The 'Must Have' Small Cap Stocks - The 5 Minute WrapUp by Equitymaster
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The 'Must Have' Small Cap Stocks

Oct 24, 2016
In this issue:
» Govt's big aviation ambitions are a big mistake
» Are Indians ready to switch to paper gold?
» Market roundup
» ...and more!
00:00
Richa Agarwal, Research analyst

The BSE Small-Cap Index is trading at a PE of 93 times. That's far above the BSE Sensex's PE of 21 times. Over the last one year, the small-cap index has trumped large-cap returns by 13%.

The high index valuations have caused many to warn against small caps. But we think the warnings could be overblown.

The problem with the much-touted index PE is that, while it does help with the big picture, it's not sufficient for individual stocks. As I wrote in a recent Research Digest:

  • We agree that such times warrant extreme caution while picking stocks. However, if anyone quotes the indices and tells you to stay away from small caps, give them a wide berth. The small cap index, after all, is not a good representation of small caps.

    Around 4,500 stocks have a market cap below Rs 53 billion (we have chosen the market cap of second biggest stock listed on small cap index as the cut off, since the biggest company with the market cap of Rs 107 bn seems to be an outlier). In comparison, just 720 stocks make up the small-cap index. In short, the index does not represent even 20% of the small-cap space.

    So as long as you aren't betting on the index itself, there is a good potential of finding value in the small cap space.

The index PE tells you nothing about the earnings growth potential of individual businesses, their balance sheet quality, their management, or the management's capital allocation skills.

It's true that small caps are a risky asset class. That said, many individual small caps are too small to have any significant impact of macro factors. So for small caps, the business potential and risks rather arise from very specific risk factors - management quality for example - which can be mitigated with diligent research and diversification.

To make big returns, look beyond the obvious - even the much-quoted index PE ratio. In an economy on the cusp of recovery, some small-cap businesses are poised to grow at better rates than their larger counterparts. Value investing with a bottom-up focus could give your portfolio a great boost over the long term.

And there are enough opportunities in the space.

In our small-cap recommendation service, Hidden Treasure, despite closing multiple successful recommendations over the past two months, we currently have a Buy view on ten stocks. Three of them are on our list - Top Stocks to Consider Buying Now (based on ERMTM - our proprietory risk model). Some of them not only offer strong upside but have consistent dividend track records and good dividend yields that can make you money even in a volatile market.

Do check out our report, Steady Income Small Caps - III (subscription required), to know more about these opportunities.

Lastly, the choice is not between small caps or large caps. Smart investing means having a healthy mix of asset classes. And if you are seeking huge returns over three to five years, you can't ignore the small cap space.

02:00

During bull markets investors typically do not worry about losing their money. But a while back, a significant study was done in India by the Indian School of Business. That study took data from the entire universe of orders and trades of Indian investors of all 755 stocks that traded on the NSE over 374 trading days. It tracked a pool of 25 lakh retail investors over 18 months (January 2005 to June 2006).

The study estimated that:

Individual retail investors lost close to Rs 83.76 billion during the sample period.

Now, during that same time period (i.e. January 2005 to June 2006) the market indices gave returns like these

NSE-Nifty - 50.4% returns

Sensex - 60.7% return

That's shocking.

The most shocking thing is that when the markets were doing exceptionally well investors lost Rs 83.76 billion...

What would happen when the markets fall?

Click here to stop these 3 hidden forces from ever touching your wealth again...

02:30

When it comes to the aviation sector, the government simply refuses to learn from past mistakes. In a recent issue of The 5 Minute WrapUp, we explained how the government was misusing public money to fund a virtually bankrupt airline.

  • Air India is a virtually bankrupt airline...sustained purely by taxpayer bailouts.

    Take a look at these numbers...

    During the financial year 2015-16, Air India reported an operating profit of Rs 1.05 billion. This was the first time in a decade that the public-sector airline reported an operating profit (driven mainly by low fuel prices). But this is nothing to cheer about. At the bottomline level, the company reported a net loss of Rs 35.87 billion.

