Tuesday, December 17, 2013

Under The Radar: 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 bonds or alternative investment strategies 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.

Monday, February 4, 2013

Under the Radar: India's Small-Cap Equities (Part Two)


About a year ago, we analysed the valuation of India's small and mid-cap indices to determine whether they were attractive for purchase by investors (see post below).

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:


Table 1: Annual valuations (2006 to 2012)
Year
High
Low
Close
Price/
Book value
2006
    7,872.80
   4,480.45
    6,892.32
           2.05
2007
 13,376.80
   6,001.33
 13,348.37
           2.78
2008
 14,239.24
   3,221.70
    3,683.11
           2.13
2009
    8,425.57
   2,864.24
    8,357.62
           1.49
2010
 11,366.68
   7,926.82
    9,670.31
           2.39
2011
    9,920.58
   5,460.31
    5,550.14
           1.84
2012
    7,525.68
   5,540.30
    7,379.94
           1.29
Median
           2.05



Table 2: Monthly valuations (Last 12 Months)
Month
High
Low
Close
Price/
Book value
Jan-12
    6,504.14
   5,540.30
    6,463.30
           1.32
Feb-12
    7,263.11
   6,464.29
    6,859.97
           1.47
Mar-12
    6,914.90
   6,434.17
    6,629.38
           1.44
Apr-12
    6,982.30
   6,641.72
    6,764.62
           1.35
May-12
    6,844.92
   6,202.13
    6,271.00
           1.22
Jun-12
    6,547.61
   6,132.10
    6,543.75
           1.21
Jul-12
    6,870.17
   6,355.15
    6,447.89
           1.21
Aug-12
    6,687.31
   6,336.09
    6,395.09
           1.17
Sep-12
    7,045.06
   6,388.01
    7,017.89
           1.21
Oct-12
    7,252.49
   6,949.96
    6,989.17
           1.29
Nov-12
    7,287.09
   6,975.15
    7,275.65
           1.29
Dec-12
    7,525.68
   7,283.14
    7,379.94
           1.33
Jan-13
    7,696.74
   7,049.69
    7,074.07
           1.34
Feb-13
    7,114.58
   7,055.59
    7,056.48
           1.29

Current Discount to Historical Median
37.1%


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 (as it has done throughout history), 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.”

Saturday, December 31, 2011

Under the Radar: India’s Mid-Cap and Small-Cap Equities


Indian stock markets have been one of the worst performers in 2011 – worse than their BRIC peers, worse than the rest of Asia and far worse than the US with the leading indices declining about 25% during the year.  Foreign investors in India have also suffered substantial declines of nearly 20% in INR currency value.

There appear to be several reasons for the market’s dislike for Indian equities in 2011, which include persistent inflation (including food inflation, which constitutes the major proportion of the typical Indian household), political paralysis (e.g. rollback of foreign investment in retail etc.) and global concerns about the solvency of several Eurozone countries.

As a result, estimated GDP growth for the next financial year has been revised downwards from about 8% earlier in the year to about 6% now - with many market commentators wondering whether this rate of growth is India’s ‘new normal’.  This is still, however, substantially higher than global average.

The world hasn’t paid much attention to India’s underperformance and noted economist/journalist Tyler Cowen tweeted at the start of December that "the current economic deterioration of India is the single most important under-reported story these days…".

We’ll tell you what’s even more under-reported – the performance of India’s broader indices.  If the leading indices have declined substantially, the broader indices (comprising small and mid-caps) have been smashed out of shape.  Contrasted to a 25% decline in the leading indices for the year, the broader indices have declined much more with the mid-cap index off about 35% and the small-cap index erasing about 42% of its market value at the start of 2011.  To put this in perspective, this is similar to declines suffered by the US S&P 500 index during the heights of the Lehman crisis in 2008.

So, how does the broader Indian equity market stack up for an investor seeking long-term values - particularly in relation to historical market valuations?

We could use several simple metrics to assess market sentiment towards equities such as price/earnings, price/book, dividend yield etc.

We have used the price/book ratio, which is sufficient for the purpose of this article, which is to gain an elementary understanding of current market sentiment towards the accumulated net worth of Indian equities – especially when compared to historical market sentiment.  Therefore, the criticisms of book value as a measurement tool are irrelevant in this perspective.   Moreover, price to earnings and dividend yields are distorted by temporarily depressed earnings and/or arbitrary management dividend policies.

Of course, Indian interest rates have gone up substantially during 2010 and 2011 and hence each INR of book value should theoretically be worth less than it was prior to 2010.  However, the investor in long-term values – while paying attention to long-term interest rates - would be more focused on investing through multiple economic cycles and in that context, interest rate movements are cyclical and temporary.   Hence, the current market sentiment relative to long-term historical standards could offer clues to long-term values.

