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10 Small-Cap Bets: McLeod Russel India

These are the stocks that institutional investors are betting on. Should you?

This is the cover story that appeared in the December, 2009 issue of Wealth Insight magazine, in which we highlight the area where institutional exposure was predominant in the small-cap universe. 

With markets saturated by the information overload on India’s largest companies, an investor eyeing a sensational stock discovery, that is going to provide him outstanding gains, has to look at the bottom of the pyramid. Period. But finding such a company, whose stock would run through the small-, middle- and large-cap categorization to stardom, is increasingly hard to find. We bring method to this madness.

Most of the time, investment focus is benchmarked to Sensex or Nifty — indices  that include the 30 or 50 biggest stocks that are equated to the entire market. However, small-cap and medium-cap performances can vary quite a lot from those of large-caps as can be seen in upward-moving markets where small-caps usually outrun their larger cousins. Conversely, they lose more ground in a bear market.

Sensational Stampede

Small-caps are beautiful holdings in bull markets.  Look at the previous rally from middle of June, 2006 to January, 2008. During the first nine months of the rally small-caps (represented by BSE Small-Cap index) delivered a gain of 1.67 per cent compared to 25.71 per cent return  from Sensex. But in the last nine months of the rally, small-caps rose a whopping 99.05 per cent while large-caps rose just  56.80 per cent. BSE Small-Cap’s tally for the whole of the 18-month rally was 109.74 per cent while large-caps gained an average of 95.09 per cent.

A look at the outliers reveals the totally different picture charted on the indices in terms of volatility. Sensex stocks delivered a performance ranging from -1.79 per cent to 645.64 per cent with a standard deviation of 149.97. The small-caps delivered a performance range between -41.07 per cent to 6,471.60 per cent and a standard deviation of 486.39.

This highlights the completely different risk:reward equation for the two sets of stocks on these indices. Large-caps carry less risk, but generate lower returns. Small-caps carry more risks, but generate greater returns. The trick, therefore, is to try and buy small-caps when the risks are likely to be minimized.

Categorising the Riddle

The roughly 3,150 stocks traded daily can be sorted according to a descending market capitalization. Large-caps, consisting of barely 70 stocks, contribute around 70 per cent of the total market capitalization. The mid-caps, consisting of some 186 stocks, contribute another 20 per cent. Only about 10 per cent are small-caps, though these form numerically the largest segment at 2,894 stocks. At Value Research, we use this dynamic (70:20:10) definition to classify stocks according to size.

One way to isolate the best possible picks among hundreds of small businesses is simply to seek institutional presence in this segment.  So, we looked through the portfolios of mutual fund schemes to identify the small-caps that they are tracking.

Our selection consists of two parameters: First, that institutional investment has risen in last two consecutive quarters. Second, number of funds betting on a particular small-cap (greater than 10) is significant.

The Small-Caps’ Lure!

If you pick the right small-cap, it can literally be like finding fortune at the bottom of the pyramid. The obvious attraction is that you may buy into the next Infosys or Bharti. In 1998, Infosys was trading at a market cap of Rs 2,963 crore. Now, it’s at Rs 126,000 crore — giving cumulative returns of over 4,000 per cent, without taking dividends into account.

There is nothing more rewarding than to buy a small company just before its take-off stage. Later on, when it attains critical mass, institutions like mutual funds, pension funds, and others, pour their money into it — since it fits their internal risk criteria, they aren’t inhibited from higher allocations. This fresh funds influx drives prices higher.

It is mathematically easier for small-caps to grow at breakneck speeds, which is not possible for large-caps. To take an example, it’s much easier for a business with Rs 5 lakh turnover to double in size every year. That growth rate is probably impossible once the company attains say, Rs 100 crore turnover. For instance, Infosys clocked triple-digit growth in both revenue and profits for several years starting at  base revenues of Rs 9.43 crore in 1992-93. It grew fast until it hit a topline of Rs 1,957 crore in 2000-01. Bharti had similar growth rates, between 50-100 per cent.  Nowadays, both have seen their growth rates mellow quite a lot.

A good small-cap business is an ideal takeover target as larger companies are always on the lookout for acquisitions to deliver inorganic growth. A fairly recent example is Mphasis. As a mid-small-cap company, it was first taken over by EDS World at the end of June, 2006. EDS was later bought by HP. During this period, its market cap has risen from Rs 3,000 crore to Rs 14,000 crore. This 483 per cent rise comes over a three-year period when Sensex gained just 86.20 per cent in market capitalisation.

A similar story seems to be unfolding in the Uttam Galva Steel scrip. ArcelorMittal, the world’s largest steel maker, wants to be a co-promoter and has offered a price of Rs 120 in September, 2009. At that time the company was trading at the Rs 100 level. This would give this small-cap company both access to raw materials, and get the backing of a global brand.

Why do small-caps offer such extraordinary potential? One answer is that the sheer number of small-caps makes it tough for analysts, in the institutional community, to cover adequately. Hence, this lack of research and poor coverage leads to misunderstanding prospects. As a result, unlike with large-caps, which are continuously tracked, the price discovery mechanism is not always efficient.

The Catch!

If the reward for buying into the right small-cap is huge, the price of getting it wrong is disastrous. Between January 8, 2008 and March 9, 2009, small-cap index lost 78.97 per cent of its market cap while Sensex lost 55.27 per cent. And that’s an average. The worst-hit small-cap, Cals Refineries, was down by 97.07 per cent, while the worst Sensex performer, DLF was down by 87.95 per cent.

Even in the worst-case scenario, ample liquidity in a large-cap offers investors opportunity to cut losses, as in Satyam. When this scam broke in January, 2009 the stock fell from Rs 179 to Rs 11.50, but it was continuously and heavily traded — trades trebled after the scam. But in a small-cap, liquidity can just disappear and you may not even get a chance to offload.  As investors of the dot-com era discovered, shares of companies like Datamatics, Pentamedia Graphics, etc., ended up being waste paper.

Minimal public scrutiny and high promoter stakes often leads to lack of transparency. Gaps in corporate governance norms are also part of small-cap investing.  There are other risks too: sometimes it’s not obvious if the turnover can be scaled without loss of margins; there may be a lack of product diversification; the company may be overly dependent on a single customer; it may suffer from working capital constraints; lack of access to capital markets, or to cheap debt. 

Yet, …

Don’t be afraid of small caps, despite the obvious risks. Some will fade into obscurity, others will remain small-caps, unable to scale up. Only a select few will be able to unlock true value. But those few are likely to be multi-baggers and ultimately, even one such candidate can over-compensate for several losers.

But, don’t go overboard while investing in small-caps. Hold only a small proportion in your portfolio and maintain a healthy combination of large-caps and small-caps, so that some stability of returns is maintained,

It’s true that small-caps require a lot more research than large-caps, but the idea is that you should do your own due diligence before putting money down. Our basic selection criteria are nothing more than primary filters to small-cap investing. If you fancy yourself as an investor who would like to beat the market, you should be able to sift the big winners present on our list.

The top 10 Small-Cap stocks will be showcased one per day: 
1. 3i Infotech
2. Apollo tyres
3. Eicher Motors 
4. Everonn Education
5. Gateway Distriparks
6. McLeod Russel India
7. NIIT Technologies
8. Polaris Software Lab
9. Sterlite Technologies
10. Vijaya Bank

This article appeared in the December 2009, issue of Wealth Insight magazine as the cover story. To read the full article, and more, subscribe.