Is the rise in smallcaps justified? - Views on News from Equitymaster

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Is the rise in smallcaps justified?

Mar 13, 2012

The Indian stock markets have risen substantially over the past quarter. While the BSE-Sensex has risen by about 15%, stocks from the smallcap index seem to have outperformed their larger peers during this period. The BSE Small Cap has risen by about 23% over the past three months.

With the same happening, valuations of both the indices have moved up, indicating that stocks have become more expensive as compared to what they were three months ago.

Source: ACE Equity

As you would be aware, a good way to gauge the attractiveness of stocks is to look at their price to earnings ratio (PE). This helps understand if the run up in stock prices is justified vis-a-vis an increase in earnings or profits to shareholders. The same works for analyzing an index, which is nothing but a collection of stocks.

By viewing the above-displayed chart, and using the logic mentioned above, it would be natural to assume that earnings of stocks forming part of the BSE-Smallcap index would have been greater than that of the stocks forming part of the BSE-Sensex. And what a strong spike it would be! Considering that the valuations of the index have moved up by more than 70%. The comparable figure of the BSE-Sensex is a much modest 10%.

However, from the looks of it, it seems though that the earnings of the smallcap stocks have not been the factor behind the spike in valuations and therefore the index on the whole.

Source: ACE Equity

However, on looking at the same criteria for the BSE-Sensex, one can say that the movement seems justified to a certain extent.

Source: ACE Equity

What to make of this?

The stock exchanges have the tendency to move companies in and out of a particular index, based on various parameters and procedures. While the churn rate is lower for the indices which have the larger companies as part of it, the same cannot be said about the indices that form the indices of the smaller stocks. This could probably be the reason for the sudden decline in EPS. However, since the proportion of companies being replaced would not be very substantial, one cannot help but consider that the past quarter to be a difficult one for smaller companies. At the end of the day, stocks forming part of the BSE-Smallcap index are made up of companies from various sectors and industries. Not to mention that other aspects such institution involvement and market sentiments also do play their parts in moving stocks, and therefore, index movements.

Therefore, what comes out is that the current run up in stock prices of smallcaps was definitely not a factor of their fundamentals. As such, small caps tend to have very low liquidity levels. As a result even small purchases tend to get magnified in sharp increases in stock prices. This appears to be the main reason behind the recent rally in the smallcaps. Therefore, an investor would do well to follow a bottom-up approach when it comes to investing in small cap stocks. Only buy those that have fundamentals strong enough to justify their valuations.

Devanshu Sampat

Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.

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