10-yr high valuation gap good to invest in smallcaps? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

10-yr high valuation gap good to invest in smallcaps? 

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In this issue:
» Will the inflation indexed bonds address inflation problem?
» China's banking crisis in the making
» EU's downgrade from AAA status
» Why is China piling up on gold?
» ...and more!

The US Federal Reserve promising to not raise interest rates for a prolonged period. The Finance Minister asking investors not to worry about the Fed taper. The RBI not raising interest rates. Elections results in northern states and the Lokpal Bill providing hope for a less corrupt and proactive government. With so much happening around, investors do not need to make too much of an effort to be influenced by what we call 'false cheer'.

Markets have already begun factoring in the possibility of better governance, cheap liquidity and global stability in stock valuations. Hence the challenge for investors now is to not give in to the temptation of riding the so-called rally.

A leading business daily yesterday pointed out that the gap between the valuations of largecap and smallcap stocks is at a 10 year high. That alone, according to the publication, makes smallcap stocks a mouthwatering bet for retail investors. It justifies that the dirt cheap valuations could see a significant re-rating once the hopes about liquidity and new government come true. Now this is what really worries us.

The valuation gap between large and smallcap stocks is not without reason. The crises in global and domestic economy are far from over. Irrespective of the political party that comes to power, the quality of governance will not change overnight. And the possibility of smallcaps getting re-rated remains subject to their ability to weather economic and political storms. Unlike large companies, the very existence of smaller companies comes into question during periods of extreme stress. And hence investors' preference for largecap stocks in an effort to de-risk their portfolio is justified.

True that discounted valuations could offer investors an opportunity to buy few really solid midcap and small cap stocks. But the selection of stocks in such a case needs to be based on thorough study of fundamental track record and check on quality of management. Getting swayed by the attractiveness of valuation gap, amidst the false cheer, could be a fatal error that investors could make.

We would like to gently remind investors that safeguarding their wealth and making their portfolio resilient to economic crisis should be investors' top priority right now. This would also include holding some portion of the portfolio in cash and in gold. For the rest investors need to make smart choices with safety as the key criteria.

Do you think retail investors should take a higher exposure to smallcap stocks due to the valuation gap? Let us know your comments or post them on our Facebook page / Google+ page.

01:35  Chart of the day
The RBI's much publicized consumer price-linked inflation bonds could certainly have many takers. After all not only do the bonds offer a good degree of safety, due to central bank backing, but also offer 1.5% returns over and above the CPI. The spiraling inflation levels have been the biggest worry for Indians over the past few months. And as per the government and RBI, these inflation bonds will address the issue. Well, food inflation may, to a good extent, get covered by the returns from such bonds. But in an economy where nearly one-third of the population is in an age bracket of less than 25, what about education cost? As per Bloomberg, college fees in the US have risen by 420% between 1985 and 2013.

Surprisingly, as per Ministry of Statistics (MOSPI) data, the rise in school fees in rural India during this period has been very similar. Average school fees in rural India have risen from Rs 46 per month in 1985 to Rs 260 per month in 2013. This again is a rise of 431% point to point. One wonders what kind of investments will be able to cover the education inflation.

Can inflation bonds cover over 400% rise in education cost?

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The Fed may have declared its intention of going slow on its quantitative easing which sparked a wave of liquidity around the world, but China seems to be short of cash. Indeed, money market rates have shot up in China. As a result of which there is the possibility of a severe credit crunch for the dragon nation's banking system. Earlier, China's banking system had come under pressure because of the significant rise in credit. Most of this had found its way into the property market raising concerns of a bubble forming there. As a result of this, the Chinese government had taken steps to contain credit growth. But because of this, the interbank rates rose. Obviously, the government's efforts to reduce credit growth do not seem to have worked much. It remains to be seen what it chooses to do next.

Economic growth in Asia has slumped to the lowest levels since 2008. Thus it is not surprising that corporate activity too has seen a similar slump. As per Wall Street Journal, companies in this region, fearing the worse, have tried to conserve funds to brace for difficult times. As a result, the number of merger & acquisition deals fell dramatically. Thus, the investment banking fees in Asia slumped to its lowest level since 2008. In India, primary markets were flat in 2013. As per Prime Data, a market research & consulting firm, funds raised through public offerings hit a trough in 2013 from high levels of 2010. However the government's disinvestment plans may offer some fillip in the gag end of FY14. Even uncertainty over stable government post elections is forcing companies to fast track fund raising plans. As per Prime Data, Sebi-approved IPO proposals valued at Rs 720 bn are waiting in wings to take off.

