Create Long-Term Wealth With Small-Caps

Small-caps have created huge amount of wealth since the pandemic hit us in early 2020. The BSE Small-Cap index has gained by a whopping 200 per cent since March 2020 and this is after the recent 17 odd per cent correction from the highs. The market direction hereon may test retail investors’ patience. Yogesh Supekar discusses the performance of small-cap stocks in the recent past while highlighting the prospects of small-cap stocks in the coming quarters 

It is that time in the equity market when the men are separated from the boys. We say so because the increased volatility has tested the nerves of many an investor and it is normal to expect some of them to give up on equity investing. Today, when the market is volatile and in a corrective mode, we realise that one of the most important qualities for an investor is temperament, not intellect. When it comes to small-cap investing, temperament matters even more as small-caps are much more volatile and tend to test the investors’ patience and conviction during market corrections. [EasyDNNnews:PaidContentStart]

There are various ways investors can build their conviction for a particular small-cap stock. However, one of the best ways to build conviction on a small-cap idea is to talk or listen to promoters and do a thorough fundamental analysis so as to identify the triggers driving the business growth of a company. If an investor can follow this process independently there is a good chance to build conviction in the underlying story of the chosen small-cap idea. Once this conviction is built based on the strength of a business model, quality management and earnings’ visibility, there is a very good chance that an investor will not be volatile himself even if the stock prices become volatile. 

Considerable amount of research should be focused on the quality of management when it comes to small-cap stocks. Investors can build confidence in any promoter only after listening to him or even better talking to the promoter and management of the company. According to Pratik Mehta, a long-term investor, “I prefer to buy small-caps over Large-Caps as there is a very good chance of generating an alpha. I usually spend a lot of time understanding the management and if possible, interacting with the management. During the period of the pandemic many small-cap and micro-cap companies conducted webinars and several investors were able to interact and pose questions to the promoter and the management.” 

“When you do that and rest your mind after addressing your doubts, small-cap investing is one of the most fruitful investment activities. I can tell you with a lot of confidence that I am holding such small-cap companies in my portfolio where the management is realistically aiming to achieve sales equal to their current market capitalisation. Such stocks will turn out to be multibaggers in the coming years. Now it is up to me to hold on to such small-cap businesses patiently with quality management and above average growth potential. I have to track the earnings quarter-on-quarter (QoQ) and depending on the management steps and new growth triggers, I decide whether to add more such stocks that promise to grow exponentially,” he adds. 

It may not be totally wrong to say that small-caps are less risky when thoroughly researched and held for the long term. In the stock market time is your best friend when you are holding a right stock. However, for a wrong stock time proves to be an enemy. Often investors assume that any stock held for a long term may turn out to be a good investment. The fact is that investing for a long term alone is not good enough. One has to hold on to the right quality stock over the long term and not just any stock. Holding to a quality small-cap stock over a long term can create wealth beyond imagination for the investors and at the same time holding a poor quality small-cap stock for a long term can be wealth-destructive.

Here are some of the top performing small-cap stocks on YTD basis:

The small-cap stocks have underperformed over a period of five years if we go by the indices’ performance as shown in the table above. However, small-caps are seen outperforming key benchmark indices in the past one year. 

Small-Cap Stocks with Outstanding Results

We are almost done with the earnings’ season and have already seen some extraordinary performances. Several micro-cap companies declared outstanding results this season, including Supreme Holdings, Emami Papers, GTN Industries, Manaksia, Empire Industries, Lak Electricals, Suryalata Spinning, Galaxy Bearing, Orient Bell, Taj GVK Hotels, Aptech, etc. Positive earnings were reported across the sector. 

Here is a list of small-cap stocks with outstanding results. 

