Diamonds In The Rough: India’s Small-Cap Equities (Part Three)
In February of this year, we summarised the valuation parameters of the BSE Small-cap Index in India (now the S&P BSE Small Cap Index) – following on from an earlier report we wrote in December, 2011 – and drew certain conclusions.
We would like to update the valuation scenario with the data today, review those conclusions, and form new ones based on the available information.
The small-cap index closed today (17th December, 2013) at 6,150.65 with an indicated price to book value of 1.04.
The closing value as on February, 2013 was 7,006.73 representing a decline of over 12% as of today.
The current index value masks a greater fall of over 27% to a low of 5,085.56 in August, 2013.
This represents an unsatisfactory overall performance for those who invested in small caps at the beginning of the year.
In our earlier report, we made two assumptions towards the end of our report to form a conclusion as to prices then:
1) “The market has a tendency to over-react to negative news”: The market’s reaction to the news at the start of the year was undoubtedly negative as represented by the prices accorded to the book values of small caps in comparison to the historical average. What we didn’t emphasise was that the reaction can get more negative and for longer than expected (certainly greater than a year).
2) “Small businesses will operate as they have in the past”: It is plainly evident to those observing events in India over the last year that the environment in which small businesses operate has been significantly more challenging as compared to the boom period between 2004 and 2008. Elaboration of the adverse factors may be unnecessary but some of the significant aspects were inflation in input costs and compression of profit margins. (The revenues, however, grew in most cases and this may be an important positive sign.) Therefore, this assumption certainly didn’t hold true during this year.
The above factors represent some of the pitfalls of value investing by the numbers but this is part of the business.
The only point we can say in our defence in our last report is that we stated that the market has just as much chances of quoting significantly lower prices as higher – however, this is of scant comfort to those who were heavily invested in small caps at the beginning of the year (including us).
Turning our attention to the current data, we note that the price to book value is now about half of the seven-year average from 2006 to 2012 (of about 2.05 – see last report below). This certainly proves the point that “cheap can get much cheaper” but we don’t wish to labour the point since we don’t believe that market timing can be done reliably and consistently over a long period of time – however, it is something the bonafide value investor must always bear in mind (this must be distinguished from the “buy the dips” mentality that prevails in bull markets where momentum speculators masquerade as value investors).
Without doubt, the valuations are more compelling now than at the (already low) levels earlier this year.
Further evidence of the neglect in the small-cap market is provided by trading volumes. Although the historic data on trading volumes used to be available on the BSE site, it is no longer provided (same goes for historic price to book value information, which is why we don’t have updated monthly tables for this year). Therefore, we are unable to present this data in this report. Nevertheless, observations until a few weeks ago indicated that the trading volumes in small caps over the last few months were among the lowest in the last eight years – rivalling the bear market following the Lehmann collapse between September, 2008 and March, 2009.
We’ve observed that trading volumes are directly proportional to the market level in the small-cap space.
All of this bolsters our conviction that the speculative participation in the small cap space is currently at a minimum. This was accentuated by the introduction of the new auction system by SEBI during this year (which also has severe limitations for true investors; criticism reserved for another article).
Moreover, we have observed there was (and still is) substantial insider buying of stock at several small-cap companies over the last year as compared to previous years. These transactions are required to be filed with the exchanges almost immediately after purchase. This is further evidence that the current market in small caps contains more serious investors as compared to the past. (By serious investors, we mean investors focused on business values as opposed to short-term market price appreciation.)
Regardless of what others do, the price to book value is a rough indication as to the cheapness of the current market. As indicated in last year’s report, we do not recommend purchase of the small cap index as a whole – but purchase of select companies after due diligence. We write this report only to indicate the general changes in market price and valuation of the small cap universe.
On that basis and from a dispassionate perspective, the current market prices appear very low compared to historical market valuations – as to offer low risk of permanent impairment of investment capital with the potential of large gains in capital value when business conditions return to normal as past experience and probabilities indicates they should.
Significant questions remain as to timeframe for appreciation, confidence that the business environment will return to normal, political environment, etc.
Re-stating the caveats in our last report regarding markets going lower for longer than expected may seem like a cop-out and the intelligent reader is justified in asking “How Long?” – we have been forced to grapple with such questions in the Indian market in real time and will write more about this issue in another article – suffice it to say that we don’t believe an investment operation or a thesis to be successful or correct unless it can show superior performance over a rolling five-year period.
Keeping this in mind and going against the prevailing mood of pessimism at this time (which hasn’t completely escaped us), we believe that small-caps in India offer among the most attractive bargains during any time since 2006 and certainly in the entire Indian stock market today.