Valuing Companies With PE Ratio Is Inefficient, Says ASK Investment’s Bharat Shah

Exactly as what I said last Diwali: I feel like a kid in a candy shop. The opportunities are phenomenal. We just have to have a mindset to look for them. We need patience and discipline. We shouldn’t be carried away by all the general noise that we keep hearing all the time. We have to remain focused on opportunities. If you do that, there are plenty of opportunities. Just to buttress the point a bit further, we actually created a specialised finance portfolio about four months before the September 2018 IL&FS crisis. This portfolio had its baptism by fire.

If you (consider) the time when Sept. 22, 2018, IL&FS thing started, the general belief was this is a huge problem and things are going to go down under. A lot of things, of course, did go down under. We’ve seen plenty of banks have suffered. Plenty of NBFCs have been knocked down. But if we measure the finance portfolio which had actually been fully deployed before the crisis, then that’s up 24 percent.

The current situation is not a baptism by fire. I was referring to the IL&FS crisis, which began in September 2018 and therefore the portfolio that we started a few months before that obviously was fully built before that crisis happened and it would’ve looked at that point of time as if a perfect storm had happened or has begun and we got in there just before the storm started. So that was baptism by fire.

Today, I see that it’s a fantastic opportunity. I think a huge amount of churn that we see both in the economy as well as in the markets, I would describe as a phenomenally positive situation. Therefore if you’re able to spot the opportunities, we understand the transition, and we are able to properly focus on that, then this is a great opportunity.

Let me answer it in two-three ways. One, is everything priced in? We can all only opine but none of us has a laser-eye to be able to see whether everything is priced in. So, I would really rely upon opportunity for growth for the businesses and their valuation today. That to me is a more reliable guide than a lot of macro opinions that circulate around.

Secondly, we must remember growth can happen both from good capital as well as from bad capital. So, good businesses (and) good entrepreneurs will drive good growth; bad businesses and bad entrepreneurs will also result in growth when capital is committed but it will be a bad kind of a growth. Something has begun to change in the last two to three years, where increasingly both equity capital as well as lending are being denied to both the bad businesses and the bad entrepreneurs. To that extent, the bad growth, which was going parallel with the good growth, is beginning to be retarded. Therefore, we are witnessing a kind of softness. But this is a process of creative destruction and you cannot help it.

Poor quality growth has to be reined in so that good quality growth is nurtured, enhanced, and gets into a higher mode, which is exactly the process that’s going on. It’s that creative destruction that I remain very positive about. People have a variety of opinions on many of the reforms, but I remain very positive. Whether it’s the GST, which is aimed at cleaning up behaviour of businesses; demonetisation, which is aimed at cleaning up the behaviour of individuals; RERA, which is aimed at cleaning up the behaviour of the largest (but murky) sector of the country—the real estate. Equally, the Insolvency Bankruptcy Act, which is aimed at cleaning up of the behaviour of large industrialists and promoters and the huge clean-up on the bank’s balance sheets. Though the seeds for the problem were laid much, much earlier the clean-up began in earnest in the last couple of years. That’s beginning to change the lending culture as well as the borrowing discipline.

All of these reforms are staggeringly large ones; some more are probably in the pipeline, and I think reforms are bound to create some amount of hurt, otherwise they aren’t reforms. Reforms will mean disruption from the past and to that extent (in that interim period) the economy, businesses and individuals will necessarily have to go through (the disruption) in order to create a much better opportunity over a period of time. That is exactly what I believe and remain positive about.

Absolutely. You have to be careful as to what you buy and what you don’t touch. So, (look at) the quality of the business, the size of the opportunity, the quality of the management, and therefore, the underlying long-term predictable growth. More importantly, the superior quality of growth in terms of capital efficiency, your ability to determine the real value of the business and then buying with discipline at a margin of safety (are key factors). Then having the wisdom to stick with them and not flirt with them unnecessarily. So, when the value remains intact, you remain committed steadfast to the business rather than do the fashions and the fads of the market. If you do that, then I believe there is a fantastic opportunity like never before.

I don’t think of my investing (decisions) if it (the size of the stock) is in terms of large-cap or mid-cap or small-cap. I invest in terms of the underlying virtues or characteristics of the attributes which are fundamental to create value. These are basically what I mentioned earlier: the size of opportunity coupled with a great management. These together will cause growth.

Apart from that meaningful growth, it has to be sustainable, long-term and a predictable one. The quality of growth has to be right in terms of capital efficiency so that the growth converts into economic value. It’s our job as investors to judge the value rather than chase prices. Having determined real value, we must have the discipline to buy them at a margin of safety and having done all of that, don’t flirt with the positions unless the real fundamental value of the business has changed. Market fashion may fade and opinions may change, but the real value unless there are material and fundamental factors (that bring about change), remains intact. Our focus has to be on the value. So long as that remains intact, we ignore the short-term noise.

That’s what investing is about. When we find these attributes or the virtues in large caps, midcaps and smallcaps, but that’s fine. We’ve been investing in Bajaj Finance for almost 9-10 years. For companies like PI Industries, we have been investing for 10 years. 10 years ago, the market value of the firm was not even in four-digits. Today, it’s valued at around Rs 18,000 crore. Many of the businesses will cross the hump if they grow, if the quality is right and they will become bigger. But equally, large ones can become smaller if the quality isn’t right. So, virtue is not about not about midcap, smallcap or largecap. It’s about whether the businesses possess what it takes to create value. That could happen with small, mid-sized or large businesses.

That’s exactly what I’ve been saying. I mean, the portfolio will obviously consist of all the opportunities. The ones where there is a degree of size today but there is a potential for it to become bigger (then it is worthy). Equally, there may be a relatively smaller business yesterday but if it can become bigger by character, then obviously it’s worthy too.

We must have the ability to find such opportunities across the spectrum. So, there is nothing special about choosing from mid cap or large cap as a fundamental necessity. We have to look for the qualitative virtues that may reside in some of the small ones, some of the mid-sized ones and some of the large ones. Today, across the spectrum, opportunities are available. But we tend to dig the appellations and titles and give them labels as to mid and or large or ‘this’ or ‘that’. That is where I think we get carried away and make mistakes. So, the issue is not about whether the businesses or mid or large or ‘this’ or ‘that’, but about whether they have got what it takes to generate value.

Secondly, (I regard) the price-earning multiple as a superficial and inadequate measure of value. Price earnings multiple isn’t a very efficient way to measure value. Yet, at every point of time, even in the most bullish markets, by and large, a preponderant number of businesses will be at conventionally, on a price-earnings multiple basis, at a cheap number. This is because a large number of businesses are mediocre, and they deserve to be assigned a valuation. Unfortunately, people seek to infer value (from this) and make conclusions by looking at the price-earnings multiples. The real value of the business is inference about their cash flows, the incremental cash flow over the life of the business, the capital efficiency, finding a suitable discount rate to discount those future cash flows, judge the character of the business so that all of these are possible to infer. All that is both science and art. While this is a more difficult exercise, it’s a more satisfactory way to judge value.

Price today and earnings tomorrow or the day after is what the price-earning multiple is. It’s a very poor and inefficient way to judge that value. But unfortunately, because it is simple, people tend to make wrong conclusions by looking at that number.

PE is actually a derivative of a cash flow-based valuation and not the other way around. Therefore, (my point is) how can something derived from the business itself be a determinant of value? That’s the fundamental contradiction there. Therefore, many of these macro, loose conclusions often what the markets seem to make about these being cheap and that being cheap, actually are very superficial and it needs to be dug deeper.

Well, NBFC or the banking space that you just now alluded to is exactly what I was saying right at the beginning, the process of creative destruction. In the overall space, the value has remained the same, but the constituents have undergone a material change in terms of some going up materially and others going down. As far as the automobile sector is concerned, there is tremendous change, fundamentally. A lot of changes have occurred over the last one and half years—be it in the form of new insurance norms, regulatory terms and those related to safety.

There was some amount of expectation of a certain growth from the industry and there was unfortunate clogging up of distribution channels by excess pumping up of the inventory. A lot of factors have occurred and fundamentally that industry has gone through a bit of a challenge. We have to figure out whether this is permanent or temporary issue which has occurred in the character and evolution of industry over a period of time. At this juncture, rather than making a judgment, I am remaining watchful and not pre-deciding the way things are. We like to see how things evolve and will take our bets accordingly.

