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All investors want to own quality companies in their portfolios, these are all weather companies which if held over long periods of time give satisfactory returns to its holders and are better placed to handle the swings in the market.
But what is actually quality? this term may be used loosely, however it is important to lay down certain features that quality companies posses.
Some of the characteristics of quality companies are
Quality of its earnings – the P&L statement is usually where the focus lies, however the other two financial statements – balance sheet and cash flows are key as well. For instance, a company may increase its sales on the back of extended credit terms, increasing receivables in the process. In this case higher sales is reflected in the P&L, however their is a strain on the balance sheet and cash flow statement by the way of increase in receivables and drop in CFO. We had written about quality of earnings in the past.
Products and Innovation – Asian Paints was the company that brought the tinting machine to the market, this gave them an advantage that they hold even to this day. We had written about the paint industry and looked at why Asian Paints dominates the paint market. Fevicol from Pidilite is another example.
In the case of creating/innovating new products, take the case of APL Apollo. The company has been the first company in India to bring the DFT technology and constantly innovates to bring new products to the market. It runs its operations efficiently and has been gaining market share. We had covered APL Apollo in our taking stock series. These factors provide scaleability, competitive advantage and longevity in earnings for these companies.
Quality of management – Some of ways we can assess management quality is observing management in media interactions, checking related party transactions and management compensation in annual reports and researching/checking on how the management has run the company for years
Capital allocation – Ability of the company to generate cash and allocate that capital in opportunities that generate return higher than the cost of capital. Analysis of the ROE and ROIC demonstrate the capital allocation process of the company. We had written a two part series post on understanding the drivers of ROE (Part 1 and Part 2). If the company is unable to allocate capital in the business, the cash that it generates should be returned in the form of buybacks and dividends.
The above features are not exhaustive and there may be a lot of other features that also define what quality is.
Does buying quality companies at any price work? Will investors make money backed up by strong financials when stocks are trading at rich valuations?
We look at 7 companies in the mid and small cap space and see if this works.
We look at when these companies hit their all time highs and then look at important financial metrics for 5 years from the time they hit their all time high. For instance if a company hits all time high in January 2015, then we look at important financial metrics for the FY10-15 period. We do this on the assumption that earnings are the primary driver of stock prices, however there may be other factors like institutional buying that helps driving stock prices.
Below is the list of the 7 companies
Let us look at some of the important financial metrics of these companies for a 5 year period prior to their peak prices. For instance, Symphony hit its all time high in Jan 2018, we look at financials of Symphony for the FY13-18 period.
Some of our observations from the above financials are
All of the above point out to strong financials of companies, 5 years before they hit their all time highs. These were well run companies with good management quality.
We look at two valuation measures – EV/EBITDA and PE for the same period – 5 years prior and the day on when these stocks hit their all time highs.
As can be observed from the above both the valuation measures on the day of the peak are rich. For instance in the case of Atul Auto, the EV/EBITDA and PE on the date when it made its all time high was 25X and 38X, higher than in any time over the past 5 years.
What happens if we were to buy these stocks at prices when they made their all time highs and held it until recently?
Why would one buy these stocks at these prices? There may be many reasons but just to illustrate a couple
We do not know that these valuations are at peak at that point of time, yes they trade at the higher end of the valuation metric but if earnings were to grow and companies have a long run way then prices can move up even further. An investor may assess that these companies will continue their run and buy at these prices. Remember markets discount the future.
FOMO effect, for instance in the case of Atul Auto, two funds of Goldman Sachs bought the shares at near to its peak prices. Investors may consider a marque name like Goldman entering the stock as a positive sign and jump into the bandwagon. However the key thing to remember is for GS the position may be very small, however a small retail investor may invest a substantial sum of her money in the stock.
Firstly we look at the financials of companies post their peak prices up until their latest financial year – FY20. For instance, Symphony made its high in January 2018, we look at financials for FY18-20 period of the company. The time frames post the peak will differ, but the idea is look at the trend in financials post the stock has touched its high.
Some of our observations from the above financials
Let us look at the valuations of these stocks as on 9th November,2020 and the high/lows from their previous peaks
On both the EV/EBITDA and PE front, the stocks are way off from their peaks. Are these worth a buy at the current valuations? It may not be a bad idea to dig deeper into companies, as companies still have good financials. However understanding the levers of the business and having a fair idea of how these businesses will shape up in the future is essential.
