Is the amazing rise in small-cap stocks in line with the “fundamentals”? As it turns out, small-cap shares are the most expensive based on price-earnings to growth (PEG) ratio, which is simply the price-earnings (P-E) multiple divided by earnings growth.
Earnings of shares that comprise the Bombay Stock Exchange (BSE) small-cap index grew 19.6% in the September quarter, but their trailing 12-month P-E multiple was as high as 24.9, resulting in a PEG ratio of 1.3. Large-cap shares represented by the BSE 100 index had a PEG ratio of 1.1 and grew earnings by 23.8% (the P-E multiples mentioned above will differ slightly from those published by BSE because it excludes stocks on which year-on-year earnings growth data isn’t available).
The top performers were mid-cap shares, which grew earnings by as much as 37.1% and trade at a PEG ratio of just 0.7 times. Their fast-paced growth in earnings last quarter was no flash in the pan—in the past four quarters, their earnings grew by 52.5%, easily outpacing the 36.9% and 31.4% growth posted by large-cap and small-cap firms, respectively.
Mid-cap shares now enjoy the same P-E multiple as their large-cap peers, with the BSE mid-cap index P-E at around 27.8 (as published by BSE). Just two months ago, they traded at a 20% discount. It’s also important to note that while the BSE 100 enjoys a P-E multiple of 29.3 (as published by BSE), the 30-share Sensex has a lower valuation of 27.9 times trailing earnings. Investor preference has clearly shifted to where earnings growth is higher, and it seems the markets haven’t been restricted by the accepted wisdom of the past that the largest firms should demand the highest valuations (a year ago, the Sensex traded at a 13% premium to the BSE 100). True, the P-E multiple of an index may get skewed depending on industry weightages, but there’s little doubt that mid-cap valuations have caught up significantly with those of their large-cap peers.
And although small-cap companies hardly match mid caps on fundamentals such as earnings growth and return ratios, they have somehow been large beneficiaries of the shift in focus from large caps. Considering that their PEG valuations are now the highest, it’s high time they corrected.
An excellent performer in the past month, the ITC Ltd stock easily beat the Sensex. One reason could simply be its earlier underperformance—even after its recent run-up, the scrip is up around 21% more than its opening price in January—a much lower gain than for the Sensex. But analysts have also been recommending the stock for a whole host of reasons, chief among which has been the thrust given to the company’s fast moving consumer goods (FMCG) business. ITC aficionados expect the company to be able to leverage its ubiquitous sales network to sell everything from potato chips to biscuits to shampoos. Ambitious expansion plans have also been aired, such as the move to increase its “Choupal Sagar” complexes from the current 24 to 100 in the next 18 months at a cost of Rs600 crore. The most recent trigger appears to be the story that the group is going to expand its hotels chain in the mid-market segment.
But these initiatives all mean a lot of upfront investment in fixed assets as well as building brands, while returns will take time. The new businesses accounted for only about 18% of the company’s earnings before interest and tax in the September quarter and the company’s dependence on revenues from its core cigarette business will continue for a long while. As a matter of fact, the new businesses are dependent upon the cash flows from the cigarette business. That’s not such a bad thing because the company has proved that people are going to smoke in spite of higher taxes. Cigarette volumes declined 4% but revenues rose 5.5% in the September quarter as smokers absorbed a steep rise in prices.
Analysts had pencilled in a sharp fall in cigarette volumes after the imposition of the value-added tax, but volumes have proved to be far more inelastic. The other reason for the rise in the stock is perhaps its attraction as a defensive stock in uncertain times.
It’s debatable whether there’s much of an upside left in the stock in the short term, given the proximity of the Union budget. Investors have generally avoided the stock before the budget because the industry has traditionally been every finance minister’s favourite when it comes to raising taxes. And at more than 22 times fiscal 2009 consensus earnings, the stock is not cheap.
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