The art of protecting value in your holdings

As economies around the world enter tighter monetary cycles, it is common to see downward revisions in exit valuation multiples for companies across sectors. An exit multiple is the price-to-earnings ratio for a company estimated for a point in time in the future, that is, the multiple it would command were it to sell out or exit the business at a given point.

Recently, we saw large global institutions downgrading India’s information technology sector, wherein they had cut the target prices significantly across stocks.

A close look at the reports tells us that these institutions had lowered the earnings estimates by only up to 5%, but reduced the multiple by 14-35%. Close to 80% of the target price cut is from multiple reductions.

To mitigate such shock in our portfolio and reduce risk as part of our investment framework, let us explore the factors for businesses where potential exit multiples can expand or stay the same even during a tightening monetary cycle.

An improved balance sheet is a positive signal. When a company repays its long-term debt and moves to zero debt with higher cash balance, it potentially allows such firms to take long-term decisions and not worry about daily capital requirement. The longevity of a business goes up significantly. We have seen how important balance-sheet strength is during the recent COVID-19 pandemic.

Quality of earnings

As the quality of earnings goes up, it reduces long-term survival risk. Companies are valued based on one big assumption — that they get to survive during all economic cycles.

So, companies that have mastered one or more of the following tend to have higher survival rates: those whose percentage of recurring revenue significantly improves and crosses a major threshold; or, whose significant new sales are accomplished via on-cash channels due to improved competitive position vis-a-vis credit sale; or whose growth is balanced both in terms of geography and product; and companies that are consistently able to reduce concentration risk of the top 5 or 10 clients – this is particularly important for B2B companies whose sector is facing consolidation.

Fewer sales cycles

Products that do not have to face sales cycles that go up and down help raise the value for a company. Take the case of a consumer durables company that dominates the air cooler market – which is very seasonal – moving to other products such as home appliances, to reduce the cyclical nature of revenue across quarters. It helps them manage the fixed operating cost.

Improved prospects

New business verticals that are less cyclical is a welcome change. An insurance company that was heavily dependent on product sales linked to capital markets moving aggressively, adding products that are typically not impacted due to adverse movement in capital markets, is an example.

Every industry goes through an inflection point when growth gets accelerated. For example, demat accounts in India accelerated post-COVID, which led to a sharp re-rating for businesses dealing in capital markets. In such cases, either terminal growth is higher or the higher growth phase is extended beyond just a few years.

We have seen strong multiples expansion in engineering R&D companies servicing emerging businesses such as EVs, as the outlook for the end-market is very strong, leading to either sustainable higher growth or companies whose competitiveness has improved.

Industrial manufacturing companies wanting to use India as a base for global exports due to cost competitiveness, which led to sharp re-rating of valuation multiples, is an example.

A company that needs lesser capital to grow in future can command higher multiples. Asian Paints had generated ₹4,300 crore of cumulative cash flow in FYs 2003-12 and had re-invested ₹2,065 crore – approximately 48% of the cashflow – to maintain and grow the business.

In the subsequent nine years, the cumulative cash from operations stood at ₹18,851 crore (approximately fourfold growth compared with the previous decade), but it needed to invest only ₹6,149 crore back in the business (approximately 33% of the cash flow).

The average multiple expanded significantly during this time and is partially attributable to lower capital requirement for future growth. Higher free cash flow can help incubate new growth opportunities and rewards shareholders more liberally which results in higher present value.

Improved capital efficiency

As companies attain a mature state in their business, most of them start paying out higher in terms of dividend or via buy-backs.

This can result in better long-term multiples as long-term re-investment risk goes down substantially with higher payouts. Several IT companies, a few FMCG and auto companies have increased their payout ratio in recent years.

Though their growth rates tend to behave in line with a mature business, they command a better multiple as they pay out close to 90% of profits.

For example, Infosys’s profit has risen 1.5 times in the last 5 years, but equity capital has grown only about 1.1 times.

All the incremental growth has come from marginal incremental capital. Incremental ROCE is significantly higher than for the overall current business.

Companies that have scaled better with every cycle can command higher multiples. When a company scales up and creates sustainable large cash flows, it can result in higher chances of survival during a downturn. Only 300-odd companies make more than ₹500 crore of profit in a year.

Even though we have 3,900-odd companies listed and whose shares are available for trading, companies making more than ₹500 crore in profit is a rare and prestigious achievement. They tend to get the attention that large institutions command, for long-term investing.

Expanding total addressable market (TAM) is a good sign. Companies such as Astral Poly, which gained scale in its core business (as plastic pipes TAM expanded to ₹35,000 crore), used the free cash flow to enter adjacent businesses such as adhesives, tanks and paint (TAM ₹1 lakh crore), which led to a significant re-rating of stock due to strong execution of core. When TAM expands, it supports the terminal growth rate which potentially leads to higher exit multiples.

Consistent execution

It is always interesting to see the second or the third-ranked player in an industry delivering better than the top company in terms of business growth, capital productivity and improved competitiveness.

In the last few years, we have witnessed ICICI Bank and Infosys delivering much better than large comparable peers both in terms of growth and profitability, and this has led to significant re-rating and bridged the discount over the top stock in the industry close to zero.

As capital allocators, it is important for companies to preserve and grow their capital during periods of macroeconomic uncertainty.

Happy Investing!!!

(The writer is head of research and co-fund manager, ithought PMS)