FISHING FOR VALUE

Those grim days are gone when the equity market desperately needed some fresh air. Stocks are getting groovy again. Valuations are shining. As the market slowly but steadily finds its rhythm back, investors are faced with that age-old dilemma: to invest or not to invest. A lower P/E can be a temptation here. But it pays to be a little cautious. Management discretion while reporting revenue and expenses may influence reported net profit, thereby distorting P/E ratio analysis.

After recouping most of their losses over the last few weeks, Indian equity indices are once again headed for historical peaks. To some investors, this may signal soaring stock valuations, posing a dilemma when it comes to identifying investment ideas. But there is no need to panic. There are at least 26 stocks in the BSE 200 index which are trading at their 5-year low price-earnings multiples, or P/E ratios, the ubiquitous tool of investors to calibrate stock valuations. The stocks range from companies in sectors including automobiles, banking and finance, capital goods, construction and information technology to oil and gas, and power.
    Stocks of a majority of these companies have not been able to earn returns during the last six months, which could be one of the reasons why their P/Es are yet to surpass historical valuations. But does that make them worth a buy for the long term or is there more to it than meets the eye?
    While lower P/E numbers may be a preliminary cursor or guide to relatively cheap valuations, that itself cannot be a sole trigger for investment. To help you invest, the ET Intelligence Group looked at P/E valuations closely with a sharp analysis of some of the companies in the sample. Here is our pick of companies which you could look at for investing and stocks you should steer clear of.
    Price-earnings multiples of stocks offer a swift way to compare valuations. The ease of computation has made P/E ratio analysis popular among investors. P/E ratios of companies tend to move upwards in times of a sustained increase in equity indices. During the last six weeks, the Indian equity market has rebounded and so has the P/E ratios of stocks. We studied the trend in P/E ratios of companies that form part of the BSE 200 over five years ended March 2011 to identify whether there are any stocks that have historically lower valuations.
    We selected the BSE 200 index since it is a fair representation of the universe of listed Indian equities by contributing over 84% to the total market capitalisation of the Bombay Stock Exchange. The 5-year time frame which we have chosen is crucial since it covers the best and the worst of times on the Indian bourses. For instance, stock valuations were scaling new peaks in 2007 until early 2008. Equities tanked across the globe in the aftermath of the global financial crisis in the subsequent months. Valuations fell steeply during the fag end of 2008.
    Markets gradually recovered since the middle of 2009 with another bull run in 2010. As expected, the majority of the BSE 200 components today trade at higher valuations than in the past. Every four out five index companies command a P/E which exceeds the average annual P/E in each of the past five fiscals. This also reflects that at current market levels, valuations of most stocks are not cheap anymore.
    While this is true, there are still a few stocks — 26, to be precise — in the BSE 200 that currently trade at 5-year low valuations. Their average P/Es in March 2011 were lower than the average P/Es in the last five years. But mere low valuations do not justify an investment since they may not reflect the company's future growth prospects. In some cases, P/Es could be lower since growth in the long term is expected to be sluggish either because of company-specific issues or due to concerns that impact the whole sector or the economy.
    To provide more clarity, we selected 16 frequently traded stocks from our sample and analysed their past financial performance and also what lies ahead for these companies. We believe that there are 12 stocks which look attractive at current valuations, considering their prospects. Read on to find out why you should consider them and why you should avoid the rest.
What You Need to Know
Price-earnings multiple, or P/E, relates to a stock's market price to its annual net profit per share. A P/E of three indicates that the current stock price is three times its annual earnings per share. It also means that if the company maintains the current level of profits — without showing either growth or decline — then investors will take three years to make good their investment, assuming that the entire net profit is distributed in the form of a dividend.
P/E Pitfalls You Can Avoid
When a company reports a net loss, the P/E ratio becomes meaningless. In such a scenario, price-to-book or price-sales ratios may provide a better picture.
A lack of growth momentum may drive P/E valuations of a stock lower. Therefore, investors should study financia parameters and growth prospects before investing in low P/E stocks.

Vijaya Bank's bottomline grew at a compounded annual rate of 31% over the last five years.
    The growth of this South-based state run bank has been sluggish over the last two years, but over the past six months, it has streamlined its processes, and strengthened its credit appraisal system to aid advances growth.
    The bank recently received a capital infusion of 370 crore from the government. The infusion will help the bank improve credit growth and maintain its net interest margin at 2.8% or above.
    At a price-earning multiple of 6.6, the bank's valuation is cheap in comparison with P/Es of 8-10 for its peers. The future performance of the bank will hinge on its ability to maintain the momentum in advances and to curb bad loans.

