From the Ring. Bubble in small-caps may burst

The Indian equity markets are on a new high. In the US, the S&P 500 Index has almost doubled since March 2009 and risen above 2,000 (on August 25) for the first time.

In the domestic markets, investors are worried whether a dotcom-like bubble is building up in the US, which can trigger a correction.

Since 2008, Indian equity indices have been correlated to Dow Jones and the S&P 500 to the extent of 0.85. Hence the fear.

But such a crash is most unlikely. The dotcom bubble peaked when the PE of S&P 500 moved close to 30 while the same stands at around 19 now.

In India, the journey to the record peaks has been accompanied by several intermediate 10 per cent corrections.

This indicates that some profit-taking has already been incorporated in this journey. The Sensex quoting at about 14 times the FY2016 earning also gives some valuation comfort.

Other macro indicators are in favour – the rain shortfall is down to 18 per cent as of August 24. The area sown under various crops has improved to 93.5 million hectares — down just 4.8 per cent from 97.58 hectares sown last year.

The price fall in the “twin oils” — crude and palm – which form a major part of our import bill, is a major positive.

Crude oil is down about 15 per cent from the recent peak, while palm oil prices have tumbled to $633 per tonne for the first time in more than five years.

Over 2,000 companies have posted collectively over a 30 per cent year-on-year (YoY) growth in net profits in June quarter. Indicators like Index of Industrial Production (IIP) are showing growth of more than 3 per cent in the current fiscal compared to near stagnation last year.

But, one source of potential risk to markets is the foreign portfolio investors’ (FPIs) booking profit. FPIs bought $2.2 billion of Indian bonds in August, taking this year’s total inflows to $16.5 billion.

However, in case there is any small stress from the FPIs in terms of withdrawal, LIC is in a position to infuse over $8 billion into the equity markets as it has stated it would invest about ₹50,000 crore in the equities in FY2015. But, a huge outflow by the FPIs looks less probable in the near future.

All this suggests that when FY2017 earnings are incorporated by the analysts in April 2015, the markets could register another 20 per cent upside.

Hence, while the overall index return could be capped around 5 per cent for the period ending December 2014, in the next 18 months, it could give us another 20 per cent return — that is, the Sensex is likely to cross 31,000 by end of 2015.

However, there are two areas of concern in the short term. First, the Indian markets could see some volatility from October 2014-March 2015 due to complete phase out of the US quantitative easing and interest rate hike.

Also, the fact that India has to repay about $174 billion of external debt by March 31, 2015, would create some pressure on the markets and the rupee.

Secondly, there are “bold” investors who are chasing the mid-cap stocks without any care about the valuations.

Several mid-cap stocks, which are known to change name and post robust results during the bull run, are back.

Some of the mid-cap pharma stocks — with turnover of less than ₹1,000 crore — are quoting at 30 to 40 PEs, costlier than Dr Reddy’s Lab and Sun Pharma.

Some mid-sized companies, after posting losses in June quarter, are moving up considerably. “Better the return, poorer the fundamentals!” is the new norm for about half the small-cap stocks.

Expected volatility in the markets during the second half could lead to a burst in the bubble being built in the small-cap stocks (with less than ₹500 crore market cap). Smart investors could use the opportunity in the markets now to correct the past mistakes — by shedding the stocks of inefficient firms and unethical managements.

Hence, investors can remain invested in the Indian equities without losing comfort on the quality of management and valuations. Also stay on cash, if possible, up to 5-10 per cent of your portfolio.

In case the bubble bursts, this cash can be deployed in good value stocks. The upside to the overall market is limited till March 2015. This, however, offers good scope for some individual stocks in the small-cap category, which still remain attractive.

The writer is founder and managing director, Equinomics Research & Advisory

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