Novice investors like you and me have the bad habit of losing sleep over stock valuations. We fret about aspects like the P/E ratio and the P/BV ratio and worry that we may be paying too high a price for the stock. We decide to wait for the stock price to correct and then find that we have missed the bus. This leaves us in a very sorry state of affairs and we feel miserable about the missed opportunity.
Valuation bogey is made up by analysts to justify their monthly pay cheques
Shankar Sharma has now offered the definitive advice that we are making a mistake by worrying so much about the valuations.
“I have always said that I do not at all ever look at valuations” Shankar said in his deep baritone.
“This is all made up by analysts to justify their monthly pay cheques”, he added contemptuously.
Shankar explained that there is no watertight rule of law which states that a stock has to be treated as cheap when it is at 16x and that it has to be treated as expensive when it is at 19x.
Forget large-cap stocks and focus on mid and small-cap stocks
It may be recalled that Shankar has earlier issued the clarion call that we should forget about large-cap stocks and focus exclusively on small and mid-cap stocks.
Shankar’s theory is based on the sound reasoning that even a slight uptick in the economy is sufficient to send the small-cap stocks surging while the blue-chip behemoths will struggle to eke out a living even if the GDP grows at 5%. This happens because the small-cap stocks operate in niche areas and in localized areas and are generally insulated from the sluggishness of the economy.
Morgan Stanley’s report corroborates Shankar’s hypothesis. Morgan Stanley produced data to prove that micro and nano-cap stocks have heavily outperformed the Nifty and Sensex in the past 10 years.
No “valuation froth” – Small and Mid-Cap stocks deserve a premium
Shankar rubbished the fear that there is a “valuation froth” that is developing owing to the disparity between the valuations of small and mid-cap stocks and the large-cap counterparts.
Shankar explained that small caps are benefiting from very strong balance sheet restructuring, very strong earnings growth and very strong revival in ROEs and ROCs, which factors are absent in large cap stocks.
“So there is no reason why small-caps should not have a premium to the largecaps” Shankar said in an authoritative tone.
Small-caps are now the dog and large-caps are the tail
Shankar questioned the conventional wisdom that the large-cap stocks are the “dog” and that the small-cap stocks are the “tail” and that the latter has to be subservient to the former.
“Maybe the whole story has changed right under our nose” Shankar said with a chuckle, giving insights into his non-conformist and maverick personality.
But worry about extreme valuations
Shankar cautioned that his advice does not mean that we should throw caution to the winds and even disregard extreme valuations.
If there is a “valuation extreme” such as a 5x versus a 60x, then we should be wary. However, if it is a contest between a 15x and a 25x, there is not much reason to worry, he opined.
Saurabh Mukherjea also opined that valuations are irrelevant for long-term investors
It is notable that Saurabh Mukherjea, the whiz-kid from Ambit, offered similar advice in his latest treatise “The Unusual Billionaires”.
Saurabh opined that investors would do well to focus on ROCE & revenue growth & not on valuations.
“If you are short term trader then you should worry out valuations quite a lot. Valuations matter hugely for short term traders. For long term investors, today’s P/E or P/B multiple or tomorrow’s P/E or P/B multiple is of little relevance; their focus is the fundamental quality of the franchise” Saurabh said with his usual clarity of thinking.
“There is zero correlation between valuation multiples and share price returns over long run time periods” he added.
Saurabh cautioned that investors who try to buy cheaper stocks almost always end up with lower quality portfolio which generates inferior growth in cash flow and earnings.
Saurabh cited the example of Warren Buffett to prove his point. Warren has no hesitation in paying a stiff premium for a stock if he is assured that the stock will churn out high revenue growth and ROCE for years to come.
So, in keeping with the wisdom of the stalwarts, the next time we spot an attractive stock churning out high RoEs, we should grab it first and worry about valuations later!