The markets are trading at the all-time high and this is where many investors get scared to invest in the fear of fall. We do not invest looking at where the market is trading, but invest in the business where we feel that they are not trading at their potential values plus also has a bright prospects for their products.

The very first thing comes in our mind is, what stock should we avoid to invest to bring down our risk of losing our capital. If you are a commerce student or are involved in any business activity then you will understand when I say that the major risks any businesses can face is all about its liquidity. That means it’s either or all the below points:

  1. They are heavily involved in debt (high leverage)
  2. When there is a threat of not making any profits (Low ROE)
  3. When they have cash problems to pay their bills (Cash flow issues).

Apart from the above points, we also need to be very comfortable and confident about the future demand of their respective products.

Today I will be sharing with you all my insight to invest in the automotive sector. This sector is ticking up its revenues by 10 – 12% every year in the market conditions where demand is low and also interest rates are very high. Indian companies who are involved in this business are also exporting overseas into other markets and exploring other markets for opportunities for their products.

There are 13 businesses that we have shortlisted from our universe of investments in this sector. They are as follows:

Bajaj Auto Hind Motors
Hero Motocorp Tata Motors
TVS Motors Eicher Motors
Mah Scooters Ashok Leyland
Atul Auto SML Isuzu
LML
Maruti Suzuki
Mahindra Motors

 

If you look at the list above, the list is made up of from two wheelers to four wheelers and heavy vehicle manufacturers, from small companies to big companies. We do not want to invest in any of the above business who are involved heavily in the debt. We are not against the debt. Businesses can borrow to grow their business, as long as they have a history or habit or a plan to get rid of those debts in 3 to 5 years without affecting negatively to their returns and they are not getting in habit of leveraging heavily with them.

For example, we use to like Bharti Airtel business a lot before they came out with their plans to invest in Africa. We liked their investment ideas to invest in that part of the world. But the level of leverage they started investing in those countries was shaping very risky. We moved out of that business after looking at their numbers for three quarters after their investments as we were not comfortable with their debt levels. Bharti Airtel price has not gone anywhere in last 5 years. They have given a net return of 38% in last 5 years which averages out 7.6% per-anum. Investors who had invested in this business from last 5 years would have got better returns by investing in the fixed term during those period. Have a look at their income statements and compare their interest payments with operating profits. You will understand what I am trying to put my point.

After going through leverage test, we deleted 4 businesses which we thought are risky to invest with them today.

The businesses that passed successfully the leverage test are listed below.

Bajaj Auto Atul Auto
Hero Motocorp Maruti Suzuki
TVS Motors Tata Motors
Mah Scooters Eicher Motors
SML ISUZU

 

The next step is to invest in the business which are generating enormous profits (extraordinary profits as I say) on the investor’s capital. We are looking for the businesses with high returns on equity. We believe that price of the stocks in the market appreciate or match to their returns on equity. Which means if you invest in the business which are consistently giving 20% return on equity, their stock price will pick up 20% every year in the market. So always look for the companies that are expected to give higher returns in the future.

For example, compare the price and returns on equity of the HDFC Bank and Andhra Bank. In the last year HDFC Bank have given a returns of 22% on its equity and its stock price had given a return of 30% in the last one year. For the same period Andhra Bank had given a return of 5% on its equity and its stock price has given 15% return from last year.

In the long run, prices do follow the values of those businesses which are derived from its returns on equity. When you analyse more years for the both companies then you will also start believing that prices do follow its intrinsic values.

Below is the list of remaining businesses that had passed out our test of at least 20% return on equity by average every year.

Bajaj Auto Atul Auto
Hero Motocorp Tata Motors
Mah Scooters Eicher Motors

 

So now we are with only 6 companies remaining to do research with. If you ask us one of the most important characteristics of a good business then I would say that, “businesses that generate surplus cash flow to pay their all bills and have enough to pay dividends to its shareholders and have enough remaining to invest in the business to expand it if required.”

