Big losses in the stock market: 5 mistakes to avoid – Part 1 (Rich valuations)

Even one big loss in a stock where you hold sizeable position is enough to hurt your wealth, especially if you had entered the stock at rich valuation. This poses the risk of making stock investing a nightmare and can force you to quit midway. One way to avoid big losses in your equity investing is disciplined capital allocation. But that needs years of understanding and application. An easier way is to avoid a few mistakes that typically lead to big losses. 

Big losses in the stock market: 5 mistakes to avoid – Part 1 (Rich valuations)

 Howard Marks explains ‘Risk’ in his book ‘The most important thing’. Real risk in investing is risk of permanent loss of capital. While ups and downs are common in market and stocks, the risk of permanent of loss of capital is what one should avoid. According to him, higher the risk, higher the return is a myth.   

Here’s also a link to his Wharton School lecture on Risk.

Losing capital is part of stock market investing, you might think, since market falls and your own portfolio decline is inevitable. But the key lies in curtailing such falls. Why? Simply because the journey back requires twice as much effort. Take the oft-used example: if a stock falls from Rs.100 to Rs.50, the loss is 50%. But it requires the same stock or a different stock to give 100% return to recover the invested capital in the first place, leave alone the returns. So big losses can lead to significant and permanent loss of capital and needs to be prevented or minimised.

In this four-part series – we are going to take  5 most frequently committed mistakes that lead to permanent loss of capital and how to avoid each one of these. This series is packed with real-stock examples to help you understand these mistakes in the real world of equity. We highly recommend that you bookmark and read them all.

  1. Big losses from rich valuation (in this article)
  2. Losses from cyclical businesses
  3. Losses from low quality businesses
  4. Losses from seeming turnaround stories and no-growth businesses

In this article, we are going to discuss the losses that arise from entering richly valued companies. 

Big losses from rich valuation

Entering a stock that has rallied strongly is a common behaviour observed in most early stage investors.

Most new investors enter markets during a boom and every boom will carry popular themes or sectors. Such sectors tend to hog the market limelight and will also see a whole lot of IPOs being lined up. 

Just to give examples: it was the technology, media, and telecom (TMT) stocks that were booming in 2001 while it was the infrastructure, real estate, and power (capex) in 2008 and the new-age technology companies in 2021. 

Let’s take the last-mentioned theme. In new-age tech companies, the thesis in favour of super rich valuations was that – “the winner takes all” (which means a single company taking a very large share of the market given some form of edge that they might have over others)

Chairman of Motilal Oswal said in a public forum that, “they convinced me that Zomato is the next terrific thing and made me bet big on it”.

MOSL also came up with a Wealth creation study titled “Atoms to Bits” backing the investment argument in new-age tech companies. 

But these big bets (Zomato, Nykaa, PayTM and Policybazaar to name a few) really turned sour for investors post the IPO build up.

In hindsight, these IPOs didn’t look any different from the 2001 technology boom. If the tag line was “eyeballs” then, it was “Gross Merchandise Value (GMV)” this time. The starting point in P&L was a hypothetical metric (instead of revenue/ net sales) called GMV and then an “adjusted profit” at the bottom to make them fit into some kind of growth metric needed for forecasts.  

But post IPOs, companies had to contend with the reality of how to show profitable growth to the stake holders. And in this, they failed. And the result? Investors lost anywhere between 30-70% in these companies as the path to profitability remained unclear. It is now evident that only profitable growth can take these stocks past their previous highs. 

To take some hints from the past, Infosys shares fell 80% in the 1-year post the 2000 tech bubble and took 6 years to surpass its high. At the same time, Wipro surpassed its 2000 high only in 2020. This, even as a lot of other tech stocks completely vanished. Two other popular stocks of the 2000 boom – Saregama and TIPS – broke their 2001 highs after 20 years in 2021 as the new-age tech boom provided an opportunity for them to monetise their IP rights (songs for which they own rights) through Youtube, Spofity, Saavn, etc .

