Small cap stocks: Expensive or still cheap? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Small cap stocks: Expensive or still cheap? 

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In this issue:
» Asian stocks rise on promise of continued stimulus
» Fund manager Nilesh Shah's views on markets
» India Inc's R&D woes
» Buffett's mantra for the US economy
» ...and more!

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"Small caps jump to most expensive levels since 1996," shouts a headline on The report talks about the S&P SmallCap 600 Index that is trading at around 34 times its companies' earnings from the past year. This is around 57% more than the S&P 500 Index of the large cap US stocks, and signifies the sort of bubble that's built up in small caps there.

While small cap stocks in India aren't trading at such expensive levels, average valuations have actually become slightly uncomfortable. Take for the instance the BSE-Smallcap index, which is currently trading at around 16 times trailing 12-months earnings, as compared to 6 times that it was trading at the start of this year. As compared to this, the BSE-100 index of large companies is currently trading at nearly 21 times, as compared to 14 times in January 2009.

Our view on small caps is that of cautious optimism. While it has certainly gotten difficult to find very compelling small-cap buys these days, one still gets to knock at the doors of some large wealth creating long term opportunities but only after a prolonged search.

If you're going to invest in small-cap stocks that will create tremendous wealth over the long run, please avoid the tips and hot stock advice that you get at social gatherings, or from your friend or broker. Also, contrary to popular perception, you don't need to take great risk to invest in the best small cap companies. You only need to train yourself to look for disciplined, conservatively run small businesses that can stand the test of time in the long run.

01:07  Chart of the day
The sharp surge in small cap stocks since March 2009 can easily be explained by the expansion in P/E multiples of these stocks. As the chart below shows, the P/E of BSE-Smallcap index has risen by 177% since March. This is almost double than the 85% surge seen in the P/E of large cap stocks represented by the BSE-Sensex.

Data Source: Prowess

In the meanwhile, stocks across market caps had a good day today. While the BSE-Sensex was trading up by around 200 points (1.2%) at the time of writing, mid and small-cap indices were trading up by 1.4% each.

Indian markets, and those across Asia, got a boost today after regional leaders pledged to maintain stimulus measures and Japan's economy grew faster than economists estimated.

Gold also traded higher today. An ounce of the same came at US$ 1,128 today as compared to US$ 10 lesser on Friday last.

No other asset class is catching as much investor fantasy at the moment as gold. In fact, even we have been guilty of spreading some of that popularity. But now, let us veer our attention to an even more important question.

Will gold hold up its value even when the other asset classes like stocks lose theirs? In other words, when stocks fall, will gold continue to rise and hence, turn out to be a very good hedge against deflation? Although logically that should definitely be the case, the facts however do not support this line of thought. It has been observed that every asset class worth its name and that includes gold as well do not hold up in price in a deflationary environment as cash becomes the undisputed king again.

But that may not be the case this time around. In the current bull-run, gold has risen against almost all currencies and not just the US dollar as was the scenario most of the times in the past. So rather than this being a dollar bear market is more of a gold bull market. Hence, the yellow metal may continue to rise even if other assets like equities suffer a fall.

But it should be remembered that even this view may fall flat in the face. Hence, we reiterate our old stand. Make gold a part of your portfolio but do not overinvest in it.

Infrastructure and telecom sectors hold tremendous potential in the long run. This is if you were to believe one of the finest Indian fund managers Mr. Nilesh Shah, who is the chief investment officer and deputy managing director at ICICI Prudential Asset Management. In an interview with The Economic Times, Mr. Shah has put forth his belief that overall valuations for India aren't attractive now.

On the telecom sector, he is of the view that stocks looks pretty attractive after the recent decline. As he says, "Right now, the market appears to be taking a view that the ongoing tariff war could go on forever. Price war is not something unique to the telecom sector. Other sectors have seen it in the past. But there is a limit to how long that (price war) can go on. For instance, we had seen it in the detergent sector when P&G dropped prices sharply. But the price war lasted only for one-and-a-half years. Similarly, in the telecom sector, too, the price war can't be sustained for long."

