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Should a value investor buy a stock at a PE ratio of 50?

Value investing principles say that buy low and sell high. One should buy stocks cheap with a wide margin of safety when no one else wants to buy stocks and sell during the next bull run when valuations may become overstretched.

March 26, 2021 / 03:39 PM IST
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By Amey Kulkarni of Candor Investing

There are a lot of things that have to be taken into consideration during stock-picking. One such key performance indicator is the PE ratio. The Price to Earnings ratio is the ratio of a company’s share price to the company’s earnings per share.

The ratio is used for valuing companies and to find out whether they are overvalued or undervalued. And so here comes the baffling question, should a value investor buy a stock at PE ratio 50?

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Value investing principles say that buy low and sell high. One should buy stocks cheap with a wide margin of safety when no one else wants to buy stocks and sell during the next bull run when valuations may become overstretched.

Let us challenge our understanding of value investing using the case study of Deepak Nitrite.

What happened if you bought Deepak Nitrite in Jan-18 – a Rs 4,000 Cr market-cap company was trading at a PE ratio of 50.

The Finance Minister imposed the long-term capital gains tax (LTCG) when she announced the budget on 1 st Feb-18. The markets reacted violently to this announcement and Jan-18 turned out to be the top of the Sep-13 to Jan-18 bull-run.

Small and midcap stocks were especially battered and midcap investors lost a lot of money over the next 2 years. In fact, anyone who bought mid/small caps then was considered foolish.

But, Deepak Nitrite, a midcap company, was running a different race. Was it foolish to buy Deepak Nitrite in Jan-18 at a PE ratio of 50 at the top of the Sep-13 to Jan-18 bull market?

Let’s look at the numbers.

Smallcase 1

Let us try and reverse engineer why Deepak Nitrite was a compelling buy in the month of Jan-18. Yes, even at a PE of 50!

This is the financial summary of Deepak Nitrite in the month of Jan-18.
Sales = Rs 1651 Cr
PAT = Rs 79 Cr
Market-Cap = Rs 4000 Cr
Total Debt = Rs 724 CrWhen analyzing a company, one of the first things that an investor must do is read the annual report. Start with the shareholder letter that the Chairman/CEO writes to the shareholders.What did the 2017 annual report of Deepak Nitrite say?Smallcase 2

The company is expanding by investing Rs 1400 Cr. What were the total fixed assets of the company on Jan-18? It was Rs 590 cr.

Deepak Nitrite is taking a massive bet by investing almost 2.5 times of what it have invested in the last 46 years since they started operations in 1972.

This can be a game-changer. Why is the company so confident about such a massive expansion?

The company is basically expanding into 2 new chemical products – acetone and phenol. Back in Jan-18, the demand-supply dynamics for phenol looked like this

Smallcase 3

And the demand-supply dynamics for acetone looked like this

Smallcase 4

Reading a little more of the annual report, one would come across the following

Excerpt:Smallcase 5

The company raised equity capital from institutional investors. This meant that not only is the company confident about its massive expansion project, other institutional investors are willing to commit to the capital too.

Sitting in Jan-18, let us try to imagine what the future will look like for Deepak Nitrite.

The Rs 1400 cr expansion plant will be commissioned sometime in calendar 2018.
Given the high imports of phenol and acetone, capacity utilization might not be a big issue for Deepak Nitrite.

In 2017, Deepak did a sales turnover of Rs 1650 Cr on fixed assets of approx. Rs
590 Cr. When fixed assets increase to Rs 2000 Cr, what could the sales and PAT increase to?

Here’s my assumption:

Smallcase 7

Given the massive capacity expansion, one expects the revenue and profits of
Deepak Nitrite to increase by 3/4 times in the next 2 years.

In this context, this was an obvious buy-in Jan-18, even at a PE of 50.

As an investor, here are some of the key takeaways from the case study:
1. Most retail investors worry about Sensex/Nifty PEs and whether the indices will go up or down and do not pay attention to the specific business dynamics. You see how this can be a very costly mistake for your portfolio.

2. If profits of the company increase, the stock price will increase GDP, interest rates, Coronavirus, pandemic, bull market/bear market does not matter.

3. Microeconomics of the business always trumps macro-economics.

4. Value investor or not, one need not necessarily stay away from high PE stocks
Similarly, all low PE stocks are not worth investing

5. Finally, business analysis is underrated and trend analysis is overrated. You need business analysis to create wealth with equities.

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Candor Investing - Wealth Compounders smallcase by Candor Investing

Note: Please do not consider this article as a stock recommendation. The article is an illustration of the kind of analysis that goes into fundamental research and equity investing. The author Amey Kulkarni (@amey_candor) is a SEBI registered Investment Advisor.

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