Why this is a good time to buy smaller company stocks
After a steep fall, a number of indicators points to why bottom-fishing may be a good idea for investors
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Prefer us on GoogleLast Updated: Sep 20, 2019, 17:21 IST6 min
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This valuation boom soon exposed many shortcomings of the rally. First was the lack of liquidity in midcap stocks. Trades of a few thousand shares were enough to have them locked on upper circuits (20 percent or 10 percent depending on the stock) as investors bought into future growth projections. (The same story repeated on the way down as well.) As the cost of capital for smaller companies fell, their balance sheets began to look a lot leaner, which resulted in a valuation rerating.
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Second, the lack of earnings growth caught up with valuations. In hindsight, the rerating of the Midcap 50 Index from 12 times to 85 times shows that valuations rose seven times faster than earnings—a classic hope rally. Exceptions where the increased valuations have held have been few and far between. For instance, Relaxo Footwear rerated from about six times earnings before the start of the 2013 rally to 60 times as it delivered a steady earnings growth of 21 percent a year.
Third, an October 2017 circular issued by market regulator SEBI laid down how mid and small caps are classified. Any company between the 100th and 250th market cap is now a midcap, and any company after the 250th market cap mark is a small cap.
In the absence of a strict classification earlier there were instances of fund managers buying mid and small caps in schemes not meant for them in order to boost returns. According to research from Emkay Securities, between January and June 2018, this resulted in the Nifty Midcap 100 falling 14 percent and the Nifty Smallcap 100 falling 21 percent only due to an outflow of funds from these schemes.
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Last was the excessive leverage that promoters of midcap companies took. As share prices rose, share pledges increased. Money raised against those pledges was used to fund newer businesses often outside the listed company. So in many cases, while the balance sheet of the listed company whose shares were pledged improved, the promoter was heavily leveraged.
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In the case of Eveready, India’s largest manufacturer of dry-cell batteries, an increase in the company’s valuation from ₹210 crore in August 2013 to ₹3,230 crore in January 2018 saw the number of pledged shares rise from 10.15 percent to 88.51 percent. As markets came off and the company defaulted on its loan covenants, the lenders had no option but to sell pledged shares in the market. From the peak, the company has lost 87 percent of its market value.
Cheap Valuations Fast forward to September 2019. The valuations on the mid and small cap indices have reverted to the mean, making it a good time to enter. “The markets have baked in too much pessimism,” says Sunil Damania, chief investment officer at MarketsMojo, explaining that midcaps always do better once the market turns. A number of factors point to why this is the case.
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The BSE Smallcap index is at its cheapest at any point in the last five years (see chart). At 1.01, its dividend yield is close to 2015 levels but the price earnings ratio is 36 percent cheaper. Midcaps, though more expensive, are also in the buy zone.
At these valuations, companies have baked in low earnings growth and any outperformance can result in a quick rerating on the upside. Indo Count Industries, a home textile company which made a profit of ₹34 crore in the first quarter of 2019-20 as compared to a profit of ₹59.8 crore in the year 2018-19, saw its stock rise 62 percent in the last month.
From the second quarter of this year, as the base effect kicks in, several numbers—auto sales, consumer goods sales and mining—will start to look better from a year-on-year perspective and companies can get back to growth albeit from a lower base. Still, Damania cautions that investors wading into midcaps must not look to made quick money.
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“Look for growth prospects, no promoter pledging, and a low or zero debt to equity ratio. These are the companies that will rerate first when the cycle turns,” he says before reiterating that the cycle always turns.
First Published: Sep 20, 2019, 17:21
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