Growth & comfort from rear-view mirror

Investors tend to display an innate characteristic of buying stocks that are cheap. The comfort that one derives through this thought process is the view of losing less money when an investment is bought cheaply. Investors tend to extend this concept by talking about valuation comfort when they buy cheap stocks. Today, one of the common examples given as to why the markets should be correct is the fact that businesses are trading at extremely high valuations (from a historical average). While there is merit in this argument for the market, it’s important for the investor to segregate businesses into high and low growth businesses such that, not all are painted in the same bucket.  

Unfortunately, growth stocks rarely are valued cheaply by the market. In fact, on the contrary, they tend to be valued on the expensive side of most traditional valuation metrics.  

Amazon, which is one of the largest market cap companies, trades at a price/sales multiple of 4 today. It has been valued at a multiple of 2x sales for the entire decade (going all the way back to 2010, when its earnings per share were negative).  

In India, HDFC Bank has historically been valued for a good part of the decade at a price/book multiple of above 3. There have been multiple naysayers around the quality and valuations of the bank; however, the bank continues to gain market share on the ground over the last 20+ years. For an investor to be successful, it’s important to identify levers around growth and understand when one must be willing to pay up to own these businesses.  

Why should investors focus on growth first and valuations second?  

Assume a business, where you pay up to own the business (assume you pay a multiple of 50x cash flow to buy this business). However, this business grows at a 20 per cent CAGR (20 per cent annualised growth) over the next 10Y.  

Table 1 (below) shows the multiple, an investor makes on the investment over a 10-year period. One can notice that even if the multiple of cash flow compresses to less than half after 10Y (drops from 50x to 20x), the investor ends up making a 2.5x on the capital. It’s important to understand that an investor can afford to get the valuation wrong in a growth business and pay up, but still earns a good return on capital. 

Table 1: Valuing a growth business (growing at 20 per cent) after 10Y at different P/FCF multiple (purchase price at 50x P/FCF) 

However, let’s assume that an extremely value-conscious investor wants to buy cheap and ends up paying a 20x cash flow to own the business. However, this business is growing at 10 per cent per year.  

Table 2 shows the varying cases of the returns, the investor makes assuming the price/cash flow multiple expands. In a lower growth business, an investor can have a 2.5x growth in valuation (with the P/FCFx growing from 20 to 50x over 10Y, but the net return the investor makes is only 2.59x of the capital).  

Table 2: Valuing a growth business (growing at 10 per cent) after 10Y at different P/FCF multiple (purchase price at 20x P/FCF) 

As one can see, in the latter, an investor could have bought at a cheap valuation, made a significant gain on the valuation re-rating, but the net end result is similar to an investor, who has bought a higher growth stock but has got the valuation wrong completely.  

A wise man said that growth and comfort never go hand in hand. It’s important to realise the same for investing too. As an investor, one needs to spend time evaluating the growth of the business rather than obsess about buying cheap. In the worst case, one has a significant margin of safety in getting the valuation multiple wrongs by more than half, but still, comes out with a compounded growth on capital.  

If you’re going to invest, you have to follow certain rules. If you want to ski, you ought to go to the top of a hill and learn how to stop. It doesn’t make you an Olympic skier, but then in certain cases, you will have an edge over the professional managers of the world. You might be in the pharma industry and suddenly orders pick up. You can see things better. You will have a view of the growth rate of the industry as an insider. This insight is more important than focussing on complex valuations. One thing that investors, who are buying individual stocks, have to focus on is that they have to understand the story, the five reasons something is going to go right for the company. Buying growth while never comfortable at the moment will always be rewarding from the rear-view mirror.  

(The author (Naveen Chandramohan) is a Fund Manager & Founder of Itus Capital, a PMS fund managing a multi-cap focussed fund in India).