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How to avoid value traps

A cheap-looking stock naturally attracts investors but it could fall further, thus destroying investor wealth. Here are a few attractively priced stocks that you must avoid

How to avoid value traps

Stock market can be irrational at times. But it is this irrationality that also generates opportunities. While stock prices can significantly move in both directions, there is often a reason why a stock is in the dumps. This means that when the market gives an opportunity to buy a stock at an unbelievably low price, it's likely that there is something fishy about the company. If a company has also been growing its earnings at a fast pace but is still trading at a mouthwatering multiples, it merits a deeper investigation before you invest in it.

Retail investors are frequently lured by cheap valuations and don't delve into the reasons why the company is trading at such low multiples. A stock with cheap valuations can be a 'value trap', i.e., its cheap valuations don't signify value but are due to bad underlying fundamentals.

How to avoid value traps? Ask why the stock is trading at cheap valuations. To illustrate this, we studied certain companies that have grown their earnings over the short and long terms and yet are available at attractive valuations. We filtered out stocks that have grown their profits by more than 20 per cent annually over the last three years and by more than 20 per cent in Q2 YoY. Further, we selected those which are available at a price-to-earnings multiple of less than seven and market capitalisations of more than Rs 500 crore (see the table). We then found out the reason for their ultra-low valuations. While the answers were not readily apparent, one key issue common to all these companies is the quality of earnings. Let's have a look at them.

HEG
HEG manufactures graphite electrodes that are mainly used in making steel. Its earnings have grown at an annualised rate of 357 per cent in the last three years. Its share price has multiplied by 24 times during this period. The return on equity stands at 75 per cent.

What has caused HEG to deliver such spectacular numbers? The reason for this was the sudden rise in the price of the graphite electrode from $3,000 per tonne to $15,000 per tonne in the past two years. This happened because China clamped down on polluting industries, leading to 30 per cent fall in the capacities of Chinese graphite-electrode makers. The fall in supply proved to be a boon for Indian graphite-electrode companies. HEG's stock is available at a P/E of just five.

What explains the valuation
HEG has thrived on declining competition and not because of an improvement in its own fundamentals. A sudden rise in the prices of a commoditised product, like graphite electrodes, may not last long as more players in India and globally join the market to fill the gap. Moreover, many Chinese companies whose operations were shut down have started getting environmental clearances and are adding new capacities. This may reinstate competition.

India is also facing similar issues on the environmental front as China does and this may lead to production curbs here, too. A few months back, the government imposed a 20 per cent tariff on the export of graphite electrodes. These uncertainties have raised questions about the sustainability of HEG's growth.

Graphite India
Graphite India, like HEG, manufactures graphite electrodes. So, it is also a beneficiary of the spurt in graphite-electrode prices. Its earnings have grown at an annualised rate of 208 per cent in the past three years. During this period, the stock has returned 112 per cent annualised but is still available at a P/E of 5.3 times. At 45 per cent, the RoE is also very high.

What explains the valuation
Graphite India has even more company-specific issues than HEG. Firstly, on the pollution front, it has started getting the regulator's attention. After protests erupted against the company's plant in Bangalore, the Supreme Court directed the company to pay compensation, which is yet to be decided.

Secondly, the company is embroiled in a case related to its auditor, PricewaterhouseCoopers. PwC has been alleged of violations in accounting practices in nine companies, including Graphite India.

Dewan Housing Finance Corporation
Dewan Housing Finance (DHFL) is an NBFC which lends to retail customers and developers. Despite profit growth of 30 per cent annualised in the last three years and more than 50 per cent in Q2 year on year, the company's stock has fallen more than 60 per cent from its peak in September 2018. This was the result of the liquidity crunch post the IL&FS default and the panic selling of company's bonds by mutual funds. The stock is trading at a P/E of 4.7 times and a P/B of 0.65 times.

What explains the valuation
Other than the panic in the NBFC sector, there are company-specific issues which are responsible for DHFL's cheap valuations. The holding company of DHFL, Wadhawan Global Capital, raised Rs 2,125 crore through zero-coupon non-convertible debentures. These debentures have a backing of DHFL through its subsidiaries. A default on these bonds would spell trouble for DHFL.

Indiabulls Real Estate
Indiabulls Real Estate is focused on residential and commercial properties in tier 1 cities. The company has grown its revenue by 29 per cent and net profit by 78 per cent annualised in the past three years. This looks commendable, given the state of the real-estate sector. The company's total debt has come down from Rs 9,510 crore in FY17 to Rs 6,600 crore in FY18. Despite the growth, the stock has fallen by more than 60 per cent in the last one year. This was primarily due to the liquidity crunch faced by housing-finance companies, which meant lower funds for realty developers like Indiabulls Real Estate. The stock is trading at a P/E of just two.

