Monday 3 March 2014

Small caps at irrational values

Last week, we wrote about the return of retail investors to the stock market, as indicated by the larger share of small cap stocks to the total value of transactions on Bursa Malaysia, and their net buying activities on the local bourse.

Retail investors have done well since January 2013. The FBM SCAP index of small cap stocks on Bursa Malaysia has risen by 47%, compared with the FBM KLCI’s gain of only 8.6% for the same period.

The biggest single monthly gain for the FBM SCAP Index was in May 2013, when it surged by 24%. For February 2014 so far, this index has appreciated by 7.5%.  Since our report last week, where we had advised caution, the FBM SCAP Index has lost 1.6% in the last five trading days.

This week, we explain further why we believe the rise in the FBM SCAP is not rational and, therefore, unsustainable.

Since January 2013, the price-to-earnings (P/E) ratio for the FBM KLCI Index has increased from 15.1 times to 17.3 times. In contrast, the P/E ratio for the FBM SCAP Index has almost tripled from 9 times to 25 times.

Similarly, the price-to-book for the FBM KLCI has risen marginally from 2.25 times to 2.33 times. However, the price-to-book ratio for the FBM SCAP Index increased from 0.75 times to 1.10 times.

Chart 1 tells the story. Since January 2013, the gains in the stock prices for the small cap stocks were due entirely to higher valuations. In fact, during this period, earnings and dividend growth were both negative.

This explains why the P/E ratio for FBM SCAP Index went up by a significant 179%, much more than the gain in the index of 47%.

Please let me repeat. Prices for small cap stocks have risen by 47% since January 2013 at a time when the earnings and dividends of these same companies have fallen. 

Is that reasonable? Yes, if the starting valuations were low. This was true in January 2013 when the P/E ratio was 9 times and price-to-book ratio was 0.75 times for the FBM SCAP Index.

Is it still rational now? The P/E multiple today for the small caps is 25 times and the price-to-book ratio is 1.10 times. Even if you believe in the stock market, it is better to switch to the FBM KLCI stocks.

It should be noted that the FBM SCAP price to book is almost always below one time (please see Chart 2). The reason for this is simple. Why would you buy a small cap, illiquid – and sometimes risky -- stock above its asset value? 


The last time it traded at above one time book was during the period from Feb 2007 to Feb 2008. What happened to the FBM SCAP Index subsequently? It crashed from 12,261 to 6,319 by March 2009!

Finally, Chart 3 shows the historical P/E valuations for the FBM KLCI and the FBM SCAP Indices. It is normal for the KLCI stocks to trade at a premium to the small cap stocks. Smaller and less liquid stocks trade at a discount due to higher risks, which are not just operational or governance-related. Investors are always prepared to pay a premium for liquidity – to be able to buy in and get out quickly. 


Since June 2013, the P/E ratio of the FBM SCAP Index has been higher than that of the FBM KLCI Index. This is not entirely attributable to rising prices for the small cap stocks, and has as much to do with falling earnings.

We believe the institutional investors are factoring in the rising risk bandwidth. Consequently, the FBM KLCI Index is trading more cautiously. On the other hand, we think retail investors remain too exuberant, driven by the strong performance of small cap stocks over the past year. Such irrationality may last for months before a major correction.

Note that our analysis above is for the stock market as a whole and our discussions on the FBM KLCI and the small cap stocks are in general terms. In other words, it relates to the overall indices.

Obviously, there will always be specific opportunities where great values can be found. If you do find them, we will be happy to hear from you.

“Those who don’t know history are destined to repeat it” -   Edmund Burke


  1. Another useful information for investors like us who can't afford a Bloomberg terminal, thank you sir.

    Being a small cap investor, I am actually quite surprise with the PE/PB trend. Although the small caps in my watchlist have risen substantially in recent months, but they are still within reasonable range of below 15x.

    Despite being a small caps hunter, I have never looked at the Small Cap Index because I am not an index investor. I would appreciate if someone could enlighten me on what are the constituents of FBMSC Index. Information from Google seems limited.

    The reason I like small caps is because of their high return on capital, many of them at high double digit % ROE but trading at single digit PE. But according to what Mr Tong presented in his article (PE 25x & PB 1.1x), the average ROE of small caps is just 4.4%. Surely there are many bad tomato in the basket.

    I am still holding few growing small caps and I see no reason of dumping them despite of what I saw in this article. While short term volatility may affect my portfolio performance, it sometimes creates opportunity as well. My words to the retail investors (or I should call them speculators), please do not push too hard on loss making small caps.

  2. The basis of argument by The Edge is correct (on a general terms). However, past ratio can only used as a guide. A better in-depth study will be list down the KLCI - 30 CI stocks vs Small Cap - 151 stocks. Based on FTSE.COM, the market cap is RM506bil vs RM45bil. Yes, Small Cap is illiquid vs the CI, hence the discount PE or NTA. However, I believe, if we choose the TOP 10 potential stocks in CI vs Small Cap, the growth of Small Cap stocks will likely outperform the CI stocks. And, similarly, the gain from the Small Cap will be a lot better the CI stocks. So, the issue here is about selection.

    A good example is, most of its selection is non-CI stocks, just look at his 10 ten selection stocks, all did very very well. Unless you are buying the Index for investment or an institutional fund manager, the comparison is not much of a value. Because, big fund managers invest in CI stocks (for liquidity) and Small Cap stocks attracts a different set of investors.

  3. When market is on a uptrend - momentum/trend investing would be my strategy.
    In a bear cycle - dividend/value, would be my choice of investing.

    This investing style of mine though, had yet to make me rich!

  4. when we say the return of RETAIL investors on what grounds or stats do we based it upon? usually the norm is by judging the activities of the small caps and penniless stocks. But this is only a myth. As trading volume increases on these stocks the MAIN operator (usually a syndicate) is the main culprit curning out these massive volumes using cronies upon cronies accounts. If we were to conduct a survey on the number of people investing in the market we will come to a complete reality. Remisiers and brokers businesses from retail sector is actually down. Even the seats in the galeries are empty. So the indication on the volume of small caps activities are just a purposefully propagated myth.

  5. So, the main operators are back. The retailers, are just the followers. However, due to today's high volume from low brokerage, the market already add a new batch of players, besides the main operator, the day traders. Before the internet trading and low brokerages, and physical scrips, the day traders did not exist. So, retail players has to be very cautious, and the musical chairs may end soon, or it may last longer. So the guessing game just started, when will the music STOPS (read in reverse SPOTS). Hope, someone can provide us that signal.