Cherry-Picking Fallen Angels — Part 1 | Outlook Business
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Feature

Cherry-Picking Fallen Angels — Part 1
Mid-cap stocks have corrected much more than the broad market. Where should you bottom-fish?

Prathamesh Mulye

Following an unrelenting rise over the past 18 months, the winning streak for small and mid-cap stocks has come to an end. Since the beginning of this calendar year, BSE Small-Cap Index and Mid-Cap Index have fallen by 20% and 15% from their respective highs. May was the worst month for mid-caps in the past one-and-half years with the index plunging by 6.8%. A cloud of uncertainty now looms over these indices with several coveted names no longer being investor favourites.  

Till December last year, mid-caps and small-caps had a great run due to the good macro-environment and fund flows. Over the past six months, micro-environment has improved but macro has become challenging. A weakening macro-environment triggered by increasing crude prices and depreciating rupee has fuelled market volatility forcing investors to take shelter in large-cap stocks. “When liquidity tightens, interest rates start rising and inflation returns. In an increasing interest rate scenario, the equity valuation in terms of multiple takes a beating and it’s usually the mid-cap universe that suffers more than large-caps,” says Pankaj Tibrewal, equity portfolio manager, Kotak Mahindra AMC. In the mid-cap space alone, 55 stocks plummeted between 10%-30% and another 24 fell by 30% or higher. 

That fall was not only due to the change in market sentiment. Re-categorisation of mutual fund norms has also contributed to the fall. Fund managers had to re-arrange their portfolio after Sebi-issued new guidelines for categorisation of mutual fund schemes. The mid-cap segment now includes the 101st to 250th stock ranked by market capitalisation. The 100th stock by market capitalisation today has a value of around 300 billion while the 250th stock is roughly 95 billion. “Mid and small-caps had witnessed a run-up resulting in high valuations. Emergence of new macroeconomic headwinds like rising crude oil prices and a falling rupee along with restructuring of the mutual fund schemes because of regulatory reasons, has led to unwinding in mid-cap stocks” says Amishi Kapadia, senior president, YES Securities.

The good news is not all losses in mid-caps are driven by deterioration in company fundamentals. Here are a few which continue to report healthy numbers and may get a second look from investors. 

Indraprastha Gas 

Despite reporting healthy revenue and profitability in Q4, the stock received a severe beating, losing 28% since the beginning of the year. The city gas distribution company reported robust revenue growth of 23% YoY led by 11% YoY rise in sales volume in the last quarter. India’s shift towards natural gas, which is environment-friendly, has driven sales volume and analysts believe that the volume growth momentum will continue as the government focuses on green initiatives. “The switch over to CNG continues to grow owing to regulatory push and cost benefits of using natural gas. CNG prices are currently 39% and 45% less than diesel and petrol respectively,” says Nilesh Ghuge, analyst, HDFC Securities. With the prices of gas being relatively cheaper to petroleum fuels, the company enjoys pricing power (see: Green power). IGL’s latest decision to increase prices by 3% on May 29 soon after raising them by 0.9% per kg a month back reflects the company’s ability to ride on the impact of higher crude oil prices to some degree.

Besides, the company is also in growth mode. “IGL is expanding its pipeline to new areas like Karnal, Rewari and part of Gurugram, which will add PNG volume. CNG volume will also continue to be robust, owing to conversion of Ola, Uber and private cars. Monopolistic business model and robust growth from investments in subsidiaries coupled with a foray into newer geographies make us remain positive about IGL,” says Ghuge. 

IGL offers investors a rare mix of volume growth and healthy margins, which is a sweet combination. At 253, the stock trades at 22x FY19 earnings, which seems reasonable. In times of volatility, IGL is also a safe-haven given the stable nature of its business.  

East India Hotels 

East India Hotels (EIH) has also been a victim of mid-cap sell-off, despite reporting robust growth. The hotel industry has been witnessing growth mainly led by healthy increase in the number of foreign tourists, limited new room additions and an uptick in domestic demand. “Given that the major chunk of room supply will only come post 2022, EIH is well placed to take benefit of low supply and high demand,” says Rashesh Shah, assistant vice-president at ICICI Securities (see: Sold out). 

EIH witnessed an upward trend in revenue and profit, led mainly by re-opening its main property in Delhi. While its revenue grew 19% YoY in March 2018, net profit increased by around 11% to 1.79 billion in FY18 from 1.03 billion in the previous fiscal.   

Analysts are backing the company, which runs luxury hotel chains — Oberoi and Trident, to lead the industry owing to the impending launch of six new hotels with 893 rooms that are in various stages of construction and are expected to be operational in the next three years. They expect revenue to grow at 15% CAGR in the next three years. “The properties of EIH are strategically located in business as well as leisure hubs. The rise in the occupancy levels supported by healthy demand would lead to rise in room rates going forward, thus, leading to robust margin expansion,” says Shah.  

The uptick in demand will also improve the company RoIC, which is expected to reach double digits in FY19 from 6.2% in FY18. “If you don’t expand in hotel industry you don’t make profit. We believe the company’s balance sheet is in a better position to fund these expansions,” says Shah. As the economy rebounds, EIH’s strong presence in business hubs will also boost revenue.     

Expansion at a time when government thrust on tourism is increasing puts the company in pole position to exploit rising demand, according to the analyst. At 170, the stock trades at 55x current year earnings and 3.4x book value. Its fixed assets valued at 23.78 billion should provide a good cushion to investors. 

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