Going at discount

With the availability of land on the decline and environmental issues taking priority, entry barriers across industries are rising. This will make existing businesses quoting below their replacement value attractive

Thanks to the current gloom and doom scenario, many businesses are available at far below their replacement value, thereby offering investors an opportunity to buy valuable assets at attractive prices. Replacement value is the potential amount that one will have to spend at current rates to replace the existing assets of a company. Effectively, if a company's assets are, say, worth Rs 100 crore, many of them are trading at far lower value of, say, Rs 50 crore. In a recent study by brokerage firm ENAM Securities (see table), India Cements Ltd, Madras Cements Ltd, Tata Steel Ltd and Hindalco Industries Ltd, JSW Energy Ltd and Jaiprakash Associates Ltd currently offer huge value, based on their assets as on March 2012.

The importance of the replacement cost valuation method has gained significance in the current environment because there is limited supply of land and there are tighter norms for acquiring it—environmental issues have only added to the difficulties. Hence, setting up new capacities has not only become time-consuming, but also a costly affair. Such an environment will ensure huge entry barriers across industries, thereby making existing operational assets attractive for potential buyers/investors. Hence, if the situation prolongs, the markets could be more responsive to such opportunities.

Experts say the current pessimism in the market has resulted in many companies trading at far lower valuations than they deserve, and judicious stock picking could lead to good returns. "People generally do not look at the valuations in volatile times, as the sentiments play a bigger role, which is why companies and some of the solid businesses trade below the replacement cost. Finding bargains while screening stocks based on the replacement cost could be a good strategy, provided the investors have long-term views and pay attention to the visibility," says Ambareesh Baliga, chief operating officer of Way2Wealth Brokers, an investment consultancy.
 

DEEP VALUE
In Rs crore	Adj. replacement cost (FY12)	Market cap	Potential upside (%)
India Cements	7,600	2,460	208.9
Madras Cement	6,800	3,613	88.2
Tata Steel	1,21,000

40,669 197.5 Hindalco52,00023,445121.8 JSW Energy15,9008,01198.5 JP Associates30,40014,683107.0  Adj. replacement
cost (FY15E*)Market
capPotential
upside (%) Grasim44,70022,43899.2 India Cements10,8002,460339.0 Madras Cement9,9003,613174.0 Shree Cement19,0009,197106.6 Tata Steel

 1,79,600

40,669341.6 Hindalco60,00023,445155.9 JSW Energy19,4008,011142.2 JP Power Ventures23,2009,252150.8 Phoenix Mills6,2002,560142.2 Jaypee Infratech16,1006,375152.5 GMR Infrastructure17,6008,699102.3 JP Associates44,10014,683200.3 IRB Infrastructure9,0003,938128.5 Note: Adjusted replacement cost is after factoring the debt of the respective companies 
* Replacement value for FY15 is estimated, and includes new capacities that are expected to come up
Source: Enam Securities
There are risks, too, associated with the strategy, given that markets may or may not realise the value of such assets. So, while selection of investments (stocks) is crucial, investors treading this route should also have the risk appetite as well as patience.

Where are the opportunities?
It is mostly the asset heavy businesses, where it is possible to assess or arrive at the replacement cost of a company. Currently, companies in the steel, cement, utilities, real estate and infrastructure space have the highest value relative to the replacement cost. For instance, the 15.5-million-tonne cement capacity of South-based India Cements is valued at just Rs 3,600 crore by the market, whereas its replacement cost (adjusted for debt) alone works out to Rs 6,800 crore.

Similarly, Tata Steel's European operations and its 13-million-tonne domestic steel capacity (including three-million-tonne expansion in Odisha) is being valued at about Rs 1,21,000 crore on the basis of replacement cost, whereas the market is valuing these assets at about Rs 41,000 crore. The gap in valuations is due to factors like lower steel prices, subdued demand outlook, especially for its European business, and high debt.

However, experts say companies trading below the replacement cost are bound to be in news for all the negative reasons. But, if investors can take a call and make an assessment, whether the issues are short term in nature and whether there is a fair chance of improvement in the business, it could result in good returns once a re-rating of its assets happen.

Experts say stocks like IRB Infrastructure Developers Ltd, Phoenix Mills Ltd and Shree Cement Ltd also offer good value.

Individual issues
While some could be impacted due to the macro environment, some companies are in news for their individual issues. In the utility space, JSW Energy gets lower valuations because of its high exposure to merchant power sales, which is almost 50 per cent of its operational capacity. Merchant rates have come off recently, which is hurting valuations.

Similarly, in the infrastructure space, Jaypee Infratech Ltd offers huge value, but analysts are worried about its near-term prospects, thanks to concerns over farmer’s agitation over land acquisition, which are impacting the company's project execution. Worries also emanate on account of the high debt in its books.

Notably, experts say some of these companies could be potential multi-baggers. "Many of these companies do not show up among our one year best picks due to the near-term riskiness of their business model. However, as the relevant risks abate, you could see some multi-baggers emerge from among them," says Nandan Chakraborty, managing director, institutional equity research at ENAM Securities.