Glorified Small-Cap Dwarfs - The 5 Minute WrapUp by Equitymaster
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Glorified Small-Cap Dwarfs

Aug 20, 2016
In this issue:
» Short sellers making hay in Japanese stock markets
» The threat to auto industry from contractual workers
» Weekly market roundup
» ....and more!

00:00 Chart of the day

Tanushree Banerjee, Co-Head of Research

Who doesn't love a fairy tale?

They have fairies, mermaids, dwarfs, giants, unicorns, and what not. They stretch our imaginations beyond reason. And they have happy endings!

A good way to make a remote possibility seem feasible in real life is to associate it with fairy tales. No wonder tech startups are called unicorns. (The term 'unicorn' is used for new-age digital business at billion dollar valuations.)

The overwhelming majority of startups want to become unicorns as fast as possible. The entire focus of newbie entrepreneurs has shifted from building great businesses to fetching unimaginable valuations.

Silicon Valley - startup Mecca - has produced dozens of unicorns, chiefly Google (now Alphabet) and Facebook. Their success is encouraging startups in India to race towards the billion-dollar mark.

And now, shockingly, the average time it takes for a tech startup to become a unicorn has halved. It took Infosys, Just Dial, Info Edge, and MakeMy Trip over a decade to fetch unicorn valuations. But angel investors have now rewarded ecommerce and social media companies unicorn valuations in less than five years.

The latest to join the tally is Hike Messenger, which became a unicorn in less than four years.

Lost on investors is that the fact that comparing a Google or Infosys with an entity like Hike Messenger is like comparing giants to dwarfs.

These small businesses may be nimble and growing fast. But they've never gone through a business cycle...never jumped through hurdles. In reality, these businesses can actually be deformed by the hectic pace of growth.

Measuring the success these ventures with vanity metrics like 'gross merchandise value' does not help. At some point, investors will want to see profits. To stay in business, employees will have to get paid and customers will have to be serviced. Otherwise, these billion-dollar valuations could be eroded overnight.

Don't assume the unlisted unicorns are the only problems. Small-cap dwarfs can be found in every sector. They're typically promoted just prior to getting listed. And investors fall over each other to get a piece of these glorified small-cap dwarfs when they debut on the bourses.

Investing in stock markets, unfortunately, does not work too well beyond the realms of reason. So whether it is the billion-dollar valuation of unicorns or overvalued small-cap IPOs, one needs to be careful if one wants a fairy-tale ending.

At Equitymaster we have another approach to picking winning smallcaps. One that has offered three times the returns of the benchmark smallcap index since inception. In case you are still wondering whether such an approach actually works, we have proof to share as well! Just click here for details...

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01:40

In India, one of the strongest pitch to investing is that the economy, businesses and hence the stock markets would do well in the long term. The optimism has brought a lot of investors, domestic and foreign, back to the market.

But this is not the case everywhere. Consider Japan. Well-known Japanese companies are witnessing erosion in the market cap as their corporate governance practices, inadequate disclosures and aggressive accounting practices are under attack. This has dented investors' confidence. But all is not bad. The Japanese Government is trying to clean up the corporate culture. While that would serve the interests of long term investors, short term sellers have sensed a huge opportunity. As suggested in an article in Reuters, in a short time, short sellers have launched campaigns against companies. This has led to slide in the stock price of these companies, and short sellers are making hay.

While some of these short sellers have been lucky, we believe this could be quite a risky strategy to make money from the markets. First of all, despite one's conviction, getting timing right is crucial - an aspect where short sellers are likely to fail. Second, it involves borrowed money. As such, a wrong call could hurt a lot.

For a long term investor in Indian markets, we believe that what one should instead focus on is margin of safety. And if you are wondering if there are enough such opportunities to make money and if this approach works, you should know that Rahul Shah and his team recommend deep value stocks using such a strategy. A strategy, which since inception, has outperformed Sensex by a fabulous 59.7%.

