Revathi Asset Management

An industry is the sum of its parts

In theory, you would think that if a sector is expected to grow at a certain rate, then the weighted average growth of its constituents would also grow at a similar pace; this is basic math and logic. However, if we look at certain sectors of the Indian market, this is not the case. And the discrepancy is too large to justify by any rational means.

Let us take a quick look at the cement industry. Below is the consumption volume of cement in India from the financial year 2009 to 2023. The growth represents a CAGR of 4.54% over the 11 years. What we see is a very predictable trend. We are not at any extreme lows within that trend either, so we can’t even say that we should see some idiosyncratic growth in the next few years. Overall, this is exactly what a mature, well-known industrial sector looks like in any developed economy.

Meanwhile, prices have increased at a CAGR of 4.72% over the last 5.5 years from 225/bag in Jul 2019 to 290 in Dec 2024. So, combining the price CAGR and volume CAGR, we see a net annual multiplier of 1.0472 * 1.0454 = 1.0947, i.e. 9.47% growth, in the cement industry.

Furthermore, such a price increase is actually below the inflation rate from the same period. We bring this up because this will be important later. The inflation rate was at a CAGR of 5.69% from 2019 to 2024.

How narratives drive valuations

For our analysis, we take 7 of the largest companies in the cement industry. Their combined market share is just over 65%. The graph also shows a slight consolidation, with Ultratech Cement gradually climbing from 20% of the market share towards 30% over the last 5 years. Meanwhile, there has been no significant change in the overall market share of the next 6 companies.

This consolidation in a single company’s market share has led market participants to believe the narrative that higher consolidation in the industry will lead to higher pricing power and thus higher margins. This has led to a rise in the average EV/EBITDA that the market is willing to pay for the companies over the last 5 years. There has been a gradual but irrefutable increase in the average valuation of all cement companies since 2019. This is even though only one out of these top 7 seven companies has actually shown an increase in market share.

Does the narrative correspond to reality?

Logically, the argument is that higher consolidation leads to higher pricing power, which leads to higher margins and profitability. However, this is not the case when we look at the numbers. We see that profit margins have actually decreased over the same period as the valuations have increased.

Essentially, we are seeing that the narrative that was used to drive the higher valuations was being debunked in real-time as it developed. The industry consolidation may have played out (and that too, for one company only) but the margins have only gone down over the same period. We saw earlier that cement prices have gone up slower than inflation has over the same period, refuting any argument that consolidation has led to pricing power.

We also see that profit margins are approximately at historical averages. Thus, since we are not at extreme lows, it would be unreasonable to assume that the industry can massively increase margins over the next 5 years. From the perspective of estimating future cash flows and fair values for the companies, having profit margins at historical averages is a good thing; it makes the estimates more reasonable and fair.

Calculating implied growth rates from stock prices

Let’s now conduct a study using the reverse DCF methodology that we had used earlier. We take the same assumptions of a 7% discount rate and a terminal growth rate of 12% after 10 years. The table below maps the implied growth rate for the next 10 years that will justify each of the current stock prices. Out of the 7 stocks, only ACC is pricing in a “reasonable” growth rate and that’s partially because it has idiosyncratic issues like corporate governance.

There is an irreconcilable difference between the projected growth rate of 9.47% for the industry as a whole and the weighted average expected growth rate of 18.28% for the top 7 companies. About 65% of the industry is expected to contribute a growth of 11.95% towards the industry net 9.47% total.

This means that the remaining 35% should be priced to contribute a total of -2.48% of the industry’s net growth. This implies an average growth rate of about -7.18% for the remaining companies, for the math to work out on an industry basis.

However, this is not the case if we look at the valuations being paid for all the listed cement companies. The average EV/EBITDA of the top 7 companies is around 20.34. The average EV/EBITDA of the remaining cement companies is 30.25. Therefore, the average valuation that the market is willing to pay for the companies that should grow at -7.18% is even higher than that paid for the top 7 companies expected to grow at 18.28%. Consequently, no de-growth is being priced into the remaining companies.

When the parts are worth more than the industry

What we are seeing here is a mispricing in the constituents of a specific industry. There is no factual evidence (e.g. excessive upcoming government expenditure on infrastructure) nor any other idiosyncratic reason to assume that the cement industry should grow at a significantly faster rate than it has over the past 11 years. This is a mature, extremely well-known industry; it is not like the US technology industry for example, which has scaling laws or network effects.

The takeaway from studying sectors and stocks in this manner is that we should first deal with the question of whether a sector is worth investing in at a given point in time. It makes sense to do this before grappling with the question of which company in the sector to invest in because we might miss the forest for the trees. Over the mid-to-long run, it will be difficult for badly priced sectors to contribute to portfolio outperformance.

What we have seen is that:

• An industry growth rate is the top-line growth rate capable for its constituents as a whole.
• Narratives can take valuations out of whack for many stocks within a sector.
• The constituents can end up pricing in absurd levels of growth compared to the expected top-line growth for the industry.
• Before allocating within a sector, it may be worthwhile to answer whether it is worth allocating to that sector at all.