The Three Stocks We Plan To Never Sell

“Our favorite holding period is forever”- Warren Buffet.

Along the same vein, there are three stocks in our portfolio that we plan to hold on forever. These companies have generated super normal returns while delivering consistent growth for decades. Sometimes it is difficult to understand why these companies, whose products are very nearly a commodity, are so dominant and why the competition has not been able to catch up to them. The answer probably lies in the question itself as the commoditized nature of the product makes it difficult for a new entrant to differentiate themselves.

Of course, there is no guarantee that the earnings of these companies will grow at the same rate in the future, but they are well-positioned to continue to generate a superior return viz-a-viz the economy and the industry. This is also in line with our mandate to outperform the broader market over the long run.

The three stocks we are talking about are HDFC Bank, Asian Paints, and Pidilite Industries. HDFC Bank operates in the highly regulated banking sector. Asian Paints and Pidilite operate in the adjacent Paints and Adhesives industry.

Incumbent’s Advantage

One common theme across these companies is the incumbent’s advantage. These companies are market leaders in the segment they operate. Incumbent players usually have an advantage and more so in an emerging market like India, where it is next to impossible for a completely new entrant to challenge these established players. The various regulatory hurdles and the challenges in acquiring the required Land & Capital to set up manufacturing plants would be a daunting task even for established business houses leave alone new entrepreneurs. Also, if a different business family enters this space, it would be difficult to replicate the single-minded focus of these companies and their management expertise.

Brand as a Moat

The three companies have built an enduring brand and are some of the most identifiable brands in India with extraordinary brand recall. Given this, they are usually able to pass on the increase in costs to their customers and thus able to maintain their phenomenal margins and return ratios. For instance, HDFC bank was able to hold on to its saving deposits in spite of the higher interest rates offered by, the newer players in the banking industry after the deregulation of interest rates earlier this decade.

Management Integrity

Another common and the most important theme across these companies is the integrity of the Management. This is a subjective element, but there are a few factors such as promoter Shareholder pledging, Related party transactions, Acquisitions in entirely unrelated business, Unnecessary foreign subsidiaries, etc. to assess the integrity of the promoters and their commitment towards minority shareholders. The practices above are not per se illegal, but from experience, these are some of the common red flags we get to see in a company with weak corporate governance.

Concerns over Valuation

Sometimes it is pointed out that these companies are trading at expensive valuations. HDFC bank is trading at around 28 times earnings and more than four times its book value. Asian Paints and Pidilite are trading at a PE ratio of more than 60. So yes, it does look expensive, and that is the premium you pay for such high-quality stocks. Of course, we would like to lap up those Net-nets and deep value stocks, but they don’t come by easily, and the seemingly attractive stocks in terms of valuation often end up having shaky corporate governance and business ethics.

Does this overvaluation make these companies unattractive for a long term investor? Let’s assume that these companies will continue to grow their earnings per share at a similar rate as their historical growth rate of around 20%, and the PE compresses by a factor of 2 during different holding periods to calculate the returns.

The longer you hold, the better it is

As you can see, the effective returns still look phenomenally high, especially if you have a very long term investment horizon. For a 30 year holding period, we are looking at an annualized return of 17.28%. Even with a shorter time frame of 10 years, the annualized return is a good 13.65%.

Of all the metrics that we use to make a buy or sell on a stock, the valuation is the last step for us, and we are willing to pay a premium for quality businesses that we plan to hold on forever.