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January 2016
Dear Investors and my dear Advisor friends,
Wish you a very happy and prosperous 2016.
This month instead of writing a newsletter to you, I am taking the liberty of reproducing (with permission), the extracts of an
interesting blog written by Mr. Jatin Khemani of Stalwart Advisors. You may use the link http://stalwartvalue.com/obsession-withpe-multiple/ to access the article. I find it extremely useful and I believe it would serve as very interesting reading.
“Indians are known to be very smart consumers; always looking for value-for-money offerings. Fortunately or unfortunately, that
should make us very good ‘Value Investors’.
However, how do we know if a stock is a bargain or not? By default P/E ratio has become that barometer on which majority is trying
to answer this critical question. You mention a stock and the first question would be ‘Boss iska P/E kitnahai?’(How much is its P/E?)
P/E which is price-to-earnings ratio is the most commonly used valuation ratio to make sense of how expensive or cheap a stock is.
The reason for its popularity is its simplicity; P/E of 20 means the business is available at a market capitalization which is 20 times its
annual earnings, in other words the stock price is trading at 20 times its earnings per share (EPS). The ratio which can anyways be quickly
calculated mentally is also available widely on all portals and invariably the first most people would check.
Through this post, I will briefly cover three ways in which lot of us get it wrong when it comes to making sense out of P/E:
Folly 1: Lower the better; always true?
A lower P/E does not always imply that the stock is a bargain. Though the numerator of this ratio (price) is for everybody to
see, what we ignore is the denominator (quality of earnings) where lies the most important information. This is all the more
important in case of cyclical businesses. For instance look at following information pertaining to CEAT Tyres:
An investor basing decision only on P/E would find it expensive in 2012 at P/E of ~17 and may give a pass to a potential 10bagger, without realizing that the earnings are depressed due to sky rocketing rubber prices (key raw material) that almost
went 3x in previous three years and effected profitability of entire industry.
EPS
P/E
Stock Price
CEAT
FY12
5.2
16.7
87
FY15
78.4
10.3
804
(Data as on 31st March, 2015)
The same investor might find CEAT attractive now given the P/E is much lower at 10 times, again missing the point that operating margins and hence earnings are
cyclically high, thanks to huge tailwind provided by falling rubber prices which doubled margins.
In reality, CEAT was cheap at 17 P/E in 2012 and could be relatively expensive today at 10 P/E in 2015.
Then there are some businesses where inherent economics are bad or are run by crooks. These businesses are being offered to you at low P/E because of some ‘reason’ and
not necessarily because they are ‘hidden gems’. Until and unless there is a trigger like change of management, change of heart or a new strategy, buying such businesses
only on the basis of low P/E may be akin to catching a falling knife.
On the other side of the spectrum, there are some beautiful companies out there which trade at optically ‘High’ multiples; but what many ignore is how their earnings are
grossly understated.
Investment pundits talk about such companies as ones with ‘capacity to suffer’ in the short term to reap benefits in the long term. These companies are investing today to
remain relevant and to have ability to continue to grow tomorrow, with meaningful investments going into research & development, technology, branding etc. which all
may be creating intangible assets but are being expensed to P&L every year.
Folly 2: Comparing apple with oranges
Based on the limited data given in the table below, please answer the following three questions
Company
P/E (22-Dec-15)
Liberty Shoes
21.2
Bata India Relaxo Footwears
26.6
46.4
1. Given that all three operate in the footwear industry, can we assume they are all ditto same?
2. Can we conclude Liberty is cheap given valuation multiple of other two?
3. Can we conclude Relaxo is expensive given market leader Bata trades at lower multiple?
The correct answer to all three questions is ‘Insufficient Information’. The reason is because all three may be vastly different in terms of:
1. Presence in different categories within that industry,
2. Business Model: In-house manufacturing Vs. Outsourcing (Asset light),
3. Different geographic exposures, reach and growth strategies
4. Beneficiary of Industry Tailwind vs. Own Efforts
5. Leveraged Balance Sheet Vs Debt-free
6. Complacent Management Vs Fire-in-the-belly
7. Lala Vs Professional Management
8. Big Talk vs. Proven Execution Capabilities
9. Standards of Corporate Governance, Transparent & Timely Disclosures
10. Respect for Minority Shareholders and other Stakeholders
11. Me too Vs. Differentiated, Established/Emerging Brand……..
(Continued overleaf)
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Just the way no two humans are 100% alike and hence cannot be compared; we should ideally not be comparing two different companies to benchmark valuations
against each other.
