bias results in large errors of omission because it prevents them from reaching out and paying up for quality, without actually overpaying for it. It’s a bias Buffett overcame by moving away from net-nets to franchise value, isn’t it?
I completely agree when you say ‘Moat’ Investing is better than low PE-PB investing. Moat based investing is much more rewarding and less stressful than the pure Graham style & ,Sir, I got the main theme of your outlook article also, which was pointing to all those Graham value followers.
Just felt the examples chosen are doing too well in current times… better than their long term average (though long term averages of these super business will be better than general market) thus distorting the CAGR returns calculated.
Even going back in time m/c won’t be helpful Sir, as Taleb’s alternate- parallel Worlds come to mind 🙂
But too high PE is also risky as your example of Infy in 2000 comes to mind.
Of-course deciding when high PE is not actually high is the real art, which makes investing difficult !!!
In fact, after a few direct experiences, I think there is one style which is even better than just moat based investing.. that is-
Moat + No demand issue + No supply issue
This strategy will take only moats & then will look at demand-supply situation..
By ‘No demand issue’, I mean good present demand for its products. This will remove MCX, TTK prestige & Mayur Uni from portfolio.. All are facing some issues on demand side.
Similarly sell side issue would have removed Hawkins 2 years back (pollution issue) & Amara raja now (capacity constraints).
But these would become a definite Buy after resolving their issues.
Sometimes it takes a few good stories to get the needed point across. 🙂 The article was based on a talk on India value investing opportunities given to a global audience who, I believe, needed to be told that issues like political uncertainty, currency depreciation, and relatively high P/E multiples are not good reasons to prevent them from making sensible investments in Indian public markets…
Amidst all the negativity around, refreshing to hear something positive on India Story.
brilliant as usual, prof!!
Please keep enlightening us with more frequent posts..
BTW, if you get time kindly look at the posts below by Aswath Damodaran..
need i say more…
Warren Buffett once said, “the best buys have been when the numbers almost tell you not to.” Indeed, investing in the great business, which possesses a wide moat, requires more of the qualitative analysis than the quantitative analysis.
How can investors identify whether or not a great business is a bargain?
Buffett commented on this during the Berkshire Hathaway shareholders’ meeting in 1995. In order to determine the attractiveness of an equity, the market multiple should interact with the opportunity to reinvest capital and the rate at which that capital is invested.
A Fortune article about investing in Coca-Cola, dated December 1938: “Several times every year a weighty and serious investor looks long and with a profound respect at Coca-Cola’s record but comes regretfully to the conclusion that he is looking too late.”
Market it seems continuously fails to identify the Competitive Advantage Period (CAP) (Period of excess returns earned by the company over its cost of capital) of the wide-moat companies.
Well said, Vinay. Thanks.
eh …. http://en.wikipedia.org/wiki/Nifty_Fifty ??
And no I don’t think this (http://www.aaii.com/journal/article/valuing-growth-stocks-revisiting-the-nifty-fifty) is a good enough explanation. The “long-run” for a money manager without buffett like OPM is not long enough to wait for mistakes to correct themselves over time.
So, in effect, are you saying, low p/e stock buyers probably gain from p/e expansion while high p/e stock buyers possibly gain from earnings growth?
No, I am trying to convey the logic of de-linking from the idea of P/E while thinking about valuation. As Mr. Buffett wrote in his 1992 letter:
“The term “value investing” is widely used to imply the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics…are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.”
In his 2000 letter, Mr. Buffett wrote:
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.”
And in his 1992 letter, he wrote:
“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.”
Notice, he is talking about P/E multiple as the EFFECT of valuation, not the CAUSE of it. So while doing VALUATION, you should IGNORE P/E Multiples.
However, while estimating likely investment returns from any equity security, you have to think about two components of those returns: (1) dividend income; and (2) capital gains. Capital gains, have two components too: (1) Earnings growth; and (2) P/E multiple expansion or contraction.
It’s only when you think about likely sources and quantum of expected returns, you have to think about P/E multiples.
Having said that, it’s very HARD for hard-core deep value enthusiasts to overcome the anchoring bias of P/E multiples. However, I feel it’s a necessary REQUIREMENT for training oneself to buy really high quality businesses which have large, self-funding, and very long-term, growth prospects.
I feel it’s terribly important to de-link from anchors like book value and P/E multiples while thinking about valuation.
