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 8, 2010

It's too dificult to understand the Small Cap Management.They are not transperant enough.Though not all the Co's.but recently SEBI blacklisted some of the broking firms & CO.cause of Circuler Trading.So I never tried this area.But if anything as EM suggest to check the Qualities of Management,I'd like to go for it.
After all I'm in Market to make profit.


Srinivasa Rao M

Dec 8, 2010

Before investing, i do research on the following points:
1. Management & Board of Directors (2) Line of business to access the demand supply gap and how the company is positioned in the said industry (3) Debt Equity ratio to access the debt service and have a edge in margins (4) PE Ratio and sensitivity analysis and (5) Dividend payment track record. Inspite of doing research, certain mid cap stocks managed by reputed 2nd or 3rd Generation enterpreneurs, are still fluctuate a lot and result in booking losses.


hem thaku

Dec 8, 2010

i agree with l.laxmi,but we can also check other sites for information about the company in non financial media



Dec 8, 2010

If you go through the communication by the corporates with stock exchanges you will have a glimpse of what is going on in the company.Next,you cannot pretend to be rich unless you make a show off of your richness. This is revealed through dividend distribution. Last 5 years' working is an indication of functioning.


G. Natarajan

Dec 8, 2010

No! I select by recommendations by ET and the sector and the business growth. Occasionally I ck the board of
directors. I do not no where the details of management is available. I do ck with peers.


Aliabbas Surti

Dec 8, 2010

I had that point of taking the quality of management into consideration. The only trouble is information in this area. The measurement of quality of management is difficult for a normal retail investor even if he does a lot of search on the internet for the people. That is why I have subscribed to your HTR.

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