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How to Make Smart Small-Cap Bets

There is a fundamental reason why small-cap stocks

There is a fundamental reason why small-cap stocks should comprise a part of your equity portfolio. Small-sized companies that get their strategies right can grow at a very fast pace. Their faster earnings growth translates into rapid appreciation in stock price. When the same companies grow larger, growth slows down or plateaus (due to the larger base effect, saturation of markets, and so on).

In India there is an additional factor at play. Says Pune-based financial planner Veer Sardesai: “In India small-cap stocks are not as closely tracked as large-cap stocks, hence greater pricing inefficiencies exist in this space. You can sometimes get these stocks at a high discount to their intrinsic value.”

Empirical evidence in favour of small-caps
Academic studies in the US market have shown that small-cap stocks outperform large-cap stocks over the long term. US-based researchers Eugene Fama and Kenneth French examined the long-term performance of value stocks versus growth stocks. They took all the stocks on the New York Stock Exchange, the American Stock Exchange, and the Nasdaq for which they could get reliable data and divided them into 10 groups based on their price to book value ratio. Group one consisted of the most extreme value stocks while group 10 consisted of the most extreme growth stocks. The researchers analysed data over a 27-year period that straddled both bull and bear markets. They found that value stocks significantly outperformed growth stocks. On an average, the price of the most extreme value stocks - those in group one - went up seven times over 10 years, which amounted to a 21 per cent annual rate of return. The most extreme growth stocks - those in group 10 - only about doubled in price in 10 years, which amounted to a rather disappointing 8 per cent rate of return. Their conclusion: over the long term, value stocks tend to outperform growth stocks.

What is more relevant for our purpose is that Fama and French repeated the same exercise to evaluate the impact of size (measured by market capitalisation) on performance. Once again, they divided all the stocks into 10 groups, this time on the basis of market capitalisation. Group one included stocks with the smallest market caps and group 10 had the highest market cap stocks. Over a 10-year period, they found that stocks with the smallest market cap went up almost six times in price while the stocks with the largest market cap went up less than thrice.

Based on these studies, academicians have concluded that long-term investors who want to maximise their returns should have some exposure to small-cap value (not growth) stocks.

The risks
Many small-cap companies do nothing but blunder along as small-caps all their lives because of their inability to scale up. And some go under.

Scarcity of capital. As orders come in, small companies need capital immediately to enhance capacity. The question is: where will the promoter get the additional capital from? Does he at least have a convincing gameplan for doing so?

Mortality risk. Many small firms don't manage to survive difficult economic environments because they lack the deep pockets of larger firms. Many also take on excessive debt and increase their capacity. Sometimes the anticipated demand doesn't materialise, leading to a debt default.

Liquidity risk. In a downturn, it becomes difficult to sell off small-cap stocks as investors flee to the safety of large-cap blue chips. Poor liquidity also results in the prices of small-caps taking a much bigger knocking than those of large-caps.

How to limit your risk
Limited exposure. According to Sardesai, a conservative investor should not have more than 20 per cent small-cap stocks in his equity portfolio.

Don't fall for the valuation trap. Investors should be wary about paying too much, but they should also not invest in a company just because it is inexpensive. Says Kenneth Andrade, chief investment officer, IDBI Mutual Fund says: “A weak business will continue to trade at a low valuation. Cheap does not necessarily mean great.”

Avoid fly-by-night operators. The small-cap space is the one where you are most likely to encounter fly-by-night operators. If your qualitative research reveals that the promoters have in the past floated other companies that have not done well, that they have kept shifting from one business to another, or that they have entered the current business not out of conviction but because it belongs to an industry that is hot currently, get wary. Take the example of a Pune-based company called Patheja Forgings and Auto Parts Manufacturers. Investors did not know how credible the promoters were. The company has wound up now. Investors who invested in this stock would have lost everything.

