One of the saying in the professional investing world is that “sab base effect ka khel hai” (it’s a game of base effect)
This saying reflects a common phenomenon that plays out in the markets wherein when a company is facing some challenges and its earnings goes down during this challenging phase, there is a series of downgrades and the stock gets de-rates and thus there is a correction in stock’s price.
But for the stock price to recover, it does not need these challenges to completely go away. Because after a while, the base in terms of numbers, valuation levels and perception are already established at lower levels and thus subsequent numbers no longer looks bad.
For example, if a company had 20% operating margins and due to some challenges it reduced to 15%; now for next couple of quarters the overall numbers will look bad because there will be a de-growth over the earlier base of 20% margins. But after few quarters, the base will normalize to 15% margins and thus subsequent numbers will not show de-growth and with an improved outlook for numbers (due to lower base), even the perception & thus the valuations will also improve, leading to recovery in stock’s price.
A good recent example of the same is that of banking stocks (especially PSU banks). Post covid, all banks had very high credit losses and thus overall numbers got depressed. But in last year or so, these stocks are reporting exceptional growth in profits, because the current credit losses being booked in the PnL is nowhere near the high base of post covid periods. In some cases, the credit losses are even lower than historic averages given that most of them created excess cushion and thus they are reporting historically high ROEs. Same thing with growth, stocks have moved from no-growth/low growth period of post covid to growth period over last year. And this has led to some exceptional moves in these stocks.
Now the above is more of a short-term phenomenon. But base plays a very important role in the long-term growth of a company and thus is important for investors looking at a longer time period.
For any company to grow over its last year’s base, it must first generate business that it did last year and then add new business above that. So, for a business wherein sales are recurring in nature, its base business is secured and thus it largely has to work towards generating business over that base. And thus, growth is relatively easy to come by and is something that sustains over very long periods of time without interruptions.
Take an example of an FMCG business vs something like a real estate business. In real estate, each sale is largely a one-time activity. The same customer will not be a customer for decades and thus business done in one year does not contribute anything to next year. And thus, for such businesses, each year the entire business (base + growth) has to be generated from scratch.
Whereas for an FMCG business, each customer is a recurring customer for many years and thus the base business is largely secured and one only has to work for incremental (growth) business.
And thus, in businesses wherein the base business is recurring, it is relatively easy for the business to grow continuously for very long periods and that too to a relatively large scale.
Consider two segments within lending- Housing Finance and Gold Loans
Housing loans are long term in nature and thus loans disbursed in current year stays on the balancesheet for future years and thus the base business is secured. Whereas, Gold Loans are short term loans (most gets repaid in 6-months) and thus every year a gold lender will have to again disburse loans that it gave last year just to avoid a de-growth.
And this effect of base reflects in the size & growth of these businesses wherein the largest gold lender has a book size of ~50-60K crores vs the largest housing financer with 10x that size and still growing at higher rates than the gold lender.
Something similar can be observed in pharma business of Domestic vs US Pharma-
In US Pharma business, the existing base business is always de-growing (because of pricing erosion) and thus for a company to grow it needs to first launch enough new products to fill that base business erosion and then more to generate any growth over last year. And doing this is extremely difficult over sustained long periods.
Whereas in Domestic pharma business, there is hardly any pricing pressure, in fact a decent part of any domestic pharma businesses’ growth comes from pricing. Even for products that are under NLEM price control are allowed to take price increases in line with inflation index.
And thus, the base of a domestic pharma business is much more resilient and thus it is a business that delivers secular growth and thus is valued higher.
In summary, base has an important role to play in both- short term & long-term outlook of a stock. Biggest long-term wealth will be created in businesses wherein the base business is secured & resilient.
That’s it for this week, new insight coming up next week. So stayed tuned!
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