There is no disputing the fact that there was more wealth at the bottom of the pyramid over the last two years. Large-cap stocks, which rallied in an impressive manner prior to the Lok Sabha elections in 2014 and for a few months following the event, turned lukewarm from 2015, hit by poor earnings, slow pace of reforms, global commodity melt-down and growing global risk-aversion.

Small-cap stocks have, however, continued to sizzle and the S&P BSE Smallcap Index is currently close to its life-time high. This index has returned 26 per cent annually since the beginning of 2014 while the Sensex grew at less that half this rate, at just 12 per cent.

The performance of individual stocks has been even more spectacular. If we consider the movement of the actively traded stocks forming the S&P BSE Smallcap Index between January 1, 2014 and now, more than 73 per cent of the 730 stocks have gained more than 30 per cent. What is more, 380 stocks have more than doubled their price over the last two-and-a-half years and 135 stocks have given more than three-fold return. The multi-bagger list contains some well-known names such as ITD Cement, TVS Srichakra, Century Ply and NBCC.

So, why are these small-caps rallying? Are they backed by fundamentals?

Supported by numbers A look at the earnings of the companies in the small-cap index shows that many of these companies have managed to improve their performance over the last two years. Four out of every 10 stocks in the BSE Smallcap Index have recorded more than 30 per cent increase in their net profits between FY14 and FY16. About a third of the basket has recorded more than 50 per cent increase in profits in this period and almost 18 per cent have recorded earnings growth of over 100 per cent. Some stocks such as Rico Auto, BEML and Tube Investments have recorded five-fold growth in their earnings in the last two fiscals. Presence in niche segments and smaller size appears to have worked in the favour of many companies.

The improvement in earnings has come in difficult conditions. This is reflected in the revenue growth; about a third of the companies recorded less that 5 per cent growth in sales between FY14 and FY16.

Not too burdened by interest It is true that some of the smaller stocks in the infrastructure, steel and real estate space such as ABG Shipyard, Indiabulls Real Estate and GVK Power have taken on too much debt and are struggling to service it, but small-caps on the whole have not taken up too much debt. Interest cost as a proportion of revenue is less that 4 per cent for 40 per cent of the small-cap universe.

Unlike their larger counterparts, the small-caps appear less leveraged. While this does mean that they could be cutting back on capex, it is apparent that the smaller companies are more intent on reining expenses to get through this tough phase.

Getting pricey The biggest risk with small-caps is, low liquidity. Low floating stock and high promoter holding tends to increase impact costs in small-cap stocks. So, once a large institutional investor starts buying, prices tend to rise steeply, making these stocks pricey. Similarly, if a large investor offloads stocks, prices can crash. These sharp price movements are absent in large-caps where participation and hence volumes are higher.

The BSE Smallcap Index is currently trading at a price-earning multiple of 68 times, far above the earning multiple of 20 at which the Sensex trades currently. Many of the stocks in the index have been re-rated since January 2014; almost 60 per cent of the stocks in the index have seen their PE expand more than 20 per cent in this period and almost a third of the stocks trade at multiple of over 30.

It is obvious that with investors chasing smaller stocks, they have turned quite pricey. So should you buy at these levels?

It is true that the risk is higher at such elevated valuations due to the higher impact cost associated with these stocks. Again, information about smaller companies tends to be scanty. Many of these companies also have poor governance, making it difficult to judge a company’s prospects accurately. Not everyone can devote enough time to equity investment to enable entry and exit at the right time either.

While the risk averse can steer clear of small-caps, those with a stomach for risk can allocate a small portion of their portfolio to these stocks; for there are good growth stories in this space.

For those who want to take the plunge, here are five stocks you could consider.

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VST Tillers Tractors: Green prospects, thanks to rains

Radhika Merwin

A good monsoon after two consecutive years of deficient rainfall and the Centre’s focus on improving farm productivity through greater thrust on farm mechanisation bode well for VST Tillers, a market leader in the tillers segment. The stock’s valuation has run up sharply from 8-9 times five years back to 18 times one year forward earnings . However the company’s debt-free status, leading market presence and strong returns makes it a must-have in one’s portfolio for the long run.

VST Tillers Tractors was founded in 1967 as a joint venture in technical collaboration between VST Motors and Mitsubishi Heavy Industries (Japan). It is a leading player in the domestic farm equipment industry. The company’s key products are power tillers and low hp tractors that mainly cater to small farmers. Given the fragmented land holdings of farmers in India — small farmers account for more than 70 per cent of the land holding — its product line offers large opportunity for growth.