Let’s say even if both have a lot in common, aren’t we assuming the peer stock is rightly valued? What if even that is grossly overvalued/undervalued and hence making
this stock seem cheap/expensive?
As they say, “if you want to justify buying a 30 P/E stock, compare it with a 50 P/E stock and your job is done”.
Benchmarking valuations to a competitor is lame and a convenient short-cut which can lead to wrong decision making. Let investment bankers do that, but any serious
long term investor should ideally avoid this folly.
How you value a business should only be dependent on two things:
1. Business Quality and
2. Management Quality
And then assign a P/E you think this business should command, rather than starting by first looking at stock’s and its peer’s P/E.
Folly 3: To drive while looking at rear view mirror
Majority of the investors talk about trailing-twelve-months (ttm) multiple, as that is what is widely available at finance portals like moneycontrol or BSE’s website. This is
nothing but earnings per share of previous four quarters / 12 months.
But aren’t we betting on the future earnings? So, do entry multiples really matter? I am sure a lot of people would still answer ‘yes’ to it.
In that case my follow-up question would be- how would one arrive at a P/E for a company that incurred one-time loss last year and has negative earnings? One cannot as
the denominator is now negative. In this case the same person will try to work out the expected earnings next year or year after that and decide whether its attractive or
not. This essentially makes last year’s profit/loss figure less relevant and future earnings potential the key factor.
Whether you pay a trailing P/E of 10 or 30 or 50, in the long term your returns broadly would depend on three factors:
1. Future earnings growth: A function of sales growth, margin expansion due to operating leverage and/or sales-mix change and interest cost saving (retiring
debt).
A 10 P/E stock would fail to generate good returns if the business fails to grow its earnings per share, whereas a 30 P/E stock can create massive wealth if its
earnings grow consistently at 30-40% CAGR. That is what makes earnings growth the most important driver of stock returns in the long run. Classic example
is Page Industries which was never ‘cheap’ but due to consistent and high growth in earnings created massive wealth over last 5-6 years.
2. Exit multiple: A function of market perception of further growth potential in the business, over the next period.
Aneminent professor, who has been a guiding force in investing community, has explained the relevance of thinking in terms of ‘exit multiples’ really well. He
suggests that investors should be conservative while assigning exit P/E. According to him an investor should use conservative assumptions as compared to
the actual performance of the business in the past and never assumean exit multiple more than 20x, the idea behind the assumption is to create multiple
sources of margin of safety.
3. Dividends: A function of reinvestment opportunity within the business
If you invest in large companies generating lot of free cash and high payout, dividends can make meaningful contribution to returns. However in our case, we
primarily invest in emerging companies from small & mid cap space, and these companies have a huge run way to grow by reinvesting capital; dividend
payouts are low and hence the yields contribute insignificantly to overall returns.
Now, there is no way we can predict the earnings of a company for next year or for 2020 with any precision. However, as investors we would fail in our role if
we do not even have a range of possible outcomes with their likely probabilities.
We do not know whether company X from our portfolio can report Rs 23.56 EPS in 2020, but can we attach a high (lets say 70-80%) probability that the figure
will be above Rs 20 and with a reasonable exit multiple of 15 we can at least make XX% CAGR in this stock, which is above or close to our hurdle rate? And the
answer is ‘Yes We Can’. By keeping assumptions conservative and working out a base case (highly likely) scenario, one can position himself for good luck. At
the end of the day, investing is never certain, it’s all about probabilities.
To Summarize:
While using P/E as a valuation tool we need to make sure we are not committing any of the following mistakes:
1. Assuming lower is always better and vice-versa
2. Benchmarking P/E against peers or industry average ignoring the differences in business quality and management quality
3. Considering only trailing multiples with little regard to exit multiple and future earnings potential.”
I would like to thank Mr. Jatin Khemani for his permission to reproduce from his blog.
Talking of PEs I had an interesting experience when I recently met a prospective investor in Delhi in the end of December 2015. After a long discussion on investing in
equities and our stock picking process of buying Q-G-L-P stocks, he asked me what’s the average PE on the Sensex. I told him it is approximately 18 times. This means I
have to pay Rs. 18 for every Re. 1 of earnings received. I said yes that’s what it means. Being a smart business man his immediate retort was; what kind of business is this!!!
