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Weekly Insights #28- Thoughts on Order Book Stocks

The strongest trend in the market over last year or so has been that of Order Book stocks- companies within the defense, railways, EPC etc; wherein the business are economic & government sensitive and are driven by winning orders and the stocks are being driven by hyper discounting of an increasing order book without much due regards being paid to future risks of execution, cashflows, counterparty etc.


The views on this segment of stocks are highly polarized in the market;

  • On one side you have the whole pack of quality & growth investors who are of the view that these companies don’t deserve the kind of valuations that they are getting and that this will not end well; they seem to be anchored onto what happened in 2017-2018 cycle of the market.

  • And then on the other end we have the whole value pack of investors for whom this seems like a redemption of their long-held belief of deep value and payback for last decade of underperformance & cursing of value investing; they are like Apna Time Aagaya; and they seem to be anchored onto the 2003-2008 cycle.


For us, this segment of the market is something we have never tracked or have looked into and thus we have missed this entire move. And now when this segment has attracted our attention (like for the whole market) we are not comfortable in investing given that we believe that the risk:reward is not that favorable for new investments here.


And this is where I want to share the first important thought which is that-

  • No investor will ever be able to track the entire market and thus there will always be certain segments of the market which one will miss out on purely because you were not aware of the move during its early part.

  • And even within the segments that you do end up tracking, there will always be grey areas that you will not be able to invest in due to variety of issues like heighten risks, valuation discomfort, lack of conviction etc


And thus, one must be content with the fact that there will always be stocks & trends which you will end up missing out on that others will make money on. Everyone will end up making returns from a variety of different stocks and you don’t have to be part of each & every move to be able to generate good returns.


Don’t get into FOMO and invest into something which you know you don’t understand or wherein you know you are late. Give it a pass and look for something new wherein you are early such that risk:reward is favorable and you understand the investment to be able to hold it through tough times.


One of the worst feelings in the market is having seen, tracked or even invested in a certain idea at some point in time and then seeing it do well in the future when you no longer own it. In such situations, one has to appreciate the growth of the business & stock from the sidelines and invest your time & energy in trying to learn what you missed or where you went wrong; rather than kicking yourself for not owning it.



The 2nd thought that I want to share is on the valuations of these stocks-

Most of these stocks are trading at some very high earnings multiple; they are trading in multiples that have historically been reserved for consumer companies.


But looking at current TTM earnings multiple is not right here given the kind of growth that some of these names will deliver; a lot of these stocks would probably increase their earnings by 50-100% in next 1-2 years. And thus, what needs to be looked at is the market cap vs the forward 1-2 years earnings.


At 1-2 year forward earnings; most of these stocks are trading at half the multiple.


But having said that; expecting that the current high multiples will sustain even after next 1-2 years would also not be prudent given that at that stage & size the kind of future growth that these companies would be looking at might not be that high and thus valuation multiple will adjust lower to reflect that reduced expected growth rate.


Which is why a probable outcome here going ahead would be that these stocks would go into some sort of time consolidation wherein the earnings growth would fill-in for these high current multiples.



The 3rd thought that I want to share is around how market discounts these stocks, which to an extent also explains the current rally & valuations of these stocks-

Market is a discounting machine wherein it discounts the future earnings of a company and reflects that in the market cap it gives to a company. And market is always on the look out for as much clarity & visibility that it can get on these future earnings and then wants to discount them as soon as possible.


In case of these order book stocks; this visibility & clarity is relatively high because every quarter the market gets a new data point of current order book and with a sense of timeline when it will get executed, it immediately discounts that in the stock price. Which is why we are seeing such sharp moves in these stocks wherein each new order win is taking the stock higher in no-time.


But such discounting also creates a challenge. The underlying theme of say something like Defence & Railways capex might actually have a decent 4-5 year long run, but these stock’s trends won’t last that long because the orderbook will peak out way before that and thus the market will start discounting lower future earnings quite rapidly.


So, for anyone invested here, tracking the delta ie. the change & growth in order book is extremely crucial. Once that rate of change slows down or stops, the party here will end quite fast.



The 4th thought that I want to share is around cashflows-

The biggest challenge as a business for most of these order book stocks is the cashflows. These businesses have extremely high working capital cycle of 1-year and even beyond in many cases, leading to a sub-par ROCE profile of the business.


Now with the kind of growth rate that these companies are witnessing, the underlying cash generation is nowhere enough to sustain this. Most these companies are growing at 30-40% with mid-teens kind of ROCE profile.


Thus, they will either have to take on more debt or dilute equity; one can already see many of these companies announcing large QIPs.


Because of this dilution or increased leverage; the full potential of topline growth will never translate into EPS growth. And this is something that investors & at some point even the market will bake into its discounting that the growth in profits would be lower than the growth in order book.


Another small though here that I want to add here is that excessive increase in a stock’s liquidity is always bad for stock’s price trend (it puts a downward pressure). And if history is of any evidence; the strongest theme of a bull maket always ends with excessive liquidity at the top either through capital raises by existing companies and/or many new IPOs within that theme.



So those are the thoughts that I wanted to share today. Also, we are sharing an interesting stock idea along with its comprehensive research report with everyone who sign-up on our website; so do sign-up to benefit from it. Those who have already signed-up will be receiving a separate mail for the same shortly.



That’s it for this week, new insight coming up next week. So stayed tuned!


 

Disclosure

Surge Capital is a trade/brand name used by Ankush Agrawal (Individual SEBI Registered Research Analyst INH000008941) to provide equity research services in the Indian Equity Markets.


“Registration granted by SEBI, and certification from NISM in no way guarantee performance of the Research Analyst or provide any assurance of returns to investors”


“Investments in securities market are subject to market risks. Read all the related documents carefully before investing.”


“The securities quoted are for illustration only and are not recommendatory”


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