Overvaluation in Heated Market – In What Context?

I have mentioned of this blog, keep your investment ideas or processes or choices very simple. Remain focused on your objectives. You may keep dissecting into multiple styles and methods. All said and done, all it will do is add a little panache to your chit chat or it may make you look good for few hours. It is my view that style and panacea does not give sustainable results. In one of my earlier post, I mentioned holding companies can be good long term investments. Only question remains is “how do you define a holding company”. If you constraint yourself with definitions in financial literature, then it is likely you will miss the essence of a holding company.


To me, the essence of holding company is like a parent company. A parent who are trying to raise their kids, i.e. new businesses or future companies, in a hope that all of them will be able to sustainable themselves in future. Parents work hard take risk, and kids… you know what I am trying to say, right?

A true meaning of long term investing philosophy is – growing with the business. So while I wait for management to grow their business, they should continue to pay me dividends. In many cases, companies are investing and developing new business. As these individual businesses grow bigger and bigger, they are likely to sustain themselves. There are many such parent companies who are trying to grow new businesses. Before I give you some examples, let me present you snippets of few emails I received.

Reliance Capital is trading at 45+ PE ratio. Under no valuation method could this considered to be cheap. Even if we look from your dividends point of view, I believe selling at current price would give you much more cash flow that dividends would give in 20 years time. So why not sell it? Not booking profit is leaving money on table, is that smart investing?

How can you hold Reliance Capital at 50+ PE ratio. It will take 20%+ growth rate for next few years to reach that decent acceptable valuation. So why not cash out now? What makes you wait and not book profit?

Don’t you think HDFC Bank which is trading at PE of 30+? Does it make sense to hold it at such a high valuations? Don’t you think it is logical to book profits because at money would be much much more than your dividends in 15 years or more?


Sorry folks I did not ignore you by not responding. I just did not want to retort back.


These are few examples of narrowing the definition of valuation. It shows lack of understanding the business, and it will push you to make that mistake. Reliance Capital is not your typical financial services company. In my view, it is parent company of many future kid companies. In essence it is working like a holding company with multiple businesses, many of which are at a nascent stage. I have mentioned in my earlier post about Reliance Capital being ‘holding type’ of companies.


Reliance Capital has slew of different businesses such as money, insurance, asset management, broking/distribution, etc. It is now planning to start a banking business also. The point being, it sowed the seed for each business and nurturing it. As they grow, they will be spun off as an independent entity. Are you following Reliance Capital and its AGM? Have you noticed its plans? Reliance Capital is planning to spin off its life insurance business into separate entity. This will increase the valuation. When all of them are part of the same company, history suggests, they are all undervalued. As other businesses also grow, I am sure those will be made independent entity. At that point, it is likely I would look back and regret the missed opportunity!


Now, when the company is demerged, it is not always necessary that share holders of parent company will get shares of new entity. The parent company will keep the capital either to invest in new business or just shore up the balance sheet. In such a case, the parent company has percentage holdings. The valuation for parent company is likely to increase. For example, the shareholders of parent company Reliance Energy did not get any shares of Reliance Power. However, the valuations of Reliance Energy shot up.


Some other likely candidates from my holdings are

  • HDFC Bank: Candidates could be funds or asset management business, and insurance business. The current market price would certainly look like over-valuation based on standalone PE ratios. But assuming, these businesses go independent, it is possible that price or value will increase in future. As long as HDFC Bank continues to pay decent dividends, I think it is worth to continue to hold.

  • L&T: Candidates could be Infotech business and finance business. The same thought process applies here also.


Now, I hope you do not start wondering about actual quantitative valuations. I hope you do not try to figure out what is the value of parent Reliance Capital or HDFC Bank or L&T. I hope you do not start making comparisons of standalone parent company vs. individual entities. Can you really value how much a kid will earn when he grows up? I am a proponent of doing the best in given context, let the process of growth be robust, and results will take care of itself. As of today, these companies do not fall short on these metrics. So qualitatively, there is much more than what PE ratio will tell you.


Another aspect is, this does not mean the current prices are cheap enough to buy a new position. The discussion here was in the context of selling. When you buy a house, you want as cheap as possible. When you sell a house, you want as high price as you could muster. So considering the characteristics of these companies, I think it is not high enough to call them insanely overvalued.


Summary is: Understand valuation in a given context. Think beyond PE ratios. Understand how it relates to business and what it really means. That is the essence of a holding company, or a parent company. This is what long term investing means – grow with the business.










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19 Responses to “Overvaluation in Heated Market – In What Context?”

  1. Young@Market says:

    Hi Tip,
    Wow…. what a great post…. I really appreciate the way you bring the whole picture…. Thanks for this nice lesson/ post…

  2. Erika Roach says:

    I have come to a conclusion that you are probably associated with a teaching profession. Your style of explaining with examples and analogy is band on target.

    This post is in Tweet-o-sphere.

  3. Chetan S. Raut says:

    HI tiguy,
    when any company have demerger and if company not going to issue shares of new child company to existing share holders then how it will be sure that share value of parent company going to get reflect value which got unlocked?
    any criteria for this?
    I think for existing share holders point of view providing shares of new child company will benefit them more.

    Thanx,
    Chetan Sadanand Raut

    • TIP Guy says:

      Hello Chetan,

      In equity investing, nothing is sure. If you want things to be “sure”, then my friend, you are in a wrong business. It’s all about risk and how you (only you) think it is going to evolve. To figure out, “how it will evolve”, you need your own understanding — not what media says or promoter says.

      Regarding getting shares of child company…. not necessarily always true. Sometimes it may benefit, sometimes it may not.. it is on case-by-case basis! There is no black and white.

      Best Wishes,

  4. Anonymous says:

    Hi Tip Guy,

    When a company is trading at such a high PE as 40-45x, don’t you think the market is already pricing in the value of “children”?

    Regards,
    XYZ

  5. Ravi says:

    Hi,

    A nice post. As per my understanding HDFC bank is the child of HDFC and HDFC is the one that holds the insurance and asset managment business. HDFC is the parent or the grand parent that holds lot of children including other finance companies and VC companies. I am not sure if you correct in mentioning that insurance and AMC are under HDFC bank. They are the children of HDFC as per my understanding
    Regards
    Ravi

  6. You are a purist about value investing! Graham, Buffet….TIPGuy 🙂

    • GRM says:

      Graham, Dodd, Buffet, Rakesh jhunjhunwala, TipGuy. But no one else shares their philosophy as clearly as TipGuy.

      Please read Security Analysis by Graham-Dodd. Not all of it is relevant today or to markets other than the US.

      I think TipGuy is getting there.

      Cheers,
      GRM

      • TIP Guy says:

        GRM,

        I believe Graham-Dodd is priceless. The issue is not about relevance, it is about understanding the essence of it and then practicing it (and not taking it literally).

        Best Wishes,

  7. I discovered your blog site on yahoo and checked a couple of your earlier posts. Continue to hold up the very excellent operate. I just additional up your RSS feed to my MSN News Reader. Looking forward to reading more out of you later on!

  8. Hi.

    I m impressed by your article.But if i talk about investors who don’t have knowledge on financial ratios, how much you write they still can’t understand.Thats where they look for advice and trust the research from broking.What in your opinion, should be the strategy of such investors.Moreover, the research from broking companies are different for different investors on the same stock.
    Thus an investor is lot confused today for getting that quality research which can really advice him.

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