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Quality Quagmire Are Quality Stocks Getting Overvalued

Author: Kumar Shankar Roy/Wednesday, December 4, 2019/Categories: Exclusive

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Quality Quagmire Are Quality Stocks Getting Overvalued

There are a whole host of large companies in India whose stocks are trading at high price-earnings (PE) ratio, an indicator that quality stocks today are being given that extra premium. The Indian market is rewarding quality, but the question is how much is too much? The Indian markets have lately been hit by a series of corporate governance crises. Assessing corporate governance and ‘quality’ of investible stocks are not as straight forward as say assessing the financials of a company. Since there are a lot of intangibles involved when an investor assesses the quality of stocks, companies that have a good reputation are getting a lion's share of inflows. With more inflows coming their way, the stock prices of these companies are going up faster than others. As a result, valuations are getting stretched. In this article, we will take a look at whether quality stocks are getting overvalued. Read on....

If you look at the top-100 stocks in terms of price/earnings ratio (P/E), you can find companies such as Avenue Supermart, Trent, UPL, P&G, Gillette India, Berger Paints, HDFC Life, Nestle, 3M India, Titan, BASF, Future Consumer, HUL, Godrej Properties in them. We are not looking at financial companies through P/E prism: this is because the right valuation metric for them is price/book (P/B). Coming back to high P/E stocks, it is not difficult to find names that trade at 70-100 times of their annual earnings. Why are investors paying such a premium for these stocks? This question baffles many.

Quality Punch

The reasons for high P/E are manifold. One, Indian arms of MNCs historically enjoyed premium valuations. Over the years, however, some 'Indian MNCs' and 'Indian business groups' have also started enjoying those stratospheric valuations. Investors today are comfortable about owning them. Two, some companies Avenue Supermart, etc., have consistently showed fast growth. This has made investors believe that even if they pay a premium valuation, there is steam left in the stock. For instance, despite premium valuation of Avenue Supermart, the stock has gained 28 per cent in last 12 months (ended November 28), handily beating the Sensex's 15 per cent rise. Three, fund managers, both domestic and foreign, today are not ready to risk big money in stocks about which they are unsure about. Known enemy is better than unknown friend! Given that storied names like Dewan Housing, IL&FS, Indiabulls and even Zee/Essel have given roller-coaster rides to investors, today the enlightened institutional investor is ready to back only trust-worthy names.

The divergence in stocks of same sector is unmistakable. If the IT sector has seen NIIT, Persistent Systems, and Hexaware make double digit returns in last one year, the same time frame has seen HCL Infosystems, Birlasoft, eClerx, Cyient, Intellect Design, Firstsource lose in double digit in per centage terms. Healthcare is another sector, like IT, which is a refuge for investors whenever they are unable to make sense of markets. Healthcare stocks are supposed to be recession/slowdown proof stories, and hence investors often flock towards them during a flux. In the last one year, even healthcare stocks have shown divergence. We must mention here that how much of the divergence in IT and healthcare is due to 'quality' is something that we can't say. In healthcare specifically, Dr Lal Pathlabs, AstraZeneca, Abbott India, Pfizer, P&G Health have seen 40-80 per cent stock price gains. But, in the same sector, companies like Vivimed, Opto Circuits, Wockhardt, Glenmark, Aurobindo Pharma, Hikal, Cadila, etc., have found markets coming down upon them with full selling force.

Performing Theme

The common belief in markets today is that quality stocks continue to do well, and better than others. The five year annualized returns of S&P BSE Quality Index are 9.58 per cent versus 7.47 per cent of S&P BSE Sensex. The gap between ten year annualized returns is wider with quality getting 14.26 per cent versus Sensex's 9.48 per cent. Many experts and brokerages have been quick to spot the flight towards quality.

"We introduced our ‘Quality’ lists framework in June 2017 and have since rebalanced our lists every few months. Since our last rebalancing (23 Sep 2019), our Quality Growth list has marginally outperformed the Nifty by 0.3ppt (percentage point), while the Quality Value list has outperformed by 1.6ppt. Both lists have beaten the BSE500," Abhiram Eleswarapu, head of India equity research, BNP Paribas, wrote in an investor note.

Quality matters especially when it comes to financial companies like banks. Often, it is 'asset quality' that compels investors to chose a set of companies over the other. "While we are positive on private sector retail lenders and insurance companies. We remain cautious on PSU banks, NBFCs and HFCs. We are keenly focused on the asset quality and the valuations that we are invested at," says Kotak Mutual Fund. A similar theme is adopted for metals and mining stocks as well. "Our allocation in the small cap and emerging equity fund is driven by availability of attractive valuation opportunities for quality businesses," Kotak MF said.

