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2.2 What are Volatiles

AII companies that are not

This way, the entire co be divided into just two categories of companies -
Consistents and Volatiles.

Note that these definitions stone. Readers are free to use their own metrics as
long as there is some Iogic them, and preferably easy to use.

We provide few acade

a below to clarify the above definitions, which are
key to the rest of this report.

Exhiait 1 Academic examples of Consistents & Volatiles

Year YoY PAT growth
A Com D Com FC
2008 A AO/ l ao/ AO/
!!/a

2009 -1.1% L35% 16%

2010 24% 29% -8% 20%
20tt 23% 39% -37% 1,6% s2%
20L2 -36% A40/
13% 26% t6% +L/a

2013 11,% 45% 15% 42%

201,4 2t% 17% 1.6% -12% 16% 62%
32% B5% 20% 26%
2016 25% 39% -qq0/ t6% 44%
201,7 19% -45% -12% 26%
2018 2t% 1B% 26%
110/
201.9 1,8% rt/a 36%
LL-a//O
a -Ls%
2020 22% -9% 34%
2021_ 7s% -20% -37% 26% Eaa/
-)) /o

2022 2s% ss% 26% 1,9%

Category Consistent Consistent Consistent Volatile

Exhiblt 2 Academic examples explained

Company Consistent The math
or Volatile
A Co nsistent obviou sca no PAT de-growth at all
B Co sistent
n hs, but only 3 greater than 10%
C Volatile of which 4 greater than 10%
D Consistent but on ly 2 greater than 10%
E Volatile greater than 50%
Co nsiste nt n 10% allowed in 10 yea rs

G Volatile Only but ater than 50%

i"
)'''"

i;xi-r;lit .l Actual examples of Consistents & Volatiles

,AT h
Yea r
HDFC Bank sBt ree cement Cummins ABB Reliance BPCL

2008 40% 4I%

2009 4).% 22%
201 0 34% 7%
?"01.1 33%
2012 31% 40% 64%
2013 31,% r7% 13% 24% -2s% 5% 1,39%
2014 71% -21,% 28% 6% 98%
110/
201 5 22% 2A% -4% 1,8% 29% LL /O

2016 20% -28% 26% 4% 32% 69%

10/
2017 79% -100% 10% L/O L8% 8%
20l-B 21,% PtoL -8% t8% 21% 3%
20t9 LT/A LtoP 8% 78% 1,0% '::Wl:lt|%
:

2020 22% 613% L31% 0% 8% :;;;::;,,:;!0.|9/9 :

2021 17% 3B% -3% 4B% -L3% 2% 166%

2022 20% sB% 30% 29% 1.48% 34%
Ca Consistent Volatile Co nsiste nt Volatile Consistent Volatile Consistent Volatile

3. Characteristics & Distinctions

How Consistents & Volatiles stack up

The table below captures the various characteristics and distinctions of Consistents and Volatiles.

Irhik;it rtr How Consistents & Volatiles stack up

Criteria Consistents Volatiles

Secular Cycl i ca I

Mostly leaders Many non-leaders

Yes No

Favourable U nfavourable
Strong value proposition Weak value proposition

Non-negotia ble

H igh

Relatively more predictable Unpredictable

Low

Relatively high:
Relatively higher Relatively lower

Earnings-based Asset-ba sed

P/B

Narrow Wide

Weak compounders

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lxhibit 1.8 Quality-Growth Matrix

Performance Expectation Actual Average Returns (see note below)

GROWTH TRAPS
High Tran$itorv High 2L%
M ulti-tlilgsers

GROWTH GROWTH

WEALTH DESTROYERS QUALITY TRAPS

Low Permaileftt capital loss Underprrforrners Low f: *Ja L4%

Low High Low High

QUALITY QUALITY

Note: ActualAverage Returns is the "Average" column of Exhibit 17, plotted on the Quality-Growth lVatrix.
The comparable Sensex performance ts t4%.

-- -t
r)

6. Reasonable Price
What works, what

Having gleaned some insights we proceed to explore some potential pricing

strategies. What's the di uation and pricing of any asset, in our case stocks?
As stated earlier, valuation mental as sessment of a stock's intrinsic value,
based on the expected cash the same. ln contrast, pricing is more empirical
and heuristic. The basis based on applying appropriate multiples - P/E,
Price/Book, Price/Sales, is also likely to be relative rather than absolute

i.e. depending on what benchmark is priced

We studied the alpha track years (1998 to 2018) of four pricing techniques - P/E,
p/E relative to market, PEG and Payback Ratio. Based on the same, we arrive at some idea of
what potentially works and what doesn't.

