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Are smallcaps attractive now?

Dec 15, 2010

Just over a month ago, the BSE-Smallcap Index's stood at 11,244 points. As of yesterday's closing, it stood at 9,283 points. In a matter of a month, the index is down by more than 21%. This is a sharp decline when compared to just a 5% decline in the BSE-Sensex.

A large part of the panic in smallcaps over the past month has been driven by the SEBI's crackdown on insider trading practices by the promoters of lesser known companies.

Below is a list of some of the worst hit stocks from the smallcap space over the last month.

Company NamePrice on 10th Nov. 2010Price on 14th Dec. 2010Change
Bheema Cements Ltd.155.1548.7-69%
G S S America Infotech Ltd.409.25157.55-62%
S V C Resources Ltd.317.15122.15-61%
Comfort Intech Ltd.13.975.4-61%
Midfield Industries Ltd.431.45167.5-61%
Data Source: CMIE Prowess

Here are some other alarming facts:
  • Out of a total of 550 stocks that are part of the BSE-Sensex, nearly 30% of the stocks underperformed (dropped by more than 21%) the BSE-Smallcap Index.

  • Thirteen stocks dropped by more than 50% during this period.

  • Forty seven stocks fell by more than 30% but less than 50% during this period.
All said and done, investors have punished the companies and their promoters who have done wrong.

But here's one important question that may be doing the round - "Is it a good time to buy smallcap stocks?"

In the rest of this article, we will try to bring some clarity on this question.

The BSE-Sensex is usually taken as a benchmark index for any comparison, be it returns or valuations. These comparisons can be made to a performance of a particular stock over a time frame as also for comparing valuations. In this article, we have compared the P/E ratios of the two indices - the BSE-Sensex and the BSE-Smallcap Index.

We would like to mention here that we have taken data only after 2008 as information for the prior period was not available.

What we have done is that we have compared the price to earnings ratio (P/E) ratios of the BSE-Smallcap Index with the P/E of the BSE-Sensex. For example, on 14th December 2010 i.e., yesterday, the BSE-Sensex was valued at 22.8 times earnings, while the BSE-Smallcap Index was trading at a valuation of about 14.7 times. Therefore, the ratio is about 0.6 times (14.7/22.8).

This calculation is effectively done to try and figure out the difference between the valuations that the BSE-Sensex commands in comparison to that of the BSE-Smallcap Index. In other words, one can know how the BSE-Smallcap Index is valued as compared to the benchmark index, the BSE-Sensex, over a period of time.

The higher the ratio, the narrower is the difference between the P/E ratios of the two-indices.

The chart below will explain things in a better manner.

Data Source: CMIE Prowess

As of yesterday, the BSE-Smallcap Index's P/E ratio was 0.64 times that of the BSE-Sensex's P/E ratio. A month ago, when the BSE-Smallcap Index touched its 52-week high figure of 11,244 points, the difference between the ratios was 0.79 times.

As such, one can say that in a period of one month, the BSE-Smallcap Index's valuation relative to that of the BSE-Sensex's has dropped by about 19%.

Quite a sharp fall indeed!

"But does that mean we can start investing in smallcaps now?" you may be wondering.

If we take the average of this ratio (PE of BSE-Smallcap / PE of BSE-Sensex) over this three year period, it stands at 0.68 times.

So yes! Purely in terms of valuations of the index as a whole, it is attractive. But at the same time investors must realise that the BSE-Sensex itself is not trading at an attractive valuation. As mentioned above, the BSE-Sensex traded at a price to earnings multiple of about 22.8 times as of yesterday's closing price.

Conclusion

What the sharp decline in the BSE-Smallcap Index has shown us is that management integrity is a very important factor when it comes to investing. 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, smallcap 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.


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8 Responses to "Are smallcaps attractive now?"

R.RAMAKRISHNAN

Jan 4, 2011

Statistics, they say, is bikini worn by a lady. While it reveals her bare body, it conceals her vital parts! Now you know what all research firms in stock markets are.

R.RAMAKRISHNAN
BANGALORE

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Ramanathan

Dec 26, 2010

I have to agree with the view of few others below that recent recommendations by EM aren't doing great. I observed EM for a while and then decided to go with your recommentations, but till now I am in a loss - mainly due to small caps. EM needs a definite improvement in terms of research team - has someone or many quit recently?

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sethu

Dec 19, 2010

I fully endorse the views of Krishnan and rk77.I am also life time member.Many of your recommendations in small cap,midcap,large cap, valuepro have done so badly during last one year.During 2009 period any fool would have made money and no great efort was needed.Some scrips you recommended to SELL did very well and some scripsyou recommended to buy/hold did miserably.quite often we have to reanalyse your recommendations and take our call.I feel some thing wrong with your Reseach methodology,analysis,persons etc etc.please have a thorough evaluation of all these stuff at your end.

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Chetan Kamat

Dec 19, 2010

I agree with S Krishnan completely. Your recommendations are way off the mark in the past one year given that you have come up with several useless products in order to make a quick buck and consequently lost focus. I am a member of your hyped "Value Pro". The total agregate return so far on your stock picks is 28% while the BSE/NSE has been up over 70% over the past year and a half.

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shah

Dec 19, 2010

I agree with others that of late most of the recomendation of EquityMaster Hidden Treasure and Stock Select are not doing well. I am making a huge loss currently. But I am waiting as the period mentioned is between 2 - 4 years.
EM research is really helping me to track the companies.

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rk77

Dec 16, 2010

S Krishnan has rightly pointed out that by increasing the number of products you seem to have lost focus. There have been significant misses in your recommendations in last one year. Please review your research methods and the performance of your research team. Why only small and mid cap but even large cap and value pro recommendations seem to be way off the mark. Equity master seems to be slipping.

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Subramaniam Krishnan

Dec 15, 2010

In a previous article you indicated that it is good to enter the market when BSE Sensex P/E ratio is about 15 and exit when it is at 21 to reap maximum profit. In another earlier article you indicated that the average P/E ratio of BSE sensex is 18.7. In the present article you say the average ratio between BSE small cap index and BSE Sensex is 0.68. Does it mean that it is good to enter small cap when its index is 10.2 (=15x0.68)?

Another entirely different point (or opinion) I would like to convey to you. In recent times, you recommendations on smallcap and midcap (Hidden Treasure and Midcap Select) are not doing that great. I think you should tone up your research teams. I think that your entering into too many products has resulted in less depth in your analyses.
I am one of your lifetime members.
Krishnan

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deepak

Dec 15, 2010

in india small and midcap shares will always be treated stepmotherly because we do not have a good takeover or merger policy not to mention hostile takeover .hence the value is never surfaced for most of the times. the good managements never get the valuatioons which they deserve or desire and the bad ones neither intend nor deliver any rewards to the minority shareholders. no wonder small and midcaps are valued higher in USA where the laws are very condusive for mergers ,takeovers and acquisitions. i sincerely hope that india also has such inclinations and we be lucky to witness that atleast in our lifetime before we hand over the baton to the progeny

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