Diamonds In The Dust
The ABC Of Indian Stocks
As they will see in subsequent chapters, the Consistent Compounding approach to investing is simple to understand but not easy to practice. The critical challenge investors face at the very outset is that ‘consistent compounder’ stocks are few and far between in the Indian stock market. This book is not about the vast majority of stocks that do not possess the three foundational pillars of consistent compounding mentioned earlier. Instead, this section discusses the kind of stocks that make up this vast majority of the Indian stock market and the kind of stocks that are the small minority of ‘consistent compounders’.
Given how price multiples have expanded for high-quality companies over the last decade, should investors be concerned about the sustainability of stock returns from such companies if they buy at current levels? Their answer is a resounding NO . . . whether they look at bull market phases of the Indian stock market or bear market phases, all the evidence points in one direction—starting-period valuations have minimal impact on long-medium-run investment returns in India. Moreover, the lack of correlation between starting period valuations and long-term holding period returns seems specific to India.
Eighty years ago, Benjamin Graham and David Dodd introduced to the investing world the then-revolutionary and interlinked concepts of ‘value investing’ and ‘margin of safety' in their book Security Analysis. In an era ravaged by the Great Depression, the two men pointed out that the way to make money in the stock market with a high degree of certainty is to buy companies with low P/B, low P/E multiples and low debt. In addition, such investments meant that your purchase price would be significantly below the fair value of the stock, thus providing a ‘margin of safety for the investor.
Since the publication of Security Analysis, numerous academics have shown that value investing does generate superior results in the US market and elsewhere. Even more famously, Warren Buffett, in his famous 1984 speech at Columbia University—which they referenced earlier in this chapter—reaffirmed the superiority of value investing to other investing approaches:
The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. Essentially, they exploit those discrepancies without the efficient market theorist’s concern about whether the stocks are bought on Monday or Thursday, whether it is January or July, etc. Incidentally, when businessmen buy businesses, which is just what our Graham & Dodd investors are doing through the medium of marketable stocks . . . Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities.
These are not subjects of any interest to them . . . So instead, investors focus on two variables: price and value.
In India, too, one could argue that value investing (i.e., buying companies when they are inexpensive on P/E) makes sense for most stocks. One can divide the Indian stock market into broadly three sets of companies:
TYPE A stocks comprise around 80–90% of the Indian market. Such companies find it difficult to grow earnings over extended periods. This is because they have no sustainable competitive advantages and hence no ability to generate a Return on Capital Employed (RoCE) in excess of the Cost of Capital (CoC). Lacking sustainable free cash flows, such companies struggle to invest in growing their businesses.
Examples of such companies are India’s telecom providers and its airlines, with never-ending volume growth but with no sustainable competitive advantages and hence no earnings growth.
If you assume that you make returns from investing in any company from two sources—either the P/E expands or the earnings expand—with Type A stocks, your only hope of making money is that the P/E grows (since the earnings are unlikely to expand). If you find a fund manager who can double the Type A company’s P/E over a decade, your returns will compound at 7% CAGR. If the fund manager you found mistimed his investment, i.e., he entered when the P/E was high (he wasn’t a value investor) and exited when the P/E had halved, your return will be -7% CAGR.
TYPE B stocks account for a further 5–10% of the Indian market, and this segment includes good franchises like Maruti or HUL, which have meaningful competitive advantages. As a result, these companies will have a RoCE higher than the CoC in most years. Moreover, reinvestment of the free cash flow will allow these companies to grow their business at around 10–12% CAGR, i.e., the same rate as nominal GDP growth on a cross-cycle basis.
Here too, value investing works. If you can find a fund manager who enters Maruti Suzuki at 13x P/E and exits a decade later at 26x P/E, the stock would give you returns of around 18–19% (10–12% from earnings growth and 7% from P/E doubling). If, on the other hand, your fund manager has mistimed your investment, i.e., he entered when the P/E was high (he wasn’t a value investor) and exited when the P/E had halved, your return will be 3–5% CAGR (10–12% from earnings minus 7% from P/E compression). A committed value investor like Warren Buffett can generate high-teen returns with Type B stocks if he times his entry point well. This is exactly what Buffett’s legend is built around.
If we were living in America (or in any other large economy, barring India), Type A & B stocks would form the entire investment universe. However, there is a third subset of stocks in the Indian stock market— Type C.
This book is all about Type C stocks. However, such stocks constitute less than 1% of the Indian stock market (if measured by the number of stocks). So, why did the author write a book about a handful of companies which make up less than 1% of the Indian stock market?
India is perhaps the only large economy where one or two players dominate several industries, and these dominant players make returns on capital employed (RoCE—earnings generated on each unit of capital employed on the balance sheet) that are significantly higher than the cost of capital (CoC) for several decades. For instance, it is not hard to find global players who dominate their industries—Walmart dominates US grocery retailing, Carrefour dominates French grocery retailing, Toyota dominates the mid-segment car market in Japan, and Hanes dominates Europe’s innerwear market. However, none of these companies makes RoEs substantially higher than their cost of equity. On the other hand, India has several industries where one or two companies have a dominant market share. Still, their RoCEs have also remained substantially above the cost of equity for decades in a row.
We can call these Indian companies—whose RoCEs are a million miles above their CoC for decades on end—Type C. The vast free cash flows that these firms generate decade after decade allow them to pay generous dividends (dividend yields for such firms tend to be 2–3%) and reinvest in growing the business. As a result, earnings growth for such firms tends to be around 25% per annum.
With a Type C firm, if the fund manager can get the timing of his entry and exit right, the results are spectacular: 25% earnings growth + 7% from doubling of P/E + 2% from dividend yield = 34% per annum return. However, since many of these firms are trading at optically high P/Es, let’s assume that their P/Es halve over the next decade. These Type C firms produce a return of 20% (25% earnings growth—7% for P/E halving + 2% dividend yield). Interestingly, even with P/Es halving over ten years, Type C firms produce returns similar to Type B firms with P/E doubling (20% vs 17–19%]. For 99% of Indian stocks, value investing provides the only route to decent returns (in the mid-high teens). The challenge that India’s Type C firms pose to Graham & Dodd’s value investment paradigm can be understood in the context of the investment framework that these legends had laid out in Security Analysis.
The value of a firm is nothing more than its future cash flows (discounted appropriately). These future cash flows are nothing more than the gap between RoCE and CoC. When a firm or firms in any industry are earning a return on capital far higher than their cost of capital, they attract new players into the industry who also wish to make attractive returns. The more the number of players, the greater the competitive intensity in the industry, putting pressure on profitability and returns for all players, including the incumbents. As a result, the gap between the RoCE and CoC keeps narrowing. However, if the gap between the RoCE and CoC does not close (say, because the Indian economy is not as competitive as the US economy or the Chinese economy)—as often happens with Type C companies in India—the future cash flows of such firms remain healthy. Hence, they drive a high value for the firm.
Such firms can therefore command very high P/E multiples. But, as they have said before, less than 1% of the stocks in the Indian market fall in this category! For the remainder of the investment universe in India—as in America—the rules of Graham and Doddsville can be successfully applied.
In this book, the author discusses why Type C firms exist in India, how you can spot them, and how much money you can make from them. The table below summarizes the taxonomy of Types A, B, and C outlined above.