5 cool stocks in a hot market

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Stocks / Cover Stories MAGAZINE | NOV 17, 2010

COVER STORY

5 Cool Stocks In A Hot MarketEven with the market on fire, here are a handful of stocks that could give investors good returns in the longer term

KUMAR GAUTAM , RAJESH KUMAR

Retail investors, hoping to make money quickly, typically find it difficult to resist the temptation to buy shares when

the stockmarket is rising. That temptation, anecdotal evidence suggests, is even stronger now than before as many of them missed the rally over the last year waiting for a correction to enter the market. However, the fundamental problemwith investors in such a market is that they tend to pay too high a price for the estimated growth of the companies theyinvest in, assuming, of course, that the companies can deliver according to expectation. Therefore, in conditions likethese, safety of investment assumes greater importance than commonly perceived.

It has been written at length, both in this magazine and elsewhere, that the current rally in the equity market is, to a verylarge extent, being driven by liquidity in the global markets. The more money central banks around the world print toboost their own economies, the greater is the inflow into markets like India. With the market at its current level, moststocks have seen substantial appreciation and their prices are either on the edge of reason or beyond. One option for theretail investor trying to enter this market, therefore, is to wait for a correction to enter the market, in other words, try totime it. To get it right, however, the retail investor would need a liberal helping of luck, even though one school of thoughtstrongly believes that the stockmarket is likely to see deep cuts.

The other option is to look for value and find stocks with upside left even in this market. But one needs to be careful aboutfundamentals and track record. The second exercise is what we have undertaken, and here are five good medium- tolong-term buys.

Jyoti Structures

Strong businesses are built, normally, when challenges are converted into opportunities. It is an accepted fact thatinfrastructure is the biggest impediment to achieving the desired double-digit growth in India, and power shortage haslong been responsible for a low level of manufacturing activity. Thankfully, the government is taking the matter seriouslynow. Activity in the sector has also gone up significantly with private sector entering the business. To put this inperspective, India will require additional power supply of 100,000 MW by 2017 and, according to plans, an estimated Rs2,40,000 crore will be spent on the sector during the Twelfth Five-year Plan period. It makes perfect sense for the

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investors to be part of this huge opportunity to enhance long-term gains. Outlook Money in the past has recommended twocompanies in power sector financing business—Power FinanceCorporation and Rural Electrification Corporation. This time wehighlight Jyoti Structures, a mid-sized company, in the businessrelated to the power transmission sector.

The company works in areas of transmission lines, sub-stationsand setting up distribution networks, with the capability to

execute turnkey projects in all areas of power distribution. Ithas proved its credentials by clocking a five-year compoundedannual growth rate (CAGR) of 35 and 50 per cent, in toplineand bottomline, respectively. Also, the fact that it sitting on anorder book of over Rs 4,000 crore, roughly twice its fiscal year (FY10) revenue, should give confidence to investors about itsfuture. From the order book of Rs 4,106 crore, 82 per cent isfrom domestic companies. On the domestic side, Power GridCorporation of India, a public sector distribution company,contributes about 35 per cent of the orders. In terms of verticals, 68 per cent would be transmission, 21 per centdistribution, while the rest will come from sub-stations. Thecompany remains upbeat on the further flow of orders.

In the quarter ended June 2010, the company’s revenues wereup 16.30 per cent, while the net profits increased by 17.69 per

cent. In the market, the stock is currently trading at 12 times earnings, and with a strong order book, proven track recordand earning visibility, it makes a strong case for a buy.

Shree Cement

The problems affecting the cement industry are well-established. Despite a strong correlation between demand for cement and economic growth, the industry has struggled toachieve high bottomline growth. An overcapacity, which bringsdown the cement price and thus the margin, is certainly thebiggest problem. The volatile price of power and fuel, which arethe major costs for cement companies, further makes it difficultto maintain margins.

However, Shree Cement, north India’s largest cement

producer, has delivered strong growth both during the upturnand the downturn of the cement cycle despite all these risks.Overall, the industry’s capacity utilisation went up from fiscalyear 2003 (FY03) to FY08. Shree Cement also benefitted fromit and reported around 34 per cent and 107 per cent growth intotal income and profit, respectively. In the following years, FY09 and FY10, the realisation for the industry declined.Nevertheless, Shree Cement’s growth figures were stillattractive during this period. The topline and bottomline roseannually by 27 per cent and 61 per cent, respectively.

