This article is authored by MOI Global instructor Rohit Chauhan.
Value investing has traditionally been associated with words like “bargain” or “cheap”. It was originally associated with low P/E or price-to-book ratios, companies selling for less than liquidation value, and so on. As the thinking evolved, the definition changed to a discount to intrinsic value (or other measures of value).
The common thread in all these approaches was an emphasis on a bargain price to value – irrespective of how value was computed. This mode of thinking is now becoming outdated.
In recent years, the success of various social, platform, or network-effect companies means that traditional measures of value are no longer enough. It is important for value investors to update their mental models and consider alternative approaches to estimating value.
P/E of 100: Is it value?
In the recent years, we have had companies like Amazon, Netflix and others which have traded at nose bleed valuation for a very long time and refused to correct or revert to any sort of mean valuations.
If you are a value investor, what should your reaction be to the success of investors who buy and hold such seemingly overvalued stocks?
I know what the first objection is to this line of thinking – The success of these investors is just dumb luck. These guys are not really practicing value investing, but a form of momentum investing. It is just that momentum has lasted for five or more years in some cases, and sooner or later this bubble would burst.
My counterpoint: Sure, that is possible, but what if this bubble has lasted for 10-15 years in some cases. Will you still just wave away these anomalies and label them as flukes?
I prefer to take a different approach. There is no religious debate to this in my mind – if something has worked for 3+ years in the stock market, then it is worthy of investigation. A lot of bubbles and temporary fads usually get washed out in two to three years and so three years is a good cutoff point to start the analysis.
What can one learn from this oddity where some companies manage to sell at seemingly high valuations for a very long time.
New business model or value capture
I think the first point to look for is whether there is a change occurring in the business model/ design, wherein, due to changing customer needs and priorities, a new type of design is now more suited to meet them more profitably.
I would recommend reading the book Value Migration, which goes over this concept in quite a bit of detail. The main point is that changing customer needs and priorities cause a change in the business design best suited to meet them. Companies which can identify and develop a business model to meet this new reality are able to accrue a lot of value for their shareholders.
For example, a rise in income levels has caused the retail consumer in India to now value quality, brand image and convenience in addition to price. As a result, companies which can meet these new set of needs have been able to create a lot of value.
It is easy to see this phenomenon around us – Bathroom fittings, automotive batteries, garments etc. Some of these products were commodities in the past, sold largely based on price. However, increasing consumer purchasing power has meant that priorities have shifted beyond price.
Companies which have been able to adapt their business model to deliver on these new priorities of brand, quality and convenience in addition to price have delivered exceptional returns.
Example: Cera Sanitaryware, Amara Raja Batteries, Astral Poly Technik, etc., where the companies appear to be overpriced based on their recent earnings, but have a lot of potential runway in their target markets.
Opportunity size with durability
It is not sufficient to be able to meet the changing needs of the consumer, better than competition. For starters, the opportunity size should be large so that the company can grow for a long time.
This is a major advantage of the Indian markets over almost all other foreign markets. Even niches in India have a market size running to millions of consumers and hence a company with a good business model can grow for years to come.
Asian paints ltd is one such company which started out as a small paint manufacturer in the late 1980s, but has grown consistently since then and delivered a CAGR of 35+% since its IPO.
An additional point to keep in mind is the need for the company to develop a durable competitive advantage. Let’s take the case of the telecom industry in the early 2000s. The need for communication and mobile telephony was recognized by a few companies such as Airtel in the late 1990s and these companies moved in quickly to satisfy the need.
The market size was in the 100s of millions and most of the telecom companies were able to scale rapidly. However, the edge or competitive advantage turned out to be transitory and as a result after a few years of high profitability, we soon had a lot of price based competition. As a result, by 2007-08, most companies were losing money and have not created any value since then.
In such cases seemingly overvalued companies were truly overvalued.
Kings of their domain
A productive area for finding multi-baggers is in the micro-cap space, where the company operates in a niche and is growing rapidly as its business model is uniquely suited for that niche. In addition, the niche is large enough for the company to grow for a long time, yet not so big that it attracts large competitors initially.
