Indian Bank: The Dark Horse

While many medium-sized banks are struggling, Indian Bank has robust fundamentals

Beta 1.0 Institutional Holding 15.8% Dividend Yield 3.8% CMP Rs 129 Current Mkt Cap Rs 5,542 cr Current P/E 4.8
 It is also one of the best-managed staterun banks in India. Its performance in the last three years, since it absorbed all its accumulated losses in its capital, is at par with best in its industry. Investors are advised to consider it for long-term investment.
BUSINESS
Headquarted in Chennai, Indian Bank is a leading bank in South India with widespread presence in Tamil Nadu, Kerala, Andhra Pradesh and Pondicherry. It was nationalised in 1969. It is a medium-sized bank and its balance sheet size stood at Rs 84,122 crore in FY 2009. It has 1,642 branches.
    In the current decade, the bank has seen a turn-around. At the end of March 2000, bad loans, or net non-performing assets, formed 16% of Indian bank’s net advances. In FY06 it absorbed all the losses in its capital, which fell to Rs 744 crore from Rs 4,574 crore in the previous year. Since then, Indian Bank’s profit has grown at compounded annual growth rate (CAGR) of 35% every year, while its balance sheet has grown at a CAGR of 21%. This shows that it has enough reach and scale to leverage.
GROWTH DRIVERS
Indian Bank’s performance is clearly a cut above most state-run banks, notorious for inconsistent performance that puts down investors. The bank has performed well on all quality parameters while maintaining an impressive growth rate, achieving a delicate balance that has eluded several of its peers.
    For instance, its net interest margin (NIM) stood at more than 3.5% in last six financial years. The only banks, which can better Indian Bank on this count are Kotak Mahindra Bank, Federal Bank and HDFC Bank. Its return on assets (RoA), at 1.6% in FY 2009, was the highest across all banks.
    Its bad loans formed less than 0.2% of its net advances at the end of the year. Only Punjab National Bank has better record than Indian Bank on this count. The composition of its lending portfolio is very much on the lines of other state-run banks: agriculture loans constituted 15%, SME loan formed 11% and corporate sector contributed 50% to total loan book.
    That the bank’s performance is superior despite similar lending profile shows the efforts being put in to choose the customers. The bank is expanding its presence. It opened 101 new branches in FY 2009.
VALUATION
Indian Bank is trading at a price to earning (P/E) multiple of 4.8 times. This is lower than the average of smaller banks that are no match to it in performance.
    This indicates that the stock market is not giving premium to its performance. Moreover, the earnings growth is far ahead of P/E, which shows that the possibility of rise in stock price is much higher. In terms of price-to-book value P/BV), the stock is trading at close to 1, which is the average at which other banks are trading. Even based on P/BV, the bank is not getting the premium it deserves in terms of valuations.
    We think it will be re-rated some time in future and therefore advise long-term investors to buy the stock at current levels.

8 key ratios to spot the right stocks

It’s a very common dilemma for first time stock buyers. You want to invest in ’safe’ stocks yet have no idea about the process involved. Should you trust your broker? Or should you trust the markets analysts. And at the end of the day you are left confused by the myriad of opinions and advices that are thrown at you.

Instead, why not understand the parameters yourself so that you can make the best choice? To help you understand the intricate art of choosing the best stocks to invest in, here are eight key ratios. Read on, understand…and happy investing!

Ploughback/reserves: Every year, a company divides its net profit (profit left after subtracting various expenses including taxes) in two portions: ploughback and dividends. While dividends are handed out to the shareholders, ploughback is kept by the company for its future use and is included in its reserves.

Ploughback is essential because besides boosting the company’s reserves, it is a source of funds for the company’s expansion plans. Hence if you are looking for a company with good growth prospects, check its ploughback figures.

Reserves are also known as shareholders’ funds, since they belong to the shareholders. If a company’s reserves are twice its equity capital it can then reward its shareholders with a generous bonus. Also any increase in reserves will push the share price of your share.

Book value per share: This ratio shows the worth of each share of a company as per the company’s accounting books. It is calculated as:

Book Value per share = Shareholders’ funds / Total quantity of equity shares issued

Shareholders’ funds can be computed by subtracting the total liabilities (money owed to creditors) of the company from its total assets. It can also be calculated by adding the equity capital to the company’s reserves.