Our methodology for PlE,PlE relative to market and PEG -

r 1998, alpha would
3-year alpha implies outperformance over the Sensex for the next 3 years' Thus, for
over 1999 lo2002, and so on till
be outperformance over 1998 to 2001, for 1999, outperformance
outperformance over 2015 to 20t8for alpha in 2015'
o For each year from 1998 to 2015, we started off with stocks which had
market capitalization of at least

INR 10 bn.
o (e.g. P/E 0-10x, 10-20x, and so on)'
For each year, we observed the alpha under each category
r years, 1998 to 2015'
Finally, we averaged the performance of the 18 observation
r & 30'
The observations for each year are presented in Annexure 2, pages 29
 6.L P/E

Without doubt, this is pricing tool. And the most common mantra among
investors is "Buy low 19 shows, this is just barely right.

{:rhi::ir i, P/E: What

Average 1998 to 2015
P/E (x)
3-year alpha % of total
0-10 5% 945 24%
10-20 ao/
L/O 1,385 34%
20-30 -2% 812 20%
30-40 -t% 3s5
40-50 -t% 767 4%
50*75 -8% 150 4%
>75 -78% 201 5%
TOTAL 4,015

6.1.1 What works

,/ Buying single-digit a small chance of a statistically not-too-significant alpha
However, even this is not consistent e.g. in 8 of the last 18 years (199g to zo1,s),even
single-
digit P/E stocks returned average negative alpha (see Annexure 2, page 29).

5.1.2 What doesn't work

x Clearly, buying richly 't work, especially p/E of 50x and above,
x More often than not, that much of the optimistic information about the
stock is already in the W. Phelps says in his classic X_00 to 1ln The Stock
Morket, "A lemon that by a steam roller has more juice in it than a piece
of information the d iscounted."

6.2 PIE relative

When markets as a ividual stocks appear expensive in absolute terms,

pegging their valuat justified. lt may even be argued that stocks whose
fundamentals are superior to that of the be nchmark, even merit a premium
to market valuation
multiples. As Exhibit 20 shows, the

txlrlbrt ,ril P/E relative to what doesn't

P/E relative 1998 to 2015
to market (x) Nos. %of total
<=1 1,,984 49%
1- 1.5 946 24%
1.5*2 442 1L%
L5 330 8%
>3 313
TOTAL
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PEG < 1x is also a solid returns

r For the purposes of (P/E to Growth ratio) is obtained by dividing trailing
12-month P/E by CAGR.
r We have used rs'earnings to calculate pEG. Thus, if a stock,s p/E in
2013 was 20x, and is25%, its 2013 PEG works out to 0.8x (20 + 25).
t Clearly, lower the etu rn.
r Our theme study this 31) has almost conclusively established that stocks
with PEG less than ly outperform the market.
r As tabled below, the for the 2018 Wealth Creators. Nearly half the
Wealth Creators less than 1x in 2013, and delivered the highest return

Exhibir 22 PEG less than retu rns

PEG Range No. of WC % Share CAGR (%) RoE %)
in 2013 Cos. (rNR b) of WC Price PAT 20L8 2013

<0.5 17 19 10
0.5-1 40 15 l4
1-1.5 11 18 18
1,5-2 11 4,952 1,1, 25 ZO
2-3 2,09L 5 11 76
5,3 65 12 1B 23
2 LtoP 13 20
3 -t7 3 1.6
Total 100 44,883 100 24 19 15 t4
divided by 2013-18 PAT CAGR
6.2.1 What works
'/ Buying stocks below some chance of a statistically not-too-significant
alpha. However, as was P/E, even this is not consistent *in7 of the last 18
years, stocks bought rned negative alpha (s,ee Annexure 2, page 29)

6.2.2 What doesn't work

x Clearly, buying 2x and levels is a sure recipe for underperformance

6.3 PEG

PEG is short for P/E to Growth late it as TTM (trailing twelve-month) P/E divided
by forward earnings growth. I d for any number of forward year's earnings

For the purposes of this section, used perfect foresight of 3-years'forward earnings to
calculate 3-year PEG i.e. TTM next 3-year PAT CAGR. Thus, if lVlarch 2015 P/E is
30x and 2015-18 PAT CAGR en IVlarch 2015 PEG is 1.2x (30+25)

Exhibit 21 presents the 3-year alpha track record of PEG,based stock buying.

