Undervalued Companies – An Approach

a) I am experimenting with the approach stated below (which I am pretty sure I’ve read somewhere but can’t recollect where). Let me know your views.

The interest rate offered on a AAA bond in India is around 9.75% (SBI AAA, issued in Feb 2011). Now that we have all that interest increase jazz, let’s assume that if any firm would issue a AAA bond today, the interest rate would be around 10.7%. Post-tax, the return would be 7.5%.

Imagine there is some company somewhere in the Indian stock market which delivers around 30% post tax return. That is, its Return on Capital Employed is 30%. Since this company has utilised the capital 4 times better than a AAA bond (4*7.5), it should ideally command a price 4 times the price of a AAA bond.

In summary,

Post-tax return of AAA bond = 7.5%

Post-tax return on some company = 30% (4 times AAA)

Therefore, the fair value of this company will be around 4 times P/B.

I usually don’t invest in companies with RoCE < 20%. For experimental purposes, I am trying to find companies with RoCE >= 30% with P/B < 4. Since a company can deliver very high returns in any single year, I have taken an average (rather, a median) over the past 7 years (10 yrs would be even better,but I don’t have the data). Extra caution has been exercised to list out only those companies where there has been a continous increase in Book value per share. (Devesh did point to me that this would work only for non-cyclical companies. Also, credit to Moneysights and Valuepickr for the data and tools provided). Here’s a initial list – Thoughts are invited.

S.No Company CMP Median RoCE 7 yrs Current P/B Fair Value P/B
1 Sesa Goa 223.5 58.88 1.65 7.85
2 Voltamp Transformers 510 27.78 1.38 3.70
4 NESCO 594 45.47 3.67 6.06
5 Mangalam Cement 101 31.22 0.69 4.16
6 Goodyear India 313 31.21 2.51 4.16
8 Facor Alloys 3.75 33.3 0.53 4.44
9 DISA India 1453 36.5 3.8 4.87
10 Bharat Bijlee 718 33.58 1.44 4.48

Of the above list, I like Sesa Goa, NESCO, Goodyear, DISA and Bharat Bijlee. Sesa Goa especially seems highly undervalued according to this parameter (economic conditions, shipping downturn and all that – but is this entry price alright?).

b) This one is for momentum investors. And maybe I am the last person in the universe to realize this trick. Whenever a company declares a stock split or a bonus issue, the share price rises considerably (in cases I have seen, atleast by 20%). So maybe there is a theme here (or probably I am plagued by availability bias – not sure yet). Buy stock of any company (not any company literally – some basic checks on revenue, EPS, RoCE etc. are required) which declares a stock split or bonus (If you think about it, it doesn’t matter whether the company’s face value is Rs. 10/- or Rs. 5/- (2:1 split or bonus) or Rs. 2/- (5:1 split or bonus). The company earnings are not going to change. The only change would be increased liquidity in the market which has nothing to do with the company (but this is after the split, and not before the split) and yet the stock price shoots up. Maybe irrationality. Maybe its a corporate signal that dividends/earnings are going to increase in the future (how?).) No idea. Titan Industries, HDFC Bank are some of the prime examples. Alternately, NESCO share price rose on the split announcement and fell considerably once the split announcement got cancelled.

c) Wonderful read from Prof. Sanjay Bakshi, written way back in 1997 –

http://www.sanjaybakshi.net/Sanjay_Bakshi/Articles_files/The_Relatively_Unpopular_Large_Company.HTM

Name some companies in the current environment which fall in this ‘relatively unpopular large company’?

 

Disc: Invested in NESCO. Kindly do your due diligence before investing in any of these companies and all that.

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  1. #1 by Nilesh on September 20, 2011 - 10:56 PM

    Like your thought process and the post. Just a small query. If you are using BV as the base parameter, won’t RoE be better return indicator as compared to RoCE (Return on D+E). This will increase the size of your list.

  2. #2 by rahuk on September 21, 2011 - 12:02 AM

    Will go against Sesa Goa.
    Sesa goa has license to several mines. The license was acquired many years ago at a low price (some bribe here and there). Now, the ore of that mine will finish in 4-10 years, at the current rate of extraction (source- secret). So, how will the company make money or sustain high ROE after 5 years. The govt has stopped giving new licenses (even after taking the bribe)

  3. #3 by Jagadeeswaran (@eeswardev) on September 21, 2011 - 2:25 AM

    Nice post. I think SBI fits the bill of ‘relatively unpopular large company’ which is trading @ 52wk low due to the higher provisions taken by the bank in the past 2 quarters. The chairman indicated that the provision would continue in sept quarter. i expect the stock to tank further due to this provision and the gloom of rising NPAs in public sector banks. I guess it would be great buy around 1500/-. I feel its true earning power of the franchise will be obvious after the present gloom and doom of falling GDP and rising interest rates. what do you think?
    At what price did u entered in NESCO??

    Regards
    Jagadees

  4. #4 by Kiran on September 21, 2011 - 5:11 PM

    @Nilesh – The correct way is to use RoE when using Book Value rather than the RoCE that I have used. But then again, you’d also want to check on the capital structure through which the firm has generated the returns. One way to do this would be to calculate the average D/E for the past 7 years to be less than say 0.5 or 1 and then use RoE and BV. I didn’t have the patience to calculate D/E averages too, so conveniently used RoCE (usually RoCE < RoE) which accounts for capital structure and is lesser than RoE. However, would certainly be interested if someone does the RoE and D/E thing.

