Is there a ‘Bubble’ in Quality?

The entry of ‘quality’ and ‘moat’ into the lexicon of most investors has resulted in valuations of these businesses touching stratospheric levels. Consequently, investors of today are faced with some difficult decisions.

There seem to be two schools of thought emerging.

Camp 1 seems to believe that valuation has nothing to do with the sell decision. As long as a great ‘moat’ company with great management has a visible growth outlook, the best time to sell is quite literally, never.

To us in Camp 2, this seems like a case of forgotten lessons from the past. Investors who overpaid in Infosys and Hindustan Lever had to wait for a decade or more for their investments to start generating some returns in spite of continued growth of the underlying business. We are confident that for many of today’s darlings, this time is not going to be any different!!

Neither does that mean that we throw the baby out with the bathwater and exit ALL seemingly pricey positions. There is undoubtedly still great merit in holding on to some winners and one needs to guard against selling out too early from some huge long term compounders. Since trees will not grow to the sky, this post is an attempt to pen our thoughts towards building some framework identifying which trees to climb in the current frothy environment and which to jump off.

Implied ‘look out’ earnings growth

In two recent posts here & here, Prof Bakshi has provided us some excellent insights into his thinking on the valuation debate, while suggesting that valuation indeed has something to do with the sell decision.

To Quote:

I don’t think in terms of entry multiples. I do think about exit multiples though and never value a business at more than 20 times owner earnings ten years from now.

And Elsewhere

Also when I said 20x multiple ten years from now as maximum I will value the firm at, I mean it. Many of them are valued at 15x and some as low as 10x…

While most would have worked on ‘Implied’ DCF models, let us try to invert what Prof is saying and understand what this ‘implies’ as per our understanding. Few caveats before we start.

First, As Prof has mentioned, not all companies are suitable for this kind of evaluation. Second while he likes to apply a multiple on owner earnings as compared to stated earnings and has also in the past talked about pre tax earnings multiples, for the sake of simplicity we conduct this exercise with post tax stated earnings.

To illustrate numerically, let us say a company has an EPS in year 0 of Re 1. If we are able to visualise a growth of 20% in earnings, then in 10 years, the EPS should compound to Rs 6.19. Now if we apply an exit multiple of 20x to this earning, we arrive at a price of Rs 123.8. As a next step we need to discount this with OUR hurdle rate. Let us say this is 18%. On discounting with this hurdle rate for 10 years we arrive at a PV of 23.7 which translates essentially to a multiple of 23.7 times on Re 1 of current earnings.

What the above implies is the following. If you have a hurdle (expected) rate of 18% and are not prepared to pay an exit multiple of more than 20x on 10 years look out earnings, you should buy/hold this company with an earnings growth outlook of 20% only if it is available at less than 23.7x current earnings.

Now armed with clarity in understanding, let us fool around with some real numbers.

In today’s day and age, a PE of 23.7 is considered cheap for the kind of companies we are talking about J Let us be more realistic and analyse say Hawkins Cookers trading at 45 PE. What is my asking rate for growth in profits with an exit multiple of 20 and a hurdle rate of 18%? The answer is - I should buy into Hawkins only if I expect profits to compound at more than 28% over the next 10 years. [You can arrive at this by doing a simple goal seek function here]  This would translate into current profits of 35-40 crs growing to more than 400 crs in 10 years. This helps us put in perspective what we probably know i.e. Higher the entry multiple, higher the growth required to justify the purchase.

Let us look at some other examples to buttress this point, all for an exit multiple of 20 and a hurdle rate of 18%

				Rs Crores
Company	Current PE (TTM)	Implied Asking rate for 10 year PAT growth	PAT (TTM)	Implied PAT 10 years forward
Jubiliant Food	80	36%	117	2444
Symphony	77	35%	127	2561
Page Industries	78	35%	185	3781
Bosch	71	34%	1050	19476
Astral Poly	70	34%	80	1456
Relaxo Footware	52	30%	82	1112
Motherson Sumi	51	30%	825	11067
Cera Sanitaryware	44	28%	65	745
Kitex Garments	36	25%	99	943

Data as of 23^rd April 2015, approximate numbers ignoring exceptionals

It is thus quite evident that under these assumptions of exit multiple and hurdle rate, markets already seem to be pricing in fairly strong future earnings growth.