Let’s discuss few recent examples of companies with rich valuation that gave a hard landing to investors.

Sona BLW: Off the auto highway

If there was one auto stock that moved in the opposite direction during the auto sector rally of the last 1 year, it was this recent-IPO stock. At its peak price of Rs.790, post IPO, its market cap hit Rs 48,000 crore and PE at an insane 200 times!  

This was for a company that reported Rs.2,676 crore revenue and Rs.395 crore PAT in FY23. This kind of valuation was unheard of in the auto ancillary sector before this IPO.

While this company’s private equity investor Blackstone, sold its entire stake of 66% through IPO and then open market (pocketing Rs 14,000 crore totally), the more concerning issue is that its promoter holding fell from 67% during listing to 30% now.

Even after the correction, the stock trades at 77 times earnings. With such huge public float and super rich valuation, the company will have to deliver far higher growth than industry to move its stock price. 

Dixon Technologies: Punished for disappointing

Though Dixon was a 2018 IPO stock, it stole the limelight post Covid as the blame game on China, necessity to reduce imports and PLI schemes for electronic manufacturing made it the sole stock to go behind. The stock rallied 8X post Covid during the market rally that peaked out in October 2021 and its valuations hit 180PE.

But after all the hype, the decline it reported in its topline during Q3, FY23, both year-on-year and quarter-on-quarter, took the stock down south. Market is not kind to the stock of a company that is expected to grow at 30-35% and is priced to perfection. The concerns behind such a decline were largely external and not internal (read our take on this in Prime Community) as mobile phone shipments globally fell to a 9-year low in Oct-Dec 2022.

The company won back investors’ confidence post its Q4, FY23 results as it delivered on margins, cash flows and RoCE with NET debt free balance sheet. But the stock is still below its November 2021 peak. So those who had bought it in its peak would still be in losses, a year and half post their investment.

Chemicals: Demanding valuations for “specialty” tag

A hot theme that markets chased, apart from new-age tech companies, was specialty chemicals. As with the latter, there was a rush of IPOs in this space as well. Supply disruptions and inventory stocking by customers gave a sudden leg up to their growth and profitability. As this happened, companies and bankers queued up for IPOs. And the market was also hot enough to absorb them. But a year and a half later, this too turned sour for investors.  Here’s a quick look into the valuation picture of some of those IPOs and their correction from peak.

Even post such a sharp correction, valuations stand rich for most of them as can be seen from their elevated PE ratio or Market cap to sales ratios. 

How to avoid the 'rich valuation' trap?

#1 Get the growth vs valuation match right

Generally, rich valuations are accorded for growth combined with quality of growth (measured in terms of RoCE). Higher the growth rate, higher the PE multiple for a stock.  In other words, people are willing to pay a price for higher growth. Why is this so? It is due to a lack of similar opportunities elsewhere. 

Take any risk-free instrument like government bonds. On an average it takes about 10 years to double your money (at roughly 7%) in such a risk-free instrument. 

But a company that grows its earnings at 25% will multiply your money 8-fold in 10 years (assuming you enter exactly at 25 PE). 

So weighing the option between a 2-fold growth and an 8-fold growth, the market (which is nothing but the collective wisdom of investors) believes that the latter is a lucrative opportunity. Thus more investors start buying the stock, pushing its PE. 

Of course, discerning investors know that the stock is not perfectly priced when everyone goes behind it. For example, they would need to enter at 25 times PE in a stock that is expected to deliver 25% growth to get the same 25% CAGR returns. But as more people buy, the PE goes up. But many investors still enter as they believe they can afford to settle for lower returns, if it is still far better than the 7% risk-free return. 

