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.