03:00

In 2012, there were riots in Maruti's manufacturing plant in Manesar. It especially became violent when an HR manager was burnt to death. Earlier, the plant also made the headlines because of a prolonged labour strike. One of the causes was attributed to contract workers demanding better wages and employment contracts equal to what the permanent employees were getting.

Has this incident in any way dissuaded automobile companies in India to hire contract workers? Not really. As per an article in Business Standard, the share of contract workers to total workforce has only increased over the years. Indeed, for Tata Motors, Mahindra and Maruti Suzuki, the share of contract workers stands at more than 40%. Companies typically hire contract labour when the demand outstrips supply. For instance, Maruti has been seeing good response for its new models such as Brezza, Baleno and Ciaz and so the company hired contract workers in good numbers to cater to this demand. The idea is that because they are temporary workers, during times of an economic slowdown, they can be laid off.

The problem is that the lack of skilled labour force many companies to hire more contract labour. They are often paid lower than permanent workers but sometimes end up doing equally-important jobs. Which is why if sense of disillusionment grows among the temporary workers, another Manesar like incident cannot be entirely ruled out. Of course, if the government does a lot in overhauling India's archaic labour laws, it will benefit not the just the automobile industry but the entire manufacturing sector immensely. How all of this will play out remains to be seen.

04:15

Global indices closed on a mixed note for the week. China (up 1.9%) and Brazil (up 1.4%) were among the biggest gainers. Japan (down 2.2%) and France (down 2.2%) were the top losers in the pack.

European share markets posted their biggest weekly loss in two months, while the US market edged lower, led by declines in utility shares as investors weighed prospects for an interest rate increase in the coming months.

The minutes of Federal Open Market Committee (FOMC) meeting held last month released this week signalled that doors are still open for 2016 interest rate hike. This comes as The US central bank's policymakers expect that an interest rate increase will be needed soon. However, the general agreement is that more data will be looked upon before such a move becomes reality.

Back in Asia, China's industrial output for July grew 6% YoY July retail sales grew a respectable 10.2% on year. Similarly, fixed asset investment (FAI) for the January-to-July period rose 8.1%. China's statistics bureau mentioned that the economy remained under downward pressure amid a period of adjustment. The mainland has been working to transition its economy toward domestic consumption and away from reliance on investment- and manufacturing-led growth.

In Hong Kong, the share market had a belatedly positive reaction to China's confirmation that the Shenzhen-Hong Kong Stock Connect program will proceed later this year. China on Tuesday gave the green light to a stock-trading link between Hong Kong and Shenzhen, which is expected to boost trading flows into both markets. Under the program, global investors would be able to buy Shenzhen stocks and Shenzhen investors would be allowed to buy Hong Kong stocks.

Japan's Nikkei remained choppy and was down by 2.2% this week as investors remained wary over the strength of the yen, which has taken a heavy toll on exporters.

Oil prices surged this week on expectations of revived talks to freeze output levels. Global benchmark Brent crude touched an eight-week high of US$51.1 on Friday and was last trading at US$48.5.

In currency markets, The U.S. dollar was near an eight-week low against major currencies in the wake of minutes from the Federal Reserve's July meeting published on Wednesday showing policymakers were unlikely to raise interest rates soon.

Back home, the Indian indices ended with a negative zone. Weak global cues, profit booking and a weak rupee subdued the Indian equity markets. Investors also turned cautious ahead of the announcement of the next RBI governor. The BSE Sensex was down by 0.3% for the week.

Read more on global market roundup for the week here.

Performance During the Week Ended 20th August, 2016

04:50 Weekend Investing mantra

"The individual investor should act consistently as an investor and not as a speculator. This means that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase."- Benjamin Graham

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst).

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1 Responses to "Glorified Small-Cap Dwarfs"

Govind

Aug 20, 2016

This response is not to "Glorified Small-Cap Dwarfs". It is regarding presenting of these articles. Apparently the information being given in these newsletters is important but reading so much material everyday on the computer screen is tiring and uninteresting. Instead I wish to suggest the presentation be in the form of a video expressing vocally by a good orator. Surely nobody wants to miss the valuable insights being shared here.

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