My Top Diwali Recommendation

As I got up yesterday, there were multiple notifications on my mobile related to 'Top Diwali Picks', Some of these were touted to be the next multibagger stocks.

I thought why not share my recommendation with my readers on this auspicious occasion.

Stay with me. The returns from what I'm going to recommend is not just limited to this festive season but could be a great wealth creator for the years to come.

Let me first set the right context that will help you appreciate the value of my recommendation.

The stock of Nykaa is in news these days. No surprise there. Nykaa's share price is falling. In fact, it's touching record lows and is now close to its issue price.

Of all the new age companies that listed last year, it's a rare business that is not losing money.

And yet, has not been spared.

Its biggest believers last year are citing intense competition as one of the reasons for the sharp decline.

However, I have a different view.

The competition was, and will always be, fierce. That's a well-known fact.

The reason the stock has fallen is that it never deserved the valuations it commanded in the first place.

It was never about the business fundamentals or growth, but the cheap money sloshing around and marketing skills of people with vested interests in the investor community and finfluencers.

The winter season is already here for startups. As per Tracxn, startup funding is down 80% YoY.

With all the gloom and uncertainty on the macro front - possibility of a recession in the US, the slowdown in China and Europe, the valuations of these stocks have corrected...and the fall is bigger for the most expensive ones.

While I'm still positive on the long-term potential of India for stock market investors, it comes with a high regard for margin of safety in valuations. And businesses like Nykaa don't make the cut.

Its PE ratio is over 500 times, difficult to make sense of.

So let's turn to more recent metrics that were devised to justify valuations of new age businesses.

In terms of marketcap to sales, the stock has fallen from 32 times in November 2021, a ridiculously expensive level, to 13 times today. That's still expensive.

You could witness the biggest bull run in the market, and yet end up losing a lot if you are not careful of the price you are paying.

But this is easier said than done, especially for growth investors.

If you search online for the term growth investing, the answer is often 'companies that increase their revenue and earnings at a faster rate than the average business in their industry'.

Now given the amount free information available on internet, it's not difficult to screen stocks with growing profits or revenues at high rates. You can use Equitymaster's screener for top growth stocks in India.

While this is a very helpful tool, if you are using this as the sole criteria to pick stocks, you might be doing it wrong.

You see, in investing, not all growth is equal. A Price to earnings screener or a price to book screener can help only so much.

Allow me to illustrate this with the help of an example...

Consider two companies - Company A and Company B. Both are from the agrochemicals sector.

Company A has grown its sales and net profits at a CAGR of 18.4% and 12.8% respectively over last five years.

The growth in company B's sales and profits have been 23% and 16% respectively over last five years.

Clearly company B fares better than company A on both sales and profit growth over a 5-year period.

	5 Year Sales CAGR (%)	5 Year Profit CAGR(%)	PE 5 Years Ago
Company A	18.4%	12.8%	24
Company B	23%	16%	21

Source: Ace Equity, Equitymaster

Assuming you could forecast growth correctly 5 years ago, and given their valuations, at a PE of 21 times, company B would seem like a better bet.

But was it?

Let's see how these stocks turned out.

I'm using the actual returns these two stocks have offered over last five years.

The 5 year CAGR return of Stock B, that seemed like a better bet on growth and was cheaper on PE, is down 6%. The CAGR return on Stock A, over the same period, is 31.4%.

	5 Year Sales CAGR (%)	5 Year Profit CAGR(%)	PE 5 Years Ago	Stock Price Performance 5 Year CAGR (%)	Current PE
Company A	18.4%	12.8%	24	31.4%	51.0
Company B	23%	16%	21	-1.1%	13.4

Clearly, stock A, despite lower growth, and higher PE, has been a winner, and by a wide margin.

In fact, at present, the market is valuing lower growth company A at 51 times PE. The stock of company B is trading at a PE of 13.4 times.

Why do you think the market has favoured company A over B, despite a lag in the growth in both sales and profits?

Well, let's look at a few more numbers and ratios, and the picture starts getting clearer.

You see, while company B has grown overall at a better rate, its quality of growth has been poorer than company A.

How can I say that?

You could figure this from returns on capital employed (ROCE) for both the companies.

	5 Year Sales CAGR (%)	5 Year Profit CAGR(%)	PE 5 Years Ago	Stock Price Performance 5 Year CAGR (%)	Current PE	Returns on Capital Employed, ROCE (%)
Company A	18.4%	12.8%	24	31.4%	51.0	22.6
Company B	23%	16%	21	-1.1%	13.4	13.6

Source: Ace Equity, Equitymaster

Company A has been enjoying a 5-year average return on capital employed of 22.6%, compared to 13.6% for company B.

This means every unit of net profit reinvested in company A will offer much higher return, i.e. will compound at a higher rate, than company B.

What's more, the growth in case of company A is self-sustainable, as you can see from its close to nil debt to equity ratio (five-year average).

	5 Year Sales CAGR (%)	5 Year Profit CAGR(%)	PE 5 Years Ago	Stock Price Performance 5 Year CAGR (%)	Current PE	Returns on Capital Employed, ROCE (%)	Debt / Equity (%)
Company A	18.4%	12.8%	24	31.4%	51.0	22.6	0.1
Company B	23%	16%	21	-1.1%	13.4	13.6	1.3

Source: Ace Equity, Equitymaster

Company B on the other hand, seems to be relying on borrowed capital in order to expand the business. It has a debt to equity ratio of more than one.

In short, company A is doing a much better job with regards to capital allocation compared to company B. And the stock market knows it.

Company A is PI Industries.

Company B is UPL.

	5 Year Sales CAGR (%)	5 Year Profit CAGR(%)	PE 5 Years Ago	Stock Price Performance 5 Year CAGR (%)	Current PE	Returns on Capital Employed, ROCE (%)	Debt / Equity (%)
Pi Inds	18.4%	12.8%	24	31.4%	51.0	22.6	0.1
UPL	23%	16%	21	-1.1%	13.4	13.6	1.3

Source: Ace Equity, Equitymaster

The market has favoured PI Industries over UPL, despite its relatively lower growth and higher PE entry because...

• The growth for PI Industries is self-sustainable.
• Every rupee of net profit invested in the business is likely to offer much higher return, making it a powerful compounding engine.

The moral of the story

More than growth, it's the quality of growth that matters.

To assess quality, you need to dig a lot deeper than growth guidance given by the managements or the output of growth stock stock screeners.

You need to assess if the business generates enough cash to fund the growth, or if it needs to burden the balance sheet with debt in order to fund its future growth, which could adversely impact its returns on capital.

If it's the second case, the resilience and even survival of the business gets tough when the macro environment becomes challenging or in case of a prolonged industry slowdown. And these could turn out to be growth traps which you are better off avoiding.

For tech businesses, even if they grow, unless that growth is anything less than spectacular, the valuations are likely to correct.

Their past growth, driven by external money that was intended to be burnt anyway, is not a reliable indicator of how the future will pan out.

So when you pick stocks this Diwali season dear reader, my recommendation is to not fall for growth at any price. Assess the quality of growth as well.

Wish you all a very Happy Diwali!

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure