Stocks to Buy: Look for stocks with better earnings quality; 5 companies with growth potential of up to 28%.

The Federal Reserve’s 50 basis point cut in interest rates boosted global markets, with the MSCI World Market Index gaining more than 2.5% from September 18-26. Key domestic market benchmarks also continue to hit new highs after the Fed signaled that inflation is under control and the U.S. economy is unlikely to slip into recession. India’s rapid economic growth prospects and other favorable macroeconomics such as reduced fiscal deficit and manageable current account deficit are also driving the current market recovery.

Improved liquidity (due to Fed rate cut) also boosted FPI inflows into equities, which stood at Rs 48,822 crore in September, the highest monthly net inflow in the current financial year (April-September 2024). The total FPI inflow in 2024-25 was Rs 80,815 crore. The FPI data covers the period up to September 26 and was collected from the NSDL website. Experts believe that FPI purchases may increase, especially in banking sector stocks.

“Bank shares became attractive after reports of a narrowing of the credit-deposit gap. Since bank stocks are fairly valued in this otherwise overvalued market, the buying trend in bank stocks may continue and thus push the indices higher,” says VK Vijayakumar, chief investment strategist at Geojit Financial Services. However, there are concerns that the market will overheat. According to a recent report by Emkay, despite high valuations, foreign investors are looking at India constructively. Moreover, investors are exploring non-BFSI sectors and are open to SMID. “Growth-adjusted valuations, management quality and balance sheet strength are key variables that play a role for SMID,” the Emkay report adds. Sectorally, the cycle of interest rate cuts will benefit companies in the real estate, infrastructure, automotive and telecommunications industries. On the other hand, the weakening of the dollar index may affect the results of companies from the IT and pharmaceutical sectors.

Despite a solid growth narrative in India, Amit Golia, Group CEO, MarketsMojo, believes that the potential benefits from a cut in interest rates have been largely factored into the current elevated valuations, with the expectation of strong returns on investments in growth-sensitive stocks. Changing interest rates may no longer be a viable strategy. He suggests that individual investors should focus on selecting promising companies in relevant sectors.

To identify good companies, we took into account year-over-year improvement in earnings quality score. This assessment of earnings quality comes from the Reuters-Refinitiv database and is based on a model obtained by combining many basic indicators. Rates the company on a scale from 1 to 100.

A score of 100 represents the highest-rated stock in the region; a score of 1 indicates the lowest rated companies in the region. The closer the rank is to 100, the better the quality of the stock’s returns. According to Refinitiv, the Earnings Quality Score measures the degree to which past earnings are reliable and likely to be sustained. Companies with a high earnings quality score have sustainable earnings and strengthening fundamentals, which will help them outperform their benchmarks. The result is calculated on the basis of accruals (current assets/liabilities), cash flows (including cash flows from operating activities and capital expenditures) and the operational efficiency of the company. The first two variables are analyzed in terms of their annual change in relation to average net operating assets. Operational efficiency is analyzed using operating profit margin and asset turnover ratio. This earnings quality score is retrieved from the Reuters-Refinitiv database for 2022-23 and 2023-24 (last financial year) for 2,351 companies (excluding BSFI shares) with a market cap of more than Rs 100 crore. Of these, 53% of companies saw a deterioration in their earnings quality score, 44% saw an improvement, and 3% saw no change in their earnings quality score in 2023-2024 (compared to 2022-2023).

We analyzed companies that improved their earnings quality score by more than 50% year-on-year, and included those that achieved a minimum earnings quality score above 50 in 2023–2024.

However, because the score is based on an original algorithm, it is not publicly available. The goal is not to understand the functioning or fundamentals of the algorithm, but to use the result to identify companies that have improved the quality of their earnings in 2023-2024. Below are five such stocks that have a decent amount of analyst coverage and currently offer double-digit share price potential.

APL APOLLO PIPES
The structural steel pipe maker reported weak results in June, despite a strong 9% year-on-year increase in sales volume. Higher operating costs and dealer discounts impacted EBITDA, which decreased by more than 2% year over year. September is expected to be more difficult, also due to lower dealer restocking due to falling steel prices.

However, a strong recovery is expected in the second half of the current financial year, driven by pick-up in post-monsoon construction activity, cost rationalization initiatives, operating leverage benefits, improved product mix and improved export volumes. The company is expected to increase market share as the price difference between primary and secondary steel producers decreases. Additionally, the expansion of factories in Raipur and Dubai will improve the VAP (value-added products) range, which will support margins.

To penetrate regional markets (and reduce transportation costs), the management is planning three new plants in Siliguri, Gorakhpur and Ahmedabad. The new plants will help it increase its production capacity to 5 million tonnes in 2025–2026 and will contribute to its revenues.

Analysts cite the company’s strong brand positioning, solid distribution network, cash generating ability and industry-leading capability as key strengths.