[xhibir 21 PEG: What works, what

3-year Average lnstances from 1998 to 2015 _
PEG 3-vear aloha Nos. % of total
0-1 1,3 10 33%
0-0.5 633 16%
0.5-1 617 It%
1- 1.5 393 70%
-2
1,.5 221 6%
2-3 266 1%
3+ 463 11%
<0 34%
TOTAL 4,015
Note: PEG < 0 implies PAT degrowth in 3 yea rs

6.3.1 What works

'/ Buying stocks at PEG less than 1x is supremely profitable (less than 0.5x even more so)
Also interesting is the number of instances of PEG less than 1x. As the "% of lotal" column in
Exhibit 21 suggests, on average, 1 of every 3 stocks is likely to trade at PEG of less than 1x.
Finally, what is most remarkable is the efficacy of PEG ratio when it comes to the number of
years of growth insight that investors may have. Thus, PEG of less than 1x works for growth
forecasts of ).,2,3, 4 or 5 yearsl t 22 suggests, PEG of 1x delivered handsome alpha
in 14 out of 15 observations. time it failed was during the vertical 38% market
collapse in 2009 over 2008 global financial crisis.

a-l
 ixi!::rt 22 PEG works, whatever horizon over 1 to 5 years
4-year
2000-05
Sensex return -28% 17% -15% 3% s%
PEG < 1x return -I4% 12% 37% 31%
13%

2008-13
Sensex return -38% AO/
6% 8% 3% +/o
PEG < 1x return -42% 26% 18% 1s%
-4% L9% 77Ya,.',

2013-18
Sensex return 1 1a/
19% zL/o L2% 1,2%
PEG < 1x return 36% 38% 4s% 39%
77%

6.3.2 What doesn't work

x Buying stocks at PEG > 1.5x is avoidable,
x The high level of underperformance at PEG of 3x+ should be a warning signal especially in the
current market where stocks which are high on quality (read, high RoE) but low on growth
are trading at fancy P/E multiples.

6.4 Payback Ratio

Payback Ratio is a proprietary Oswal, and is calculated as -

Payback Ratio -- Cu rrent
Sum of
Clearly, lower the ratio, higher rn5.

For the purposes of this section, we have used next five years of PAT with perfect foresight e.g.
in 1998, we calculate Payback Ratio by dividing 1998 Market Cap by the sum of actual pAT of
1999, 2000, 2001, 2002 and 2003.

Exhibit 23 presents the 5-year alpha track record of Payback Ratio based stock buying.

i:rlritil 2l Payback Ratio: What

Payback Ratio Average lnstances from 1998 to 2013_
5-year alpha Nos. % ol total
0-1 77% 454
1- 1.5 5% 42L
-
1..5 2 4% 3s3
2*3 0% 616
3+ -72% 1,153
<0 -26% 375 11,%
TOTAL 3,372
Note: Payback < 0 implies the cumulative PAT of next five years is negative
For detailed annual workings, see Annexure 2, page 30
6.4.1 What

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8. Conclusions
Buy QGLP - Longevity at reasonable Price

a The two key drivers of and Earnings growth

a Companies create I when they earn RoE higher than Cost of Equity
lf RoE is exactly equal to ny level of growth creates no value

a Low RoE companies must focus on increasing RoE, high RoE companies on increasing growth.

a Both high RoE and high Earnings growth are difficult to sustain, especially Earnings growth.
Hence, stocks whose rich valuations factor in such high growth rates to sustain will most likely
d isa ppoint.

a PEG less than 1x is a near-infallible formula for healthy outperformance

a Any growth insight is valuable, even if it means only for the next one year

a Valuations above 50x P/E have a very low probability of generating market outperformance.

a Buy QCtp - stocks with high-Quality business run by high-Quality management, with healthy
earnings Growth to be sustained over a Long period (at least 5-6 years), at reasonable Price,
preferably PEG less than 1x.

a And finally, investors must seriously consider selling stocks in their portfolio trading at 3x PEG
or 2x relative to market, whichever is higher.

[xhibit 30 Summa
Pricing heuristic WHAT WORKS .., WHAT DOESN'T...
Metric Metric
PEG <1x >3x
: 'L2oj/.d::"'.':r'
Payback <1x >3x
P/E < l"Ox > 50x
P/E relative to market <1x >2x
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L.t What causes Hockey-Stick Returns

The most basic equation of equity investing is -
EPS (Earning Per Share) xP/E (Price-to-Earnings) = Stock price
or
PAT (Profit After Tax) x p/E = Market capitalization

The above makes it clear that Hockey-Stick Returns is caused by Hockey-Stlck earnings andlor
Hockey-StickP/E(oranyotherrelevantvaluationmetric).Exhibit2presentsthe20l3 22earnings
CAGR and valuation expansion for the 6 stocks charted earlier.