Froth Factor

Many investors are openly talking about their comfort zone with high P/E stocks. They argue that if high P/E stocks are the best companies, then the decision is easy. "We have always been proponents of owning the best businesses. These businesses do well in both good and bad economic scenarios. The price-to-earnings multiples are no doubt extended in some cases, however, in several cases the growth and the predictability justifies the valuation," says Prabhakar Kudva, Director, Samvitti Capital.

However, there is also the chance of excess. How much is too much is often a question asked in retrospect. "I won’t disagree that there is some froth and some of these companies may correct if things get worse, but one can’t try and play these 10-20 per cent moves. You may get out of a good company and never get back, pay taxes and there is also what I call a huge reinvestment risk. Booking profits in a good company and buying a mediocre one. That almost never ends well. Net net, the first filter should always be a good business and then one has to look at the price," reasons Kudva.

Some fund managers are cognizant of the quality quagmire. What these fund managers are doing is reducing portfolio beta via rotation away from high valuation equities. Is that a blanket call to sell high valuation stocks? No. Fund managers are pruning high valuations stocks that offer low growth potential. "...as we head into 2020, markets and the economy have diverged somewhat meaningfully. Avoiding the most expensive parts of the market and reducing beta risk in portfolios is a prudent choice in the current environment, post a fairly strong rally, in a weak economic environment with high valuations, and a stagnant consumer.  We advise gradually reducing exposure to high valuation, low growth equities," says Sunil Sharma, Chief Investment Officer, Sanctum Wealth Management.

A few experts are categorical about the quality quagmire. They are of the opinion that the existing super premiums enjoyed by quality stocks are not likely to linger for long. One section of market participants are saying premium quality stocks deserve higher valuations. This is being said in the backdrop of certain corporate misgovernance events. "This was also due to a decent amount of liquidity floating in the equity market with limited opportunities to invest, leading to premiumization. They chased for stable businesses in spite of enough demand & earnings growth. The losing stocks & sectors were cyclical, indebted, pledged & mid-small caps. This trend will reverse as the broad economy improves. Super-premium is unlikely to stay for a long time," Vinod Nair, Head of Research, Geojit Financial Services pointed out.

One of the main things about quality stocks is that their performance can also be volatile since Indian markets are notoriously moody. For instance, in October 2019 quality stocks gave 2.7 per cent monthly gain, but as market participants moved more into high-beta names in November 2019, quality stocks have given up most of the gain notched up last month.

ESG way

To assess the quality of a listed company/business, investors today use a variety of metrics. One of the popular ways is 'ESG' that stands for Environmental, Social and Governance (ESG). It refers to the three central factors in measuring the sustainability and societal impact of an investment in a company or business.

According to Edelweiss Research, at an all-India level (top-100 stocks), ESG Disclosure Score stands at 38/100. This lags global peers (200 plus stocks across regions, sectors) which score 43/100; but the lag is not significant. India’s score on ‘Social’ is at par, slightly lower in ‘Governance’, but lags heavily on ‘Environmental’ disclosures. But, over the past decade, India’s aggregate ESG Disclosure Score has improved meaningfully (from 20 to 38), reflecting rising corporate awareness on ESG-related disclosures.

Of the 11 large sectors that Edelweiss has analyzed, only three (IT, cement, engineering) have higher ESG disclosure scores than their global counterparts. These three also have the highest ESG disclosure scores in India. A few sectors such as BFSI, consumer, energy, pharma, and telecom lag global peers across all three categories of E, S & G. It’s pertinent to note that BFSI and pharma have the lowest scores of 27/100 each, primarily due to sub-15 scores on environmental disclosures.

The Edelweiss analysis indicates that over the past decade, overall ESG disclosures have improved the most in cement and engineering. This is commendable given that globally disclosures in these sectors have improved only moderately. "India’s IT sector too has improved steadily (34 to 50), in line with global IT peers (30 to 45). On the other hand, consumer/retail and pharma have clocked the least improvement since 2008, wherein disclosures progress has lagged other sectors," Edelweiss' Alok Deshpande and Jal Irani say.

Characteristics of Quality

Here are a few parameters that are often referred to by investors in their hunt for quality stocks.

* Good Management: These companies have stable upper/top management and low turnover/attrition rates throughout upper and middle management.

* Strong Balance Sheet: Avoid companies with high debts. Companies with comfortable leverage (debt/equity) and interest coverage (EBITDA/interest expense) are preferred.

* Economic Moat: Investment guru Warren Buffett used the term 'economic moat' to describe competitive advantages over competitors. Competitive advantages can protect a company by creating entry barriers for potential competitors.

* Dividend Paying: Companies with a long history of growing dividend payments are a characteristic of quality companies. However, in India, meaningful dividends are popular only in PSU and some private sector companies. Growth in dividends that a company pays over five years or more can be an indicator of quality investment.

* Earnings Stability: A company with erratic earnings makes forecasting a nightmare. Quality stocks are quite dependable when it comes to earnings growth, even if they are low-growth in absolute terms.

(The writer is a journalist with 14 years of experience)

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