Catch Stocks Before They Get Re-Rated!
It is frequently mentioned in any commentary by analysts that the Indian stocks are being re-rated. When such headlines are published on several platforms, at times investors do not fully understand what it could mean for their portfolios and what action should be taken in order to maximise the portfolio returns. Shreya Chaware discusses at length what exactly re-rating means and how should investors interpret re-rated stocks and take profitable portfolio decisions
Kiran Maniyar, a chartered accountant and an avid investor in the Indian stock market, invested in a stock whose EPS was Rs 2.10 in March 2015. The stock price of the company was Rs 18 per share at that time, reflecting a PE of 8.57. Now the same stock is trading at a PE multiple of 73 with an EPS of Rs 10.97 per share and is trading at nearly Rs 800 per share. The stock we are discussing here is Shivalik Rasayan. It is a perfect example of PE re-rating. We can see in this case that the EPS grew by nearly five times while the stock price multiplied by almost 44 times. It just goes to show what PE re-rating can do to the stock price.
Investors such as Kiran Maniyar bought the stock just before the stock got re-rated and showed patience to hold on to the stock for more than five years. Huge amount of wealth got created for him just by buying the right growth stock before it got re-rated. There are several examples of stocks that have created huge amount of wealth after being re-rated. In the case of MRF, for example, the EPS grew from Rs 338.21 to Rs 3,354, which is almost a ten-fold jump from September 2008 to March 2020. While the EPS jumped almost tenfold, the stock prices multiplied by almost 17 times for MRF during the same period.
The same can be said about Page Industries and Pidilite Industries. In 2008, Page Industries’ EPS was Rs 20 while in 2019 the EPS reported by the company was Rs 350. The EPS grew by 17.5 times for Page Industries between 2008 and 2019 while the share price increased by 50 times from Rs 450 per share to nearly Rs 22,000 per share. Similarly, Pidilite Industries was trading at Rs 700 per share in September 2016 while the EPS reported by the company was Rs 15, thus reflecting a price multiple close to 45. By 2019 the stock’s EPS increased to Rs 21, indicating an increase by 40 per cent in earnings while the stock price almost doubled to Rs 1,400 per share, reflecting a PE of 65.
What we have discussed are all examples of re-rated companies where the PE multiples expanded with improving fundamentals. The point to note here is that the earnings improve, yes, but the PE expansion is what creates wealth. Now there could be various reasons for such a PE expansion. Whenever there is re-rating what happens is that serious (institutional) investors are excited about the prospects of the company and in general the investors are more excited about the stocks now than before. There is a visible change in investor sentiment and it gets reflected in no time by tracking investors’ buying behaviour.
At times re-rating happens when an out of favour stock or sector sees an increase in investor interest. Recently we saw PSU stocks getting re-rated and even the commodity stocks are being re-rated as we speak. Some experts believe IT stocks are being re-rated by investors with five years’ time horizons. The IT sector is ripe for re-rating and may lead to expansion in PE because of various triggers for demand. Better growth distribution across verticals, cloud migration, strong deal funnel and rising competitive advantage of Indian IT companies in large deals are just some of the factors working in favour of the IT sector. The demand environment improving further is one of the main reasons why the IT sector may get re-rated and hence several IT companies both large and mid-sized can be expected to benefit from the improving demand situation.
Re-Rating Versus De-Rating
De-rating, contrary to re-rating, leads to contraction of the PE multiple. Usually this phase of PE contraction is not healthy for investors and a lot of wealth can get destructed during any such phase. If we take the example of Medicamen Biotech, the EPS for the stock was Rs 8.89 in March 2018 which grew to Rs 10.04 in March 2020. This suggests that the EPS grew by 10 per cent. Meanwhile, the share price decreased from Rs 744 per share to Rs 283 per share during the same period. That means the EPS increased by 10 per cent; however, the stock price declined by nearly 61 per cent. The PE multiple contracted from 83 to 28.
HDFC Securities Institutional Research
"We expect the IT sector revenue to grow at 14.4/10.8 per cent (in USD terms) for FY22/23E with mid-tier IT growth to come in at 15.1/12.5 per cent. We expect a margin expansion of about 55 bps over FY21-23E (10/45 bps expansion in FY22/23E), following a 220 bps expansion in FY21, leading to about 17 per cent EPS CAGR over FY21-23E. We increase multiples for Mindtree, Cyient, Zensar and Sonata and roll forward to March23E for our coverage universe. Earnings for Wipro are revised downwards by 6.5/3.9 per cent due to acquisition impact while we have increased estimates for Mindtree, Zensar, Sonata and Teamlease. We prefer INFY, HCLT, Persistent and Sonata."
During this period the earnings increased but the investors’ sentiment turned sour and there was liquidity problem facing the markets even as the overall market correction pushed the stock prices lower. De-rating usually happens when the earnings growth does not catch up with the valuations. Hence, it is always a risky proposition to buy high-growth stocks trading at high-price multiples. If the growth is not delivered, de-rating takes place and there is a good probability that the wealth gets destructed.
Conclusion
To identify a stock before it gets re-rated may not always be easy; however, it is suffice to say that the price multiple has to be low while investing and then as the fundamentals improve and growth opportunities are tapped by the company, the stock’s price multiple is expected to expand disproportionately to the earnings growth. It is very difficult to imagine a high PE stock to witness a further PE expansion. There is a difference between buying a quality high-growth stock and buying a high-growth stock that is about to get re-rated.
Market timing and deep understanding of valuation while knowing the exact triggers that may drive the re-rating of the underlying company and the industry are the key to success in equity markets. Here, in this case, merely tracking earnings and betting on earnings’ growth is not enough. One has to understand and feel the improving investors’ sentiment. The US market (S & P 500) was negative in 2018 by almost 4 odd per cent even when the operating earnings for companies in the S & P 500 index rose 22.9 per cent. What pushed the market down in spite of quality earnings was the investor sentiment. The investor sentiment was negative. The investors had built in a low-growth scenario and betted on difficult days ahead of 2018 in spite of the operating earnings being very good.
Earnings grew but multiples contracted. It means that investors do not see bright prospects for future earnings. The thing with re-rated stocks is that investors see good prospects for future earnings and hence are willing to pay more for growing earnings per share and hence the price multiple can expand, thus creating opportunities for early investors. The investing game is much wider than earnings and earnings growth. For wealth to be created the earnings growth has to have an ally in the form of positive investors’ sentiment and that positive investor sentiment needs to sustain for a considerable amount of time so as to create mindboggling wealth for investors.
Investor sentiment can remain positive if the liquidity is high and the fundamentals are believed to improve considerably. History shows it is not impossible. But history also shows re-rating is not something you can expect to happen every year. Thus, one has to be extremely careful and choosy about the stock and the sector. Re-rating in simple words means that the investors are willing to pay higher multiple for the earnings. Looking at the current market situation, investors can find opportunities in PSU stocks, commodity stocks and IT stocks as these set of stocks are being re-rated. The trick is to look for stocks with lower PE multiple with decent growth in earnings visibility and triggers in place for the sector re-rating.