20% + CAGR of profits – is it possible?

While high profit growth over 10 years is not unheard of, we did a reality check to see how fast quality companies have been able to grow in the past. Out of a universe of roughly 5200 companies that we ran a screen on, 203 (3.9%) had ROCE of over 20% in at least 7 out of the past 9 years. There being no formal definition for judging quality, we used this filter as a proxy for ‘quality’ companies. Next we checked on the CAGR growth in PAT that these companies demonstrated over the nine year period.

PAT CAGR	No of companies	% of Quality	% of all listed stocks
<10%	44	21.7%	0.8%
10-20%	59	29.1%	1.1%
20-30%	44	21.7%	0.8%
30-40%	31	15.3%	0.6%
>40%	25	12.3%	0.5%
Total	203	100%	3.9%

Key observations from the back testing exercise:

• Mere 2% of all companies were able to demonstrate both quality and high growth.
• Of the quality companies more than 50% grew profits at less than 20% CAGR, which also implies that the balance grew at more than 20%. The narrow point being made here is that while markets are today sanguine that all the companies in the above table (and many others) will be able to compound profits at high rates for the next 10 years, past data suggests only an even probability of success.
• The hyper growth companies (more than 30% CAGR) where the big money was made in the past is a mere 1% of the listed universe of the companies, almost akin to find a needle in a haystack.

But is it fair to use 18% hurdle rate?

To complicate matters further, many investors rightly or wrongly, have a hurdle rate well higher than 18%. Quite obviously Higher the hurdle rate, even higher the growth required to justify the purchase. You can play around with the numbers for yourself by choosing a hurdle rate to see how the nos change. If you have a hurdle rate of 30% [Seriously, we have come across investors with hurdle rates even higher] Kitex will deliver for you only if it is able to grow its profits at greater than 37% compounded for 10 years to nearly 2500 cr.

So if you think this to be a tall ask, you have only two choices. The first is to tone down your hurdle rate and continue to hold Kitex, the second to look for greener pastures.

Without opining on what an appropriate hurdle rate should be, it is important in our view for serious investors to have a realistic hurdle rate. Having too high a hurdle rate can force you out of some great businesses available at sensible valuations in favour of moderate businesses at cheap valuations, thereby exposing you to higher risk of permanent losses.

Why an exit multiple of 20x?

Finally if the required implied growth looks too daunting, investors always have the option of remaining invested in the hope that the market will provide an exit multiple higher than 20. To understand if it is a good idea, let us start with what Prof Bakshi writes on this matter.

Finally all expected return models as an exercise in discipline, even though I know that many businesses would be worth a lot more than 20x earnings a decade from now, given their profitability and growth potential even beyond 10 years.

(Emphasis mine)

Conservative principles of valuation suggest that one could be neutral between a ‘0 growth’ company and a high quality bond. Therefore seeking earnings yield of 6-7% or roughly 15x PE may not be irrational. Paying a higher multiple implies a growth expectation. Using the same principle, assuming no significant changes in general level of interest rates 10 years hence, it may not be unfair to give a 15x multiple to a no growth entity. Therefore, a 20x multiple already assumes some growth even beyond 10 years.

Put differently applying a 20x multiple means that in your judgement the business would be able to demonstrate growth not for 10 but maybe 20 years or beyond. Most would agree that the risk that we may end up rationalising the unknown is high. In this light applying 20x in our view is aggressive enough. Going even further may be nothing short of pure adventurism.

To summarize, while not all, valuations of some quality companies seem to have overshot their intrinsic growth potential by a fair margin. While buying today or holding on to these ideas may not result in permanent loss of capital given the inherent growth in many companies, those investing today should be prepared to face sub optimal returns over elongated periods. Investors would do well to be careful in their stock selection in the current environment.

Best of Manufactured Luck!!

Disclosure: Examples used in this post is for educational purpose only and is not intended as a buy or sell decision on any stock. Neither us nor our family members have invested in any of the mentioned examples over the past 1 year