Is it worth investing in small caps

We have all heard/know of people who have made fortunes investing in small caps.

They definitely posses exceptional stock picking skills.
Now, statistically most of us will tend to be average stock pickers and our returns would hug sensex returns. And that is where problem lies.

Now last 10 years returns of Nifty 50 have been around 7.5% where as Nifty smallcap return has been around only 6.5%. Add to this typical risk of liquidity, corp governance etc.

Now for last 5 years Nifty 50 returns have been 11% where as Nifty smallcap returns has been 18%.

So most of the small cap returns has been a recent phenomena.

Now if smallcap return were to converge with Nifty50 returns, we are likely to see more under performance from smallcap in future.

Very high PE is smallcap index coupled with recent melt up in small caps does not present a rosy picture either.

So, is smallcap investing for most of the investors just a wild goose chase?

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Its better to go for Value Investing rather than Smallcap. You may find good stocks in smallcap, microcap, mid or large. You should not be paying too much and growith should be visible for atleast 2-3 years.
Generally average trader invest in smallcap when price is already discounted in it, so he may see large downside afterwards.

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My approach (which is by the way, still work in progress) is to think of stock investments in themes.

Issue 1. Small cap stocks could have high failure rate .
Approach : (a) Invest in a basket of shares and track them as such. Even if 1/2 of the basket give exponential returns, the basket will perform pretty decently.
(b) Investment in small caps only from surplus money (or from a small portion of profits).

Issue 2. Small cap stocks could have high volatality.
Approach (a) Investing only surplus money helps to manage drawdowns.
(b) Personally I invest a small amount and then pyramid (this part is WIP) over a period of time.
© Psychologically, I write off the whole amount on the day I invest.
(d) Exit will be based on the failure of my investment thesis and then whatever money I recover is treated as bonus. For example. I invested in Ujaas but based on stock performance and also some research, felt it is better to exit. The money I have received post booking loss will be reallocated to the small caps pool for the next idea.

A significant part of my portfolio is in debt and large cap stocks as I am still on the journey to understand small and mid caps and identifying quality companies early in the game. This also helps in not losing sleep over mtm losses on small cap portfolio.

I have entered recently, had the good luck of investing in a few stocks and tasted the success of multi-baggers. However, bull market makes everyone feel like an expert. I am awaiting for a round of correction to pick up some high quality stocks at reasonable valuations :slight_smile:

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Dont fully invest in Small cap…please ensure to have a mix of large cap and mid cap as well. In a market fall small cap may have huge impact than others.

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Seems like real pain in small caps is just beginning.

Beyond index level number which clearly shows large caps are likely to give better overall returns.

Another major risk is permanent loss of capital in small caps if we end up with wrong stocks. Probability of same happening with large caps is much lower .

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TCS reported a 23.5 per cent year-on-year (YoY) growth in consolidated profit for June quarter at Rs. 7,340 crore.

Not sure why people keep looking for gems in smallcap when you have TCS and HDFC Bank of world giving 20%+ profit growth.

Disc: Not invested in TCS. Invested in Infy and HDFC bank

TCS is trading at 9X book value and HDFC at 5X. Dividend yields are 1.3% and 0.6% respectively.
Growth is not return, if one has to listen to Jeremy Siegel.
Gems should be looked for in all caps.

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TCS is asset light IT consulting business. It can almost go to negligible book if it decides to lease offices and dole out cash as dividends. In that case P/B will look even much higher.

Accenture trades at 11 book. Higher it is better it is.

Can you elaborate on Jeremy Siegel’s views.

Sorry, i don’t have the patience of typing that much. A google search “Jeremy Siegel Growth Trap” will fetch you considerable result. You may also refer his book “The Future for Investors”

Siegel haven’t considered P/B in his research, that was just me. He talked about P/E.

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Love this thread that it puts smallcap investing in perspective with historic return. How can we get statistics about EPS growth of Small cap universe over last 5, 10 years?

One way to reverse engineering by looking at PE expansion. Small caps have been huge PE expansion stories in last 5-6 years rather than EPS growth.

one anomaly in comparing small cap index return Vs Large cap index return is that the small cap group is very large (in the order of 1000s) but still only 50 stocks are part of its index whereas large cap group itself is small (about 110 if we take 25000 cr & above) out of which 50 are part of index. Hence the ratio of index:Total stocks is 1:20 for small cap but 1:2 for large cap. when the difference is only 1% less for 10 yrs in terms of index, this should encourage small cap investors.

if we take overall small cap group, what is the return ? If it is less than large cap, still we cannot say small cap investing underperforms. Because it is relatively easier to filter small cap stocks having issues balance sheet and valuation risks (which are easier to judge than business & corporate governance risks).

So can an investor who picks 100 such small cap stocks end up making higher returns than large cap investing ?

I am not talking about super investors who can outperform index on an ongoing basis like Bufffet. For normal investors returns will be around index returns. Small cap index is down about 20% in a year. This news headline tells me index should have 100 stocks and not 50.

