Learn How To Pick Value Stocks

Learn how to pick value stocks - The Economic Times
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By Narendra Nathan, Sanjay Kumar Singh & Sanket Dhanorkar, ET Bureau | 18 May, 2015, 10.19AM IST
When hypermarkets, online retailers and real estate developers offer discounts, the whole
world gets to know. But spotting a discount on Dalal Street is less obvious and more
complicated. Since the time of Benjamin Graham, the gurus of value investing have tried
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various ways to identify stocks that are trading at a discount to their actual value.
When you buy a share with a tremendous growth potential, you are a growth investor.
Value investing is different, and involves picking out shares that are priced below their
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intrinsic value. It's a contrarian strategy because it requires investors to embrace unloved
stocks.
"When you practice value investing, you are not jumping on to the bandwagon. You stand
alone," says Sankaran Naren, CIO of ICICI Prudential Mutual Fund. But swimming against
the tide can prove enormously rewarding for the simple reason that you buy good stocks at
beaten down prices. "Since you buy at a low price, the probability of loss of capital is
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lower," says Atul Kumar, Head of Equities, Quantum Mutual Fund.

Our cover story this week looks at this hugely successful albeit contrarian investing strategy. We put the 200 stocks in the S&P BSE 200
index through 10 filters. With the application of each filter, some stocks dropped out. In the end we were left with just 14 scrips. Of these
14 stocks, we have looked in detail at the fundamentals of the 10 scrips most recommended by analysts.
Value versus price
The price-to-earnings (PE) and price-to-book value (PBV) ratios are favourite tools of value investors. But a low PE or PBV alone does
not make a value stock. In fact, such stocks could well be value traps. "Many PSU banks, leveraged enterprises and real estate
companies are trading below their book value. They are not value stocks but value traps," says Nilesh Shah, Managing Director of Kotak
Mutual Fund. This is why no PSU bank made it to our final list. On the other hand, a quality stock at a high price is also not a good
investment. That is why we have eliminated all companies with a PE of more than 20 and a PBV of more than 5.
BPCL, along with other public sector oil marketing companies, stands to benefit from the government's decontrol of diesel prices. The
resultant subsidy reduction on oil products will reduce its working capital requirement and its interest cost.
Since international crude oil prices have now stabilised, there should not be any inventory losses in the coming quarters. What makes
BPCL unique, however, is its exposure to foreign upstream oil assetsin Brazil and Mozambique.
Though the counter suffered when crude oil prices of the Brent variety crashed from $115 dollars a barrel to less than $40 a barrel, the
recent recovery is helping BPCL.
"Since oil production from assets in Brazil and Mozambique is 2-3 years away, the recent fall in crude oil prices has only a sentimental
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impact on BPCL and the same may get corrected due to the recent surge in crude oil prices," says Sudeep Anand, Oil & Gas Analyst at
IDBI Capital.
To avoid the value traps, we have included only those companies that have consistently generated profits in the past five years.
Not only that, these companies should have registered at least a 10% annualised growth in net profit during these years. We also took a
close look at the operating margin and selected only those companies with a positive operating margin. This was to make sure that the
net profit was coming from business operations and was not extraordinary income.
ICICI Bank, led by robust growth in credit and better net interest margins (NIMs), reported a healthy set of numbers in the March quarter.
However, slippages from restructured loans rose higher, even as the number of loans that were restructured fell. With the management
expecting stressed asset formulation in the current fiscal year to be lower than last year's, concerns on asset quality should be allayed.
The bank, with capital adequacy of 17%, remains extremely well capitalised. Analysts insist that its capital cushion is more than adequate
to absorb further asset quality shocks, as well as exploit future credit growth opportunities.
Clyton Fernandes, Analyst, Emkay Global Financial Services, says, "We expect the bank's profitability during 2014-15 and 2016-17 to be
healthy, led by robust business growth, better NIM and stable credit costs. After the recent stock price correction, we upgraded our rating
from Accumulate to Buy."
We also took into account the return on capital employed (ROCE) ratio as well as the return on equity (ROE) and return on net worth
(RONW). This ensured that only efficiently run businesses made the cut. Also, companies with a very high level of debt can be risky. So,
all companies with a debt-equity ratio of more than 2 were eliminated.
The government's decision to allocate domestic natural gas to CNG and PNG distributors has come in as a boon for Indraprastha Gas.
In addition to this, the fall in international natural gas prices should also reduce the cost for consumers and thereby revive the company's
volume growth in the coming years.
With gas pipelines already laid across most of Delhi, the company's high capex phase is also almost over.
This will help it generate high free cash flows in the coming years. "With an expected free cash flow of Rs 1,400 crore between 2014-15
and 2016-17, Indraprastha Gas may also go for inorganic growthsmaller acquisitions in the city-gas distribution space," says a recent