I think its more clear what you are trying to say. Still one thing which is not very clear is how to decide that we are not OVERPAYING for stock. How to decide we are not overestimating growth. Identifying EXCELLENT QUALITY business is not much of a challenge for me, where I GET STUCK is determining is the SUSTAINABLE GROWTH and RIGHT PRICE.
Thanks a lot….
“Who said the below and what changed since then is an interesting question”
Let me just give you very quick example. Here are two companies
Rs 100 cr.
Rs 100 cr.
Return on Capital
Rs 1,000 cr.
Rs 20 cr.
Rs 35 cr.
Rs 10 cr.
Rs 7 cr.
Rs 2 cr.
Both companies have same amount of capital invested — Rs. 100 crores. Return on capital — 35 percent in A and a pretty mediocre 10 percent in B. A sells for 10 times book, B sells for 20 percent of book. Market Cap – 1,000 crores for A and 20 crores for B. PAT — 35 and 10. Price to earnings — 29 and 2. Dividend payout — same in both the cases. Dividend actual payment 7 crores and 2 crores. Dividend yield — 0.7 percent and 10 percent.
Now, one looks like a growth stock, the other looks like a value stock. Now, if you keep the assumptions intact, if you assume that the future will be pretty much as what is been displayed on this slide then obviously company A well turn out to be, not only a better company, but also a better investment.
Company A is no doubt a better business than company B because it earns a higher return on capital and has a rational dividend policy because it retains most of its earnings and so long as the return on capital is high, this money will build up and like an internal compound machine should eventually show up in increased market valuation.
Now, if the model assumptions hold, and if we assume that 5 years from now the same assumptions apply, then over those five years A will produce a 175 percent return, while B will return 95 percent. So A would have been not only a better business but also a better investment.
But how sure are you that these assumptions will hold? That is the key thing here. What history tells us — how many companies are able to sustain that kind of growth which is implicit in that kind of a return and low dividend payout ratio and how many companies are able to sustain that kind of a high return on capital? I think they are very very few.
So if we were to vary this model, if we were to make some changes in that model and if we were to say for example that: (1) in year 5, A\’s return on invested capital declines to 20 percent – maybe due to competition, market saturation, managerial stupidity etc.; and (2) A’s P/E multiple declines from 29x to 25x. And we also assume that in the year 5, B\’s P/E increases from 2x to 3x. And I will drop that assumption about B’s P/E multiple later. Let’s see what will happen if we were to make these assumptions.
And with these new more realistic and possible assumptions, I think you\’ll find that A will return 40 percent over five years and B will return 163 percent over the same period. So a drop in return on capital in the year 5 results in a dramatic change in our earlier conclusion that A is a better investment.
If we drop the assumption that B\’s P/E multiple increases, if we assume that everything about B remains unchanged, but we assume that A’s P/E has changed from 29x to 25x, even then B will outperform A by a large margin by returning 95 percent as opposed to 40 percent for A.
And that is the power of value investing, when you pay low prices then you don\’t need very good things to happen for you to have a good return. When you pay those low prices, then even if some bad news comes out about the company, it\’s already discounted, the market ignores it. Whereas if any good news comes out, you have a jump, you have a positive, skewed result. So you end up with P/E multiple going from 2 to 3 which is not expensive by any means, but you can see what impact it has on the overall returns.
That looks familiar. My words, eons ago. That’s Graham’s influence…
Indeed, if I look at my class presentation slides of 2001, and 2012, I feel like I am looking at slides made by two very different persons. If you read Buffett Partnership letters from 1957 to 1976, and read Mr. Buffett’s letters in Berkshire Hathaway reports which came later, you’d recognise his evolution too.
A really nice paper, which I read many years ago, which captures this very well can be seen from:
Consider three comapnies with same profit of 300cr and PEG=PE/Growth=1
Company-A with ROCE 30% (Profit=300/Capital=1000)and PE 30, has mkt cap of 9000. If comapny-A show same ROCE with 50% fall in PE to 15, mkt cap should be 16708(1.85 times). AND PAT of 1110 at end of 5 years represent 12.33% of initial mkt cap of 9000.
Comapny-B with ROCE 15%(Profit=300/Capital=2000) and PE of 15,has mkt cap of 4500. If comapny-B show same ROCE with no fall in PE over five years, mkt cap should be 6000(2 times). AND PAT of 600 at end of 5 years reperesent 13.33% of initial mkt cap of 4500
Comapny-C with ROCE 10%(Profit=300/Capital=3000) and PE of 10,has mkt cap of 3000. If comapny-C show same ROCE with no fall in PE over five years, mkt cap should be 4831(1.6 times). AND PAT of 480 at end of 5 years reperesent 16% of initial mkt cap of 3000
assuming no payout and growth = roce
First of all thanks a lot for sharing your learning and insights through your blog and lecture presentations. Through your presentation I got to know of so many other good investors and their investment philosophy.
