On The Radar: India’s Small-Cap Equities [Concluded] by Investing Reflections On India

We have been running a series of articles titled ‘Under The Radar: India’s Small-Cap Equities’ beginning in December 2011 – and followed up twice – with the last article in December 2013.

We would like to conclude this series after updating the small-cap index level and returns, comparing it to our expectations ex-ante, and analyzing the current scenario.  Following this, we have also outlined where we may take this blog in the future.

The small-cap index closed at 11,087.07 on December 31st, 2014.  This compares to a level of 6,150.65 in our last article – resulting in an advance of over 80% to date.

This is a handsome absolute return by any standard, particularly compared to Indian government bonds, which yielded around 8-9% for the period.

This justifies the conclusion at the end of our previous article 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”.

Of course external events have played out in our favour; but the focus of the true investor is to do his buying carefully and let external events take care of themselves – for value will be reflected in the financial markets eventually, as our mentor Benjamin Graham taught several decades ago.

The major ostensible reason for such an advance is the change of government at the centre and resulting expectations for earnings growth.  It might also be worth bearing in mind that the depth of the slump in the latter years of the previous regime has also contributed to such a spectacular advance.

The advance masks individual stocks that have advanced substantially and others which have failed relatively.  Even though many companies with poor managements have participated in this rally, we have observed that there has been some discrimination against stocks with poor governance (as is appropriate).  Therefore, the advance has not been all-encompassing.

We are unable to use the price to book value metric to analyse the current situation as the BSE website appears to have changed its methodology substantially – resulting in a meaningless comparison.

From our own experience analysing individual stocks, we can express that the number of quantitative bargains in the small-cap market has reduced substantially – almost to the point of extinction. This appears to be the result of earnings growth being priced into most small-cap stocks.

The implication of the above observation is that companies would need to achieve the earnings growth baked into their stock prices to justify those prices.

It is beyond our competence to judge the likelihood and extent of such growth; all that is clear is that stock prices have incorporated a substantially cheerier consensus than last year.

We would conclude that the small-cap index today does not offer the same possibilities of substantial profit with low risk that it offered at the end of last year.

This does not mean that the small-cap index will not appreciate substantially from here; it just means that we are not convinced that it remains substantially undervalued.

To that extent, we believe that smaller stocks in India are now on the radar of most investors – a scenario 180 degrees from that prevailing in 2011 to 2013 – and this justifies the conclusion of this series of articles.

This series has revealed the considerations, actions, and vindication of a simple value approach applied to the small-cap stock index in India over a multi-year time period in real time.

In the future, we would like for this blog to remain a voice for minority shareholders in India. Under this over-arching purpose, we may comment on news that impact minority shareholder rights, analyse certain ‘special situations’ arising from corporate announcements (rather than market movements) that provide possibilities for profit, and produce other articles for the general education and edification of minority shareholders in India.  In this context, we welcome comments from our readers on matters that would help them.

India Sanjay Bakshi Indian Companies