Nagarjuna Construction Company's stock has almost reduced to half and is trading at a monthly average price earning multiple of 11.
    Even though the company has reported disappointing numbers in the quarter ended December 2010 due to execution delays, the inflow of orders remains strong in the last nine months.
    In addition to it, NCC recently acquired a 55% stake in the power plant, along with Gayatri projects. This is in line with its long-term strategy of getting into the power business, which is going to be a catalyst for a further upside, besides earning from regular revenue streams.
    Since NCC is well-placed to reap the benefits due to a well-diversified portfolio across the infrastructure segment, investors with a 2-year horizon can take exposure.

Hero Honda is the largest player in the domestic motorcycle market. However, its operating margins are significantly lower than its nearest rival, Bajaj Auto, as it has not been able to deal as well with rising input costs.
    For instance, during the trailing 12 months ended December 2010 quarter, Hero Honda's net sales grew 19.5% year-on-year to 18,132 crore while operating profit margin declined 390 basis points to 13.3%. This was much lower than Bajaj Auto's net sales which grew 51.9% during this period while operating margins grew 250 basis points to 20.6%.
    Furthermore, the entire process of Honda exiting from the Indian listed joint venture Hero Honda has been perceived to be opaque. Hero Honda trades at a P/E of 17.5 times on a trailing basis. Investors can reduce their position in this stock.

Tata Motors has benefited from a sharp revival in key European operations since the March 10 quarter. This is largely due to a pick-up in demand for these luxury brands in fast-growing emerging markets, including China and Russia. Apart from that, cost-cutting measures implemented at its European facilities have shown signs of paying off. Its overseas operations constitute nearly 62% of its consolidated turnover in the first nine months of FY11. Tata Motors trades at a P/E of 8.9 times on a consolidated basis on a trailing 4-quarter basis and appears attractively valued.

A slowdown in the contract research and manufacturing services (CRAMS) industry resulted in lower earnings for Divi's Labs. However, the segment is steadily recovering. Besides contract manufacturing, Divi's is engaged in manufacturing active pharmaceutical ingredients and nutraceuticals that have clearer earnings visibility. Nutraceuticals, though a small segment now, has a good growth potential. The company logged strong growth in the December 2010 quarter. Its high operating margins, strong balance sheet and debt-free status makes it an attractive player in the CRAMS segment.

Exide Industries posted a decline in net profit during the December 2010 quarter due to high raw material costs and moderation in sales revenue due to capacity constraints. Being the largest player in the segment, the company still has the discretion to fix prices, which helps in maintaining a higher margin as compared to its peer group. Furthermore, the continued boom in the automobile sector is going to act as a catalyst for better earnings in coming years. Investors can take an exposure to the stock in being a leader in its segment with the sustainable business model.

India Infoline (IIFL) has a diversified core business of equity broking and a bunch of other financial services. The company, unlike most of its peers, has been able to maintain its market share at 3.7% from the past three quarters. It also managed to report yields of around 8 basis points, which is much higher than 5-6 bps for the peers. In the December 2011 quarter, the growth of the company was mainly due to higher financing income of 225 crore. The brokerage sector in India is not doing well due to erratic capital markets and a shift in investors' focus on derivatives trading, which is a low revenue generating business. Given this, IIFL's prospects appear bleak in the medium term.

The stock price of IVRCL Infrastructures & Projects has reduced to half in the last one year. This is partly due to its depressed financial performance. Its revenue has grown at a compounded annual growth rate of 32% over the last three years, but its net profit grew only 10% on a consolidated basis during the same period due to an increase in cost overruns related to project delays. The company's orderbook-sales ratio of 4 looks promising, but execution is the major concern in coming quarters, which can impact the bottomline if there is any further delay. Investors may avoid fresh exposure to the stock despite its attractive valuation at least in the medium to long term.

A poor show in the December quarter and confusion over its proposed foray into unrelated business has led to a fall in Jain Irrigation's share price during the last three months. However, the worries appear overdone. The company's growth slowed down in the December 2010 quarter due to extended monsoons in various parts of the country. The sales of its irrigation products are expected to resume a normal growth trajectory in the March 2011 quarter. Its plans for preferential equity allotment and setting up a non-banking finance company (NBFC) are expected to lower its debt burden. With a vast untapped market for the micro-irrigation within India, the company's future appears bright.

