If you and I were living in America (or in any other large economy barring India), Type A&B stocks would form our entire investment universe. In fact, this is exactly what Buffett’s legend is built around. With Type B stocks, a committed value investor like Warren Buffett can generate high teens returns if he times his entry point well. he entered when the P/E was high (he wasn’t a value investor) and exited when the P/E had halved, your return will be 5 per cent CAGR. If, on the other hand, your fund manager has mistimed your investment i.e. If you can find a fund manager who enters Maruti at 13 times P/E and exits a decade later at 26 times P/E, the stock would give you returns of around 19 per cent. the same rate as nominal GDP growth on a cross-cycle basis.
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The reinvestment of the free cash flow will allow these companies to grow the business at around 12 per cent i.e. As a result, in most years, these companies will have a ROC in excess of COC. Type B stocks account for a further 5-10 per cent of the Indian market and this segment includes good franchises like Maruti or HUL which have meaningful competitive advantages. he entered when the P/E was high (he wasn’t a value investor) and exited when the P/E had halved, your return will be -7 per cent CAGR. If the fund manager you have found has mistimed his investment i.e. If you find a fund manager who can double the Type A company’s P/E over a decade, your returns will compound at 7 per cent CAGR.
If you assume that you make returns from investing in any company from two sources – either the P/E expands or the earnings expand – with Type A stocks, your only hope of making money is that the P/E expands (since the earnings are unlikely to expand). Examples of such companies are India’s telcos and airlines – companies with never-ending volume growth but no sustainable competitive advantages and hence no earnings growth. Lacking sustainable FCF such companies struggle to invest in growing their businesses. The gap between ROC and COC is free cash flow, which in turn in the means by which a company finances its growth.
Such companies find it difficult to grow earnings over extended periods of time as they have no sustainable competitive advantages and hence no ability to generate a return on capital (ROC) in excess of the cost of capital (COC). Type A stocks comprise around 80-90 per cent of the Indian market. In fact, one can divide the Indian stock market broadly into three sets of companies: buying companies when they are inexpensive on P/E) makes sense. In India too, one could argue that for the majority of stocks, value investing (i.e. These are not subjects of any interest to them….The investors simply focus on two variables: price and value.” Incidentally, when businessmen buy businesses, which is just what our Graham & Dodd investors are doing through the medium of marketable stocks… Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc. Even more famously, Warren Buffett in a celebrated 1984 speech at Columbia University reaffirmed the superiority of value investing to other investing approaches: “The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market. SUBMITIn the years since the publication of Security Analysis, numerous academics have shown that value investing does generate superior results in the US market and elsewhere. The lack of correlation between starting-period valuations and long-term holding period returns seems to be specific to India.” Rakshit Ranjan, Pranab Uniyal and Saurabh Mukherjea in ‘Coffee Can Investing: The Low Risk Road to Stupendous Wealth’. Whether we look at bull market phases of the Indian stock market or bear market phases, all the evidence points in one direction – starting period valuations have very little impact on long medium-term investment returns in India. “Given the way price multiples have expanded for high-quality companies over the past decade, should investors be concerned about the sustainability of stock returns from such companies if they buy at current levels? Our answer is a resounding ‘No’. These companies are best understood using our ‘Consistent Compounders’ paradigm. However, for a small minority of stocks in India, the classical value investing paradigm does not readily work. Around the world, making money from stocks does involve a significant element of market timing.
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