On Rs. 18, in some instruments the interest I can earn itself is Rs 1.8 per year, which means by paying Rs. 18 I can earn Rs.1.8 in fixed income, why should I Rs. 18Rs to earn
Re.1 in your equities??? I explained to him that yes we are today buying investment worth Rs. 18 that is yielding Re. 1 currently but if it is indeed a Q-G-L-P investment the
Re. 1 will be compounding at 20% year on year. At the end of 10 years from now the bond would have added cash flows of Rs. 18 on an investment of Rs. 18 while the stock
based on its 20% earnings growth would have added cash flows worth Rs.31.15!!! Which one is better?
And then the investor just shocked me with his next question! He asked me: Oh! If that’s the case why do people try to buy companies that are cheap but do not have a
bankable track record or probability of growth!!! Because if you buy cheap – say at 12 PE and the earnings do not grow – they remain at Re. 1 or thereabouts or they do not
bounce back for 3-4 years after you supposedly bought cheap and turn around only after a delay what happens??? This insightful question on buying cheap vs buying
“expensive” set me thinking and I have worked out some permutations and combinations of how an investment in cheap vs expensive could play out. Suffice it to say –
(Continued overleaf)
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buying cheap is not necessarily a winning proposition and buying “expensive” is definitely not necessarily a risky bet. It all depends on earnings profile and growth in
earnings and if at all there is any conclusion – I’d say one is better off buying companies with track record of growth even if they are perceived to be “expensive”!!! Have a
look and the only thing this reminds me of is the popular Marathi adage – Dista tasa nasta (what appears is not)!!!
The table above is used to explain the concept and is for illustration purpose only. It should not be used for development or implementation of an investment strategy and
should not be construed as an investment advice to any party. Past performance may or may not be sustained in future.
Case 1
Cash Flow
Company with Earnings
Growth @ 15%
Bond with Annual
Interest @ 10%
Case 2
Cash Flow
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Dec-15
Dec-16
Dec-17
Dec-18
Dec-19
Dec-20
Dec-21
Dec-22
Dec-23
Dec-24
Dec-25
-18
1.15
1.32
1.52
1.75
2.01
2.31
2.66
3.06
3.52
4.05
-18
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Dec-15
Dec-16
Dec-17
Dec-18
Dec-19
Dec-20
Dec-21
Dec-22
Dec-23
Dec-24
Dec-25
Year 10 (Principal assuming
no change in share price)
Dec-25
18.00
18
IRR
11.46%
9.99%
Case 3
Cash Flow
Company with Earnings
Growth @ 20% for first
5 years & then 15%
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Dec-15
Dec-16
Dec-17
Dec-18
Dec-19
Dec-20
Dec-21
Dec-22
Dec-23
Dec-24
Dec-25
-18
1.20
1.44
1.73
2.07
2.49
2.86
3.29
3.78
4.35
5.00
Year 10 (Principal assuming
no change in share price)
Year 10 (Principal assuming
no change in share price)
Bond with Annual
Interest @ 10%
Case 4
Cash
Flow
-18
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Dec-15
Dec-16
Dec-17
Dec-18
Dec-19
Dec-20
Dec-21
Dec-22
Dec-23
Dec-24
Dec-25
Dec-25
18.00
18
IRR
13.37%
9.99%
Year 10 (Principal assuming
no change in share price)
Cheap company with
low PE but Growth
doesn’t play out
-12
1.0
1.0
1.0
1.0
1.0
1.0
1.0
1.0
1.0
1.0
Bond with Annual
Interest @ 10%
-18
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
Dec-25
12.0
18
IRR
8.33%
9.99%
Cheap Company with low
PE but Growth doesn’t
play out for 3 years and
then its 20% CAGR
-12
1.0
1.0
1.0
1.2
1.4
1.7
2.1
2.5
3.0
3.6
Bond with Annual
Interest @ 10%
-18
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
1.8
Dec-25
12.0
18
IRR
13.14%
9.99%
The table above is used to explain the concept and is for illustration purpose only. It should not be used for development or implementation of an investment strategy and should not be construed as an
investment advice to any party. Past performance may or may not be sustained in future.
