The period between June 2020 and September 2021 was one of the best for the Indian equity market but 2022 is turning out to be a gut-wrenching time. The liquidity/volumes in the market have fallen by half and correction in small- and midcaps in India is severe.
All the hyped growth stocks—even the likes of HDFC Bank, Asian Paints and Divis Labs—apart from cement and metal stocks are taking a beating. The sea (broad market indices like the Nifty and Sensex) appears calm but there’s an undertow lurking in both global markets and Indian mid- and small-cap stocks.
Nearly 50 percent of the stocks are down by roughly half from their 52-week highs. The average fall is around 38 percent from their all-time highs. In the US, the S&P 500 has seen one of the worst starts of the year and the NASDAQ is down by more than 20 percent (officially, this is said to be the start of a bear market) and the darlings of the COVID period like technology initial public offerings or IPOs, SPACs or special-purpose acquisition companies, cryptocurrency, etc. are down by 30-70 percent. So what went wrong?
Answer: Recency bias, or extrapolation based on recent events.
Not all growth is good
It was assumed that all the businesses that were growing at a good rate for the past decade or in the recent period would grow at this speed forever, and that led market participants to provide astronomical valuations to them. The most important thing for investors is to understand that not all growth is good. Sometimes growing beyond a certain rate actually kills a business.
If you look at Avenue Supermarts, HDFC Bank, Asian Paints and so on, you would conclude that all it takes to generate great returns in the equity market is consistent growth in revenues/operating profits and cash flows.
As the legendary investor Charlie Munger says, “Invert, always invert.” In this case, does this mean that every business that has grown revenues and profits has rewarded shareholders handsomely?
Let’s take an example of a company where revenue grew 174 percent, 123 percent and 106 percent in 2020, 2021 and 2022, respectively. Now, I want you to guess the return of this stock in the last one year. This stock is down 75 percent from its all-time high and down 44 percent in last one year alone. The name of the stock is Snowflake (Berkshire Hathaway also invested some portion of its portfolio into it).
Also see the fate of some IPOs in India like those of Paytm, Zomato, CarTrade, etc. Zomato is down 58 percent, Paytm 66 percent and CarTrade 65 percent. Again, any guesses on the growth rates of the above businesses? Revenue at CarTrade grew at a five-year compound annual growth rate (CAGR) of 32 percent, Zomato at 71 percent and Paytm at 44 percent.
Valuing the company right
A company’s valuation multiple is an outcome of the following:
1. Growth rates in profits and revenues
2. Duration for which growth rate is greater than the economy can sustain (growth advantage period)
3. Level of return on invested capital (ROIC)/return on equity (ROE)
4. Duration for which such high returns can be maintained (competitive advantage period)
5. Discount rates/opportunity cost of capital
If a business is growing at a fast rate with ROIC/ROE much lower than its discount rates, it actually reduces the valuation of the company. Let’s take an example.
Imagine you broke your fixed deposit, which was earning you 8 percent, to start a business. Now that business has earned on average 6 percent in the past five years. Would you put more money in this business to grow it or shut shop?
Practically, you have lost money at the rate of 2 percent per annum by starting this business. If you initially invested Rs 1 crore into this you lost Rs 1 crore x 2 percent per annum, or a total of Rs 10 lakh in five years. Now if you put another Rs 1 crore in this, will your losses increase or decrease? Assuming here that the health of the business remains the same, you will lose 2 percent on Rs 2 crore. A loss of Rs 4 lakh per annum, instead of Rs 2 lakh per annum. The increased losses will reduce your valuation. We know a lot of startups that operate this way. Well, that’s a topic for a different day.
When the bull run ends, analysts suddenly realise that a lot of businesses were like a pig with lipstick. They were growing with ROEs much below their opportunity cost, actually destroying the value of business rather than creating it.
Hence, not all growth businesses deserve high valuations. There are lot of other factors like competitive intensity changing (Asian Paints with the entry of Grasim and JSW in the segment), industry getting saturated (Colgate Palmolive in toothpastes) and so on that also support our thesis that just because a business has grown at a high rate in the past, it does not automatically deserve a high price-earnings multiple today.
How long might this correction last?
That is anybody’s guess. There have been multiple instances of sharp reversals when even after correcting by 20 percent the markets recovered within seven days (for example, in 1997, 1999, 2006 and 2012) and sometimes there are long periods of drawdowns where the market remained below the 20 percent correction level for more than a year (1992-1993, 1995, 2000-2003, 2008).
For investors willing to work hard, there are always investable ideas available in every kind of market. There are some sweet spots (growth plus reasonable valuations) like businesses related to data centres, capital goods segment, agro-chemicals space, defence, and so on.
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