I was concerned with the relentless rise in IRCTC's share price a year ago. So I did a video on the stock.
I had only a basic understanding of the company's business back then. But its valuations gave me the jitters. Based on its normalised earnings, the stock was commanding a huge PE ratio of about 100x.
I don't think there are many stocks that you buy at a PE of 100x and end up making good money over the next 3-5 years.
However, my opinion and those of other like-minded investors continued to fall on deaf ears. The stock kept going higher. Within a couple of weeks of my video, the stock was up another 44%.
I hope investors who ignored the valuations and kept buying it, were able to sell at the top. If they haven't, they missed a golden opportunity in my view. The stock is down more than 40% from its 52-week highs and it doesn't look like it will scale those again anytime soon.
IRCTC is not the only stock that has suffered this fate. A couple of other investor favourites or the so called multibagger stocks like IEX (Indian Energy Exchange) Ltd and Dr Lal Pathlabs, now find themselves in a similar situation.
Both saw their stock prices being taken to multi-year highs with little or no regards to valuations. Both have been taken to the cleaners in the last one year or so.
In fact, in the case of IEX share price, the decline has been more than 50%. Any investor who made the mistake of investing at the top, is certainly staring down a deep abyss.
In case you are wondering how it came to this, well, a large part of the blame must be laid at the doors of human greed. When the greed of making a quick buck dulls your senses, no PE is high enough. Your mind keeps concocting new reasons to keep taking the PE even higher.
I think Ben Graham has put it quite well in his fantastic book, Security Analysis.
Here's what he has observed...
- The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis.
If a...stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the pre-boom standard, the conclusion to be drawn was not that the stock was now too high but merely that the standard of value had been raised.
Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price.
Well, here's the crux of what Graham is trying to say.
The greedy Mr Market is a brilliant salesman. If you have no idea how much you are willing to pay for a company, the glib salesman that he is, Mr Market will convince you to buy the stock at any PE multiple.
He will keep on concocting these wonderful stories and assure you the multiple you are paying is not very high.
Therefore, an easy way out of this trap is to fix an upper limit yourself. Decide what is the maximum PE you would like to pay for a stock and stick to it. You should not budge no matter how good the fundamentals or how promising the growth of the underlying business.
My experience and the way the Indian stock market has worked historically, tells me this upper limit should not be more than 25-30x for Indian stocks. If you consistently pay more than 30x in the name of quality or high growth, I don't think you will make market beating returns over the long term.
Of course, it's a different matter if you believe you are highly skilled and can figure out in advance whether few stocks are worth buying even at a PE of 50-60x.
But please note there's a very thin line between confidence and over-confidence. It's always better to be conservative when it comes to matters of valuation.
I'm sure investors who bought Dr Lal Pathlabs or IEX Ltd a year back may have done their homework and considered themselves to be an expert on these companies.
However, even the most in-depth analysis cannot prepare you for the kind of disruptions these businesses seem to be facing right now.
Both are considered market leaders in their respective fields and are now likely to witness a much higher competition intensity. This puts a big question mark over their future profitability.
And this is precisely the danger with paying a very high PE multiple for any stock. As so much of expectation is already priced into the stock, investors get jittery at a small whiff of trouble and start dumping the stock.
Hence, due to these downside risks, it's always better to be conservative and incorporate a sufficient margin of safety into the multiple that you are willing to pay.
Now, to answer the question we asked in the title, 'When will these stocks recover?', the key lies in minimising your risk and not trying to maximise your upside.
First, you will have to decide the maximum PE multiple you are willing to pay for these stocks. And you better be conservative here.
Second, if you've bought these stocks close to their all-time highs, then you can perhaps average out at or below the PE multiple that you've fixed for these stocks. While doing this, be mindful you don't make any one stock more than 5-6% of your entire portfolio.
Now, all you have to do is sit back and track their fundamentals. If they improve, the price will also move up, hopefully making you a good profit. If they don't, you may have to bite the bullet and exit these stocks.
The good thing here is that you now have a proper framework of investing. It's a framework that limits your losses if you are wrong and rewards you with a good upside if you are right.
Without a proper framework and without any idea of the maximum multiple you should pay for a stock, you would be lost and may even end up making huge, irreversible losses.
Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com.
(This story has not been edited by NDTV staff and is auto-generated from a syndicated feed.)