Happy Investing
Aashish P Somaiyaa
Managing Director & CEO
The information contained herein should not be altered in any way, transmitted to, copied or distributed, in part or in whole, to any other person or to the media or reproduced in any form, without prior
written consent of Motilal Oswal Asset Management Company Limited (MOAMC). Any information herein contained does not constitute an advice, an offer to sell/purchase or as an invitation or solicitation
to do so for any securities. MOAMC shall not be liable for any direct or indirect loss arising from the use of any information contained in this document from time to time. Readers shall be fully
responsible/liable for any decision taken on the basis of this document. The information / data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment
strategy. Investments in Securities are subject to market and other risks and there is no assurance or guarantee that the objectives of any of the strategies of the Portfolio Management Services will be
achieved. Clients under Portfolio Management Services are not being offered any guaranteed/assured returns. Past performance of the Portfolio Manager does not indicate the future performance of any of
the strategies. Please read on carefully before investing.
The Stocks mentioned above are used to explain the concept and is for illustration purpose only and should not be used for development or implementation of an investment strategy. It should not be
construed as investment advice to any party. The stocks may or may not be part of our portfolio/strategy/ schemes. Past performance may or may not be sustained in future.
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Value Strategy
Top Sectors
Strategy Objective
Sector Allocation
Auto & Auto Ancillaries
Banking & Finance
Pharmaceuticals
Airlines
Oil and Gas
FMCG
Infotech
Cash
The Strategy aims to benefit from the long term
compounding effect on investments done in good
businesses, run by great business managers for
superior wealth creation.
% Allocation*
27.10
25.31
10.68
7.19
6.99
6.77
6.31
0.35
Data as on 31st December 2015
Investment Strategy
*Above 5% & Cash
Top Holdings
• Value based stock selection
• Investment Approach: Buy & Hold
Particulars
• Investments with Long term perspective
Sun Pharmaceuticals Ltd.
Eicher Motors Ltd.
Bosch Ltd.
HDFC Bank Ltd.
Interglobe Aviation Ltd.
Bharat Petroleum Corpn. Ltd
Asian Paints Ltd.
Kotak Mahindra Bank Ltd.
Tata Consultancy Services Ltd.
State Bank Of India
Housing Development Finance Corporation Ltd.
Bharat Forge Ltd.
• Maximize post tax return due to Low Churn
Details
Fund Manager
:
Strategy Type
:
Date of Inception :
Benchmark
:
Investment Horizon :
Subscription
:
Redemption
:
Valuation Point
:
Manish Sonthalia
Open ended
24th March 2003
Nifty 50 Index
3 Years +
Daily
Daily
Daily
% Allocation*
10.68
9.37
8.08
7.85
7.19
6.99
6.77
6.49
6.31
5.80
5.17
5.07
Data as on 31st December 2015
*Above 5%
Key Portfolio Analysis
Value Strategy
Nifty 50 Index
Standard Deviation (%)
21.37
23.80
Beta
0.81
1.00
Performance Data
Data as on 31st December 2015
Value Strategy
Nifty 50 Index
All Figures in %
30
26.33
25.79
25
20
18.92
% of returns
17.55
17.5
14.48
15
12.27
11.89
10.4
10
5.31
5
0
-5
0.43
-4.06
1 Year
2 Year
3 Year
4 Year
5 Year
Since Inception*
-10
Period
Data as on 31st December 2015
The Above strategy returns are of a Model Client. Returns of individual clients may differ depending on factors such as time of entry/exit/ additional inflows in the strategy. The Above returns are
calculated on NAV basis and are based on the closing market prices as on 31st December 2015. Past performance may or may not be sustained in future. Returns above 1 year are annualized. Please
refer to the disclosure document for further information.
Portfolio Management Services | Regn No. PMS INP 000000670
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Next Trillion Dollar Opportunity Strategy
Top Sectors
Strategy Objective
Sector Allocation
Banking & Finance
The Strategy aims to deliver superior returns by
investing in stocks from sectors that can benefit
from the Next Trillion Dollar GDP growth.
It aims to predominantly invest in Small and Mid
Cap stocks with a focus on identifying potential
winners that would participate in successive
phases of GDP growth.
% Allocation*
27.91
Auto & Auto Ancillaries
19.76
FMCG
17.68
Oil and Gas
11.50
Pharmaceuticals
7.80
Diversified
6.72
Engineering & Electricals
5.53
Cash
0.39
Data as on 31st December 2015
Investment Strategy
*Above 5% & Cash
Top Holdings
• Stocks with Reasonable Valuation
Particulars
• Concentration on Emerging Themes
Bajaj Finance Ltd.
