When gruesome businesses attract sky-high valuations, watch out

Different investors have different ways of classifying businesses. One of my favourite classifications is inspired by Warren Buffett, who likes to categorise businesses as great, good and gruesome.

Let me repeat that.

According to Buffett, businesses are mostly of three types – great businesses, good businesses and gruesome businesses.

The great

In the table above are three that qualify as great businesses – Page Industries, PI Industries, and Pidilite Ltd.

I have deliberately chosen businesses that start with the letter 'P' so that I am not accused of cherry-picking them to suit my narrative.

One look at their key financials and you will know why they can all be considered great businesses.

Look at the last two rows – the average return on equity and the average return on capital employed. A high ROE and ROCE are what make a business great.

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Great businesses are highly capital efficient and have a moat or a competitive advantage that allows them to earn more per rupee of capital invested in the business than other companies.

It is like opening a savings account in a bank where you earn a minimum of 25-30% interest on your fixed deposit, and consistently to boot.

As you can see, they are also zero-debt companies with little to no borrowings. Consistently high ROEs and strong balance sheets are the necessary conditions for a business to qualify as great and all the three businesses fulfil these.

The good

Up next are good businesses. I have again chosen ones that start with the same letter - A. Ambika Cotton, Angel One, and Apar Industries can be classified as good businesses because their ROEs and ROCEs are a notch below those of great businesses.

These companies are not as capital efficient as great businesses but are nevertheless decent. They are mostly profitable, have strong balance sheets, and also have consistency in their earnings. As you can see, all the three have either stable or growing earnings per share (EPS).

As I have said, the consistency with which they earn ROCE matters a lot and all the three businesses have done a decent job on this parameter.

The gruesome

Next on the list are the gruesome businesses.

These companies are characterised by losses, high debt to equity, and very poor return ratios. All the three stocks have exhibited these qualities in spades for the seven-year period between FY15 and FY21.

I am sure you are surprised that I have classified Suzlon as a gruesome business because both the business as well as the stock have done so well recently.

Well, I went simply by its performance between FY15 and FY21, during which time the company did really struggle. Its profitability was all over the place and it also had a lot of balance-sheet challenges to address.

Such is the case with the other two companies as well – Swan Energy and Shoppers' Stop. These companies also struggled during that period and could correctly be termed gruesome businesses.

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To summarise, great businesses have strong competitive advantages and earn consistently high a ROE and ROCE. Good businesses are not as good as great ones in capital efficiency but are nevertheless decent. In gruesome businesses, not only is the core business weak and loss-making, but the balance sheet is also loaded with a lot of debt.

If you invest in a gruesome businesses, there is a strong chance you will destroy wealth instead of creating it.

Here's a very important chart showing the share price returns of each of these groups for the two years from December 2021 to December 2023.

Now, this is surprising. Every ₹100 invested equally between the three businesses of each group has grown to only ₹107 for the three great businesses.

On the other hand, investing ₹100 in the good companies would have multiplied your money almost four-fold over the same period, growing it to an impressive ₹386.

The biggest surprise, however, is the gruesome group, which includes what we have called ‘wealth-destroying companies’. The ₹100 investment would have grown to ₹320. So, the gruesome group did not destroy wealth, rather multiplied it more than three-fold.

What explains this divergence? Shouldn't the ‘great’ group have done the best, followed by ‘good’ and then gruesome?

Well, it doesn't matter that the gruesome group multiplied wealth over this period. You see, there is investment and there is speculation. Investment is an operation which, upon thorough analysis, promises safety of principle and an adequate return.

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The gruesome businesses we saw were loss-making and had stretched balance sheets. There is no way they could have qualified as investments based on their historical performance. Of course, they may improve in the future.

However, a bright future alone is not necessary for a stock to qualify as an investment. A business needs to be sound both in terms of its past and expected future performance.

Absent any of these criteria the stock does not qualify to be an investment. The three gruesome businesses we saw had a poor past and hence would be termed as speculative.

One cannot make such companies the core of one's portfolio. Even though they ended up giving 3x returns as a group, they were speculative stocks.

Coming to the great and the good businesses, this table will show one big reason why they performed the way they did.

As you can see, all the three great businesses were trading at very high price to earnings (PE) ratios in December 2021. Page and Pidilite were trading at a PE of almost 100, and PI Industries wasn't cheap either at almost 60.

Thus, these stocks were banking heavily on earnings growth for their share prices to go up significantly. When the earnings growth did not come in as high as expected, the stocks were almost stagnant and the group underperformed.

The good businesses, on the other hand, were trading at reasonable valuations. All of them had a PE of under 20, which is decent. Hence, when high earnings growth came in, the stocks took off, returning almost 4x between December 2021 and December 2023.

So, the takeaway is clear.

Buying good businesses at reasonable PE ratios can give you much better results than buying great businesses at very high PE ratios, especially if the time horizon is just two to three years.

Over a longer period, you may still get away with paying slightly higher PE multiples for great businesses. But over a short period, paying a very high PE multiple, even for a great business, can destroy wealth.

Ok, now what do you think about the following business?

It’s clear this is not a great business. Not only has it made losses in the past, but the average ROE and the ROCE are also nothing to write home about. It is not a great business by any stretch of the imagination – not based on its past performance at least.

Is it a good business? Well, even this is doubtful. A great or a good business must be profitable at least and must have an average ROE and ROCE of more than 15%. This stock fails on both counts.

So, if you go strictly by the definition, this falls into the category of a gruesome business. In other words, if one invests in this stock, he is not investing but speculating.

Also, check out the PE ratio of the company. It’s more than 1,000x. Yes, you read that right.

Forget gruesome businesses, this is too high a PE multiple even for a great business. If you have invested in this stock or are thinking of doing so, let this be a warning.

It’s not that making money on this stock over the next two to three years is impossible. However, the risk-reward ratio is certainly not in the investor’s favour.

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Now, let me reveal the name of the stock to you. It’s none other than FSN E-commerce ventures, better known as Nykaa.

Based on this framework, Nykaa qualifies as a gruesome business.

Now, this does not mean that the company cannot turn around in the future. It certainly can. The market seems to think so, or the stock wouldn't be trading for more than 1,000 times earnings.

However, I'd rather focus on a business that's already great or good instead of the one that is expected to make the difficult transition from gruesome to good or even to great.

Remember, even Mamaearth was touted to be the next big thing. But we all know what happened to the stock. The sky-high expectations were not met, and it came crashing down.

A similar danger lies ahead for a lot of gruesome businesses with sky-high valuations. Please be careful and invest sensibly.

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