One of the tools of value-investing is too see if a companys assets are undervalued. The Smart Investor looks at some stocks where the market capitalisation is lower than its working capital.
The stock markets normally reflect public opinion about a company and not its actual worth. If a company is showing excellent growth and expectations are that it will do well in the future, the market overvalues the stock. From this, it is logical to conclude that it will und-ervalue stocks that are affected by temporary bad news. In a bear market, undervalued stocks abound as mass psychology of investors is to play safe and to sell out.
An enterprising investor, who wants to beat market has to be a contrarian. If he has the ability to pick a stock which is undervalued and holds it till the market realises its worth, he would make abnormal returns. But this style of investing requires conviction and patience to hold out against popular opinion.
It would be safer to concentrate on large companies that are undervalued for two reasons. These companies are large and get noticed sooner when they are turning around and also tend to have the resources to hold out during a bad period. It would be better if these companies have been paying steady dividends and even better if dividend yields were comparable with the risk free rate of return.
One way of finding if a stock is undervalued would be to take the future cash flows of the company and discount it by a rate of returns and if the net present value is higher than the current value, the stock is undervalued. But this would mean that one knows the company inside out and is also able to predict its future.
Another way of doing it is to see if the companys assets are undervalued. If one lists all companies whose market capitalisation is less than the net current assets or working capital. One has to however be careful that the company is not over-leveraged and also, that its interest coverage ratio is comfortable. It should preferably not have very high debtors or very high inventory. It should have a strong business, preferably where demand is higher than supply, a dominant market share and the assets should be world class so that the company does not get marginalised in the currently globalising economy. Even if these companies were bought over by a strategic partner, they would be bought at a higher value.
The Smart Investor embarked on an exercise to identify such stocks and make an initial investigation. We found that 143 of the Crisil-500 stocks have their total market capitalisation below net current assets (1996-97 figures). We finally decided to explore a pruned list of six stocks Spic, Madras Refineries, Bharat Earth Movers, SRF, Bharat Electronics and Chemplast Sanmar. The stock prices of all these stocks have crashed since August 1997 along with the BSE-Sensex which fell from 4523 points to 3329 points in mid-December. They have not yet reacted even though the Sensex has since touched 3600 points.
Madras Refineries (MRL)
Price: Rs 41.75, Market cap: Rs 599.5 crore, Net current assets: Rs 632.26
The Rs 2594 crore MRL, a joint venture between the Government of India (51 per cent) and National Iran Oil Company (13 per cent), is a pure refining company with a capacity of 7 million tonnes. The company is a marginal player in this segment with a market share of 6 to 7 per cent.
The scrip has been getting low discounting because it does not have a marketing network. Analysts feel that the company cannot raise resources for increasing its capacity in 2000, because of its high debt-equity ratio of 1.16 (because of oil pool receivables).
But there have been talks that IBP and MRL could be merged because IBP is a pure marketing company and the two companies even have a common chairman. Also, it is expected that the oil pool receivables will be securitised. Another upside for the scrip would be de-control of the administered price mechanism. ICICI Securities estimates that even under the most pessimistic scenario, that is under decontrol, MRLs EPS would grow 93 per cent by the year 2000. They also feel that the scrip is undervalued because a greenfield refining capacity would now cost Rs 6000-8000 per tonne against MRLs cost of Rs 1650.
The share price of this scrip has shown a continuous downtrend after a brief run up prior to its public issue in March 1994 when it rose to Rs 240. But the scrip was trading at Rs 65 in August 1997 and has now fallen to Rs 41.75. There does not seem to much downside from here. The company has been paying a dividend of 25 per cent for the last 5 years. The dividend yield works out to 6 per cent.
Bharat Earth Movers (BEML)
Price: Rs 73, Market cap: Rs 268.64 crore, Net current assets: Rs 613.80 crore
The Government of India holds a 60 per cent stake in BEML. It has four distinct product segments earth moving equipment which accounts for 50 per cent, railway division, defence products and spares. In earth moving and construction equipment, the company has been trying to indigenise continuously. It is also trying to diversify its customer base from only PSU customers. It is also finalising a joint venture with Heathfield of Europe for exports to the UK. In the railway segment, it is trying to cut costs and develop new products and increase exports. It has a dominant market position in all its product categories.
BEML has a gearing of 119 per cent because of very high debtors which is mainly because of Coal India. But this year, the World Bank loan to Coal India would take care of those receivables. Till now, the company had problems because it could not finance its customers, but now it has tied up with GE Capital and is also arranging lease financing through financial institutions. The companys cost of financing is also very high which it is now trying to replace with cheaper debt. This will increase the companys EPS and RONW significantly.
A risk with BEML is the entry of competition in the Indian market. One would have to watch this cautiously because the companys operating profit margins dropped from 15.26 per cent in 1996 to 13.93 per cent in 1997. The stock price of BEML has fallen from Rs 155 in August to Rs 73 now.
