In our previous article, we discussed whether midcap stocks seemed to look attractive at this point in time. We used the BSE-Sensex as a benchmark for the same. This time we will be discussing whether the BSE-Smallcap index seems overvalued or undervalued. There are over 500 stocks in this index, which is almost twice the number in the mid-cap index and 18 times the number in the Sensex. Although this is a large universe to choose from, a large majority of them are virtually unknown. But, some are household names including Fame India, Spicejet, Moser-Baer, Provogue etc. Let us now see, how they have been performing on a collective basis.
The BSE-Sensex is just around 17% short of its historical highs, seemingly overvalued. Let us now see what this indicates for the smallcap stocks, whose representative index (the BSE-Smallcap Index) is benchmarked against the BSE-Sensex?
Below we have displayed a comparative data for both the indices – BSE-Sensex and BSE-Smallcap index.
Data Source: CMIE Prowess
If one had invested Rs 100 at the beginning of 2008 in the BSE-Sensex and the BSE-Smallcap indices each, it would have been worth Rs 90 and 72 respectively. This indicates that the Sensex has outperformed the BSE-Smallcap Index over this two and a half year period. However, the BSE-Smallcap Index has by far outperformed the BSE-Sensex over the last year (2009) as well as during the year till date (YTD; January 1 2010 to August 24 2010). While the BSE-Sensex has risen by 17% over the last year, the BSE-Smallcap Index has risen by 49%. As for the YTD comparison, the BSE-Sensex is up by 5%, while the BSE- Smallcap Index is up by 18%. As we saw earlier, the BSE-Midcap index was up 17%, showing that their performance was more or less in line.
However, the best way to gauge the attractiveness of stocks is to look at their price to earnings ratio (PE). This helps shows if the run up in stock prices is justified viz-a-vis an increase in earnings or profits to shareholders. The same works for analysing an index, which is basically a collection of stocks. A good way to gauge the same is to compare the valuations of the BSE-Smallcap Index with the benchmark index, the BSE-Sensex.
Below is a chart indicating the PE ratios of both the indices since 2008. We have also shown the average PE ratios of both these indices during this two and a half year period (prior period data was not available at this time). While there is no doubt that the BSE-Smallcap Index would trade at lower valuations as compared to the BSE-Sensex (for multiple reasons), the main question is that despite this, are smallcaps attractive at this point in time?
Data Source: CMIE Prowess
We shall look at the next chart to find out. Below is a chart displaying the difference in valuations over this period. We have calculated the same by dividing the PE ratio of the BSE-Sensex by the BSE-Smallcap Index.
What does this chart foretell? Well, as the ratio moves towards the 1 times mark, this means the difference in the PE ratios of the two indices is less. This could mean two things – Either that the Sensex is undervalued or that smallcaps are expensive. What we can also learn from this is that the market is pricing midcaps as well as smallcaps similarly. This is despite the fact that smallcaps are supposed to be more volatile.
Data Source: CMIE Prowess; *Average period considered as Jan 2008 till date
Similarly, when the ratio drifts away from the 1 times mark; this could indicate that the BSE-Sensex is expensive or that the smallcap stocks look fairly attractive.
What does it indicate at this juncture?
Well, considering that the BSE-Sensex is trading at a price to earnings of about 21.8 times, it seems to be a tad on the expensive side (as compared to its long term average valuation of about 16 to 17 times). The BSE-Smallcap Index's valuations seem to be close to the 1 times mark, indicating that smallcaps (as a whole) also seem to be 'not so attractive'. Since, they trade at a slight discount to midcap stocks, it seems that both indices, on the whole seem to be fairly valued at this point. This means that most of the upside is already priced in.
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