There is some amount of presence in some of those names where we think probably the level of decimation has been overdone in our opinion, but nothing is cast in iron and stone. We have to remain watchful and we’re keeping a close eye. My belief is, this is a passing phase and probably one year down, we will think of things differently.

You’re absolutely right. I mean, it’s the job of any investor to identify short-term changes versus the long-term changes. And if the market price is mispriced because too much attention is paid to short term, which could be different from the long term, therefore that may spell an opportunity otherwise. And therefore, it’s the job of every investor to keep judging the long-term change versus the short term and whether the market behaviour is governed at a point of time more by short-term or the long-term. Therefore, this remains an important idea at every point of time.

I think the finance space is one area where I believe, there is that cyclical short-term relatively smaller growth, but the long-term opportunity and long-term growth remains intact. There has been a series of challenges, there has been a fear in the minds of lot of people. A lot of it is justified by what is happening in the environment for those businesses. But to that extent, if you remain a disciplined and careful observer, then I believe a relatively softer overall growth of the credit over last one year or so is symptomatic of these changes rather than any long-term changes in the character. Therefore, to my mind that represents a perfect opportunity.

As far as automobile (sector) is concerned, my heart is telling me this is probably a short-term one and not a structural debility or weakness. But I’m still keeping my opinion somewhat guarded. I’m watching it carefully and as I said my belief is that the slowdown, (not slowdown actually reduction in both negative growth) is probably short-term but I will look for more signs and signals before making a conclusive judgment on that.

As far as the other areas are concerned, for example, consumption, I think it’s a perfect case of short-term slowdown while long-term opportunity to my mind remains powerfully strong as ever. It represents a great and perfect opportunity.

Well, two or three things there. One, we can’t really talk about the valuation of the sector. We have to talk about the valuation of each business and each stock. That is the only meaningful way to debate about anything about whether valuation is high or low, because overall sector valuation reveals nothing.

It really rides on the generality and therefore any opinion riding on the generality has the risk of being a flawed. Secondly, broadly speaking of course, that is correct what you said, the opinion of the valuation cannot be based on the price-earning multiple. It’ll have to be based on judging the real value of the business, which as I mentioned, is both an art and science. Therefore, the rigour of the entire process to judge the value has to be gone into, has to be maintained with discipline and one cannot get carried away by loose opinion that markets or opinion makers may be throwing around.

Thirdly, I am fairly satisfied, given the real size of opportunity, given the fact that the recent softness in the growth rate is actually a short-term tactical kind of a change. Sustainable long-term growth is superior to what is short-term tactical growth rate today. And to that extent, if we are able to build that number properly the long-term value and the cash flows, we will get more accurate and more sensible answers and that answer should really decide our actions. And in my opinion as far as the consumption space is concerned, there was an undue amount of pessimism driven by short-term negation (by) completely disregarding the long-term opportunity and sustainability. Therefore, there was a material mispricing. Some amount of that mispricing in many quality stock prices is being corrected. Some amount of mispricing, when I look at the individual businesses still remains.

Of course, we remain watchful. We like certain opportunities and the character of some of those businesses. But you must also be aware that if you look over the last five years, market indices have posted double-digit positive returns while, PSU as an index, has probably declined between 35-40 percent.

So, therefore there has been a material change in the spectrum of the overall opportunity and public sector businesses as a percentage of the total market value has declined materially over the last five years or thereabouts. But that’s just the data point. We cannot get carried away by that data point. There remains an opportunity. There are some outstanding public sector businesses that are available and which have appropriate prices and with appropriate stimulus, in terms of change of the ownership, I think of that as wonderful opportunity. I think the recent focus in terms of the privatisation is exactly what’s required.

Probably one of the most important remaining reforms apart from the ones that I referred to earlier (GST, demonetisation, RERA, bank balance sheet clean-up, and the NCLT mechanism to resolve bankruptcy) are privatisation, labour, agriculture and land acquisition reforms.

So, privatisation is a very vital deal and I think, recently what we’re seeing is a very important and huge positive change which has occurred in terms of how it has been looked at by the principle owner of these businesses, which is the government of India. I look at it as a hugely positive sign, so we remain watchful. We are very much interested and we will find appropriate expressions of it in our portfolios.