Small Caps High Risk Big Gains!

Kiran Dhawale

Small-caps have been the reason for portfolio underperformance for most of the investors in 2018. Yogesh Supekar and Dnyanada Kulkarni explore the merits of staying invested in small-caps, while the DSIJ research team recommends top two small-cap stocks to invest in

Small-cap investing and higher returns go hand-in-hand, that is if you look at the long-term historical data. Indeed, over the long-term, small-caps and mid-caps have shown a tendency to outperform the large-caps by a couple of percentage points on an annualized basis. The story, however, looks different when we focus on the data on a YTD basis. For the equity investors, the underperformance of the small-caps universe has been the highlight of CY18 so far. After the recent correction in the small-caps, most of the investors are faced with a difficult situation of dealing with a portfolio comprising of underperforming small-cap stocks. Some of the difficult dilemmas faced by investors are: - 
✓ Whether and how to restructure the small-cap portfolio 
✓ Have small-caps bottomed out and will they outperform the large-caps in the coming quarters.

Ritesh Ashar Chief Strategy Officer, KIFS TradeCapital

"Small-caps have a tendency to outperform the key benchmark indices. Looking at the fundamental side of small-cap companies, these usually tend to be less capital intensive businesses, having lower debt levels, presence in different business models and operating in niche areas which helps to deliver faster earnings growth and justification for the higher valuations."

Why invest in small-caps?
Small-caps and mid-caps ruled the markets in CY16 and CY17 and the investors expected a repeat performance in CY18, but investors found themselves disappointed. If it was greed in FY17 that prompted investors to invest in small caps, currently it is fear in the minds of the investors that is keeping them away from investing in small-caps.

Here are a few of the reasons why we believe investors should look at small-caps:-


Performance

Historically, the small-cap stocks have delivered superior returns when compared to large-caps in the long run. Agreed that the small-caps are more volatile than the large-caps; however, the superior returns justify exposure to small-caps. If we consider the historical data, we find that over a five-year period, the BSE Small-Cap index has generated 26.84 percent returns, whereas the BSE Sensex has delivered 14.88 percent returns.Out of the total 761 stocks that are constituents of BSE Small-Cap index, we find that almost 38 stocks more than doubled in one year alone. There are almost 66 stocks that generated returns in the range of 50 to 100 percent, while there are 82 stocks that 

in the range of 25 percent to 50 percent. If any investor is targeting returns greater than 25 percent, the investor had 186 such investment ideas within the small-cap space in the last one year.delivered returns 

Maximum investment opportunities
If we look at the market capitalization of stocks as per the new SEBI guidelines, wherein the top 100 companies are categorized as large-caps, next 150 as midcaps and the rest as small-caps, we find that the large-caps constitute nearly 70 percent of the total equity market capitalization, mid-caps constitute 16 percent of the market capitalization while a meager 14 percent of total market capitalization is constituted by small-caps.

However, if we consider investing opportunities, a maximum number of opportunities are available in the small-cap space. Going by the number of stocks, small-caps make up approximately 90 percent of the investment opportunities.

"The fear factor over the last few months have made investors to move to safety and large-caps."

Acuite Ratings and Research

"While sustainability of 8 percent plus growth is yet to be established, economic revival post demonetization and GST implementation is reaffirmed"

"In theory, lesser known stocks and smaller companies should not do well, however, in practice these stocks do a spectacular job"

Globally too, small-caps comprise about 12 percent of the world’s investible equities by market capitalisation. However, these stocks constitute approximately 60 percent of the world’s investment opportunities by number of stocks.
 
Small-caps are usually domestic plays
Small-cap companies usually are not affected by global issues such as currency wars or trade wars or protectionism which have recently affected stocks in the IT and automobile sectors (Tata Motors). Thus, it can be said that small-caps function best in growing economies as most of the small-caps cater to the domestic demand. This allows small-caps to offer an alternative pattern of performance and characteristics when mixed with a portfolio of stocks whose fortunes are linked to the global economy.

Diversification
The characteristics of small-cap stocks differ from that of large-caps, hence these stocks provide the much-needed diversification in the portfolio while offering the potential for enhanced returns. Besides, there is no linear correlation between large-caps and small-caps as is evident from the YTD performance of both these set of stocks.

