six under valued stocks that have potetial to grow--OUTLOOK MONEY

18 Aug 2007
Get high on growth  
We list six under-valued stocks that have the potential to grow. Give your portfolio wings with these stocks. But, don't forget the associated risk.  

Anand Rawani
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Buy cheap and sell dear. A simple formula for making money. From this obvious thought rose the highly developed science of 'value investing', which aimed at digging below the surface of company reports to discover the inherent value of a company's business. Early gurus of the game, like Ben Graham, made fortunes for themselves and others by identifying under-valued stocks and holding them till the market recognised their true worth.

The bull phase that has ruled our markets since 2003 has resulted in a situation where the average Nifty stock sells at over 5 times book value. Finding undervalued stocks has, therefore, become a great deal more difficult. And perhaps it is not that relevant since the real upside in a growth economy comes from growth.

An analyst looking for value in, say, Bharti Airtel's balance sheet in January 2003, would probably have found its ruling stock price—Rs 22.65—to fairly reflect its true worth. A 'buy' decision at the time would have had to be based on expectations of growth in the sector, and in the ability of company management to exploit that growth opportunity. Taking a leap into the stock based on this faith would have resulted in a compounded annual growth rate (CAGR) of over 150 per cent.

The Method

Since 'value' will always work, and 'growth' is the mantra of our times, can we look for both in one stock? We have just completed an exercise designed to identify such stocks.
This six-stage process put the universe of listed Indian stocks through filters aimed at finding under-valued stocks, which have already demonstrated the ability to grow. First, we looked only at companies with a market capitalisation greater than Rs 75 crore. Secondly, net assets had to exceed market cap by at least 20 per cent (this was a key criterion set out by Ben Graham) to show companies that are under-valued. Thirdly, the PE ratio should be less than 15, which would mean that stocks passing through the filter are priced at a discount to the larger market. Sensex stocks rule at an average PE of 21 and other identified growth companies, like Bharti Airtel and Pantaloon Retail discount earnings at 36 and 161 times, respectively. The fourth filter is aimed at uncovering growth, and looks for companies which have seen profit after tax grow by more than 50 per cent per year for the last two consecutive years. At the fifth stage, we dropped companies with a PAT (profit after tax) to sales ratio of less than 12 per cent. The thought behind this filter was that a healthy margin allows companies to deal better with temporary disturbances in costs and currency fluctuations. The PAT to sales ratio for Sensex companies is 15.74 per cent.

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1 A single portal for trading securities like equity, MFs, commodity and derivatives has made life easy

2 Brokerage has come down from 2-3 per cent of the deal a decade ago to 0.02 per cent today

3 Online trading has reduced dependence on brokers

Our last filter focused on return on net worth (RONW). Companies use capital—the shareholders' and borrowed funds—to make a profit. Efficiency in using these funds to make money is a key indicator of good management. We set this filter at a minimum RONW of 15 per cent. This means that the residual income (final income) to shareholders is Rs 15 for each Rs 100 they invested.

When we set these ever-narrowing hoops in place, many on our team thought they were so stringent that we would not find even one company that could jump through all six. We think that it is a tribute to the dynamism of our entrepreneurs that we could find six companies that demonstrate both growth and a reasonable price. The caveat here is that though these are companies that have the potential, demonstrated by past performance, efficiencies and the use of capital, along with order books, to grow at rates that can give multi-bagger stocks, they remain in the high-risk category. Sure, all stocks are risky, but some stocks are more risky than others. These belong to the latter category. So invest not more than 5 per cent of your stock portfolio in these stocks and that too not all at once in a major chunk. Stagger your investment. Watch the stock. Of course, you would have done your due diligence by looking at the balance sheet and understanding why you are buying.

Ansal Housing & Construction. One of the entities emerging from the break-up of the Ansal group, the company was incorporated in 1986. It operates across the entire real estate spectrum, having successfully developed commercial, residential and township projects.

This ISO 9001-2000 certified company is available at a PE multiple of 7.89, while other peers with a similar market capitalisation, such as Pratibha Industries, or Link House Industries, enjoy PE multiples of 15.98 and 193.10 respectively. Though the roots of the company's business are in the Delhi-NCR region, it plans to increasingly focus on township development in mini-metros and smaller towns.

India is one of the least urbanised nations in the world, and economic growth will lead to increasing demand for real estate in towns and cities across the nation. The IT sector alone is projected to need around 150 million square feet of area in the next three to four years.

Meanwhile, a study by AT Kearney affirms that India is one of the three most attractive emerging markets for investment in the retail sector. Ongoing investments in industry, IT and organised retail will create their own demand for real estate. At the same time, these will become avenues of employment for the young in our villages, which will help sustain demand for residential space as well.

Its past track record would indicate that Ansal Housing and Construction has the ability to encash the opportunities presented by Indian economic growth. At the same time, we will say that the real estate business tends to be cyclical, and the recent boom may be followed by more difficult times. Investments in real estate companies must be made with a long-term view.