Finding issues is often post facto. If research teams from fund houses missed Vakarangee and Manpasand are we sure we can not miss those. Also check Kitex thread on this form how people were loading on this smallcap with high conviction.

https://www.business-standard.com/article/markets/67-stocks-from-bse-smallcap-index-fall-more-than-50-in-2018-118060500249_1.html

Where can we find correct PE for small/mid caps? Any website. NSE and BSE not showing correct picture.

Best to look for latest EPS from the quarterly consilidated P&L statement

The better way to think is whether you have an edge when you are investing in this company. Whether it’s a small or large cap or how such artificial categorisations work is useless as an individual investor investing in an individual company.

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Reversion to mean has finally caught up with small caps for good. What appeared as temporary correction seems to be derating.

Unfortunately we were ignoring historical data.

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All of us have been there. I can fill up a book with the stocks where I selected a stock, lost my nerve, and saw the stock rising the same day.

A very good article. I hope the fellow members will find it useful. As it is a premier article, and will not open unless you have premium membership of the Hindubusinessline, I am quoting it in full. I am giving the link too. How to pick small cap stocks; a guide - The Hindu BusinessLine

It’s a process. How to mine for small-cap stocks, March 09, 2023

For more than a year now, the benchmark indices have been largely volatile, with a tug of war playing out between the bulls and the bears. The trend of buying anything and making money seen in 2020 to early 2022 is long gone now, bringing to light the importance of judicious stock-picking to make gains in the market.
A systematic approach is especially helpful in the small-cap segment where corrections in the last year may provide some pockets of opportunities now.

The Association of Mutual Funds in India (AMFI) classifies small-caps as companies falling below the top 250 listed companies in the Indian stock exchanges in terms of market capitalisation. This means that the small-cap universe contains thousands of stocks, making the odds of finding the next Page Industries very challenging. However, screening through certain quantitative and qualitative metrics — and finding out potential investment candidates using a bottom-up approach — makes the process systematic. We have attempted this here.
To begin with, using Capitaline database, we have filtered out the small-cap companies (barring those in the financials space) with at least ₹250 crore of revenue in FY22. Such revenue-based filter has been applied so that we can look at those companies that have shown some sort of ability to scale up, in the past. Also, a company of a certain size might pose less risk comparatively. Based on this filter, we have a universe of about 692 listed small-cap companies available for screening purposes.
Here are the five filters we have used:

1. Eye on leverage

Leverage is a double-edged sword. In a world of high inflation and increasing interest rates, it can make business plans go awry. If you have any doubts, just think of Adani! Thus, while scouting for opportunities in the small-cap space, it is imperative in the current context to focus on companies with sound balance sheets and cash flows.
Small-cap companies tend to have higher mortality rates as against large-cap and mid-cap players. They don’t enjoy the benefits that economies of scale give large companies. Further, they may not have access to debt at reasonable interest rate. Hence, it’s better to see potential investment opportunities in companies not burdened with excess debt in the wake of interest payments.

Here, a starting point can be the Interest coverage ratio (ICR) i.e. earnings before interest and tax divided by the interest expense. The higher the ratio, the better-placed the company is, in servicing its interest and debt obligations and tiding over the current interest rate environment.

In the list of 692, we have eliminated those with interest coverage ratio (ICR) less than 3, leaving us with 306 companies that seem pretty comfortable paying their interest expenses. Kaveri Seeds. and Caplin Point Labs have high ICR, for instance.
For companies such as GTPL Hathway and Quick Heal, ICR couldn’t be calculated as they don’t have any interest payment to be made. This could be a positive, in such net cash companies . On the other hand, keeping ICR as a filter helps weed out unprofitable companies at the operating level — Bombay Rayon and Varroc Engineering being examples.
Using the debt to equity ratio (ratio of total debt to net worth) as the next filter, seven of the 306 companies that showed promise on ICR have been weeded out due to D/E more than 1. Companies with D/E less than 1 are considered safe. Companies having high D/E include Chennai Petroleum Corp Ltd, NACL Industries and Shah Alloys while about nine companies, including TD Power Systems, India Motor Parts and Sakuma Exports, don’t have any debt on their balance sheets.

2. Revenue and profit growth matter

The motto of Reliance Industries – ‘Growth is Life’ — is a good maxim to follow in picking stocks. Companies such as Eicher Motors and Page Industries saw years of exponential growth which helped them become large-cap stocks. However, after growing into such size, they now might not be able to deliver the same growth as they did earlier. Hence, growth is the area where the small-cap universe gets more attractive and interesting as investment opportunity. Investors are better off avoiding small-caps without ability to grow.
Here, we have used a minimum of 10 per cent growth in revenue and PAT (profit after tax) during 2018-2023 (H1 annualised) as screening criteria. Out of 297 companies, 123 have passed this screener. Companies such as Nazara Technologies and Fine Organics have seen staggering growth in their revenue and PAT during the time, ranging 30-40 per cent and 50-130 per cent respectively, while Sakuma Exports and Dhampur Sugar have seen their revenues and profits declining.
This criteria also removes companies with good growth in their revenues but not able to do the same with their bottom line – examples being KIMS and TD Power Systems, which had reasonable growth in their revenues but couldn’t make the cut due to losses in earlier periods.