Positive attributes to look for
High profitability. A small-cap company should have a higher level of profitability than large-caps within the same industry because of their lower overheads and higher growth potential. Higher profitability will also compensate you for the higher risk that you incur by investing in these stocks.

USP or a niche. Opt for small-cap stocks that enjoy a unique competitive advantage. Sardesai cites the example of Sundaram Fasteners. “They started off by manufacturing a product that the bigger players in the automobile ancillary industry were not interested in producing. And they produced products that met the exacting quality standards of the likes of General Motors internationally. That is what allowed them to grow,” he says.

Sizeable opportunity area. When Andrade evaluates small-cap companies for his mid- and small-cap fund, what he looks for is companies that belong to significantly large industries. “The magnitude of opportunity has to be significant,” he says.

Quality management. The quality of management is crucial in small-caps. As Andrade says: “The key driver in a company that is in the formative stage is the entrepreneur. Much depends on his ability to redefine the business model within his industry and capture a higher market share therein.”

One sign of quality management could be longevity. If the promoters have been around for some time, own other group companies that are thriving, and have managed to maintain a blemish-free track record, you could take a chance on their fledgling company. Says Sardesai: “At the time when Sundaram Fasteners was an upcoming player, another group company called Sundaram Finance was an established name with a sound reputation. This gave investors the confidence to invest in the group's younger company.”

A key attribute of quality management is execution skills. “Many of today's industry leaders such as Bharti, HDFC Bank, Hero Honda or Infosys all started off small. What took them ahead was that they executed well,” says Andrade.

Differentiated strategy. The company's product, delivery profile, or service standard should be a cut above that of the industry.

Andrade cites the instance of the capital-intensive sugar industry. Bajaj Hindustan and Balrampur Chini, the big players, undertook massive capital expenditure in mid-2000. On the other hand, Renuka Sugars opted for an asset-light model. Yet today it is Renuka Sugars that commands the highest market capitalisation. “Efficient use of capital was what differentiated it from the rest of the players,” he says.

Early in the Infosys' growth cycle, Nandan Nilekani offered his friend, the journalist Vir Sanghvi, stocks of his company. The latter, to his later regret, declined to buy them. Perhaps you would have done the same. Predicting in advance which small company will grow into a world beater is like searching for the proverbial needle in the haystack. The imponderables are far too many. More often than not, you end up with comets that shine briefly and then fizzle out. But with the guidelines we have provided, you stand a good chance of building a small-cap portfolio where the performers outnumber the duds.

Smart Small-cap bets
The seven small-cap stocks that we have analysed in this issue (these are small-caps according to Value Research's own classification) are all well-established names. We employed several qualitative as well quantitative filters to ensure that our picks are safe bets that offer attractive upside potential.

First, we decided to leverage Value Research's strength in mutual-fund research for making these picks. The basic universe from which we culled the final seven stocks consisted of 55 stocks in which mutual funds had the highest investment (by market cap). To add another level of vetting, we chose only those stocks in which at least five funds had invested. Thus, you would be investing in stocks that are also mutual fund managers' favourites in the small-cap space.

Next, we did not want to overpay for these stocks. At present the yield of the 10-year treasury bond is around 7.60 per cent. Now if the risk-free 10-year treasury bond is today giving a yield of 7.60 per cent, we would naturally demand a higher earnings yield from risky equities. The inverse of yield is the price to earnings ratio. A yield of 7.60 per cent is equal to a PE ratio of 13.15 (= 100/7.60). If you want a stock to give a higher earnings yield than that of the 10-year treasury paper, it should have a PE less than 13.15. All the stocks in this selection fulfil this criterion.

In case of small-cap stocks, a heavy debt burden can be fatal. All the stocks in our list have a debt-to-equity ratio of less than two (March 2009).

And finally, we demanded that these stocks should show an attractive level of return. All the stocks in out list have a return on capital employed (ROCE) of more than 10 (March 2009 figure).