What are prices as on 9th November and how do they compare with their peak prices
We compare these drawdowns/prices with the Midcap and Small Cap index
To compare the index return with the stock return, we take index values at the end of month when the stock had hit its all time high. For instance, we compare Cera with the Midcap index and take the value of the index at the end of January,2018 when the stock had made the high. These values are then compared with end of day values of the indices on 9th November,2020.
Source: Nifty Indices
As can be observed from the above, all stocks have lost more than the indices. What could have lead to this outcome?
Some of the factors that could have lead to the fall apart from the fall in earnings as discussed above are as below
Stock prices went up not only on earnings but also on PE expansion.
As can be observed from the above table, change in PE is way higher than change in the EPS. PE multiples had expanded sharply. We look at the PE for the 5 financial years before the peak. Since all the companies have not been able to keep pace with the earnings growths, PE’s have contracted. Some of the companies even trade at higher PE ratios currently, to understand how to interpret PE ratios, read here.
This is one of the points that need to be kept in mind before investing in mid and small cap companies. If the earnings are not able to maintain momentum, then share price falls are much steeper. In other words, the market does not give them the benefit even if the drop in earnings is temporary, if they trade at rich valuations.
Trimming by MFs/FIIs
Buying/Selling of securities by MFs and FII’s/FPIs also aid in stock price movement.
For instance, take the case of Mayur Uniquoters. Mutual funds and FII holdings have increased from 11.76% to 20.49% in FY18. At the end of FY20, their holding has come down to 10.83% from the peak. Large institutions entering/exiting stocks, do also impact share prices to a certain extent.
In another case the FOMO effect may induce retail investors to buy stocks as has been discussed in the case of Atul Auto earlier.
Mid and small companies are run by families and naturally so. If the promoter has the vision and execution capability then these companies go onto to become big and then professionalise their operations. However, when they are small or medium in size lot of issues may crop up.
Take the case of Mayur Uniquoters, the son of the current MD Suresh Podder left the company and had a dispute with the family back in FY18. Mr Suresh Podder who runs the business is +70, hence the business faces key man risk even today.
The market does not like these kind of uncertainties and stock prices do take a beating when events like this occur, even though the business might be doing well.
It gets all the more important to understand the levers of business and basic understanding of how the business works in the case of small and mid cap companies. Not to say, this does not hold true for large companies, however one needs to be more diligent while valuing small companies.
For instance take the case of Symphony, the peak valuation of the company was Rs 15,000 Cr. The air cooler market in India – residential and industrial air cooler market at that point was about 7,000-8,000 Cr. The company was trading at 2X the industry size. While the company did have opportunities in the global market – USA, Mexico, Brazil and China, those markets were Rs 5,000-6,000 Cr and Symphony was trying to enter those markets. While this is looking at the situation in hindsight, however this simple fact of the company’s market capitilization higher than the industry size and stock trading at 90X earnings at its peak would be a signal to look for alternative opportunities.
In another case, Atul Auto while the financials of the company were top notch. The company operates in the competitive 3W space. Bajaj is the leader with market share of 50% in the passenger 3W segment and Piaggio in the cargo segment. While evaluating investments, key questions to be answered are If the company enjoys any competitive advantages? Is the business scaleable? and longevity of earnings. The company currently has good financials, however it was not able to scale up its business. Bajaj Auto traded at an PE of 15-22X between 2012-15.
All of the above companies have decent ROE and ROCEs currently, however ROCEs need to be backed up by earnings and growth. If the company has higher ROCEs and no/low growth, then the cash that it generates from the business has to be returned to shareholders in the form of dividends/buybacks.
An interesting discussion on how to think about ROCE on twitter by Professor. Sanjay Bakshi
It is no doubt that investing in mid and small companies is hard, investors need to be more diligent and lot of variables need to be understood before jumping the gun and adding companies. It is evident from the above if stocks are bought at rich valuations even backed by good numbers, returns may not be satisfactory or the holding period has to be extended if the business/earnings were to gain traction.
Some of the factors to keep in mind while evaluating investments in mid and small size companies are
We have looked at companies which have hit all time highs and have languished since then, however there may be cases where companies have continued to march on after hitting all time highs. This would be interesting to explore and can be topic of another post.
This article is for information and should not be considered as recommendation to buy or sell any stock. Stocks mentioned could be part of Capitalmind Premium Portfolios.
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