Small-caps, mid-caps and mutual funds

One of the reasons behind the above average returns in small-caps is heavy participation of retail investors in India via the small-cap and mid-cap mutual funds. We have seen that retail investors historically have always chosen to chase returns. Very few investors participated in the markets when the markets corrected in 2008. The real participation by investors was seen in FY15, FY16 and FY17. There was no mutual fund scheme that failed to deliver returns in the two years (FY16 and FY17). Investors participated when markets started delivering positive returns. Almost 60 percent of the SIP accounts were opened in the past three years.

Going ahead, investors participation in mutual funds via SIPs may fade away if the returns are not commensurate with investors' expectations. This is the single biggest risk facing the broader markets currently. Out of 124 schemes in the equity diversified SIP scheme, 23 schemes have generated negative returns. This performance is disappointing as the mid-cap index is positive on a yearly basis. The performance of the schemes can take a further beating if the mid-cap index turns negative. The deciding factor for the markets will be how the investors react when the broader markets turn negative – Will they stop their SIPs or, worse still, will they book profits and withdraw their monies from equity MF schemes?

As of now, there is enough confidence among investors when it comes to Indian economy and stock market performance (looking at the performance over the past three years). The flows into the mid-caps and small-caps will be directly impacted if the SIP flows slow down or stop, thus impacting the valuations for the small caps and mid-caps. There is an inherent risk in investing in small-caps and mid-caps in case the SIP flows slow down in the coming months.

Dr Dhruv Desai
Director & COO, Tradebulls on Small Cap

How were the results in Q1FY19 for small-caps compared to large-caps?

Since the beginning of the year 2018, it is the large-caps that have really outperformed the mid-caps and the small-caps. This is contrary to the trend since 2015 when mid-caps were consistently outperforming the large-caps. If you look at the returns from the beginning of January 2018, the returns on the Nifty index is +1.93%, while the returns on the Nifty Mid-Cap 50 Index is -3.38% and the returns on the Nifty Small-Cap 50 Index is a deeply negative at -18.66%. In terms of the extent of downgrades, the small-cap stocks have seen more number of downgrades compared to the large-caps. However, the consensus EPS estimate of the large-caps and the small-caps is almost constant for the next year, while mid-caps have been revised sharply lower.

Is it correct that there is higher probability of multibaggers from small-cap space when compared to the large-caps?

Technically, that was the argument till the end of 2017, when small-caps and mid-caps were outperforming the large-caps. However, in the year 2018, institutions have sold small-cap stocks to the tune of nearly $1.2 billion and these funds are unlikely to come back in a hurry with the kind of returns that large-cap index stocks are giving. That is evident from the fact that while the large-caps and the mid-caps bounced from the lower levels in the last couple of months, the small-caps have hardly showed any remarkable bounce. The pressure of additional surveillance margins (ASM) has been the most profound on the small-cap stocks and that is likely to keep the appetite for small-cap stocks quite low. For now, it looks like any action in small-caps would be very stock-specific, whereas the real alpha in the market may actually come from the large-caps and to an extent from the mid-cap stocks.

What is your outlook on small-caps?

Small-caps have been under pressure for a variety of reasons. Firstly, there was the pressure of booking profits ahead of the introduction of the tax on long-term capital gains effective April 1, 2018. This is unlikely to revive in a hurry. Secondly, the ASM has hit the small-cap stocks the most as the regulator has been the most wary of these smaller stocks which are more susceptible to sharp price movements. The ASM continues as of now. Thirdly, we have seen some serious issues of corporate governance in a host of smaller corporate names like Vakrangee, PC Jewellers, Manpasand Beverages, etc. These have not been too conducive to the performance of the small-cap stocks. Last, but not the least, the small-cap stocks have been big beneficiaries of weak oil prices and that has changed and looks unlikely to get back to the lows of yore. That is going to put further pressure on the profitability of these small-cap companies. Remember, while the index impact has been around 18% on small-caps, individual losses in most cases are as high as 50-70%. As of now, the triggers for a small-cap bounce appears to be elusive, and at these valuations, most investors may prefer the relative safety of large stocks with defensive business models.