Right from the time I had gone through your lecture presentation on Nestle which you have put up on your website I am little confused. I have also gone through your comments that market systematically underestimates the growth stocks.
1. I remember you always talk about base probabilities in your interview and other presentations. And the base probabilities tell us that buying excellent business at high price is a losing proposition or a very low probability event. Then does not it mean that finding a company like Nestle which despite of high PE has done well may appear to be good only in hindsight. What are the chances that at current PE multiple Nestle or for what matter any company trading at such high multiple may prove to be rewarding 10 years later. Market is pricing only rosy future, what if all of a sudden there is some competition; company enters into unrelated areas etc. Where the margin of safety comes for such stocks. Buffet controls the management of companies which he buys, so he can control capital allocation and managerial incentive, but what about minority shareholders who cannot exercise any such control.
2. I have not read buffet as much as you have, so probably I may be wrong. But most of the time Buffet investment in companies like Coca-cola, American express etc was at a time when these companies were hit by some short term problem and market became extremely pessimistic about them. But buying stocks like Nestle, Asian Paints or for that matter any stock which is extensively covered by stock analyst and widely loved by institutional and retail investors will be trading at pretty high multiple. I think better to wait when these stocks get hit by some short term problems.
3. I am more influenced by John Templeton [or may be because I find his strategies simple to follow than Buffet]. I am more in favour of buying out of favour stocks which enjoy some reasonable to strong entry barriers. Because in stocks like Nestle and Asian paints there is no margin for making any errors and it might be more suitable for highly experienced investors.
Lastly I think to buy stocks at their fair prices, one needs to do MUCH MORE EXTENSIVE analysis. To be precise one should do the kind of analysis mentioned by Philip Fisher in his book ‘Common stocks and Uncommon profits’.
Thanks for your outlook article and sharing The Mysterious Factor ‘P’.
I found the following presentation by Mr Rajeev Thakkar, captioned as “Financial Equivalents of the Optical Illusion” and relevant for this subject.
How do you calculate intrinsic value and margin of safety in Nestle’s case ?
Sir, when you talk about a Asian paints/Bosch/Nestle etc, aren’t you not only suffering from hindsight bias but also from survival bias. there may be 10s of other companies 30 areas ago in same industry that would have died down without any of us today knowing it. for these kind of stories, in the end what matters is investors ability to figure out long term dynamics of a market and capability of management to harness it (and good amount of luck if you look at a company individually), which is not a easy thing to do.
as you yourself found out these same companies did not grow as much in their own market as they grew in India (although thats good point to make to lure global investors to India), so their overall management was also not that great they just got benefit from expanding middle class and inflation in India to get that kind of growth.
to drive my point, can you find a company today which even if is selling @ PE of 68 for which you will invest significant portion (but not having controlling stack in it).
Nilesh, I am making two key points. My first point is that if you study the history of true long-term wealth creators (for which you need to have hindsight information), then you’ll find that averaged out, investors have underestimated the important of long-term competitive advantages in their valuation models.
In his updated and well-written “Measuring the Moat,” Michael Mauboussin writes:
“The second dimension of sustainable value creation is how long a company can earn returns in excess of the cost of capital. This concept is also known as fade rate, competitive advantage period (CAP), value growth duration, and T. Despite the unquestionable significance of the longevity dimension, researchers and investors give it insufficient attention.”
I agree with the author. Tell me, if you want to measure whether or not investors under-estimated the importance of long-term competitive advantages in their valuation models, how would you go about doing that? You will necessarily go back in time and find companies that indeed created exceptional fundamental and stock market returns over the future (which you already know as you went back in time). Now, imagine that you found a bunch of such companies which delivered exceptional stock market returns, despite the entry prices being much higher than those typical “P/E” fixated value investors are accustomed to? If you found such stocks and despite the entry prices being, say at a P/E of 25, you observed returns far in excess of AAA bond yield returns, when what will be your conclusion? Would not your conclusion be that even at P/E of 25, the stock was undervalued (provided of course the stock market performance is reflecting improved operating performance and is not just driven by a bubble)?