All these years, the company rapidly ramped up its productionfacility to boost its topline, but also took care that the margins

continue to improve, which is now the highest compared to its peers, to grow the profit. Several factors have allowed it todo so. First, the gestation period of capacity addition is low, which help it react quickly to demand surge and avoid idlecapacity. The company also has the advantage of proximity of its plants to the market, which reduces freight cost. Also,as Shree Cement’s market is mainly north India, which has traditionally been a high-value market, the realisation for thecompany is high compared to players in other regions.

The most critical factor for Shree Cement is its venture into the power business. Building captive power units, which nowmeet the entire power needs of the company, has not just helped reduce costs, but will also help it in times of downturn inthe industry. Shree Cement now sells excess power on merchant basis (market-determined price), and in FY10 thiscontributed around 14 per cent of the company’s revenues. It is working towards commissioning more capacity, and whenthe power business becomes a significant part of the overall business, it will cushion Shree Cement’s earnings in thecement downturns. This suggests that even as the company can bank on construction activities in the economy, in thedown cycle, because of a utility business such as power, it will be impacted less. With the growth drivers in place, a price-to-earnings ratio of 14 is not too much to pay for its shares.





Allied Digital Services

Managing currency volatility has now become the norm for information technology (IT) companies. Most of their revenuescome from exports and if the rupee appreciates against any of the major currencies, such as dollar or euro, their revenue inrupee terms is hit hard. However, if a company has deliveredhigh volumes, its growth in rupee-terms remains attractive evenafter shedding few basis point growth on account of currencymovement. And that is the case of IT services provider AlliedDigital Services (ADS). Its growth is impacted by currencymovements, but high volume growth has ensured attractive top- and bottom-line growth in rupees.

ADS has over two decades of experience in providing ITservices to its clients across several domains and geographies.IT services is categorised under verticals such as infrastructuremanagement services, remote management services,networking and communication solutions, and enterpriseconsulting solutions, among others. In Q1FY11, around 70 per cent of revenue was generated domestically whereas 30 per cent came from exports to geographies such as the US andAustralia.

The services provided by ADS are similar to other ITcompanies, but it has managed to deliver superior growth rates. Between FY07 and FY10, the total income has increasedover fourfold from Rs 156 crore to Rs 697 crore, or a CAGR of 64.71 per cent. The bottomline increased at a similar pace. In FY09, when volume growth of the overall IT industry was low, ADS managed a topline growth of 26 per cent. Ahigher growth in profit of 38 per cent indicate that unlike other IT companies, it was not impacted much by pricingpressure in the downturn. One reason that allowed it to grow was that it took the inorganic route to growth, which wasreflected in high growth figures on the consolidated income statement. But even if performance of the subsidiaries isignored, in FY10 the company reported 32.30 per cent and 78 per cent growth in total income and profit, respectively.Company’s focus on domestic market, which is 70 per cent of the revenue, was the major reason for it to sail safelythrough recession in the developed nations.

In the coming quarters, the company is expected to report high growth. In post Q1FY11 analysts’ conference call, themanagement has said the order book is to the tune of Rs 565 crore, which is over two quarters of total revenue. Themargin, which improved in the past few quarters, is expected to improve further, as the company focuses more on high-margin value added services to its customers. At the end of Q1FY11, the company had a cash balance of Rs 180 crore,

and that helped it in taking inorganic routes to growth. With its annualised earnings-per-share for FY 11 is estimated at Rs28 and price of its share of Rs 224.40, the stock certainly looks undervalued at a price-earnings multiple of eight.

EClerx Services

One parameter that went into selecting stock recommendationsfor this issue was to judge a company’s performance even inbad economic conditions, and eClerx Services—a knowledgeprocess outsourcing (KPO) services provider—stood out on it.The KPO industry was in the doldrums in 2009. Though there isno industry-specific data to support this as most of the playersare not listed, anecdotal evidence such as freezes in hiring andsalary cuts suggest so. However, it was an interesting time for eClerx. It hired more that year (almost 30 per cent rise inheadcount) and the revenue went up by 62 per cent. It doesindicate eClerx’s differential nature of business in a cluttered ITindustry.

