Avoid stocks with higher PE and weak asset base

Avoid stocks with higher PE and weak asset base

“While the old generation keeps forgetting the bitter past, the new generation allows itself to become gullible!”

The broad Indian equity indices are at record high levels – sure, it is a part of a structural bull run. However, the current bull run raises doubts on some of “wealth creation stories”. A company with a debt of over Rs 3,500 crore, which is 150% of its annual sales seen its stock price moving up almost 3-fold in the last 52 weeks and trades at over 100 PE! Moreover, its reported inventories and receivables are about 250% of its half yearly sales!
Another company has reported receivables and inventories accounting for about 4.5 times its half yearly sales in September 2014. Further sales and debt are almost equal at around Rs 1,500 crore. It raises doubt about the viability of the business itself – still stock price remains firm post its results! Reliance Industries, a leader in the petrochemical business with an annual turnover of over Rs 4.5 lakh crore, trades around 10x FY2015 estimated earnings. However, many small chemical companies with a turnover of few hundred crore trade over 15-20 PE! Few chemical companies with MNC tag reporting losses also do not deter their market cap build-up!
ITC generates sales revenue of over Rs 36,000 crore and expects to report a net profit of over Rs 9,000 crore this year and trades around 25x FY2015 estimated earnings. However, there is a small consumer product company with a turnover of Rs.700 crore commands a marketcap of more than Rs 7,000 crore 10 times sales!) and enjoys PE multiple of more than 45! Of course, the equity markets love incremental growth of the businesses – but what is the limit to valuation premium one can offer to such growth stories with a low base? A company with just “a couple of crore rupees worth of tangible assets” creates ten-fold jump in its market-cap close to Rs 1,000 crore within 12 months – very “difficult” to understand such a “success story” with a weak asset base!
Then there are few companies which have promoters’ stake in single digit, but enjoying market cap to sales (not profits) ratio of 40 times!
“All is not well” with the entire corporate sector – over 3,000 companies have collectively reported just about 3% yoy sales growth in the September quarter. Even the Sensex companies, which are primarily large corporate, have reported a mere 6% yoy revenue growth in the September quarter. Every bull market witnesses thematic run up in the stock prices and post such bull runs, several stocks end up being quoted in single digits.
Bubbles in valuation never last for long – even in a structural bull run, when “smart” investors take out their “harvests” first, their prices would fall badly. It would be worth reading once again “A Short History of Financial Euphoria” by the Nobel laureate Kenneth Galbraith. “Investors’ memory is very short”, “while the old generation keeps forgetting the bitter past, the new generation allows itself to become gullible”.