Is depth of analysis the most important aspect of bottom-up stock investing? Yes, in the initial stages. However, beyond a threshold of skill breadth adds more value to bottom-up investors than striving for more depth.
This is a bit counterintuitive since many investing gurus advocate knowing the businesses much better than most other investors. If you analyze a business well enough and for long enough, the depth of your understanding can give you insights that eventually translates into alpha generation.
What is not explicitly said is this – Depth of understanding does lead to higher conviction but it does not mean one can anticipate earnings or developments in the business better than other investors. Higher conviction leads to a longer holding period that increases the probability of alpha generation over the long term.
This is how the mechanics of analytical depth works in my personal experience, more depth does not magically translate into a more accurate estimate of what the next quarters earnings are or what the business will do 5 years down the line. It might in theory but not in practice. Some good investors I know get their thesis wrong even after spending 6 months doing deep research. In a few cases even if the thesis turns out to be right, the valuation multiple given by the market goes down and they end up with average investing outcomes.
We have lot of content and focus on depth of analysis but not enough on breadth of coverage IMO. Investors need the right balance across both to get sector rotation and allocation right across cycles.
In that case, what does breadth of understanding bring to the table? The most important value addition of breadth is the ability to critically evaluate which segments of the market offers the best risk to reward ratio. Breadth sets the overall context and the lay of the investing land within which one can evaluate individual stocks and come up with a relative attractiveness ranking of stocks.
Breadth is what enables an investor to logically compare the best business within pharma to a tier 2 business within IT Services and consistently evaluate which of them can be the better stock in the current context. In real world investing every investment instrument can be compared, you can compare a stock with a bond and determine where your money should be going right now. This is the thinking behind the quarterly earnings summary we print. We analyse each business within our coverage universe, then place them in the context of what is happening within that specific sector. Then we place that sector in the overall context of the market. Once we do this, it is relatively easier to prioritize which segment of the market to focus on.
Do take a look at a sample of our quarterly tracker if you haven’t yet. You will see how this helps us structure our thinking on sector allocation and portfolio construction.
In investing you can and you should compare apples to oranges. Always remember that the objective is to optimize the overall portfolio return. If that optimized return has a better probability of occurring in fixed income over your investment tenor, so be it.
We prefer to think in terms of Market Cap and PAT rather than stock price & EPS
Such a basic thing, don’t they both lead us to the same thing – PE multiple (assuming there is no new issuance of stock)? In theory yes, but in practice CMP & EPS mask a very important element of real-world investing.
Thinking in terms of market cap is what led us to sell L&T Infotech and buy L&T instead in 2021. Towards the end of 2021 all IT stock were on a tear, L&T Infotech was one of the poster boys of the IT run since it went up 4x in 2.5 years. At it’s peak the stock was trading at a price of more than 7,000 at an EPS of ~125. But this told us nothing about relative valuation.
What helped us think in terms of relative valuation was thinking in terms of market cap and PAT. At a PAT of ~2,000 Cr the business was trading at a market cap of ~1.2 lakh Cr. The parent L&T’s standalone business (Sum of the Parts valuation, adjusting for the stake in L&T Infotech, LTTS, Mindtree & L&T Finance and applying a holding company discount of 20%) was trading at less than 1 lakh Cr with an annual profit generating ability of more than 6,000 Cr. The largest engineering business of the country was trading at a lower standalone valuation than a mid segment IT business.
Divis Labs at a TTM PAT of 2,500 Cr was trading at a market cap of 1.3 lakh Cr while ITC with an annual PAT of ~15,000 Cr but traded at a market cap of 2.5 lakh Cr. While the businesses are very different from one another, it is easy to see which one offers better risk reward as an investment instrument.
Without this context it would have been easy to miss the forest for the trees and to fall in love with the superior management of Divis Labs and L&T Infotech. Where we screwed up was that we executed well on L&T Infotech but for some reason chose not to pull the trigger on Divis Labs. We did prevent our subscribers from chasing the price on Divis though, our assessment of the reasonable price stayed between 3400-3700 then. We looked like idiots for one whole year, we still look like idiots today but for a different reason. But we prevented our subscribers from loading up on Divis Labs at the peak of the cycle when everything looked good about the business.
Two more examples of how thinking in terms of market cap, PAT of a business and linking it to the overall industry size and profit pool can help. A simple back of the hand calculation sometimes helps us stay on the right track and not get influenced by FOMO
Simple view on PB Fintech valuation – Dec 2021
Understanding the incentives of business operators
IDFC Mutual Fund had a very interesting set of data points whenever they launched a new scheme, all of these were just an extension of how Kenneth Andrade thought about the markets. Their publications would present these data points in a tabular form for the past decade for NSE 500
- Debt to equity ratio
- Average Return on Equity for each year
- Average Yield of the G-Sec for each year
- Spread of ROE over G-Sec for each year
- Dividend yield, Earnings Yield and Earnings growth
- Capacity Utilization ex Banking & IT Services
- Credit growth & Credit to Deposit ratio
The thesis was very simple –
When the spread of ROE over G-Sec is lower than 3%, what incentive does a business operator have to invest more into the business?
Why would private capex revive when the utilization does not yet exceed 70%?
Why shouldn’t a business operator deploy capital into fixed income and take the safe yield of 8.5% p.a. than invest more into the business?
Thinking on these lines is what enabled Kenneth to load up on the consumption theme as the world economy came out of the clutches of GFC. This kind of overall thinking is what enabled IDFC mutual fund to launched products like Equity Opportunities fund series which were built on themes like operating leverage (Series 2) and dividend yield (series 3).
Go back to the growth rates of corporate lending focused banks and retail lending focused banks between 2013-2021 and see this play out. Check the valuation multiple gives to the retail focused banks and compare them with the historical 10-year multiple.
Understanding the relative valuation across market segment is what gave ICICI Pru PMS the conviction to close their best performing PIPE scheme at the peak of the small cap frenzy in January 2018. Many investors were perplexed when Naren decided to wrap up this scheme and return money to them rather than continue to participate in a segment that was delivering 25%+ p.a. over 3 years.
There is always a method to the market madness.
You have better chance of understanding the method if you focus on breadth of analysis once get past a threshold skill on bottom-up business analysis.