Are Nestle shares finally within the reach of small investors?
Last week, amid the frenzy surrounding power, infrastructure, and railway stocks, Nestle’s trending status on the internet caught me off guard. On closer look, it turned out the Maggi manufacturer had just implemented a 1:10 stock split, with Friday marking its first ex-split trading day. This development made India’s sixth most expensive stock 90% more affordable, attracting investors previously deterred by its lofty price.
However, it’s crucial to remember that a stock split, which increases share quantity and liquidity but doesn’t affect a company’s long-term fundamentals, shouldn’t be the sole basis for trading decisions. Investing should be grounded in long-term fundamentals and intrinsic value, not merely on whether a stock has split.
Those eyeing Nestle post-split, lured by its lower price, might not be adopting the best investment approach, in my opinion. It’s important to distinguish between price and value – the latter should be the primary focus.
In this context, determining a fair entry price for Nestle is essential. A useful strategy is to identify a price below which a stock is considered an investment and above which it veers into speculation.
Many successful investors excel at this differentiation, maintaining a clear divide between investment and speculation, and reaping significant rewards by staying within the investment domain. Most people, however, struggle to differentiate and control their investment behaviour, often veering into speculation.
So, how do we distinguish between investment and speculation? Walter Schloss, a highly successful yet under-the-radar investor and a friend of Warren Buffett, believed in buying stocks below their book value. He strictly adhered to this principle, considering anything above book value as speculation.
So, if a stock had a book value of ₹100, he won’t buy it if the price was significantly higher than 100. Paying anything more than ₹100 constituted speculation as per him.
For instance, if Schloss were to consider Nestle, which trades at ₹2,666 per share – a staggering 90x its book value – he’d deem it too speculative. It doesn’t matter to him that a quality blue chip like Nestle will never become an investment as per his criterion.
This did not make him sad. He knew there were plenty of stocks that satisfied his criterion of investment and he was happy investing in those stocks.
In fact, he has put together one of the best track records and has beaten the smartest investors by putting up a big wall between investment and speculation and hardly every jumping over on to the speculative side.
What about his friend Warren Buffett? Will Warren Buffett buy Nestle at the current price?
Well, please read the book ‘Inside the Investments of Warren Buffett: Twenty Cases’ by Yefei Lu.
I have it on my Amazon kindle app but haven’t read it yet.
What is the book about? Well, the single-most important takeaway is the valuation multiple that Warren Buffett paid in order 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.
What does this tell you about Buffett’s definition of investment vs speculation.
Well, as per Buffett anything below 18x constitutes an investment and anything above that a speculation. Buffett has hardly ever strayed from this definition of investment. He has always stayed inside the investment zone the wall of which he himself has erected.
Applying this to Nestle, Buffett would only consider buying it at around ₹554 per share, far below its current price, suggesting a speculative element at its current valuation.
Although Buffett is willing to pay a lot more than his dear friend Walter, it is still well below the current price of Nestle which is close to ₹2,700 per share. Thus, even as per Buffett’s valuation standards, Nestle stock price has a large speculative element.
Interestingly, both Schloss and Buffett, despite their success, wouldn’t find Nestle an attractive investment at present prices. Contrastingly, the Indian market has historically valued Nestle with an average PE of around 50x, indicating a buying price of ₹1,600 or lower – yet still 40% below its current market price.
This analysis suggests Nestle appears overvalued, even considering a generous PE of 50x. While one might be tempted to invest in a high-quality stock like Nestle at a PE of 80-90, historical evidence suggests market-beating returns are more often achieved with lower PE multiples.
Do check out all the multi-baggers in your portfolio. I am sure almost all of them you’d have purchased at a low PE multiple.
So, why break your rule and buy a stock with such a high PE multiple even though it is as good quality as Nestle?
Therefore, it’s vital to define personal investment and speculation boundaries based on logical valuation multiples that have proven effective. Investing in Nestle at its current price could be seen as intelligent speculation, but it’s doubtful whether it will yield market-beating returns over the next 3-5 years.
Intelligent investing requires a more conservative valuation approach.
Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com
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