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.

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