November 28, 2011

Why do stocks go up?

This is an odd post to write when markets are dropping by the day. However I think that at times like these, it is important to remind ourselves of the basics so that one does not get overwhelmed by the negativity and fear around us.
So coming back to the question – Why do stocks go up? Well it depends on who you ask.
 If you ask a day trader, he or she is likely to say that it is due to volumes, the day’s news and finally due to sentiments. If you ask a technical analyst, the reason could range from the ordinary (volumes, patterns etc) to the esoteric (Elliot wave theory, Fibonacci sequence etc). If you ask the lay person, they would usually have no answer for it (as most consider the stock market to be nothing more than a casino).
As a long term investor, I prefer to ask the question in a different way. I am not concerned directly with the stock price, which merely reflects the business value over the long run. I am more concerned with what causes the business value to rise. If the intrinsic value of the business rises, the stock price is bound to follow sooner or later.
What is the difference?
If you agree with my argument that the key question to ask is what increases the intrinsic value, then the focus of analysis changes completely. One is no longer concerned with the market price (which will follow intrinsic value in time), but more concerned with the fundamentals of the business.
A focus on business value means that one is now concerned with the economics of the business, the competitive dynamics of the industry and finally the actions of the management.
The time horizon also changes from the short (price action) to the long term (business value). The reason for this change is also due to the fact that business value does not change much from day to day and usually takes anything from a few quarters to years to change.
What causes the business value to increase?
So let’s come back to the original question and restate it as – what causes the business value to increase?
Let me put a simple hypothesis – The value of a business usually increases if the management is able to invest, incremental capital at high rates of return.
Let me explain – Let’s say a company is earning around 15% on invested capital. If the management can re-invest the profits or borrowed money (incremental capital) at 20-25% on a sustained basis (say 5-8 yrs), intrinsic value is bound to increase and the stock price will follow in due course of time.
In the above example, if the management can re-invest at these high rates through new or existing businesses, then growth (which is what almost everyone is focused on) will follow automatically. Growth thus becomes a derivative of high rates of re-investment.
Examples of the value creators
Let try to understand the implication of the above hypothesis for various types of companies and see if it matches with reality.
Let’s look at the case of a few highly successful companies such as Hero Honda motors (10 yr CAGR = 34%) and HDFC (10 yr CAGR = 29.1%).
HDFC bank has maintained an average ROE in excess of 16% during the last 10 years and has grown its book value (which is a good proxy for intrinsic value) at the rate of 23% during the same period. The overall stock returns have followed this growth in book value, with a small delta coming through an increase in valuations (PE ratio).
The company has re-invested almost 75% of the profits (dividend payout is 25%) at high rates of return and thus increased the intrinsic value of the business
Hero Honda has an effective Return on capital of 100% or higher in its core business. It is very very difficult to re-invest all the profits back into the business at such high rates of return. The company has paid out a dividend of around 65% of its profits and re-invested the rest into the  business or held it as cash equivalents on its books.
Any business which can earn such stupendous rates of return on capital and re-invest even part of it at such high rates is likely to increase the intrinsic value of the business.
The value destroyers
The second group of companies are those which have a high return on capital, are not able to re-invest the profits at high returns but have chosen to retain this capital and invest it into low yielding deposits or mutual funds. These type of companies are actually destroying value as they are retaining the excess capital and ‘re-investing’ it at low rates.
The market clearly dislikes these type of companies and tends to give them a low valuation. An example which come to mind is a company  like Cheviot Company. These type of companies have above average rates of return in their core business, but choose to hold back majority of the profits on their balance sheet in low yielding deposits. These companies are value traps (in which yours truly has invested in the past)
The final group of companies are those which earn a low rate of return and tend to re- invest all the incremental capital at these low rates of return. This would include most of the commodity companies in sectors such as cement, steel, sugar  etc. These companies destroy value as they grow and hence never get decent valuations in the stock market. For example, pickup any sugar company and look at their  5 and 10 year returns. Investors have lost money over a 5 to 10 year period in these companies.
Does the hypothesis help in picking stocks?
The above proposition does not help one in picking the next multi-bagger. Although it is easy to see which company performed well in hindsight, returns come from being able to identify which company will do well in the future and then buy it at a reasonable price.
Inspite of this limitation, the above thought process helps one to avoid a certain set of companies. Not losing money is half the battle in the stock market.
If one has a 3-5 year time horizon, then it is important to avoid companies which are likely to destroy value by re-investing at low rates of return – in the core business or by just holding the cash.

