Long-term growth prospects as ‘perceived’ by the collective wisdom of investors (famously allegorised as Mr Market in The Intelligent Investor by Ben Graham) are embedded in stock prices which leads to major fluctuations whenever those perceptions change.
Change in perception regarding long-term prospects due to short-term events provides maximum opportunities in investing. For example, the opportunity provided by the initial shock of a lockdown in March 2020 after the first Covid wave.
How does one quantify Mr Market’s optimism and pessimism? One way is to look at valuation parameters like P/E. Another way is to ‘reverse-engineer’ stock price to arrive at how much value is being assigned by the market to long-term growth in earnings. Using our proprietary ‘reverse-engineering’ MILTGV (Market Implied Long-Term Growth Value) framework, we can classify stocks into segments based on Mr Market’s various degrees of pessimism and optimism.
Given the focus on long-term growth which depends on sustainability, investors should prefer stocks with relatively lower ESG risk or the riskier ones showing improvement in their score.
Market’s pessimism or optimism can be divided broadly into five buckets. First is extreme pessimism where the market assigns negative value to long-term growth in earnings beyond FY23, which implies expectation of negative or near-zero growth beyond FY23 consensus earnings into perpetuity.
Stocks in this group are largely PSUs engaged in economic activities of utilities, oil and gas and financials with a higher proportion scoring low on ESG. Market’s assumption of negative growth into perpetuity appears too pessimistic for some of the stocks with prospects to grow and add value (RoE>ke) while improving ESG scores.
Next is low expectations bucket, with a MILTGV between 0 and 30 per cent. Market assigns less than 30 per cent of the current market value to long-term growth in earnings beyond FY23. Financials, metals and energy sector constitute the second bucket with a larger proportion of low ESG scores. This bucket presents an opportunity to pick improving earnings growth and minimum value creating profile stocks with long-term business track record and improving or low risk ESG scores.
Low to moderate expectations come up next where market assigns 30 per cent to 50 per cent of the current market value to long-term growth in earnings beyond FY23. Stocks are majorly from auto, financials, healthcare, IT and a mix of other sectors with lower incidence of high risk ESG scores. This bucket provides an opportunity to buy quality stocks with growth at reasonable valuations. The fourth bucket is moderate to high expectations where the market assigns 50 per cent to 70 per cent of the current market value to earnings growth beyond FY23. Stocks include industry leaders majorly from cement, industrials, IT, auto, pharma and financials. Opportunity to buy quality leadership stocks with consistent earnings growth or improving growth profile, albeit at a reasonable price.
The last bucket is the highest expectations where the market expects bulk of the value (more than 70 per cent) from such stocks to be derived from long-term earnings growth rather than the earnings trajectory till FY23. Hence, the most important factor for such stocks is the potential earnings growth over the long term, along with the adequate balance sheet strength and capital allocation decisions to achieve such high long term growth. Stocks are majorly from consumer, auto, financials, pharma, industrials and new age sectors such as retail, digital, green energy etc. Buying should be restricted to high quality growth stocks (earnings CAGR is 15-20 per cent) with upside potential involved in economic activities which have high long term growth visibility. Also, such stocks should be consistently beating or meeting estimates as valuation re-rating is unlikely.
The author is Head of Strategic Research at ICICI Securities