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Is it right to re-value stocks?

Value stocks have the potential to rise but one can't apply a broad brush

With reform announcements taking centre stage and pushing up markets 8% in two months, interest is getting generated in hitherto neglected stocks. The last two years have been dominated by high growth stocks, which, investors were willing to keep buying despite high valuations. Broadly these were shares of companies with high cash flow visibility and growth rates higher than the market. These were largely in sectors such as consumer durables, non-durables and healthcare. Of the top 15 stocks (by return) on the BSE 200, nine are from the sectors mentioned above. All these stocks have delivered more than 55% return in the last one year, where as the Nifty has delivered around 10%.

But now the macro environment is changing with the government announcing various measures to arrest the fiscal deficit, to support the currency and other measures to shore up growth. Additionally, the monetary easing cycle may be around the corner as inflation looks less likely to move higher while concerns on growth are mounting. Given this backdrop, many analysts and fund managers are optimistic about the tide turning in favour of some undervalued stocks which have good return on equity but that hasn’t been reflected in stock prices.

Value versus growth

First let’s make sure you can distinguish between growth and value stocks. Growth stocks are those where the underlying company’s earnings are growing at an above average rate. Earnings visibility with a strong balance sheet is reason enough for such stocks to quote at a premium especially when times are uncertain. Value stocks have a good return on investment and earnings, but due to either external pressures or balance sheet stress in the form of debt, don’t get a fair value in the market. At present, such stocks are seen in sectors such as capital goods, infrastructure and even state-run banking where price-to-book values are low, but earnings and return on equity are stable. Says Harsha Upadhyaya, head-equities, Kotak Asset Management Co. Ltd, “Classification of value stocks can vary, but essentially they represent stocks of those companies which are trading (market price) at a discount to their replacement value. High dividend yield, low price-to-book ratio and low price-to-earnings ratio are some of the common characteristics of value stocks."

Why value stocks now

The second half of 2012 has seen a change of air in the country. The first half saw a moribund government even as inflation and growth concerns abounded. It is only after the change of guard in the North Block that there are indications that the government intends to address these serious issues. Though the announcements so far, such as the diesel and liquefied petroleum gas price hike (to combat fiscal deficit), foreign direct investment increase in various sectors and power sector reforms aren’t directly correlated to all undervalued segments of the market, they give confidence that steps are being taken. As result, some of the increased global liquidity has got channelized to domestic equities and undervalued stocks have been getting some attention. For example, Jain Irrigation Ltd which fell 44% in the last one year, is up 12.5% since September, the company has a reasonable return on equity (RoE)of around 14% and price-to-book value of around 1.5 times. Similarly, Torrent Power Ltd, which fell 32% in the last one year, is up 9% since September and that company has an RoE of around 24% with a price-to-book value of just 1.3 times.

Secondly, expectations on interest rate cuts and softening commodity prices are helping these stocks. According to Varun Goel, head–portfolio management service, Karvy Private Wealth, “There is a case for domestic cyclicals as there are expectations of rate cuts in the next few months." Moreover, Goel expects commodities will cool off as China, a large consumer in that space, is not investing as much in infrastructure. Lower rates will reduce interest payments and lower commodity prices will reduce the raw material burden, thereby improving earnings.

Lastly, growth stocks have had a really good run in a bad market. For certain segment this can be attributed to re-rating of valuations. Upadhyaya explains, “There was some re-rating in FMCG stocks which were neglected in the 2009 upswing. They were trading at lower multiples and have sustainable growth rates; hence, we saw a price-earnings re-rating." This means that such stocks played a bit of a catch up and prices moved higher with investors choosing stable earnings. Experts agree that further re-rating is unlikely but if companies continue to deliver stable growth stock price movement will also reflect that. So, the big rally in these stocks is done for the time being and investors will be looking at profit booking and re-investing in other stocks.

Can’t ignore risks

Experts we spoke to unanimously agree that you can’t take a top down view on value stocks just yet. Just because the macro is changing doesn’t mean some undervalued companies shouldn’t trade at low valuations; for example, state-run banking stocks are under pressure for rising non-performing assets and that can keep valuation low for some time. You will have to pick and choose by looking at the financial details and earnings potential of individual companies, and not pick value stocks blindly. Upadhyaya says, “Balance sheets for undervalued companies in the infrastructure and capital goods space are stressed so you have to consider them individually; though there is advantage in looking at them now given the changes, you can’t apply a broad brush."

Moreover, changes at the macro level aren’t cemented yet. Rajesh Cheruvu, head of investment strategy, RBS Private Banking (India), says, “You need to wait another few months to consider undervalued stocks; once demand picks up and there is some monetary easing a risk on rally in those (undervalued) segments can be more sustainable." He also adds, so far there haven’t been any tangible reforms done by the government so it’s better to wait another couple of months to see how things progress. So, there is no hurry to jump into these stocks.

The ideal strategy

For active stock pickers, it may be time to reallocate the portfolio and give some space to value, taking away from growth. Says Prateek Agarwal, chief investment officer, ASK Investment Managers Pvt. Ltd, “A portfolio has to be a blend of both. Look for high quality companies with balance sheet strength where rate cuts will help." But caveats exist before you can jump fully into the value bucket. Of course you know that in the long run the best strategy is to pick good quality firms, both growth and value.

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