When cheap does not mean value

Are the markets giving you a sense of deja vu ? And why not; when they have fallen to levels that have dragged the valuations of quite a few stocks close to their 2008 lows. For instance, the PE multiple of blue chip BHEL, at 14 times its trailing earnings, is lower than the 22-25 times it managed during the low of October 2008. Mid-cap infrastructure play IVRCL at 7 times its trailing earnings has touched its March 2009 valuations. However, if you think a low PE automatically signals a buying opportunity, beware of the risks that lie beneath. To sift the wheat from the chaff, investors will have to go ‘micro'– looking at the earnings picture and the reasons behind stocks/sectors being beaten down.

Beaten for good reason

Let us first look at the beaten down sectors. A look at the themes that bore the brunt of the fall since November 2010 does not throw up too many surprises. The usual suspects – real estate, capital goods and infrastructure - featured there, with utilities,metals and oil joining this bandwagon. These sectors as represented by their indices in the BSE/NSE lost any where between 25-55 per cent between November 5, 2010 and now. That is a good 5-35 percentage points higher than the Sensex fall. A quick run-down on some of the sectors would immediately tell you that global cyclicals such as steel took a hit as a result of the commodity downturn. The stock of SAIL for instance, may appear attractive from 14 times PE in April to 9 times now but a 30 per cent decline in its net profits for June over a year ago, indicates lower realisations. For commodity stocks, valuations may be cheap, but the expected soft patch in commodity prices owing to slowdown suggests weaker earnings.

Are they fundamentally cheap?

Then there are cases where a seemingly cheap stock turns out to be more expensive because the earnings have dropped. Real estate is one such example. Despite their beaten down status, stocks such as Unitech or DLF trade at a higher PE thanks to decline in earnings. A 50-70 per cent decline in their stock prices between November and now has hardly made them cheaper, fundamentally. Infrastructure company IVRCL at 7 times PE is perhaps trading closer to its lowest-ever trailing PE. But steep delcine in earnings for last two quarters only weakens the case for a value investment. It however, needs to be said that for every underperformer within a sector there was in contrast an outperformer. A Carborundum Universal actually gained when BHEL fell. Power Grid Corporation stood tall when power generation utilities such as Adani Power were pummelled.

Even if identifying winners may be a tough task, passive investors can prevent further damage to their portfolio by holding safer bets. Going by the way markets have so far reacted, here are a few factors that you can keep in mind while scouting for ‘value' picks.

One, is the company a victim of a general downturn or does it have specific concerns? The litigation issues in Lanco Infratech for instance, may make it a high risk bet compared with a Tata Power which is beaten down on account of sector concerns over cost and availability of coal.

Two, after the 2008 downturn, highly leveraged companies are not favoured by the markets for a couple of reasons: one, leverage comes at very high cost in the current high interest rate scenario. Unless, there is clarity on such leverage contributing to improved top line, servicing debt would be a concern. Three, companies that derive high revenues from developed markets such as Europe and U.S may need a close watch. Suzlon Energy and Punj Lloyd have been victims of poor performance by their overseas subsidiaries.

Four, given the volatility in currency movements, high levels of unhedged currency exposure, especially in the case of mid-tier IT companies may pose a threat. Five, companies with corporate governance issues such as DB Realty or some of the scam-hit telecom stocks may look beaten down but may have fundamental concerns relating to their ability to function as a ‘going concern' .

What's the use of buying a stock cheap, if it not going to rebound when the market or the economy does?

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