What are the extra filters an individual investors should use while identifying small-cap investing opportunities?

Small-cap investing is less about identifying and more about the checks and balances which need to be done. Here are a few basic checks that you must do before buying into a small-cap stock. To begin with, focus on companies that possess disruptive models. That is how companies like Lupin and Infosys went from small-cap to large-cap. Secondly, focus on the management quality extensively. Check the management track record, track their insider activity and also be cautious if there are too many group transactions. Thirdly, look at corporate governance issues. Go through the MDA and the AGM discussions in detail. See if there is any liability hidden under contingent liability. Be wary if there are any audit qualifications. Finally, do your channel checks. Most businesses and dealers show a healthy respect for good competition and that is something that will tell you how good the company is. Above all, check if there is any serious disruption in the business model. Such companies are the most vulnerable to sudden shifts in the business model.

Soumen Chatterjee,
Director- Research, Guiness Securities

What is your outlook on small-cap stocks?


After notching records highs in January 2018, the S&P BSE Small-Cap Index has dropped almost 20% from its peak. Post this sharp correction in the past eight months, valuations in selective small-cap space look attractive as the earnings growth visibility in them is still high and stable. We expect the broader market to catch up with the main indices and relatively outperform in the rest of the FY19. One should find out opportunity to buy quality beaten down names from the mid-cap and small-cap indices and build a portfolio with long-term perspectives.

What are the challenges while investing in small-caps?

Lately, the correction in broader market (mid-cap and small-cap space) was triggered by over-exuberant valuations, introduction of capital gains tax in the budget and inclusion of stocks in Additional Surveillance Measure (ASM) framework. However, the major challenges faced by investors while investing in small-caps is low liquidity, which makes the small-cap space much more volatile and relatively tough to exit.

Naveen Kulkarni,
Head Research, Reliance Securities

Will small-caps outperform large-caps in coming years?

Small-caps stocks have started underperforming in 2018 as many of them had started building up irrational exuberance. With increase in market volatility and rising interest rates globally, the risk appetite for small-cap stocks has reduced. This phenomenon has been witnessed even in the previous election years where large-cap stocks outperformed the small-cap and mid-cap stocks. Therefore, this election year or the next 12 months should not be different. We are likely to see the large-caps outperforming the small-cap stocks as rising volatility generally means reduction in portfolio beta by large investors, which impacts the small-cap stocks.

Are valuations attractive for small-caps, post correction?


Yes, valuations are attractive in some cases, but small-caps are growth stocks and dictated by broader market conditions. Quality small-caps with strong return ratios, cash flow profile and growth will continue to be preferred, even though they might be perceived as expensive over the value small-cap stocks.

In an individual portfolio, how much weightage should be given to small caps?

In the current scenario, small-cap weightage should be around 15% of an individual's equity investment, followed by mid-caps (Rs.8000 crore to Rs.28,000 crore in market capitalisation) with weightage between 20% to 25% and the rest 60% to 65% should be invested in large-cap stocks.

Vivek Ranjan Misra
Head of Fundamental Research, Karvy Stock Broking

Is it right time to buy small-cap stocks?

While it may be tempting to buy small-caps, we would prefer to wait as the valuations of small-caps remain high and volatility in asset markets is rising. Large-caps present better opportunities. However, there are specific stocks in the small-cap space that are attractive from a one-year view.

How much weightage should be given to small-cap stocks in the portfolio?

A neutral weight would be about 15%, but we would have a small underweight position. A weight of 10-14% would be our recommendation.

In your view, do small-caps generate more returns over the large-caps in the long run?


Over the last ten years, small-caps have slightly outperformed the Sensex, generating a CAGR of 10.3% as against 9.8% CAGR for the Sensex. However, the small-caps have outperformed significantly (CAGR of 26.2% vs 16% for Sensex) over the last 5 years. Since large-caps are mature firms, small-caps should outperform over the long term. As a result of their strong outperformance in the recent past, small-caps are likely to lag large-caps over the next 12-month period.