Book value is an old record that uses the original purchase prices of the assets. However it doesn’t show the present market price of the company’s assets. As a result, this ratio has a restricted use when it comes to estimating the market price of the shares, but can give you an estimate of the minimum price of the company’s shares. It will also help you judge if the share price is overpriced or under-priced.

Earnings per share (EPS): One of the most popular investment ratios, it can be computed as:

Earnings Per Share (EPS) = Profit Post Tax / Total quantity of equity shares issued

This ratio computes the company’s earnings on a per share basis. E.g. you own 100 shares of ABC Co., each having a face value of Rs 10.

Assume the earnings per share is Rs 10 and the dividend declared is 30 per cent, or Rs 3 per share. This implies that on every share of ABC Co, you earn Rs. 6 each year, but you actually get Rs 3 via dividend. The balance of Rs 4 per share goes into the ploughback (retained earnings). Had you purchased these shares at par, it implies a return of 60 per cent.

This example shows that instead of looking at the dividends received from to company as the base of investment returns, always look at earnings per share, as it is the actual indicator of the returns earned by your shares.

Price earnings ratio (P/E): This ratio highlights the connection between the market price of a share and its EPS.

Price/Earnings Ratio (P/E) = Price of the share / Earnings per share

It shows the degree to which earnings of a share are protected by its price. E.g. if the P/E is 40, it means the share price is 40 times its earnings. So if the company’s EPS is constant, it will need about 40 years to make up for the purchase price of the share, after taking into account the dividends and the capital appreciation. Hence low P/E means you will recover your money quickly.

P/E ratio shows what the market thinks about the earnings potential and future business forecast of a company. Companies with high P/E ratios are the darlings of the investors and thus enjoy a higher market rating.

In order to use the P/E ratio properly, take into account the future earnings and growth projections of the company. If the current P/E ratio is low, as against the future prospects of a company, then the shares make an attractive investment option.

But if the company is saddled with losses and falling sales, stay away from it, despite the low P/E ratio.

Dividend & yield: Dividend is the portion of the profit that is distributed amongst shareholders. Companies offering high dividends, normally don’t have much of growth to talk about.

This is because the ploughback required to finance future development is insufficient. Similarly, those companies in high growth sector don’t give any dividend. Instead here they give sharp capital appreciation, which ultimately will lead to higher dividends.

So it makes much more sense to invest for capital appreciation instead of dividends. Rather it makes more sense to invest for yield, which is nothing but the association between the dividends and the market price of the shares. Yield (dividend yield) can be calculated as:

Yield = (Dividend per share / market price of a share) x 100

Yield shows the returns in percentage that you can expect via dividends earned by your investment at the current market price. It is more useful than simply focusing on the dividends.

Return on capital employed (ROCE): ROCE is the ratio that is calculated as:

ROCE: Operating profit / capital employed (net value + debt)

To get operating profit, add old taxes paid, depreciation, special one-off expenses, and special one-off income and miscellaneous income to get the net profit. The operating profit is a far better indicator of the profits earned by the company instead of the net profit.

Hence this ratio is the better indicator of the general performance of the company and the company’s operational efficiency. It is one of the most useful ratio that lets you compare amongst the companies.

Return on net worth (RONW): RONW is calculated as

RONW = Net Profit / Net Worth

This ratio gives you an idea of the returns generated by investing in the company. While ROCE is an effective measure to get a general overview of the profitability of the company’s business operations, RONW lets you gauge the returns you can earn on your investment.

When used along with ROCE, you get an overview of the company’s competence, financial standing and its capacity to generate returns on shareholders’ finances and capital employed.

PEG ratio: PEG is an essential and extensively used ratio for calculating the inbuilt worth of a share. It helps you decide whether the share is under-priced, totally priced or overpriced.

To derive the ratio, you have to associate the P/E ratio with the expected growth rate of the company. It assumes that higher the growth rate of the company, higher the P/E ratio of the company’s shares. Vice versa also holds true.

PEG = P/E / expected growth rate of the EPS of the company

In general, a PEG lesser than 0.5 is a lucrative investment opportunity. However if the PEG exceeds 1.5, it is time to sell.

