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Big Story | How to hunt for small-cap stocks

Maulik Madhu BL Research Bureau | Updated on January 24, 2021

What filters should you apply when mining for under-the-radar small-cap stocks? Read on to find more

The Sensex has surged 88 per cent since its March 23, 2020, lows, with the benchmark index finally breaching the 50k mark last Thursday. During this time, the S&P BSE 250 SmallCap Index, too, climbed 113 per cent.

While you must tread with caution in such a market, you are far more likely to find under-valued and under-the-radar stocks in the broader listed universe now, rather than in the spotlighted index names.

Most retail investors nurse a fondness for small-caps because they’re keen to uncover the next Asian Paints or Bajaj Finance while they’re still a toddler. But for every successful small-cap pick that turns out a multi-bagger, there are several others that turn out to be wealth-destroyers. At the risk of stating the obvious — careful stock-picking holds the key here. And you can never be too careful when it comes to small-cap companies that are under-researched and under-covered by professional investors.

Here, we lay out a few checks — financial and non-financial — that you can run in your hunt for the next small-cap winner.

We begin with a shortlist of 592 small-cap companies taken from the list of around 4,790 small-cap stocks published by the Association of Mutual Funds in India (AMFI).

The selected 592 are small-cap companies (excluding banks and financial companies) with a market cap of at least ₹500 crore.

The largest among the shortlisted 592 — KEC International — and the smallest — NCL Industries — have a market cap of ₹9,180 crore and ₹675 crore, respectively.

Cash is king

Profits are an opinion, cash is a fact, said American economist Alfred Rappaport. The ability of a company to consistently generate positive cash flows from operations indicates the good health of its core operations and its ability to survive tough business conditions.

A company that consistently fails to generate much cash from operations while reporting healthy earnings, is best avoided as a potential investment.

Using the last five years’ (FY16 to FY20) data, we select companies that have reported positive operating cash flows (OCF) for at least four out of the five years. Of the companies considered, 468 satisfy this criterion. Meghmani Organics (agrochemicals), Alkyl Amines Chemicals and Advanced Enzyme Technologies (chemicals), Eris Lifesciences (pharma), and Thyrocare Technologies (diagnostic services) are a few examples.

For a better understanding and for a comparison across companies, you can also consider how efficiently a company converts its operating profit into cash. According to Aniruddha Naha, Senior Fund Manager - Equities, PGIM India Mutual Fund, for a business to withstand a downcycle or increased competition, it needs both consistently strong operating cash flows and a clean balance sheet.

To test the strength of a company’s OCFs, he suggests one needs to track the OCF to operating profit ratio (EBITDA) overtime.

No debt, no bankruptcy

As important as a strong balance sheet is for a large company, it is even more so for smaller companies. Mortality rates due to debt build-up can be quite high for small companies.

It is more difficult for smaller companies to raise debt, and when they do, the borrowings often come at a higher cost, leading to debt servicing problems. Companies with a debt-to-equity ratio (DER) of under 1 can be considered safe.

In the small-cap space, what matters is not just efficiency of operations but also the ability to keep going as a solvent firm. Apart from the absolute amount of debt, the company’s capacity to meet its interest cost, too, is equally important.

The interest coverage ratio (ICR, which is operating profit divided by interest cost) is an important metric to look at. While some companies may not be highly leveraged, they may not be comfortably placed to meet their interest expenses even at modest levels of debt. These are best avoided.

Higher the ICR, the better, and anything under 2 times can be considered low. An ICR of 2 times implies that the company’s operating profit (earnings before interest and tax) is only twice as much as its interest expense.

Of the 468 companies shortlisted earlier, 339 had a DER of lower than 1 time as of September-end 2020 (or latest available period) as well as an ICR of more than 2 times in each of the last five years. A few of these include Advanced Enzyme Technologies and Valiant Organics (both chemicals), Maithan Alloys (ferro alloys) and Caplin Point Laboratories (pharma).

