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.”
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