These are some of the most critical ratios that must be considered when purchasing a share. Extensive reading of the financial performance of the company in newspapers and magazines will help you get all the relevant information to get the correct decision

Indian cos world’s most reputed; Tatas above Google, Microsoft

PTI, New York: They may not be as big as their global peers in terms of
revenue and profits, but Indian companies are top of the lot in terms
of their reputation, as per a study that has ranked Tatas as more
reputed than the likes of Google, Microsoft, Coca-Cola, GE and Walt
Disney.

Noting that the world looks to “corporate India to find trust,
admiration and good feeling,” the US-based brand and reputation
management consulting firm Reputation Institute has named five Indian
firms among the top-50 in its annual list of the world’s most reputed
companies.

While the global list has been topped by Italy’s chocolate maker
Ferrero, Sweden’s retailer IKEA, and Johnson & Johnson in the US, the
Tata group has been ranked 11th.

Among Indian companies, Tatas are followed by SBI (29), Infosys (39),
Larsen & Toubro (47) and Maruti Suzuki (49th).

There are 22 other Indian companies on the list of 600 largest
companies, ranked in terms of their reputation.

“Corporate India has the best reputed companies. Of the 27 Indian
companies ranked among the 600 largest in the world, almost 90 per
cent received scores above the global mean, with five ranking among
the Top 50,” the Reputation Institute said in its annual study for
2009.

Only the US had more number of companies in the top-50 (17 companies),
the report noted. In terms of overall presence also, the US had five
times the number of companies in the list than India.

The list is made on the basis of admiration, trust and good feeling
that consumers have towards a company.

Other Indian companies on the list include — Hindustan Unilever (70th
rank), ITC (96), Canara Bank (103), HPCL (112), Indian Oil (113),
Wipro (117), Reliance Group (133), Mahindra & Mahindra (138), Bharti
Airtel (164), Bank of Baroda (175), BPCL (176) and Punjab National
Bank (178).

The report did not clarify whether the Reliance group means the Mukesh
Ambani Group or Anil Ambani group of companies.

The report revealed that corporate trust is higher in the emerging
markets, while companies in industrialised markets are trusted less.

“Proportionally, the largest companies in Brazil, Russia, India and
China (BRIC) enjoy a stronger emotional connection with consumers than
the largest companies in the industrialized world,” it added.

Out of the 289 companies from the US, Japan, the UK, France and
Germany, 45 per cent have reputations below the global average, while
only 34 per cent of the 142 companies from BRIC nations have
below-average reputations, with Chinese companies dragging down the
BRIC average substantially.

Industrial and Commercial Bank of China saw the largest gain in
reputation, 16.38 points from 2008 to 2009, while AIG lost the most
reputation capital with a drop of 27.52 points.

Internet giant Google has been ranked at the 23rd position, while
Microsoft grabbed the 30th rank and Walt Disney was at 21st place.
Nokia is at 45th, PepsiCo is 46th and GE is ranked 50th.

In 2008, Toyota and Google were number one and two, they now rank 59th
and 23rd, respectively.

DON’T file your tax returns just yet!

The devil, they say, lies in the detail. And here’s one that threatens
to derail the income tax return filing process. Individuals now need
to mention a unique transaction number (UTN) against every tax
deducted at source entry.

The problem, though, is that infrastructure to generate UTNs is still
not in place, leaving income tax assessees in a lurch as July 31,
2009, the last date to file returns for the financial year 2008-09,
fast approaches. “Nobody can say whether the returns will be valid if
filed without UTN,” says Sandeep Shanbhag, a chartered accountant and
director, investment and tax advisory, Wonderland Consultants.

In a circular dated May 21, 2009, Munesh Kumar, secretary, Central
Board of Direct Taxes, said, “The credit for any TDS…claim will be
allowed…if the assessee quotes the relevant UTN for every TDS.”
Simply put, if a UTN is not mentioned against a TDS transaction then
the tax already paid by the individual will be considered unpaid.

It then becomes necessary that companies, who deduct tax every month
against salaries, provide employees with UTNs against these
deductions. This UTN then needs to be mentioned in the Indian Income
Tax Return form that is used for filing tax returns.

“You won’t get the tax credit unless the UTN is quoted. If they go
ahead with the regulation, the person will have to pay the tax all
over again along with the interest and penalty,” says Shanbhag.

