Two Stocks to ‘Buy’ with Better Risk/Reward Ratio

Updated: Dec 7, 2019

If a trader buys a stock at 100 Rs., places a stop loss at 99 Rs. and a profit target at 103 Rs., then the risk on the trade is 1 Rs. (100–99) and the profit potential is 3 Rs. (103–100). The risk is then compared to the profit to create the ratio: risk/reward = 1 / 3 = 0.33.

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If the ratio is great than 1.0, the risk is greater than the profit potential on the trade. If the ratio is less than 1.0, the profit potential is greater than the risk.

The risk/reward doesn’t need to be very low to be effective, though; anything below 1.0 is likely to produce better results than taking trades with a greater than 1.0 risk/reward ratio.

You need to be extra cautious when you go shopping at the time when the market is at its peak. A better risk/rewards give you a chance to buy stocks with considerable upside potential with limited downside risk.

Nowadays, Investors are more focussed on microcaps, small-caps and midcaps segments. Even today, since about the last two years, while Nifty has risen 16%, small-caps have on average fallen 35%. Thus, small caps are trading cheaper than they were two years ago –in an absolute sense; and also in relation to large-caps. Moreover, if the history is anything to go by, whenever there has been a bad year for small-caps and midcaps, it has usually been followed by a three-year rally. This has happened multiple times in the past and it remains to be seen if the trend repeats this time around.

After Collecting the data I came up with two stocks which I think hold better risk/reward at current market price.

1) Vedanta Ltd (Current Price: 140 Rs.)

Target Price (Short term): 175 Rs. Target Price (Long term): 245 Rs.

About the Company:

Vedanta Limited is a natural resource company engaged in the business of manufacturing copper and copper products, and aluminum and aluminum products. The Company’s segments include Copper, which consists of manufacturing of copper cathode, continuous cast copper rod and anode slime, including from purchased concentrate and manufacturing of precious metal from anode slime, sulfuric acid, phosphoric acid; Iron ore; Aluminium, which consists of manufacturing of alumina and various aluminum products; Power, which consists of power, including power facilities engaged in generation and sale of commercial power, and Other, which consists pig iron and metallurgical coke. Its iron ore business consists of iron ore exploration, mining, beneficiation and exports. The Company has iron ore mining operations in the States of Goa and Karnataka. Its copper business consists of custom smelting. Its power business consists of 2,400-megawatt thermal coal based power facility in the State of Odisha.

Fundamental Analysis:

Stock is trading at 0.81 times its book value and delivered a Compounded Sales Growth of 34% in the last 10 years. Pledged percentage: 0.00 % and with ROE of 10.96 %. One of the best points about Vedanta investors is Company has been maintaining a healthy dividend payout of 86.18% (Dividend Yield: 13.49%). EBITDA is at 3 times of its interest expenses and, Free cash flow last year: 14,937 Cr. so no cash crunch. Debt to equity is 0.70 and the Inventory turnover ratio at 7.32.

One of the biggest reason for selecting VEDL it is undervalued. Vedanta is trading below our estimate of fair value (₹217.64).

What is fair value?  Answer: An estimate of what the stock price is today, based on the cash flow the company is expected to generate in the future.

Note : Vedanta is currently bearish on charts so any short term correction is possible but Vedanta has not had significant price volatility in the past 3 months.

2) Apollo Tyres (Current Price: 166 Rs.)

Target Price (Short term): 200 Rs. Target Price (Long term): 250 Rs.

About the Company:

Apollo Tyres Limited is engaged in manufacturing and sale of automotive tires. The Company’s segments include India, Europe and Others. The Indian segment includes manufacturing and sales operations through India. The European segment includes manufacturing and sales operations through the plant at the Netherlands along with its subsidiaries. The Others segment includes the subsidiary in the United Arab Emirates, South Africa, Thailand and other operating subsidiaries. It manufactures tires, tubes and flaps. Its products include Passenger Vehicle, including ALNAC, ALNAC 4G, AMAZER 3G MAXX and AMAZER 4G; Commercial Vehicle, including AMAR, AMAR AT-RIB, AMAR DLX, AMAR GOLD and CARGO PLUS XR; Off Highway Tyre, including AGREX 85, BHIM, DHRUV, FX 515 (ROW CROP) and FX 525, and Two Wheeler Tyre. The Company has approximately four tire manufacturing plants, over two located in Cochin, and one each at Vadodara and Chennai.

Fundamental Analysis:

Stock is trading at 0.98 times its book value and delivered a Compounded Sales Growth of 14% in the last 10 years. Despite the heavy headwinds of automobile slowdown Company has been maintaining a healthy dividend payout of 21.65%. Interest Coverage Ratio: 4.66 as it is fully capable to pay its short term liabilities and a Return on Equity of 15.90% for the last 10 years.

Today (03 Dec 2019) Apollo tyres entered Saudi Arabia through a tie-up with Al-Jomaih Tyres Company Limited. The company is looking at the large and growing truck-bus radial and passenger car tyre market, aiming to capture a sizeable market share, in each of the segments, in the next couple of years. This may boost the bottom-line of the company so its stock price.

``The entry into the Kingdom of Saudi Arabia is the culmination of a long-term product planning and development programme. We are now ready with products suited to cater to the Saudi market, which is the largest and important replacement tyre market in the Middle East region,”— Shubhro Ghosh, group head ASEAN, Middle East & Africa of Apollo Tyres

APOLLOTYRE’s forecast earnings growth (28.2% per year) is above the savings rate (7%).

Note : Apollo Tyres is currently bearish on charts so any short term correction is possible but Apollo tyres has not had significant price volatility in the past 3 months.

Akshay Seth Linkedin | Twitter Learn Stock Analysis in 30 Days here

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