Beaten down industrial sectors offer many bargains. But stay clear of companies with debt troubles and those with a large appetite for dollars.

Inverting Wall Street’s shoeshine boy maxim (Sell when the shoe-shine boy gives you stock tips), this must be the right time to buy stocks. After all, everybody from your grandmom to the auto rickshaw driver is now gloomy about the market and the economy.

To the analyst as well, everything about corporate India appears bleak at this juncture. In the latest June quarter, corporate profits flat-lined, margins slipped and sales barely inched up. The magical triggers, if any, that can bring on the next big bull market are well hidden from view.

If you are a long-term investor, though, this is the time to accumulate quality stocks at very attractive prices. History tells us that timing equity purchases to periods of pessimism gets you much better long-term results than doing so during a boom.

So, if you are convinced about buying for the long-term, which stocks should you buy?

It is best to arrive at your shopping list by elimination. Here are four strategies to avoid at this juncture.

Playing the index

Usually, the easiest (and laziest) way to bet on equities is to simply ‘buy the market’, by investing in the Sensex basket or the passive funds that track it.

But now isn’t the right time to take this approach. At about 17 times trailing 12-month earnings, the Sensex trades at an expensive valuation today and appears ripe for a steep correction.

For one, profits of Sensex companies have grown at no more than 6 per cent annually over the last three years. Until recently, the market expected profit growth will accelerate to 13 per cent this fiscal. But such estimates are now beginning to look overly optimistic and are being hastily cut.

Two, over two-thirds of the stocks outside the bellwether indices are already in a bear market, having hurtled down by 20 per cent or more in the last few months. Many even languish below their 2008 lows.

A withdrawal of foreign investors from Indian stocks, in preparation for the US Fed’s tapering, may provide just the trigger for this much-needed correction in the Sensex. But don’t wait for it.

You can add to your equity portfolio by cherry-picking stocks outside the indices that trade at a bargain.

Making defensive bets

You may be tempted to start your shopping trip by buying FMCG or pharma stocks, which have been the centre of attention in the last two years. Don’t yield to this temptation.

It is defensive stocks that have wholly driven the Sensex’ 20 per cent gain since December 2011. And because of this, their valuations are at an unsustainable premium, both to the market and their own historical levels.

To drive home the point, ITC — the top stock in the BSE FMCG index — today trades at over 11 times its book value. But Tata Steel — the top weight in the BSE Metal index — struggles at 0.8 times its book value.

Comparing valuations across sectors using the BSE sectoral indices shows just how big a divergence there is in this market. FMCG and healthcare stocks, now the most fancied, trade at a lofty price-earnings multiple of 39 times. IT stocks also trade at 23 times.

But stocks from sectors such as banking, power, metals and capital goods languish at price-earnings ratios of between 8 and 11.

This sharp divide in multiples clearly tells you where ‘value’ lies in this market. It lies in the much-disliked sectors such as public sector banks, capital goods, metals and industrial goods.

Yes, FMCG, pharma or the top IT names have proved resilient to the slowdown. But if foreign investors decide to do some heavy selling, they are likely to sell positions where they made the most profits.

Even if they hang on and defensive stocks do not correct much, their stiff valuations today will prevent them from delivering big gains from here on.

Battered industrial companies or banks, in contrast, can deliver manifold gains over 3 to 5 years, if an industrial recovery begins. (If it doesn’t begin at all, you may as well stay entirely away from stocks!).

Be safe, be sorry

While it is best to be contrary in your choice of sectors, it is prudent to be safe in stock selection. Confused? Well, many of the stocks in the industrial space have been beaten down for very good reason — their business prospects are exceedingly uncertain.

To illustrate, Suzlon Energy or Lanco Infra aren’t ‘value’ buys today even though they trade at less than their book value; their debt-equity ratios of well over 3 times raise concerns about how they will sustain operations.

Companies such as HDIL or Unitech, which trade at less than half their book value, are equally dicey bets because the precarious interest cover of 2 times makes them vulnerable to defaults in a liquidity crisis. Public sector banks such as Andhra Bank with sizeable restructured loans also trade below book value for good reason. They may well be forced to take a haircut, if their restructured assets turn into bad loans.

Yet, there are public sector banks which aren’t in the danger of being wiped out by bad loans, infrastructure companies that have generous interest covers and industrial companies that are sitting pretty on large cash piles.

That’s why the wholesale de-rating of these sectors creates opportunities for investors to acquire some quality stocks in the beaten down stocks at cheap valuations.

A good way to get at these stocks is to drill down the numbers for battered sectors such as capital goods, metals, power, banks and realty. Home in on companies with low debt-equity ratios (total debt that is less than 2 times the net worth) and comfortable interest cover (operating profits covering interest payments by over 5 times).

Taking the cheaper route

Let’s not forget currency. While selecting stocks today, it is also imperative to avoid businesses that stand to lose from a depreciating rupee. This calls for avoiding companies which are significant net spenders of dollars on raw materials or fuel. It also argues for staying away from companies which hold large dollar-denominated debt.

The rupee’s 12 per cent plunge in the last two months can severely squeeze the margins of the former and balloon the interest and principal repayments of the latter.

Given that the recent decline in the rupee is yet to reflect in the quarterly numbers, this risk is unlikely to be fully factored into stock prices. For instance, at just 0.5 times its book value, SAIL may appear a tearing buy at current levels, with its low debt and comfortable interest cover.

But what rules out the stock as a good bet today is the company’s sizeable annual spend (over Rs 12,000 crore) on importing fuel and raw materials. Nor does it have any export earnings to make up for these spends. Investors looking to avoid risks from an extended slump must, therefore, stay well away from the net forex spenders.

Finally, with the India story in such a sorry state, why not diversify away from it? Companies with sizeable overseas operations or exports that bring in dollar-denominated revenues, if they are available at low valuations, should be preferred over purely domestic plays.

Don’t follow the crowd

Stay with out-of-favour sectors. Watch out for too much debt. Avoid the ones with poor interest cover. Don’t even think of the ones with large dollar obligations. We’ve listed out so many conditions to identify beaten down blue-chips to buy today.

Wondering if there any stocks at all which meet all these requirements? There are many. Taking the BSE 500 companies and screening the list for companies from out-of-favour sectors that have manageable debt, high interest cover and little risk from the depreciating rupee, and applying some quantitative criteria for business prospects too, we arrive at buys for the contrarian investor (see table). Go ahead, and buy them.

They may not pay off within the next month or even the next year. But hold on for three-five years and we think you will be handsomely rewarded for not following the crowd.

(This article was published on August 31, 2013)
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