Any crisis throws up undervalued stocks

But look at quality of management, and another one unique to this crisis is finding businesses which will emerge stronger

In mid-April, the website Capitalmind.in ran an exercise that tried to identify value in midcaps. This focussed on the 150 constituents of the Nifty Midcap 150 Index. At that point of time, the index had already plunged from the heights of 6,800-plus to a low of about 4,100 and started a recovery.

As of last week, the index pushed back to above 4,900-mark. That’s a retraction of 40 per cent in just over a month (February 20-March 24) followed by a bounce of 20 per cent off the low in the last 9 weeks.
 

Anyway, the website discovered over half the stocks in the index were below their median long-term price-to-earnings (PE). Then it dug into their finances using the early April values. They used a simple conceptual model with two financial ratios.  

One was the enterprise value (EV) as a ratio of the operating profits (Ebitda) and the second was the PE. EV is a company’s market capitalisation plus its debt, minus cash (and cash equivalents) on the balance sheet. If you bought the company and took it over, this is what you pay and take on as liability, net of encashable reserves. The EV/Ebitda compares what the investor is paying, to the operating profits. The PE is of course, the price of earnings. It consists of market cap divided by shares outstanding. Both ratios need to look reasonable in terms of available risk-free interest rates.

The long-term values of these two ratios was calculated and the current values compared to the median values over three, five and eight years.  By definition, the median is the mid- point, which means that half the time the ratio will be higher than the median.

At that stage, in April, some 80 companies were trading below their respective median ratios. The website also compared the average (mean) ratios, which were higher than the medians (it is usual for the mean to be higher if there have been more extreme high values).  Some 95 companies were below their long-term mean ratios.

Under the assumption that value should be available in this list of stocks trading below long-term averages, they looked for companies, which had steady growth in revenues, Ebitda and PAT over the last ten years. This narrowed the search down to about 25 companies – about one-sixth of the sample. The 20 per cent rebound has meant that the shortlist has further shrunk. Fewer stocks are now trading below the PE and EV/Ebitda benchmarks set as filters. Also earnings and PEs have changed for much of the set as results have come in.

That list of 25 is still worth looking at. As Capitalmind pointed out, this is only mid-way through an exercise to find stocks that may be good value. The investor would have to make a judgment call about the quality of management, and follow up by making another judgment call about how the core business is affected by pandemic and lockdown.

The principle of trying to find value in this way remains sound whether there’s a pandemic or not, and whether the market is in a bull-run, or not. Pick some financial ratios; Look for stocks that are below long-term valuations in terms of those ratios. Then seek out stocks in that sample, which appear to have stable financial growth records.

Another analysis may choose to compare some other financial ratios versus the respective historical means or medians. For example, book-value based calculations are said to have been accurate at finding undervalued stocks during the Great Depression (1929-37).

Note that there also is an implicit admission that market action does a better job of long-term valuation than any human analyst. By using historical medians (or means) as the benchmarks, the market is allowed to decide what is reasonable value, rather than some human judgment being applied.

The pandemic or any other financial crisis throws up larger potential lists of undervalued stocks. But this sort of multi-step exercise is always necessary to zero in. Two steps in the process are more art than number-crunching.

One is judging quality of management. This must always be done. The other call is unique to this crisis. Which businesses will not only survive but emerge stronger? How long will this process take for a given business? Those answers are also critical.