Friday 8 November 2019

The Quality Conundrum

This note is more to myself and for other small investors. Last few years, I have had the opportunity to interact with a very large number of small investors and have seen first hand atleast a thousand different portfolios. This note is more to reassert to me the importance of looking for quality first and price thereafter.

People are deriding quality companies and saying that quality is in a bubble.

But let’s take a step back and ask what is quality? Is it defined only by high PE stocks? Does quality exist in midcaps and small caps or is only large/mega-cap companies’ quality? Can quality exist in companies whose stocks are cheap? Are all expensive stocks good quality businesses?

Secondly, why is there a premium to perceived quality companies today? Or conversely, why have small & mid-cap stocks corrected so much? Are they all poor quality?

Some of the reasons that I think of are as follows:
  • Failure of companies, including in large and famous corporates – Zee, NCLT cases
  • Governance deficit in large well-known companies – Infosys whistle-blower, Yes Bank, DHFL
  • Frauds and other issues – PNB, PMC Bank, IIFL
  • Lack of ready information about small and mid-cap companies
  • Midcaps & smallcaps had rallied to obscene valuations by 2017
  • Weakness in the economy impacts the smaller companies slightly more than the larger ones

Investors are scared. Return of capital has taken precedence over return on capital. That is why stocks of companies which investors think are safe is at a premium. And everything else is relatively cheap.

Now, let me look at over-pricing. A lot of companies are at very high PE multiple. Though I am not a very strong believer in looking at PE in isolation, it does help in understanding the overall market sentiment when used as a collective. I had tweeted a couple of days back about people talking about high PE are ignoring the interest rate reduction. All things equal, if you reduce interest rates from 12% to say 6%, the fair value that a DCF will throw up is about 4 times. Now, you might argue that if interest rates fall, all other things can’t remain equal. Fair point. So, lets discount that 4x to 3x. Heck, let's reduce it some more, say 2x or 1.5x. The broad point I am making is that the median PE of stocks as a whole rise. And we have seen this play out in real life as well. The NIFTY PE, for example, has moved up from 16-17 a few years back to now about 26-27.

Now think from this angle, 10 years back, people were ready to pay a 2.5-3x premium on median PE for the so-called high-quality companies. Now, my contention is that that multiple for perceived quality will not change. Even now investors would pay a similar markup. So, a high-quality company used to be available at 30-40 PE when the market was at 15-16PE. How has that ratio changed now? It is more or less the same.

I am for sure not making a case for buying a stock with very high multiples or which is expensive based on its future earnings. But I do have a problem when people are saying that quality is expensive, what remains unsaid is “therefore move to cheaper, poorer quality businesses”.

Perhaps the most important thing is for those who can identify great companies at cheap prices, then they should do precisely that. But a vast majority of people can’t do that and end up buying mediocre or poor companies just because they fixate on cheapness.

In my personal experience, retail investors are much much better off being in quality companies with longevity than poorer companies which can cause permanent capital damage. If you can find equally great kind of companies at cheaper prices, then it is a no-brainer and no need to discuss at all.

So, the next question is what happens next? I don’t know. My take is this phenomenon will also mean revert. It may take some time, but it surely will. We are going through a massive exercise of cleaning up corporate India and also a sort of formalisation of the economy. As the good quality smaller companies come up on governance as well as consistency of results, the premium for others will reduce. People will then not take refuge in only a handful of stocks. 

Are there bubble-like valuations there today? Sure, a lot of stocks to me definitely feel that way. But like any phase, this phase of over-valued quality stocks will also change facilitating a more broad-based rally.

I am, like always, trying to find good quality companies which are cheap based on their earning potential. But quality comes as the first filter and cheapness next. I am willing to compromise on cheapness but not on the quality of the business. Because history and my personal experience tell me that buying and sticking to good quality does not hurt. 

Another example of holding on to quality that most people often cite is HUL’s flat returns for 10 years. Trust me, I was there. I bought and finally sold HUL at about the same price after a decade. Now, as a retail investor, the way I look at it is this. 
  • I did not only have HUL in my portfolio, but there were also other stocks which did much better (or worse). 
  • I kept getting good dividends and also a good debenture, 
  • I did not lose money. I know a lot of people who put money in JP Associates, DLF, Unitech and other similar companies and lost 40-50% or more during the same period, 
  • If I had put a basket of 10 such strong business companies, I would actually have done quite well. I actually did this exercise much later after found that even well discovered fundamentally sound strong businesses have given exceptionally good CAGR returns over 20-25-year periods.

