In the last month of the year, the Kerala government inaugurated a state guesthouse in Mumbai. That a resolutely communist state should find it necessary to have a foot in the country's commercial capital is a sign of our times.

Over in West Bengal, Mamatadi is protesting that the communist-led state is bending too far backwards to broker a land deal for the House of Tatas. Clearly, even the followers of Karl Marx have begun to get it -- it's all about the Economy!

In the past few years as the political mood has changed, and restrictive economic policy has eased up, money has begun to flow into India, both as FDI (foreign direct investment), and from FII (foreign institutional investment).

The first kind comes from companies with expertise in specific areas, which want to bring both their capital and management talent to bear on India. The second kind is just like your money and mine, looking for returns from investing in shares of Indian companies.

Inflows from both FDI and FIIs have grown significantly during the year -- the former is up 128 per cent to Rs 28,378 crore ($6.3 billion) as of September 2006, and the latter 30 per cent to Rs 40,111 crore (Rs 401.11 billion) as of November.

The FDI numbers are still tiny compared to China, where foreign direct investment is about nine times as great, at $54.3 billion for the first eleven months of 2006. Portfolio investment into China, though, has not been as significant -- our stock markets are relatively more attractive to foreign institutional investors because our financial markets are considered more robust and sophisticated, and a greater proportion of our companies are listed on the stock markets.

Stock markets are 'hot'

In fact, FIIs have been active in the so-called 'emerging' economies across the globe, and if the Sensex has racked up 45 per cent gain this year, this is part of a world-wide trend, led by stocks in Peru, up 157 per cent for the year, Venezuela, at 123 per cent, and Russia up about 50 per cent.

FII money is considered 'hot', liable to turn tail at the slightest hint of trouble, as it did from our markets in May-June of 2006. While this could happen again, such developments will be temporary -- money seeks higher returns, which are most likely to come from economies with growing populations and an increased taste for the fruits of economic liberalisation.

In any case, Indian stock markets are not entirely dependent on foreign funds -- as markets have consistently appreciated since 2003, domestic investors have gradually increased their exposure to stock markets, encouraged by a wide range of mutual fund products.

Today, the total value of assets managed by Indian mutual funds (also called assets under management) stands at Rs 3,30,000 crore (Rs 3,300 billion), of which over Rs 9,000 crore (90 billion) is in equity funds. This represents less than four per cent of the capitalisation of shares listed on the National Stock Exchange, leaving lots of room for increased domestic participation in stock markets.

Success breeds success and, over time, even risk-averse Indian households will begin to compare consistent equity returns of 20 per cent plus with the seven to nine per cent in fixed-income investments.

Possible spoilers

The pressures of growth are beginning to create inflationary tendencies in the economy. On the one hand, the central bank is trying to fight these with higher interest rates, which could become a spoiler. On the other hand, the finance minister says inflation is to be expected in a high-growth scenario, thus aiming to create political space for him to manage the economy with somewhat looser fiscal control.

In this, he has been aided by an unexpected surge in tax collections, and by a reversal in global commodity prices. In May 2006, crude oil was at $78 a barrel and metals were at all-time highs. International sugar shortages drove shares of Indian sugar producers to new heights, and later in the year, wheat prices looked threatening. The other, less-discussed oils -- groundnut, coconut and palm -- too, saw price surges, putting pressure on margins of companies that use these for various purposes like food or soap.

Partly because of this, shares of these companies have been sticky, and are yet to fully regain their May highs. The good news, for the time being, seems to be that commodity prices are edging down. If the trend continues, it should augur well for FMCG companies, and for the economy as a whole.

Sector plays

If the economy continues to grow, and commodity prices remain under check, we will see a resurgence of interest in FMCG counters. One we particularly like is Britannia, which has recently seen lows for the year, around the Rs 1,050 to Rs 1,100 levels. But, with both sugar and wheat prices in retreat, it is clearly going to see better margins in the quarters to come.

Hindustan Lever, too, seems to be resurgent, with both growing margins and volumes, but the share price is subdued. This is part of a larger change in attitude -- in the past, FMCG counters were considered safe investments, with profits growing consistently year after year, though investors paid for this consistency with higher price-to-earning (PE) ratios. But, over the last three to four years, as other sectors have grown equally consistently, and with higher growth rates, their PE ratios have overtaken FMCG numbers.

IT companies, for example, deliver results ahead of expectations, quarter after quarter. In telecom too Bharti Airtel, has leapt into the top four of the market cap stakes.

Infrastructure and capital goods, too, have reaped the India growth dividend and seen unprecedented appreciation during the year -- Lakshmi Machine Works (LMW) is up 111 per cent, Thermax 100 per cent, and Crompton Greaves 90 per cent. Not to forget the real estate stocks, where an investment of Rs 10,000 in Unitech on 1 January 2006 would be worth Rs 2,83,845 at the time of writing.

