KUALA LUMPUR: Small-cap stocks seem to have swung back into favour following the recent broad market sell-off in August which drove their valuations down to relatively attractive levels.

The FBM Small Cap Index staged a recovery yesterday, closing 43.09 points or 0.31% higher at 13,999.54, suggesting that investors are returning to small-cap stocks. This was on the back of a 6.31-point or 0.4% decline in the FBM KLCI, which ended the day lower at 1,582.85, as the ringgit weakened further.

The FBM Small Cap Index fell by 16.33% from Aug 3 to 24, underperforming the KLCI which dropped 12% over the same period. Since Aug 24, the index had rebounded 4.61%. So, is it time for investors to consider small-cap stocks? 

Looking at the price-earnings (PE) ratio, the FBM Small Cap Index is trading at 11.7 times, just a whisker below the five-year average of 12.6 times, said CIMB Research, who is  “overweight” on the small-cap sector, in a report yesterday.

It added that the FBM Small Cap Index is trading at a 0.7-times or 30% discount to the KLCI’s PE ratio.

Nevertheless, it opined that the small-caps could correct further, given that historical trends indicate that the discount between the benchmark index and the small-cap’s usually widens to 40% before the small-cap sector bottoms out.

Areca Capital Sdn Bhd chief executive officer Danny Wong Teck Meng said with the recent sell-off, small- to mid-cap stocks appear attractive now.

“Investors’ risk appetite is low now and some stocks that usually demand high PE [ratios] have now become lower, making some of them attractive at [the] current levels,” he told the digitaledge DAILY. 

Wong said small- to mid-cap stocks whose valuations had become attractive are those that were awarded contracts for the last three quarters, as this indicates that their earnings will continue to be reasonable over the next one to two years. 

“Some of these stocks suffered the recent sell-off. It would be a good opportunity to look at them now,” he said, but did not name any.

CIMB Research, in its report, named MyEG Services Bhd, Prestariang Bhd, Only World Group Holdings Bhd, Evergreen Fibreboard Bhd and Signature International Bhd as its top picks in the small-cap sector.

However, some observers warned that the share prices of small-caps are not resilient and are exposed to high levels of volatility. There is also the issue of low liquidity in small-caps that investors have to come to terms with.

PublicInvest Research head Ching Weng Jin is of the view that investors with holding power of six months to a year would not have a liquidity issue. 

“For small-cap [stocks], while it’s cheap [today], it could be cheaper tomorrow. Investors should keep their eyes open, pick carefully instead of rushing in to buy,” he said, advising investors to buy selectively.

However, not all agree small-caps are attractive now.

“Frankly, they (small-cap stocks) have not dropped very much. Yes, some may deserve some premiums, but generally, small-cap stocks should be at a discount to blue-chip counters — which used to have a double-digit PE [ratio],” Inter-Pacific Securities head of research Pong Teng Siew told the digitaledge DAILY.

Pong said some small-caps had been assigned  “blue-chip valuations” although their earnings stability is uncertain. He said investors could find better value in blue chips, which have also fallen considerably since August. 

In the longer period, he said the FTSE Bursa Malaysia ACE Index and the FBM Small Cap Index had in fact gained more than the larger indices, like the KLCI and the FBM Mid 70 Index.

“Even after considering their recent declines, the ACE Market and Small Cap Index have outperformed the KLCI and Mid 70 by two to four times since the outbreak of the euro crisis, but have their earnings quadrupled? I don’t think so,” Pong reasoned.

This article first appeared in digitaledge Daily, on September 8, 2015.