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The no. 1 reason you should sell small caps?

Jun 14, 2012

Before we move into the core content of this article, we would like you to see some data points that we have come across, which we found to be quite interesting.

Chart 1
Data Source: ACE Equity, BSE

Chart 1 displayed above indicates the price to earnings multiple (PE) chart of the BSE-Sensex (red line) and the BSE Small Cap Index (blue line) since March 2006 till November last year. As you would have gauged, historically, smallcaps have traded cheaper than their larger counterparts.

Now let's see Chart 2.

Chart 2
Data Source: ACE Equity, BSE

That's right! You would have guessed it. The data points are the same. But the only difference is that the data is of the period post November 2011 till date. In pure valuation terms, smallcaps have become more expensive in recent times.

While smallcaps have outperformed the BSE-Sensex during the period post November 2011 till date, the move up has not been significant enough for valuations to change so drastically.

Rs 100 invested would be worth
Data Source: ACE Equity, BSE

The chart above shows the same.

Relative PE

We believe relative PE is a good method for gauging valuations. The average PE of the Sensex is around 20 times over this period (March 2006 till date). BSE-Smallcap index's is 13.9 times. On excluding the top and bottom 10% multiples (for extreme pessimistic or optimistic scenarios), the average figure for the Sensex remains the same. However, the same figure for the BSE-Smallcap Index stands a little higher at 14.4 times.

So, one could say that historically the market has priced smallcaps at about 0.72 times (14.4/20) that of the blue chips.

So what's been the reason for the valuations of the smallcaps to run up so significantly in the past few months?

Change in EPS for blue chips and smallcaps
Data Source: ACE Equity, BSE

The above chart pretty much explains it all. It displays the change in earning per share (EPS) of both the indices.

What to make of this?

Sensex's PE over a longer term - say from January 2000 till date - stands at an average of about 18.7 times. On excluding the extreme 10% of periods of aberrations (as done above), it stands at a marginally lower figure of about 18.4 times.

Going by the above logic, smallcaps have usually been priced at about 0.72 times that of the Sensex's PE. The figure we are looking for it 13.24 times (0.72 x 18.4). Currently, the BSE-Smallcap Index is trading at a very high multiple of 21.3 times.

Relative P-E Smallcap Sensex
Data Source: ACE Equity, BSE

A sharp decline in smallcaps on the cards? Some signs may be pointing towards it.

That is of course unless a huge upsurge in the earnings of small cap companies is expected. The BSE-Smallcap Index's EPS stands at about Rs 298 currently. The index itself is at about 6,395 points. For it to be trading at an average PE multiple of 14.4 times (as mentioned above) on year forward, the EPS one year down the line needs to be at levels of Rs 444, which is higher by about 50% from the current EPS of Rs 298.

Are current valuations justified? Are smallcaps just going through a phase of down cycle? Will their earnings levels bounce back strongly going forward?

Interesting times ahead...

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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