Small cap stocks in bubble zone, do value-investing

Recently I saw quite entertaining (or educative?) a 'low-budget' southern movie – a guy tries to develop sympathy for him to cheat an innocent passerby, but fails. However, he succeeds when he follows his boss' (hero with a negative role) advice of creating 'greed' for the target, rather than the sympathy for himself!

Today there is a huge bubble in many small cap stocks – a few small pharma companies with less than Rs 200 crore of sales trade around 30 PE while Dr Reddy's Labs with annual sales of close to
Rs 15,000 crore valued at 22 times FY2015E EPS! A couple of IT companies with less than Rs 200 crore of revenue trade around 34 times, while the IT giant TCS with revenue of nearly Rs 1 lakh crore valued around 23 times FY2015E EPS!

There are many small cap stocks, which have moved up 400% or more within 12 months, but their daily trading volumes are less than 1000 shares! This fact reveals the buildup of valuation bubble without any depth in the markets. We hear from many "traders" – 'don't get scared off 300 PE or inability of companies to make any profits - buy "distant" futuristic stories'. Stock flares up 60% in about a week and then falls 16% in a matter of about 2 or 3 trading days! In the last 12 months, a small IT stock falls about 43% in 4 months, and then doubles in the next 5 months and in the following 3 months, it crashes again 55%! The great Nobel Laureate Dr Kenneth Galbraith once said, "…financial memory is notoriously short…". But in this kind of small cap stocks, it seems to be "notoriously toooo short"!

In fact, a few ethical promoters explicitly wonder that they are unable to understand multiplying market caps while their business is still limping!

There are over 7,300 stocks listed on BSE, out of which about 4,000 stocks are regularly traded. Today, the market cap of all BSE stocks is about Rs 103.50 lakh crore. Out of which, BSE500 stocks alone are worth Rs 97.3 lakh crore. So the balance of Rs 6.2 lakh crore of market value is accounted for by 3,500 active stocks, which are mostly mid and small cap stocks.

The industrial economy is almost stagnating for the last 2 years. Even the service sector, which used to grow in double digit, is growing in a single digit! In fact, the tax collections from the service sector, which used to grow at a robust rate of over 25% yoy, have grown in a single digit in December. Bank deposits are growing in the range of 10% to 11% as against over 18% till a few years ago. The demand for real estate is down significantly.

In such a liquidity-tight developing economy, if smart investors decide to book profits even to the extent of just 10% of Rs 6.2 lakh crore worth of mid and small cap stocks outside the BSE500, where is the liquidity and who can absorb them? Finding Rs 60,000 crore worth of liquidity would be too tough in this market as most of the institutional players do not participate in such stocks. In such a possible event, what could be the bottom for small cap stocks, which are in the bubble zone of valuation? The time is ripe for value-investing.