Pritam Deuskar Fund Manager- Bonanza Portfolio

"Currently, with interest rate hikes, high crude prices and currency volatility, this space may not create value for large investors. The key risks are that the margins can shrink for small-caps and re-rating may not happen immediately."

Past Small-Cap Recommendation Performance

In issue no. 21 volume 32 dated Sept 18-Oct 1 , 2017 we had recommended five small-cap stocks in our cover story titled , " Small-Cap Stocks ".

We had recommended 20 Microns Limited, Atlanta Limited , Indian Hume Pipe Company , Prima Plastics Limited and Yash papers. Out of these five recommended stocks, 20 Microns , Yash Papers and Atlanta Limited have delivered positive returns, whereas Indian Hume Pipes and Prima Plastics Limited have delivered negative returns. 20 Microns Limited delivered annualised return of 114.28 percent, Atlanta and Yash Papers were up 99.44 percent and 157.96 percent respectively. On the other hand Indian Hume Pipe was down by 49.69 percent while Prima Plastic Limited was down by 48.54 percent.


Conclusion
Looking at the historical data, it seems like small-cap investing is a panacea for beating the Sensex. We have seen that the performance of small-caps tend to lead when the markets have directional strength (either up or down). This makes investing in small-caps a double-edged sword, where these stocks offer investors the opportunity to participate more in uptrending markets, but carries the risk of downside exposure when the broader market trend turns negative. The opportunity to provide growth in the portfolio is a good enough reason to explore small-cap investing.

While exploring the small-caps, investors have to simply check whether or not the valuations are in line with the fundamentals. For beginners, investing in small-cap stocks can be a painful experience, hence one should avoid it. However, exposure via mutual funds can be a good idea for the first-time investors in the equity markets. 

Following are two small-cap stocks that may do well in coming quarters:-

Sandur Manganese and Iron Ores Ltd.

CMP                      Rs. 1,145.55

BSE CODE          504918
FACE VALUE     Rs. 10 
Market Cap         279.30
F F (Cr.)

Here is why
Outstanding quarterly financial trend
Very attractive valuation
Growth prospects in the steel sector


Sandur Manganese and Iron Ores Ltd. is an integrated commodity producer, engaged in the business of scientific mining, ferro alloy and power facilities, solar power and hospitality. The company plans to expand and upgrade its operations for manganese and iron ore, which will add value to the ores produced at its mines. In addition to this, the company also aims to produce steel and stainless steel in phases. Recently, the company has undertaken the production of solar photo-voltaic modules for various applications.

On a standalone quarterly basis, the company reported a 9.62 percent surge in sales to Rs.205 crore in Q1FY19 versus Rs.187 crore in Q4FY18. The EBITDA shot up 32.30 percent to Rs.86 crore in Q1FY19 from Rs.65 crore in Q4FY18. The net profit was reported at Rs.52 crore in Q1FY19 as against Rs.39 crore in Q4FY18, thereby posting an increase of 33.33 percent.

On a consolidated annual basis, the sales registered an increase of 41.01 percent to Rs.612 crore in FY18 from Rs.434 crore in FY17. The EBITDA improved significantly to Rs.186 crore in FY18 from Rs.109 crore in FY17, thereby posting an impressive growth of 70.64 percent. The net profit shot up by 83.33 percent to Rs.110 crore in FY18 from Rs.60 crore in FY17.

The EPS in Q1FY19 surged 32.81 percent to Rs.59.74 from Rs.44.98 in Q4FY18. The company’s net profit margin (NPM) in Q1FY19 was reported at 25.56 percent in comparison to 20.99 percent in Q4FY18.

The company’s success is linked to the performance of the steel market, which appears to have promising prospects owing to the initiatives undertaken by the government to encourage the usage of domestic steel in all infrastructure projects. This will provide a push to the demand for the company’s products. While the industry witnessed a downward trend in the price of iron ore due to a mismatch between demand and supply, the increase in supply in Karnataka and Odisha will help moderate the prices. The company’s cash position improved by 10.38 percent to Rs.2,268.54 lakh as on March 31, 2018 from Rs.2,055.03 lakh as on March 31, 2017. The company is completely debt-free since 2016 and the capital structure is entirely composed of equity. The company has demonstrated consistent profit growth of 26.80 percent over the last five years. In the last year, earnings (102.78%) have appreciated more than price (36.33%).