This logic will also hold for any TDS that a bank might have cut on
interest earned on fixed deposit. Like employers, even banks will need
to provide a UTN.

As per the May 21 circular, the National Securities Depository Ltd is
supposed to issue UTNs to the deductor of TDS (companies, banks) who,
in turn, has to pass on the UTN to the deductee.

That, clearly, isn’t happening anytime soon primarily because the
change was introduced on May 21, 2009, nearly two months after the
last financial year came to an end.

“We don’t issue certificates in the middle of the year and the UTN
number will be given only by May 2010,” says KVS Manian, group head -
retail liabilities & branch banking, Kotak Mahindra Bank.

None of the form 16s received from salaried clients has any mention of
UTNs, say chartered accountants. “UTN is to be provided for the
accounting year 2008-09.Everybody – banks, employers etc – has issued
TDS certificates and form 16 as per the old law,” says Ameet Patel,
partner at chartered accountancy firm Sudit K Parekh & Co.

Aware of the problem, the CBDT is in the process of amending this
rule. Shishir Jha, CBDT spokesperson, says, “Action is being taken to
ensure that assessees do not face any difficulty. Individuals are
requested to wait a week for clarifications.”

Given the uncertainty, it is advisable to wait for a week or two
before filing your IT-return, says Shanbhag. “We have 40 more days to
go till July 31. So, when there is such a big issue involved, one
should wait,” he says.

—————————————————————————————
Since I cannot increase the content of life by increasing its duration,
I will increase it by increasing its intensity…Art, Music, Poetry,
and everything else that I do have this one purpose—increasing the
intensity of my consciousness and life.
HOMI BHABHA (1934)

Three eclipses in a month

The world will witness a rare astronomical event- a series of triple eclipses starting July 2009. The fist in the series of triple eclipses will be a lunar eclipse on July 7 which will be followed by a solar eclipse on July 22 and then a lunar eclipse on August 6.

What does this celestial phenomenon mean to the world and does this astronomical event portend anything for us. D K Hari and his wife Hema Hari discuss the above mentioned issues in their new book, Will History Repeat Itself? Triple Eclipse of July 2009. Omnious or Promising? the book has been published as part of the Bharath Gyan series by the Sri Sri publications.

What is strange is that if one looks back at the events that have unfolded in the past, triple eclipses have always been followed by destruction. Hari told rediff.com that the first of the triple eclipses was recorded way back in 3067 BCE (Before Common Era). Following this triple eclipse there was the Kurukshethra war which was fought between the Pandavas and Kauravas in which 47 lakh people took part. The sequence of the first triple eclipse was as follows- Lunar eclipse on 29 September 3067, Solar eclipse on 14 October 3067 and Lunar eclipse on 28 October 3067 BCE.

