Do it yourself

Some famous finfluencers of social media have recently commented that some large-cap stocks have underperformed the benchmark Nifty50 in the past couple of years, while the earnings and balance sheets of these companies have improved decently. These stocks are trading well below their peak valuations. Many of these stocks are trading well below their 5-year median valuations. The finfluencers are arguing that valuations of these stocks shall witness a “mean reversion” soon and these could give 30 to 40% return without any further improvement in earnings or balance sheet matrices. The most popular example cited by these finfluencers is the share price behavior of ITC Limited in 2022-2023.

I have no issues with these social media stars. I will be happy if large-cap stocks like HDFC Bank, Kotak Bank, Hindustan Lever, etc., outperform the benchmark indices and yield a 35-40% return. I am happy to ignore the fact that ITC has yielded a negative return in the past year. My small inquisition to these self-proclaimed market experts is whether they have evaluated the proposition that perhaps the underperformance of many of these large-cap stocks might be a part of their reversion to mean on a much longer timescale.

To understand my point in more simple terms, consider this. If the news headline tomorrow says that Delhi witnessed its highest daytime temperature in six decades, what would be your first thought? It is more likely that your first thought would be “Climate change is for real, and global warming is hitting us all”. You may not consider that six decades ago when Delhi’s population was much less, carbon emission was a fraction of the present level, the ozone shield was much stronger, and climate control was not even a buzzword – Delhi had witnessed a similar high temperature. Maybe the current high temperature is also due to a longer climate cycle; not merely because of damage to the ozone shield.

We would perhaps know the correct answer in another four decades. Till then we may continue to endeavor to cut carbon emissions. Similarly, whether we are reverting to mean valuations for many large-cap stocks or an up move is needed to converge with the mean would be known in 2-3 years.

In this context, it is also important to consider that business dynamics have changed significantly in the past decade. For example-

1.    Most new-age businesses have a larger proportion of intangible assets. The share of intangibles is rising even in conventional businesses.

2.    Many new-age businesses do not differentiate between operating cash-flows and financing cash-flows. They burn capital for revenue expenses.

3.    Most platform businesses are consistently evolving. They do not have a predictable revenue model.

4.    Many large businesses in India have transformed into conglomerates with diverse business profiles.

5.    The current rate environment is too unpredictable to assume a fair long-term rate for DCF.

It’s a challenge to incorporate these factors optimally in the valuation models. Traditional consideration of these factors may not be relevant under the latest circumstances.