Small-Cap Multibaggers

Consistency in positive results (earnings) will be the key for small-caps as consistency in earnings’ growth can fetch premium valuations for small-caps. We have seen small-caps create wealth in the long term when consistent earnings are delivered. There are small-cap stocks such as Jyoti Resins and Sadhana Nitro Chem that have gained up to 27,000 per cent since May 2014. Both the stocks belong to the chemical sector. The profit CAGR for Jyoti Resins has been ~120 per cent in the last five years. The EPS has grown from 0.60 per share to ₹ 49.40 per share since 2014. The earnings momentum is strong and the consistency in earnings’ growth is helping the stocks gain in price. This shows the rich rewards one can get after identifying a small-cap company with earnings’ explosion. 

Here is a list of small-cap stocks that have turned out to be multibaggers since 2014.

Conclusion 

Small-caps can be an essential part of any core portfolio for a long-term investor. The weightage given to small-cap stocks in a core portfolio is always a function of risk profile. High risk appetite investors with time horizon of more than five years at least should focus on small-caps for aggressive returns. There are over 4,500 small-cap stocks available to choose from and hence the filters that are used for selection of small-cap stocks are crucial. All one must do is focus on those small-cap stocks where the earnings’ explosion is expected to happen over the years. To understand such possibility in any small-cap stock one has to have a very good understanding of the overall sectoral trend. A top-down approach in such cases becomes as much essential as a bottom-up approach. 

In other words, for a small-cap company to grow its profit manifold, it needs to be in operation in sectors that are witnessing above average growth trends. At the company level an investor must identify the growth triggers, as for example the launch of new products, change in government regulations, key strategic initiatives taken leading to boost in earnings, etc. As a practice, it may be a good idea to concentrate on small-cap stocks that have recently announced outstanding set of results. For a start, such small-caps with extraordinary earnings can be kept in the watch list. Overall, the market mood is still negative as the required positive triggers are missing. The market no doubt is in the oversold zone and a technical bounce is already in motion. Similar is the case for small-cap stocks. It is quite possible that small-cap stocks may bounce more than the large-cap stocks, yet one must be able to distinguish between a short-term technical bounce and a change in trend. After a steep correction, the outlook for equities for the remaining period of 2022 remains positive as the probability of equities outperforming fixed income assets improves. The small-cap stocks may continue to outperform large-caps in the second half. 

Empirically speaking, in the US’ markets there is evidence of small-cap stocks outperforming the large-cap stocks even in the rising interest rate environment. Interestingly, small-caps and Mid-Caps are trading cheaper than the large-caps on a forward earnings’ growth basis. With cheaper valuation on their side along with expected domestic money flow into the asset class, the broader markets may grab investors’ attention in the second half of 2022. While the outlook remains cautiously optimistic for the small-caps after the recent market correction, it is important to note that small-caps tend to outperform when liquidity in the markets is high. 

If the domestic fund flows dry up, small-caps may suffer the most. That is the reason why investors are advised to be extra careful while investing in small-caps. The fundamentals tend to change swiftly for small-cap stocks when compared to the large-caps and hence accumulating small-caps is an extremely difficult task when compared to large-cap stocks. The earnings volatility calls for close monitoring. For success in equity investing market timing is important. Market timing is even more important when it comes to small-cap investing. A small-cap stock bought at its peak may contribute negatively to the portfolio returns for quite a long time. That may not be the case with a high-quality large-cap stock. Thus, entry level in small-caps is extremely important for successful small-cap investing. 

Methodology 

To come up with a list of performing small-cap stocks, we took into consideration five crucial parameters. The first includes market capitalization. The second and third parameters obtained from the Profit & Loss Account include Sales, Operating Profit and Net Profit. We have also taken into consideration the efficiency of the companies by analyzing profit margins. Each parameter was then ranked by awarding it a carefully determined weightage based on its significance.

We then segregated the small-cap companies into three categories as follows: 

• Turnaround Performance: These companies include those that successfully managed to turnaround the losses incurred in FY20 into profits in FY21. 

• Improving Financials: Although these companies still reported losses in FY21 as they did in FY20, 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 those companies that have seen their profits increasing on yearly basis for FY21. 

All the raw financial data is sourced from Ace Equity and price-related information is as of May 24, 2022. 

Download the complete financial data of 414 small cap companies by scanning this QR code.

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