report by UK-based investment bank Elara Capital.
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Margin of safety
One abiding principle of value investing is to buy a stock with a margin of safety. The margin of safety is the difference between the
intrinsic value of the stock and the price you pay for it. If the intrinsic value of a stock is Rs 100 and it is quoting at Rs 80, the margin of
safety is 20%. The higher the margin of safety, the lower is the risk and higher the returns potential.
The erstwhile IT bellwether is in a transformative phase under its new CEO Vishal Sikka. Even as the firm lags behind peers such as TCS
and HCL Tech, Sikka aims to make Infosys a $20-billion company by 2020 and return to an above-industry growth rate.
His strategy includes heavy-mining the company's top 100 clients, with dedicated partners for each, driving up margins through
automation, squeezing higher share of revenue from services such as consulting, and acquisitions.
Analysts are optimistic about Sikka's vision of taking Infosys away from its traditional maintenance-centric business model to a
next-generation technology solutions provider. Its current valuations make it a compelling buy, despite weakness in earnings.
Sarabjit Kaur Nangra, Analyst, Angel Broking, says, "The stock is cheap at current valuations, trading at a discount to its peers such as
TCS. We believe the gap in valuation can narrow down once growth picks up at Infosys."
As mentioned earlier, even a good stock at a high price is a risky investment. During bull runs, investors can get swayed by irrational
exuberance. In 2000, Satyam Computer was trading at a PE of 200. Many investors justified this valuation by citing Infosys' PE of 400.
LIC Housing Finance is a dominant player in the mortgage finance segment. Since 2006-07, the company has increased its loan book at
more than 25% compound annual growth rate compared to industry average of around 15-17%.
Its market share, at nearly 10%, has almost doubled in the last seven years. Disbursements have been largely driven by individual
borrowers a segment which will support a loan book growth of around 20% over the next three years.
Asset quality also remains healthy. Analysts see improvement in margins as interest rates come down due to an enhanced focus on
high-yielding developer loans.
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"Being a lead player in the housing finance space with margin improvement triggers, the company stands to benefit from the favourable
interest rate cycle, which will result in higher earnings visibility and superior return ratios," says Kunal Shah, Analyst, Edelweiss
Securities.
Says Sanjay Bakshi, Adjunct Professor at the Management Development Institute, Gurgaon: "You can't justify buying an overvalued
stock just because other scrips in the sector are trading at even higher valuations." On the other hand, if you buy an undervalued stock,
you not only reduce the risk but enhance your chances of earning higher returns.
M&M Financial Services, for the past several years, has been going through a bad patch. While the slowdown in commercial vehicle sales
was the trigger for an earlier correction, fear of a poor monsoon is dragging the counter now.
However, analysts feel while the cyclical stress has impacted its profitability, the inherent business model is still robust and, therefore, the
company will bounce back when the rural economy starts turning around.
That is why Rajiv Mehta of IIFL India believes the current valuation levels provide an accumulation opportunity.
"By 2016-17, we expect RoA (return on asset) to improve to 3.2% and RoE (return on equity) to improve to 20%, underpinned by
acceleration in asset growth, recovery in NIMs and moderation in credit cost," he says.
Most investors don't buy a stock for its dividends. Even so, the periodic payment of dividends to shareholders is a good indicator of the
company's financial soundness. What's more, the dividend yield (which is the dividend as a percentage of the share price) is high
enough, it lends a margin of safety to the stock.
NMDC, because of the drastic fall in international commodity prices and a sluggish demand from domestic steel mills, has been forced to
reduce iron ore prices in recent months.
This is to ensure that steel mills do not continue to rely on imports to avail of high-quality, low-cost, ore.
Price cut has led to a steady decline in NMDC's stock price, and it is now emerging as a good value pick, given that it continues to grow
its share in the country's iron ore production at a steady pace.
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Also, being the cheapest producer, it boasts of the highest operating margins in the sector. It has also embarked on value addition projects
by setting up pelletisation plants as well as a 3 million tonne per annum ultra mega steel plant in Chhattisgarh.
In our study, we have included companies that have consistently paid dividends for the past five years. Also, the dividend payout (which
is the dividend as a percentage of the earnings per share) should have been at least 10% of the profit in each of the five years.
The Indian demand is expected to pick up significantly due to lower liquefied natural gas (LNG) prices and this should help to improve
Petronet LNG's margin in the coming quarters.
However, the counter is under pressure now because of its high-cost, long-term LNG purchasing contract. Analysts, though, are hopeful
that this problem will get solved soon.
"Petronet LNG has backto-back contracts with the gas distributors GAIL, BPCL and IOCand Petronet LNG expects them to honour
those contracts," says Sudeep Anand, Oil & Gas Analyst at IDBI Capital.
So, investors should use the current correction in the counter for long-term accumulation.
Value versus growth

