Trent Ltd is down more than 20% from its 52-week high as I write this. In other words, the stock has officially entered a bear market. Why this sudden bearishness though? I can think of two reasons.
First, the broader market is under pressure. Both the Sensex and the BSE 500 are down around 7% from their 52-week highs.
Second, Trent's September-quarter results don't seem to have gone down well with investors, even though the company reported a 47% on-year growth in profit on the back of 39% on-year growth in revenue.
Now, a company's stock being hammered despite a 47% increase in profits is certainly surprising as growth of this magnitude would cause the stock price of most companies to soar. But not Trent. The stock trades at a very high price-to earnings (PE) ratio, in the region of 170, so investors had very high expectations. It looks like even 47% profit growth wasn’t enough to sate their appetites, leading to the drop.
Do you know what’s common to all the great investors such as Ben Graham, Warren Buffett, Peter Lynch, and Walter Schloss? Discipline. They all have, or had, a maximum valuation multiple they would pay for any stock. No matter how good the management or how great the company's growth prospects, they almost never exceeded this limit.
Walter Schloss rarely paid beyond the book value for any stock he bought in his multi-decade career. In fact, said he would rather give up money management and retire than violate this rule. Ditto for Warren Buffett. I haven't seen him pay more than 20 times earnings for any stock in the past few decades. Peter Lynch also swore not to pay more than 25 times earnings for any stock.
Such discipline is crucial as it prevents us from overpaying, a habit we can easily fall prey to, especially during the highs of a bull market. It allows us to keep our head when everyone around is losing theirs.
So, have investors lost their heads when it comes to Trent Ltd? Is the 20% fall an indication that they were too optimistic and now need to tone down their expectations?
Well, I don't know of many stocks for which one has paid close to 170 times earnings and ended up with a multibagger. Even in a growth market like India, a PE ratio of more than 50 is risky and isn’t sustainable for most companies over the long term.
Is Trent an exception to this? Can it continue to grow rapidly for many years to come and justify its current PE ratio? Perhaps it could. However, when it comes to investing, it is better to pay attention to what works on average and not the exception.
Market-beating long-term returns are made when investors buy good-quality stocks at reasonable valuations. No stock is so good that it can't be overpriced and become a bad investment.
This is an important point to consider for investors who don't mind paying more than 100 times earnings in the name of quality and high growth on a consistent basis. History is not their side as such purchases have usually not worked out well over the long term.
Happy investing!
Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com