eClerx’s analytics, process and data management services isdivided into two verticals—financial services and sales andmarketing support. Services under financial services headinclude back office services, finance and accounting and riskmanagement. Sales and markets support bundles servicessuch as competitive pricing and catalogue analytics and datamanagement. The company boasts of servicing 13 of theFortune 500 companies. What has really differentiated itsservices from that of other KPO companies is that they supportthe core activities of the clients that are non-discretionary in





nature. So, during the financial crisis of FY09 and FY10, even as many of eClerx’s clients in the banking industry wentunder, were desperately restructuring, or were acquired by stronger ones, eClerx didn’t lose its business. The companyalso used the opportunity during the downturn to attract the best talents in the industry. Another factor that differentiatesthe company is the nature of contracts it undertakes. Most of the companies in the KPO industry get revenue fromprojects that are short-term in nature and comes at inconsistent intervals. However, eClerx undertakes projects that are 2-3 years long, and are on an annuity basis. It also avoids “request for proposal” route to win projects. In fact, most of themare repeat projects from the existing clients. These factors add an element of stability and predictability to its revenue.

eClerx just has a decade’s experience, and it got listed on the exchange as recently as 2007. It has shown a phenomenal

growth in the past few years. From 2006 onwards, the revenue rose at a CAGR of 51 per cent from Rs 47.8 crore to Rs246.5 crore in FY10. During this period the profit grew at 32 per cent. The balance sheet is liquid with no debt and highamount of cash.

The profitability ratio, such as return on equity, is also high at 40 per cent. You can rest assured that the company’s stockhas gained attention from investors, and has moved up 63 per cent in the past 12 months. However, if we ignore thecharts, at an annualised EPS of around Rs 40 and price of Rs 597, a PE level of 15 is still attractive enough for you tobuy the stock.

Supreme Industries

With rising activity in the economy, there are a few industriesthat do not attract sufficient investor attention. The reasonprobably is that their growth is derived. Plastic is one suchexample. From industrial production, construction to consumer durables, plastics play a vital role. Plastics consumption was up

16 per cent in India in FY10. PVC consumption was 1.8 milliontonnes, and with total installed capacity around 1.2 milliontonnes, demand clearly outpaced supply. Further, with risingeconomic activity, the gap could widen. Supreme Industries,the well-established brand in plastics, with a proven trackrecord, is well poised to reap the benefits. The company,established in 1942, has registered revenue and net profitgrowth of 12 and 35 per cent CAGR, respectively, in the lastfive years. In the quarter ended September 2010, sales wereup 37 per cent, while the net profits registered a jump of 103per cent. Supreme, with 19 production sites, derives revenuemainly from four verticals—plastic piping systems, consumer products, industrial products and packaging products—withpiping contributing the highest at 43 per cent.

Going forward, the company is investing in capacity creationand intends to move up the value chain. In the current fiscal,the company plans to invest Rs 180 crore for this. It expects

the replacement market to gain prominence in the coming years as more and more buildings go for renovation. To thecapture the opportunity, it is focusing on its pan-Indian retail network.

Also, to grab the rural market, the company plans to introduce budget-level plumbing solutions which are fit for singlestoried building. One concern while investing on this counter could be the sharp runup in stock prices, which has morethan doubled over the last one year. Barring that worry, this stock is still available at about 12 times earnings. Thecompany also has a strong track record of paying dividends, an indication of a stable financial position. All of whichmakes it an ideal buying option for the medium and long terms.

The Way To Go

Our research indicates that these five companies are inherently strong. That, coupled with the fact that they are stillavailable at reasonable valuations means that their prices may not appreciate substantially tomorrow, or in the short term.

To grow the invested capital, the investor will have to take a long-term view on these companies. There is also thepossibility that these stocks, too, would correct in the event of a wider market fall. Therefore, investors should enter thesecompanies with an investment horizon of at least three years. For, in the short term, there is no saying what will happen.

How We Did It

Finding undervalued stocks, especially when too much money is chasing too few stocks, is probably more difficult todaythan ever. Our search began with first putting a lower limit of `500 crore market cap for the companies we looked at, aswe did not want to end up with small names, too small to trade and track. We than looked at five-year financialperformances for consistency, as in the past five years, companies have been subject to all the conditions of a business





cycle.Simultaneously, we also kept an eye on the valuation of the stock and compared it to the company’s performance, toavoid even good companies at bad prices. After a looking at softer issues like management, a final list was arrived at.However, we are still excluding some names from this list as they have recently been figured as our picks of the fortnight.

kumargautam AT outlookindia.com, rajeshkumar AT outlookindia.com

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5 cool stocks in a hot market

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