By virtue of these factors and the outstanding financial performance of the June quarter, we recommend our reader-investors to BUY the stock.

CMI Ltd.

CMP                      Rs. 151.00
BSE CODE           517330
FACE VALUE      Rs. 10 
Market Cap          129.55
F F (Cr.)


Here is why
Very attractive valuation
Growth prospects in infrastructure segment
Rise in demand in telecom sector

CMI Ltd.is engaged in the designing, manufacturing and development of cables and caters to a wide range of industries including railways, oil and gas, telecommunications, energy, industrial, power and petrochemicals. The company provides electric cables for railways, metro projects, utilities, buildings, data transmission, and much more. It has also diversified its activities by setting up facilities for the manufacture of Dry Core Telecommunication Cables.

The company's primary source of revenue is sales of signalling cables and safety cables to railways and government agencies. CMI Ltd. is the sole supplier of specific cables for Indian Space Research Organisation. It exports cables to Sri Lanka, Bangladesh and Iran Railways. Over the past years, the company has also focused on developing specialty products.

On a consolidated quarterly basis, the sales dropped 19.72 percent to Rs.128.22 crore in Q1FY19 as against Rs.159.73 crore in Q4FY18. The EBITDA dropped 8.24 percent to Rs.20.58 crore in Q1FY19 from Rs.22.43 crore in Q4FY18. The net profit was reported at Rs.5.89 crore in Q1FY19 versus Rs.6.79 crore in Q4FY18, registering a fall of 13.25 percent

On a consolidated YoY basis, the sales dropped 2.50 percent to Rs.128.22 crore in the year ended June 30, 2018 from Rs.131.52 crore in June-17. The EBITDA, however, increased 14.46 percent to Rs.20.58 crore in June-18 from Rs.17.98 crore in June-17. The net profit of Rs.5.89 crore in June-18 dropped from Rs. 6.03 crore in June-17, marking a decline of 2.32 percent

In Q1FY19, the EPS of the company was at Rs.4.61 as against an EPS of Rs.4.25 in Q4FY18, thereby registering an increase of 8.47 percent The net profit margin (NPM) surged 23.28 percent to 6.99 percent in Q1FY19 from 5.67 percent in Q4FY18.

Although the quarterly financials look bleak now, the company is expected to give a good quarter. The stock is trading at 1.10 times its book value and the promoters' stake in the company has increased. Also, the company has demonstrated consistent profit growth of 94.51 percent over the last five years.

CMI Ltd. has entered the high voltage cable business and has bagged an order from Engineers India Limited (EIL), thereby bolstering its business opportunities.

The global wire and cable market is likely to grow from USD 205 billion in 2014 to USD 297 billion in 2019, registering a CAGR of 7.7 percent during the period.

The rapid urbanisation and infrastructure development along the lines of increasing transmission grid capacity, grid replacement and modernisation initiatives present market growth opportunities. The surge in demand in the telecom sector bodes well for the company. Thus, we recommend our reader-investors to BUY this stock. 
(Closing price as of Sept 25, 2018)

A methodology of Picking up 400 Small-cap Stocks

To emerge with “400 Small-Caps” we have considered four factors. First factor is related to market data i.e. market capitalization; second and third factor is from profit and loss account that are sales and net profit; fourth is return to investors in terms of dividend. We ranked every data and then gave equal weight-age of 25 bps points to each parameter so that ranking does not get tilted due towards any one factor. One could wonder why we have taken dividend as one of the parameters. This is to safeguard that investor friendly companies should represent in our “400 Small-Caps” list. It also gives effect of different face value. We took dividend as a percentage to ensure that face value (FV) of 1 or 2 put them at disadvantage over companies having face value (FV) of 10. Since we have run the query in the last week of August 2018, all the data available of the companies during that period has been comprised in our study. (All the financial data are sourced from Dion Global Solutions Ltd. and ACE Equity)

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