FCS Software Solutions. The company is into the e-learning, digital content services, IT consultancy and product engineering services. The company is Delhi-based and it's non-promoter holding is 30.57 per cent.

It has deployed its shareholders' money extremely effectively, with a return on capital employed (ROCE) and RONW of around 30 per cent and 29 per cent respectively. (ROCE of 30 per cent means the company earns Rs 30 for each Rs 100 invested either through equity or debt, while 29 per cent RONW means, shareholders get a residual return of Rs 29 for each Rs 100 they invested). 

For the last two years, the company has managed to maintain its net margin (the ratio of profit after tax to sales that shows margin of safety to the profit of the company as well as the efficiency of the management to maintain such margins) above 12 per cent. The PE rules at an extremely low figure of 4.38, and the last dividend announced was 15 per cent. All the numbers indicate a 'buy' with an expected low downside.

GIC Housing Finance. The company got incorporated in December 1989 as GIC Grih Vitta. The fundamental business of the company is to provide loan for housing to individuals and entities engaged in construction of houses for residential purposes. The promoters of the company are General Insurance Corporation of India and its subsidiaries and UTI, ICICI, IFCI, HDFC and SBI. It has presence in more than 24 locations in the country, with a strong marketing team.

It has a strong tie-up with corporates, and builders. The top and bottom line have increased substantially, by 25 per cent and 51 per cent respectively in financial year 2006-07.

The company has a profit margin of 25.54 per cent and a PE of 4.98, which makes it much more attractive than others in the same space, such as Dewan Housing Finance (DHFL), with a profit margin of 14.74 per cent and PE of 18.04, or LIC Housing Finance with 7.24 per cent and PE of 5.44 respectively. 

Sanghi Industries. This diversified company based in Hyderabad is run by chairman S.C. Kuchhal and managing director Ravi Sanghi. Set up in 1985 under the name of Sanghi Leathers, it started shop with the manufacture of PVC foam leather cloth. Later on, it diversified into the manufacture of PVC insulation tapes, hard leather, tarpaulins, stock labels, and rigid PVC sheeting. It has also forayed into cement.

The profit figure has grown by around 75 per cent in 2006-07, while pure cement players like Ambuja Cement and ACC have seen a growth of 43 per cent and 54.5 per cent, respectively, in the same period. At the same time, being a diversified company, its cash flows will not be as adversely affected by ups and downs in the construction cycle. Given its track record, the current PE multiple of 10.43 makes Sanghi Industries an attractive buy. 

SREI Infrastructure Finance. The Kolkata-based outfit is a non-banking finance company. The three main business lines of the company are infrastructure equipment finance, infrastructure projects finance and renewable energy product finance, all high-growth areas. The prospects for growth in this business are underlined by India's 11th Five-Year Plan, which estimates that around $475 billion (Rs 19,19,000 crore) at current price would need to be invested in infrastructure.

Do not invest more than 5 per cent of your portfolio in these stocks as they carry 
a very high degree of risk

While 60 per cent of this amount will be invested by the public sector, the balance 40 per cent would be financed through public-private-partnership, offering a huge business opportunity for SREI Infrastructure Finance.

The company enjoys a leading position in the financing of infrastructure equipment, making funds available for the leasing and hire purchase of infrastructure and construction equipment, particularly for projects related to roads and independent power projects. The company is a leader in financing renewable energy projects, which is a high-growth sector, likely to see ongoing interest in the coming years. SREI also provides leasing service for infrastructure equipment in Germany and Russia.

Compared to other players in the business, SREI is extremely reasonably priced—IDFC currently rules at a PE multiple of 32.37, while SREI Infrastructure Finance enjoys a PE multiple of 11.72.

Teledata Informatics. Teledata Informatics, an ISO 9001-2000 certified company, is a global provider of software solutions to industries like marine, education, utility and telecom. The company has already built a huge talent pool, with more than 3,700 people working for the company globally. The World Bank has enlisted Teledata as an approved software vendor, and its global depository receipts (GDRs) are listed on the Luxembourg stock exchange.

The company has maintained a strong growth record. From 2006, the bottom line has shown a growth of around 156 per cent. It has a good, and growing, profit margin—29 per cent in FY07 compared to 21 per cent in FY06. As a result of these healthy margins, the company enjoys an RONW of 29 per cent. 

Despite the current gloom over earnings from software, Indian companies should continue to be major players in this field. According to Nasscom, Indian software and services companies will ramp up to

$50-billion turnover in 2007-08 with a growth rate of around 25-28 per cent. With a potential addressable market of over $300 billion, the actual growth will depend on the ability of our companies to exploit both existing businesses and new service line opportunities.

Word of caution

Stocks that have not yet been sufficiently valued will offer the greatest reward to their investors. However, lacking the scale and depth of larger, more recognised companies, such investments carry a higher degree of risk. While our research has been highly rigorous, we advise you again that don't sell all your chickens to buy these eggs. Invest not more than 5 per cent of your portfolio in these stocks.;