The Hindu Business Line : <I>Why invest in small companies? </I>

One good thing about stock market rallies, like the current one, is that they are broad-based and even smaller, unknown companies participate in them. This is definitely good for smaller businesses (small-cap and mid-cap companies) as they otherwise have little, if any, access to public capital for growth. If promoters of these businesses truly believe in shareholder value creation, as opposed to taking them for a ride, the capital market can help them make the grade and jump to the next stage of their evolution,so to speak. You can come up with umpteen names of small listed companies that you wouldn't have heard before this rally. Chances are that many of these you will never hear of after this rally. Such is the nature of these rallies. As most of us have realised after the May crash, investors ended up poorer if not wiser for having taken exposure to these smaller companies without exercising due diligence. There are two moot questions that need answers: Why invest in small companies? And how do we go about picking up the right small stocks?

Question 1: Why? It is traditional wisdom on Dalal Street: small-cap and mid-cap stocks outperform large cap stocks as smaller companies have higher growth potential and investors are willing to pay more for this growth. These companies tend to be under-researched and present a higher level of risk that has to be mitigated by hitting the dusty trail yourself.

The BSE Sensex has returned an impressive 168 per cent over a three-year time-frame. The BSE Midcap index, in the same time-frame, has returned an even more impressive 215 per cent. The difference does not appear that great, till you dig deeper: Rs 100 invested in the best mid-cap stock would have become Rs 33,700 whereas if you had invested the same in the best Sensex stock it would have grown to just Rs 546. Now, we know why investors seek out these small and mid-cap companies to include in their portfolio — it's the fantabulous returns! As testimony to this interest, MSCI has announced measures to expand the Emerging Market (EM) stock universe and one such measure is the creation of an EM Small Cap index by March 2007.

Question 2: How? Admittedly, like everything else in life, there is no straightforward answer to this question. However, there is one that may present a superior way to pick these winners. Investors flock to smaller companies not just for cheap valuations (which, by the way, are a thing of the past) but for earnings growth momentum and high return on equity. As a smart investor it is imperative that you focus on quality of earnings and sustainability of these earnings rather than just earnings growth. As a thumb-rule, pick stocks that have higher earnings momentum, with earnings being from core operations rather than one-off or unsustainable sources, and higher return on equity.

There is a simple equation SGR = RR x ROE, where SGR is Sustainable Growth Rate, RR is Retention Ratio and ROE is Return on Equity. In simple English, the higher the profits retained and higher the returns a business can generate on these retained funds, the more sustainable will be its growth. The real world, however, is not so simple.

RR can be either that reported last year, expected this year or some target that is guided by the management. Similarly, ROE can be that of last year, expected this year or over one complete business cycle. One still has to decide which ones to pick. One simple way out of this conundrum is to look globally and choose the RR and ROE that a similar large business has, since the investor is assuming that after the high growth phase, this business will be a large one itself. If you have heard of the Du Pont model, then you can further delve into SGR, as it can be expressed as Net Profit Margin (NPM) x Retention Ratio x Asset Turnover Ratio (ATO) x Financial Leverage Multiplier (FLM).

To generate higher shareholder returns, smaller companies have to make two correct financing decisions: how much profit to retain (Retention Ratio) and how to fund growth through an appropriate debt equity mix (FLM). In addition, they have to deliver on two aspects: maintain higher profitability (NPM) and make efficient use of their assets (ATO). As investors, we have to assess the capability of the guys running the show in delivering these results. If you have adequate confidence, then buy — you've got a good thing going. Happy Investing!!

(The author is with Emerging Markets Group of Franklin Templeton Investments. The views expressed are personal.)