The Big Call: A Bubble In Quality?BloombergQuintOpinion
The Indian equity markets have never witnessed as high a valuation in a few stocks for such a prolonged period as we see today. Most of these stocks are usually associated with a perception of high and increasing growth and improving capital efficiency. While these characteristics are true for a few stocks, a closer look tells us a completely different story for the majority. Our study of 27 high P/E prominent companies in India shows that a majority have not delivered performance that justifies current valuations, and there can be little return expectation from these investments.
- Majority have grown even below nominal GDP since 2010;
- Majority will need to trade at 50x-75x P/E in FY28 for a mere 12 percent annual return in next 9 years;
- Global peers have grown faster and have better capital efficiency, but trade at 1/3rd valuations;
- Reverse DCF shows 30-40 years of consistent growth is required to merely affirm current peak valuations.
We attempt to unearth and understand the valuation bubble in perceived quality stocks in India. In conclusion, investors would do well to diversify allocations out of such stocks to a broader market.
Select quality stocks are in a bubble zone and could give zero or negative returns over the next few years.
Equity markets and investing have always been challenging and all participants are always in a perennial learning mode. We don’t know of a single person who would admit to being a know-it-all. Of course, we have grown up reading, listening and experiencing the greats of investing; right from value investors like Benjamin Graham, Warren Buffet, Peter Lynch and the likes of passive investment greats like John Bogle or enterprising hedge fund greats like Bill Gross, George Soros, Carl Icahn, and others.
There are various methodologies followed for the valuation of stocks and most fundamental based investors would follow one of the same or a mix of them. These would vary from a simple P/E (Price to Earnings), P/B (Price to Book), PEG (Price Earnings to Growth) kind of ratios to the more extensive Discounted Cash Flows (DCF) using the Capital Asset Pricing Model (CAPM). The basics of investing though remain the same: investing in a company’s stock is like becoming a partner in the company and the price paid for that share should justify the value for the business of the company that one is buying into.
Of course, there are always times when new innovative valuation methods come into play; like market capitalisation per pair of eyeballs during the ‘dot-com’ era, Enterprise Value (EV) per MegaWatt (MW) during the Indian power sector boom in 2007-08, Price-to-book for NBFCs based on likely future capital raise in India, Market Value to Gross Merchandise Value (GMV) for e-commerce, footfalls for retail, and various newer methods of valuing companies in the current era of disruption.
The future cash flows have to justify the price an investor pays for a stock today.
Over the last couple of years, the global economy and equity markets have seen enhanced volatility. A combination of global factors, protectionism, political uncertainty, record low bond yields, disruptions and new business models, massive private equity funding and the likes have led to polarised market behaviour. In India, another phenomenon experienced is the cleaning up of crony capitalism, liquidity related issues, corporate governance questions, increased banking non-performing assets, etc. The independence of auditors and rating agencies, apart from other fiduciaries have also been questioned, leading investors to become extra cautious.
All the above has led to a unique phenomenon: A bipolar market where the concepts of consistency, quality, stable earnings, low volatility, and perceived safety have done disproportionately well while the other side of the markets languishes due to investor apathy. A recent report by Goldman Sachs also highlights that an index of “stable earnings” U.S. companies is now trading at an all-time high 65 percent premium to “volatile growth” companies
Similarly, globally, the outperformance of Growth versus Value Stocks has had the strongest and longest run in the last 10 years or so since 1970 (MSCI World).
Being an intrigued investor and always willing to learn, the current performance of some of the “quality” stocks had us thinking. Based on all traditional metrics, these stocks seem to be extraordinarily expensive and therefore logically, not in our investment shortlists nor in our portfolios. We, at Abakkus, were not convinced about their valuation a few months back too and with their recent up moves, they have become more expensive. We got together to introspect what we were missing that other smarter investors understood and we did not. And that is where a very detailed study, analysing most of these stocks started.
We made a list of the current high P/E stocks as a start. A very detailed analysis and number crunching followed. Yes, it is said that stock investing is an art. It can never be only numbers and financials and there must be some qualitative & future growth perspective to it. But ultimately every valuation methodology has one underlying principle: the value paid today should justify the future earnings potential of the company.
The valuation premium of stable growth versus volatile growth stocks in the U.S. has gone well above its long-term median of 11 percent and well into bubble territory.
We made a list of a few prominent perceived-high-quality expensive listed Indian companies.
The revenue, EBITDA and net profit growth of each of the companies were tabulated from FY10-19. We also analysed the same growth over three and five years to clear the notion that near-term growth for such companies has been higher and therefore the high valuations.
We analysed the nominal GDP growth for India during this period, as logically superior companies should grow at a much higher rate than nominal GDP. Also analysed was the CPI inflation during the last 9 years. Most of the companies selected are consumer-facing companies and sales growth for each one of them is a combination of inflation and volume growth.
