"Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return — even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” — Charlie Munger in “The Art of Stock Picking” (2013).

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The “fundamentalists” at Marcellus

Over the past couple of years, we have reiterated time and again the folly of using P/E multiples as a gauge of which stocks one should invest in. For example, in a recent newsletter for our small cap Little Champs Portfolio, we said: "The last 10 years clearly indicate that the best performing small cap stocks have been those which have generated the highest earnings growth as well as the highest return on capital employed (ROCE). For instance, as shown in the charts below, for both the time periods FY09-14 and FY14-19, the companies which delivered the highest PBT growth also ended up delivering the highest share price returns.”

More provocatively, in our July 2019 newsletter for a our Consistent Compounders Portfolio we explained: "A weak franchise trading at 10x P/E multiple appears cheap, when its fair value P/E might actually be 5x. On the other hand, a consistent compounder trading at 50x appears expensive, when its fair value P/E could be higher than 100x. Conviction on the ability of a firm to deliver sustainable competitive advantage (represented by ROCE) as well as growth (which requires capital reinvestment) is often underappreciated in a P/E multiples based valuation methodology.” In fact, in the newsletter we demonstrated that in 1994 Nestle’s fair valuation P/E multiple was 290x!

The futility of P/E multiple-based investing

In this note, we assess the relative power of a variety of metrics when explaining stock price movements. In the three charts shown below we have illustrated the ability of three different fundamental metrics — revenue growth, profit growth and free cash flow (FCF) growth — to explain stock prices of the BSE100 constituents over the last 10 years.

As you can see from the charts, whilst revenue growth can explain only 14 percent of the stock price movement seen over the past decade, profit growth can explain a healthy 48 percent of the stock price movement. But the star of the show is FCF growth — it can explain nearly 60 percent of the movement in BSE100 stock prices over the past decade. That is truly extraordinary and it suggests that amongst all fundamental metrics FCF growth is by far the biggest driver of shareholder value.

So what is FCF? Technically speaking it is the operating cash flow that a company generates less the money it spends on investing in property, plant, equipment and other assets that it acquires. The formula for FCF we have used is “operating cash flow - (capex+ advances for capex) - investment in subsidiaries and intercorporate deposits”. In plain English, FCF is a true measure of how much money a company makes after paying not just for its expenses but also paying for various assets and equipment that it needs to run the show.

In contrast to the potency of FCF growth in explaining stock price movements, it is worth seeing a visual illustration of how useless P/E multiples are when it comes to explaining stock price movement — P/E explains about 0 percent of the movement in stock prices. (No, that is not a typo. It is 0 percent.)

In plain English, the rise and fall in BSE100 constituents’ share prices over the past decade had NOTHING to do with the P/E multiples of these stocks. If you want to see how useless P/E, P/B and EV/EBITDA multiples are in India over horizons such as 1-year, 3, 5 and 10 years, please refer to Appendix 5 of our bestselling book "Coffee Can Investing: The Low Risk Route to Stupendous Wealth" (2018).

Investment implications

As highlighted in the quote from Charlie Munger at the beginning of the note, how much money an investor will make from an investment depends fundamentally on one thing and one thing alone — what is the return on capital generated by the investee company. If the company’s pre-tax ROCE is below 15 percent (which is the case for just over a third of the BSE100 constituents in FY19), it will be very difficult for an investor to generate a healthy return from buying shares in such a company even if the P/E of the company is low.

Conversely, as Mr Munger explains, if we buy shares in, say, Pidilite — a company with a pre-tax ROCE of 34 percent in FY19 — we are likely to make a very healthy return from the investment even if Pidilite's P/E is optically high. (By the way, the point made here for Pidilite is equally applicable to a stock like ITC which hasn’t in recent years enjoyed as stellar a share price run as Pidilite.)

FCF growth captures this aspect of investment success far better than P/E does because FCF is nothing more than ROCE less the cost of capital. Therefore, healthy growth in FCF necessarily implies equally healthy growth in ROCE. That is why, as shown in Exhibit 2, FCF growth is able to explain nearly 60 percent of the change in the share prices of BSE100 constituents.

(Disclosure: Please note that Pidilite and ITC are held in most of Marcellus’ portfolios)

Saurabh Mukherjea and Deven Kulkarni are founder and analyst respectively at Marcellus Investment Managers (www.marcellus.in).

First Published:Mar 2, 2020 8:18 AM IST