Over the past few months, we have liked HDFC (Rs. 630) as an investment, and have invested in the same.

HDFC is India’s leading housing mortgage financier, having started operations in 1977, and incubated leading financial powerhouses like HDFC Bank, HDFC Insurance, HDFC Mutual Fund etc. HDFC has generated tremendous value for its shareholders over the past 2 decades, and is classic product of “Lollapalooza Effect”:

1. Strong tailwind of secular growth in business

2. Great Risk Management System

3. High degree of corporate governance

No wonder, the stock is up 15 times over the past 12 years, in addition to generous dividends!

Now, let’s look at the stock price over the past 4 years, for the period Jan 2008 – May 2012.

The stock price has been effectively stagnant over the period Jan 2008 – Mar 2012 at around Rs. 600 per share, as shown in the above chart. As the business has grown by around 20% a year, the business value has actually doubled over the past 4 years. Now, one can argue that since Sensex is down by 20% over the same period, the stock has outperformed. But that is only relative outperformance, what we as investors require is absolute outperformance over long term, beating inflation at the minimum.

What happened? If we look at the valuations in Jan 2008, they were way off the charts – it was trading at high 5x forward P/B (after adjusting for investments). So while the mortgage business continued to grow at CAGR of 20%, the valuations have fallen to more sensible 2.7x forward P/B (again after adjusting for investments).

So, while there has always been a debate about pros and cons about investing in quality vz. cheap, there are two key lessons in this:

1. Over long period of time, quality stocks outperform normal stocks (represented by Sensex in this case).

2. If you pay high initial price for quality, the subsequent returns can be quite mediocre, defeating the purpose/ risk reward equation of investing in equities.

Happy Investing !