Financial analysts usually know which companies are healthy and which are not. Naturally, they are expected to advise investors to buy the stocks of good firms, while avoiding the stocks of bad ones. So why should a research report from Nomura International (HK) Ltd advise investors in India that there’s “Poor value in ‘Good’ stocks. Good value in the ‘Bad’. Buy the ‘Bad’”.
The reasons are pretty simple. The research group has classified firms as “good”, “bad” and “ugly” based on their Altman Z-scores. These scores are based on a formula that attempts to arrive at the financial health of a firm by measuring its liquidity, profitability, operating efficiency, asset turnover and market expectations. Originally, it was used to predict the probability of a bankruptcy. But why look at a credit measure instead of an earnings one? Because, as Nomura analysts Paul Schulte and Mixo Das write: “We are in a solvency crisis—not an earnings crisis. Deleveraging will affect us for the coming years. P/Es will not help us very much, we believe. We need to fall back on book values and solvency criteria to determine the probabilities of insolvency and the value of equity at the bottom of the capital structure.”
Also See The Dash For Trash (Graphics)
So which firms, according to Nomura, are “good” among Indian firms? Among the companies with a high Altman Z-score are Oil and Natural Gas Corp. Ltd (ONGC), Reliance Industries Ltd, NTPC Ltd, Wipro Ltd, Tata Consultancy Services Ltd (TCS), Bharat Heavy Electricals Ltd (Bhel), Sun Pharmaceutical Industries Ltd, Infosys Technologies Ltd, ITC Ltd, Hindustan Unilever Ltd (HUL), Grasim Industries Ltd, ACC Ltd, Ambuja Cements Ltd, Crompton Greaves Ltd, Ultratech Cement Ltd and Hindustan Petroleum Corp. Ltd (HPCL). (Very surprisingly, this list also includes Satyam Computer Services Ltd, though it’s unclear how they could gauge its financials—they probably forgot to take it off the list.)
Among the “bad” are Tata Steel Ltd, Indian Oil Corp. Ltd, Tata Power Co. Ltd, Jindal Steel and Power Ltd, Larsen and Toubro Ltd (L&T), Tata Motors Ltd, Reliance Infrastructure Ltd, Ranbaxy Laboratories Ltd and Indiabulls Real Estate Ltd. And some of the “ugly” companies mentioned by Nomura in terms of the Z-score are Power Grid Corp. of India Ltd, Suzlon Energy Ltd, GMR Infrastructure Ltd, Jaiprakash Associates Ltd and Unitech Ltd.
After classifying these companies, the analysts then determine their valuation, with price-to-book value being the main factor. They then classify each of the good, bad and ugly company into “cheap”, “fair value”, “expensive” and “sky high”. The report points out that “India’s ‘good’ franchises have been among the worst-performing groups in Asia. The ‘bad’ moved hard and the ‘ugly’ rocketed and beat the ‘good’ by a factor of two. The ‘good’ in India also offer among the best Return on Equity in Asia.” The analysts advise investors to avoid the “ugly” stocks because they have moved up too fast.
But why should anybody love “ugly” stocks? Because as the government reduced insolvency risk, these beaten-down stocks revived. Nomura believes, however, that this risk-reduction trade is over and it’s time to switch attention to the “bad” group. Also, as the note points out, “if we slip on any macroeconomic or policy banana peel, the ugly will likely get clobbered.” But the “good” group is already over-owned, because investors had bought into many of them as defensives. Among them, though, they do recommend a few cheap stocks such as ONGC, HPCL and Housing Development and Infrastructure Ltd (HDIL). Their main recommendations are among the “bad” group, with stocks such as IOC, Mahindra and Mahindra Ltd (M&M) and Tata Tea Ltd. They also say that Tata Motors is restructuring its balance sheet, which is often an attractive opportunity for equity shareholders.
Well, Tata Motors was up 22% since the declaration of the election results. HDIL has moved up 44%. But Tata Tea hardly moved at all and IOC was up moderately, as was M&M. Yet stocks such as Unitech and GMR Infrastructure too have gained considerable ground recently.
Incidentally, the “dash for trash”—the equivalent of Nomura’s ugly stocks—in the recent rally has been a constant complaint. A JPMorgan note on European equity strategy, for instance, had this to say: “Low-quality names did very well during the rally (broadly defined as the most leveraged, the biggest underperformers, lower ROE and ‘value’ stocks). The fundamental factors, such as earnings momentum, did badly, actually showing an inverse correlation with stocks’ relative performance. As volatility edges lower, we believe this will start to change, and we expect investors to become more selective, looking for ‘higher quality’ stocks. In addition, we see earnings momentum becoming an important positive driver of relative stock performance again with the stocks of companies showing upgrades to earnings starting to outperform.”
That sentiment is echoed by the Nomura analysts. They say that “the default risk reduction rally (brought to you by governments) is over. A muted sequential recovery rally is now to come, in our view. Unlevered Asia will receive Western liquidity. Differentiation will be prominent”.
While that differentiation may favour the “bad” over the “good”, the markets is increasingly showing signs that the dash for ugly stocks is over.
Graphics by Ahmed Raza Khan / Mint
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