For example, an institutional investor may be happy with a 4-fold return (which is 15% CAGR) for a stock that is expected to deliver 25% earnings growth, by entering at say 50 PE (PEG of 2 times). What happened here? The investor settles for almost half the original potential simply because he is entering at a far higher PE. Someone else happy with just 3-fold returns in 10 years will pay an even higher PE multiple for the same stock.  

But not every investor understands this. Newbies and not-so-seasoned investors tend to keep the return potential intact, even as PE goes up. And they may not know the point when the excess return over risk-free rate is negative. That is – the stock cannot deliver any more as it has priced in the maximum long-term growth with a high PE. 

And it is not just the risk of return contraction. The risk of growth disappointment is a bigger risk. We discussed how the stock of Dixon Technologies was punished for a disappointing quarter of earnings! As they say, the higher you go, the harder the fall! 😊

Stocks will also take a big hit if the quality of growth deteriorates with increasing debt, higher than expected capital spends and falling RoCE. 

For example, assume a company reporting 25% margin undertakes a major capex. The market assumes the new investment to generate similar margins and in turn RoCE. What if the margin of the company shrinks to 18% or 15%? The future RoCE assumption will go for a toss. This happened in some cases in the chemicals space. This is a greater risk to valuation than even growth disappointment.  

Let us sum it all up with what Warren Buffett saidAn investor of today does not profit from yesterday’s growth. 

That means, you need to do the following:

  • It is extremely important to do a double check on growth as well as quality of growth while betting on high growth companies at rich valuations. There will be little margin for error if things go wrong.
  • You will need to lower your return expectation when you realise you are late for the party. You should also prep yourself for losses, like it happened with Dixon or with the specialty chemical companies.

#2 Keep an eye on competitive landscape and new technologies

Businesses that are categorised as leaders may undergo change. So also the industry structure and competitive landscape. Let’s give some examples of such changes:

  • There was a time pre-1990s when personal care and cosmetic products had 120% import duties which then came down to 50%, 30% and literally NIL now. Coincidentally, the same duty structure now exists in luxury cars. 
  • Unilever once almost threatened Marico with a business takeover. Now, we have homegrown companies in personal care challenging MNCs and winning consumer minds. 
  • Under an MNC parentage, ACC and Ambuja Cements did not see much expansion activity, paving the way for stupendous growth for players like Ultratech and Shree Cement. But with ACC and Ambuja going for aggressive capacity expansion under Adani Group, the increasing competitive intensity may lead to a big check on growth, profitability, and valuations for Ultratech, Shree Cements and others. Things can come a full circle.
  • Dixon and Nykaa did not face the same competitive intensity at the time of their IPO, as they do now. Things can change very quickly! Nykaa will have to face cut-throat competition in its fashion diversification while beauty segment is seeing entry of Tata and Reliance. The electronics manufacturing sector is also seeing the entry of Tata and other large industrial groups.

All such changes will have significant impact on valuations of companies and investors have to be cognizant of it while buying companies at rich valuations. Even if you are not cognisant of such risks, factoring in unforeseen changes in the valuation (essentially applying a discount for high growth companies) will tell you whether any money will be left in the table for you. 

The securities quoted are for illustration purposes only and are not recommendatory.

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5 thoughts on “Big losses in the stock market: 5 mistakes to avoid – Part 1 (Rich valuations)”

  1. Good article Message is clear. But the article sometimes is very mathematical.
    “they would need to enter at 25 times PE in a stock that is expected to deliver 25% growth to get the same 25% CAGR returns. But as more people buy, the PE goes up. But many investors still enter as they believe they can afford to settle for lower returns, if it is still far better than the 7% risk-free return.

    For example, an institutional investor may be happy with a 4-fold return (which is 15% CAGR) for a stock that is expected to deliver 25% earnings growth, by entering at say 50 PE (PEG of 2 times). ”
    Can you please write another article explaining all these with an example in EXCEL?

  2. Brilliant. This 4 part series is full of lessons based on the history of Indian stock market. Great examples and well written. Kudos to you..

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