Nykaa: The Next Mamaearth?

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

Different investors have different ways of classifying businesses.

One of my favourite classifications is inspired by Warren Buffett who likes to classify businesses as great, good and gruesome.

Let me repeat that.

As per Buffett, businesses come in three categories mostly and these are great busineses, good businesses and gruesome businesses.

Given here are three businesses that can qualify as great businesses. These are Page Industries, PI Industries and Pidilite Ltd.

I have deliberately chosen businesses starting with the letter 'P' so that I am not accused of cherry picking them to suit my narrative.

One look at their key financials and you would know why they can all be considered as great businesses.

Look at the last two rows i.e. the average ROE and the average ROCE. The high return on equity and return on capital employed is what makes a great business.

Great businesses are highly capital efficient and have a moat or a competitive advantage that allows them to earn more per rupee of capital employed in the business as compared to other businesses.

It is like opening a savings account in a bank where you earn a minimum of 25%-30% interest on your fixed deposit and that too, year after year on a consistent basis.

As you can see, they are also zero debt companies with little to no borrowings. Therefore, consistently high ROEs and strong balance sheets are the necessary conditions for a business to qualify as great and all the three businesses fulfil these criteria.

Up next are good businesses. I have again chosen them such that they all start with the same letter i.e. the letter 'A'.

Ambika Cotton, Angel One and Apar Industries can be classified as good businesses because their ROEs and ROCEs are a notch below great business.

These companies are not as capital efficient as great businesses but are decent businesses, nevertheless. They are mostly profit making, have strong balance sheets and also have consistency in their earnings power.

As can be seen, all the three companies have either stable or growing EPS.

However, as I have said, the consistency with which they earn returns on the capital employed matters a lot and all the three businesses have done a decent job on this parameter.

Next on the list are the gruesome businesses.

As you can see, these companies are characterised by loss making operations, high debt to equity and very poor return ratios.

All the three stocks have exhibited these qualities in spades for the seven-year period between FY15 and FY21.

I am sure you are surprised as to why I have classified Suzlon as a gruesome business because both the business as well as the stock price has done so well recently.

Well, I went simply by the past performance between FY15 and FY21 and the company did really struggle during this period. Its profitability was all over the place during this period and it also had a lot of balance sheet challenges to address.

So is the case with the other two companies i.e. Swan Energy and Shoppers' Stop. These companies have also struggled during the same period and can be correctly called as gruesome businesses.

To summarise so far, Great businesses have strong competitive advantages and earn consistently higher ROEs and ROCEs.

Good businesses are not as good as Great businesses in capital efficiency but are decent businesses nevertheless. And lastly, the Gruesome businesses, where not only the core business is weak and loss making, the balance sheet is also loaded with a lot of debt.

To be honest, if you invest in gruesome businesses, there is a strong chance you will destroy wealth instead of making it.

Here's a very important chart. The share price returns of each of these groups for the two-year period between December 2021 and December 2023.

Now, this is surprising. Every Rs 100 invested equally between the three businesses of each group, has become only Rs 107 for the 3 great businesses.

On the other hand, an investment of Rs 100 in the good group of companies would have almost multiplied your money by 4x during the same period. This group has turned every Rs 100 into an impressive Rs 386.

The biggest surprise however is the gruesome group, the group that we have called the wealth destroying group.

An equal allocation amongst all the 3 companies in this group would have multiplied invested money by almost 3.2x. So, the gruesome group has not destroyed wealth. Instead, it has multiplied wealth by more than 3x between FY21 and FY23.

What explains this divergence? Shouldn't the great group have done the best followed by good. Why has the gruesome group multiplied wealth by 3x instead of destroying it?

Well, it doesn't matter that the gruesome group has multiplied wealth by 3x. You see in investing, there is investment and there is speculation. Investment is an operation which upon thorough analysis promises safety of principle and an adequate return.

Gruesome businesses that we saw were loss making and had stretched balance sheets.

There is no way they could have qualified as investments based upon their historical performance. Of course, they may show improvement in the future.

However, a bright future alone is not necessary for a stock to qualify as an investment. A business needs to be sound both in terms of its past as well as future performance.

Absent any of these criteria and the stock does not qualify to be an investment. Well, the three gruesome business we saw had a poor past and hence, they would be termed as speculative.

One cannot make them a core part of one's portfolio. Therefore, even though they gave 3x returns as a group, they continued to be speculative stocks.

Coming to the great and the good businesses, this table will show one big reason why they performed the way they did.

As you can see, all the three great businesses were trading at very high PE multiples back in December 21. While Page and Pidilite were trading at almost 100x PE multiple, PI Industries wasn't cheap either at almost 60x multiple.

Thus, these stocks were banking heavily on earnings growth for their share prices to go up significantly. When the earnings growth did not come in as high as expected, the stock price remained almost stagnant and the group underperformed.

The good businesses on the other hand, were trading at reasonable valuations. All of them were under 20 PE multiple which is quite decent in my view. Hence, when high earnings growth came in, the share price of these companies took off and the group went up by almost 4x between December 21 and December 23.

So, the takeaway is clear.

Buying good businesses at reasonable PE multiples can give you much better results over buying great businesses at very high PE multiples. Especially, if the time horizon is just 2-3 years.

Over a longer time horizon, you may still get away by paying slightly higher PE multiples for great businesses. But over a shorter horizon, a very high PE multiple for even a great business can prove to be a wealth destroying decision.

Ok, now what do you think about the following business.

Well, this is no great business to be honest. Not only has it made losses in the past, but the average ROE and the ROCE is also nothing to write home about. It is not a great business by any stretch of imagination, not based on its past performance at least.

Is it a good business? Well, I have my doubts even on this one. A great or a good business must be profitable at least and must have an average ROE and ROCE of at least more than 15%. However, this stock fails on both the counts.

Hence, if you go strictly by the definition, this business falls into the category of a gruesome business. In other words, if one invests in this stock, he is not investing in my view but speculating.

Also, check out the PE ratio of the company. It is more than 1,000x. Yes, you read that right. The stock is trading at a whopping PE multiple of more than 1,000x.

I believe that forget gruesome business, this is a very high PE multiple to be paid even to a gruesome business. Hence, if you are thinking of investing in this stock or have already invested, this session should act as a warning sign.

Not that making money on this stock over the next 2-3 years is going to be impossible. However, the risk-reward ratio is certainly not in favour of the investor.

Now, let me reveal the name of the stock to you. Well, it is none other than FSN E-commerce ventures, better known as Nykaa.

Yes, based on my framework, Nykaa qualifies as a gruesome business. Now, this does not mean that the company cannot turnaround in the future. It certainly can and at least the market seems to be thinking so. Otherwise, it wouldn't have assigned it a PE multiple of more than 1,000x.

As for me, I'd rather focus on a business that's already great or good instead of the one that is expected to make the difficult transition from gruesome to good or even great.

Remember, even Mamaearth was touted to be the next big thing.

However, we all know what happened to the stock. The sky-high expectations were not met, and the stock price came crashing down. A similar danger lies ahead for lot of gruesome businesses where the valuations also are sky high. So, please be careful and invest sensibly.

I will see you again. Good bye and happy investing.