2013 is the first year since 2000 when international gold prices have reported a decline. Recently, currently gold prices are hovering around US$ 1,200 per ounce. This is a three-year low level. In recent months, many commentators have started calling this correction as the end of the gold bully rally. The Fed taper plan seems to have further vindicated their belief.

But there is a fair chance that these predictions could go completely wrong. We came across an interesting interview on Bloomberg that highlighted the increasing Chinese appetite for gold. As you may know, over recent years Chinese gold imports have increased at a rapid pace. In fact, as per the World Gold Council, China is expected to topple India and emerge as the numero uno importer of gold in 2013.

We would like to remind you that in the last decade, China emerged as a giant consumer of commodities. In fact, the dragon economy has been accounting for about half of the total global production of several commodities. Many analysts made the mistake of undermining China's appetite and went horribly wrong in their commodity forecasts. And the same could happen in the case of gold. It must be noted that the Chinese central bank has already said that it is no longer in its interest to increase US dollar reserves. And this is the reason they are piling up gold reserves. The world has seen in the past what China alone can do to commodity prices. So it wouldn't be very surprising if gold doomsayers are proved completely wrong.

The European Union (EU) has finally suffered a credit downgrade. As per a business daily, leading rating agency S&P has downgraded the rating of EU from AAA to AA+. Increasing debt problems and inefficacy in budget management have led to a downgrade. The downgrade is not likely to have a material impact on the borrowing cost of EU as AA+ is still an investment grade rating. However, what is surprising is the way most EU officials have reacted to this downgrade. Some have even gone on to question the S&Ps understanding on budgetary matters. While sovereign ratings are just opinions they determine the borrowing strength of the country. Downgrade signals weaker repayment capacity and indicates that investment risk is high. Thus, the EUs reaction to downgrade was understandable. However, the way they have refuted the downgrade is noteworthy. While we are not big fans of rating agencies due to conflict of interests in such ratings EUs rebuttal showed its eagerness to maintain its rating. It should be noted that EU borrows in its own name with contributions from member countries used as collateral. A downgrade has questioned its repayment capacity which may raise its borrowing cost and ability to raise money in future. And this is no good news for EU.

The US Federal Reserve finally did what investors had been anticipating for seven months. It announced that it would begin to scale back its monthly bond buying to US $75 bn from US $85 bn in January. Investors responded enthusiastically, taking the move as a sign of confidence in the US economic recovery. The response was in sharp contrast to earlier fears. The announcement pushed gold prices down to a low for 2013. Through the week, global stocks rallied, particularly European stocks, while Asian shares were mixed. The US markets closed up 3% for the week.

In addition to stronger US figures for productivity and industrial production, consumer inflation in the United States, United Kingdom and Eurozone remains very low. German economic expectations are also rising. UK unemployment fell to 7.4% in the three months ending in October, its lowest level since April 2009. The jobless rate is approaching the 7% threshold, the point where Bank of England officials say they will consider raising interest rates.

The Indian equity markets kicked off the week on a muted note considering quiet global cues. On Wednesday, key indices surged in response to the RBI's status quo stance on key policy rates. However, this optimism didn't last too long as the taper talk from the US Fed led to a selloff in banking counters. The concluding session once again surprised market participants as we witnessed a massive rally. The BSE Sensex advanced by 1.8% over the previous week's closing.

Performance during the week ended December 20th, 2013
Source: Yahoo Finance, Kitco

04:50  Weekend investing mantra
"Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company's owners are slim at best" - Charlie Munger

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5 Responses to "10-yr high valuation gap good to invest in smallcaps?"

amlan mukherjee

Jan 1, 2014

some example



Dec 28, 2013



Like (1)


Dec 26, 2013

Bapna may have good reasons to criticize MF Industry for its poor performance across the board with few exceptions. How can anyone promise and deliver 15% p.a. returns in a MF investment?

Inflation indexed bonds are a very good investment that will be beneficial in the long run as in a growing economy inflation is a built-in feature.

Like (1)

viiredra bapna

Dec 22, 2013

to be frank retail investors should never never invest in stock markets.The time has come if any mutual fund can give guaranteed 15% minimum per annum (sebi approved)after a fixed tenure then only a retailer should invest,as all mutual funds have looted/cheated retailers and ditributed all the profits/money to their own people by giving them higher salaries and commissions at the cost of retailer.

Like (1)

bharat shah

Dec 21, 2013

this has reference with your observation ' Can inflation bonds cover over 400% rise in education cost?' that 400% in 25 yrs , translates into @5-6% yearly. i think, the inflation would be same during the period. so i think ,inflation bonds stipulated to give @1.5% more than CII would definitely cover the rising cost of education. of course , income tax may spoil the target.

Like (1)
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