26 comments:

farmland investments said...

Does this mean that any company which has a huge amount of cash on their books, such as Microsoft maybe, is a value destroyer? Microsoft has been a tortuous value trap for a long time. Once keeps thinking it is going to break-out but never does. Also, why do certain good companies, like Wal-Mart, have their price tread water for close to 10 years, despite hugely increased profits?

Rohit Chauhan said...

walmart had high valuations 10 yrs back and implied growth in those valuations never happend. so the company went from a growth stock to a regular to a value stock. its intrinsic value has gone up, but stock price remained stagnant

microsoft has huge cash, but the company has raised dividend and is buying back stock. so it is returning cash to shareholders and re-investing in its own stock. in that sense it is not destroying value. if it did not dividend out or buyback, that would be a bigger issue

rgds
rohit

John said...

Your post got me thinking...

You see, if a business is predictable, an investor can factor in the incremental ROE factor in his DCF calculation. As such, the intrinsic value (i.e. the NPV) he gets will already take the value of growth into account. And if the market is efficient, the shares will be traded at this value. Then, in real term, the share price shouldn't go up at all!! Everything is priced in.

That's counter-intuitive. Is any part of my reasoning wrong?

Anonymous said...

Hi rohit,
by selecting the companies which have a huge market to capture and have strong moat, isn't the re-investment of profits problem taken care of.

With Hero-Honda its ofcourse a different issue.

Dhwanil said...

Hi Rohit,

Once again an excellent article, very succinctly describing characteristics of value accretive business.

Hindustan Zinc is one such stock that is in my portfolio, where compnay has enjoyed very high ROCE however it is not able to reinvest FCF that it is generating at the same pace hence ROCE/ROE is muted compared to what it could be. They currently carry around 14,000 Cr of cash and generate around 4000 -5000 crores of FCF. It is a debt free company.

Second company is JB chemicals. It is a pharma company and has a decent business. They currently sold their Russian business to Jhonson & Jhonson for 1200 Crores ( 4-5x Sales). they have received cash and have distributed 25 % of the proceeds to shareholders. Theie ROE hovers around 16-18%. Currently it is trading below its NWC. I have done detailed analysis at http://valueinvestinginpractice.blogspot.com/. I would appreciate your views on both the companies.

Killivalavan said...

Are you talking abt "RETURN ON RETAINED EARNINGS"?

Vic said...

Thanks Rohit for a timely post.

It is easy to get influenced by the stock price in such wild market fluctuations.

Thanks again for emphasizing on what we should focus on instead i.e. the long term value of a business.

Vic

Anonymous said...

Hi Rohit,

thanks for insightful post.

Engineers India appears to be one such company reinvesting at low rate of return. It has 2000 cr of cash in the books as it's consulting business is high margnin, high ROE business throwing cash with moderate growth.

EIL then started EPC business which is low margin, high growth business but still doesn't require 2000 cr cash hoard.

So, now company is investing 1000 cr to revive a fertilizer plant with another PSU as a partner!

Despite strong earnings growth and good orderbook, stock now down 46% from peak till date!

As Munger commented on one of the annual meeting, 'to value Berkshire, apart from estimating FCF in the future one also needs to consider how efficiently that cash would be deployed in the future'.

Regards,

Ashok

mayur said...

hi rohit,
i am interested in learning dcf method. you have written about it in your previous posts but i am still not able to understand the concept fully. can you a write on it in detail or suggest any good link?..n also i am not able to see spreadsheets in google group.pls help me for that also.thanks

Navy Cut said...

I believe the process of finding multibaggers misleads most of the ppl in ignoring the value of stock.

Nice article Rohit.

Unknown said...

Rohit -
Keeping it very simple & stupid:
ROCE = Using capital efficiently
OPM = better than competition
% payout = management ka dil kitna bada bai :-)
Finally, P/E : When do I buy!