Funds shuffle scrips as Nifty floats

The shift in S&P CNX Nifty, the favourite index of numerous investment schemes both at home and abroad, to a new system of computation is likely to get the fund managers busy this week.
The index, which is a benchmark for at least 73 equity diversified schemes of Indian mutual funds, is going for a major change in its composition.
The National Stock Exchange’s flagship index will shift to free-float capitalisation method from June 26.
Under the method, the weightage of each of the 50 component stocks in the index will be proportionate to the amount of free float.
Free float is the number of shares of a company in public hands — stock that is “floating free”, that which is not with the promoters.
Globally, most indices are moving to this system as it is perceived to be more representative of market action.
Experts say, with the new system coming into vogue, funds would need to adjust their portfolios accordingly.
“Managers who are tracking the Nifty closely, may have to make allocation changes. People who are mirroring the index should make bigger changes,” said Deepak Mohoni, MD, www.trendwatchindia.com.
Benchmark indices are important to two broad kinds of investment schemes: ones that track market indexes (index funds) and funds whose managers choose securities to buy and sell (actively managed funds).
While index funds mirror the index components, active funds operate on a relative return basis, wherein performance of the fund is judged by comparing it to the performance of the benchmark.
Some of the action is already visible in the prices. Stocks which are bound to lose weightage post this reorganisation, especially the PSUs, are out of favour.
“A significant portion of the adjustment has already played out and one can see the result of that in the fall of NTPC and ONGC and the outperformance of L&T and private banks,” said Anand Shah, head of equities at Canara Robeco MF.
While Reliance Industries will retain its position as the top-weighted stock due to its high free-float component (50%), ONGC and NTPC are likely to lose weightage.
Oil and Natural Gas Corporation (ONGC) has the second-highest weightage (8% )in the Nifty under the Total M-cap regime. This is bound to come down to 3.5%.
Similarly, the index weight of National Thermal Power Corporation will drop from 6% to 1.9%.
The reverse will also be true as some stocks such as Infosys will have a high free-float gain at the expense of these.
The weightage of Infosys, currently at 3.77% in the Nifty, will increase to 7%. So an index fund will appropriately double its holding of Infy shares.
ICICI Bank will increase its weightage from 2.96% to 6.45%, while Larsen & Toubro goes from 3.27% to 6.41%.
Some absolute-return products based on the index and long-term players like insurance companies who tend to mirror the index would go for shuffling of portfolios, said fund managers.
“Arbitrage funds and structured products, which track the Nifty, would also see some changes made. The majority of the action would take place on June 26 for index funds,” said Gopal Agarwal, head of equity at Mirae Asset Global Investments.
Jayesh Shroff, fund manager at SBI Mutual Fund, said, insurance companies and the funds managed by them are more likely to be affected by such a change.
“As far as they are concerned, it would already have started,” said Shroff.
The effect on the broader will be very short-term, feel experts.
A Balasubramanian, CIO of Birla Sun Life Mutual Fund, said there might be some minor changes in the portfolios of schemes. “A fund manager will change his scheme’s holdings on the basis of valuation rather than events such as these,” Balasubramanian believes.

Hedge-Fund Gate Bashing to start now

It may be time for investors to storm the hedge-fund gates.

During the market’s crisis last year, more than 15% of all hedge funds imposed restrictions on the withdrawal of money by investors. The explanation from managers: Illiquid markets for some assets meant that selling would destroy value for their clients.

But one furious rally later, only a handful of funds have disclosed concrete plans to hand back money, raising questions about whether some are actually resisting the move, perhaps to keep their firms alive.

There remain assets, such as some convertible bonds and insurance products, with limited trading. But some traders suspect that a number of hedge funds have placed improper values on some of their investments, and if they sold positions, it would force them to lower their returns.

Investors need to levy pressure on funds to sell positions and hand back cash. If not, they risk being caught in a cynical game where funds cling to positions. By not complaining, funds of funds, for example, can pretend an investment still commands a high valuation and continue to charge high management fees by telling their own clients they can’t get the money back.

There are rumblings that investors are beginning to fight back and push for liquidations. For example, Carl Icahn and other investors tried to stop Warren Lichtenstein’s Steel Partners II fund from converting into a listed investment company, demanding a liquidation of the fund instead.

It may cause some short-term pain, but as the hedge-fund industry tries to recover from a year of broken promises, dropping gates is a vital component for regaining investors’ trust.

Minister offers a 42 crore crown to Lord Tirupati

TIRUPATI: Karnataka tourism minister and Bellary mine baron Gali Janardhan Reddy will probably be better known for something else: with an offering diamond-studded crown worth Rs 42 crore, he became the biggest donor to Lord Venkateswara at Tirupati since the Vijayanagara kings 400 years ago.

The 20-kg stunner was a “thanksgiving” gesture, the minister said. Sources added that 32kg of `aparanji (pure)’ gold went into its making, besides 70,000 diamonds weighing 4,000 carats. The 2.5-ft crown has a huge 890-carat emerald from Africa engraved in the centre which alone costs around Rs 10 crore.

The crown will be placed the Lord’s idol during Abhishekam seva on Friday morning. It was earlier kept in the Vaibhavotsava Mandapam in Tirumala and special pujas were performed. After a ritual called Sahasra Deepalankara seva, it was taken around on a procession along with the deity, Lord Malayappa Swamy. Around 7pm, the crown was taken inside the sanctum sanctorum.

Keertilal Jewellers of Coimbatore in Tamil Nadu took nine months to fashion the crown.

There are no records of more expensive donations to the temple and Gali’s donation is considered as the costliest gift offered to the Lord after the Vijayanagara kings in the 16th century. The Vijayanagara kings ruled from Hampi not far from modern day Bellary.

