Investment Shastra

Investors’ common mistake during bullish market

You as an investor, may be considering trailing earnings or ROEs as base case for arriving at any valuation. The problem in this assumption is that high ROEs and margins are not sustainable as every company or industry reverses to the mean.

Consider Airline and Refining industry currently. Many of you may be buying the stock looking at cheap P/E they trade at. What you may not be realizing is that margins and working capital cycle is at its peak. The P/E may seem subdued due to higher earnings base. Its prudent to consider cross cyclical P/E and ROEs while valuing a company.

As Howard Marks says, “I think it’s essential to remember that just about everything is cyclical.”

Similarly, if you see that companies which had one time contract order, low raw material costs, faster inventory turns due to short term tailwind may be trading at low P/E or EV/EBIT. Don’t fall for low valuation and buy them. You may be buying company at much higher price in relation to its cross cyclical earnings.

At the same time, don’t get astonished seeing some undervalued companies trading at high multiples in their downcycle. Currently, you may feel that Pharmaceuticals are expensive. However, this may be due to depressed earnings in the denominator of P/E. Also, you may see that stressed banks are trading at high Price to Book or Price to Earnings due to their peak provisioning cycle. In infrastructure space, valuation may look expensive based on basic DCF valuation however, you may see lot of working capital freeing up going ahead which will improve the valuation. Hence such companies may not be as expensive as they appear.

In certain capital intensive sectors, for example a few telecom or oil exploration or port companies, you may see that large capex is behind and future cash flow is likely to flow directly to shareholders. In that case, don’t punish the company on basis of free cash flow track record but assess whether we are past the worst free cash flow period.

Our main intention for writing this blog to warn investors that you shouldn’t buy the companies which are enjoying peak earnings. Peak earnings often create Recency Bias and you may tend to assign higher P/E multiples for higher growth in recent periods. By doing this what are you essentially doing is double accounting for positives in your valuation.

If we were to believe statistics, just like cyclical low earnings, the peak earnings also reverse to the mean. We have seen this across market cycles and expect future to follow the same trajectory.

Currently, the way few FMCG, Cement and auto ancillary companies are priced, we believe that long term rate of return from them will be lower than the past. Most of the companies have enjoyed very high margins aided by low raw material costs and improvement in realizations. At the same time, cyclical companies with high working capital cycle and low margins due to unfavourable operating leverage are expected to reverse to the mean and experience steep growth rate in cash flows.

An intelligent investor would spend more time studying companies which are at cyclical lows and trade at cheap valuation on normalized basis since market would have discounted these companies like there is no tomorrow for them. And SELL the companies which are trading at their peak earnings and peak multiples. This way you can always buy low and sell high.

If you liked what you read and would like to put it in to practice Register at MoneyWorks4me.com. You will get amazing FREE features that will enable you to invest in Stocks and Mutual Funds the right way.


Join our Telegram Channel:
Stock Investing
Mutual Fund Investing

Join our Telegram Channel:
Stock Investing
Mutual Fund Investing

Need help on Investing? And more….Puchho Befikar

Kyunki yeh paise ka mamala hai
Start Chat | Request a Callback | Call 020 6725 833 | WhatsApp 8055769463

Ketan Gujarathi

1 comment

Search

Archives

MoneyWorks4ME