Natural deduction follows that given the much lower inflation now in India, nominal GDP growth for the next 9 years should average much lower than the last 9 years, even presuming a similar real GDP growth rate of 7 percent-plus. It is also natural to believe that the penetration levels today of most of these products is much higher than what it was 9-10 years back and hence the growth for the next few years should be lower than what it was over the last few years. Nonetheless, we are presuming that all the companies in our universe of study will grow at the same pace over the next 9 years as they have over the last 9 years.
Extrapolating it further, we have built a scenario analysis of return expectations from these stocks.
For example, HUL has grown its revenues at 9 percent CAGR and net profit at 12 percent CAGR in the last 9 years (table above). This also has to be seen in the light of nominal GDP growth of 13 percent during the same period, implying a growth for Hindustan Unilever of less than the GDP growth.
Even if HUL’s profits continue to grow at 12 percent CAGR till FY28, its P/E in FY28 will have to be 55x for a mere 10 percent annual share price return and 82x for 15 percent annual share price return. Similar projections were done for all the other companies under the study.
1. Out of 27 companies in the study, in the last nine years,
- Average annual profit, EBITDA, and revenue growth has been 11 percent, 12 percent and 12 percent respectively.
- Six companies have grown profits at less than 5 percent CAGR.
- Seven companies have grown revenue at less than 10 percent CAGR.
2. 18 of the 27 companies need to trade at P/E more than 50x in FY28 for a 12 percent annual return.
3. Seven companies out of these need to trade at P/E of higher than 100x in FY28 for a 12 percent annual return.
The reason attributed by analysts and investors in favour of these high P/E companies has largely centred around the stability of earnings and much superior growth. A few market participants whom we spoke to, justified the high PEs as they believed that these companies were growing at rates of 20-25 percent every year.
However, surprisingly most of the companies have grown in line or around the pace of nominal GDP growth.
Colgate India for example has grown revenues at a CAGR of 10 percent and profit at a CAGR of 7 percent over FY10-19. One important reason presented for the high P/E ratios for these companies is stable and higher growth. This data of growth is not too different than nominal GDP growth, thus making the argument of 50x-75x P/E multiples based on higher growth untenable.
If we look at the table above, we can see the implied P/E ratios which these companies should trade at in FY28 to generate 10 percent, 12 percent and 15 percent CAGR returns over the next 9 years. Thus, for Asian Paints to yield the investors a return of 10 percent CAGR over the next 9 years, it will have to trade at a P/E of 71x FY28 earnings and for a 15 percent CAGR return, the P/E will have to be only 106x FY28. Similar data is extrapolated for all the companies under study. We don’t think anywhere in the world at any point of time, companies have traded at P/Es of 50-100 for 10-15 years at a stretch.
Contrary to the perception of high growth in expensive companies, a majority of companies in our study have grown below the nominal GDP growth rate since FY10.
We also analysed, global companies that are comparable to respective Indian companies. Again, the general belief is that Indian consumer companies are expensive compared to their global peers because of superior revenue and profit growth. Let’s take a look at the table below.
Sherwin Williams and Asian Paints are the largest and most valuable paint companies in the world and India respectively. A quick look at their fundamentals shows that Asian Paints has reported revenue growth of 13 percent CAGR over the last nine years, same as nominal GDP growth of India and just 2 percent higher than that of Sherwin Williams. However, the profit growth of Asian Paints over this period is only 11 percent compared to a healthier 16 percent for that of Sherwin Williams. Even RoE of Sherwin Williams for the last reported annual numbers are higher than that of Asian Paints. But, let’s take a look at the valuations. Asian Paints trades at a P/E of 78x FY19 compared to Sherwin William’s 29x based on CY18 numbers. Even on market/sales, the premium is startling. Asian Paints trades at market cap/sales of 9x vs Sherwin William’s of 3x.
Belying the perception of high growth justifying high PE, Asian Paints profit has grown much slower than Sherwin Williams since FY10, but still trades at a 300 percent premium.
Implication Of Reverse DCF Of Fair Value
Another logical reason given for the high multiples of these companies has been their stable earnings, great balance sheets and low volatility. There is a thought that given their low beta, a DCF valuation matrix is more ideal. We undertake even that analysis of two prominent FMCG companies: HUL and Nestle India.
While the average cost of equity for Indian markets is cited close to 13 percent, we have given a much lower cost of equity of 9 percent to both HUL and Nestle, by taking a very conservative beta assumption in the CAPM model. Understandably, 9 percent cost of equity is very generous, given the risk-free rate of India is around 7 percent.
