The fundamental principle of equity investing states that the investors should buy stocks that are trading at reasonable valuations. Generally, valuations are considered reasonable, if they are below their long-term average. Metrics like earnings, margins and valuation ratios tend to converge to their average values in the long run. Therefore, metrics that are above average are expected to come down and those below average are expected to rise.Price-to-earnings (PE) ratio is one of the widely used valuation metrics for identifying stocks. The PE ratio fluctuates around its long-term average and indicates how much investors are willing to pay for a stock for every rupee it earns.All stocks trading below their long-term average PE can be included in the universe of stocks from which undervalued stocks can then be picked by applying the bell curve or normal distribution. The bell curve theory states that nearly 95% of the trading days, a stock’s PE lies between two times the standard deviations from its average. Therefore, anything beyond two standard deviations indicates exceptions. A stock’s PE that is trading below 2-times the standard deviation from its average could indicate a strong buy signal. On the other hand, a stock with PE more than 2-times standard deviation above its average could be a warning sign.Using normal distribution, we identified stocks trading two standard deviations below their 3-year average PEs. We considered stocks from the BSE500 universe and extracted their daily PEs for the past three years—18 September 2015 to 19 September 2018. After excluding companies whose PEs were not available for the entire 3-year term (due to losses, new listings), we were left with 348 companies. Three year averages and standard deviations were calculated for each of these 348 companies. Stocks with latest PE less than its average PE minus two times its standard deviation were filtered out, leaving us with just 14 companies. The average upside potential of these 14 companies for the next one year in terms of their share prices is close to 50% as per consensus estimates given by Bloomberg. Between 2015-16 and 2017-18, the absolute consolidated sales revenue, operating profits and net profits of these 14 companies grew 26.7%, 20.3% and 21.4% respectively. Comparatively, aggregate revenue, operating and net profit of BSE500 index grew 22.2%, 11.1% and 20% respectively during the same time period.Let’s look at seven undervalued stocks out of these 14 that promise the highest growth:1. Ashoka Buildcon 66002825 An infrastructure development company, Ashoka Buildcon is engaged in building highways, bridges, power transmission and distribution infrastructure on EPC (engineering, procurement and construction) basis. The government’s thrust on infrastructure and road development projects are key triggers for the industry going forward and will help companies like Ashoka. ICICI Direct is bullish on the stock due to its strong track record, robust order book and well-funded BOT (buildoperate-transfer) project portfolio. According to Bloomberg consensus estimates, the stock could grow by more than 79% over the next one year. 66002831 2. Bharat Electronics 66002838 A Navratna PSU, Bharat Electronics is engaged in designing, manufacturing and supplying electronic products/systems for defence requirements. Its products include weapon systems, radar, fire control systems, and communication transmitters and receivers. JP Morgan is bullish on the stock due to India’s growing capital outlay on defence and thrust on import substitution, the company’s strong order inflows and availability of large nondefence and export opportunities. Moreover, the company’s in-house focus on R&D along with DRDO provides it a competitive advantage. The stock could grow by around 70% over the next one year. 66002844 3. Castrol India 66002862 It’s a manufacturer, distributor and marketer of premium lubricating oils, greases and related services to auto, industrial, marine and oil exploration industries. According to a report by IDBI Capital, strong free cash flow generation, minimal capital requirements, high ROEs and strong payouts make the stock attractive.The brokerage house expects pricing action by Castrol in the near future to counter its contracting margins. The stock could grow by more than 32% over the next one year. 66002866 4. Gulf Oil Lubricants 66002870 A Lubricants industry player with operations in auto and industrial segments, Gulf OIl’s business includes manufacturing, marketing and trading auto and non-auto lubricants, and greases. Dolat Capital believes that the company’s growth will be driven by new product launches, expansion of distribution channels and focus on teaming up with more original equipment manufacturers. In addition, improvement in the working capital cycle will improve the balance sheet of the company. The stock has an upside potential of 38% over the next one year. 66002877 5. Jagran Prakashan 66002881 A media and communications company, Jagran Prakashan’s business comprises newspapers, magazines, below the line marketing solutions, and mobile value-added services. According to a report by Maybank Kim Eng, the stock’s valuations are inexpensive and are supported by attractive free cash flows.The ad revenue is likely to recover in 2018-19 due to the upcoming national elections and there’s likely to be an upsurge in ad rates. The stock is expected to grow by around 38% over the next one year. 66002887 6. Himatsingka Seide 66002897 This textile company is engaged in manufacturing, retailing and distributing home textile products. The company’s wholesale distribution divisions are spread across Asia, Europe and North America. It reported doubledigit top line growth in the first quarter of 2018-19, led by strong performance of its brands. According to a report by IndSec, the company’s newly acquired brands are expected to contribute to its overall revenue by end of 2018-19. The stock could grow by 85% over the next one year. 66002902 7. Sadbhav Engineering 66002907 An infrastructure company, Sadbhav Engineering is engaged in the construction of roads, highways, bridges, and mining and irrigation projects. HDFC securities is bullish on the stock due to the company’s robust order book—3-times its 2017-18 revenue—improving debt-equity ratio, expansion in Ebitda margin and new orders from the mining segment. Also, the government spending on infrastructure will continue to drive the company’s performance. The stock could grow by around 63% over the next one year. 66002915 *3-year average PE minus 2-times the standard deviation. Analysts’ recommendations and target price from Bloomberg. Current PE and price as on 25 Sep 2018. Source: ACE Equity & Bloomberg.
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