Is the equity market still undervalued?

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BALANCE sheet values and current price to book value ratios may suggest that listed companies are under-valued. But where it matters most i.e. earnings, the majority of the companies are, at best, fairly priced.  In many cases disappointing earnings have put a lid on company intrinsic values, making such stocks look dear. That said, the notion of a grossly undervalued market can now be challenged.
Should investors care how company valuations are faring on both asset and earnings levels? We think both buyout investors and stock market traders need to know. On one end, Buyout firms will be keen to acquire undervalued assets which have room for optimising cash-flows. Depressed asset prices have spurred an uptick in delistings in the last five years. On the other hand, investors and traders may care to avoid value traps by observing earnings outlook for companies they invest in.
Flight to quality gone too far!!
An uncertain economic future has kept many investors at bay. The few optimistic investors have parked their money in the large caps – presumably quality stocks for safety’s sake.
Our research has suggested that this flight towards “quality” among institutional investors has pushed prices for big caps beyond what is reasonable.
BAT and Delta are two examples. We think these companies are now trading at premium on account of perceived safety. For example based on reverse DCF, a valuation approach that calculates the growth assumption factored in stock price – BAT’s current price of 1,150 cents is priced based on an implicit annual growth rate of 18 percent for the next 5years. Contrast this growth assumption with the company’s current contraction in bottom line.
There is nothing in the fundamentals that suggests that BAT will grow its free cash-flow at anywhere north of five percent. Fierce competition and lobbying against smoking are all strong headwinds on the company’s path.
Delta’s share price of 107 cents is based on a growth rate of 12 percent. Delta would be described as fairly priced if it could post at least a modest five percent growth rate. But reality is somewhat disappointing. Revenue growth in sorghum beers and alternative drinks is not accelerating fast enough to compensate the fall in lager and sparkling beverage revenues.Advertisement

In the last financial year, our research shows that sorghum and alternative beverages added $30 million at a time lager and sparkling beverages were losing approximately $60 million in revenue. Again we would expect lagers and sparkling drinks to have higher profit margins than sorghum and alternative beverages. We think that under the current economic conditions shrinkage of the bottom line will persist.
Pockets of value
Our strong view of fully and over-priced stocks is not enduring across the entire market -they are some anomalies which interest us. Hippo Valley is one such example. A year ago we published a post titled “Hippo vs. OK: a tale of a cash compounder and value destroyer”. At the time, Hippo’s seemingly bloated CAPEX was diluting returns on capital.
We contrasted Hippo with OK. OK looked nimble then and had jumped up 2.4 times in stock price in three years ending 2013 against a halving in price for Hippo in the equivalent period. But, today we think fundamentals favour Hippo. Enhanced efficiencies from years of huge capital expenditure; tariffs on sugar imports and unexploited pockets of the domestic market make Hippo exciting. It is on this backdrop that we find the current price of 35 cents bewildering.  If anything, the current market price is suggesting that the company’s free cash-flow will shrink by -21 percent, a far cry from the positive growth we are anticipating.
Unless we are missing something huge we think Hippo is undervalued on both income and asset based valuation approaches. We wait to see how the forthcoming annual results will guide us. We venture that even if FY2015 earnings lose ground by anything not more than 10 percent, Hippo will remain an undervalued stock.
Divergence: choices to make!
Stocks described above paint a picture of a valuation divergence. On one hand we have traditionally safe stocks which in our opinion are straddling in the fully valued to over-priced territory. On the other, we have predominantly small and mid-caps which are undervalued but are perceived to be susceptible to economic swings.
Contrary to common belief that it is size that provides stability, we are of the view that nimble companies are better able to adapt to varying economic conditions. Investors will have a challenging choice to make.  One could limit the downside risk by opting for large caps, but pay more with little upside potential. The opposite is true for value stocks.
An investor could go for value with a large up-side potential but expose oneself to price volatility which is prevalent among mid to small caps.  We would urge the investor to pay more attention to the intrinsic value of the company more than its market price volatility.
Ray Chipendo is Head of Research at Emergent Research. He can be reached on: