Tata Elxsi still trades at a TTM (trailing twelve month) PE of more than 50x.
If an article in ET is to be believed, nearly 80% of the analysts who track Tata Elxsi and LTTS (L&T Technology Services), have a negative view on both.
Out of 7 analysts that they zeroed in on, 6 have a ‘SELL’ or ‘Reduce’ rating on Tata Elxsi.
Likewise, out of 25 analysts, almost 20 have either a ‘SELL’, ‘Reduce’ or a ‘Hold’ rating on LTTS.
Interestingly, only 1 analyst has a ‘Strong Buy’ rating on each of these stocks.
I find these ratings a little perplexing to be honest. A ‘SELL’ rating when both these stocks are down massively from their all-time highs does not make sense.
A ‘SELL’ call should have come when these erstwhile multibagger stocks were trading at life-time highs and not after they have already corrected almost 40% from the top.
Have these analysts erred and have fallen prey to the herd mentality or is there more pain in the offing for both Tata Elxsi as well as LTTS?
To be fair to the analysts though, both the stocks are not cheap even after the 40% correction from the top.
Tata Elxsi still trades at a TTM (trailing twelve month) PE of more than 50x. This is significantly higher than its 5-year as well as 10-year median PE which is in the range of 30x.
Therefore, even if we assume that Tata Elxsi’s earnings were to double in 3 years and apply the long term PE multiple of 30x, the potential upside is nothing much to talk about.
The only way the stock can end up giving good returns from here is if the earnings continue to grow at a strong pace and the PE multiple stays in the current zone of 45x-50x.
Ditto for LTTS as well. Although the stock does not command a PE multiple as high as Tata Elxsi, its TTM PE of 32x is greater than its long term average of 25x.
Therefore, even for LTTS to give good returns, it will have to stay at the current elevated PE levels for a considerable stretch of time.
Another way of approaching this is following the famous Warren Buffett dictum. He is often heard saying that one should not rely upon a great selling price.
His view is that one should have the purchase price to be so attractive that even a mediocre selling price brings good results.
And he has indeed walked the talk on this.
You see, there’s a book by the title ‘Inside the Investments of Warren Buffett: Twenty Cases’ by Yefei Lu.
What is the book about? Well, the single-most important takeaway is the valuation multiple that Warren Buffett paid to buy 20 of his best investments.
The answer is a PE multiple of between 7x to 18x. Yes, that’s correct.
If the book is to be believed, Buffett never paid more than 18x trailing twelve-month earnings even if it meant buying a high-quality stock.
This shows that Buffett has indeed walked the talk when he said that never count on making a good sale.
He has ensured that his purchase price was so attractive that even a mediocre sale would bring him good results.
If we apply similar logic to both Tata Elxsi as well as LTTS, we don’t think we should pay a PE multiple of 52x and 32x respectively that these stocks are currently trading at.
A PE multiple which is in line with their long-term average looks more realistic in my view.
Hence, when approached this way, both the stocks need to correct further for the risk-reward equation to turn in our favour.
There’s one more way to check if this is the right time to turn bullish on both Tata Elxsi as well as LTTS.
We need to ask ourselves a simple question.
You see, the March quarter results for both the companies will come out soon.
Can you guess what kind of an impact a positive earnings surprise or a negative earnings surprise will have on the share price of both the companies?
You see, one of my favourite investors, David Dreman, has done one of the most comprehensive studies around this.
He found that positive or negative earnings surprises have different effect on the share price depending on whether the stock is undervalued (low PE) or overvalued (high PE).
A positive earnings surprise often leads to a low PE stock outperforming the market the following year. But it will not have any major impact on the share price of a high PE stock.
A negative earnings surprise on the other hand, has a devastating impact on the share price of a high PE or an overvalued stock. These stocks underperform the market in a big way over the next one year.
A low PE stock on the other hand, stays almost flat even after a negative earnings surprise. Therefore, negative surprises go almost unnoticed by low PE stocks.
Therefore, the net result is that out-of-favour, low PE stocks outperform high PE stocks over time.
Now, let’s apply this logic to the share price of both Tata Elxsi and LTTS.
Given their current high PEs, I think a positive earnings surprise will not move the stock prices of both these companies much.
Both the stocks have a fair amount of growth already priced into their share price.
But a negative earnings surprise is likely to have a slightly damaging if not a devastating impact on the share price of both the stocks in my view.
You see, there are no guarantees in investing.
You can choose the most expensive and worst quality stocks and still end up on the winning side and you can choose the most attractive and the best quality stocks and still end up losing.
Over the long term though, it is the second approach that pays off and puts you in a great position to earn market beating returns.
So, while both Tata Elxsi and LTTS are good quality stocks, I don’t think valuation wise, the risk-reward equation is in our favour.
They are still at levels that doesn’t qualify them to be value buys.
Besides, a negative earnings surprise may prove to be damaging to their share price while a positive surprise may not lead to a sizeable appreciation.
Therefore, I am with the 80% analysts on this one and believe that it may be a good idea to allow the prices to fall further before making a move.
Happy Investing.
Disclaimer: This article is for informationpurposes only. It is not a stock recommendation and should not be treated assuch.
This article is syndicated from Equitymaster.com
(Except for the headline, this story has not been edited by NDTV staff and is published from a syndicated feed.)
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