
Stock trek: Valuations are going where nobody has gone before

Summary
- Venturing boldly forth into the unknown can be exciting but retail investors must invest carefully rather than putting all the eggs in one basket. Spreading investments across different categories of stocks and avenues still remains the best game in town.
Markets discount possibilities, and when these possibilities change, the direction of the market also tends to change, something that seems to have happened to the Indian stock market since end October. The BSE Sensex, India’s premier stock market index, has risen by around 9% since end-October, fighting with the 70,000 level on 12 December.
So, what has changed? Foreign institutional investors (FIIs) had net sold stocks worth ₹39,316 crore in September and October, but have net bought stocks worth ₹40,372 crore from 1 November to 12 December.
Of course, domestic institutional investors have continued to buy. In September and October, they net bought stocks worth ₹48,567 crore, more than offsetting the FII sales.
From 1 November to 11 December, they have net bought stocks worth ₹18,995 crore. This, along with FIIs buying, has pushed the market to a newer high. DIIs are basically firms like mutual funds, insurance companies, pension and provident funds, banks, etc. Much of the money they invest is handed to them by retail investors.
So, what’s the reason behind FIIs behaving differently of late? The yield on the 10-year US Treasury bond has been falling since end-October. The yield on a bond at any point of time is the per-year return investors can expect to earn if they buy the bond and hold on to it until its maturity. Treasury bonds are issued by the US government to finance its fiscal deficit.
The yield on the 10-year US treasury stood at 4.95% as on 25 October. It has since fallen to 4.24% as of 11 December. So, what’s the bond market discounting for? It feels that inflation in the US is more or less under control and that the US Federal Reserve will start cutting interest rates sooner rather than later. Discounting this possibility, the returns on US Treasury bonds have been falling. Between the Fed cutting interest rates and bond yields falling, interest rates through the US financial system and much of the Western world are likely to fall. This has led FIIs to look for higher returns and invest in Indian stocks as part of that process.
Now, FIIs typically invest in large-cap stocks and mid-cap stocks, which are stocks ranked in the top 250 in terms of market capitalization. This explains why large-cap indices, like the Sensex, and mid-cap indices are rallying. But what explains the rapid rise in the price of small-cap stocks? Stocks ranked 251st and below in terms of market capitalization are termed small-cap.
The BSE SmallCap Index has risen by around 12% since end-October and up to 12 December. In fact, from end March and up to 12 December, the index has risen by more than 53%. This has now taken the valuations of small-cap stocks—measured in terms of their price-to-earnings (PE) ratios—to very high levels, which implies that investors are now paying far more as the market price for every rupee of these companies’ earnings than in the past.
How do the valuation figures look? Data from Bloomberg suggests that 952 companies are a part of the BSE SmallCap index. But we will consider only 835 companies here, given that the PE ratios of many of these small companies aren’t available.
In fact, as of 8 December, there were 75 companies with a PE ratio higher than 100 and 233 companies with a PE ratio higher than 50. How were things as of 31 March? As many as 35 businesses had a PE ratio higher than 100 and 120 companies had a PE ratio higher than 50.
Clearly, valuations have been bumped up, perhaps even nudging Nilesh Shah, managing director at Kotak Mahindra Asset Management, to tweet quoting Captain Kirk of the Star Trek TV series to say that valuations seem to be boldly going “where no man has gone before." And this has primarily been on account of retail money flowing into small-cap stocks, directly and indirectly. Of course, lately, what investor and columnist Debashis Basu calls “the Modi premium" has also been at work, and this applies to the broader market and not just small-cap stocks.
Getting back to the retail interest in small-cap stocks, this can be seen in small-cap mutual funds getting net inflows of ₹30,246 crore since end- March, whereas large-cap mutual funds have seen net outflows of ₹4,668 crore, in an environment where large-cap stocks have reasonable valuations in comparison with small-cap ones. But, of course, retail investors may not have been looking at PE ratios, enamoured as many are by stocks which have gone up swiftly, a criterion that small-cap stocks have fulfilled in recent times.
The trouble is that the retail part of the market is now made up of largely newbie investors, with more than 70% of the demat accounts currently in operation having been opened over the last four years. And these investors have seen the market go only one way—up! Nonetheless, as has been seen in the past, small-cap stocks can fall faster than they rise, which is why diversification—or not putting all your eggs in one basket and spreading investments across different categories of stocks and avenues like fixed deposits, gold, etc—still remains the best game in town. But then, that’s boring.