Two stocks where quality meets bargain in the small-cap space
Here are two quality stocks in small cap that are available at an attractive price
By Rajan Gulati | May 30, 2019
Charlie Munger, the legendary investor and partner of Warren Buffett, played a key role in changing Buffett's strategy of selecting high-quality stocks rather than cheap cigar butts. As underlined by Charlie, 'A great business at a fair price is superior to a fair business at a great price.'
In the Indian market, coming across businesses having sustainable moats and high-quality management yet selling at an attractive price is something of a rarity. But still, we have put our best efforts to unearth such stocks, if any.
We have run various quality checking filters in the small-cap space, as this is probably a good fishing ground to identify big wealth creation ideas. We have filtered the companies having high Altman Z (>2.99) score and F score (>7). An Altman Z score predicts a company's financial distress or the possibility of its going bankruptcy within two years. A score of more than two is desirable. On the other hand, an F score highlights the present financial performance as compared to that in the previous year. An F score of seven or above is considered good. We have also taken into consideration that the companies should be trading at reasonable valuation such as high earnings yield depicting higher return on the invested capital, lower price earnings to growth, depicting growth at lower valuation and others.
a) Altman Z- score > 2.99 & Piotroski F-score > seven
b) Earnings yield > Five per cent
c) PEG: zero to one
d) PE to median PE < 1.5
e) ROE > 15% and Debt to equity < one
Finally, we have come across the following stocks:
Sharda motors: It is a manufacturer of motor vehicle parts, such as suspension, silencer, exhaust pipes (71 per cent of the total FY18 revenue), car seat frames and seat covers (27 per cent) and others parts. Backed by an experience of over three decades, its customers include Mahindra & Mahindra (as per Crisil, the company is the exclusive supplier of front suspension systems), Hyundai, Maruti Suzuki, to name a few.
Its top three customers account for 75 per cent of its total revenue; however, it is trying to diversify its customer base. Recently, it has entered into a 50:50 joint venture agreement with EET GmbH for producing BSVI-compliant after-treatment exhaust systems required for commercial vehicles in India. Also, it increased its R&D spend to about 1.2 per cent of its net sales as of March 2018 as against 0.5 per cent as of March 2013. It helped improve its production process, especially in line with BS-VI emission norms. And all these provided a major fillip to its operating margins, which improved to 14 per cent as of March 2019 as compared to 7.5 per cent in March 2014.
The company has generated positive cash flow from operations over the last five years. In March 2018, it funded its capex and became debt-free, using internal accruals. At the promoter level, it is undergoing restructuring to demerge its seating business and transfer the assets to a wholly owned subsidiary. Its stock has corrected by around 25 per cent in the last one year and currently trades at a PE of 9.4x.
The Indian automobile industry (including component manufacturers) is expected to reach $251-282 billion by 2026. Nevertheless, it is now facing some major headwinds on the back of rising fuel prices, increasing insurance costs, farm distress and regulatory changes around emission norms. Besides, a slowing economy has emerged as a major roadblock for the sector, compelling a number of OEMs to cut their production target. Further, the onslaught of electric vehicles - which require only 20 moving parts as compared to 2,000 in an internal combustion engine vehicle - is posing a threat to auto component manufacturers.
Maithan Alloys: Starting its commercial operations in 1997, it is the largest producer and exporter of manganese alloys in India, with a production capacity of ~235 ktpa. It manufactures various ferro alloys like ferro manganese, ferro silicon and silicon manganese used for steel production.
The company predominantly sources manganese ore from Africa and Australia and only around 10 per cent from the country's premier manganese mining company, MOIL. Its domestic, as well as export business, contributed around 50 per cent each to its total revenue in March 2019. In India, it has customers like SAIL, JSW Steel, JSPL and others. The company has been associated with them for over seven years, maintaining customer stickiness.
While its revenue has grown by ~6 per cent over the last one year, its profit has dropped by 12 per cent, owing to the higher cost of raw material. Nevertheless, its recently announced greenfield project in West Bengal to increase capacity by 1.5 times with a capital outlay of ~Rs 275 crore is expected to provide the company with room for further growth as it is currently operating near full capacity. Its stock has corrected by around 11 per cent over the last one year and currently trades near to its five-year median PE at 7.1x.
The company is highly dependent on the steel industry, which is cyclical in nature. Besides, the ongoing trade war between the US and China, a slowing global growth rate and ongoing political turmoil around Brexit in Europe have an adverse effect on the steel industry, leading to the company's stock price dropping by around 50 per cent from its peak over the last one year. However, it has now recovered from that level. Besides, anti-dumping duty on steel products, a renewed push towards infrastructure and construction and robust domestic growth are some major tailwinds for the company.
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.
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