Hope you are doing good and enjoying the interesting times.
While the economy is going through slowdown, high quality stocks are trading at exorbitant valuations and a lot of other reasonably good companies are available at throwaway prices.
Unless, you are from the group that justifies buying high quality low growth stocks at almost any valuations, you may find our latest stock idea and the thesis behind the same interesting.
Just to be clear, we are only discussing the thesis because the stock idea has been shared only recently with Premium Members and included in Model Portfolio.
So, as mentioned above, we are obviously avoiding the high-quality stocks as we don’t have the narrative to just their obscenely high valuations (You can read more about it HERE)
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What have we added? We are willing to put in extra efforts to look for companies which have planted the seeds of growth and also showing improvement on various fronts: Balance sheet, Cash flows, Capacity utilization, pledge reduction, etc.
By planting the seeds of growth, we mean companies that have created capabilities, capacities, etc and are likely to deliver strong growth in profitability in the years ahead.
In our view, the stock that we have added recently does well on both the points:
- It has completed a major CAPEX and has created capacities that will help it sustain good growth for the next several years.
- Already, the company has started reporting improvement in numbers
- Most importantly, the company has started repaying debt from the operating cash flows and has already re-paid around 10% of outstanding debt in the last 1 year.
- If our projections hold true, the company could end up reporting 28% CAGR in sales, more than 30% CAGR in EBITDA and probably more than 40% CAGR in PBT
Now, the above in our view is a very potent combination.
When you have a company whose stock price has been beaten down, the business is showing signs of improvement and the debt is being repaid using operating cash flows, a few years down the line there could be multiplier effect on both the profitability and the valuations of the company.
Basically, if we assume X to be the current market cap and Y the debt (Y > X) and thereby X + Y to be the enterprise value. More often than not, when Y starts tending towards zero (using operating cash flows), the new X becomes much larger than the original value of X and Y combined, i.e. the market cap increases in multiples with reduction in debt.
However, it can take 2-3 years for the markets to fully realize the potential of the company and thereby suitable only for patient investors who can hold the stock for such periods.
We believe, in the current market situation, it’s so much more important to have a slightly contrarian view and look for opportunities differently than the regular trumpeting of high quality or the large caps.
Like Fashion, markets work in cycles. If something becomes too fashionable and widespread, be rest assured it is likely to go out of favour very soon.
In 2017, mid and small caps became the talk of the town and soon lost appeal. Now, owning large caps and the high-quality stocks at any valuations has become fashionable and we won’t be surprised if there are large draw-downs or very long periods of almost zero return on such stocks.