• Buy & Hold Strategy
Hindustan Petroleum Corporation Ltd.
11.50
Eicher Motors Ltd.
10.37
Page Industries Ltd.
8.72
Voltas Ltd.
6.72
Bosch Ltd.
6.65
Max India Limited
5.65
Kotak Mahindra Bank Ltd
5.53
Cummins India Ltd.
5.08
Details
Fund Manager
Strategy Type
Date of Inception
Benchmark
Investment Horizon
Subscription
Redemption
Valuation Point
: Manish Sonthalia
: Open ended
: 11th Dec. 2007
: Nifty Midcap 100 Index
: 3 Years +
: Daily
: Daily
: Daily
% Allocation*
12.15
Data as on 31st December 2015
*Above 5%
Key Portfolio Analysis
Performance Data
Standard Deviation (%)
NTDOP
18.28
Nifty Midcap 100
22.78
0.70
1.00
Beta
Data as on 31st December 2015
NTDOP Strategy
50
Nifty Midcap 100
43.78
45
39.87
40
34.63
% of returns
35
28.83
30
25.48
25
20
All Figures in %
21.66
16.03
17.77
16.35
15
10
8.62
6.46
5.85
5
0
1 Year
2 Year
3 Year
4 Year
5 Year
Since Inception *
Period
Data as on 31st December 2015
The Above strategy returns are of a Model Client. Returns of individual clients may differ depending on factors such as time of entry/exit/ additional inflows in the strategy. The Above returns are
calculated on NAV basis and are based on the closing market prices as on 31st December 2015. Past performance may or may not be sustained in future. Returns above 1 year are annualized. Please
refer to the disclosure document for further information.
Portfolio Management Services | Regn No. PMS INP 000000670
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India Opportunity Portfolio Strategy
Top Sectors
Strategy Objective
Sector Allocation
Banking & Finance
Pharmaceuticals
Auto & Auto Ancillaries
Oil and Gas
Airlines
Cash
The Strategy aims to generate long term capital
appreciation by creating a focused portfolio of
high growth stocks having the potential to grow
more than the nominal GDP for next 5-7 years
across market capitalization and which are
available at reasonable market prices.
% Allocation*
31.07
18.09
16.54
11.13
7.38
2.24
Data as on 31st December 2015
*Above 5% & Cash
Investment Strategy
•
•
Top Holdings
Buy Growth Stocks across Market
capitalization which have the potential to
grow at 1.5 times the nominal GDP for next
5-7 years.
Particulars
Bajaj Finance Ltd.
Hindustan Petroleum Corporation Ltd.
Lupin Ltd.
Interglobe Aviation Ltd.
Eicher Motors Ltd.
HDFC Bank Ltd.
Ajanta Pharma Ltd.
H D F C Ltd.
BUY & HOLD strategy, leading to low to
medium churn thereby enhancing post-tax
returns
Details
% Allocation*
14.04
11.13
8.66
7.38
7.34
6.51
5.91
5.55
Data as on 31st December 2015
Fund Manager
: Varun Goel
Strategy Type
: Open ended
Date of Inception
: 11th Feb. 2010
Benchmark
: BSE 200
Key Portfolio Analysis
Investment Horizon : 3 Years +
Subscription
: Daily
Redemption
: Daily
Valuation Point
*Above 5%
Performance Data
IOPS
BSE 200
Standard Deviation (%)
14.85
16.12
Beta
0.79
1.00
Data as on 31st December 2015
: Daily
India Opportunity Portfolio Strategy
BSE 200
All Figures in %
30.00
24.86
25.00
21.14
% of returns
20.00
15.53
16.21
16.57
15.00
13.22
11.69
10.17
10.00
8.87
5.91
5.30
5.00
0.00
-1.48
-5.00
1 Year
2 Year
3 Year
4 Year
5 Year
Since Inception
Period
Data as on 31st December 2015
The Above strategy returns are of a Model Client. Returns of individual clients may differ depending on factors such as time of entry/exit/ additional inflows in the strategy. The Above returns are
calculated on NAV basis and are based on the closing market prices as on 31st December 2015. Past performance may or may not be sustained in future. Returns above 1 year are annualized. Please
refer to the disclosure document for further information.
Portfolio Management Services | Regn No. PMS INP 000000670
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