What explains the valuation
In FY18, the company's revenue jumped to Rs 5,927 crore from Rs 2,320 crore a year ago. When looked at closely, the annual report reveals that the revenue includes profit from sale of subsidiaries and rental commercial projects. Generally, such profits are shown separately in the income statement and not included in the revenue. However, being a real-estate company, Indiabulls has reported them as revenue.

In absence of such items in the next financial year, it's likely that the company will report a far less revenue and thus lower earnings.

Nava Bharat Ventures
Nava Bharat Ventures is a diversified company, with businesses in power, mining, ferro alloys, agriculture and healthcare. The company's earnings have grown at a healthy pace of 27 per cent annually over the past three years on the back of good performance from the ferro-alloy and power divisions. Despite a decent show at the consolidated level, the stock is trading at a P/E of 5.3 times.

What explains the valuation
Firstly, the stock is trading at a so-called 'conglomerate discount' as the company has multiple unrelated businesses. Secondly, while the income statement shows healthy growth in revenues and earnings, if one sees the cash-flow statement and the balance sheet, the cheap valuation looks justified. Although the company has made accounting gains, the actual cash flow from operating activities remains low. The growth has come due to an increase in debtors. In FY18, the receivables stood at Rs 726 crore. These are more than 30 per cent of the company's total revenue of Rs 2,348 crore. The ratio of receivables to revenue was just 6.4 per cent in FY14 but has grown gradually over the years. Moreover, the company's debt stands at Rs 4,008 crore as against the net worth of Rs 3,385 crore.

The promoter's credibility has been suspect, too. In 2014, the Directorate of Enforcement attached properties, worth Rs 186 crore, belonging to two promoters and directors of Nava Bharat Power Projects. Two of the company's directors were alleged to have been involved in the coal-block scam that time.

Sanwaria Consumer
Sanwaria Consumer is into food grains and edible-oil businesses. Earlier, it was only in the edible-oil business but later forayed into other segments like packaged rice, pulses, sugar, soya chunks, etc. The company's revenue has grown by 25 per cent and earnings by 68 per cent annualised in the last three years. Sanwaria has opened company-exclusive stores called 'Sanwaria Kirana' to sell its products directly. The stock is still available at a P/E of 5.6 times.

What explains the valuation
There have been multiple instances of large variations in the unaudited and audited results announced by the company. For example, in Q4 FY18, the company had declared a profit of Rs 36 crore in its unaudited results. When the audited results came a month later, it changed the profit figure to Rs 20 crore.

In 2013, SEBI fined the company and its promoter, Anil Agarwal, Rs 1 crore each for stock-price manipulation. The stock price had gone up from Rs 22.95 in February 2009 to Rs 98 in July 2009.

Century Enka
Century Enka is a part of the B K Birla Group. It manufactures nylon-tyre fabric, which is used as a reinforcement material in 'bias tyres' (used in heavy and off-road vehicles) and nylon yarn used mainly in the apparels industry. The company's earnings have grown by 32 per cent annualised in the last three years, mainly on account of the rise in nylon prices. Despite this healthy growth, the stock is trading at a P/E of 6.2 times.

What explains the valuation
The company derives 60 per cent of its revenue from nylon-tyre fabric, which is used to manufacture bias tyres. However, the new-age radial tyre, which is gradually replacing the bias tyre in every segment, uses polyester rather than nylon. If radial tyres dominate the industry, Century Enka's business is likely to come under threat.

On the other hand, the company's directors and promoters, who also sit on the board of the group company Kesoram Industries, have been alleged of insider trading. Kesoram had sold stake in Century Textiles, another group company, to a firm called Camden Industries for Rs 141 crore in March 2016. Kesoram then invested the money in another subsidiary, Cygnet Industries. Cygnet, in turn, bought back the stake of Camden for Rs 355 crore the very next year. It was alleged that Camden made a profit of Rs 214 crore but Kesoram shareholders lost Rs 100 crore. It's suspected that such transactions have happened in Centurey Enka, too.

Conclusion
Long-term investors look for quality, growth and valuation as major factors. However, when a growth stock is available unreasonably cheap, they often forget the third aspect: quality. Make sure that you consider all three factors while picking stocks and try to find the reason for cheap valuations. At Value Research Stock Advisor, we do this all the time for our subscribers.

Vikas Vardhan is Senior Equity Analyst at Value Research Stock Advisor


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