Is it a good time to re-look at smaller companies? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Is it a good time to re-look at smaller companies? 

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In this issue:
» Tough times continue for the auto sector
» Power sector & investors: A love hate relationship
» Why economic activity is shifting out of India
» Manufacturing mars India's IIP, again
» and more....

One glance at the earnings trend of companies forming part of the BSE-Sensex shows that the scenario is not quite as bad. Their profits continue to grow steadily; albeit at a slower pace in recent times. But as one looks at the same trend for the mid and small-sized companies, the scenarios become quite different. The slowing economy and high debt costs are just some of the factors that have impacted their performances in recent times. As put by the Economic Times, factors such as poor infrastructure (including irregular power supply) coupled with rampant corruption are also reasons that are hurting smaller companies.

The combined earnings of the stocks forming part of the Midcap index have risen sharply in the past six months - after a very sharp decline in the same period before. However, for smallcaps, the earnings have been declining for about two and a half years now. It may however be noted that the constituents of these indices change on a regular basis thereby not giving an exact comparable number or trend. Nevertheless, judging by the way the BSE Mid Cap and BSE Small Cap indices have declined in the year till date, investors seemed to have completely lost hope. The indices are down by as much as 25-30% in the past seven and a half months.

With such sharp declines in recent times, it does make us wonder whether it is time for investors to start looking at midcaps and smallcaps as possible investment opportunities. Looking at the attractiveness of such companies using the price to earnings multiple would not really make sense. This is because it might give a distorted picture on the back of the volatile/ declining earnings. However, when gauging such stocks using the price to book value method (PBV), we believe investors could take up this opportunity to look for good companies.

The current PBVs of the BSE-Midcap and BSE Smallcaps are the lowest they have been in over four years. The BSE-Midcap index trades at about 1.5 times. The BSE-Smallcap index trades at a little over 1 time its book value. The key here would obviously be to look for companies having excellent financial track records, especially strong balance sheets to sail through forthcoming difficult times, amongst other qualitative parameters. Also, given the tough times, some of the seemingly good companies have also seen their earnings erode. Here, it would be wise to understand the reasons for declining earnings. Investors should seek the answer to the question - Is the earnings decline just due to the depressed economy or is there something structurally wrong? On an overall basis, we believe investors could take help of the poor sentiments surrounding the smaller companies to pick out gems trading at attractive valuations.

Do you think it is a good time to start looking at mid and smallcap stocks? Please share your comments or post them on our Facebook page / Google+ page

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01:25  Chart of the day
Auto sales continue to decline. The month of July 2013 was the 9th straight month of declining sales volumes for passenger vehicles. The scenario is much worse for the commercial vehicle industry as this last month's decline takes the count to a whopping 17 months of successive decline in volumes of heavy and commercial vehicles. Higher fuel prices, interest rates, subdued sentiments have all been factors behind the decline. The discounts offered by the auto companies have also not led to any change in sentiments.

How long the decline would continue is anyone's guess. Lower interest rates and a stimulus for the auto industry are the key demands of the auto industry - the latter being in the form of lower duties and taxes, amongst others. The general consensus is that the poor volume trend is likely to continue till the end of the current fiscal. We believe it's a matter of time before the base effect kicks in to display the industry's growth figures. Also, given the declining sales volumes of the non-commercial vehicles could possibly increase the pent up demand for such vehicles. As such, the upcoming festive season could possibly throw up surprises.

Data Source: Economic Times
UVs - Utility vehicles, T&Bs - Trucks and buses, PCs - Passenger cars, w - wheelers

The story is not unique to this sector. There are several others that have been tagged as 'sunshine sector' by investors in the past. Only to be abandoned when the prospects start looking relatively bleak. The prospect of the power sector, in reality, is more real and promising than dotcom, solar energy and real estate. Being the backbone of industrial and infrastructure growth, the power sector has been the focus area for consecutive governments. However, barring a few measures like the Electricity Act, most have been half baked. The result being that projects that were started with much enthusiasm were abandoned midway. Lack of flexibility in tariff hikes and poor recoveries from state electricity boards (SEBs) were a big dampener for power producers. Curbing the losses in power transmission and distribution (T&D) sector was the objective of the Electricity Act. However, a decade later we are back of square one in terms of T&D losses.

