23% crash, 100% opportunity

Small-cap stocks are learning a hard lesson: gravity works. And that nothing goes up forever. Once the stars of a liquidity-fueled rally, they are now getting some serious drubbing. Serious because it's only slightly less bad than the pummelling seen during Covid. The BSE SmallCap has plunged 23 per cent, its worst six-month stretch in history, after the 27 per cent drop in March 2020. The pessimists say the worst might not be over yet. But there's a catch, a good one, for those who know that corrections should be used as stress tests for separating winners from the losers. After all, even within this bloodbath, not all small caps have bled equally. High-quality small caps with underlying fundamental strength have, in fact, held up better. And history suggests they will likely rebound stronger. All you have to do is find them, sit back and wait as they work their way back to the top. The good news is we have done the work for you. But first, let us give you some evidence of why quality works as a reliable compass during a market purge. A fall, but not for all How much of a difference does quality make? A whole 1.5 percentage points if you compare the six-month performance of BSE 250 SmallCap index constituents versus those in the broader BSE SmallCap. The largest 250 small caps are down 25 per cent (on a median basis), a smaller decline than the 27.5 per cent median drop for the 962 that belong to the broader index. One might conclude that larger small caps are inherently superior investments, but simply avoiding companies at the bottom of the barrel has led to a better outcome. It all comes down to picking the best of the lot. Mutual funds demonstrate this better than anyone else. Active small-cap funds have handily outdone their benchmark in this crash with a healthy one-year outperformance of 4.4 percentage points. All of them (except one) have beaten the benchmark in absolute terms, too. That's no fluke. It's the result of fund managers' deliberate hunt for quality companies. Picking small caps with solid balance sheets, consistent earnings, and superior cash flows is what has shielded their portfolios from deeper losses as opposed to the broader market. Their portfolio companies further trounce the broader universe in on key qualitative metrics as presented in the 'Fundamentals first' table. Stronger fundamentals = smaller fall The thesis holds true across the broader universe as well. We analysed all small caps on three fundamental factors: profitability, leverage, and revenue growth—to see how they influenced their six-month returns. The results were clear: Small caps with a five-year average ROE of above 15 per cent outperformed those below this threshold. Those with high leverage (debt-to-equity above two) saw a steeper decline than their low-debt peers. Those that grew their revenue over 10 per cent per annum over the past five years corrected much less than those that didn't. Stocks that performed poorly on all three metrics saw a crushing 30 per cent decline against the much smaller 23.6 per cent drop for those that met all the parameters. See the 'How the best stood the test' graphic. What about recovery? Robust fundamentals not only enable limited losses but also stronger recovery. Something that can be traced back to 2018, another painful year for small caps that saw their BSE benchmark tumble 24 per cent. We backtested the three metrics mentioned earlier for small caps at the time. The best performers, those that met all three parameters, declined much less at 16 per cent against a brutal 43 per cent drop for those that didn't. The former pack also posted a sharper outperformance of 3 per cent per annum over the next five years. See the figure 'Survival of the fittest?' The silver lining We're not suggesting that quality stocks don't fall—far from it. But they fall less and recover better. Even applying simple quality filters before stock selection can create a cushion against market downturns and increase the probability of strong recoveries. If basic quality metrics yield superior results, as proved by our earlier exercises, being slightly more stringent could help uncover exceptional stocks in this beaten-down market. We've done that for you in the next sections. The hunt for quality: How we narrowed down our search for resilient small caps We've seen how quality can protect a portfolio. But why stop at the basics? If simple filters can help, what happens when we sharpen the lens? To find the most compelling small caps in this beaten-down market, we raised the bar with stricter filters. First, the basics. We defined small caps as companies in the 90-99 percentile of market capitalisation, ranging from Rs 550 crore to Rs 10,500 crore. We excluded banks and financial services, where assessing quality requires a different toolkit. Then, we focused on growth. We looked for companies that delivered at least 10 per cent annual growth in revenue, operating profit, and profit after tax over five years. This ensured that topline growth translated well to the bottomline too. Profitability came next. We set the bar at a five-year average ROE and ROCE of 20 per cent. Why both? Because a high ROCE but low ROE signals high-interest costs eating into profits. Cash flow was non-negotiable. We insisted on a five-year cumulative CFO-to-EBITDA ratio of at least 0.7 times to ensure reported profits actually translated into cash. Finally, valuation. We focused on companies trading at a discount to their five-year median P/E and excluded any trading above 40 times earnings. Cheap, with a historical discount? That's the sweet spot. The result? Just 48 small caps made the cut. To narrow it further, we picked the top 10 based on their Quality Score in our Stock Ratings. We've dissected these 10 stocks in detail in the pages ahead. But a word of caution: these are not stock recommendations. Investors should conduct their own due diligence. For direct recommendations, check out our service, Value Research Stock Advisor. Balaji Amines: The chemical compounder Balaji Amines is India's largest manufacturer of aliphatic amines, a class of o

This article was originally published on April 01, 2025.