Some of us are hardwired to be “bargain hunters” i.e. we are always looking for “cheap” stocks. We associate “cheap” stocks with those quoting at a “low P/E”. We shun stocks quoting at a “high P/E” in the misconception that such stocks are “expensive” and will not give returns in the future.
However, we are making a terrible mistake according to the collective wisdom of Prof. Sanjay Bakshi and Basant Maheshwari.
Warren Buffett and Charlie Munger are one of the first proponents of the theory that it is better to pay a higher price for a quality stock with high ROE and longevity of earnings.
One of Charlie Munger’s famous quotes is “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you are not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you will end up with one hell of a result.”
Charlie Munger’s advice clearly states that if you buy stocks with high ROE and you hold them for a long period of time, then owing to the magic of compounding, you will make much more money as compared to stocks with low ROE, even if you pay a high P/E for the stocks with high ROE.
Prof. Sanjay Bakshi has further explained this theory in his latest lecture to the students of IIM Ranchi.
“You should pay for quality … Do not assume that a business at a P/E multiple of 5 is “cheaper” than a business at a P/E multiple of 15 …. The business quoting at the higher P/E multiple may actually be more attractive than the business quoting at a lower P/E” he said.
The Prof added (@1.42.00): “.. all of these building blocks … add up to create the high return of capital, the scale, the brand, the pricing power, the longevity and the compounding effect .. and if you can buy these businesses at 15 to 18 or even 25 P/E multiple, you will do very well”.
He further emphasized (@1.43.00) “What appears empirically to the value investors to be superficially “expensive” is not expensive. You only have to go back in a time machine and if you had bought the stocks then at the so-called high P/E multiple, you would see how much money you could have made”.
Basant Maheshwari offered the same advice in his latest talk.
He pointed out that companies like Page Industries, though quoting at an exorbitant P/E multiple of 70x, would always be in demand so long as their earnings are growing at a rate (25-30 per cent) which is higher than the growth rate (8.5 per cent) for the entire economy.
He added that if the high growth companies can grow at 30 per cent when the GDP is growing at 5.5 per cent, then, when GDP growth accelerates to 8 per cent, such companies can grow at 40 per cent.
Basant also explained that in the case of companies like Page Industries, investors had to focus on the free cash flow generation. “If it is a free cash flow company, then the stock price would not collapse in the long term …. the trick with these high PE companies is as long as their cash flow remains positive, one should not be in a hurry to sell them.”
Basant was very clear that we need not fear high P/E stocks if the scale of opportunity is so large that there is visible longevity of earnings.
“… dismissing a stock by saying it is at a high PE is not a correct thing to do because the entire market cap of housing finance sector is so small in comparison to the scale of opportunity. Hence, the high PE will remain there. As long as the predictability is there, these stocks will sustain” Basant added with immense confidence in his voice.