3. Cash is king

‘Cash is king’ can truly work while scouting for investment opportunities in small-cap equities. If a company is able to scale its business along with generating sufficient cash, it can withstand a downcycle with resilience. Net profit is based on accrual accounting principles and hence it is necessary to check if a firm is able to generate cash from its business along with having net profits on its books.
Operating cash flow (OCF) is an important benchmark to check whether a company is able to generate sufficient cash from its core operations, consistently — failing which it may have to rely more on external financing for its business expansion. Investors should exercise caution before considering such companies.
Here, the screening criteria is that a company should have OCF during each of the last five years (FY2018-22). We have restricted OCF analysis till FY22 and not taken 1HFY23 due to inconsistency in data availablility. Out of 123 earlier screened companies, 81 have been able to do so, including Companies such as Balaji Amines and Mastek. There have been companies such as RCF (fertilisers), Neogen Chemicals (chemicals) and Gravita India (metals) which have staggering growth in their revenue and PAT but haven’t been able to generate positive OCF consistently.
. Investors can keep a track of OCF trends of companies — whether OCF has been rising and whether it is moving in tandem with revenue and PAT on a longer time frame.

4. Profitability

Ability to scale while keeping a check on costs and also generating good margins might make a case for a potential investment opportunity. EBITDA margin (earnings before interest, tax and depreciation as a percentage of sales) is an important indicator of a firm’s ability to generate profit from its core operations. Also important is return on equity (ROE). A good ROE number for a listed player on a consistent basis indicates that the company utilises capital efficiently.
Hence here we have further taken those with EBITDA margins and ROE more than 15 per cent for the last three periods i.e. H1FY23 (annualised), FY22 and FY21. Applying the filters, about 25 companies have been screened out of 81 companies.
Balaji Amines (Chemicals), Godawari Power and Ispat Ltd(Steel) and Caplin Point Lab (Pharmaceuticals) have been able to generate some of the best EBITDA margins and ROE on a consistent basis. IFB Agro Industries, Greenlam Industries, Gallantt Ispat and Confidence Petroleum have not been able to pass the 15 per cent threshold for EBITDA margins and ROE for any of the three periods. Further, seven companies have consistently generated good EBITDA margins but have not been able to do the same at ROE level, including Ramco Industries (Cement) and healthcare firms Shalby and Poly Medicure.

5. Valuation

We have come out with the list of about 25 companies using various fundamental filters. However, the screening might not just end here. A stock can be considered as a potential investment only if a company with quality fundamentals is available at reasonable valuations. Here, valuation metrics such as price to earnings (P/E) ratio come into play.
In the list of 25, companies such as J B Chemicals & Pharma, Rajratan Global and Century Plyboards are trading at the highest valuations among the lot with P/E ranging 30-35 times. Filtering companies based on the P/E lower than 15 times, we are left with 10 out of 25. Here, trailing twelve months PAT is taken as earnings for valuation purpose. Companies having lowest valuations include packaging firms Uflex and Polyplex Corp and others like Godawari Power and Ispat Ltd with P/E ranging 2-5 times.

However. all companies with low valuations may still not be the best investments to make as other qualitative checks are also essential.

Further, along with the final list of shortlist companies, we have also mentioned companies which through are fundamentally sound but couldn’t make it to the shortlist due to minor miss in a particular filter. Keeping a track of those companies might also be helpful.

Qualitative checks

The investing decision shouldn’t be based on just financial screening. Investors need to look at some other qualitative checks on the screened small-caps.
Corporate governance is a key factor. For instance, the Income-Tax department launched searches on various premises of Uflex recently. The stock is down 15 per cent since then. While the outcome is uncertain, when it comes to small-caps, it is better to approach with caution. Likewise, one can further check disclosures regarding related party transactions and compare the remuneration of key management personnel with industry level. Sometimes, simple internet checks and tracking news of the said companies can help.
One needs to assess promoter pledging. Promoters pledge shares with a financial institution to raise funds. This may not always be a concern. However, one needs to take a closer look at firms where the promoter is pledging a high stake. For instance, take the recent instance of high volatility witnessed in few Adani Group company shares that had higher percentage of shares pledged. Thus, when sentiment turns awry, pledged shares can become an issue. If promoter is unable to pay the dues, then the FI might sell the shares, resulting in further pressure in the stock price.

Also, small-cap stocks generally tend to have low liquidity in daily trading. In such instances, a few days of heavy trading can cause a lot of volatility, resulting in the stocks trading at extreme ends — or over-valuation and under-valuation. Investors must take cognizance of this.
Investors should also assess whether the stake held by mutual funds is high. For instance, mutual funds’ stake in Gujarat State Petronet Ltd (GSPL) and Dhanuka Agritech are as high as 21 per cent and 13 per cent respectively. Though the MF holdings provide a certain level of comfort, they also show that the stock is not undiscovered.

Lastly, one should keep a sharp eye on aspects such as industry growth prospects, regulatory environment, the company’s moat, market share, and the like, before zeroing in on the investment.

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