Do you have this at the top of your smallcap checklist?

Dec 8, 2010

In this issue:
» More transparency in awarding road projects
» High government debt plagues India as well
» Where an economist drives a taxi...
» Important takeaways for India's education reforms
» ...and more!!

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To most investors, investing in mid and small cap stocks comes with the lure of making lots of money. That too very quickly. But unfortunately, for most retail investors this objective remains a distant dream. Every rally in mid and smallcap stocks ends with some retail investors burning their fingers. Being relatively less transparent as compared to bluechips, such stocks do entail much higher level of risk taking. However, the risks could be reduced to an extent if an investor has done his homework properly.

This is not to say that the process of researching bluechips is very different from that of researching their smaller peers. Even bluechips can lack transparency. But the criteria that should top your checklist for selecting stocks, especially in the mid and smallcap space, is management quality. Nothing better to support this argument than statistics on the performance of smallcaps in recent times. Nearly a third of them have hit the lower circuit in recent days. Agreed, some of the negative sentiments may be backed by concerns on valuations. We appreciate that. But a large part of the panic has been driven by the SEBI's crackdown on insider trading practices by the promoters of lesser known companies. Such risks are not evident in the annual reports and valuations of these companies. Nevertheless, a critical observation of the management's reputation in steering the business can give some cues on its quality. And we believe that this should top an investor's checklist while researching mid and smallcaps.

Do you check the management quality while selecting smallcap stocks? Let us know.

 Chart of the day
Most products and services globally are invented keeping the urban consumers in mind. Especially the ones residing in the metros. But interestingly, not in every part of the world do the metros contribute a lion's share of the national GDP. Asian cities like Mumbai and Shanghai for instance, which are also the financial capital of their respective economies, have less than 6% share of the national GDP. It is therefore pertinent for companies in India and China to concentrate on products catering particularly to the semi urban and rural consumers.

Data source: Metromonitor report 2010

Now this is something unusual. The government is looking at reducing its governance to speed up decision making. We are talking about the finance ministry that has suggested a transparent auction system for road projects. And by 'transparent', it means no involvement of the government in awarding the projects. The idea is to bring about a greater competition between private sector developers. This, the ministry thinks, will lead the contractors to offer projects on most cost-effective terms. While we are sure that a transparent mechanism as proposed will help in a faster progress, it is the actual implementation of these plans that is highly doubtful.

An economist driving a taxi and a post graduate waiting at a restaurant. There cannot be perhaps a worse example of a gross misallocation of resources. And this is what happens when you ignore a building up of a bubble so massive that the entire economy gets derailed. We are indeed referring to the troubled euro nation of Spain. As per a leading daily, apart from the scenes mentioned above, there is also this huge problem of massive unemployment in the country. The most distressing number is the youth unemployment rate. According to latest data, a whopping 40% of the population that is under 25 years of age is unemployed in Spain.

How did things come to such a pass in Spain? Blame it on the country's real estate bubble. Taking advantage of the Euro Zone's low interest rate, people started speculating heavily in real estate. The country's banking system too joined in the fun by extending loans by the truckloads to the sector. As per a study, the Spanish market accounted for a huge 67% of all the housing units built in Europe between 1999 and 2007. And since this was not real and just an illusion based on low interest rates, the hardening of the rates led to the entire sector go bust and with it also brought the entire banking sector in trouble. A long period of rebuilding is thus required and until such time, an economist, employed previously in the real estate sector, will have to keep driving a taxi perhaps.

Some key statistics from the mid-year economic review were comforting indeed. Especially, the projected GDP growth of 9.1% GDP for this financial year. However, the high domestic debt-to-GDP ratio remains an area of concern. The government debt is forecasted to fall to 80% of GDP by end-March 2011. The same stood at 83% at end-FY10. A stronger GDP growth and one-off revenues from the 3G licence and broadband spectrum auctions will have a benign impact. Nevertheless, given the kind of problems that high debt has brought to Western economies, even this ratio elicits concerns. Think of the Government of India as a company. Debt to GDP of 80% means an interest coverage ratio of 1.25. Something to worry about, isn't it?

The US has been lagging behind China and India in terms of economic growth. There are several reasons that have been cited in the past for this. But one that has not been explored till now is the difference in education systems in the West and the East. In a recently held international test, students from China topped their American peers. The prime reason for this could be that the Asian education system is far more superior. Culturally the Asians prioritize education over all else. On top of this, countries like China have raised the teachers' pay, given more choices to its students in terms of curriculum and have improved the standards of the teachers in their schools. Instructors are awarded for results rather than for their seniority and the number of degrees that they hold. We hope that Indian education system adopts these standards as well. Only then will we be in a position to utilize our most abundant resource productively.

