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Investing in high PE stocks – Observations
The cornerstone of the thread here is a paper by M Mauboussin wherein he discusses the drivers of PE & breaks it down in 2 components – Steady state value & future value creation. We will focus on the second part – Future VC
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The cornerstone of the thread here is a paper by M Mauboussin wherein he discusses the drivers of PE & breaks it down in 2 components – Steady state value & future value creation. We will focus on the second part – Future VC
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Now for a company not growing with Return on Capital at least as much as cost of capital, the correct PE is inverse of its long term growth rate. So, for argument, since long term growth rate in India is at 7%, ~14x is the correct PE for that type of business.
Now for a company not growing with Return on Capital at least as much as cost of capital, the correct PE is inverse of its long term growth rate. So, for argument, since long term growth rate in India is at 7%, ~14x is the correct PE for that type of business.
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Now, for a growing company with RoCE higher than cost of capital, it gets very interesting -> RoCE is a much bigger driver than growth for PE for theses businesses. Look at the formula closely and RoIC is a huge factor. More than growth, it's the longevity of that growth.
Now, for a growing company with RoCE higher than cost of capital, it gets very interesting -> RoCE is a much bigger driver than growth for PE for theses businesses. Look at the formula closely and RoIC is a huge factor. More than growth, it's the longevity of that growth.
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And of course, how much investment the company can make at those high RoC. Now, having all of that, what's interesting is that a company growing at same rate but higher RoC deserves higher multiple - Reason being it needs lower incremental capital to grow.
And of course, how much investment the company can make at those high RoC. Now, having all of that, what's interesting is that a company growing at same rate but higher RoC deserves higher multiple - Reason being it needs lower incremental capital to grow.
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A corollary is that companies with high RoCs will return higher than companies with lower RoCs even if their valuation comes down in future. A company bought at 4x PB and sold at 2x will outperform the one bought at 2x, sold at 4x if former's RoC is 2x, at same gowth
A corollary is that companies with high RoCs will return higher than companies with lower RoCs even if their valuation comes down in future. A company bought at 4x PB and sold at 2x will outperform the one bought at 2x, sold at 4x if former's RoC is 2x, at same gowth
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So how do decide when to invest in high PE stocks?
Key is in realizing high PE is co-related with high RoCs, not high growth. And then asking the question - How long can the company sustain these high RoCs? How long can it keep re-investing at high return on captial?
So how do decide when to invest in high PE stocks?
Key is in realizing high PE is co-related with high RoCs, not high growth. And then asking the question - How long can the company sustain these high RoCs? How long can it keep re-investing at high return on captial?
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So, what are the characteristics of a business that can do the above? Some pointers on that :
Company should have resilience in tough times, should have high predictability, moats which allows it to generate high RoCs. And then some intangible elements (brand, cost?)
So, what are the characteristics of a business that can do the above? Some pointers on that :
Company should have resilience in tough times, should have high predictability, moats which allows it to generate high RoCs. And then some intangible elements (brand, cost?)
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Another important metrics is they should be increasing their market share in the industry they operate in - If they are not, something is wrong? Why?
Where are they deploying the capital then?
Another important metrics is they should be increasing their market share in the industry they operate in - If they are not, something is wrong? Why?
Where are they deploying the capital then?
9/n
Some of the other characteristics of high PE stocks should be embedded nationality in stock price. This helps generate supernormal returns for longer period.
Also, in terms of why the market is valuing them high, there should be some uniqueness in what they are doing!
Some of the other characteristics of high PE stocks should be embedded nationality in stock price. This helps generate supernormal returns for longer period.
Also, in terms of why the market is valuing them high, there should be some uniqueness in what they are doing!
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So overall, the key lies in being selective and choosing companies where the moat (Ability to generate higher RoCs) are enduring instead of fleeting.
So overall, the key lies in being selective and choosing companies where the moat (Ability to generate higher RoCs) are enduring instead of fleeting.
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Some of the key risks in investing in high PE stocks would be then
Miscalculating either capability to generate high RoC or period for which it can do that - A costly mistake.
Another worry is that often, these companies will not generate returns during initial years
Some of the key risks in investing in high PE stocks would be then
Miscalculating either capability to generate high RoC or period for which it can do that - A costly mistake.
Another worry is that often, these companies will not generate returns during initial years
12/n
Overall, be very sure about the business in these scenarios and invest in very selective stocks with proven resilience and multi year period of generating high RoC and huge runway to keep doing the same.
Overall, be very sure about the business in these scenarios and invest in very selective stocks with proven resilience and multi year period of generating high RoC and huge runway to keep doing the same.
Please read as embedded optionality.
