July 14, 2011

Paying more for quality

As part of my paid subscription, I recently added a stock in the portfolio. I bought this company at around 16 times earnings and as I am constantly preaching about buying stocks on the cheap, it must have surprised a few subscribers.

A good friend of mine wrote to me and we exchanged a few emails where I shared my thinking behind this pick. I have lightly edited the conversation and added some additional commentary to detail out my thought process. Think of this post as a continuation of the previous post on value traps.

Hi Rohit,
What is the reasoning behind buying XXX? The stock already is trading at P/E of 23+. Also they don’t seem to be in a market where they have monopoly.

Bye,
Kedar

Hi kedar
Because i like the company :) and it will look good in the portfolio

Jokes apart, the company on a consolidated basis is selling for around 16-17 times earnings and earns 60%+ return on capital. In addition the company has been growing at 15%+ (slowed down lately a bit) and expanding globally and in India too.

The company is also making small acquisitions to add to the product/ technology portfolio and is planning to spend 3%+ on R&D in the future. Finally the company has an associate company at book value for 250 crs on the balance sheet, which is worth much more than that.

All in all a good business with good competitive advantage, but it is not cheap.

Hi Rohit,
The business may be good but if the market price is close to fair value, why will you buy it. I have not seen you buying stocks unless the market value is at least at 40% discount to fair value.

regards
Kedar

Hi kedar
It is not really selling at fair value ...still a 25-30% discount. There is a key difference in the approach here. I am paying up for quality here.

One approach is to buy at a 50% discount for a decent business and wait for the gap to close...like seamec which is cheap and the returns will come when the PE re-rating happens. As the fair value is increasing slowly, the stock price will rise slowly after that. In all such cases we have the re-investment risk - what to do with the money once the company sells at fair value?

The other approach is to buy a good business which is selling at a smaller discount, but at the same time is also growing its intrinsic value - think LMW, gujarat gas, crisil etc. These are high quality businesses which will increase fair value at a decent rate - call these steady compounders.

In such cases you can get a step jump due to re-rating of the PE as the market recognizes the quality of the business. At the same time as the fair value is growing at a fair clip, one can hold onto the stock and get above average returns from the rise in fair value. This increase will not happen in a nice smooth upward trend, but over time it works out pretty well.

The best situation will be to buy these companies at a discount ..isnt it ? but that is not likely to happen very often ..unless there is a crisis in the market like 2008, but then we have to wait forever for that.

I have been thinking on these lines for some time and have always invested this way (Crisil, LMW etc are in that bucket) , just now doing more explicitly with the new picks.

A personal experiment

My drift towards higher quality companies has not been a sudden one. I still cannot resist a cheap stock :).

I have maintained a dual portfolio for sometime now. The main portfolio has carried my high conviction bets with sizeable positions in each of the idea. At the same time, i have maintained a smaller portfolio of cheap, unloved stocks such as ultramarine pigments, Denso india etc.

The results, as expected have been mixed. A few companies such as Denso india gave high returns, but others such as ultramine pigments have dissapointed. In the final analysis, the main portfolio has beaten the cheap , graham style portfolio by a wide margin.

I will continue to opportunistically pick the cheap and unloved stocks, but at the same time i am more comfortable now with quality stocks and paying up for it. It is one thing to read about it and something else to arrive at a conclusion based on personal experiences. The latter remains with you much longer.

21 comments:

Pawan said...

Thanks Rohit for this post. I was having the same questions as Kedar but I was too lazy/too sure that you would give an explanation sure.

I would myself feel uneasy buying an HDFC bank at PE 30 versus Axis bank at PE 15 but I have friends who would vehemently support HDFC.

How do you decide how much to overpay for quality? Where to draw the line?

Pradeep said...

Hi Rohit,

I am a bit lost on your statement:

"re-rating of the PE"

where is the baseline "rating" for PE coming from?

What I got from your post is it's not only "value" but sometime you also buy stocks based on its "momentum" -- that is, its forward earning outlook (what you state by saying growing intrinsic value)

There is a timely article on SeekingAlpha (sorry, can not locate that article anymore) that talks about the standard followed around this is that PE should be double of growth rate at fair-value.

So in this case if the earnings growth rate is more than 9-12 times then the stock is cheaper than fair value.

This, though, does not guarantee anything that the stock will certainly go up as the article shows how cheap Apple is at current price.

Pradeep

PS: I also noticed that a while back you were writing articles on SA. Kudos on that!

rajesh sankar said...

