INVEST IN ZERO- OR LOW-DEBT COMPANIES BECAUSE:
• Rising interest rates will not impact their earnings.
• They don’t need to expand equity base that could dilute earnings.
• They would be the first to bounce back when the economy revives.
BUT BUY THEM ONLY IF:
Price is below book value: It gives a margin of safety.
Current ratio is high: Ensures comfortable liquidity position.
Cash flows are positive: Indicates if company is making money.
Return ratios are consistent: Means resources are used optimally.
Every time the stock market crashes, long-term investors start angling for value. For many such investors, the crash of 2008 has presented many opportunities. Within 10 months, the bears have wiped out the gains of three years. It’s not just the small- and mid-caps but even some bellwether large-cap stocks that have come down by almost 80%.
But low price does not always imply value. Value investors look beyond the 52-week high or the 200-day daily moving average of a stock to pick long-term winners. They examine the fundamentals of a stock rather than the technicals. From Benjamin Graham to today’s savvy fund managers, all have zeroed in on undervalued stocks. “Value investors believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company’s long-term fundamentals,” says Sanjeev Zarbade, associate vice president, Private Client Group Research, Kotak Securities.
Traditionally, earnings and earnings growth have been the basic measures of a stock’s value. But the impending slowdown puts a question mark on the future earnings of almost every company. A profitable company may slip into the red next year as sales come down. So more important is whether a company can tide over the credit crunch that’s facing corporate India. Equally important is the book value of its assets and cash flows.
Debt levels: A company needs money to expand or diversify into a new business. Till a few years ago, it was easy to borrow because the interest rates were low and the debt market was flush with liquidity. Not anymore. The interest rates have shot up and there’s a credit crunch in the financial markets. For companies with a very high debt, this is a double whammy. Not only do they have to grapple with falling profits due to the slump in sales, but the high interest outgo will also eat into their earnings.
Companies also raise capital through foreign currency convertible bonds (FCCBs). These bonds have a fixed interest rate for a certain period and offer the holders the option to convert them into equity shares at a predetermined conversion price on maturity. When stock markets are booming, bondholders prefer to convert these FCCBs into equity shares and gain from the rise in stock price.
TOP 5 ZERO-DEBT STOCKS TRADING BELOW BOOK VALUE
With no debt on their balance sheets, these companies are not affected by the rise in interest rates
|Company name||Debt-equity ratio||Book value per share|
|Profit after tax|
in Rs crore
|EPS annualised in Rs||Dividend annualised in %||Current ratio||Return on net worth in %|
Best pick: Cairn India offers best value for money as the company's earnings are expected to pick up once its Rajasthan oil fields begin operation in the second half of 2009.
|Data source: Capitaline |
However, with the stock markets in the dumps, bondholders would prefer cash to converting these bonds into shares because the market price would be lower than the conversion price. This would force the borrowing companies to either dip into their resources or raise fresh money to meet the debt obligations. “Raising money at a higher cost to service existing debts and putting capacity expansion on hold would have a bearing on future earnings. It would contract the price-toearnings multiples of these stocks,” says Mitesh Shah, vice-president, BRICS Securities.
MTNL has faced rough weather due to intense competition from private players. Even though the company is not a market leader, it has valuable telecom infrastructure in Mumbai and Delhi. With a total subscriber base of 7.5 million and an 18% market share, the stock offers good value at the current price. “We see an upside of 28-32% from the current market price,” says Devyani Javeri of Edelweiss.
Book value: An investor aims to buy stocks for less than what they are worth. How does he do that? One way is to zero in on shares that are trading below their book values. The book value is the net value of the company’s assets as it appears on its balance sheet. It is derived by deducting all liabilities and intangible assets like good will. If the book value is higher than the share’s market price, it means the company’s assets are being traded at a lower price than what they are worth.
“It gives a huge margin of safety if a company is trading at discount to the book value,” says Shah. Gujarat based AIA Engineering is one such company. With a cash reserve of Rs 90 crore on its books, it has a book value of Rs 279 per share. But the stock has fallen to Rs 153 due to the crash in commodity prices in the second half of 2008. The order book backlog of Rs 470 crore also provides it good earnings visibility. “We are on track to maintaining the sales and profit outlook,” says Kunal Shah, executive director, finance, AIA Engineering. IDFC SSKI has an outperformer rating on the stock.
|Top 5 LOW-DEBT STOCKS TRADING BELOW BOOK VALUE|
With very little debt and a market price that is below the book value, these stocks are attractive
|Company name||Debt-equity ratio (%)||Book value per share|
|Profit after tax|
in Rs crore
|EPS annualised in Rs||Dividend annualised in %||Current ratio||Return on net worth|
|Gitanjali Gems ||0.82||209.59||86||138.15||15.94||18||1.89||10.87|
|Best pick: Biocon. The recent sell-off of enzymes business has further strengthened Biocon’s balance sheet. Its strong portfolio of biosimilars is expected to sustain earnings momentum in the future.|
|Data source: Capitaline|
High current assets and positive cash flows: Even if a company has a low debt or its shares are trading below its book value, it may not have sufficient liquidity. The current ratio—which gauges the company’s liquidity position and is derived by dividing the cash and current assets by short-term debt obligations—is an ideal tool to use. A ratio value of more than 1 signifies a comfortable liquidity position.
“Companies with low debt levels, a share price below the book value, positive cash flows and high current assets make for good investments. This is because they will declare dividends and will be in a better position to leverage their balance sheets at first signs of the revival of the economy,” says Shah. A current ratio of more than 1 and positive cash flows make it a good bet in the current market conditions.
Biocon and Champagne Indage are two companies with low debt levels and favourable current ratios. Both are trading below their book values and are among the best managed firms. Champagne Indage’s debt is 0.59% of its equity capital, while Biocon’s is just 0.11%. “Champagne Indage has built scale, but has de-risked its business model from over-dependence on domestic business,” says Nikhil Vora, research analyst at IDFC SSKI.
The current price seems to have factored in the worst-case scenario of consistent low crude prices, which is why the stock found support when it hit Rs 88 in October. The company earnings are expected to pick up once the Rajasthan block starts generating revenue. “Cairn’s stock price has corrected in line with the fall in crude prices. But the correction is unwarranted as the Rajasthan field is set to commence production. With a conservative long-term crude oil realisation assumption of $55 per barrel, we maintain a buy on the stock with a target price of Rs 219,” says a research report by India Infoline.
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