We second this opinion of his. One should not ignore the fact that a handful of new telecom operators are facing operational losses. Unviable (though affordable) tariff plans and high marketing and branding costs are the key reasons for the same. We expect these small players to capitulate over time. This will happen as their losses will mount and eventually they will end up being acquired or shutting down. As such, the phase of industry consolidation is not very far away. And it is very likely, or let us say it is only possible for well established players to emerge fitter and stronger from this.

Indian firms may be growing faster than their peers in the developed world, but when it comes to R&D we still lag way behind. See for instance, only 4 Indian companies have made it to a list of the top 1,000 publicly traded companies in the world which are the biggest spenders on R&D. These are Tata Motors, BHEL, Dr. Reddy's and Sun Pharma.

As reported in The Economic Times, despite having moderate sales growth of 15.5% with US$ 10.8 bn in combined sales in 2008, the combined R&D expenditure of these 4 companies grew 43% to US$ 516 m. This highlights the fact that all four of them consider R&D to be a very important part of growing a business in the long term and will not curtail these spends in the years their performance is tepid.

Not just that, R&D is necessary not only for product development but also for expanding the lifecycle of existing products and should be given the importance that it deserves. Thus, while it is commendable that 4 Indian companies have made it to the list, other Indian behemoths who want to establish a footprint in the global arena will have to buckle!

In a recent interview, investment guru Warren Buffet commented that the US needs to first put out the economic fire in the country and only then can it think of stop throwing water. By that, he means that the US' enormous fiscal deficit is a huge problem that needs to be addressed, but not before they have made sure that the economic fire is completely out.

And how does one come to know that the fire is out? "Well, it will be retail sales. It'll be automobile sales. It'll be when home construction starts coming back," says Buffett. This does have a lot of relevance to us here in India too, as we ourselves have our own large fiscal deficit to deal with. But in terms the metrics that Buffett has described, unlike the US, we seem to be well on our way to recovery.

04:57  Today's investing mantra
"If you took our top fifteen decisions out, we'd have a pretty average record. It wasn't hyperactivity, but a hell of a lot of patience. You stuck to your principles and when opportunities came along, you pounced on them with vigor." - Charlie Munger
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9 Responses to "Small cap stocks: Expensive or still cheap?"


Nov 16, 2009

i agreesirs,,,
excellent,,, out standing ,,pl.,keepitup,



Nov 16, 2009

Your "chart of the day" is very interesting,informative and to the point. We have the feel of the happenings in the market at a glance,more than reading


Rao Bellam

Nov 16, 2009

Today's (16-11-09) chart of the day is highly misleading and did not expect such a thing from Equitymaster.
If BSE smalal cap index has gone down by 74% and then gone up by 177%, it will still be trading at 28% lower than where it was in Jan 08.
The chart does not give that impression.
Plese correct the way the data is presented



Nov 16, 2009

To become Warren buffet, you need penny to sart with but patienc of multi billioner level



Nov 16, 2009

While the broader universe of small cap Indian scrips do look fairly valued, there is one stock that is available at a PE 0f around 3 to 4. This scrip is: Shri Lakshmi Cotsyn Ltd (closed at Rs.100 today) whose results for the QE Sept 09 were decent. It has plans to diversify in to defence supplies, power & infrastructure. Do your own study & if convinced, buy this scrip for the long term.



Nov 16, 2009

I agree will Vijay . EPS & PE combined together are strong indicators .



Nov 16, 2009

sir intraday tips mr jasbeersingh bareilly
( up) surash ji and vijay sir no



Nov 16, 2009

This surge in the BSE beyond 17000 levels looks unsustainable. Already the valuations look near historic highs. I hope we dont see some severe correction due to the FII profit booking, the year end is round the corner. I would request Equitymaster to carry a report on the last 10 years PE value of Sensex, this would give us some idea on how the Sensex could behave. I dont think that the BSE SENSEX EPS would grow beyond 10% in this FY.We look forward to the Equity Master for their super ideas on stock picking.



Abdul Hakim

Nov 16, 2009

Very good cmment. By reading this we can realise the fact and may decide the future course of action.
Regarding small cap this cheap now and should be more high.

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