Net profits reported by the businesses are not real profits. The real profits is the cash generated from its real operations. For example, Larsen and Toubro reported Net Profits of Rs 4,855 crore for the year end 2014 and they reported cash flow from its operations of negative Rs 4,000 crore and paid on top taxes of Rs 2,900 crore. They borrowed net Rs 12,950 crore and paid Rs 1,200 crore dividends. If you ask me what they did in short then, they borrowed from the market to pay dividends and pay their bills. On the other hand if you look at the Swaraj Engine, they reported net profits of Rs 67 crore and generated Rs 69 crore from its operations. They invested surplus money to upgrade their manufacturing unit and paid hefty dividends to shareholders. The stock price of Larsen had shouted up by 75% and Swaraj Engine by 107% last year.

There are many drivers involved in the fluctuation of the stock price in the market, but if you make sure that you are looking at the right drivers and understand your risk, your investment will do far better than the overall market returns.

After going through the cash flow test we ended up with the following businesses to look into the future prospects.

Bajaj Auto Atul Auto
Hero Motocorp Tata Motors
Eicher Motors

 

Let’s talk about these business looking at their estimates of future intrinsic values and performance.

Bajaj Auto:

Bajaj Auto is the manufacturer of two and three wheeler vehicles which also exports its products overseas. We calculated its intrinsic value for the year end 2014 to be in range of Rs 1,250 – 1,450 per share. We expect that to go up to in range of Rs 1,300 -1,525 for the year end 2015 and Rs 1,600 – 1,900 for the year end 2016 per share. Now these are calculated on what the market is expecting its future earnings.

Looking at their last two quarter results their revenues have risen by mere 2% and their operating profits have fallen down by almost 15%.

Hero Motocorp:

Another two wheeler manufacturer and exporter and one of the biggest competitor of Bajaj Auto. We valued this business intrinsic value for the year end 2014 to be in range of Rs 1,020 – 1,177. We expect its intrinsic value for 2015 in the range of Rs 1,502 – 1,800 and Rs 1,935 – 2,355 for the year end 2016.

Looking at their last two quarter results their net revenues have gone up by mere 2% and their operating profits have climbed up by 7%.

Atul Auto:

Atul auto is the micro company with market cap of Rs 800 crore and manufactures 3 wheeler and other passenger and cargo segment. They are located in Gujarat and we valued their intrinsic value for the year end 2014 to be in range of Rs 255 -305 per share. We do expect its intrinsic value for the year end 2015 to be in range of Rs 224 – 255 and Rs 291 – 328 for the year end 2016.

Looking at its last two quarter results, its revenues have dropped down by 20% and its operating profits by almost 15%.

Tata Motors:

One of the biggest company by market cap and exposure to European countries. This business manufacturers the 4 wheeler as well as buses and trucks. We calculated its intrinsic value in the range of Rs 610 -725 for the year end 2014. We do expect its intrinsic value for the year end 2015 in the range of Rs 700 – 825 and Rs 790 – 835 for the year end 2016.

Looking at the last two quarters of the business their net revenues have increased mere 2% and their operating profits by around 15%.

Eicher Motors:

Eicher Motors manufactures two wheelers and also trucks and buses. Royal Enfield is the very popular bike and a very powerful brand existence. We calculated its intrinsic value for the year end December 2013 in range of Rs 1,900 – 2,300. We expect its 2014 intrinsic value in the range of Rs 3,300 – 4,000 and for the year end 2015 in range of Rs 5,300 – 6,800.

Looking at the last two quarters of Eicher Motors revenues have grown by 25% and their operating profits by almost around 90%.

While talking about intrinsic values, we thought to share with you the enterprise values for all the 5 businesses.

Enterprise value

Bajaj Auto 16.28 times
Hero Motocorp 16.22 times
Atul Auto 9.06 times
Tata Motors 6.22 times
Eicher Motors 44.81 times

 

Finally, it is not the time to jump and buy these 5 stocks or any of the above. You have to understand their business and read their annual reports. Our advice is to read at least last 3 years management discussion and try to judge management whether they are in touch and are working towards the interest of shareholders.

Have a look at their products and study their bright prospects. Tata Motors is the only stock that is trading cheap today. But also it is the only in the basket of all the automobile sector which hardly gives any dividends.

You have to decide and pull the trigger yourself. I am ready for any discussion or more details to talk about any of the above stock.

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