Small - Caps Flavour of the Season!

Even as the whole game of investing has got tougher in the last couple of years, investing in small-caps has become even more challenging. The irony is that broader investing opportunities still exist in the small-cap space, while the market is witnessing rally in a select few large-cap stocks. This reality is testing the small-cap investors' patience. It has been a tough time no doubt for small-cap investors with close to 255 stocks from the basket of BSE Smallcap index trading near their respective 52-week lows and a handful 88 stocks from the same list of 860 stocks trading close to their respective 52-week highs.



The bulls investing in small-caps argue that the valuation gap between the small-cap and large-cap is narrowing and that the prolonged under performance in small-caps cannot prevail for long. Small-caps will catch up, sooner rather than later.

The less optimistic investors argue that the corporate governance and liquidity squeeze has impacted small-caps more than the large-caps and there are no signs of quick reversal in the trend.

While it is only logical to expect a rally in the small-caps once the issues related to liquidity are resolved and the earnings revival happens, long term investors in small-caps can take solace from the fact that the returns generated by the small-caps can be slightly higher on an average when compared to that of large-caps. The following table shows the outperformance of small-cap stocks over the large-capsin the last 15 years: -  




As is seen from the above table, the BSE Smallcap index on an average has delivered 6 per cent more returns than the Sensex, i.e large-caps. However, since January 2018, the under performance of small-caps is visible. Mid-caps have also under-delivered in the last 18 months.

Looking at the recent poor performance, it will not be outlandish to expect a smart recovery in the small-caps. Says Vivek Bajaj, Managing Director & Co-Founder, Kredent InfoEdge, “The small-cap stocks must be selected very carefully with proper analysis because it has the potential to create both multibaggers as well as erode the entire capital of the investors if the selection backfires. After the correction in 2018, some of the small-caps have become relatively cheaper and look attractive in terms of valuations. Moreover, after the re-election of NDA in the recent elections, the small-cap stocks can get a boost by the various government policies and initiatives. The small-cap stocks should not be viewed in totality, but should be viewed in isolation, depending upon the business model, quality of the 



management, valuations, etc. In the current scenari

o, the expectation that all small-caps will generate returns has been belied and, after the recent meltdown, only the quality stocks with good pedigree of business would continue to generate returns for the investors.”

Small-cap stocks performance:

In spite of one of the worst performances in the small-cap universe in the past couple of years, the last year has had some outliers. 



"Since January 2018, Nifty Small Cap 100 index is down around 30.8% due to various reasons such as NBFC liquidity issues, rural slowdown, global stagnation due to the ongoing trade war and delay in earnings growth. We feel that the earnings growth revival is yet to be seen, therefore, we would advise to tread cautiously, especially in the small-cap space as they tend to be highly volatile. Valuation-wise, the small-caps might be trading close to their historical valuations since they are still down 30.8% since January 2018. From an investment point of view, we would prefer companies with clean balance sheet, earning visibility and good corporate governance track record in entertainment, chemical, banking and capital goods space."

If we define small-cap stocks as those companies that fall between Rs. 200 crore and Rs. 1350 crore market cap, we find that there are at least 591 stocks that can be categorised as small caps as on June 10, 2019. Out of these 591 small caps, we find that there are almost 130 stocks that generated positive returns in one year time frame, while 461 stocks delivered negative returns in a similar period. Almost 21 per cent of the total small-cap stocks in the basket delivered positive returns in the year gone by. There were at least 13 stocks that generated returns greater than 100 per cent in the year gone by and almost 57 stocks were able to generate returns in excess of 25 per cent. 

Umesh Mehta, Head of Research, SAMCO Securitie

What is your outlook on small-caps? 

Small-caps have faced a lot of flak in the past year and valuations are now looking very attractive as their one-year forward PE is way below their historic averages. There is a wide divergence between the large-caps and mid and small-caps, where the large-caps shot up and rallied, while the mid-caps and small-caps failed to join them. Hence, the time is ripe for an exposure in quality and selective small-cap stocks. 

What is your advise to investors who are stuck with smallcaps (underperforming) in their portfolio? 

It will be unreasonable to presume that all small-caps will rise since they are available at cheaper valuations. Investors must hold on to the quality small-cap stocks, while they must follow a strategy of sell on rise to get out of small-caps which may be of inferior quality in order to stabilize their portfolio. 

What is the ideal exposure to small-caps an investor (high risk/moderate risk/low risk taker) should have in a portfolio context? 

Highly risk-taking investors can have an exposure of around 30-35% in small-caps, moderate risk seeking players can have around 20-25% and low-risk takers can have a 5-10% exposure in their total portfolio. 

How did small-caps perform in the latest earnings season? 

Broadly speaking, this result season has seen muted growth numbers. However, there are exceptions since there are always quality companies, which have been giving stable growth, delivering decent return ratios and maintaining focus on innovations and expansions. It is best to find those hidden gems and turnaround stories that can become wealth creating picks. 

Conclusion 

In the normal course of business, the small-cap stocks should be less impacted by the global issues and trends. Slowing global economy should not bother small-cap stocks much as their business is more domestic-oriented. The recent slowdown has mostly to do with the domestic issues and the slowing growth of the economy from 7.5 per cent to 5.8 per cent. This drop in GDP, consumption slowdown and liquidity squeeze all put together have impacted small-cap stocks universe negatively. 

Going forward, the GDP growth is expected to pick up and with real interest rates expected to come down, the liquidity issues will also be addressed which, in turn, may lead to improvement in the overall consumption in the economy. The expected improvement in internal macros augurs well for the small-cap stock universe at this point of time. There is no euphoria around small-caps right now and there are multiple opportunities that exist in the broader markets. 

All investors have to do is keep away from those companies that are susceptible to corporate governance issues and are finding it difficult to deleverage. 

Methodology For Picking Small-Cap Stocks 

To come up with a ranked list of smallcap stocks, we took into consideration four crucial parameters. The first includes market capitalisation. The second and third parameters obtained from the Profit & Loss Account include Sales and Net Profit. Lastly, we factored in the returns earned by investors by means of dividends. This is because we want investor-friendly companies to be featured in our list. Since the face value of the shares is different for each company, we made sure to rebase the dividends by calculating them as a percentage of the face value. This rebased dividend then became comparable for the purpose of ranking. Each parameter was then ranked by awarding it a carefully determined weightage based on its significance. We then segregated the companies into three categories as follows: 

Turnaround Performance : These companies include those that successfully managed to turnaround the losses incurred in FY18 into profits in FY19. 

Improving Financials: Although these companies still reported losses in FY19 as they did in FY18, they succeeded in reducing these losses by a notable amount. This indicates that they are on the road to recovery. 

Thriving Companies: This list includes all the remaining small-cap stocks and their financial performance. 

A consolidated ranking was done in each category. All the raw financial raw is sourced from Ace Equity


Click Here to Download Small Caps Data Bank 

A consolidated ranking was done in each category. All the raw financial raw is sourced from Ace Equity.

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