These Market Veterans Want Investors To Look Beyond Valuations
Price-earnings multiple as a metric has no sense about discounting of the future, says Shah of Ask Group.
India’s equity benchmarks scaled new highs driven by large-cap stocks while the broader markets struggled. This polarisation sent valuations of well-performing stocks soaring.
But market veterans Nilesh Shah of Kotak Asset Management and Bharat Shah of ASK Group think valuation may sometimes not reflect the true potential of a stock. Here’s what they told BloombergQuint at this year’s edition of PMS AIF World Summit in Mumbai.
Valuations
Price-to-earnings multiple is merely a price today with profits one or two years down the line and that can hardly capture the essence of the business, Bharat Shah said. “It has become very fashionable to make loose statements that something is a bubble, 50-80 P/E. I see this kind of gibberish on a daily basis during my work.”
Investors, he said, have to account for the growth potential, incremental cash flows, patents and economic life of businesses while calculating valuation.
On Impact Of Passive Investing
Nilesh Shah said quality companies, irrespective of price and valuation, will have demand as long as they’re part of the index funds that imitate benchmarks.
Passive money is coming into indices as fund managers are globally buying , not driven by valuation, but what’s there in the index. That, he said, would continue to help valuations of companies like Hindustan Unilever Ltd. whose shares are in limited supply as promoters own over 60 percent. “Incremental buying by a passive fund will keep on lifting Hindustan Unilever’s valuation. Now, is it a bubble? Is it not a bubble? It is too early to say.”
Watch the full interaction here
Here’s the edited transcript of the conversation:
It’s interesting debate because we’ve all been taught that corporate earnings should grow at a higher rate than GDP growth. But Nifty 50 stock earnings has trailed GDP growth in the last 10 years. So, is it the construct of the Nifty? It is representative of the GDP?
Bharat: The GDP to market movement is a favourite fetish for a long period of time. A lot of people make these bombastic kinds of predictions based on the movement to GDP and the movement of the markets in trying to say that the markets are a ratio of GDP- whether it is reasonable or otherwise.
This is very generalised. I would say unsophisticated real forecasting stock prices. This can be a view of economists and general bystanders. Market participants cannot have a luxury of making some generalised predictions. They have to buy an individual business and understand what the characteristics are, what the earnings are, what they are likely to be, what will be the patent to vary and whether it is representing sensible risk compared to the price that is quoting at the market.
Therefore, these generalised understanding that corporate earnings have to be higher than the nominal GDP growth rate, is somewhat an overstretched argument. Normally, in a growth economy that is likely to be the case. I’m not saying the corporate sector is typically is the most dynamic element of the economy and therefore likely to do better than the average growth of the economy. But not always so. Please remember right now what is going through is creative destruction. A lot of rubbish businesses, a lot of terrible promoters are getting destroyed and businesses are getting finished. It is this process, which is hurting the earnings, but if you analyse below that there are so many businesses which are doing phenomenally well.
Also, it has become fashionable of late to say that the market is being driven by 15 and 20 names. Again, this is a very generalised and a bombastic statement. If you analyse- across many sectors, a lot of them are doing well. Some of them happen to be large ones, some of them are mid-size, some of them are smaller. This again- the fetish with a large and mid-cap and small cap are really not investment staples. So, if you see and analyse individual businesses, you will realise all the good ones who deserve to do well, are actually doing very well. But the fact is, a large number of businesses are rubbish and a large number of businesses will do badly.
Nilesh, can you weigh in on what Bharat talked about- in terms of some of the stocks getting high very high valuations but there are other companies in the market that are also doing well. So what is your take on this entire debate around the quality bubble?
Nilesh: So, there is passive money coming into the index. EPFO puts about Rs 40,000 crore into index stocks. Now, the fund manager there is buying what is there in the index. The ETFs and index funds globally also buying what is there in the MSCI Index. These investments are not driven by valuation, these investments are driven by what is there in the index. Now, imagine for a company like Hindustan Unilever- they are about 5 percent weight in the Nifty.
There is a buying of about Rs 2,000 crore every year from the index fund which doesn’t care what the valuation is, what the price is. There’s no supply in Hindustan Unilever since last 5 decades. 60 percent is owned by promoters and the rest is also with committed investors. So, incremental buying by a passive fund will keep on lifting Hindustan Unilever’s valuation. Now, is it a bubble? Is it not a bubble? It is too early to say. Markets can remain irrational more than I can remain solvent or I can retain my job.
