Here’s a selection of stocks with robust ROCE and low PE ratios

Investors who search for quality stocks in the market on the basis of their fundamentals look at various parameters—some capturing growth of the top line and others focusing on the operating or net income variables.

Another yardstick that long-term investors look at while picking quality stocks is how efficiently a company manages its employed capital or financial resources—debt as well as equity. This is captured via return on capital employed (ROCE), which measures how efficiently the company is utilizing its capital to churn out a profit.

This is derived by looking at the operating profit as a percentage of capital employed. One can even marry this criterion with firms that have a low valuation ratio such as price-to-earnings multiples to identify quality stocks that may be undervalued currently.

We used this filter to pick a set of companies that have ROCE of over 20% but currently out of favour of the market with low PE ratios.

This throws up a list of around 100 names with ROCE above 20% and PE ratios for the 12 trailing months below 15. Given the state of valuations in the market, such low PE ratio implies these stocks may not be overpriced.

But we go a step further to factor out small caps as they may have liquidity issues or too small a scale to create alpha over time.

Interestingly, around nine out of every ten such stocks fall in the small-cap category, or companies with a market valuation of less than Rs 5,000 crore.

However, there are a few larger firms that could present a long-term buying opportunity even though they may fall under a sector that is going through turbulence or a temporary slowdown.

In the large-cap space, just two stocks pass the filter: Bajaj Auto and state-controlled miner NMDC.

There are a set of around half a dozen other such firms in the mid-cap space, or those with a valuation of Rs 5,000-20,000 crore.

In this set, we have stocks like Chambal Fertilisers, Finolex Industries, Redington (India), IIFL Finance, Jindal Stainless, Supreme Petrochem and Kama Holdings.

Small caps

Some of the prominent names in the small-cap space that meet this condition include Phillips Carbon Black, HG Infra Engineering, Godawari Power, Kirloskar Ferrous, Maithan Alloys and IIFL Securities.

Bhansali Engineering, Somany Home, Hindustan Construction, Apar Industries, TV Today Network and LT Foods, among others, are also part of this club.