Another very important point to remember is that we invest in a portfolio of stocks. Peter Lynch, one of the most successful money managers, had different categories of stocks in his portfolio – slow growers, stalwarts, fast growers, asset plays, turnarounds and cyclicals. So, in a diversified portfolio is not about having only one or two categories of stocks but a mix of different types of stocks.

Another point that is missed in this discussion is the time horizon. For fund managers and advisors, usually, the time horizon is a problem because they get “judged” by the returns in the short term. And quite a few times, what is good in the short term ends up being harmful in the long term. Individual investors can and should have much longer time horizons. As a retail small investor, you don’t need to do anything all the time. If you are in the market for the next 20-30-40 years, you are much better off with a collection of great businesses than trying to get in and out of iffy companies because they are cheap by some arbitrary parameter. For example, one approach to this is to just pick 9-10 industries you like and which have long term growth characteristics and pick either the best or two best companies in that industry and build a portfolio. And then do nothing. Re-look at the portfolio once every year. If you think the businesses are doing well in their respective industry, again, do nothing. After 10 years, you are likely to end up much better than most people who are trying to get in and out of stocks and markets by giving the flavour-of-the-month reasons.

Bottom line, if you are a small investor, and do not know how to pick great stocks, then you are better of building a basket of strong businesses, focusing on quality first and price second (but don’t ignore price altogether), have a long investing time horizon and follow the business cycle. 

Happy investing.


  1. Well said Abhishek, it all finally boils down to the definition of quality. If an investor can identify that a little bit early than others can, then in my view , it's highly remunerative.


  2. Still better opt for mf , return of capital is more important than return on capital if investor is not sure what a person is entering into
    Nobody talks of satyam dhfl yes bank tata motors which were the favourites

    1. Agreed or a mix of Nifty ETF or Nifty Junior ETF is a good starting point.

  3. I quite agree with you on most counts. However, my problem is the valuation conundrum.

    A company may be great or even one among the greatest but it's stock may not be good as an investment for no stock is good or bad per se, it is the price you pay that makes it good or bad, this is because, as Warren Buffet said during the tech boom of 2000, if you pay too high a price you are sacrificing several years of growth down the road. While Mr Buffet's thesis hindered him from buying Amazon, Apple and Google but for most others he was right.

    1. You are right. That is why we need to have a sense of valuation and not buy really overvalued stocks. My point was simply that valuation is not judging by a single metric of PE, which a lot of people are doing these days. To value properly, we need to understand the business, its operational metrics and it future prospects.

      Also, for most retail investors betting on good companies is, in my opinion, a better bet than speculating on whether Yes Bank will go up or down from here :-D

  4. Thank you Dada for your well articulated comments. I am also a regular reader of your weekly reading links and must say i always look forward to them. I have a question/thought on valuations based on your interest rate reduction argument and consequent PE expansion. What happens if and when interest rates also mean revert and rise finally? Should that not result in serious contraction in multiples? Is betting on extremely high PE stocks also not the equivalent of betting that low/negative interest rates are here to stay for long if not forever? To that extent is it a fair bet?

    1. Aarey, thanks sirji!!

      If rates reduce,it will for sure trigger a downward revision of median valuation. If you see this has more or less consistently happened across markets globally.

      On your second point. There are debates on in the developed markets whether we have entered a time of permanent low interest rates.
      so, I don't know the answer to your question, but it is something worth considering.

      Will try and write a separate post on it, more to clarify my thoughts.

  5. Dear sir I am small investor and don't know how to pick a great business for long time. Also I have been invested long time but totally failed. I had misguided so many people. Pls help me. Thanking you.

  6. You could start off by investing in mutual funds or Nifty and Junior Nifty ETFs or go through good mutual funds.

    For direct stocks, at the cost of self-promotion, you can look at my advisory, where we focus equally on building a good long term portfolio and also help investors improve themselves through continuous learning.