What's Ailing Diagnostics Stocks?

On 14 February: Nifty was down 500 points.

On 15 February: Nifty was up 500 points.

Such is the volatility on D-Street these days. Markets have become very reactive to news flow.

A joke doing the rounds on WhatsApp says, 'Putin bombs Nifty; Ukraine is ok'.

Whatever the reason may be, the downward trend in some stocks and sectors has already begun.

I've been following the market for many years. I've realised only 2 things determine stock returns.

• Earnings growth and its consistency
• The valuation band

The rest is just noise.

Over priced stocks always find a trigger to correct.

This trigger can be the threat of a war, interest rates hikes, rising commodity prices, or anything else.

The real problem is the valuations of many stocks which have run way beyond fundamentals.

I read somewhere that the operating profit of a steel company for FY22 is expected to be more than the entire addressable market of many of these recently listed new age tech companies.

Read it again. That's quite a statement!

Over the past many months, I've been a vocal critic of the new age loss making IPOs and of high PE ratio stocks.

I've written a lot about the unsustainable valuations in tech and platform companies.

But my views are not limited to the new listed IPOs and loss-making companies getting astronomical valuations. I'm critical of high PE stocks in general.

In fact, the whole narrative of growth at any price, which led to Buy at Any Price (BAAP) investing, fell flat on its face over the past few months.

What happens when the market prices in more than what it can digest?

I'm referring to diagnostic stocks.

Over the past 2 months, the correction in these stocks have been brutal. Metropolis has lost over 40% since start of the year. Its peers too are sulking with the exception of Dr Lal Path Labs which has corrected in line with the market.

A Sharp Fall

Stock Price	Monday, January 3, 2022	Wednesday, February 16, 2022	Change
Metropolis	3,450	1,960	-43%
Thyrocare	1,110	887	-20%
Dr Lal Path Labs	4,875	4,320	-11%

Data Source: BSE

Steep Valuations Result in a Fall

Valuations (P/E multiple)	Current	Peak	3 Year average
Metropolis	45x	66x	51x
Thyrocare	24x	43x	33x
Dr Lal Path Labs	62x	73x	44x

Data Source: Company

Valuations are a Slave to Operating Performance

EBITDA Margins	Dec-21	Dec-20	Change
Metropolis	26%	32%	-6%
Thyrocare	31%	36%	-5%
Dr Lal Path Labs	22%	31%	-9%

Data Source: Company

A Classic example of 'Priced to Perfection'

The stocks of diagnostic companies were trading at much higher valuations than their historical valuation bands.

Any disappointment in their operating performance would have led to a sharp de-rating.

And that is exactly what happened.

In a bull market, the problem always is that long term narratives are sold to justify any valuation.

A Comparison with Auto Stocks

The common story told to justify high valuations in the auto sector was, India's underpenetrated market. The ratio of India's cars per 1,000 people is very low compared to China and other countries.

But there are many negative factors which are structural in nature.

There's the impact of Ola and Uber on the entire second car purchase market.

Also, with good financing in the used car market, growth rates have been much faster for used cars.

The final learning is that the auto industry is cyclical. The narratives may be true but they will take years to play out.

Diagnostic companies are not cyclical as auto companies but the point I am trying to make is that the penetration story just like in autos will take years to play out.

The access to preventive care and availability of tests is a challenge for a majority of the population.

And penetration of high-quality healthcare and diagnostics is low in India. These are long term growth prospects but will take shape over time.

The current valuations look stretched but the long term picture is intact.

It's extremely difficult to justify steep valuations of diagnostic stocks.

I looked at the growth rates and ROEs of the top 3 listed diagnostic companies over the last 3 years.

The numbers were encouraging and consistent but still did not justify sky high valuation multiples.

Dignostic companies	3 year revenue growth	3 year ROE
Metropolis	15%	29%
Thyrocare	12%	23%
Dr Lal Path Labs	14%	25%

Data Source: Company

What followed was a set of disappointing quarterly results, leading to declines in these stocks. As I said, when things are priced to perfection, any disappointment will have an adverse impact.

The recent correction in diagnostic stocks has clearly eliminated the valuation froth in many of them.

Sharp falls in stocks like Metropolis and Thyrocare has taken their current valuations at or below their 3 years average PE.

If the margins stabilise at these levels, a time correction in these stocks could be a good opportunity to accumulate from a long term perspective.

Warm regards,


Aditya Vora
Research Analyst, Hidden Treasure

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