If you are looking at extracting long-term returns from equities, the time is getting ripe for entry.
The spread of coronavirus has spooked the markets, and rightly so. It is too early to tell how long and deep the impact of the virus and the resultant social distancing phenomena could be, or whether this pandemic will spawn a rethink of business models.
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However, there will be more than a transient impact for sure—you don’t just walk away from an experience like this without being affected. And while this experience could well change in some ways how we live, work and invest, the fundamentals of good investing won’t change.
At the core of smart equity investing is the value proposition. And today, that is starting to favour investors.
Long-standing businesses in several out-of-favour real economy sectors are today trading at attractive free cash flow to market capitalisation yields.
For the less financially savvy, free cash flows are the operational cash flows (see cash flow statements reported by companies) after working capital changes, interest payments and average annual capital expenditure required to sustain the business, or in other words the cash that is “free” for use after meeting operational needs.
Many of these companies are well-run market leaders with strong track records. And that makes their cash generated per share to stock price ratio a compelling case for value investors.
For anyone who has been in business, cash flow is king. A business that generates a healthy, steady cash flow—several IT services companies do so—and has scope for growth is a good business to invest in. The cash flow generated needs to be evaluated both as a share of the revenues as well as in relation to the capital invested. If both these numbers are healthy, you might have a winner on your hands.
For those looking for simpler alternate valuation measures, there are several companies today available at a discount to their book value.
Book value is the cumulative sum of accumulated profits and money raised from equity issuances by the company. In other words, it represents the accumulated value of shareholder wealth in the company. So if a stock is quoting at a discount to book value, it is generally a sign of undervaluation.
In addition to quoting at a discount book value, many stocks have a healthy track record of return on equity/net worth (RoE or RoNW, a ratio usually shared in investor presentations)—of more than two times the risk-free rate of return of, say, 6-7 percent.
What this means is that these companies are reporting an EPS or net profit per share divided by book value per share of 12-14 percent. Such companies could emerge as big winners once the economic cycle turns and they return to their normal path of growth. What you must be sure of though, is the quality of management—a good team at the helm is half the battle won.
But before you go hunting, a word of caution: the coronavirus phenomena is unique in nature and no one can with any degree of confidence project its impact today.
Given this, and the historical valuation around market bottoms, it isn’t possible to rule out a further 5-15 percent downside before we hit a long-term bottom.
What’s more, it could take anywhere from 6 months to over a year for a fresh bull run to commence. That said, from a pure risk-reward perspective on valuations, the scale is tilted towards going in for cherry-picking today.
And if you are a patient investor, my wager is you will relish a mouthful of gains on these investments when the time is ripe.
These are around 20 stocks that are quoting at a discount to book value and with a healthy ROE. We would like to mention here that this is not a recommendation to buy the following stocks.
|Company||P/B (times)||RoE (%)|
|Repco Home Fin||0.71||0.61||0.53||18.54||16.53||15.92|
|L&T Fin Holdings||0.94||0.81||0.7||16.82||17.02||16.65|
|Shri City Union||0.97||0.85||0.75||16.5||15.37||15|
|LIC Housing Fin||0.71||0.62||0.55||15.34||15.27||15.38|
Source: Motilal Oswal
|NIFTY CURRENT VALUATIONS|
|NIFTY BOTTOM VALUATIONS|
First Published: IST