SRF
Price: Rs 21.50, Market cap: Rs 39.6 crore, Net current assets: Rs 109.15
This Rs 689-crore nylon tyre cord company has become a market leader with over 40 per cent market share after the acquisition of Ceats tyre cord plant. It is also further trying to become a global player. It has put up a nylon yarn conversion facility in Jebel Ali in Dubai from where it expects to supply to global majors.
The company also claims that it is globally competitive and can sustain opening up of imports and reduction in tariffs. It has managed to retain its margin in the first half of the year 1997-98 in spite of surplus in the industry. It is also getting out of unrelated businesses like the optical lenses business.
This is a unique company which has an operating profit margin of 30 per cent and ROCE of 25 per cent in an industry where all other players are sick. It is also getting out of unrelated businesses like the optical lenses business.
The companys net profit has been very low because of high interest costs. The company had to fund its acquisition of the Ceat plant through high cost debt. But it has now put together a financial re-structuring package. It proposes to retire the debt through an ECB issue and a rights issue. It has already sold its financial services company which has brought in about Rs 54 crore. If capital is restructured and if all goes according to plans, the company would have a RONW of over 20 per cent in three years.
The stock currently trades at Rs 21 and is on the rise. It used to trade at Rs 33 in August 1997 and at Rs 45 in June 1996.
Bharat Electronics Limited (BEL)
Price: 28.25, Market cap: Rs 226 crore, Net current assets: Rs 234 crore
More than 50 per cent of the turnover of the Rs 1232.42-crore BEL comes from supplies to the defence. Twenty nine of the companys 31 divisions have obtained an ISO-9000 certification.
The company has a good research and technical manpower. For instance it has developed several products a Doppler weather Radar along with ISRO for the meteorological department, Automatic alarm systems for unmanned crossings, onboard electronics for the light combat aircraft, gallium arsenide technology for photo-voltaic cells used in satellites and space payloads in place of silicon.
It is one of the most profitable public sector companies with a RONW of 15.7 per cent and a ROCE of 46.46 per cent in March 1997. The operating profit margin jumped from 10.42 per cent in March 1996 to 16.97 per cent in March 1997.
BELs stock price which was as high as Rs 130 in March 1997 has since been falling freely because of the news that the US government was going to ban exports of components to the company. But it has now been formally announced that there would be no ban. The company is also reducing its dependence on the government by getting into new alliances with several multinationals for making products like two-way alphanumeric pagers. It is also getting several exports contracts.
It has been paying a dividend of 16 per cent for 5 years till 1996 and paid 20 per cent in 1997. This a seven per cent yield. The scrip trades at a P/E of under 5.
SPIC
Price: 28.75, Market cap: Rs 253, Net current assets: Rs 397.87)
SPIC has been paying a dividend of 30 per cent even in troubled years. This on the current price works out to a return of 10.43 per cent which is current more than bank fixed deposit rates. The market seems to have realised this and the price has already started reacting.
In addition, this AC Muthaiah group company is restructuring itself and trying to strengthen its core business of fertilisers. It plans to double its capacity of urea and also set up a fertiliser plant in Dubai. The company is also slowly getting out of unrelated businesses and merging companies with related businesses.
In 1997, the companys turnover at Rs 1824 crore was three per cent less than that in 1996. But that was because the plant was closed down for 45 days and low rates fixed by states for phosphatic fertilisers. The companys operating profit margin however improved from 12.66 per cent to 15.48 per cent. The disadvantage with Spic, however, is that it is leveraged more than two times. The stock which is now trading at Rs 23.50 was trading at Rs 28.75 in August 1997. Currently, the stock is trading at a P/E of less than 3 based on the 1997 EPS of Rs 8.2.
Chemplast Sanmar
Price: Rs 24, Market Cap: Rs 84.24, Net current assets: Rs 134.66
The company has four divisions -- PVC, caustic chlor division, mettron division, metkem silicon division. Although it has very small capacities in the petrochemicals sector, the company has been trying to get into the manufacture of the same for niche markets.
The caustic-chlor manufactures caustic soda and chlorine and chlorine-based chemicals are by-products. Caustic soda is a basic chemical used in all core industries and its growth depends on the growth in the economy. The Mettron division manufactures the high profit margin, chloro fluoro chemicals. The Metkem silicon division supplies silicon wafers to BEL, Continental devices etc. The company has got into chartered shipping to reduce cyclicality of earnings. They are also planning to get into industrial textiles with Marubeni.
This is a cash rich company. It also has a high operating profit margin of about 25 per cent. The company has debtors of just 51 days. The companys case EPS for March 1997 works out to Rs 19.24 which is discounted by the current price by just 1.24 times.
This is another company whose stock price has fallen since August 1997. It has fallen from Rs 44.75 to Rs 24. Here again the dividend yield works out to about 10.4 per cent with the possibility of an upside gain. The company paid 25 per cent dividend in the last two years but 40 per cent for two years before that.
