As a company increases in size, growth tends to slow down due to problems in scaling
Indian subsidiaries of foreign parent companies listed on Indian stock exchanges are unanimously considered titans of quality and “value buys” for the long term. Their high P/E valuations are a testament to their widespread reputation in the investing world. However, the perception that they serve to be compounding wealth machines is questionable.
A company such as Hindustan Unilever, with brands like Dove, Lifebuoy, Kissan, etc., has excellent brand recall and is undoubtedly a fantastic business with zero debt. This might lead one to believe that it makes for a good investment, but as Howard Marks says, “no asset is a good investment at all prices.”
Despite having solid fundamentals, HUL makes for a poor investment due to its extravagant valuations compared with its prospective investment return. As of August 11, HUL is trading at a price-to-earnings ratio of 68.55, with a dividend yield of 1.3%. The argument many investors make to buy HUL at this valuation is its supposed growth prospects and brand recognition. At most, HUL has shown a compound average growth rate of 14% from 2010-2021.
A P/E ratio of 68.55 is a valuation equivalent of a high-growth tech company. It is safe to say that HUL will not be able to post growth rivalling a high-growth technology company due to many reasons. The principal one is that as a company increases in size, growth tends to slow down due to problems in scaling.
Moreover, the problem with HUL and other foreign subsidiaries which are listed in India is that the dividend payout ratio is high. The consequence of a high payout ratio is made apparent when the parent company Unilever owns more than 60% of the company. The subsidiary (HUL) is a way for the parent (Unilever) to extract profits as dividends with minimal capital expenditure, which is necessary for maintaining growth. Unfortunately, the problem stretches further than just a high dividend payout ratio and a high P/E ratio. The subsidiary is also made to pay a ‘royalty’ to the parent aside from a profit share. This is a losing trade for the retail investor, who loses out a portion of his EPS in royalty expenses. This problem includes all principal foreign subsidiaries listed in India such as Nestle, P&G, and Colgate-Palmolive.
Nonetheless, there is a way for retail investors to invest in these wonderful businesses while avoiding the problem mentioned earlier. An investor could invest in the parent company Unilever listed on the London Stock Exchange. The RBI has allowed retail investors to purchase stocks from foreign exchanges. Further, financial firms and brokerage houses have made it possible for retail investors to purchase these parent companies. Unilever trades at a much more modest P/E valuation of 23.71 and offers a greater dividend yield of 3.53%.
Additionally, the retail investor will be able to capture the supposed high-growth prospects of its unit HUL due to Unilever’s majority stake. In contrast to a P/E ratio of 68.55 and a meagre yield of 1.3%, a P/E ratio of 23.71 and a yield of 3.53% while retaining growth prospects is a bargain. This disparity in value is not restricted to only HUL.
Also, after accounting for the depreciation of the rupee, the retail investor makes a hefty return in the long run as he invests in the dollar/pound, which gains in value. The dollar has appreciated more than 60% over a period of 10 years from 2011 to 2021. If the retail investor does not wish to invest abroad, he can invest in a low-cost passive NIFTY index fund to compound his wealth over the long term, while remaining diversified in over 50 large companies. Thus, it is prudent for the retail investor to avoid these overpriced units favouring their parent companies.
(The author can be reached at anand.s.srinivasan@