In 2010, play the ancillaries

Sometime during the 1840s, gold was discovered in California in a river known as the American river.

Tens of thousands of prospectors arrived from all over America and Europe in search of their fortunes. Some of them did make a lot of money. But the richest person in California during the gold rush of the 1840s was a merchant called Sam Brannan. Ironically, Brannan never mined for gold. He made his money in the business of selling shovels to the gold prospectors.

Is there any way that we could relate this piece of history to our current stock market situation and find ways to gain from it?
If we look at the current valuations of some of the major players in the current favourite sectors — or at least the sectors which seem to get the biggest news bites — we find that these stocks are no longer cheap.

Realty, power, retail and infrastructure companies are quoting at astronomical valuations. So what does an average investor who would like a slice of the pie in these sectors do?

For starters, he could look at some of the smaller companies which provide inputs to their larger cousins. This would benefit the value investor in two ways.

One, the larger companies, by the very nature of the businesses they operate in, typically have longer gestation periods for their projects, whereas the smaller ones would have steadier cash flow and earnings. Two, the smaller companies are still quoting at reasonable valuations which leaves room on the upside for their stock prices.

Therefore, instead of taking a direct exposure to, say, the power sector, an investor could investigate companies that manufacture transformers and rectifiers, or those that specialise in erection of large projects. Or an investor who wants an exposure to realty could play this sector indirectly by buying stocks in the building materials segment or in the home fittings segment. Similarly, those seeking to gain from the retail boom could look to buy companies that make large air conditioning plants or those in the logistics sector.

The smaller companies would not only grow along with the bigger ones, but also at higher rates because of the lower base effect. Besides, in case of a business downturn, the smaller companies would be more flexible in adapting their businesses to the changing market situation.

The adjoining table illustrates the disparity in valuation between some of the larger companies in the more favoured sector and that of their smaller suppliers.

Pantaloon Retail, for instance, quotes at a high PE ratio of 48.9. On the other hand, Blue Star, which is one of leading players in commercial air-conditioning, is still available at a more reasonable PE ratio of 17.5. Now, if the organised retailing sector does well, it is but natural that there will be greater demand for related air-conditioning equipment. Major players like Voltas and Blue Star are likely to be the logical beneficiaries of such an outcome.

Similarly, Bhel, at a PE ratio of 33.5, would appear overpriced, but the market has awarded it a relatively higher valuation, because infrastructure is one of the identified focus areas for the government. So, even though it is a given that companies like Bhel would do well, it is less acknowledged that a Sanghvi Movers, which specialises in construction equipment, would also do well.

Besides, Sanghvi Movers quotes at a PE ratio of 10.4, leaving room for appreciation not only due to its earnings growth, but also by virtue of its PE ratio possibly getting re-rated upwards.

The list is only illustrative and is intended to showcase the gap in valuation between the two groups. It takes into account only one valuation parameter, the PE ratio. Investors would be well advised to carry out a thorough financial analysis of these companies before arriving at any investment decision. Diligent and inquisitive research would reveal many such hidden stocks holding superior growth potential, but at far more reasonable prices.

A caveat for investors who would like an indirect playoff on these growth sectors: As we have seen in the recent past, when markets fall sharply, the stock prices of smaller companies tend to take a bigger fall as compared to their more established peers.

Therefore, the strategy outlined above would be more suited to aggressive investors who take a longer term view, which would help in overcoming market gyrations and short-term inconsistencies in valuation.

The writer is proprietor of Capital Management Services