India Small Cap Stocks Cheapest Since 2006

Our analysis revealed that the indices appeared undervalued by historical standards.

We decided to have another look at the current valuations of the indices to recap performance and determine the price attractiveness today.

When we wrote our post last year, the small-cap index closed out at the level of 5,550.14.

The closing level today is 7,006.73 – resulting in a gain of over 26% in a little over a year.

So, how does this level stack up against the basic fundamental metrics of the underlying businesses?  Here’s a summary of the valuations sourced from the BSE website:

As is apparent from the above tables, the small-cap index is still trading at a substantial discount from its historic valuations.

Despite the 26% appreciation in market values over the last 13 months, book values have grown at approximately the same pace.  (The smaller discount is a result of including 2012 valuations to our sample last year).

Assuming we preferred to stick to historical facts without considering future prospects, the increase in market values just about kept pace with the increase in business values without any revision in market multiples.

Of course, the market may be moving toward a lower and more permanent valuation standard for small-cap companies.  Furthermore, our previous sample of six years was shorter than ideal due to data constraints mentioned in last year’s post.

Our current sample of seven years may be more representative of a full business cycle than last year – particularly since it includes a mix of generally favourable business conditions (2006, 2007, 2008, 2010) and unfavourable ones (2009, 2011, 2012).  Therefore, the median valuation may be a more appropriate ‘normal’.  If anything, we think it may be on the conservative side.

If we continue on our path of sticking to the facts, the current valuation appears to be at a significant discount from a ‘normal’ valuation and would indicate considerable potential for appreciation before any meaningful risk (of impairment) materialises.

The reasons for such a large discount are easily obtainable from a casual reading of the prominent financial newspapers.  The real question is whether there is an opportunity to invest at current prices with limited risk.

Buoyed by the performance of the previous year, it is easy to get over-confident and presume that there is nothing but good that can happen to investors at current prices over the long-run.  But this would be naive.

We know that markets can do silly things over the short-run and it has just as much chance of quoting significantly lower prices as higher.

Since we are writing for true businesslike investors rather than market speculators, the above factor should not concern us.  What should concern us is permanent impairment of business values.

Again, a number of factors may be quoted to prove this point – such as a permanently lower growth rate for the country, unreliability of the executive branch of government, poor investment rate, etc.

We are not qualified to pass judgment on the above factors – what is clear is that the market has passed its verdict and it is evident in current prices.

IF we operate under the assumption that the market has a tendency to over-react to positive and negative news, AND that small businesses in India will continue to operate in the future pretty much as they have over the last seven years, current prices may offer an attractive buying opportunity despite last year’s price appreciation.

As the legendary investor Warren Buffett said:  “The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.” And “So if you wait for the robins, spring will be over.”