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Should one be careful about these small caps? - Views on News from Equitymaster
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  • Apr 19, 2012

    Should one be careful about these small caps?

    From a year ago, India's benchmark index, the BSE-Sensex has fallen by about 9% YoY. During the same period, the BSE Mid Cap and BSE Small Cap indices have declined by about 9.5% and 21.1% respectively. It is very evident that smallcap stocks have underperformed their larger peers significantly. With macro factors not really going in the desired direction and the future scenario being uncertain for a while now, stocks of smallcap companies have not found favor.

    However, as is always the case, many stocks outperform the broader indices. And for a case when the broader index, the BSE-Small cap index in this case, has declined so sharply, a smallcap stock doubling is a quite a big deal.

    In this article, we will be looking at some of the stocks have outperformed the broader indices significantly, but at the same time, their fundamentals do not seem to be in place.

    You might think of us as party-poopers, but given the value investing principles we follow, it would be best to go back to basics of fundamental analysis and judge for yourself.

    We have collated a few data points for you to gauge - latest P/E ratio; stocks returns over the last one year; 5-year return on equity and their average; and the latest report debt to equity ratio of the company. All these data points, we believe, are amongst the key parameters that one must consider before investing from a long term perspective - especially for stocks from the smallcap space.

    The list we have collated is as follows:

    Company Latest P/E Returns # ROE (L-4) ROE (L-3) ROE (L-2) ROE (L-1) ROE (L) Avg. ROE D/E (L)
    Blue Circle Services Ltd. 570.5 1738.9% 0.1 0.0 9.6 9.2 7.8 5.3 0.0
    KSL & Industries Ltd. NA 421.0% 11.4 11.0 5.1 0.8 -0.7 5.5 2.2
    Banas Finance Ltd. 690.6 249.1% -11.8 -16.1 -15.6 2.8 1.2 -7.9 0.0
    Ram Kaashyap Investment Ltd. NA 239.9% -6.9 2.1 1.5 3.4 6.2 1.3 0.5
    Saint-Gobain Sekurit India Ltd. 59.2 128.5% -19.1 -0.2 0.6 9.5 16.5 1.5 0.0
    Visagar Polytex Ltd. 371.8 96.9% 90.7 72.6 17.7 9.3 8.8 39.8 0.4
    Industrial Investment Trust Ltd. 84.3 82.4% -24.7 21.2 7.6 18.2 4.9 5.4 0.0
    Advanta India Ltd. 57.3 72.9% 43.3 4.8 2.0 -9.9 -7.8 6.5 1.3
    Unisys Softwares & Holding Inds. Ltd. 253.3 65.7% 0.0 0.0 0.1 0.3 3.6 0.8 0.0
    Forbes & Company Ltd 163.2 45.6% 3.5 1.0 -28.3 -8.9 0.4 -6.4 0.8
    The Byke Hospitality Ltd. 109.1 41.8% 30.5 23.2 4.0 3.0 4.7 13.1 0.0
    Sayaji Hotels Ltd. 225.5 36.2% 13.9 14.0 10.0 -0.6 4.3 8.3 1.4

    Data Source: ACE Equity; # - Returns over a period of one year; NA - not applicable; D/E - Debt to Equity ratio

    It must be noted that in the table 'L' stands for latest available data, while L-1 is the data for one year prior and so forth. In addition, the data shown in the table is for the standalone figures.

    As you can see, certain parameters of these stocks would make one stay away from such kind of companies. High valuations, deteriorating return on equity (the ultimate figure that every investors looks for) and high debt levels are all factors the make a company fundamentally weak. Profit growth should not be looked at in isolation.

    Whether these stocks will further move up from here (or decline sharply, for that matter) is difficult to say. But all we can conclude is that companies with such poor fundamentals do not deserve valuations such as what they are garnering at the moment. In fact, even some of the best quality, fast growing companies do not command such high valuations!

    A lot of weight needs to be given to qualitative aspects, which should all be looked at in conjunction with one's stock picking process. These include: Company's management for its competencies, execution skills and integrity; company's standing in the industry given the fact that small-sized companies are the first to buckle under pressure in case of a downturn; a solid financial performance history; and the quality of earnings.

    And not to forget, the final icing on the cake - valuations! While valuations differ with various companies (depending on their quality of earnings), ideally, the highest valuation a company deserves should not exceed the high teens. And for the valuations approach towards smallcaps, one should be all the more careful given their higher volatility levels as compared to their larger peers.

    While aspects such as ideal P/E multiple is a topic for discussion for another day, investors - before purchasing a stock - must ask themselves these questions before purchasing a stock:
    • If I buy the stock at x times multiple, at what pace will its earnings have to grow?

    • Is such growth possible given the historical average margins and growth rates?
    In the words of one of the most celebrated investors in the world, Peter Lynch - "If you remember nothing else about p/e ratios, remember to avoid stocks with excessively high ones. A company with a high p/e must have incredible earnings growth to justify its high price."

      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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