Regards,
Arun

mukesh said...

@Unknown
1)Regarding OPM or NPM, Sir Philip Fisher has noted a very interesting point in his book. He says that a co's margin should be just slightly above than that of its competitors & should rise slowly with time. Otherwise a very large margin gap would be a honey pot that will attract a lot of competitors in the business.

2) As far as payout is concerned, mgmt should only payout dividends when it thinks it cannot employ cash in the business at existing or higher rates of return. If a business can employ cash internally, then its the best outcome for an owner as demonstrated by Berkshire Hathaway or Bharti Airtel.

"Investing is simple, not easy." - Warren Buffett

Anand said...

Rohit,

Great post!

What you are talking here is economic return which follows business performance.

But another major aspect of any value investment is market value addition, which is an additional reward from the market once the company is recognized. This generally happens when the rest of the market looks at the value in this stock.

I think it is a combination of both these factors that give multi bagger returns. What do you say?

Anonymous said...

Hi Rohit

I have a question: Which is a better investment - an index mutual fund or ETF? It is much easier to buy ETF but wanted to know your thoughts.

regards

Gopal said...

Would you consider LMW as one which is unable to re-invest capital even though returns from the business is good ? In the last 5 years, sales & net earnings have grown 50% but cash has almost doubled.

Rohit Chauhan said...

Hi john
If we had perfect visibility into the total duration of company's competitive advantage then that would be true.
for ex: if we knew that cocacola can grow and keep its return on capital above the cost for 50 yrs in 1930s , then it was steal at that time. but an individual or market cannot see beyond a few years and hence a DCF makes sense only for a 5-7 years. if the company keeps doing well based on management action, then the intrinsic value goes up

does my argument appear logical ?

rgs
rohit

Rohit Chauhan said...

Hi anon
yes you a right. if you find a company with moat and large market opportunity..this issue is taken care. however in cases the market prices the company to perfection and you really dont have an investment opportunity

the key is to see something where the market cannot

rgds
rohit

Rohit Chauhan said...

Hi dhwanil
i have not seen hindustan zinc ..will look at it. I have looked at JB chemical closely and it is an attractive idea. i dont have a position, but i am tempted

rgds
rohit

Rohit Chauhan said...

Hi killivalan
yes and any debt you take on. a company can take on extra debt to re-invest too

rgds
rohit

Rohit Chauhan said...

Hi vic
good to see you here

Hi ashok
great example ..i know EIL is a good business ..did not realise they have started investing capital in such poor businesses.
another such business is nirma ..they took the capital from FMCG an invested it all over the place. the stock never recovered after that

rgds
rohit

Rohit Chauhan said...

Hi mayur
I use the standard textbook method. I will load the valuations soon on the blog

rgds
rohit

Rohit Chauhan said...

Hi navy
good comment

Hi arun
great comment. very crisp way of putting the entire idea of investing

rgds
rohit

Rohit Chauhan said...

Hi mukesh
you are right in pointing about dividend re-investment. i am generally surprised why investors clamor for dividends from companies which can re-invest capital at high rates of return.
i would want such companies to retain all the profit and invest it at high returns for me. that will save me income tax and also the effort of finding new ideas for the dividend earned

rgds
rohit

Rohit Chauhan said...

Hi anand
true ..at the same time the market does not value a business in lock step with value addition. sometimes the price exceeds the value and vice versa..over the long term if the value is increasing ..so will price

as an investor , i dont know when the market will respond, but i can see if value is being created and hang on to the stock

rgs
rohit

Rohit Chauhan said...

Hi anon
on ETF v/s mutual ..let me give a counter argument.

everyone says ETF is better due to low cost and because it trades as a stock

i would say mutuals inspite of higher cost ..for one reason - you set an SIP and be done with it. that takes emotions out of the picture. if you could set an SIP plan with an ETF ..then the ETF is great

rgds
rohit

Rohit Chauhan said...

Hi gopal
LMW is a little bit more nuanced. they earn very high return on capital ..their capital employed is close to 0 as they get additional cash through customer advances.

they have bought back stock ..which i think is good usage of excess capital and have decent dividend payout too

rgds
rohit