With this offering, the total number of crowns placed with the Lord has gone up to seven. This precious crown has been added to the jewel treasury of Lord which holds over 11 tonnes of gold ornaments and vessels.

“I am in this position only with the blessings of Lord Venkateswara. This is only a small offering to the Lord. I believe in Madhava seva (service to the Lord),” said Gali, who owns several iron ore mines. The minister said his Brahmani Steels, once it starts operation, would employ 25,000 people. “This I consider as manava seva (service to mankind),” he said. Andhra Pradesh chief minister YSR Reddy’s son Jagan has a large stake in Brahmani Steel that is coming up in the Andhra chief minister’s home district.

Nassim Taleb bets on hyper-inflation

By Maverick

A hedge fund firm that reaped huge rewards betting against the market last year is about to open a fund premised on another wager: that the massive stimulus efforts of global governments will lead to hyperinflation.

 

The firm, Universa Investments L.P., is known for its ties to gloomy investor Nassim Nicholas Taleb, author of the 2007 bestseller “The Black Swan,” which describes the impact of extreme events on the world and financial markets.

 

Nassim Nicholas Taleb Funds run by Universa, which is managed and owned by Mr. Taleb’s long-time collaborator Mark Spitznagel, last year gained more than 100% thanks to its bearish bets. Universa now runs about $6 billion, up from the $300 million it began with in January 2007. Earlier this year, Mr. Spitznagel closed several funds to new investors.

 

Unlike last year’s sudden market implosion, inflation isn’t an unimaginable event that few currently anticipate. In fact, many fear inflation right now amid government efforts to goose the economy. Universa’s bet, however, is that inflation will reach levels few expect.

 

By opening the inflation fund, Universa is trying to capitalize on a wave of investor demand for its products, which when they’re right can protect investors from extreme market moves.

 

The new strategy, designed by Mr. Spitznagel, aims to post big gains if inflation and interest rates take off as they did in the 1970s. Universa will invest in options tied to commodities such as corn, crude oil and copper, as well as options on stocks such as oil drillers and gold miners.  “We think these things are going to see massive volatility,” Mr. Taleb said in an interview. 

 

The fund will also bet against Treasury bonds, which tend to weaken in inflationary environments. Last week, Treasury yields shot to their highest level since November as prices fell on inflation concerns. Oil topped $66 a barrel. Gold is creeping up, nearing $1,000 an ounce.

 

The minimum investment in the firm’s other funds has been $25 million, though it rarely accepted investments less than $100 million, a person familiar with the fund says. Similar standards will likely apply to the new fund, called the Black Swan Protection Protocol-Inflation, according to the person.

 

Mr. Taleb doesn’t have an ownership interest in the Santa Monica, Calif., firm, but he has significant investments in it and helps shape its strategies.

 

The term “black swan,” which has become a market catch-phrase in the last few years, alludes to the once-widespread belief in the West that all swans are white. The notion was proven false when European explorers discovered black swans in Australia.

 

A black-swan event, according to Mr. Taleb, is something that is extreme and highly unexpected.

 

For the new inflation fund, there are risks.

 

As investors, Messrs. Spitznagel and Taleb have a mixed track record. The two managers wound down their Empirica Capital fund in 2004 after several years of lackluster returns.

 

Also, some investors are worried not about inflation but about deflation and its pernicious effects were the economy to remain stalled.

 

David Rosenberg, chief economist at Gluskin Sheff, a Toronto wealth-management firm, believes inflation won’t take hold until consumer spending rebounds, which he thinks could take years.

 

Says Mr. Rosenberg: “Not until the household sector expands its balance sheets are we likely to see the re-emergence of inflation on a sustained basis.”

 

Mr. Taleb said any deflation would be matched by an aggressive move by governments to stimulate their economies, leading inevitably to an uncontrollable surge in prices.

Small is beautiful… but can be risky too

Be it the world of cars or the stock market, “small” appears to be in vogue. In the equity rally that began early March this year, stocks in the mid- and small-cap space have delivered returns that trounce those of their large-cap competitors.

Wondering what makes these stocks so attractive? Well, it is their high-risk and high-return positioning that charms the most, though their low valuation also appeals to certain investors. Read on to understand why small- and mid-cap stocks, believed to be multi-baggers in the making, come bundled with higher risks.