That was the thought experiment part of my thesis— that relatively high P/E multiples have deterred value investors in the past from investing in some very high-quality businesses, which over time delivered exceptional returns to those long-term investors who were not so deterred, and therefore, this must mean that the stocks were undervalued at those relatively high P/E multiples in the past.
The second part of my thesis is a question: If the markets have been inefficient in the past, are they being inefficient now?
My hunch is that the market is still inefficient, but that hunch won’t be proven right or wrong until many years have gone by. My hunch is that businesses having strong moats which deliver them sustainable competitive advantages, having huge growth potential because the companies are operating in industries having that potential, and where such growth can be self-funded at high incremental returns on incremental capital, are likely to be undervalued at P/E multiples like 15, 20, or even 25 and value investors should ignore those multiples while thinking about valuation.
Thanks a lot for sharing Michael Mauboussin note on Moat. Read just 10-15 pages, but some of the concepts are very good to understand sustainable moat…..
Hi Sir ,
Even Charlie Munger has acknowledged that “The bulk of the billions in Berkshire Hathaway have come from the better businesses. Much of the first $200 or $300 million came from scrambling around with our Geiger counter. But the great bulk of the money has come from the great businesses.”
Refer http://value2wealth.blogspot.in/2013/07/charlie-munger-queries-answered.html for more details or “Art of Stock Picking” article of Charlie Munger .
thanks sir for clarifying it. it makes more sense when you talk about PE of 25 than PE of 68.
Hi, Some historical data analysis below
Data: Considered Dec 1989 to June 2010 end of the month share prices of Nestle (N), HUL (H), Asian Paints (A) and of Sensex (S)
Strategy: Buy shares of the above companies at the end of every month starting Dec 1989 up to June 2010, with a 3-yrs hold. 3-yrs hold only over last 20 plus years effectively removes any hind sight bias and does not allow recent superior performance to affect overall results
(returns for purchases after June 2010 with 3 yrs hold cannot be determined at this time)
1. N, H, A and S would have yielded 15% plus cumulative annual returns 60%, 47%, 70% and 37% of the time respectively
2. Months when 15% plus cumulative annualized returns were achieved, the PE (based on LTM) ranged between 20 – 57.5 for N, 14.4 – 75.3 for H, 11.9-35.4 for A and 9.7-17.8 for S. Clearly A has delivered 15% plus returns maximum number of times in the past as it was trading at a low PE range historically (markets consistently failed to capture its superior growth and performance capability)
3. Months when returns were lower than 15%, the PE ranged between 23.2 – 72.3 for N, 16.4 – 115.1 for H, 16.5-49.3 for A and 14-25.8 for S. Clearly, high PE leads to lower future returns. Even low PE have resulted in <15% returns essentially when the stock price stayed depressed at the time of exit after 3-yrs hold
4. Average annual returns during the entire period for a 3-yr hold strategy and every month purchases is 20% for Nestle, 18% for HUL and 25% for Asian Paints. While the same for Sensex has been 14%
One can safely deduce that investing in such defensive stocks at regular intervals is a real defensive strategy which over a long period can definitely beat Sensex!
Happy to share the worksheet, if you like (firstname.lastname@example.org)
Thanks Ritesh. Please send your worksheet to me.
Thank you sir for the great article and subsequent enlightening comments.
The legendary Bill Miller once said:
“…….Margin of safety is a really interesting issue because most value investors think of a static margin of safety because most of their business is cyclically undervalued or mispriced, and not secularly mispriced. That’s why they turn them over every two to four years as opposed to holding them for 10 years. The margin of safety doesn’t change much over a couple year horizon. Most businesses don’t earn significantly above their cost of capital. But if a company earns significantly more than its cost of capital, it creates real economic value. If it has a triple digit return on capital model like Dell, then the margin of safety rises over time. People were debating in 1980 whether Microsoft was worth $8 billion or $5 billion. Today Microsoft has a $280 billion market capitalization and nobody says it’s worth $6 billion. So where did all that extra value come from? It came from the return on capital and the buildup of value. Valuation is always subject to a time horizon. If you have high confidence that a company can maintain its competitive advantage for 10 or 15 years, the margin of safety is much higher than you think it is. Buffett want businesses that are highly predictable over long periods of time.”
An article in ET today
[…] Bakshi, where he insists on investing in high quality and scalable businesses [read here and this article in outlook business], I got convinced about investing in highly scalable business and not […]
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