So, we have to choose our portfolio with a view to outperform benchmark indices.
If you think something is becoming expensive, we will underweight it. If you think something is becoming cheap, we will be overweight it. That combination hopefully will allow us to outperform benchmark index and generate alpha. Money flow, sentiments future earnings—these are all variables which will come into play.Nilesh Shah, Managing Director, Kotak Asset Management.
As a fund manager, my job is to ensure that they continued to generate alpha over benchmark index keeping in mind how these variables are going to play.
It’s a tough one because as you said that the money keeps coming up into the larger stocks and some of it is blind money, passive investments. If you look at the U.S. in 2019, today now passive index funds and ETFs are more than what active fund managers manage? Do you see that the problem will continue to work like better or worse than depending on which side of the table you are? Do you see that a lot of passive investments will also start coming in India as well?
Nilesh: One when globally benchmark index performance is compared, if it’s the total return index, then the expenses are added back into performance. In India, we are comparing a fund’s performance with total return index without taking into account that funds provide daily redemption.
The index does not provide any daily redemption. Second, index stock enters or exits it happens without impact cost in India. Globally, it happens with impact cost. Now, imagine a stock going out or stock coming in and there is no impact cost. Can you fund ever achieve that? I think the answer is no. So, when we are comparing total return index vis-à-vis funds performance, we don’t add expenses, we don’t take into account that funds provide daily redemption and third, we don’t take into account the impact cost that the fund has to bear but in the index doesn’t.
Despite those non-level playing field comparison, by and large, most of the funds have outperformed their benchmark index albeit alpha generation which was in double-digit, has now come into lower single digits. This is coming at the context where Nifty-50 has done far better than next Nifty junior, 51 – 100. 101 to 250, Nifty mid-cap is done far worse and 251 to beyond small cap has done far worse.
How were we generating outperformance? We were generating outperformance by taking bets outside of the index. Any bets outside of index, by and large, has not worked and despite that, we are still generating lower single-digit alpha. Now, will this trend continue forever? The answer is no.
At some point in time, the valuation gap between 15-20 large-cap companies vis-à-vis bottom and small-cap companies will narrow. At some point in time, investors will look at money towards. 51 to 250 or 300 or 500 companies. Whenever that cycle begins, the fund alpha will come back.
Now, over a period of time, will we continue to lose our ability to generate alpha? The answer is yes. We will have to reinvent ourselves from long-only funds to maybe long-short funds, leverage funds, concentrated funds, offshore funds- who knows? Will there be a passive index industry coming? The answer is yes, of course. But will there be a job for active fund manager? The answer is yes.
Even in the U.S., I think a large portion of mutual funds under performance is a function of the talent. This market talent is going into hedge funds, private equity and venture capital. I’m not saying that all the people in the U.S. mutual fund industry are not so smart, they are smart but if you have a choice as a smart person to go, you are more likely to go towards venture capital and private equity and hedge fund which is far more rewarding.
In mutual funds, as the expense ratio came down, their ability to attract talent also came down significantly. In India, fortunately, we have no dearth of talent. So, we have the talent available for venture capital, private equity, hedge fund as well as mutual funds
Everything that we’re going through now has happened sometime in the past. So, when you look at some of these quality stocks 60 times-80 times price earnings multiple. I’m sure when you’re sitting on your desk you cannot explain the logic of their valuation. How are you seeing that play out?
Bharat: Pardon my saying so but again, it has become very fashionable to make loose statements that something is a bubble, 50- 80 P/E. Loose numbers are bent about. In my work, I see this on a daily basis- this kind of gibberish.
First of all, the comparisons are odious. Valuation of a business cannot be on a price-earnings multiple. Valuation of a business has to be such that it has its entire economic life duration. Price-earning multiples is merely a price today with profits one year down the line or two years down the line that can hardly capture the whole essence of the life of the business.
Secondly, price- earning multiples are focused on the profits while valuation has to be on the cash flows. Price-earnings multiples have no sense or notion about discounting of the future. Valuation of a business cannot be considered without discounting the future.