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price"
- Warren Buffett

Neeraj Marathe said...

Very relevant post Rohit..
This has always been a confusing thot process..our natural inclination towards cheapness (which is again relative) keeps us away from certain stocks..
i personally think one shud do watevr one is comfy wid..but have a firm structure in place to avoid confusion and indecisive buying/selling actions..
cheers!
Neeraj

Anonymous said...

Hi Rohit
Using the replacement cost theory (cost of setting up a new plant etc) would ramsarup industries with a market cap of 70 crores plus debt of 1800 crores be a value buy
iTs the second largest steel wire maker in india after tata steel and it has in place forward andbackward intergration for its main product steel wires ie iron mines to infrastrusture division

Philip

kudva said...

I have been a "quality" investor for a while now and here are my experiences:

1.If you own a concentrated portfolio of less than say 6-8 stocks,owning a quality company - one with a strong business model having stable margins and which is relatively insulated from external factors like input prices etc - becomes very important.Why? Because when each company is 15% of your portfolio you don't want to make big mistakes that often come with owning cyclical and hence cheap(low PE) businesses.

2.Quality companies often fall much less than mediocre companies. So a 30 PE quality company might go to 20 PE in a crash but a 10 PE company very easily goes to a sub 5 PE. There is much lesser volatility and hence much lesser probability of your over-reacting and selling at the worst possible time.Go back to 2008 and check.

3. Quality companies bounce back on the first sign of recovery.Go back to 2008 and check.

4. While buying a quality company like Nestle at 40 PE might seem outrageous - and it might not out-perform your 10 PE cyclical in the next 2 years, if you hold Nestle for 20 years it will make you enough money that you'll be surprised.In other words good companies compound money and compounding while seems ordinary in the short term, does magic over longer periods.Ask people who bought Nestle,Hero Honda 20 years back.This time is not different with such companies.

5.You should be careful enough not to pay obscene amounts for anything - but that doesnt mean you'll wait for Nestle to trade at 10-15 PE. That might never happen and you'll have only Benjamin Graham's Security Analysis (with all due respect) while others who invested at Nestle when it came down to 25-30 times go abroad to see Phil Fisher's holiday home.

PS: Nestle is just an example.Substitute with a suitable company.

Navjot Kashyap said...

I know which company it is. Not revealing it here even when I am not a paid customer.
I found it long time ago and have reaped the benefits since then.

Ansh said...

Thoughts very well put down - Both Rohit and Kudva.

In search of multibagger stocks and small and mid cap stocks I have always ignored the Large Cap/Quality stocks.

Will certainly look at the Quality stocks from now on as valid logics have been provided for investing in these stocks.

Rohit Chauhan said...

Hi pawan
good question ...plan to write a post on that. there are hard and fast rule ..however on thumb rule helps ..if you buy a company for a PE 30, one better be very very sure of the company's future.

only the truly ignorant are 100% sure of anything in the stock market

rgds
rohit

Rohit Chauhan said...

Hi pradeep
there is nothing as a baseline PE ..what typically happens is that as the returns profile - ROE etc and growth improves the market recognizes it and increases the PE. in some case the improvement is permanent and hence the PE remains at a higher level ..in some cases it is temporary, in those cases the PE corrects in time.

On momentum - i am looking at business momentum and not stock price momentum. difference between them is day and night. I am looking at a business which will do better than what the market expects ..thts the key to high returns. whether i am successful or not is another issue ...but thats the objective

rgds
rohit

Rohit Chauhan said...

Hi rajesh
yes i am aware of the quote :) ...but easier said than done isnt it ?

hi neeraj
true ...end of the day there are different ways to make good returns.some are able to do well with deep value too. as you said, key is to have a philosohy and then follow is honestly

rgds
rohit

Rohit Chauhan said...

Hi philip
am i reading it right ..company has mcap of 70 Cr with debt of 1800 Cr ? if that is the case, then the stock is more like an out of the money option.
if i works you will make a lot of money otherwise it could go to zero. but honestly i have not read about the company and would personally avoid something with such high debt

rgds
rohit

Rohit Chauhan said...

Hi kudva
very valid point ...but i would say have a look at different time periods also for your thesis. there are quite a few graham style investors who have done well too..so

i always try to look for disconfirming evidence for my thesis..thats why had a portfolio of graham and high quality stocks together.

i personally would not based 2008 - 2011 as a very typical period ..2008 was a time when you got high quality at throwaway prices

as of today one has to pay and in some cases one is overpaying for a lot of consumer and pharma stocks.

but overall i definitely agree with your comment

rgds
rohit

Rohit Chauhan said...

