NEW DELHI: There was once a miser who, despite having enough money, refused to buy a car for himself. After repeated pleas from his family, he finally gave in and purchased a vehicle. However, he set three conditions for ever taking it out: the weather had to be perfect, the roads had to be empty, and all traffic lights had to be green. The car, of course, never left his garage.
This story mirrors a common mistake in investing. Ideally, an investor should find a stock that meets three basic criteria: the sector is growing, the company is well-managed, and the stock price is cheap. Yet, if you strictly follow this checklist, you’ll likely filter out almost the entire Indian market.
The third criterion alone, a cheap price, disqualifies most investable opportunities. The Indian equity market is the “South Bombay” of global markets—nothing is available for cheap here.
A perfect example is the hospital sector. While the pharmaceutical industry often grabs headlines, corporate hospital chains have quietly outperformed both the pharma sector and the broader market benchmark.
However, just as medicines have side-effects, a booming sector’s major fallout is that its stocks tend to trade at nosebleed valuations. If you’re uncomfortable paying 50 or 60x for a soap maker or a paint company, be ready for the hospital segment. Here, the largest company by market cap, Max Healthcare, trades at a PE ratio over 100, while the next four players are around 70.
So, what should a value investor do?
Experts argue that high valuations are only one side of the coin. The other side is how fast the company’s earnings are growing.
Take Max Healthcare, for instance. Despite its expensive valuation, its 5-year compounded profit growth is an impressive 64%, which supports the stock’s 5-year CAGR of 60%. In fact, if you had avoided this stock a year ago because of its high PE ratio (around 80 then), you would have missed out on a 35% rally.
The technical term for this approach is the Price/Earnings-to-Growth (PEG) ratio, which divides a stock’s PE ratio by its annual earnings per share (EPS) growth rate.
This isn’t to say that high valuations are irrelevant. As many market veterans will tell you, companies with strong fundamentals but steep valuations are prone to violent sell-offs at the first sign of trouble. Such stocks can also go through long periods of underperformance without any deterioration in the underlying business, a process known as a time correction.
This means that investing in expensive stocks requires constant monitoring of both sectoral trends and company-specific developments.
In other words, eternal vigilance is the price not just of liberty, but of portfolio performance. Once your due diligence is complete, however, a certain sense of adventurousness is needed when wading into the swollen waters of the Indian equity market. Otherwise, much like the miser and his car, you’ll never leave home.
