smallcase in Focus: June 2023

Why does Windmill Capital hold high P/E stocks? 

‘Price is what you pay, Value is what you get.’

Yeah, I am pretty sure this is not the first time you heard this famous quote by Warren Buffett. What is the legendary investor trying to convey here? He essentially means that in the context of investing, one should not just focus on the price of a stock. One should also consider the value of the asset, which is determined by a variety of factors – earnings growth, interest rates, cash flows and so on. If you pay a price that is lower than the value of the asset, then it’s a good deal. Buffett’s quote is also a reminder that you should not be afraid to pay a high price for an asset if you believe that the value of the asset is even higher. 

Now, let us shift focus to a few companies that are present in multiple Windmill Capital smallcases and command high valuations relative to their industry peers –  Asian Paints, Pidilite Industries, PI Industries, and Titan Company. Although there are other companies that command high valuations and are present in Windmill Capital smallcases, we have handpicked four out of them. It goes without saying that there must be a few good reasons behind those high valuations and that is the sole focus of this blog post. 

You will find below the comparison of the 10-year historical P/E ratios of these 4 companies against their current P/E. What do these companies do that they have been able to command higher valuations than their peers? Pointers below.

Source: Refinitiv Eikon

1. Strong brand & management – These are decadal companies and have been market leaders in their industries for a long time and have built the brand and trust for themselves. Building a strong presence in a diverse country like ours is a herculean task. Not only is the customer palette too diverse in India, but the retail space is also filled with unorganized players. And if you combine the entire gamut, the unorganized market will have on average >30% market share in various retail-facing sectors. Therefore, it becomes all the more challenging, as an organized player, to make market inroads. However, once you establish your brand, you get that edge over other players and that’s exactly what these companies have managed to do. The corollary to this is having a solid management team who knows how to run the show. This is one of the most important considerations for an investor, as a solid management team ensures top-notch corporate governance. 
2. Impressive Numbers & Operational Moats – Be it earnings growth, profitability growth, or cash flow these companies have had a stellar track record of delivering healthy numbers, year-on-year. For all four companies in the discussion, their margin profile is superior as compared to their industry peers. 

Source: TickerTape

This strong margin profile is a testament to their operational supremacy. 

Did you know, Asian Paints is a logistics company and not paints? By rotating their inventory, every 3 hours, amongst 150k+ retail points across the country they actually get to charge more from the paint dealers. 

Coupled with this, these companies have exhibited high quality and growth scores consistently. What are these scores, you ask? At Windmill Capital, we maintain a bunch of proprietary scores that work around helping us weed out ‘not so good’ companies. These are quality and growth scores. Quality score checks the quality of the company based on factors like ROE growth, Debt/Equity Ratio, Earnings quality & variability. On the other hand, growth score uses a combination of earnings per share and total revenue metrics to measure historical growth rate. More often than not, these companies have been in the top quartile of both these scores, which again reinforces their operational excellence and sustainable growth.

They have commanded higher valuations in the past and continue to do so presently because of the aforementioned moats which they have built over the years. That being said, it doesn’t give them the leeway to rest on their laurels and not perform. The high valuations have come on the back of such moats and they are expected to command such valuations in the future provided their moats remain intact. Not to mention, that if there is competitive pressure or any such thing that impacts their growth rates, these companies could see valuations downgrade. At Windmill Capital, we have had high P/E stocks in our smallcases and we have dropped them at some point due to concerns around competition, margin, or any other, which is the other side of the same coin. If you want to know more about it, stay tuned to get the update in the next newsletter update.

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