To justify the current market cap of Hindustan Unilever, the company will have to grow at 10 percent CAGR for the next 35 years and thereafter 5 percent in perpetuity, or 12 percent CAGR for the next 25 years and 5 percent in perpetuity.
Just to put things in perspective, Hindustan Unilever's revenue and profits will have to be Rs 11 lakh crore ($160 billion) and Rs 1.7 lakh crore ($24 billion) after 35 years, if it were to achieve these growth rates.
A similar analysis for Nestle India is also presented in the table above.
Intrinsic valuation of Indian FMCG companies like HUL, Nestle shows they will have to grow at 10 percent for a staggering 35 years or at 12 percent for 25 years to merely justify current valuations.
Comparison With A Few Crucial And Large Indian Sectors
We also attempted to compare the valuations of these high multiple companies with some core sectors of the economy, that are very large but with more volatile earnings.
As can be seen from the table below, the total market cap of Hindustan Unilever and Nestle India is more than the market cap of all listed Indian companies in the following sectors: iron and steel, construction materials (includes cement), non-ferrous metals and ferrous metals (classification as per Ace Equity). The peak profits in the last 9 years that these companies made is around Rs 73,000 crore, almost 10x that of Hindustan Lever and Nestle India put together.
These are startling numbers and again question the all-time-high and near bubble valuations that these consumption facing companies in India are trading at.
HUL and Nestle together have higher market capitalisation than the combined market capitalisation of top 40 core sector companies, even though their peak profits is less than 1/10th by comparison.
Why Have These Companies Traded At Such Expensive Multiples And What Is The Reason For Their Continuing Near-Term outperformance?
The reason for the continued overvaluation of these companies is skewed investment inflow to these large-cap companies over the past 4-5 years. As can be seen in the chart below, incremental domestic flows that were invested into the top 100 listed companies used to be only 31 percent of total flows in 2013-14 that have now risen to a whopping 84 percent in the top 100 companies and 96 percent in the top 200 companies. On the foreign portfolio investors front, till June 2014, 48 percent of their investments were in the top 100 companies and 77 percent were in the top 200 companies. This has now risen to 88 percent in the top 100 companies and 96 percent in the top 200 companies.
The trends of institutional investments, both domestic and foreign, clearly indicate that investors have focussed only on the larger companies irrespective of valuations while ignoring the broader markets even though there is a big valuation gap. Few of the reasons for the same might be:
1. Flight To Safety: In an environment of volatility, fear, and uncertainty, these companies have presented some growth and no negative news flow. Thus, investors have been comfortable adding these stocks to their portfolio as allocation bets.
2. Inclusion In Index And Passive Funds: The outperformance of these stocks on an absolute basis and significantly on a relative basis has led to a surge in their market capitalisation. The increase in market cap has led these stocks to be included in multiple indices, both in India as well as global indices like FTSE EM and MSCI. In an era of passive investing gaining ground, more inflows in passive funds have led to more buying in these stocks irrespective of valuations.
3. Regulatory Classification: In India, the reclassification of funds initiated by the regulator, SEBI, has led to most of the mutual fund inflows moving to the top 100 companies.
4. Self-Fulfilling Cycle Of Pyramiding: Since these stocks have done relatively very well, funds that own them have done well over the last 2-3 years. Near-term performance attracts more money and then the funds buy the same stocks again. Thus, it’s a self-fulfilling cycle of buying, performance, flows and more buying in the same stocks.
Incremental investment inflow from institutional investors has been almost fully into the top 100 companies in recent years.
Why We Believe That These Companies Will Give No, Low Or Negative Returns Over The Next 5-10 Years
All-time high valuations. To make even 10 percent CAGR returns, the companies will have to trade at P/E ratios of 50-75x in FY28.
There have hardly been companies in the global markets which have traded at multiples of 50-75x for periods of 10-15 years. In fact, we found that very few companies in the U.S. have traded at P/E over 50x for even five years cumulatively since 1990 even though this period included ‘dot-com bubble’ and ‘subprime crisis’.
Modern trade and e-commerce are making competition in a lot of these segments much easier and funded by risk-taking private equity funds.
Our view is very clear: unless the growth expectations of these companies over the next few years goes up significantly, there is absolutely no fundamental justification for these valuations to sustain.
There have been many instances in India itself, where the same companies or similar companies have seen no or negative returns over long stretches of time, for example HUL between 2000 to 2010 or recently even companies like ITC, Castrol and Page Industries.
While it is difficult to foresee what will cause these companies to underperform, history has shown that something happens that pricks the bubble balloon.
What Can Cause Our Conclusion To Go Wrong?
- In the near term, risk aversion may lead to more flows being invested in the “clean, safe, quality” basket.
- A company or a few of them may surprise on growth being much higher than that over the last few years.