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Stay in with quality stocks

Two quality large caps trading at a discount to their five-year median

Stay in with quality stocks

The global economy is witnessing a black swan event caused by the Covid 19 pandemic. To deal with the situation, a complete lockdown has been imposed in India. While businesses have shuddered to a halt, the Sensex has taken a beating amid the slowing economy over the last one month. Against this sombre business environment, survival of the fittest seems to be the investment mantra. Fundamentally strong companies with lean balance sheets are likely to survive this phase, while weaker ones may fall prey if they don't receive any government support.

Against this backdrop, we zeroed in on large-cap companies that have delivered ROE in excess of 15 per cent in each of the last five years, have negligible debt and trade below their five-year median PE.

HCL Technologies
Established in 1991, the third largest Indian IT firm rode the IT boom in India along with companies like Infosys. Taking an alternate route to software testing, it started by making personal computers. Since then, it has reimagined its business several times. Over the last decade, it has moved from low-margin (but high growth) infrastructure management services to engineering and R&D.

It follows a three-pronged strategy. Mode 1 focuses mostly on the company's traditional business like IMS (infrastructure management services), application, engineering and R&D and BPO. Mode 2 focuses on services like digital & analytics, IoT (internet of things) and cloud-related services, whereas Mode 3 revolves around products and platforms, which are mostly IP driven. Under this mode (3), HCL acquired seven products from IBM for $1.8 billion in late 2018.

Like many other IT firms, the company derives a major part of its revenue from North America (around 63 per cent), while financial services and manufacturing industries continue to be its major customers, accounting for ~42 per cent of its Q3FY20 revenue. Unlike its peers, HCL is relatively safeguarded from growing visa issues, as around 70 per cent of its US workforce is local.

In terms of financials, revenue grew by around 15 per cent, while net profit was up by nine per cent over the trailing three years ending December 2019. ROE has been consistently over 20 per cent in the last decade. Debt is negligible.

Going ahead, the company is likely to face a slowdown caused by the coronavirus epidemic. However, its exposure to defensive sectors like telecom, coupled with legacy infrastructure management business, which is less discretionary, is likely to cushion the overall impact on the company as compared to its peers. The stock has corrected by around 25 per cent in the last one month and trades at a PE of 10.9, as compared to its five-year median of 15 times.

ITC
This century-old company has transitioned from a pure tobacco company to a FMCG plus tobacco powerhouse. Today, ITC has an umbrella of businesses, including: tobacco (46 per cent of FY19 revenue), FMCG (25 per cent), agri business (12 per cent), paper and packaging (8.5 per cent) and hotels (3.5 per cent). It has a stable of well-known, category-leader brands, for example in the cigarettes segment, its brands, Classic and Gold Flake, dominate. In FMCG, Sunfeast biscuits, Aashirvaad Atta and Bingo chips are well known. In the hospitality segment, ITC and ITC-Welcom are top-of-the- mind brands for travellers.

The group's strategy to diversify into non-tobacco business, which was adopted over two decades ago, resulted in more than 50 per cent revenue coming from the non-tobacco business in FY19. ITC has extensively used its rural to urban distribution channels of tobacco business to grow its FMCG business. Besides, the company has come up with innovative ideas like e-choupal, wherein it directly connects with farmers by leveraging technology.

Although the aggregate consumption of tobacco in the country has increased over the last few years, excessive taxation on cigarettes has led to a shift towards illegal cigarettes, beedi, gutka etc. Hence, the sales of cigarettes have slowed down. However, its tobacco business continues to be a cash cow for the company.

In the last three years till March 2019, ITC's sales increased by around seven per cent, while its net profit increased by around 10 per cent. Due to its cash-cow cigarette business, it remains a high dividend payer. Over the last five years, it has generated a free cash flow of around Rs 41,000 crore and out of this, around Rs 30,000 crore has been paid as dividends. The company recently announced it would pay out around 80-85 per cent of its profit after tax as dividends. The stock has corrected by around 17 per cent in the last one month and currently trades at a PE of only 13 as compared to its five-year median PE of 29.3.

Disclosure: The intent of the article is not to recommend any specific stocks. If you wish to invest in any of the above-mentioned securities, please do thorough research.