In fact, 208 companies had negligible debt — less than 0.2 times as of September-end 2020.

Contrary to expectations, many companies brought down their debt levels in the post- Covid period.

Growth, margins and ROE

 

Midget-sized firms make sense as a long-term investment only if they can scale into Goliaths.

If that growth is missing, one can safely skip such a company.

The USP of small-cap companies is that they offer the possibility of a fast, and sometimes, furious-paced growth compared with large and more mature companies. A small-cap company that fails to grow sales and profit even at a certain minimum rate (of say 10 per cent) cannot be justified as potential stock investments.

While we haven’t used this as a screening criteria, what also matters is whether a company has managed to grow its market share.

Growth apart, margins, too, matter. High profit margins are a sign of a company keeping a tight control on costs as well as enjoying pricing power.

Additionally, companies that can sustain growth without going back to the markets for frequent equity financing manage a high return on equity (ROE). These are strong earnings compounders because they have proven that they can manage a high return on profits reinvested into the business. (ROE is the net profit of a company after taxes, divided by its net worth, ie, share capital plus reserves).

The 339 companies that pass the earlier two screeners are tested on a few key financial metrics.

The following filters — average ROE of at least 15 per cent, an average operating profit margin (EBIT margin) of at least 15 per cent between FY16 and FY20, and five-year sales and net profit growth (CAGR) of at least 10 per cent between FY15 and FY20 — are applied to these companies.

With this, our final shortlist comes down to 25 companies (see table).

Valuations

 

While a strong financial position is a key criterion, it is not the be-all-and-end-all for picking a good stock.

Unless valuations are reasonable, you may land up investing in a good company that turns out to be a bad investment.

Price-to-earnings (PE) ratio can be used to gauge valuations. Investing in a relatively low PE stock provides a margin of safety to investors.

Of the final shortlist of companies, six were trading at a trailing 12-momth (TTM) PE multiple of under 15 times, and five at 15- 25 times.

Price earning-to-growth (PEG) ratio, which is stock PE ratio divided by the expected earnings growth rate for that company, is another valution metric.

However, given the post-pandemic disruption, it would be better to look at this ratio once companies’ earnings growth return to a more normal level.

Beyond financials

Financial checks alone may not be sufficient to unearth good small-caps. Other practical factors, too, affect their valuations.

Liquidity: You can gauge liquidity of a stock by checking its past trading volumes, say over the preceding six months.

You must adjust the volumes for bulk deals, if any. Liquidity matters for small-cap stocks because the sudden availability or lack of it can cause wild swings in the stock price.

Also, remember that total trading volumes comprise intra-day trades (no movement of shares from one trading account to another) and deliverable trades.

You are, therefore, better off looking at the delivered volumes rather than total volumes.

Corporate governance: Most often, a simple internet search with appropriate words such as ‘fraud’, ‘promoter fraud’ and ‘SEBI violations’ can be a good starting point.

You can check the company annual report for details on remuneration of key management personnel and the disclosures on related party transactions.

Websites such as fundooprofessor.wordpress.com, forum.valuepickr.com and drvijaymalik.com are good places to get information and analyses on many companies.

Promoter stake:While a decreasing promoter stake may not be a negative per se (though it’s worth investigating), a rising stake is a positive and a sign of the promoters’ confidence in the future of the business.

Pledged shares:These may not be a cause for concern in a bull market. But a sharp fall in the stock price in a bear market, for instance, may reduce the value of the pledged shares (collateral).

The lender can then ask the promoter for additional collateral, or on failure to do so, sell the pledged shares in the market, bringing the stock price under further pressure.

MF holdings: It’s worth checking if a small-cap stock that you want to invest in figures in the portfolios of any mutual fund schemes.

While too high a percentage of institutional holding may mean the stock is no longer ‘undiscovered’ and that a chunk of the price gain has already happened, a certain amount of institutional holding may offer some comfort on the company fundamentals and stock liquidity front.

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Published on January 23, 2021
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