Is The Stock You Like A Good House In A Bad Neighbourhood?BloombergQuintOpinion
Have a look at the metrics of Company A. Growth first: in 2020 earnings declined by 28% but in a year marred by the Covid-19 disruption, that decline happened to most businesses. Earnings are likely to climb back smartly over the next couple of years. Despite the earnings decline in 2021, the company generated a robust return on equity of 43%. That says a lot about the quality of the franchise. As earnings climb back, RoE is expected to rise to over 60%, signifying that very little incremental capital will have to be deployed to generate the earnings growth.
By Indian standards, the dividend yield is robust as well; almost 4% in Covid-challenged 2020 and stepping up to 6% in two years. And to top it all, valuations aren’t expensive. The stock trades at a trailing price-to-earnings ratio of 23x and just over 15x on 2022 earnings. The company is neither a micro-cap nor of dubious parentage; 51% of its equity is owned by a large multi-national corporation. When it comes to picking stocks, this is as ‘sarva-guna-sampann’ (possessing all the good qualities) as it gets. But in stock markets, like in an arranged marriage market, when you see something sarva-guna-sampann, your immediate question should be “but what’s the catch?”
And of course, there is a catch. Otherwise, I would have been loading up on this thing; not writing a column about it. Despite all its virtues, investors have severely de-rated this stock. From a one-year forward P/E ratio of almost 45x in January 2015 to just over 15x now. That’s like being a maanglik in an arranged marriage market. What’s caused this fall from grace are the two words that describe the product that the company sells: engine oil.
Discounted For The Future
The stock is, obviously, Castrol India and the severe de-rating is because of the fact that investors are convinced that an engine oil company will not remain a going concern for long. The logic is simple; the world moves to electric vehicles where engine oil has no role to play. The de-rating has happened, despite less than 0.5% of all vehicles sold in India being electric. This means, apart from almost all vehicles that you currently see on the road plus over 99% of those being sold right now, will keep needing engine oil.
This is a case where the narrative of the future is strangulating current numbers.
You will find instances of such strangulation from industries ranging from coal, utilities, newspapers, broadcasters, cigarette makers to certain auto ancillaries that have fallen on the wrong side of EV transition, with similar or worse dents in market perception.
As investors, we are told “if you find a good house in a bad neighbourhood, don’t buy it. The neighbourhood wins.” This heuristic generally works and investors rightly stay away from such bad neighbourhoods. But once in a while, a house is able to change its zip code. Not by calling itself Upper Bandra but by actually changing its business composition. And if as investors, you can catch on to this early, there is a lot of money to be made.
Back From The (Near) Dead
Here’s Company B. This time a price chart that is hovering around an all-time high but seems to have resurrected from a near-death experience a decade ago.
The stock is The New York Times Company and it has freed itself from the narrative stranglehold. For the last decade, NYT has aggressively steered its business into the digital arena for both subscription and advertising revenues. Of the 7.9 million NYT subscribers, only 0.8 million are print subscribers. In 2020, NYT’s digital subscription revenue surpassed its print subscription and digital revenues (subscription and advertising) now account for almost two-thirds of the topline.
In 2011, it would have been easy to write NYT’s obituary but if you could envisage a successful pivot, there was a lot of money to be made. What digital subscribers are to newspapers, renewable capacity is to utilities and on that front, European utilities seem to be leading the transition and starting to get rewarded by investors.
The first filter should be management commentary. Many narrative-challenged companies whine about the market not rewarding their stellar fundamentals. Some even contemplate name changes to market-equivalents of Upper Bandra. These companies are like ostriches who have buried their heads in the sand. Steer clear.
If they pass this filter, check what they intend to do with their cash flows. Such companies are generally blessed with abundant cash flows as incremental capital expenditure is limited. Some might just opt to return all the cash to shareholders as dividend, which by itself is not a bad idea. Evaluate them with a fixed-income lens if you are a yield investor.
Then, there would be some who are looking to deploy their cash flow into new businesses. The first check for them should be to see if management teams have any competence in areas they want to venture into. If the new venture keeps the core of the business intact or is an adjacency to the existing businesss, odds of success are higher. The second check requires imagination from investors; to answer whether this new business can be what digital subscription was to NYT and if yes, how fast can its scale become relevant and eventually dominant in the overall scheme of things. Having numerical milestones to evaluate this journey is useful.
And even after all this, you are going to need abundant patience before you might be rewarded. Ask any ITC investor!
Swanand Kelkar is an investor and former Managing Director at Morgan Stanley. Views are personal.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.