Benjamin GrahamLearnings from the Giants

What explains a ‘multi-bagger’?

Couple of days back, I & my philosopher friend were having an interesting discussion and that was not about life 🙂 We were arguing whether small caps & mid-caps stocks regularly trade at their closer to their intrinsic values or not. In the midst of all this there came this question to us – if markets were to be efficient in their jobs, what explains some of these smaller market cap companies going multi-fold in their market values within a short span without their core business seeing much of a change? And this gave us some interesting insights.

For understanding this, let us take the case of a company which saw their market values going up by a couple of times in a very short period (i.e. < 12 months).  And compare this with its intrinsic values.

Case Study: Ratnamani Metals & Tubes Ltd

It happens to be an efficiently managed pipe making company, as it past numbers would suggest. Its longer term RoEs have been ~25-30% over a capex cycle.

If we were to make some simplifying assumptions and were to value it on price to book multiples, it would look something like this –

Fair Price to Book Value Multiple Calculation

Now, clearly these are quite conservative assumptions to have. To put things in perspective, over last 10 years, company has managed to grow its sales over 23% CAGR while what have factored is inflationary rate of growth of 5%. It certainly could do better, but let’s keep that aside for a moment. Our RoE assumption also happens to be on a lower side than what company earns over a cycle.

So, with these conservative assumptions one can pay up to as much as 1.9x the book value of the company and still make 12% CoC and any upside if sales were to grow faster than 5% & RoE better than 18%

This is how it has traded in the market if were to look it at Price to book multiples alongside its RoE.

Price chart considering price to book multiples and RoEs

Surprising isn’t it? Company like this was trading at closer to its book value between 2010-2013 – at nearly 50% discount to its fair value of ~1.9x.  Then on one fine day in 2014 market said ‘Oops, my bad’ and took it way past this.

Currently, it trades at closer to 3x book which leaves very little margin of safety for us.

During these five years, company was debt-free, growing it sales at ~10% CAGR & book value at 20% CAGR but still markets did not notice or took 5yrs to make good its wrong.

Well, then how was the scenario for a 2010 investor? Did he made anything of significance till 2014? Answer is a resounding yes! A 2010 buy & hold investor made 16% CAGR till 2014 and a year later, if he still continued to hold it, stock went up 3.5x taking his total CAGR to ~45%! And all this while company continued to do the exact same thing – making hollow metallic tubes & selling it at a descent margin.

This was not just one case, starting from 2014 there have been hundreds of stocks, mostly in the small & mid-caps space, which has doubled or more in a very short span without their business seeing much of a change.

In fact, BSE small cap & mid cap indices have roughly doubled between 2014 & 2015 which is certainly a rare occurrence.

But let’s not get carried away, there is a yet important thing to understand here. If a stock was trading ~2.5x does it still makes sense for our purposes as value investors? I think it sounds less attractive despite all our conservative assumptions about the company which it is certainly going to exceed in the foreseeable future.

Why? Simply because as shown above, it could be a mistake – though not a terrible one – to buy these smaller market cap stocks paying full price or rather a fair price for it. Market generally has a tendency to price them lower than their fair values for reasons which are difficult to understand. But if you look back to our price to book chart, you would see that market value for Ratnamani went up to 4x book back in 2008 and when it started to correct, it did not stop at 2x, it went on sinking lower and took 6 years to correct this ‘mistake’.

This is what Graham said about the topic in his beautiful work The Intelligent Investor. It worth spending some time thinking on this. He refers what we call small & mid caps as ‘secondary’ companies:

“In the great bull market of 1920s relatively little distinction was drawn between industry leaders and other listed issues, provided the latter were of respectable size. The public felt that a middle-sized company was strong enough to weather storms and that it had a better chance for really spectacular expansion that one that was already of major dimensions. The depression years 1931-32, however, had a particularly devastating impact on the companies below the first rank either in size or in inherent stability. As a result of that experience investors have since developed a pronounced preference for industry leaders and a corresponding lack of interest most of the time in the ordinary company of secondary importance. This has meant that the latter group have usually sold at much lower prices in relation to earnings and assets than have the former. It has meant further that in many instances the price has fallen so low as to establish the issue in the bargain class.

When investors rejected the stocks of secondary companies, even though these sold at relatively low prices, they were expressing a belief or fear that such companies faced a dismal future. In fact, at least subconsciously, they calculated that any price was too high for them because they were heading for extinction – just as in 1929 the companion theory for the “blue chips” was that no price was too high for them because their future possibilities were limitless. Both of these views were exaggerations and were productive of serious investment errors.”

Notice how the above psyche squarely correlates with what we are seeing today in the market! He further writes –

“This brief review indicates that the stock market’s attitude toward secondary companies tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation. As it happens, the World War II period and the postwar boom were more beneficial to the smaller concerns than to the larger ones, because then the normal competition for sales was suspended and the former could expand sales and profit margins more spectacularly. Thus by 1946 the market’s pattern had completely reversed itself from that before the war. Whereas the leading stocks in the Dow Jones Industrial Average had advanced only 40% from the end of 1938 to the 1946 high, Standard & Poor’s index of low-priced stocks had shot up no less than 280% in the same period. Speculators and many self-styled investors—with the proverbial short memories of people in the stock market—were eager to buy both old and new issues of unimportant companies at inflated levels. Thus the pendulum had swung clear to the opposite extreme. The very class of secondary issues that had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of overenthusiasm and overvaluation. In a different way this phenomenon was repeated in 1961 and 1968—the emphasis now being placed on new offerings of the shares of small companies of less than secondary character, and on nearly all companies in certain favored fields such as “electronics,” “computers,” “franchise” concerns, and others.

As was to be expected the ensuing market declines fell most heavily on these overvaluations. In some cases the pendulum swing may have gone as far as definite under valuation.”

One can correlate what Graham says with the price chart above. 2007 & 2008 saw price multiples for the company zooming to 4x only to trade at 1x a year later! And do so for almost next 5 years. Paying up fair price for it meant that investor had to face prolong periods of lack lustre returns and even after considering the re-rating which happened again in 2014, his CAGR would be lot less as against the case if he waited for an attractive discount to fair value to enter in the stock.

The concluding para by Graham on the topic is worth absorbing –

“If most secondary issues tend normally to be undervalued, what reason has the investor to believe that he can profit from such a situation? For if it persists indefinitely, will he not always be in the same market position as when he bought the issue? The answer here is somewhat complicated. Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways.

First, the dividend return is relatively high. Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price. In a five-to seven-year period these advantages can bulk quite large in a well-selected list. Third, a bull market is ordinarily most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level. Fourth, even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security. Fifth, the specific factors that in many cases made for a disappointing record of earnings may be corrected by the advent of new conditions, or the adoption of new policies, or by a change in management.”

This is the privilege of being a value investor 🙂

To sum-up, it is always good to enter into a small or mid-cap company which is trading at a substantial discount to its fair value. Because then earnings yield are good and assuming average rate of growth for the business, we can have a reasonable return expected out of it – all this while keeping enough margin of safety in hand which could translate into excess returns when first dosage of enthusiasm strikes the market. This could be, though not meant to be, a recipe for a potential multi-bagger.

But while buying something around fair value one needs to be aware that when the periods of dopamine inspired years end, prolong period of depressingly low multiples would follow. It could be a recipe of potential and unintended disaster.

As the saying goes ‘be greedy when others are fearful and be fearful when others are greedy’.

 


Niraj

P.S. Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions.

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