This huge appetite for Indian equity is the greatest threat to stock market returns during the year -- when you end one year with the Nifty trading at over 22 times earnings, there is not much scope for higher PE multiples, and higher stock prices are going to depend largely on quarterly numbers. We see no reason to be pessimistic about these. Yet, in our quest for stock market returns, we believe there is another road to explore.

Lesser known stocks

As Indian stock markets surged consistently for the three years from May 2003 to May 2006, the retail investor felt left out. Scared by the astronomical prices of front-line stocks, he put his bets on the so-called penny stocks. As a result, small-cap indices grew almost 30 per cent in the first 20 weeks of 2006. When markets reversed, small caps went into stall mode, and fell 23 per cent in 20 days. They are yet to recover fully, and are still 14.65 per cent below their May highs.

If the economy continues to grow, as we believe it will, and unless there are huge reversals in stock markets, we believe there will be a gradual development of interest in small-cap stocks again, both by individual investors, as well as by fund managers looking for niche plays. Of course, there is a need for discrimination here, since the universe of small-cap stocks is enormous.

Looking for small cap value

In our search for hidden value in lesser-known stocks, we followed a rigorous, purely quantitative analysis:

Step 1. Since the relatively undiscovered stocks are most likely to be those of smaller companies, we looked at all the listed stocks with a market cap below Rs 500 crore (Rs 5 billion), but above Rs 50 crore (Rs 500 million) so as to filter out the least liquid stocks. This process yielded a total of 836 companies.

Step 2. Out of these, we selected those which looked to be the cheapest, namely those with a PE ratio of less than 15. We were now left with 405 companies.

Step 3. We now looked for consistent growth -- those that have seen profit after tax (PAT) grow by at least 15 per cent year-on-year for the last three years. This left us with the 12 companies profiled below.

This exercise is meant only as a starting point for deciding whether to invest in these companies. Small-cap stocks are typically more volatile than large caps, and present both higher risks and higher rewards.

If any of these stocks takes your fancy, we suggest you put only a small amount into it, and stay invested until wider buying interest develops.

1. Aegis Logistics: Incorporated in 1956, the company is in the specialised business of storage and handling of bulk items, especially oils, chemicals and petroleum. It has

consistently given its shareholders dividends, and is currently quoting at about Rs 140, well below its 2005 peak of over Rs 300.

2. Crew B.O.S. Products: A leading leather exporter, the company is also listed on Luxembourg stock exchange and has consistently paid dividends. It recently announced plans to issue preference shares to promoters, which will have the effect of diluting earnings per share (EPS).

3. Dewan Housing Finance Corp: In business since 1984, the share currently quotes at about 30 per cent below its highs in June 2006. It has recently expanded operations into the Gulf area to facilitate NRI investment in Indian housing.

4. Eastern Silk Industries: This Kolkata-based company was started in 1946. Its broad production range includes silk yarn, fabrics, embroidery and accessories.

5. GIC Housing Finance: Promoted in 1993 by General Insurance Corporation, the company is largely held by public sector insurance companies. Business has benefited from the current real estate boom, and as a bonus, the regular dividend of 15 per cent offers a high yield.

6. Jetking Infotrain: Incorporated in 1984, Jetking offers computer education through 60 centres -- company-owned and franchised. It specialises in hardware and networking education and readies students for direct entry into the job market.

7. RTS Power Corp: In operation since 1947, this manufacturer of electrical transformers and related products seems to have benefited from the recent infrastructure boom. It has also made a tentative foray into wind energy, with a 1.25-MW wind power plant at Dhule, Maharashtra.

8. Raj Rayon: In business since 1993, Raj Rayon recently set up a polyester yarn plant at Silvassa. It has paid 10 per cent dividend for the last two years, and currently trades at Rs 43, more than double its June-low of less than Rs 20, but a long way from the earlier high of Rs 81.

9. Shri Dinesh Mills: In operation for 70 years, the composite textile set up has recently entered into a joint venture with US-based company McGean Rohco Inc to produce speciality chemicals.

10. Surya Pharmaceutical: With four units in the tax-exempt areas of Himachal Pradesh, Surya focuses on penicillin and its derivatives. Other products include cephalosporins and anti-histamines. It exports over 50 per cent of its production.

11. Tricom India: Started in 1992, Tricom is an early entrant into the BPO business, specialising in electronic management of business documents for overseas clients. It recently announced a 1:1 bonus.

12. Vivimed Labs: Set up in 1988, Vivimed has a large product offering of healthcare products, including over the counter products. It also partners customers in synthesizing and developing new products.