Greetings from Team Carnelian!!!
“Fools act on imagination without knowledge; pedants act on knowledge without imagination” – Alfred North Whitehead
In our view, investing requires a combination of knowledge and imagination both but knowledge should be the foundation and imagination should be built on top of knowledge – the current state of the markets in many segments have reversed the order and we believe that this is going to be fatal.
Looking at the current state of the markets, it is very clear that only new trends / fads matter, what everyone is doing matters, many conventional time-tested valuations /evaluation tools like profitability and cashflows are not applied.
We are clearly in the times where one side new age companies are being chased and spoken about. Over the last one year everyone is reading about Unicorns getting created and valuations multiplying in the matter of months. This, of course has created a huge feeling of FOMO amongst investors who did not participate in these. Most investors admit that they don’t understand this, but it is working. On the other hand, well established businesses with cash flows yields of 8-10% and growing have lost the fancy of investors and ignored by the markets.
History has taught us numerous times, that it is not the basic and common sense which disappoints, but always fads and ecstasy… when the ecstasy goes down, we realise how stupid we were.
What were we thinking when we assigned a PE of 100-150 to tech companies in 2000 dot com bubble or valuation based on “eyeballs” on the website or what were we smoking when we valued Infra/real estate companies assigning a multiple to order book/land bank? Current glaring examples are 1) how markets are ignoring already listed established business franchisees, and valuing similar stocks in IPO or private markets far higher! 2) Companies making more profits than the revenues of other company still valued less than half!
There are two tales of current markets, one driven by FAD & FOMO and other indifference to old – It starts with FAD driving the valuation of new age/IPO investments with complete disregard to risk-reward metrics, followed by FOMO effect amongst investors who have been feeling left out.
The above creates circular effect of FAD and FOMO --- FAD driving up valuation and with valuation going up, FOMO effect kicks in and more investors jumping in thereby further fueling the valuation.
When we hear exotic modes of valuing companies, we see clear signs of excesses:
Valuations have moved from P/E to price to sales. It is scary to hear, if a company make profits, we will use P/E ratio but if a company makes losses, then we will apply the price to sales multiple or some vague concept.
Valuations based on the number of eyeballs, number of clicks, price to order book, price to sales are clear symptoms of existence of FOMO and Fad in the market.
When companies are valued as a multiple to sales or other exotic modes, profitability takes back seat even in the board rooms and investors also push management to push the growth paddle with complete disregard to profitability.
“It is difficult to get a man to understand something when his salary depends on his not understanding it” --- Upton Sinclair
When we compare history with the current scenario, we find a lot of resemblance, confirming our hypothesis that at least a large section of the stocks are driven by fad and ecstasy…
Wipro at its peak in February 2000, used to trade at a market cap. of INR 2,02,900 crs which it was able to cross only in October 2020 after 20+ years. That too in case of a company which was generating profits and cashflows.
Suzlon at its peak in January 2008 use to trade at a market cap. INR 68,000 crs with a PE of about 93x, similar was the case with that of Unitech at trading at a market cap. of INR 79,000 crs and DLF trading at a market cap. of INR 1,83,000 crs (despite of leveraged balance sheet) whereas whole of Larsen and Toubro was available at market cap. INR 129,000 crs at the end 2007 (Current market cap. of INR 2,52,000 crs).
We are in markets at a state where there is complete dichotomy between newly listed new age companies and at the other end existing listed companies.
Newly Listed Technology Companies Vs Existing
Newly listed technology companies have limited history, grown without profitability, no/minimal cash flows – let aside return metrices; this to top it up with further very hazy path to profitability in the near future but trading at astronomical valuations. On the other hand, there are umpteen number of existing companies with decades of history, proven and established business models generating cash flows, paying dividend and generating high return ratios trading at significantly lower valuations. Some striking examples that have caught our eye
Policy Bazaar vs. ICICI Lombard
Newly listed Policy Bazaar (PB Fintech Ltd) which acts as a digital intermediary for selling insurance and generating commission income of about INR ~900 crs, loss of INR ~150 crs trading at market cap. of INR ~55,000 crs and on the other hand there is a manufacturer/insurer - ICICI Lombard having premium income of about INR ~13,000 crs and PAT of INR ~1,500 crs trading at market cap. of INR 72,000 crs with return on equity of 20%.
We are using Price to sales – because there are no profits for Policy Bazaar 😊
ICICI Securities vs. Next Billions (Groww)
ICICI securities has been in the business for 25+ years and one of the initiators of online trading having a huge customer base of 63 lakhs managing/handling INR 3.8.trn of client’s assets, generating revenue and profitability of INR ~2,600 crs and INR ~1100 crs respectively with 65% of its profits distributed as dividend, on the other hand we have Groww which started in 2016/2017, with revenues in lakhs for FY 2019-2020 (March 2021 data not available) as recent as August 2021 valued at about INR ~22,500 crs.
We should not forget, –
“Revenue is Vanity, Profit is Sanity only cash is reality”
Latent View Vs IT Services Company
Recently listed Latent View Analytics Company which is offering data analytics and digital solutions trades at a market cap. of INR ~12,500 crs which generates revenues and profit of INR ~300 crs and INR ~90 crs respectively (implied valuation of 41x sales). IT companies which have a strong advantage of scale and have proprietary digital platforms offered to several industry leaders trade at much more reasonable valuations. LTI Infotech, a case in example trades at about ~10x sales having 3-year Profit CAGR north of 20%.
Risk of Failure: Are we assigning 100% occurrence probability to optimistic forecasts?
We are not making any case against emergence of new trends if it’s here to stay or not. We surely believe constant emergence of new trends and disruption of old business models to be normal and this has accelerated in recent times. While disruption is welcomed and higher valuations are justified for a few companies but for most of them, it will be interesting to see how they carve their path ahead which looks hazy currently. Investing is all about probabilities. Probability of failure or de-rating in Fad driven newly listed companies in comparison to the existing established and cash flow generating companies is much high, especially when the liquidity dries out. Much like in the past, most new IPOs will be trading below their IPO prices and many of them wouldn’t even exist.
Charlie Munger quoted – “there is no better teacher than history in determining the future …. there are answers worth billions of dollars in 30$ history book”
We have historically seen exuberance as well be it the Tulip Mania, Nifty Fifty boom in the US, Dot Com bubble, 2008 Sub-Prime boom and many more such instances where irrationality overtakes everything else.
We are not saying that new age companies will not create wealth but when market assigns equal probability of success to established franchisee vis-à-vis to new business models, there is clear signal that risk-reward metrics is ignored. While few of new age companies will create immense wealth but surely not all of them.
Our suggestions are:
FOMO should be clearly avoided. Do not make any decision based on missing out something. Most “fads” look most convincing at the peak.
Allocate capital to stocks with high cash flow, least prone to disruption, sound management teams, hedged against inflationary pressures and distributing good yields. There are plenty of them.
We are still super bullish on India from longer term point of view. There will be deep corrections along the way. Use them to allocate capital and avoid chasing Fads and stay grounded.