Rally in low RoE stocks - winners and losers

Some stocks may see gains fizzle out on subdued fundamentals, others make for good investment ideas

BSE 200 index and Sensex have run up 18 per cent and 15 per cent, respectively, from their recent lows of December 26, 2016, on the back of domestic and global factors. Domestically, the latest December quarter numbers for most companies were better than subdued expectations and most macroeconomic indicators too did not show any significant deterioration on account of note ban. Bharatiya Janata Party's win in Uttar Pradesh lifted the markets, which are now in bull zone. Global markets, too, cheered US President Donald Trump's economic strategies and clarity on lending rate hikes by the US central bank. But, the worry is that even stocks with low return on equity (RoE) have surged in this rally. 

Of the 90 stocks in BSE 200 index that surged 20 per cent or more in this period, 26 had RoE below 10 per cent in FY16, with six having negative RoE. 

RoE or net worth ratio is arrived at by dividing the net profit of a company by its shareholders' funds, and it reflects how profitably a company uses its shareholders' funds. If a company is making net losses, RoE will be negative. An RoE cut-off is set at 10 per cent as banks typically charge 9-11 per cent for loans and profits should be reasonably higher than the lending rate. 

Experts say the rally looks unsustainable for stocks of companies with low RoE. However, one must also look at expected earnings growth in FY18 over FY17, to separate out the weaker names. 

Amar Ambani, head of research at IIFL, says, "If it's a rally for all of these low RoE companies, investors must exercise caution. A lot of these low RoE stocks also run up in anticipation of a better future. If there is an expectation of improvement in such companies' financials, the rally would be justified and sustainable." Here's how some numbers look.

Jindal Steel and Power Limited (JSPL), Adani Enterprises, Housing Development & Infrastructure Limited (HDIL), Reliance Capital, and Federal Bank are the top five gainers on BSE 200 in this period. Barring JSPL and Federal Bank, the other three stocks seem to be pricing in improving earnings adequately. Some stocks with low RoEs such as Central Bank of India and HDIL have rallied significantly but do not have Bloomberg earnings estimates as they are not tracked by many analysts. Investors may need to be more careful in such cases.

Interestingly, most metals companies are expected to post strong growth in profits (28-137 per cent) in FY18 due to higher metal prices globally. These include Tata Steel, Vedanta, Hindalco, and National Aluminium Company (Nalco). While Steel Authority of India Limited (SAIL) is likely to report a profit in FY18 as against a net loss in FY17, losses for JSPL are estimated to fall 90 per cent in FY18. Part of the good news is already factored into these stocks. Add stock valuations, and one can get a sense of how pricey these metal companies are. Tata Steel, for instance, is still trading closer to its historical average one-year forward price to earnings, while SAIL is at 27 times FY18 estimated earnings, reflecting an early stage of turnaround. In base metals, while Nalco trades close to 13 times FY18 estimated earnings, Vedanta and Hindalco trade at multiples of seven-eight times, despite better projected growth.

Among others, Bank of India (BoI) and Adani Power are likely to post profits in FY18 after losses in FY17. These stocks are still trading at their historical average one-year forward price to book value and don't look over-priced. However, analysts at JPMorgan say, "BoI's low capital level could result in frequent funding by the government, which could have a negative impact on return ratios and valuations. The low capital levels could also affect growth opportunities for the bank." Adani Power stands to benefit from favourable revision in rates as well as debt reduction. 

Mahindra and Mahindra Financial Services and Piramal Enterprises are also expected to see healthy earnings growth in FY18 but are still trading at reasonable valuations. 

Bharat Heavy Electricals Limited, CESC, Century Textiles, Punjab National Bank, and Indian Hotels Company are also likely to post healthy earnings growth in FY18 and are trading at multiples much higher than their historical average.