Needless to say investors too have had a love hate relationship with the power sector. There was a time power sector IPOs were a rage. Investors would recollect the Reliance Power IPO that was over-subscribed several times without a penny in revenue. And now even the largest and most efficient power generators are trading at historically low valuations. As per a former union Power Minister, the very promising blueprints of Ultra Mega Power Projects are now gathering dust.

We believe investors must not get swayed by the 'sunshine sector' theme. Instead a careful analysis of long term potential would hold good for equity investments. And by that logic, several solid stocks in the power sector are now available at mouthwatering bargains.

Bad news continues to pour for the Indian economy. The latest is that the IIP (Index for Industrial Production) has contracted for the second month in a row. The IIP was down by 2.2% YoY in June 2013. The decline was triggered by the dismal performance of manufacturing, mining and power sectors. Of these the decline in manufacturing has been cited as the most worrisome. Industry bodies FICCI and CII have cited this as a major concern. As per Firstpost, they have stressed on the need for an interest rate rollback to boost investments. The industry bodies have also stressed on the need for the government to take and implement policy initiatives to revive investments and stimulate demand in the country. Unless that happens, demand would continue to take a hit and investments would continue to decline. And that would result in lower IIP numbers. If that happens, then the economy would just slowdown further. In our opinion the onus for reviving investments and demand lies on the government. If it is able to remove the structural roadblocks, then the cycle would turn for the favorable. Once that happens, the RBI would follow with rate cuts which would further boost growth in the economy.

Where will businessmen go? Is growth potential all that matters? The answer seems to be no. Some very critical factors that play a decisive role in where businessmen will invest are red tape, corruption, infrastructure, etc. India ranks very poorly on these important parameters. This explains why despite having great untapped growth potential, the Indian economy is struggling. And this is also why economic activity is shifting out of India.

An article in The Economist very aptly articulates this point. Here are some noteworthy instances. Indian airplanes are usually serviced in Dubai, Malaysia and Singapore. Why not in India? The reasons are high penal taxes in India and high customs duties on imported spare parts. Many Indians have headquartered their businesses in Dubai. The reason is simple. Dubai offers a much better logistical base with its ports, air links and immigration rules.

Take Singapore. It is said to be the largest hub for Indian trade. It thrives as an investment banking centre owing to stringent regulation of India's banks and debt markets. Indian e-commerce firms too often get their data crunched in Singapore. Similar is the case with legal services. It is worth noting that at least half of all rupee trading takes place outside India.

Then there is Colombo, a very important port in Sri Lanka. Of the containers bound to India, about 30% go via intermediate hubs fed by small vessels. Why so? There are majorly two reasons. Either big shipping lines do not want to deal with India's customs regime or their ships are too big for India's ports.

One can understand economic activity moving out of developed economies owing to high costs. But for a developing country like India, it is a very grave sign. Policymakers ought to wake up before India's growth prospects go down the drain.

Did you know that as per the Wall Street Journal, there's a less than 15% chance on another recession hitting US in the next 12 months? And also that there's only a 13% chance that growth in GDP this year will be stronger than the long term average of 3.5%. Well, if you didn't, don't really bother. Simply because while these numbers give the impression that economists know the economy like the back of their hands, nothing could be further from the truth. The fact is that most Economists suffer from what is known as the Physics envy. In other words, they try to apply the tools of natural science to what is essentially a social science. In other words, disciplines such as physics deal with interactions between mostly inanimate objects. Social sciences such as economics on the other hand have thinking participants in them. Therefore, to model a social science based on the principles of natural sciences is the mistake of the highest order we believe. Thus, investors would do well to not read too much into the above predictions and instead, focus on preparing themselves for the future rather than predict it.

After opening the day on a negative note, the Indian equity markets moved to trade in the green. At the time of writing, the BSE-Sensex was up by about 196 points (1.0%). The major Asian equity markets closed the day in the green as well with markets in Japan and South Korea leading the gains in the region.

04:50  Today's investing mantra
"I have owned one stock since 1969, two since 1988 and one I started buying in 1986 or so. That's my portfolio. Six stocks. I once owned 17, but that was way too much."- Philip Fisher
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2 Responses to "Is it a good time to re-look at smaller companies?"

Rajendran. T

Aug 14, 2013

I think you have to make a list of such companies and provide them to your subscribers.

Like (1)

Dr Joseph Babu

Aug 13, 2013

smaller the scrip price riskier the investment

Like (1)
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