You have a lot of cash burning in the pocket and are looking for an opportunity to invest. An old time favorite is now selling for cheap. All and sundry feel that the company is undervalued especially if a series of ifs and buts get resolved. You look at the annual report of the company and it appears cheap by historical standards. Feeling confident, you go ahead and put in a decent amount of money.

Smart decision? maybe, but then maybe not.

Looking forward
Although no one can predict the future, it is an unfortunate reality of the stock market that stocks are priced based on the expected future of the company. I am using the word ‘expected’ as no one knows for sure. If someone claims that they are a 100% confident, then either the person is a complete moron or trying to sell you something.

If you are in the business of stock recommendations and tips, appearing anything but 100% confident is professional suicide. So I would blame the investor more for the garbage sold in the market than the seller. Do you really think all this junk would sell if there was no demand? anyway I digress.

So if one cannot predict the future, how does one invest? There is no surefire approach, though one can improve the chances of success by picking a company in stable industry. If the industry is fairly stable and not undergoing too much change, it possible to guess (all investing is finally a guess ..sometimes a good one or sometimes bad) with reasonable accuracy on how the company will do in the next 3-5 years.

A few examples
Let’s consider two companies. I am comparing these companies not from a valuation or investing standpoint, but purely trying to contrast their business performance. Stock performance in the short term is a different issue.

Let’s take the example of Gujarat Ambuja and Bharti airtel.
Gujarat ambuja is in the business of manufacturing and selling cement. It has grown at an average CAGR of 13-15%, maintained a net margin of 15% and an ROE in excess of 25%. It is not possible to know the exact profit or sales (many try that though) for the next 2-3 years, but looking  at the business and the economics one can make a fair guess that business could clock 5%+ growth and 15% ROE for the next few years. Anything can happen, but the probability of the business achieving these numbers is high.

Bharti telecom is a telecom service provider, which has done extremely well over the last few years. The company has grown the topline at 30%+ and profit at 45% per annum for the last 5 years. The company has maintained an ROE in excess of 25%. These kind of numbers would warrant a PE in excess of 20. However the market is currently assigning a PE of 11 which values it as a commodity business. So is the market wrong? Some would say so looking at the past performance.

However there are certain structural changes and realities in the telecom industry

  • The industry has been witnessing severe price competition for sometime now. All the other companies other than bharti do not have great fundamentals (please look at the complete financial statement for all these companies and not the P&L account alone to understand what I am saying)
  • The industry has faced a lot of change in the past and will do so in the future. Do you really think anyone can be sure how the industry will look like in the next 5 years? What will be the technological changes, new entrants, government regulations etc?
  • Bharti is now expanding internationally via the Zain acquisition. They are looking at additional acquisitions too. All this activity at the very least introduces more uncertainty into the equation.

The reason I have taken the example of bharti and ambuja cement is because I have analyzed both the companies in the past and gave a pass to both for different reasons. Ambuja cement was not cheap enough for me.

In case of bharti, if i was looking at the just the past data, it would be an incredible buy. However as I said earlier, investing and valuation requires looking ahead and in case of bharti my crystal ball is completely cloudy. It may be my own limitations, but that is precisely the point. If one does not have the confidence of being able to assess the long term economics of a company and its industry, then one should give the stock a pass. The last thing one should do is depend on someone else’s analysis to make a decision.

There is no penalty for missing on a stock idea – there are 5000 public companies and a decent portfolio requires 15-20 stocks at the most. I see no point in buying something where there are too many unknowns and I am not confident on how it will all work out.

One Comment

  1. Niranjan Kumar says:

    A question: in the example you have mentioned about Bharti to have PE of about 20. How to estimate or guess what PE a company should have?
    Your articles are really a complimentary/practical eye for my reading “Valuation and Investment Appraisal” by Ross Geddes.

    Thanks
    Niranjan

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