LARGE CERAMIC
Tile supplier and manufacturer DECOR SOLUTIONS reported weak results in the June quarter due to the impact of the heatwave and general election. Consolidated revenues and EBITDA decreased year-over-year by 1.4% and 3.2%, respectively. However, performance is expected to improve in the second half of 2024-2025, driven by increased demand for housing and exports.

EBITDA margins are also expected to improve in the coming quarters due to improved product mix (higher share of glazed ceramic tiles), operating leverage benefits, stable gas costs and increased capacity utilization. The company is a beneficiary of dynamic development prospects for the tiles and sanitary ceramics industry.

While the growth of the real estate, retail and hospitality sectors and the growing demand for personalized ceramic products are some of the factors driving the former’s growth, it is driven by the growing preference for feature-rich bathrooms and the growing demand for interior decoration in residential and commercial spaces. the growth of the latter.

Due to the lack of major investment plans (only maintenance expenditure in 2024-2025) and the lack of significant debt repayment, analysts expect that the level of cash generation will remain at a good level in 2024-2025. The company’s diverse product range, wide distribution network, strong brand value, technological progress in the form of modernization of machinery and geographical diversification of production plants are just some of the key advantages.

HONASA CONSUMER
The PERSONAL CARE products company reported strong results in June, with revenue growing 19% year-on-year, driven by distribution expansion, scaling of emerging brands and market share gains. In turn, lower overhead costs supported EBITDA, which increased by 57.3%. Mamaearth continues to perform well and has increased its market share in the face wash and shampoo segments.

Management is expanding offline distribution, gradually switching to mainstream distributors from smaller distributors. The company maintained its secondary sales growth forecast of over 20% for 2024-2025. Recent brokerage reports from Ambit Capital and Emkay are optimistic about the company’s prospects.

Product innovation, newer brands, expanding digital and offline reach, strengthening consumer engagement strategies and rapid pace of new product launches based on understanding emerging consumer interests are some of the factors mentioned in the Ambit report that will help it stay ahead of its FMCG competitors in terms of taxation.

Emkay’s report predicts double-digit margins from 2025-2026, driven by logistics cost optimization and operating leverage benefits. He cites the company’s asset-based approach, focus on acquiring new brands, strengthening business efficiency and presence in many niche areas of Indian BPC as key advantages.

ACC
The June quarterly results of CEMENT PLAYER were affected by a decline in implementation. Despite the increase in volumes, revenues decreased by 0.9% year-on-year. Benefits from the master supply agreement with parent Ambuja Cement and growth in premium products contributed to volumes growing 9% year-on-year in the quarter. The management board is optimistic about the growth in demand for cement in 2024-2025, which will be driven by increased government spending on infrastructure and growing demand for housing.

Additionally, the acquisition of Sanghi Industries and Penna Cement, commissioning of the integrated Ametha unit in the last financial year and acquisition of stake in Asian Cement provide visibility into volume growth. The company increases the share of WHRS (Waste Heat Recovery Systems) in its fuel mix. The management also intends to increase the share of green energy by 60% by 2027-28.

Moreover, the company is expected to benefit from its parent company Ambuja Cement’s cost-saving strategy, which aims to optimize in raw material sourcing, logistics and energy and fuel costs. According to Reuters-Refintiv data, the company’s shares are valued at a forward 12-month EV/EBITDA of 12.02 times, which is an attractive amount and corresponds to the cement industry’s median multiple of 12 times.

MARUTI SUZUKI
THE CAR MANUFACTURER reported a 10% year-on-year improvement in unit revenue in the June quarter, driven by increased volumes and a higher UV (commercial vehicle) mix. On the other hand, benefits from operating leverage and favorable commodity prices supported EBITDA, which increased by 50.9% year-on-year.

To overcome the slowdown in the entry-level and small car segment, the company is increasing the number of UV filters in its lineup. It plans to increase its annual production capacity to 40 lakh units by 2030-2031 from the current 20 lakh units. To achieve this, it plans to build a new greenfield facility in Gujarat and work on a new construction facility in Haryana is already well underway. It is also focusing on diversifying its powertrain mix towards battery electric vehicles, hybrid vehicles, CNG and biofuels to meet emission standards. Analysts cite recent launches, brownfield expansion, SMG acquisition benefits, increased CNG penetration, export opportunities and revival in demand during the festive season as key growth drivers.

A recent report by Motilal Oswal predicts that the company will outperform industry growth during 2023-2024 and 2025-2026, with a consistent 15% earnings CAGR. Moreover, any GST cut or favorable government policy on hybrid vehicles could trigger a rating change as the main beneficiary would be Maruti Suzuki.

Note:Current price as of September 24, 2024. Nifty 50 12M forward PE: 22.2. Source: Reuters Refinitiv.