The S&P BSE 500 index has rallied about 29 per cent in 2014 so far, fuelled by an improving global scenario and formation of a stable government in India. Expectations of a revival in macroeconomic growth and, hence, better performance by companies have made investors incrementally positive.
A pick-up in macroeconomic growth, improving profitability of companies and potentially lower interest rates are likely to rub off positively on India Inc’s earnings and the return on equity (RoE) ratio. The latter, a key valuation parameter the Street tracks, is calculated by dividing net profit by shareholders’ equity. It indicates how much money or return a company earns on the shareholders’ funds.
Business Standard has identified some of the companies having potential for strong RoE expansion, of over 300 basis points (bps) in both FY15 and FY16, and robust earnings per share (EPS) growth, based on consensus Bloomberg estimates. Most of these companies belong to beaten-down cyclical sectors and, hence, are likely to witness significant RoE expansion with a revival in macroeconomic growth.
Of the BSE 500 companies, about 30 are likely to witness RoE expansion of over 300 bps each in FY15 and FY16. Of these, 12 are likely to turn profitable over FY14-16 versus a loss in FY14. Four are likely to report a higher compounded annual growth rate (CAGR) in EPS over FY14-16. These are Jaiprakash Power Ventures (up 334 per cent), Ramco Cements (up 311.9 per cent), Motilal Oswal Securities or MOSL (145.6 per cent) and Gujarat Fluorochemicals (118.6 per cent). Barring Lanco Infratech, all other companies are expected to post an earnings CAGR of 26 per cent, to 94.6 per cent over FY14-16.
There could be multiple reasons for RoE expansion. Premal Madhavji, head of equities, Espirito Santo Securities, says: “The key reason for expansion in RoE is that most of these companies are unlikely to raise fresh capital in the next couple of years and the management will focus on delivering stronger earnings. Also, if a company can issue debt at a lower interest rate than the rate of return on its investments, its ROE can increase.”
Pick-up in industrial/consumer demand and, consequently, capacity utilisation is another factor that can lead to better return ratios. Softening input costs (particularly crude oil prices and its derivatives) for companies with better pricing power will also rub off favourably on return ratios.
Market experts believe domestic cyclicals such as banks and cement companies have high potential for RoE expansion from here on.
Pankaj Pandey, head of research, ICICI Securities, says: “Based on the theme of RoE expansion, we like sectors such as cement, banks, capital goods, automobiles and telecom. In these, our key stock picks include UltraTech Cement, JK Cement, Larsen & Toubro, Greaves Cotton, SKF India, State Bank of India, Federal Bank, Bharti Airtel, Maruti, Bosch India and Exide Industries.”
Madhavji, too, believes the cement sector has scope for sustained RoE expansion in the next two years. “The recent uptick in demand and stable pricing is a positive sign. We expect a gradual recovery in cement demand on the back of our analysis of central plan and state spends in key states. We like JK Cement and Prism Cements in this sector,” he adds.
The valuations of some of these companies, however, have already partially captured the improving prospects. As many as 13 of these 30 companies are trading at 15 times or less than their FY16 estimated earnings — at par/below the benchmark Sensex, trading at about 15 times the estimated FY16 price/earnings. Of the rest, seven are trading between 16 times and 20 times the FY16 estimated earnings, and nine at 20 times or above. While Lanco is expected to report losses, Hathway Cable and Datacom, Shoppers Stop and Blue Dart Express have the highest valuations of 63-116 times.
“We believe the valuations, as of now, do offer opportunities to make reasonable returns over a three-to-five year period. If the required reforms do happen in line with expectations, the recovery might be stronger, which would further propel earnings’ growth rate/RoE expansion. This would make the current valuations more attractive,” says Pandey of ICICI Securities.