Though value investing can yield handsome returns, it has not done too well in the past six years. In a recent report, Mumbai-based
Phillips Capital points out that value investing does not work when investor sentiment is down. Between 2009 and 2015, when the
slowdown in the GDP growth stalled projects and hyperinflation dampened investor sentiment, the MSCI India Value index
underperformed the MSCI India Growth index by almost 300 basis points.
However, Phillips Capital also notes that this is set to change because the economy is now getting back on track and investors are willing
to take more risks.
The ongoing power sector reforms initiated by the government bode well for financier Rural Electrification Corporation (REC). While the
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financial viability of state electricity boards is improving with their restructuring, steps taken by the government towards augmenting fuel
supply are also encouraging.
REC's competitive position remains strong in the power financing space, supported by its nodal agency status, ability to lend for longer
tenures, and the benefit of lower funding cost.
Its NIM has significantly improved over the past few years, aided by a strengthened pricing power and higher share of private sector
generation.
Akshay Dalmia, Analyst, IIFL, says, "The company is likely to witness a pick-up in disbursements and asset growth over the coming three
years. It would deliver RoA of above 3% and RoE in excess of 20% in the longer run."
The brokerage has allocated almost 36% of its model portfolio to value stocks. "As we expect the onset of a capacity-creation phase,
value investing will soon become the dominant investment strategy," it concludes.
Despite being one of the fast growing banksits net profit has grown at an annualised rate of 41% in the last five yearsit is still quoting
at reasonable valuations.
Yes Bank is now focussing on the retail segment and, given its relatively low share, this should be its next growth engine.
Due to higher interest rate offered by the bank on its savings accounts, its CASA (current and savings account) funding base is also been
improving over the years, helping the bank bring down its cost of funds.
Due to increased reach and softening interest rate structure, its NIM should improve further from the current 3.2%.
What not to expect

A few caveats for investors. Value investing is another name for patient investing. Don't expect fireworks from your value picks. "Value
investing reduces the downside risk to some extent but value stocks also take time to appreciate. The stocks may remain at a discount
for a prolonged time," warns Dinesh Thakkar, Chairman and Managing Director, Angel Broking.
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Then again, you need to hold these stocks for the long term to be able to get the best returns. Warren Buffett, arguably the most
successful value investor of all time, is still holding stocks he bought 30-40 years ago. Buffett says his favourite holding period is
"forever". While we do not agree with this philosophy of investing in perpetuity, the stocks we have shortlisted for you could offer good
returns over the next 8-10 years. Happy (value) investing.
HOW WE DID IT
Here's how we applied 10 filters to identify value stocks from the BSE 200 universe.
1. We started with the 200 stocks in the S&P BSE 200 index. Since it is a large cap index, small and midcap stocks get eliminated
2. To avoid value traps, only companies that made profits during the past five years were considered29 companies fell out, leaving only
171 stocks.
3. Of these profitable companies, only those with at least 10% annualised net profit growth were considered67 companies fell out,
leaving only 104 stocks.
4. Next, only companies with positive operating margin were retained to ensure that the net profit is from business operations and not
from other incomes1 stock moved out, leaving 103 stocks.
5. While profits are good, they must justify the investment in the business. Only stocks with at least 10% ROCE were kept8 companies
fell through, leaving us with 95 stocks.
6. Also, the RONW should be at least 15% to ensure that only companies generating enough profits are considered. 17 companies
moved out, leaving only 78 stocks.
7. The next filter was a debt to equity ratio of less than 2. None of the companies had a debtequity ratio of more than 2 so all 78 stocks
remained.
8. Next, only stocks that paid dividends in the past five years and distributed at least 10% of their profits as dividend were kept20
companies fell out, leaving us with 58 stocks.
9. A good company can be a bad buy at a high price. Stocks with a PE of over 20 were kept out40 high priced stocks fell out, leaving
us with 18 stocks.
10. Another valuation metric is the price to book value (PBV). The PBV can vary greatly, so we kept a liberal cut off of 5. Three
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companies got dropped, leaving us with 15 stocks.

11. Lastly, only stocks with a dividend yield of at least 1% were considered. One company moved out. Leaving us with 14 value picks.
Of these, we have analysed 10 stocks for you in detail. These 10 stocks have been chosen on the basis of analysts' recommendations.
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Search for News, Stock Quotes & NAV's

You are here: ET Home Markets Stocks News

Quick Release Bail Bonds.

ET SPECIAL: Love visual aspect of news? Enjoy

lower," says Atul Kumar, Head of Equities, Quantum Mutual Fund.