Many of the aspects of price-earning multiple, in attempt to make simplistic judgments or inferences out of it, is entirely flawed and it does a great disservice to the entire mathematics of the computation of the valuation. The only merit of the price-earnings multiple is that it is simple to understand and therefore it is over-abused.Bharat Shah, executive director, Ask Group
But a lot of times, people make comparisons that in Russia, the market is 7 P/E and 8 P/e and is cheap. Cheapness is a rule in markets, in general, it is the expensiveness by that notion which is an exception. It is the zenith of a bull market- two-third of the names in the market will be quoting its single digits and thereabouts.
But people just get taken by and taking symbols and names then quoting about it. Therefore, unless and until we do the proper mathematics, the size of opportunity- therefore likely earnings growth in the hands of a capable management, not just growth but the cash flows and not just the cash flows but the incremental cash flows, judging the economic duration, making several assumptions about predating or postdating of the cash, the flows and the patents in the rate of discount at which you think it is fair to judge that business.
Unless and until you do that entire involved activity, any loose comment based on a 50 and 60 P/E, is completely erroneous. I'll give you an example, you look at banking and the finance segment, you will get a popular way to judge them- looking at price-earning multiples at price to book and you will find all kinds of animals. At half time price to book, some of the private banks at one and half times, some are slightly better and are at 2, 2.25, then there are others at 4, 5. Then there is Bajaj Finance at 7.5, Gruh before it became Bandhan, then people bought it at 12 and 13 times.
If you look at the returns generated by this business over a 10-year period, surprisingly you will find that what you regard as expensive, has actually done much better. Not only for the brink period of 6 months and 12 months or 5-15 years. Markets don't lie in a 10 year and a 15-year period. Therefore, unless and until the mathematics, science and art of valuation are done properly, loose statements vented about in the newspapers and on the television, is releasing debates like this, is actually really unfortunate and it does a great disservice to the craft of the investing.
Bharat, as we look ahead what are the key sectors that you’re seeing in the economy play out? Is the consumer discretionary, pharma- can you just give us your sense on how you’re seeing the next 5 years?
Bharat: As I alluded earlier, my investing model is really on a bottom-up basis. So, I really look at picking businesses in making selection out of the vast array of names that exist. That said, there is some sector- I’m not saying you don’t even view on those sectors but really, investment is on a bottom-up basis. In that particular business, it is cash flow, its merits.
But some sectors do kind of highlight themselves. So, I would so finance is one which is going to grow for a long period of time. Whether the technologies undergo change, whether digital technologies undergo change and fintech and all of that, but the need for finance is fundamental. Quality banks and quality non-banking finance firms- they are huge opportunities. Typically, finance is the most sophisticated segment of the economy and it is usually a lead indicator.
It is a force multiplier because typically, growth of the finances is multiple times of the growth rate of the economy itself. So, usually, finance is an engine which ensures that these things are carried ahead properly. I remain very positive on the prospects of many of these businesses.
I think insurance is a business- both to life and general offer long term opportunities, because the country is under insured, per capita incomes, are still low, as incomes get better, the need to buy the insurance cover goes up and typically, with experience it has been seen that with income, the insurance tends to grow faster.
Today, we are under insured on a per capita basis as compared to the reasonable norm- if is counted, it’s probably less than one-sixth of what per capita insurance should be. I’m not even talking about penetration. So, insurance- both general and life have great potential.
In pharmaceuticals, India has a great capability, it has a very substantial local market, it has the capability to innovate. It was at a very basic stage of reverse chemical engineering, now it has improved. Now we’ve made forays into new chemical entities. Now, the path is that people will move forward further.
So, talking about the prospects of consumption in general, this is an inspirational society. The per capita income is still very modest. As income grows, a faster consumption will come into the play. It will be services, it will be durables, it’ll be staples. All kinds of consumption have a staggering amount of opportunity for a long period of time. Related to agriculture which has been very primitive badly done in decades and decades. The first time, I think we’re seeing some semblance of order and sanity being restored there, but it’s a long journey- maybe it will take 15-20 years for all the ills which had been plaguing that sector, to be removed.
But surrounding that area, there are a number of businesses which feed themselves and there is a big opportunity. Equally on capital goods and automobiles- though last one year has been a horrendous one- India remains a very strong local market and it has a tremendous capability to service the markets internationally.
I’m not in the ‘Uber and Ola camp’ that things will just disappear and electrical vehicles will overtake everything and certainly it’ll be a world which will float around in a virtual way. I think there is a huge opportunity and India will still do very well.