Hi navjot
then you are a rich and smart guy ..good for you

rgds
rohit

Rohit Chauhan said...

Hi ansh
yes makes sense to go for quality ..the devil is always in the detail - key point is being to define and then identify quality stocks and then buying at the right price

for every titan ..there is an Himachal futuristic. one has to be careful about the survivorship bias

rgds
rohit

Anonymous said...

tnks for the prompt reply rohit
philip

kudva said...

Rohit,

I agree its a matter of style - some of us go with Graham while the rest with Fisher.

But its far easier for the average Joe to succeed by buying quality companies and holding them for a long time than looking for under-valued bargains and in some cases even beat the deep-value graham guys.

What i am trying to convey is if one buys quality like Nestle/ITC/HDFC bank and the external environment doesn't change drastically over the investing career (nothing is hold forever - one needs to do atleast an annual monitoring) the person will do reasonably well. He might/might not beat the best performing funds but he'll end up quite ok.

Scouting for deep-value on the other hand needs expertise and if a layman tries to get smart there he might be very disappointed.

On overpaying - mostly even if one overpays for quality the end result wont be so bad as running after the next infosys.

Sushant said...

This is in response to the following post of yours: http://valueinvestorindia.blogspot.com/2006/03/warren-buffett-of-india.html

I have my disagreements about the conclusion this post posits: that a high capex does not mean a growing company. In my opinion, it is just the opposite. Would we call a company that reinvests its gains in expansion of capacity (capex) a growing one (I would) or should we alternately think that a company that either sits on its cash or distributes it as dividend is seriously trying to grow?

longonly said...

Hi Rohit, Firstly i really appreciate this blog. Its great for people who are just starting to invest.got a question. I want to learn more about business models of different industries, do you know of any books of the subject? What would you recommend to someone whose trying to learn about business models of FMCG sector ?

Prashant said...

Kudva has some fair points in this quality vs cheap debate. However, my 2 bits:

- By the same toke, one can argue that it is even more difficult for a retail investor to select cos and hold them for, like, 20 years. Most probably, at the bottom of the market, he would have sold it only to see it come back. In other words, index funds might be even better. And thats why I have seen many ppl who have done better in Real Estate/PPF because of the passive nature of investments.

- Survivorship bias can't be ignored. As I mentioned above, most ppl would have sold out. Only the few anecdotes about those who had stocks for 30 years come to the fore. Also, look at the high quality companies, tha is, Sensex in 1990 vs now. How do you determine good quality stocks ?
HLL is an extremely high quality stock but what about the returns? Infosys, See pre-2000 and post 2000 10-year returns, In fact the entire IT sector, if done BUY&HOLD, will give sub-par returns.
- Most of the ppl who track must be aware in depth about Warren Buffett. However, many people do not know, in detail, about the earlier pure-value WB vs now. He crushed the markets earlier with small sums of money. Later he moved to his qualitiative stance upon handling large amounts of money. With small sums (large enough for 99% of the world), his earlier style works better though it is crazily tough.
- and the Security Analysis barb was not too appropriate. Templeton had a nice beach house as well and there are enough Graham followers who are quite well off as well.

kudva said...

Prashant,

1. There is no reason for us to believe that people will hold on to the index fund as they hold on to their land. Two-way quotes available everyday is the problem and it needs to be handled individually.If a person wants to sell when the stock doubles he will never make the big money but some people never learn.

2.A good quality stock is one with a high ROE/ROCE and an expected EPS growth comparable to that ROE/ROCE.

3.Warren Buffett - Precisely the point i am making. Very few even come close to buffett to find real value that its easier to stick to the obvious quality than do something because buffett did it.BTW when buffett was operating with his small sums he often took to investor activism to "realize" value out of such bargains which most of cant do.

4.I have read Security Analysis multiple times and i respect Graham as much as the other guy,may be more.What one needs to understand is Graham operated in a post depression era where he could find no brainers selling below NCA.Even today if you find such stocks they are the ones to buy - but the problem is you don't.If one gets rigid about one's investment policy then one is will get no where.People sticking to buying less than 10 PE stocks - no matter what- will not get anywhere.If you want to learn something from Graham learn that we should buy value - and value can originate from growth.They joined at the hip like buffett says.