Here are the historic market valuations (price to book values) of the BSE Mid and Small Cap Indices:

BSE Mid Cap

Year
High
Low
Close
Price/
Book Value
2006
6,070.53

5,805.18
       3.03 
2007
9,817.28
5,054.59
9,789.49
       4.13 
2008
10,245.81
2,763.80
3,235.05
       3.17 
2009
6,759.70
2,547.91
6,717.82
       2.24 
2010
8,791.10
6,276.91
7,802.71
       3.10 
Median
3.10


BSE Small Cap

Year
High
Low
Close
Price/
Book Value
2006
7,872.80
4,480.45
6,892.32
2.05
2007
13,376.80
6,001.33
13,348.37
2.78
2008
14,239.24
3,221.70
3,683.11
2.13
2009
8,425.57
2,864.24
8,357.62
1.49
2010
11,366.68
7,926.82
9,670.31
2.39
Median
2.13

Now take a look at the 2011 market valuations and particularly, the current (December) market valuations:

BSE Mid Cap (2011)




Month
High
Low
Close
Price/Book Value
Jan
7,929.37
6,722.59
6,868.35
          2.98
Feb
6,922.12
6,182.86
6,373.23
          2.73
Mar
6,894.10
6,373.23
6,873.40
          2.76
Apr
7,309.29
6,873.40
7,094.26
          2.97
May
7,117.32
6,607.78
6,910.24
          2.82
Jun
6,987.72
6,475.70
6,854.05
          2.83
Jul
7,115.91
6,854.13
6,915.31
          2.29
Aug
6,987.82
6,014.18
6,273.60
          2.12
Sep
6,534.66
6,066.34
6,129.59
          2.09
Oct
6,313.30
5,871.68
6,297.99
          2.06
Nov
6,341.71
5,459.92
5,627.69
          1.99
Dec
5,804.38
5,073.25
5,135.05
          1.83
 Current Discount to Historical Median                   41.0%

BSE Small Cap (2011)



Month
High
Low
Close
Price/Book Value
Jan
9,920.58
8,333.93
8,477.82
          2.28
Feb
8,551.45
7,471.77
7,817.32
          2.03
Mar
8,228.02
7,730.46
8,175.89
          2.01
Apr
8,976.17
8,175.89
8,715.31
          2.27
May
8,744.52
7,999.23
8,235.72
          2.16
Jun
8,381.73
7,753.00
8,156.60
          2.14
Jul
8,536.87
8,159.30
8,305.58
          1.81
Aug
8,377.62
6,892.98
7,131.48
          1.62
Sep
7,421.17
6,873.20
6,881.08
          1.57
Oct
6,997.39
6,638.86
6,974.61
          1.52
Nov
7,007.29
5,914.55
6,097.26
          1.44
Dec
6,248.81
5,460.31
5,550.14
          1.30


 Current Discount to Historical Median                 39.0%


All data is sourced from the Bombay Stock Exchange (BSE).

The above analysis reveals a substantial discount to historical market standards.

Obviously, past market valuations are irrelevant to the future - but viewing current valuations in the light of ‘normal’ market sentiment towards accumulated net worth of Indian equities appears to paint a picture of current market pessimism and may indicate clues to potential undervaluation for profitable action.

The above analysis could be criticised for being of unduly short duration (5 years) and therefore unrepresentative of ‘normal’ market sentiment.  We are limited, however, by easily obtainable data but more importantly, the analysis includes a period of severe market stress (2008-09) along with good years that could conceivably provide an index of ‘normal’ market sentiment.

Conventional wisdom would recommend investing in undervalued large cap indices because they “recover first in a market upturn”.   In our view, this is akin to a market timing call, which is not our area of concern.  We are concerned with acquiring long-term values and on this basis, indices of mid and small caps appear to offer far more value than large-cap indices.

The current market valuations for the broader indices relative to book value are the lowest since the Lehman collapse.  Considering the aftermath of the Lehman collapse, governments do not appear to have the appetite for a similar crisis regardless of moral hazard concerns – at least for the moment.  Regardless, these indices appear undervalued by historical standards.

Foreign investors generally do not have direct and unlimited investment access to individual stocks in the broader markets under Indian laws.  They may be able to invest directly in ETFs on the broader indices (e.g. CNX Mid Cap, CNX Small Cap etc.).   These may still be too small for large investment firms to deploy funds – nevertheless, they’re worth looking into since they appear to offer attractive risk/reward ratios at current levels.

Furthermore, foreign investors may get the additional benefit of investing in a potentially undervalued Indian Rupee.  Although we are not currency experts, we perceive that the Reserve Bank of India (India’s central bank) does not believe it’s fundamentally overvalued (at the very least).

This is not a definitive call to buy Indian mid-cap and small cap indices.  We would suggest the reader to study the matter further to arrive at his own conclusions to his own satisfaction.  Our own approach is to select specific attractive stocks after much further study.   Our assertion, however, is that the broader Indian indices look interesting by historical standards and may offer clues to their general undervaluation and point to rich individual pickings within them.

The eminent investor Warren Buffett has said: “Be greedy when others are fearful and be fearful when others are greedy”.

The current scenario appears to be calling for such action.