    Here is the reason for the big mess: As of March 2016, the company had a total debt burden of about Rs 460 billion. It was reported that Rs 280 billion comprises short-term loans and the rest is long-term borrowings.

    Now compare the operating profit of Rs 1.05 billion with a debt burden of Rs 460 billion.

Despite such massive mismanagement of public money, the government's ambitions in the aviation industry just seem to be getting bigger and bigger.

As per news reports, under the new UDAN scheme that is likely to launch in January 2017, fares for one-hour flights will be capped at Rs 2,500. With this scheme, the government aims to boost air travel between smaller cities. It has also committed to spending Rs 40 billion to reopen 50 disused airports within four years.

Now, there is no such thing as a free lunch. Everything has to be paid for. At the moment, cheap flights are viable because of low oil prices. But what if oil prices shoot up? What if the airline's cost exceeds this amount? How will the government fund the gap?

Besides keeping the taxes on these flights very low, the government plans to fund the gap by collecting more from airlines operating on profitable routes.

In our view, the government has no business to be in business. This kind of market manipulation proves to be disastrous in the longer run.

To get a true picture of what's really going on in the Indian economy, watch this video now.

03:30 Chart of the day

Indians love Gold. It's an ancient tradition. A few years ago, the World Gold Council estimated that the total gold hoard in India. They came up with a mindboggling figure of 20,000 tonnes held in homes and temples.

There isn't much gold production in India. We import almost all of it. How much? In financial year 2015-16, India imported about 750 tonnes. This puts pressure on our trade balance. Also, the imported gold isn't put to productive use in the economy.

Thus, it is in the government's interest to try and change our behaviour. They would love it if citizens choose financial assets over gold.

Their latest attempt is the Sovereign Gold Bond (SGB) scheme. The SGB is an alternative to physical gold. It is paper gold that mimics the returns of real gold. In other words, you could earn the returns on gold without actually owning gold. And to incentivise Indians to switch to SGBs, the government also offers an interest of 2.75% on the bond. Plus, some tax incentives too. (We have given our view on Sovereign Gold Bonds in The 5 Minute Premium here and here.)

Since November 2015, the government has launched five tranches of the SGB scheme. The chart of the day shows collections from each tranche. As you can see, the first and the third tranche witnessed muted demand. But gradually, investors are showing interest in owning paper gold. The government has collected an aggregate of Rs 30.6 billion through the five tranches, representing 10,155 kg of gold.

Are Indians Ready to Buy Paper Gold?


The sixth tranche of the SGB scheme opens today. The interest rate has been reduced to 2.5% from 2.75% in the earlier tranches. However, the bonds are being offered at a discount. The issue price of the bond will be Rs 50 a gram less than the nominal value. Applications will be accepted from 24 October to 2 November 2016. The RBI will issue the bonds on 17 November 2016.

04:15

After opening the day with marginal gains, the Indian stock market indices registered a steady rise in in the post-noon session. Oil & gas, banking and auto stocks are leading the sectoral gains.

The BSE Sensex is trading higher by 157 points (up 0.6%) and the NSE Nifty is trading higher 40 points (up 0.5%). The BSE Small Cap and BSE Mid Cap indices are trading higher by 0.7% and 0.3% respectively.

04:30

The child adoption scenario in India remains grim due to numerous factors. Red tape, inordinate delays, lack of clarity on rules, poor orphan conditions, social stigma associated with adoption and reluctance to adopt older children. As per HelpYourNGO, Catalysts for Social Action (CSA) actively promotes adoptions with an aim to 'Find a Family' for every orphaned child as far as possible. You can transform the lives of orphan children and be a change "Catalyst".

04:50 Investing mantra

"Simplicity has a way of improving performance through enabling us to better understand what we are doing." - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Richa Agarwal (Research Analyst) and Ankit Shah (Research Analyst).

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Nov 2, 2016

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