In the tillers segment, the company has been a market leader with over 55 per cent market share now. Since 2008, through interspersing periods of bountiful monsoon and drought, the company’s tiller volumes have grown at an annual rate of 10.6 per cent. In 2015-16, while the overall tiller industry grew by 3-4 per cent, VST managed a robust 19 per cent volume growth, thanks to its market share gains. In the tractor segment, the company’s focus has been on the low hp tractors — sub 30 hp, in which it has managed to increase its market share (now at 14 per cent) substantially over the last couple of years. This has helped the company grow its volumes by a healthy 20.8 per cent annually since 2008. The overall revenues and net profit has grown annually by 16.6 per cent and 22.7 per cent respectively since 2008.

In 2015-16, as the volumes in the industry declined by 10-odd per cent, VST was able to grow its tractor volumes by 17 per cent, through release of new tractor models and by expanding to new markets. .

The key risk to the company is a poor monsoon. However, the company’s strong market presence and growing market share should hold it in good stead. Also, the company’s increasing focus on the tractor segment should drive growth. The tiller segment is dominated by subsidy sales and hence subsidy becomes a critical factor in deciding the total market. Hence the company has been moving into the tractor segment aggressively in the last couple of years to drive growth. The management expects tractors to contribute 60 per cent of sales (power tillers is now about 55 per cent of sales) in the next five years.

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Kirloskar Pneumatic Company: Stepping on the gas

Seetharaman R

The stock price of Kirloskar Pneumatic Company has nearly doubled in the last two years, thanks to a spurt in demand for compressors driven, in turn, by the Centre’s focus on the city gas distribution market in India. KPCL, a market leader in compression technologies, has been around for over 50 years. The company provides air, gas and refrigeration compressors for oil and gas, cold chain, industrial and defence businesses. It also caters to transmission products such as wind turbine gear box and industrial gearbox.

The company’s revenue dipped between FY12 and FY15, by 12.6 per cent annually before growing 15.2 per cent in FY16. Net profit shrank faster at an annualised rate of 35.3 per cent between FY12 and FY15 before recording a robust 106.6 per cent growth in the 2016 fiscal. The revenue and profit for FY16 stood at ₹508.9 crore and ₹34.5 crore, respectively.

This revival was predominantly on the back of the Centre assigning top priority to city gas distribution in allocation of domestic gas. Revenue from compressors stood at ₹452.5 crore in 2015-16. This segment had seen a blip in revenues in the previous fiscals; revenue decreased from ₹578 crore to ₹386 crore between FY12 and FY15 respectively before reviving in the ensuing fiscal.

Revenue from the cold chain segment is also growing at a healthy pace — close to 10 per cent annually in the last couple of years. With increased support from the Centre in logistics, warehouse infrastructure and multimodal transportation, this momentum is expected to continue. Revenue growth last year was also aided by growth in demand from sectors such as textile, pharma and cement.

However, for now, it is the increase in expenditure from the public sector that is driving demand. Going ahead, private sector investment is likely to pick up on the back of improvement in rural demand, favourable monsoon, public sector banks’ clean-up and ‘Make in India’ programme gaining momentum. Indian refineries’ upgradation to BS-VI-compliant fuel by April 2020 should also see good business from process refrigeration in the coming years.

The price to earnings ratio stands at about 28 times now, higher than its five-year historical average of 20-odd times. However, the government’s plan to bring close to 150 towns under the gas distribution network over the next couple of years should increase demand for compressors, holding the company in good stead.

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Unichem Laboratories: Export focus to drive growth

Eswarkrishnan Chellam

Many Indian pharmaceutical companies have seen their stock price correct when the federal drug regulator US-FDA reported process variance or quality issues during their facility inspections. But several companies were able to pass muster, including Unichem Laboratories. Its formulation plant at Goa and Ghaziabad, Uttar Pradesh, and API plant at Roha, Maharashtra, received clean establishment inspection reports (EIR) in 2015-16. In addition, the company’s API plant at Pithampur, Madhya Pradesh, underwent a successful inspection.

In an effort to shift growth into higher gear, the company is actively pursuing export-led growth where margins are higher. Revenue from exports grew 17 per cent annually between 2011-12 and 2015-16 and the share of export revenue to total revenue increased from 26 to 32 per cent during this period. In the last fiscal, margins improved to 13.3 per cent from 10 per cent in the previous year. The tempo in sales growth is expected to continue as the company has chalked out various initiatives.

First, the company has invested around ₹140 crore in 2015-16 towards modernising its plants and in R&D projects, funded by internal accruals. In the current fiscal, it has lined up capex spends for capacity expansion of its recently acquired API facility at Kolhapur, Maharashtra.

Two, the company, which manufactures active pharmaceutical ingredient (APIs) and formulations, has plans to grow the high-margin formulation business. US formulations is the largest revenue contributor within its international business. Towards this, the company has cumulatively filed 36 ANDAs (abbreviated new drug applications) of which 20 have been approved, with 14 product launches. It also has filed 46 US-DMFs (drug master files).

