Going beyond low prices

Going beyond low prices
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First Published: Sun, Mar 22 2009. 11 27 PM IST

Updated: Sun, Mar 22 2009. 11 27 PM IST
Bargain hunters would find no time better than now. Low share prices have given investors an opportunity to buy good stocks. In the first 10 days of December alone, one-third of stocks from a sample of 846 stocks with market capitalization above Rs100 crore touched their 365-day lows. Of these, 150 stocks had price-earning ratios (PE) of below five.
So, are all cheap stocks good bargains? No, because a decision based only on these striking numbers is not stable enough. “When prices fall below a certain level, investors tend to think that the stock has become cheap. But these are just numbers in our heads. The stock’s intrinsic (real) value may be less than that number,” says Sanjay Bakshi, CEO of Delhi-based investment company Tactica Capital, and visiting professor at Management Development Institute, Gurgaon.
The right thing to do is to check why the stock is trading cheap, especially when you are basing your decision on widely quoted numbers such as earning multiples, book value (BV) and cash-flow ratios. Other risks also need to be considered.
Bad management
Three years ago, MTNL was trading at a PE of 10, one-third of its competitor Bharti Airtel. MTNL was losing its market share, growth in its core business was slow and the management was not efficient enough to drive its value. The market correctly discounted this fact and assigned a lower value to its stocks, which continues till now. Ignoring this fact, a bargain hunter could have been fooled into believing that MTNL was a value stock and would have bought it in a relatively expensive market (the Sensex PE was 18 then). MTNL stock returns have been negative in this three-year period.
Also See Not the Best Deals (PDF)
Tobacco major Kothari Products’ sales have not picked up in the last 10 years. Its total income in FY98 was Rs272 crore, and it was Rs263 crore a decade later. The market is paying only three times earnings, which, perhaps, is correct, considering the stagnant growth. Investing in Kothari Products will be a mistake, even if it’s coming cheap, because the market will continue to discount its value and the price may fall further.
Non-performing assets
A stock trading below its book value (the difference between its asset and liability) does not necessarily make it a good investment option. The market will usually discount a company’s assets below the investment incurred on it when the company has not deployed it efficiently and is generating insufficient earnings.
“Return on equity (RoE, a measure of profitability) and per share book value ratio are correlated. If RoE was 10%, then, as a thumb rule, these (stocks) would be trading at the book value or maybe half of the book value,” says Manish Sonthalia, senior vice-president, equity strategy, Motilal Oswal Securities.
Yarn manufacturer Vardhman Textiles’ RoE fell from 18.57% in FY05 to 10.82% in FY08. Its asset utilization ratios also declined and its book value fell one-tenth during this period. The same is the case with companies such as JK Paper and TVS Motor (see ‘Not The Best Deals’).
Promoter risk
The Satyam fiasco was a rude reminder of the importance of promoters’ evaluation in investment decisions. What we know now is that its promoter inflated the cash balance figures which, till recently, were considered the company’s strong point. While no one expected the nature and magnitude of the promoters’ fraud, there was always a risk of their doing something desperate to keep the company under their control as their holding was very low.
In today’s market, you may find a company whose market value has gone below the cash on its book. These stocks are cash bargains, but not all are value stocks. “When (the) market prices stocks in such a way, it is giving you a signal that it (cash) belongs to promoters and not shareholders. That’s why you have many companies trading below cash levels,” says Sonthalia.
Stacks of cash can also be questionable because if the business is not able to find ways to deploy the cash, it may mean its operations are losing profitability and may eat into the cash. Also, not all the cash on the books is coming to the shareholders. “These aren’t real bargains because you can’t liquidate the company and get the cash immediately,” says Bakshi.
Reversal in growth cycle
In January 2008, investors paid around Rs50 for each rupee of expected earnings for real estate companies. Now, you have to spend only Rs5 for each rupee of expected earnings. Many may think that they are paying the correct price at this level. What’s forgotten or ignored is the cyclical nature of the real estate sector. In January 2008, investors were paying more on the basis of the high growth expected in the sector. Now, a PE of even 5 is not low as the growth rate doesn’t correspond to it. Therefore, if you buy now, you may actually end up paying more than the actual value of the stock.
Metal companies are similar. They commanded an average PE of around 45 in January 2008, when commodity prices were high. But in the backdrop of the global economic slowdown that may further bring down metal prices, a sharp fall in PE—currently at 17—still makes metal companies unattractive.
You should run similar checks for stocks in other cyclical sectors such as automobiles, airlines, infrastructure, shipping and consumer durables.
So the next time you find a stock in a depressed market that you consider a value stock, be sure to check why it is trading at a low price. Make sure the market hasn’t mispriced it. Or, you may be left holding a dud.
The views expressed on this page are not the newspaper’s opinion and are provided for information purposes only by Outlook Money. Readers are requested to do their own research. Neither Mint nor Outlook Money will be responsible for any actions and outcomes based on information provided here.
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First Published: Sun, Mar 22 2009. 11 27 PM IST