A closer look at the small ’uns

Smaller stocks are mostly avoided by serious investors due to greater volatility and lack of transparency. Not much attention is, therefore, given to the trading pattern of these smaller stocks.

We examine some behavioural trends in these stocks.

The principal group of investors in our market are the foreign portfolio investors. Since they tend to invest in equity across the globe, their view on small-cap stocks typically tends to be the same, across regions.

A correlation analysis between MSCI India Small-cap Index with MSCI World Small-cap Index and MSCI Emerging Markets Small-cap Index shows that Indian small-cap stocks appear more strongly linked to similar stocks in other emerging markets. The link with the small-cap stocks in developed markets or the rest of the world is much weaker.

The link between Indian small-caps and small-caps in other markets is stronger when we have a trending market.

As a thumb rule, large-cap indices should trade at a higher price to earnings multiple (PE) than their mid- or small-cap peers. This is logical since the largest stocks are the ones with steady growth in revenue and earnings, stable business models and sound management. Investors are, therefore, willing to pay a premium to own such stocks.

A perusal of the movement of the PE ratio of the Sensex, the BSE Midcap Index and the BSE Smallcap Index since 2005 shows that the Sensex trades at the highest PE multiple, followed by the BSE Midcap Index, and the BSE Smallcap Index trading at the lowest PE, most of the time. Occasions when the BSE Small-cap Index traded at a higher PE than the other two are relatively rare. Such a phenomenon was observed in the second half of 2005 when the PE of the small-cap index was between 18.5 and 23 with both the Sensex and the mid-cap index trading at much lower valuations.

This kind of skew is again noticeable since early 2012. With earnings of small-cap companies hit by the economic slowdown, the run-up in their stock prices has resulted in the PE ratios trading sharply higher. This number climbed above 90 in September 2013. With improvement in earnings, the number has moderated to 28, but it is still far above the Sensex’ PE of 19 and the BSE Midcap Index’ PE of 24.

There are many reasons why investing in small-cap stocks at this juncture is not advised. As explained above, the fact that the PE ratio of the BSE Small-cap Index is much higher than the Sensex implies that this space is overheated.

Revenue growth of the BSE Small-cap Index was 22 per cent in FY12. But the growth slowed to 6 per cent in FY13 and 4.5 per cent in FY14. The earnings growth is more dismal. Net profit fell 40, 38 and 12 per cent in FY12, FY13 and FY14, respectively, over the corresponding figures in the previous year. Falling realisations, higher finance cost and regulatory hurdles have resulted in many companies slipping into the red. The total debt of the companies forming part of the BSE Smallcap Index has, however, continued to climb.

Against this backdrop, it is best to wait for an improvement in fundamentals before going bullish on small-cap stocks. A bottom-up approach to stock picking can be adopted, when stocks are available at the right valuation.