‘Return expectations must be set reasonably’

Vineet Sambre, Head-Equities, DSP Investment Managers and one of the authors of the note, explains Mint That they try to build portfolios that can withstand any tough periods by correcting less than the market during sharp downtrends. Edited excerpt:

As of note, when valuing a company using the Discounted Cash Flow Method (DCF), a low discount rate (due to the low-interest rate high-growth environment now globally) can lead to severe overestimation. As interest rates rise, what effect could this have on current valuations and how will it affect returns?

Today, globally many companies are being valued on the basis of low rates. Lower rates The valuation model uses lower discount rates which inflate the valuation (i.e. the target price). As fixed income returns have fallen, capital is pursuing other avenues such as equity and alternatives that seek higher returns. If investors are modeling today’s low rates forever, they can justify all kinds of hypervaluations. But these are all cyclical, as has been observed many times in history. If and when rates rise and liquidity becomes scarce, stocks whose price-future increases may be more adversely affected. In one example we cited in the note, if the WACC (weighted average cost of capital) increases from 1% to 9% to 10%, this would result in a ~41% multiple compression over a 30 year case. development property. This does not mean that the entire market will immediately correct 41%. However, there are many properties out there that are priced very aggressively, and therefore require some caution.

The note also mentions that the DSP uses a 30-40 year DCF analysis to evaluate certain companies. Can you explain in detail. What does this mean for an investor with an investment horizon of 7-10 years?

Long-term DCF is only one in the arsenal of tools used by our fundamental analysts, and should not be viewed in isolation. Also, this method has no direct bearing on the investment horizon of the ultimate investor in our fund. For investors looking at our equity funds, we would still recommend a longer-term horizon, preferably forever, or as long as possible, or based on individual goals and asset allocation. This time horizon should not be confused with the long-term DCF of 30-40 years. The idea behind doing such DCF is more as a sanity check – to identify whether we are overpaying for an asset, or missing something that the market is observing. Typical DCFs offer high-growth stages of 5-7 years. At such DCFs, however, many new age companies will appear overvalued. Even today many interested buyers appear in the market. So we try to give companies a long rope of 30-40 years to grow (albeit on an excel sheet), and try to find out if these high valuations are justified. In some cases, despite our very liberal assumptions of outstanding performance over the decades, we see that companies may still be overvalued. This approach eliminates all other prejudices and allows us to be more scientific and rational in our approach.

As per your return decomposition analysis, in the last two years, 50% of the returns of the Indian market have come from multiple expansion, while it is 35% for the US and 12% for the EU. Based on this, what should investors look at on their return expectations going forward?

We can’t predict future returns, no one can, and you already know this. The 50% multiplier expansion may expand even further for all of us, and may be 60% or even 70%. But it’s not something we’ve been able to wrap our heads around. When markets operate on anticipation and optimism of the future, they are also running the risk of a shortfall in actual delivery. We focus on — actual on-ground delivery by companies, not just narratives created out of thin air. Also, this multiplier expansion number is an example for the market as a whole — while different stocks will offer different characteristics, and that’s where the alpha opportunities lie.

A graph showing similar returns from the Nifty (TRI) and CRISIL Composite Bond Fund Indexes from the peak of the 2008 global financial crisis to the beginning of 2021 (13-year period) is disappointing. Which investment strategies can be followed to generate higher returns than equity?

It’s not hopeless, but realistic. We ourselves are in the equity space, so showing such comparisons is counterproductive in a sense. But it is what it is. The 13 year period referenced here is from the peak of the market just before the 2008 bubble burst. So there is some selection bias inherent in this chart. But it was done purposefully, to demonstrate that admissions assessment matters. Market participants today have a lot of FOMO (fear of missing out) and this can lead to irrational decision making. We definitely wish the bull market would continue forever – who wouldn’t? But we have also seen several market cycles in the past, and bear markets can be quite brutal, and market participants who do not know better can be at a loss. We try to build portfolios that can withstand any tough times, hopefully by short corrections from the market during sharp downtrends. This is important because long-term wealth is created not only by growth of capital but also by capital conservation.

Buying good businesses with quality management is mentioned as a point in your investment philosophy. Can you define it?

We look for companies that have scalable businesses, competitive advantages, high sustainable return on equity and increased earnings over time. We also strive to identify managements who are credible and capable, show passion and ownership, and have a demonstrated track record of execution and superior capital allocation.