ETMarkets PMS Talk | The biggest de-rating warning? When market expectations outrun business reality: Swati Khemani

Strong earnings growth does not always translate into strong stock returns. In fact, companies can compound profits at 20-30% a year and still deliver negative returns if the valuation multiple contracts sharply. For investors, that makes understanding what is already priced into a stock just as important as forecasting future earnings.

Swati Khemani, Founder & CEO of Carnelian Asset Management & Advisors, believes de-rating is the “other side of alpha” and one of the most underappreciated risks in equity investing. She argues that the biggest warning sign emerges when market expectations begin to move faster than the underlying business, leaving little room for positive surprises.

In this edition of ETMarkets PMS Talk, Khemani explains how investors can identify stocks where future growth is already priced in, why high institutional ownership can become a risk, and how competitive intensity, weakening return ratios and aggressive capital allocation can signal an impending de-rating.


She also discusses why valuation discipline becomes particularly important in mid- and smallcaps, and why a great business can still be a poor investment if bought at the wrong price. Edited Excerpts –

Q) Your latest investor letter makes an interesting point about de-rating being the “other side of alpha”. Investors typically focus on earnings growth, but how important is it to also assess the risk of valuation multiples contracting?

A) Assessing multiple contraction is absolutely critical and much under appreciated. Most investors spend considerable time forecasting earnings, but relatively less time thinking about what could happen to the multiple because earnings are easier to model. The multiple gets far less attention, even though it drives returns just as much.

We've seen companies compound profits at 20-30% CAGR and still deliver negative stock returns over five years, because the multiple contracted even as earnings grew. A rupee lost to a falling multiple hurts exactly as much as a rupee not earned from growth.

That's why we think of de-rating as MAGIC running backwards — and avoiding it is as important to alpha as finding great growth stories. If you only track earnings and ignore what the market is willing to pay for them, you're solving half the equation.

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Q) We have seen companies deliver strong earnings growth but generate relatively poor stock returns. How can investors identify when future growth is already fully priced into a stock?

A) The starting point is to work backwards from the valuation. When a stock trades at a high multiple, investors should ask: what expectations are already embedded in the price, and is there enough room for the company to outperform them?

This means looking at the growth, margins and return ratios required to justify the current valuation.

Investors can get trapped by both consensus comfort and narrative comfort. A company may have a strong track record or be part of an attractive structural theme, but that does not necessarily make the stock attractive at any price.

We saw this in new-age companies in 2021, where genuine growth themes eventually became associated with very optimistic valuations.

Another example is of Aptus Value Housing Finance. Its profits grew from about ₹267 crore to nearly ₹943 crore, a CAGR of roughly 28%, after listing, yet the stock delivered a negative return.

The tell is comparing embedded expectations (implied by the PE multiple) against realistic growth trajectories.

If a company needs to not just execute well, but exceed already-aggressive expectations to justify its price, that's a red flag. Good results confirming what's already assumed bring no extra reward.

Q) The letter highlights two different forms of de-rating — one where earnings grow but valuations contract, and another where both earnings and multiples decline. What are the early warning signals investors should watch for?

A) There are two broad forms of de-rating. The first is where earnings grow but multiples shrink. Watch for over-ownership.

When institutional holding in a stock becomes extremely high and owning it becomes consensus rather than conviction, there's no one left to bid it higher.

The second is more painful, where both earnings and multiples decline. Watch for rising competitive intensity, regulatory dependence, governance red flags, or a company suddenly committing a large part of its balance sheet to acquisitions or capex.

In each case, the market loses its anchor on what the business is actually worth, and revalues it downward well before earnings confirm the damage. Rate of change matters more than absolute levels.

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Q) When a stock becomes a consensus holding among institutional investors, can high ownership itself become a risk to future returns because there are fewer incremental buyers left?

A) Yes, and it’s one of the most underappreciated risks. Once a stock becomes something everyone holds, not out of fresh conviction but simply because it has always been held, there may be no marginal buyer left to push the multiple higher.

HDFC Bank is an example we discuss in our recent letter. It was an extremely widely owned stock, and investors continued to be anchored to its strong historical track record.

The issue was not that the company suddenly became a bad business; rather, the market’s expectations and valuation had to adjust to a different rate of growth.

So, I would treat high institutional ownership as a signal to investigate more deeply,not as a standalone sell signal. The question is whether there are still sufficient reasons for a new investor to pay a higher multiple.

Q) Markets often attach very high valuations to the “next big thing”. How can investors distinguish between a genuine structural growth opportunity and a compelling story that has simply become too expensive?

A) A genuine structural opportunity and an expensive investment can coexist. Understand whether the underlying structural change is real and sustainable, and assess how much of that opportunity is already reflected in the valuation.

A company can benefit from a strong long term trend and still be overvalued if the market has priced in an exceptionally optimistic outcome.

We saw this with new age companies and specialty chemicals, where genuine structural themes eventually led to very high valuations across a wider set of companies.

The discipline is to come back to the fundamentals: growth, profitability, return on capital, competitive advantage and cash flows, and assess whether they justify the valuation.

Ask basic questions: does this business actually have a differentiated moat, or is every company in the sector suddenly branding itself with the same buzzword?

Compare current multiples to pre-hype levels and to what growth would need to look like to justify them. If you can't tell whether you're looking at a genuine trend or early euphoria, that uncertainty itself is a signal to be cautious.

Q) Mid- and smallcaps can experience sharper re-rating and de-rating cycles. Does that make valuation discipline even more important when investing in this segment?

A) Valuation discipline is important across market capitalisations, but the consequences of getting it wrong can be sharper in mid and smallcaps.

These companies often have a narrower investor base, lower institutional ownership and thinner trading floats, which can lead to larger swings in valuation when expectations change.

This works both ways. When earnings and expectations improve together, these stocks can re rate sharply. But when the narrative changes, the de rating can be equally severe.

That is why investors need to distinguish between business momentum and valuation momentum. A rising stock does not necessarily mean the fundamentals are improving at the same pace.

In mid and smallcaps, we would therefore place greater emphasis on the margin of safety: understanding the growth assumptions embedded in the valuation and the downside if those assumptions take longer to materialise.

Q) Can a stock be fundamentally right but still be the wrong stock to own at the current valuation?

A) Absolutely. A great business is not automatically a great investment at every price. You can be right about a company’s competitive advantage, growth opportunity and long term earnings trajectory, but still earn poor returns if you pay too much for those qualities.

The market rewards growth relative to what is already embedded in the stock price. Bajaj Housing Finance is a good recent example: profits have doubled since listing, yet the stock is down sharply, because the IPO priced in years of expected growth upfront. The business didn't do anything wrong - it delivered exactly what was expected.

But when there's nothing incremental left to reward, even a great company can be a poor investment at the wrong price.

Q) What is the biggest red flag that tells you a stock may be heading towards de-rating, even before the earnings numbers deteriorate?

A) The biggest red flag is a widening gap between market expectations and the rate of change in the underlying business. The business may still be delivering strong absolute numbers, but if competitive intensity is rising, return ratios are peaking, incremental capital is generating lower returns, or the industry structure is changing, the trajectory may be weakening.

Another warning sign is when the valuation depends on increasingly optimistic assumptions. In such cases, even a small disappointment can lead to a sharp correction in the multiple.

Ultimately, de rating often begins with a change in investor belief before it shows up in earnings. The market starts questioning whether the business is as exceptional as previously believed, and the multiple can adjust well before the financial statements reflect the change.

That is why investors need to continuously challenge their assumptions, not just build them, and watch for signs that expectations have moved ahead of reality.

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times.)