    @rahuk – I am not too sure of your secret source, but valuation is usually done thinking the firm will be a going concern. Two, Sesa Goa's management – if it was short-sighted – couldn't have delivered the returns that they did. Three, Sesa Goa has already started acquiring mines abroad (Liberia was something I read about a month ago). So, sustainability shouldn't be an issue. The only arguments against Sesa Goa would be a) Can they continue to mine out of Karnataka b) Has China stopped importing from Sesa Goa c) Has Sesa Goa's iron ore quality improved/deteriorated. But then again, if everything was very clear, Sesa Goa wouldn't be quoting at such low valuations, would it? (Caution: Sesa Goa is a cyclical stock – so need to play this carefully)

    @Jagadees – Very good one. SBI definitely is a fantastic franchisee, although I have not seen it beaten down badly yet. Rs. 1500/- would be a great price to start into the stock and increase the bets as it goes down further. I invested in NESCO fairly recently around the 475-500 mark.

  5. #5 by ConservativeInv on September 21, 2011 - 7:22 PM

    is your ROCE post-tax? If your data is from those sites, I doubt, it is.
    if it is indeed post-tax, can you post the formula used to arrive at the ROCE? (there are tax implications of interest and I think it would be very difficult to use a general formula to adjust for this)

  6. #6 by sagar on October 22, 2011 - 4:34 AM

    Hi kiran

    Nesco- On page 36 of AR 2011 , there is a donation amount of Rs 15,505,000.Any idea whom Nesco is giving donation and why ? because this is a significant amount. Also Auditors consultation fees are 15,807,087. Looks higher than average ?

  7. #7 by Kiran on October 22, 2011 - 3:39 PM

    Sagar,

    Good point. I don’t know any comparable listed company to NESCO do a competitor analysis on Donations/Audit fees.

    However, I did look back on the last 5 years P&L of NESCO, and here’s what I found. In 2006-07, the donation was 50k. In 2007-2008, it shot up to 14 cr. So yeah, SG&A shot up precisely due to this difference. And that Donation component has been continuing around that figure ever since.

    They don’t give any explanation with respect to donations. The argument is donations constitute a very small percentage of the overall revenue. However, it might be a red flag on management’s integrity (maybe siphoning, maybe genuine donation).

    That’s all I can offer right now. Will check with other investors who are invested in this stock and ask their opinion.

  8. #8 by Kiran on October 22, 2011 - 5:28 PM

    Sagar,

    My bad – I read it as 14 cr, 18 cr and such, instead of adding a decimal between the two numbers.

    Also, got it clarified with a couple of other investors – a) 2% of PAT as donations it seems is not an issue and is pretty much a norm in India b) another investor had to say that with the land bank that they have, donations are pretty much necessary 😉

    So there. I think there is very little risk in the numbers there right now. If it starts moving north significantly, then that’s an issue (the auditor fees etc, includes legal consultation too and legal fees are expensive :), and that figure is pretty much a norm)

  9. #9 by Asif on November 29, 2011 - 4:04 AM

    Kiran I did not understand why you compared ROE wit P/Bk and not P/E or P/CF? Also we dont like to invest in companies that increase their debt but suddenly in a year any Company could increase debt? Are there any indicators to understand a Company would increase debt in coming years? Looking forward to your reply.

    Asif

  10. #10 by Kiran on November 30, 2011 - 6:14 PM

    @Asif – I think I have used RoCE. If your question is why did you use RoCE and not RoE, then I have answered that question to Nilesh in comments above. Maybe you can use P/E and P/CF as well, but P/B gives you an idea as to where the price is in relation the Shareholder’s equity (and reserves). P/E and P/CF are relative indicators and not absolute ones like P/B.

    Are there any indicators that a company could increase debt? Yes and No. If it was a straightforward and honest management, they would tell you in their Annual Reports that they are looking at expansion plans and they plan on expanding by taking on debt. Some firms expand only through their earnings strength. So, essentially it comes down to taking a bet on the management and their speak and their history in conjunction with the company’s expansion plans. Of course, I have been talking to multiple people of why don’t companies publish their B/S and CF stmts every quarter. Except for the answer of ‘too cumbersome’, I haven’t received a satisfactory answer. So there – with enhanced disclosure norms, if they ever come, will you know if the company has taken on debt in that particular year.

  11. #11 by Mokhtar on December 14, 2012 - 2:49 PM

    Nice article.

    Can you share your reasoning to like Goodyear India?
    When I compare it to its peers it doesnt give an edge over them. Apollo, JK, CEAT and MRF all are quoting at a price to book value lesser than Goodyear. Besides the last 3 quarter results of goodyear hasnt been up to mark considering raw material prices becoming cheaper(rubber), on the other hand its peers are showing better results.

  12. #12 by Rukun on April 11, 2013 - 4:32 PM

    Hi Kiran,

    Your blog has been an excellent source of learning.
    Regarding the relationship between P/B and RoE. Doesn’t this analysis ignore earnings growth of the companies. The way I look at it
    P = EPS/(r-g)
    where r = Post tax return on debt, g = EPS Growth and taking EPS to be a proxy for cash flows

    Dividing both sides by book value
    P/B = (EPS/Book Value)/(r-g)
    = RoE/(r-g)

    RoE and Growth are also interlinked but I prefer taking more conservative estimates of growth.
    What is your view on this?

    Regards,
    Rukun

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