The Indian generics industry exports drugs worth Rs 400 bn annually. That's huge by any standards. Indian pharma companies benefit immensely from the same. But millions of people especially the poor also get access to cheaper medicines. Therefore, there were concerns at the India-EU Summit that India might be asked to curtail its exports of generic medicines to other countries and adopt EU norms.

It must be noted that India's IP regime complies with trade related intellectual property rights. This is part of the World Trade Organisation (WTO). But its laws are not as stringent as that of the EU. What it means is that India still continues to sell cheaper generic drugs to countries that do not have the capacity to produce them. But many of these medicines still have valid patents in the EU. Despite this, the intent to make medicines accessible and affordable has gained more favour. Especially with respect to diseases such as HIV which has the largest incidence in Africa, a continent which is very poor and cannot afford patented drugs. All this has meant that the EU-India pact will not impose restrictions on the export of generics.

Led by weakness in auto, banking and commodity stocks, the Indian indices failed to make inroads into the positive territory since the start of the session today. The BSE-Sensex was trading 241 points lower at the time of writing this. The mid and small cap indices were down 1.7% and 2.7% respectively. Other Asian markets closed a mixed bag with the Japanese and Indonesian markets leading the gainers. The European markets have opened lower.

 Today's investing mantra
"Our investment style has been given a name - focus investing - which implies ten holdings, not one hundred or four hundred. The idea that it is hard to find good investments, so concentrate in a few, seems to me to be an obvious idea. But 98% of the investment world does not think this way. It's been good for us." - Charles Munger

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16 Responses to "Do you have this at the top of your smallcap checklist?"


Dec 18, 2010

Dear Sir,
In your comment as follows :
"Think of the Government of India as a company. Debt to GDP of 80% means an interest coverage ratio of 1.25. Something to worry about, isn't it? "

Interest coverage ratio is the amount of times interest is covered by income isint it?
India`s debt is 80% of GDP, not interest payments..
So Interest coverage ratio should be higher that 1.25, isint it?
Correct me if I am wrong...



Dec 13, 2010

You may be right about blue chips but it is clear that the best of the companies forge their financial their papers. I hope you have not yet forgotten the case of Satyam. Just prior to the scam, it had received award for corporate governance.


jagdish sanghvi

Dec 9, 2010

Dear Sirs/Madam
It is very easy to talk about and expect certain impossible things of small/retail investors. I am sure you as EM, who has lot of resources, must have also seen what I mean. Basically retail investors have to depend on reliable people like EM, and take it from there. In my interaction with several of your people, I can say that your management is good and trustworthy, who will not mislead the retail investors. This kind of assessment takes a long time, by then the opportunity is gone. So we go by your views.

Tell us honestly, do you really check and judge the management for our safety???

Your honest reply will be most appreciated.

Jagdish Sanghvi


Raghav Kheria

Dec 9, 2010

Its very easy to give advice that one should check on quality of management. Apart from institutional investors who have access to management does EQUITY MASTER have any tangible ideas on how to research management of small cap and mid companies? Quite honestly, its not possible for retail investors to research management unless there are some media reports. Perhaps EM should take out a FREE GUIDE on how to research management because it is next to impossible to do so.



Dec 9, 2010

It is heartening to read the education system in China where they encourage teachers with good pay on the basis of their performance rather than seniority. But in India even though their pay is recommended by the Pay Commissions, it will not be paid till they resort to strike. The reason is "No Funds". However, for payment of salaries and perks to our elected members, neither their performance nor the availability of funds is considered. This is OUR INDIA. Thank God, inspite of all these odds, we have come up not because of Governing Bodies, but by the sheer struggle of few Indians who migrated to other countries. If corruption and crab mentality was not in India, what progress we would have achieved is a point to ponder.


M Sarangi

Dec 8, 2010

In most of your recommendation, you mention to check for the quality of management. But where do we find this information?


Murali Krishnan K

Dec 8, 2010

With Equity Master recommendations, I dont, honestly.
With other investments, I do, of course. But I,m not sure whether I'm correct. Because with Tatas, Birlas and recently Infosys who follow ethics, we can blindly invest. With Essar group, I burnt my fingers. With Ambani's, I'm cautious.



Dec 8, 2010

All my investments in midcap and small caps are based on recommendations from equity master. So the question need to be asked by me to Equity Master. Can your team honestly tell that their recommendations are based on this principle or only to come out with some recommendations to satisfy subscribers. Can we get an honest answer in 5 days of this message?



Dec 8, 2010

The story on education system in China is an eye-opener and a good example for India.

Director,Foreign Policy Research Centre, New Delhi



Dec 8, 2010

No. Normally I avoid small cap companies and in Mid caps & Large Caps also I avoid companies where WEAK management has come to my knowledge thru media (Press, TV, Magazine etc.).
But, if nothing is known about the quality of management THEN how does one go about checking the same??
I think there is a need for a web site which gives all information about such issues.

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