“It was the best of times, it was the worst of times”
The last decade witnessed transfer of value within industries with significant share-holder value creation for the victors. A few examples that come to mind are Private sector banks taking share from Public sector banks, low cost airlines from full service airlines and the Indian Pharma industry from US Generic manufacturers.
We are on the cusp of another great value migration due to the war on black money and implementation of GST: “Organized players taking market share from the unorganized sector”
The share of unorganized players in many sectors in staggering.
The unorganized players have commanding market share because they evade taxes: excise, VAT, power theft, non-compliance with labour laws. As these loop holes are plugged, their unfair margins will get wiped out leaving many to exit the business. This creates a significant value creation opportunity for organized players in many industries.
But should not one wait for the fog to clear before participating in such moves?
We hold the following beliefs:
- It is futile to model short term financial results due to demonetization. The demonetization move results in two opposing effects. The immediate head wind effect is market shrinkage as demand drops. However, the tail winds for well-run companies is the opportunity to grow market share. Add in to the mix the impact on demand due to lower interest rates, wealth effect vs liquidity effect, the speed at which liquidity is restored to the economy, recovery of consumer confidence etc. and you are in excel spread sheet paradise.
- Short term PE ratios are of no use at present. When demand recovers, earnings growth will be non-linear. Many consumer companies witnessing a steep demand drop will find themselves surprised and even unprepared to service demand.
- Even if demand could be predicted, short term (Year 1-3) cash flows in high growth and quality franchises contribute no more than 5-10% to the value of a firm. Bulk of the value is in cash flows beyond Year 3 which will get stronger now as quality franchises gain market share. Stock prices have corrected by higher percentages.
- Many great companies are not very liquid counters in normal market conditions. However, ample Liquidity is available during market declines as weaker players rush for the exit. One needs to take advantage of such conditions.
- As we are playing for 15-20% annual long term compounding gains, a 5-10% lower entry point does not really matter. The bigger risk is not that of paying a high valuation today, rather the risk of not participating as one keeps waiting for prices to correct further.
Of course prices could trend lower as sentiment is weak. However, this is part of the deal. You can’t have the upside without the willingness to see declines in the portfolio.
The great value investor, Seth Klarman has opined that “the curse of the value investor is that he tends to come in too early”. One should not be rattled with temporary price declines – rather, if one has conviction, decline in stock prices from initial buying levels is actually a welcome gift to build additional exposure – if you can keep the long term perspective
We believe the crackdown on black money is very good for the country and the economy long term. Gradually, the “winter of despair” will transform into a “spring of hope”. However, as it inevitably happens, stock prices would have moved higher before the actual turnaround.