On the domestic front, chronic therapies account for around 57 per cent while acute therapies account for the remaining 43 per cent. Only around 16 per cent of its formulations portfolio is under price control.

On the back of improved sales growth, the company has witnessed a re-rating and now trades at about 24 times its trailing twelve-month earnings, compared with about 17 times five years ago. But valuations have corrected from its peak of about 37 times in October 2015.

Encouraging growth prospects brought by export focus, stable margins and minimal debt make the stock a good play.

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Redington India: Ringing in good times

Muthukumar K

Redington India is well-positioned to take advantage of its entrenched presence in the growing markets of India, West Asia and Africa. Since its listing in 2007, the company has grown its sales and profits — at a CAGR of 16 and 17 per cent, respectively. With its growth strategy pinned on the development of IT and usage of smartphones, it is well-positioned to capitalise on future government projects and expected increase in smartphone penetration in India.

The company is also de-risking its business with continued focus on its Indian operations while getting into new areas such as logistics management and e-commerce solutions. Its current price to earning multiple is 9.8 as against its three-year average of 10.6.

In FY16, it earned 47 per cent of its revenues from India. IT products such as desktop PCs, laptops, networking products, high-end servers and enterprise software comprise 75 per cent of its overall revenues.

Redington currently has a 17 per cent market share in the ₹45,000 crore IT distribution market. Globally, the PC market de-grew by about 11-12 per cent in FY16. Yet, the company managed to grow its IT revenues by 9.3 per cent in FY16.

The management is optimistic about its ability to capitalise on future investments that could be triggered by Digital India and Smart City projects as well as from pick-up in corporate demand. It expects the IT industry to grow at 8-10 per cent over FY17-20.

In smartphones, it has less than 5 per cent market share in India. The company expects to increase smartphone shipments from 103 million units in 2015 to 166 million units in 2018. It recently got into distribution of iPhones in the UAE and Nigeria.

Its growth plan is to increase its portfolio of brands by moving beyond Apple to include Indian, MNC and Chinese players. In FY16, its top vendors were HP (24 per cent), Apple (15 per cent), Lenovo (8 per cent), Samsung (5 per cent) and Microsoft (4 per cent).

The company reported sales of ₹35,429 crore in FY16, 12.3 per cent higher than the previous year. Its profit grew 10.4 per cent to ₹425 crore. Margins are, however, small in this business, with net profit margin of 1.3 per cent in FY16.

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Suprajit Engineering: Benefits from auto sales

Parvatha Vardhini C

Benign borrowing costs coupled with the Seventh Pay Commission doleouts are expected to keep demand for bikes, cars and utility vehicles strong; commercial vehicle sales will benefit from improving economic growth prospects while the pick-up in tractors will gain further steam from a good monsoon.

Suparjit Engineering, supplying mechanical control cables and instruments such as speedometers and tachometers to the auto industry, will be a beneficiary of this uptick. From being a supplier to predominantly the two-wheeler segment about 10 years ago, the company has now branched into supplying for cars, utility vehicles, commercial vehicles and tractors as well. Its list of domestic clients includes Tata Motors, Ashok Leyland, Piaggio, Maruti Suzuki, M&M, Ford, TVS, Hero, Bajaj Auto and Honda.

Market preference for cyclical stocks has seen Suprajit zoom over three times its price in January 2014. More recently, expected synergies from the acquisition of a majority stake in Phoenix Lamps and its impending merger with Suprajit has also favoured the up-move. The stock now trades at 32 times its trailing twelve-month consolidated earnings. This may seem a bit pricey as quite a few small-cap peers trade at 18-25 times. But the company’s efforts to add to its product line, long-standing relationships with almost all auto manufacturers and its diversification into after-market sales and exports stand in its favour. Given that the cyclical upturn in many segments of the auto industry is yet to peak, this stock may suit investors with a high risk appetite.

The company has built a presence in the secondary market, where it enjoys higher margins. The recent acquisition of Phoneix Lamps will also help Suprajit scale up its presence in the secondary markets by cross-selling its products. Post this acquisition, 32 per cent of the consolidated revenues come from secondary market sales compared with 10 per cent earlier. The acquisition will also help the company increase its presence in export markets.

For the year ended March 2016, consolidated net sales grew by 55 per cent to ₹950 crore over a year ago, while profits moved up by 43 per cent to ₹72 crore. Even without considering the Phoenix acquisition, it clocked 15-20 per cent growth in net sales and profits. Suprajit’s long-term debt to equity ratio stood at 0.25 as of March 2016.

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