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    Investors can make money from smaller firms narrowing the valuation gap with market leaders

    Synopsis

    Many smaller companies who have little chance of winning are catching up with market leaders, opening up opportunities for investors.

    ET Bureau
    Everyone loves an underdog story. A story in which a competitor perceived to have little chance of winning rises to the occasion, and emerges as a serious threat to their much larger or more powerful rival is very heartening.

    This could be the scenario that unfolds for several companies that have been playing second fiddle to a competitor. Investors have traditionally favoured the stronger rival, rewarding it with a premium valuation over the competition. While the higher multiple is justified, analysts reckon that there is a possibility of this valuation gap narrowing in some cases, providing investors an opportunity to reap higher rewards in select stocks.

    The market leader usually attracts a premium over other players in the segment, given factors like larger scale of operations, higher pricing power and better operating metrics. Often, a significant valuation gap opens up between the segment leader and other players. However, according to a Credit Suisse report, there have been numerous instances in the past where such valuation gaps between smaller players and the largest one have closed, following consistent and sometimes superior performance by the former.

    Valuation gaps sometimes provide an opportunity for higher stock returns by smaller companies. “The smaller company achieves reasonable scale, both financially and in terms of market capitalisation, to become investible, which draws more investors—a virtuous cycle that can result in significantly higher returns compared to the market leader,” says an analyst from Credit Suisse. Recent cases where valuation gaps have been plugged include Britannia versus Nestle, Relaxo versus Bata, TVS versus Hero Motocorp, and Berger Paints versus Asian Paints.

    In each of these situations, the smaller players have amassed much higher returns. However, Ambareesh Baliga, an independent market expert, is cautious about the risks involved in trying to exploit valuation gaps in a rising market. “It is a normal tendency of investors to buy down the barrel during a sustained market uptick, as these stocks are cheaper in comparison.”

    Should investors take advantage of similar situations when they arise? Here are some notable examples where analysts expect a smaller company to narrow its large valuation gap with a larger peer.

    LIC Housing versus HDFC
    LIC Housing Finance trades at 17 times its trailing 12 month earnings, a 41% discount to the sector behemoth HDFC. However,this discount has narrowed significantly from 50% a year ago, and is expected to drop further. A major player in the affordable housing segment, its average ticket size of loans being around Rs 20 lakh, the company is expected to benefit from the improved supply, with developers showing increased interest in building affordable houses.

    Among its peers, the company is also the largest player in providing finance for the government’s ambitious ‘housing for all’ scheme, the Pradhan Mantri Awas Yojana. Analysts expect the company’s net interest margin to improve owing to reduction in cost of borrowing and increase in the loan against property and developer segments,driving a healthy earnings growth of around 25% CAGR over the next few years. A Credit Suisse report states, “Margin expansion is already playing out, and going by high incremental spreads, should continue to do so”.

    Underdogs closing in on big brothers
    Companies that have long played second fiddle have shown superior performance
    Image article boday


    Bajaj Electricals versus Havells
    Havells has far outperformed Bajaj Electricals in the past few years owing to stronger revenue growth and operating performance. Factors like a superior product mix, focus on branding and strong execution have aided the growth of Havells. Analysts Bhargav Buddhadev and Deepesh Agarwal of Ambit Capital are of the opinion that even though Bajaj Electricals’ franchise is weaker than peers like Havells and V-Guard, it’s consumer business should not trade at such a hefty discount to its rivals, given its expected return on capital employed of 36% over the next two years, compared to 21% for Havells.

    According to the analysts, they have a buy stance on Bajaj Electricals, due to its emphasis on streamlining the distribution network by focusing more on distributors and retailers than wholesalers in the consumer durables business, which is expected to lead to 210bps improvement in margins in the course of finacial years 2016-17 and 2017-18. Futher, the company lays emphasis on raising the spend on building the brand, which will lead to sustenance of margins.

    Inox versus PVR
    In the battle of multiplexes, Inox is currently in second place with 425 screens across the country, compared to PVR’s 544 screens. PVR trades at a comfortable premium to Inox, which has lower margins and return ratios than PVR owing to lower average ticket price, ad revenue per screen and contribution of higher-margin, nonbox office revenue.

    However, analysts maintain that Inox is still a formidable challenger to the leader, given its strong pace of screen addition and presence. “We prefer Inox, given its well distributed presence and superior growth in terms of food and beverage revenues, which are at a discount to PVR. While muted ad growth is a near term concern, recovery in the same could bridge the valuations gap further,” concludes an analyst from ICICI Securities.

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