There are a few examples which come to mind – Think of air coolers a few years back (Symphony), CPVC pipes (Astral Poly) or various niches in pharma and information technology.
A small company can develop a unique set of skills for this specific segment and can dominate and grow within the segment for a long time. In addition, as the niche is not large initially, it does not attract much competition till it reaches a certain size.
However, by the time the niche is big enough to catch the attention of larger companies in the overall space, it is too late as the specific company has established a dominant competitive position and cannot be dislodged.
A lot of these companies appear to be overpriced after they started growing, but this ignores the possibility of above average growth and a dominant position for the company.
I do not have an example in the Indian markets but will try to explain this using the example of a well-known US company. Its 2004 and a well-known company called google decides to launch its IPO at a then-P/E of around 65x. A cursory look shows the company to be grossly overvalued and as a result most value investors give it a pass.
The company has since then delivered a return of around 23% p.a and I am sure this qualifies as a great return. So why did a company which appeared so overvalued turn out to be a 20-bagger.
My own understanding is that this result came about from multiple factors. To begin with, the company operates in a winner take all kind of a market where the no.1 company tends to dominate and capture almost all its value. Once google had a 60%+ market share, network effects kicked in and the company just kept getting more dominant in the search space.
Once this base was built, the company extended it to other platforms such as mobile where the next leg of growth has kicked in. These types of companies also have a very low marginal cost of production and hence any growth beyond a threshold, drops straight to the bottom line.
This however does not explain fully the reason behind its success – We have a management who in the words of Charlie Munger, are intelligent fanatics and have the capacity to suffer (as referenced by Thomas Russo). As a result, they have continuously invested in long term ideas (called moonshots) even if it meant losses in the near term. You tube, android etc which are now bearing fruit were a drain on profits at one point of time.
Such companies usually appear overvalued in the early stages of growth. Another similar company was Facebook.
A point of caution: For every successful platform company, there are at least ten pretenders that destroy value. So, it is not easy to identify such companies ex-ante.
Capacity to suffer
This is a term used by Thomas Russo (see the talk here) to describe companies which are capable and willing to make investments in the business for the long term, even though it penalizes profits in the short term.
In most cases, due to market pressures, companies are not willing to hurt short term profitability to build the business for the long term and hence the few companies which are willing to do so, appear to be overvalued due to depressed profits.
The quintessential example of this is Amazon. The company has constantly re-invested its profits into new businesses suppressing near term profits. The company re-invested profits from its retail business into expanding its logistics operations and the cloud business (AWS). The AWS business has since then achieved scale and now contributes to a substantial portion of its operating earnings. The company continues to make investments in high ROI projects which build value but suppress the near term earnings.
A name closer to home is AIA engineering. The company is a global leader in the grinding media space for the mining, cement and Power industry. The company has developed chrome based grinding media which is superior in performance to the traditional Forged media used in these industries.
To enter new accounts, the company has resorted to underpricing its products to show value of this new technology to its customers. Once established, the company normalizes the pricing with the customer.
The result of this approach is that the near term profitability of the company gets suppressed in the seeding phase with new customers. However, once a customer is acquired, the lock-in is very high. In other words, the company is operating like the SaaS providers in the software space – incur high CAC (customer acquisition cost) to acquire customers with high LTV (life time value).
In all these examples, companies are incurring high upfront costs to build value for the long term. The net result is that valuation of the company looks optically high in the initial phase of this build out.
Rate of change matters
Let me introduce another concept – business clock speed, which I read about here. This is the rate at which a business is changing. For example, the rate of change in the social media business is high and conversely there are business such as paints where the rate of change is low.
I think it is obvious that businesses with low rate of change can create a durable competitive advantage for the long term and hence a seemingly high price turns out to be cheap. Think of HUL or Nestle as an example, which have created large value for shareholders despite seemingly high valuations all the time.
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