Having spent close to two decades researching stocks, there are a few thumb rules that I hold very close to my heart. I try not to break them, no matter the temptation.
One of these is to have an upper limit while assigning a PE multiple to a stock. This PE multiple limit for me is 35x to 40x. Yes, that's correct. The maximum PE multiple that I am willing to assign to any stock is 35x to 40x.
Should I come across any stock that's trading at a significantly higher PE multiple than 40x, I reject it immediately, irrespective of its quality or growth prospects.
I hope you remember the famous advice of Ben Graham that you should make Mr Market your servant and not your guide.
This is what you are doing by insisting on an upper limit to the PE multiple. You’re asking Mr Market to serve me only those stocks that are available at a PE of 40x or lower. If he does not have enough good quality stocks fulfilling this condition, you can simply ask him to leave and return another day.
A majority of investors do not follow this advice. They don't have an upper limit for buying and rejecting stocks. In fact, if Mr Market tempts them to buy a stock at a PE of 100x by creating some nice stories around it, they are more than happy to oblige. They are making Mr Market their guide and not their servant.
Stock-market history suggests that buying a stock at a PE of 100x leaves very little room for error as a lot of growth expectations are already built into the valuation. Even a slight delay or error in meeting those expectations could send it crashing down.
Hence, it is always better to insist on a stock where there aren't a lot of growth expectations built into the PE multiple. This way, even if the growth comes in slightly lower than expected, there’s not a lot of damage to the stock price.
This simple thumb rule has helped me enormously over the years by keeping me away from extravagantly priced stocks, a major source of wealth destruction in the market.
Talking of high PE multiples, there's a stock that has done well despite consistently trading at a PE multiple of more than 100x for many years now.
Trent Ltd, which is a part of the Tata Group’s retail venture, has had a phenomenal run over the past few years. It has been a massive 47-bagger over the past 10 years and an 11-bagger over the past five.
Do you know what was the PE multiple of Trent Ltd 5 and 10 years ago?
A little less than 10 years ago, Trent Ltd was priced at an extremely high PE multiple of almost 140x on a consolidated basis. It's the same story for the five-year period – the stock was trading at a consolidated PE multiple of close to 140x five years ago, too.
And do you know what the PE multiple is right now? A whopping 183x.
In fact, there hasn't been a single day in the past 10 years or so when the stock has traded significantly below a PE multiple of 100x. The lowest was 97x, back in June 2017.
Other than this dip, the stock has consistently traded at a PE multiple of more than 100x over the entire 10-year period. Even during the covid crash of March 2020, the multiple remained significantly higher than 100x.
The market may run on emotion and sentiment in the short term but in the long run, it is the growth and fundamentals that matter. In other words, a lot of stocks can trade at high PE multiples for a year or two, driven by bullish sentiment. But to sustain those high PE multiples for as long as 10 years requires something special. It requires consistent growth, and it requires management with intelligence, energy and integrity.
It would be correct to say that Trent Ltd has all these qualities in spades. Management has done a great job taking the company from a consolidated net loss of ₹19 crore in FY14 to a profit of ₹1,500 crore in FY24. The topline has grown six-fold over this period.
Almost all this growth has come without putting any pressure on the balance sheet. The company has had negligible debt all these years and has grown almost entirely through internal accruals.
It also has a solid competitive advantage as the bulk of its revenue comes from its own private labels. Private labels not only ensure high profit margins, they also give you better control over the supply chain and massive savings on working capital. Trent has milked both these advantages to great effect.
In a nutshell, I like what the company has done historically and its aggressive expansion plans. What I don't like, of course, is the extremely high PE multiple.
So, what do you do when you like the company and management, but are not comfortable with the valuation? Well, you have two options.
First, you move on, accepting the reality that this is the sacrifice you have to make for being disciplined and staying within your circle of competence.
Second, you can set aside 5-10% of your portfolio for stocks such as Trent Ltd, which do not exactly qualify as investments and are closer to speculation.
You see, speculation is not bad so long as you know what you are doing and limit your exposure. Danger arises when you don't know that you are speculating and have large exposure to such stocks.
Trent Ltd is not an investment for me based on my rule of having an PE-multiple limit for all my stocks. It could be bought as a speculative bet so long as I know what I am doing and allocate only a small percentage of my corpus to such stocks.
What do you think? Where does Trent Ltd fit in your way of investing? Is it an investment, a speculative bet, or neither?
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