Lanco Infratech's stock has fallen sharply in the last six months mainly due to high fuel prices and low merchant tariffs. Of its total capacity of 2,744 mw, Lanco sells 32% under merchant sales. It plans to sell an equal proportion of its proposed capacity of 7,222 mw under merchant sales while the remaining will be sold on a long-term purchase basis with a fuel cost pass through.
    With an improvement in the financial health of most state electricity boards, buying of merchant tariffs is expected to increase. The fuel cost pass through will insulate it from fuel risks. The current valuation of price to book value of three reflects all these risks.

MphasiS, the Bangalore-headquartered IT services company, has been reporting a sluggish trend in sales and profits for the last two quarters. The company earns more than two-thirds of its revenue from clients of its parent — HP. This business has not grown as expected in the last few quarters despite overall demand momentum. The frequent cut in billing rates is also a concern with the HP business. MphasiS has focused on growing its direct channel business, but the effort is yet to gain traction. The company's stock fell sharply in February after the dismal quarterly results. Its current stock level seems to have factored in the lower growth trajectory. Hence, a further drop in valuations looks limited. Investors may wait for another two quarters for signs of recovery in the company's performance.

BHEL has been trailing the Sensex for over a year now but its robust order book and strong financials (as reflected in the flash results) make it a good buy at current levels.
    Its outstanding order book, at the end of FY 11, was 1,64,130 crore, which is nearly four times its provisional FY 11 turnover. This gives it a reasonable revenue visibility over the next few years.
    In the light of growing competition from Chinese suppliers and easier Chinese financing options, cash rich BHEL has been contemplating the launch of its own Non-Banking Finance Corporation (NBFC).
    The NBFC will not only earn better returns on the current cash balance but will also help the company's equipment sales division.

Power Trading Corp invests in power projects. Despite losing market share during the last few years, the company has recorded a growth in the trading business. In the first two months of March 2011 quarter, the company has already traded 3,500 million units and is expected to exceed 5,000 million units as against 3,200 million units a year ago. However, its subsidiary Power Financial Services, which got listed last month, has pulled down valuations. PFS is in the business of power financing through debt and equity and PTC holds 60% in it. Though the trading business will continue to perform well, long-term investments of PFS will reduce the return on capital. Though PTC does not appear to be the best bet in power, investors can stay invested. At price to earning of 21, PTC remains a safe bet for the long term.

United Phosphorus (UPL) has acquired 10 companies and 12 products in the past seven years. This has resulted in 30% compounded annual revenue growth over the past six years. UPL will continue pursuing organic as well as inorganic growth, given a healthy cash balance of nearly 1,900 crore and debt-to-equity ratio of 0.8. The company has posted robust a double-digit growth in its bottomline during the last two quarters compared to the year-ago period. The company's operating margin has been in the range of 18-20% over the last few quarters. However, despite a decent financial performance, UPL's stock has underperformed the broader market. Given the company's strong product portfolio, its current valuation provides an attractive entry point with an upside potential.

The fall in the company's stock price has more than discounted the negative impact of litigation and muted growth in the US business on the company's earnings.
    The long-term growth drivers for Glenmark appear intact. A strong presence in the US, Asia, Africa and CIS, steady product launches, and a healthy pipeline of niche products are promising factors for the company. The stock is trading at a significant discount to its frontline peers.
    Considering the growth prospects of the company's base business, the stock is trading at an attractive price to earnings multiple of 16. Since the growth of the company's core generics business remains promising, the current weakness in the stock offers a buying opportunity for investors scouting the mid-cap segment.

The Gujarat State-owned natural gas transporter, GSPL, owns nearly 1,700 km of pipeline network and is planning to add another 1,000 km within three years. A consortium led by GSPL has bid for trunk pipeline projects of around 4,000 km. The company has created and is expanding key infrastructure in natural gas transportation. When growing big, the only major concern is whether domestic availability of gas will be able to match the capacities created, which has weighed on the company's valuations of late. However, this is mainly a short-term concern. As the domestic natural gas production grows in the medium to long term, GSPL's infrastructure will play a key role in connecting suppliers and consumers.

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