THE valuation of BSE small-cap index, which is made of nearly 500 stocks that have market values ranging from Rs 250 crore to Rs 2,100 crore, has fallen nearly 13 per cent from the start of calendar 2010. On the other hand, valuations of both BSE mid-cap index and BSE Sensex, composed of the biggest large-caps, have seen valuations rise by 4 per cent.

Valuations here are measured by trailing price-to-earnings ratio, calculated by dividing the current stock price with the trailing earnings per share for the past 12 months. Large-caps are companies that have market capitalisations of over Rs 10,000 crore. Mid-caps are those with market caps between Rs 2,500 crore and Rs 9,999 crore and small-caps are those whose market caps are below Rs 2,500 crore.

Present values of the three indices with relation to their respective closing highs in the past four years show the small-cap index is nowhere near its high (reached during December 2007). Sensex is just 4 per cent off its high of 20,287, while the mid-cap index is 24 per cent away from its high of 9,789. The small-cap index is farthest from its high of 13,348 with a gap of close to 33 per cent.

What ails small-caps? A quick study on the trailing 12-month earnings performance shows a litany of issues dogging these stocks.

The top 10 stocks in small-caps, based on their weightage — including Orchid Chemicals, Dhanlaxmi Bank, Gitanjali Gems and VIP industries — hold 7 per cent weight. Out of the nearly 500 stocks in the index, over 200 have fallen this year with Ashapura Minechem, Sagar Cements, Orbit Corp, TV Today, Bartronics India, Dolphin Offshore, Mastek, Zenotech, Tanla Solutions, Ramsarup, Koutons Retail and Sigrun Holdings being the worst hit.

Performance: Almost one-third of the companies, 150 of the 500 scrips to be precise, in the BSE small-cap index have reported a drop in the 12-month earnings per share (EPS) over the comparable period. In the BSE mid-cap index, 70 stocks of out of 260, or 27 per cent, have reported a fall in their EPS while a similar share of companies in Sensex have reported a drop in trailing EPS over comparable periods.

Small-caps have always traded at a discount to other large-sized peers. In that sense, this valuation gap is natural. But performance is in important metric where they might have not impressed. While this is not to suggest that small-cap companies have not performed well, these counters may have failed to meet growth expectations. Growth expectations are generally high from small-caps, considered to be riskier bets than mid-caps and large-caps.

Nature of index: A typical character of the BSE small-cap index is that it is formed of nearly 500 stocks. The current index is structured in such a way that no single stock holds major influence in it. Any underperformance of the index cannot be blamed on one single stock, which could be the case with other concentrated indices.

Best performers in terms of returns include Ester Industries, IT People, Sujana Towers, Parekh Aluminex, Spice Mobility, Delta Corp, AK Capital Services, Prime Focus and Force Motors, which have doubled in value over the past 11 months.

Governance issues: It's widely held that companies with better accounting quality produce better investment returns. The market perception, which may not be true for all, is that accounting standards followed by small-caps companies is not ideal. There exist a direct relationship between share price performance across market caps and the blended accounting score across FY07-10 — higher the score, the better the share price performance. The bottom half of the BSE 500 companies with market cap of Rs 260 crore to Rs 2,000 crore shows the lowest accounting score with the lowest share price movement at less than 5 per cent between FY07 and FY10. Experts also pointed out that small-caps suffer from governance issues such as scams, corruption charges and price manipulation as seen in instances over the past two months.

Apart from issues on the global front such as renewed concerns over sovereign risk in Europe and monetary tightening in China, domestic issues such as speculation of price rigging on certain scrips and corruption charges against specific companies have weighed heavily on the market, according to Nischal Maheshwari of Edelweiss. Mid-caps and small-caps have borne the brunt of this correction and they are down almost 20 to 25 per cent from their November highs.

Retail interest: The absence of retail investors' interest in the stock market has affected the fortunes of small-cap stocks. After May 2010, client turnover data on the BSE shows clients have been net-sellers of equities for six straight months averaging between Rs 1,000 crore to Rs 1,500 crore. In just three trading days in December, clients have netsold Rs 60 crore already.

Retail investors are the ones who buy small-caps, partly because of lower absolute value of shares.

Since the retail segment has not participated in the rally, small-caps have not received any major boost in terms of returns. If bigger numbers of retail investors return to the market, you may see small-cap stocks go up. However, that happens in the last leg of the rally.