E"hibit 2 Hockey-Stick Returns are caused by Hockey-Stick Earnings and/or Hockey-Stick valuation
2013-22 CAGR PAT (lNR bn) P/E (x)
Com ny PAT 2013 2022 2013 2022
Tata E lxsi 37% 0.3 5.5 19 100
SRF 26% z9% 2.3 18.9 4 42
Bajaj Finance 32% 23% 5.9 70.5 t0 62
Astral 26% 23% 0.6 4.8 1"4 B5
P llndustries 27% 72% 1.0 8.4 1B 51
Ratnamani Metals t0% 26% 1.4 3.2 5 38

Clearly, the way to engender Hockey-Stick Returns is to invest in companies with high earnrngs
growth at reasonable valuation. Conventionally, earnings are associated with Accounting profit.
ln Section 2, we discuss the concept of Economic Profit, and why we believe it is a superior metric
to Accounting Profit.

d ,.,,t:"1.":"':"'-:l'"" '

2. ldentifying Hockey-Stick earnings

J
$1*ll::v Look for companies which will move up the Economic profit curve
*
srrcl{
uorxgv ': ln this section, we draw upon concepts and insights from the book Strategy Beyond The Hockey
^.: .:- / Stick by a team of McKinsey authors, Chris Bradley, Martin Hirt and Sven Smit. The book is
i targeted primarily towards corporate managers. However, we unearthed quite a few insights for
I
equity investors as well:
{
1. Economic Profit is (arguably) a superior metric to Accounting profit
2, All companies can be mapped to an Economic profit power Curve
3. Companies which move up the Power Curve generate healthy returns"to shareholders, and
vice versa.

2.L Economic Profit vs Accounting profit

Be it by business managers, bankers, equity investors or who have you, Accounting profit (Ap) is
the most widely used metric for various kinds of financial analysis. Sure enough, Ap is a highly
homogenized metric as it is based on the prevailing accounting principles common to all
companies in a given geography. However, one key demerit of AP is the fact that it does not take
into consideration the amount of equity (i.e. net worth) invested to generate a certarn level of
profit.

;--' - . !.
{"x*,i*tt {: Simplified Discounted Free Cash Flow to Equity Model

KEY VARIABLES - Assumed values

Earnings growth rate 20%.
RoE 25%
Continuing growth rate B%
Cost of Equity 1.3%

Yeo r o 1 2 3 u
5 6 7 8 9 10 11 12 1_3 14 15 16
PAT 83 100 120 L44 L73 207 246 290 339 391 447 506 558 630 693 7s6 816
YoY 20% 20% 20% 20% 20% L9% t8o/o 17% 16% t2o/o 11% 1.O% 9o/o 8%
De|ta PAT 0 20 24 is 39 52 56 61, 62 63 62 60
lnvestment 96 115 1,57 1,75 193 2L0 225 237 250 252 250 242
FCFE 24 29 51 7! 97 L29 166 zLO 318 378 444 5L4
Continuing Value 1 1,100
Total Cash Flow 20 35 97 318 378 444 TL,6L4
Discount Factor 1.13 L.28 1.44 1.63 1..84 2.08 2.3s 2.66 3.00 3.39 3.84 4.33 4.90 5.53 6.2s
DCFE 18 19 20 2L 28 34 41 48 5s 62 73
lntrinsic Value 2,500
lntrinsic P/E 30

Key elements explained:

o Earnings growth rate: This is the growth in PAT assumed to sustain in the first five . Continuing Value: This is the value of the firm beyond the explicit forecast period.
years. Post that the growth is tapered to the continuing growth rate of 8%. It is calculated using the present value formula of a growing annuity i.e. Year 15
o Continuing growth rate: This is the rate at which PAT and cash flow are expected FCFE x (1+Continuing growth rate) + (Cost of equity - Continuing growth rate).
to grow beyond the explicit forecast period of 15 years. Theory suggests this r DiscountFactor: Thisis (1+Costof Equity)n,wheren inthe numberofyear. :.

should be expected nominal GDP growth rate to perpetuity. . DFCFE: Discounted Free Cash Flow to Equity; this is arrived at as
o Cost of Equity: This is the market's return expectation on a particular stock. ln our Total Cash Flow + Discount Factor.
model, we have considered Cost of Equity at 1-3%, rhe long-period return of lndia's . lntrinsic Value: This is the sum total of all 15-years' DFCFE.
benchmark stock indiqes. Another alternative approach is risk-free rate (B%) plus r Intrinsic P/E: This is calculated as Intrinsic Value + PAT (of respective year).
5% risk premium, which also works out to L3%.
. Delta PAT: This is the incremental pAT over previous year. Model limitation:
. lnvestment: This isthe investmei-rt required each year to generate the Detta pAT This is a simplified version with a few assumptions -
next year. This is dependent on RoE, and is determined by Delta pAT = RoE. Thus, . Annual depreciation takes care of investments required to main current profits.
to generate Delta PAT of 20 in Year 2, the firm here needs to invest BO (ZO+25%) in . The company is currently operating at full capacity i.e. further growth is possible
Year 1. only through lurther investmenr.
. FCFE: Free Cash Flow to Equity is PAT less lnvestment needed. . There is no malor change in the company's debt position.
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