Market capitalisation, an indicator of the value placed on a company by the market at that day’s price, is a product of its market price and outstanding number of shares.

While there’s no clear-cut demarcation to differentiate the stocks based on their market capitalisation, given the dynamism of the equity markets, it can be assumed that stocks with market cap less than Rs 2,000 crore fall in the small-cap category, while those above Rs 7,500 crore are of the large-cap genre. The ones that fall in the middle zone are the mid-caps.

 

Large caps – few surprises

 

 

Large-cap stocks enjoy a large scale of operations; have established business model and hence have lower uncertainty in business. Besides, analysts, fund managers and investors alike, closely monitor these stocks. So, while the risks associated with investing in large-cap stocks are known, their likely returns aren’t unknown either.

This makes large-cap investing safer and more suitable for investors who have little stomach to relish uncertainties in investing. This is also why large-cap stocks are most sought after during periods of uncertainty in the markets. But on the other hand, investing in small and mid-cap stocks comes with higher risks, given their lower scales of operation.

While some of the companies in this cadre are still far from establishing their businesses, others are relatively new in their sector — which makes predicting their future revenues tougher. But it is precisely this heightened business risk that sweetens their return potential significantly.

History has it that multi-baggers in most equity rallies are, more often than not, stocks from the mid- and small-cap category only. It is then no surprise that the current rally too saw the small- and mid-cap stocks return higher.

When benchmarked on their year-to-date returns, the mid- and small cap stocks have scored a stellar 80 per cent and 85 per cent returns, while the BSE Sensex gained by 60 per cent.

High risk, high return

 

 

The desire to invest in smaller companies comes, from their ability to return higher. Sidelined by analysts and investors and weighed down by the higher degree of earnings risk, these stocks do not command the valuations that larger companies usually do in the stock markets.

For instance, while a large diversified company such as L&T commands a consolidated valuation of about 25 times currently, smaller ones such as McNally Bharat or Shriram EPC, which are in similar lines of business, enjoy a lower value. Why? While L&T has a wider business presence, large clientele and stable earnings outlook, the smaller ones compare less favourably with it on almost all these counts.

However, with the economy beginning to revive and credit availability easing up, investing in smaller companies may hold higher returns potential, with the advantage of a low base.

Not only do these companies hold the potential to grow at a higher pace; their earnings growth cannot also be easily replicated by their large cap peers either.

For instance, while net profits of Yes Bank have grown at a compounded rate of 53 per cent over the last three years, that of ICICI Bank has grown at about 10 per cent only.

It is this ability to scale high earnings growth that fuelled the recent rally in the mid- and small-cap space, once it became clear that the economy was beginning to get back into shape. For instance, between the cement major ACC and its smaller peers Dalmia Cements and Shree Cements, the stock performance of the latter two was way better in the run-up since January. While ACC delivered 68 per cent returns, the other two stocks registered 82 per cent and 131 per cent returns, respectively.

The trend was similar among stocks in other sectors such as FMCG and IT too. Infosys’ 38 per cent return since January appeared trifle when compared with the triple-digit gains recorded by mid-caps MindTree (117 per cent) and Hexaware (149 per cent).

Earnings trap

 

 

But if investing in small- and mid-cap stocks appears exciting, don’t turn a blind eye towards their earnings. While it is natural to get carried away by the seemingly low valuations, remember that they do so for a reason.

If the probability of these stocks to more than double their earnings is high, the probability of their non-performance is also equally high. Since their businesses are at a nascent stage, their earnings are highly vulnerable to a downturn. In 2008, a year mired with recessionary trends, the BSE Sensex declined by 53 per cent. But the mid-cap and the small-cap indices declined more, by over 67 per cent and 72 per cent, respectively.

This may explain why ACC trades at 13 times, while Dalmia Cements or Shree Cements trades lower at eight times and seven times. Here again, while the mid-caps are somewhat better off, it is their still smaller peers that become unpredictable during uncertain times.

Besides earnings risk, investing in small-cap stocks also bundles with it liquidity risk and higher impact costs. And since most small stocks sport a high promoter holding, the promoters’ credibility also becomes pivotal in determining the fate of your investments.