Asian Paints, Berger Paints, Nestle India, HUL, Kotak Bank, Britannia: Consistent compounders and the problem of induction

The problem of induction is the point where philosophy meets science. What is the guarantee that scientific laws like gravity, inertia or the laws of thermodynamics — all of which form the building blocks of the universe and sustain our living — will not stop working tomorrow?

Just because they have worked in the past always cannot be a sufficient reason that it will always work in the future. This is the argument posed by logicians like David Hume and Betrand Russell, because using the past as sufficient proof to predict the future makes it a circular argument, with no additional supporting proof. Bertrand Russell likens this to a chicken which is fed every day for a long period, till it suddenly meets its end at the hands of the farmer.

According to him, laws can change despite there being evidence of that not happening. So what is the guarantee that the laws of nature will continue to work in the future as they have in the past? There is no such guarantee, and that is why according to some scientists, science is based on the faith that the laws of nature will just continue to work forever, as they have in all of the past.

That is good for science, because there is no other option. But what happens when you extend this to investing? A, B, C stocks have consistently given X, Y, Z CAGR in the last 10 years or 20 years, and hence they will continue to deliver solid returns. Sensex has given 16 per cent CAGR since 1981 till now, so it will continue to give similar CAGR going forward! Really? If you get trapped in such a problem of induction, your portfolio will hit a brick-wall. This is the issue plaguing some of India’s famed consistent compounders of 2009-19 decade like Hindustan Unilever, Nestle India, Britannia, Asian Paints, Berger Paints, Kotak Mahindra Bank, HDFC Bank and Bajaj Finance.

These famed companies and a few more, clustered together to create a basket of stocks termed the consistent compounders, prized for the high quality of their business and execution, have mostly underwhelmed in the last five years, while the country has had a roaring bull market, the recent correction notwithstanding.

Moats shaken

What actually happened? Their moats probably weren’t as strong as what investors thought they were as new competitors entered the fray like in the paints business; similarly, earlier, weak players in banking and finance transformed to compete harder. Maybe economic cycle too is playing a part. Interest rates, too, were low earlier and the liquidity gush pushed global and domestic investors to buy stocks at any valuation. For example, when global interest was at or near zero in 2020 and 2021, owning stock at 70 PE or earnings yield (1/PE) of just 1.4 per cent may have still made some sense to a few. However, it made very little sense when interest rates in the US went up to over 5 per cent last year and are still hovering at high levels. As these factors played out, the high PEs became unsustainable and the multiple contraction combined with the current earnings slowdown has turned out to be a double whammy. For example, we can see in the charts how the PE for some of these companies peaked between FY19 and FY22 and have derated since.

The question for investors now is what if this PE derating trend continues? What is the earnings growth required for these stocks to deliver decent positive returns from here — if derating continues for the worse or if at best multiples do not expand from here?

PE multiples are a function of earnings growth, profit margins, management quality, corporate governance, balance-sheet strength, prevailing interest rates and risk-taking tendency of investors. When each of these factors change, PE too will change and derating can play out when these factors turn adverse.  

The book Security Analysis by Benjamin Graham and David L. Dodd, states “The ‘new era’ doctrine – that ‘good’ stocks were sound investments regardless of how high the price paid for them – was at bottom only a means of rationalizing under the title of ‘investment’ the well-nigh universal capitulation to the gambling fever. 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… An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.”

To be sure, the returns of most stocks mentioned above are still positive in the last five years and nowhere close to tragic, but the derating process is not complete for all. More importantly, they serve a cautious tale to do the returns math once again on irrationally-priced stocks in one’s portfolio.