Finding Treasure in the Small-Cap Space

Investing in Small-Cap stocks, often considered the wild frontier of the financial markets, can be an exhilarating and potentially rewarding endeavour. Bhavya Rathod explains why investors should not ignore small-caps and the opportunities they present for long-term wealth creation 

"Small-cap stocks are like undiscovered gems. If you can find the right ones and have the patience to nurture them, they can deliver extraordinary returns.” This well-known comment from legendary investor Peter Lynch captures the essence of small-cap investing philosophy and provides the key to how Peter Lynch has remained one of the best fund managers. As the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, Lynch averaged a 29.2 per cent annual return, consistently more than double the S&P 500 stock market index and making it the best-performing mutual fund in the world.  [EasyDNNnews:PaidContentStart]

Investing in small-cap stocks, often considered the wild frontier of the financial markets, can be an exhilarating and potentially rewarding endeavour. While they may lack the widespread recognition of larger, more established companies, small-cap stocks offer unique opportunities for astute investors. Small-cap stocks are known for their potential to deliver substantial returns over time. These companies often operate in niche markets or emerging industries, where their innovative ideas and entrepreneurial spirit can fuel impressive growth. Investing in small-cap stocks can provide investors with exposure to disruptive technologies, untapped markets and untapped potential. 

However, it’s important to note that small-cap stocks also carry higher risks compared to their larger counterparts. Their relatively low market capitalisations make them more susceptible to market volatility, liquidity constraints and increased sensitivity to economic downturns. Due diligence, thorough research and a long-term perspective are crucial when considering small-cap investments. Despite the inherent risks, small-cap stocks have historically outperformed larger stocks over the long run. Their agility, ability to adapt quickly and potential for significant growth can make them attractive additions to a well-diversified investment portfolio. Successful investors in small-cap stocks often possess a keen eye for spotting promising companies and a willingness to weather short-term fluctuations for potential long-term gains. The graph shows the performance of the Nifty indices (largecap represented by Nifty 100 and small-cap represented by Nifty Small-Cap 250). It clearly shows that small-caps have outperformed the Large-Caps in the long run. Since the start of April 2005, the small-cap index on an annualised basis has outperformed the large-cap index by 60 basis points every year. 

This might look very negligible for many investors and not worth taking risk. Nonetheless, the index may not be the right way to understand the small-cap share performance. This is because of the dual drag caused by underperforming companies that remain in an index (or drop down into an index) over time while their high-growth peers move on to larger ones. When an index reconstitutes, certain companies are removed. In smallcap indices, these names are often the star performers that move up the market-cap ladder into the Mid-Cap or large-cap universe. Conversely, troubled larger companies are added to small-cap indices as they fall in market capitalisation and lose investor interest.
 

Market Outlook

The weakness of the US dollar has attracted foreign institutional investors (FIIs) back to the Indian equity markets, while robust quarterly performances from major companies such as ICICI Bank, Axis Bank, Bajaj Auto, Maruti Suzuki and Nestle have further fuelled the rally in the Indian stock market. Additionally, the positive March 2023 results reported by banking and automobile companies have boosted the confidence of both FIIs and DIIs, as evidenced by their net buying activity at the end of the April series. However, the ongoing debt ceiling crisis in the US has slightly dampened the market sentiment. Market participants remain hopeful that the debt ceiling issue will be resolved and that the Federal Reserve might opt for a pause in its June meeting. 

The inflationary pressures have eased and are now within the acceptable range set by the Reserve Bank of India (RBI). Furthermore, the rural sector has achieved stability and is exhibiting promising early signs of improvement, providing greater assurance that the Nifty index will be capable of delivering mid-teens’ earnings growth in the fiscal year 2024. The softening of wholesale price index (WPI) inflation implies that consumer companies can anticipate a notable enhancement in their gross margins in the upcoming quarters. The FII stake as a percentage of total shareholding for Nifty 500 stocks has experienced a slight decline, decreasing from 14.45 per cent to 14.26 per cent in the previous quarter. 

Similarly, for Nifty Mid-Cap 100 index stocks, their stake in the March quarter stood at 10.66 per cent, down from 11.72 per cent in the previous quarter. On the other hand, DIIs’ stake in Nifty 500 companies witnessed an increase, rising from 15.77 per cent to 18.18 per cent. In Nifty Mid-Cap 100 companies, DIIs’ stake went up from 16.86 per cent in Q3 2023 to 23.74 per cent. In terms of promoters’ stakes, there has been a reduction across Nifty 500, mid-cap and small-cap. The stake in Nifty 500 companies decreased to 52.9 per cent from 54.66 per cent while in mid-cap companies it reduced to 49.17 per cent from 53.48 per cent. For small-cap companies, the promoters’ stake declined to 68.05 per cent from 69.88 per cent in the previous quarter.
 

Small-Cap Performance

Over the years, small-cap stocks have showcased impressive performance, often outperforming their larger counterparts. According to historical data, small-cap stocks have demonstrated higher long-term returns compared to large-cap stocks. For instance, a study conducted by DSIJ Team analysed the performance of S&P BSE Small-Cap over a 10-year period and found an average annualised return of 16 per cent, while S&P BSE Large-Cap returned an average of 11 per cent during the same period. In the table below, we have also analysed S&P BSE Small-Cap’s performance over different periods as compared with S&P BSE Large-Cap and S&P BSE Mid-Cap.

In the global markets, MSCI Developed Markets Small-Cap has generally outperformed MSCI Emerging Market Small-Cap in terms of returns over the given time periods. However, MSCI Emerging Market Small-Cap experienced higher returns over the past three years compared to MSCI Developed Markets Small-cap. Both indices had negative returns in the last year with MSCI Emerging Market Small-Cap experiencing a larger negative return. The table alongside illustrates the same over different periods. Investor interest in small-cap and mid-cap stocks has steadily been increasing over the past few months, mainly due to the higher returns offered by the broader market compared to large-cap stocks. In the last month alone, the Nifty Small-Cap 100 index generated returns exceeding 5 per cent, while the Nifty Mid-Cap 100 index delivered returns over 4 per cent. Conversely, the Sensex, representing large-cap companies, provided investors with returns of nearly 3 per cent.

The broader market indices have consistently outperformed the benchmark index, including in April. After a relatively subdued performance in March, the Indian stock market witnessed a 4.5 per cent rise in April, with the Nifty 50 increasing by approximately 4 per cent and mid-cap and small-cap stocks experiencing gains of around 5.2 per cent and 6.8 per cent, respectively. In 2022, small-cap stocks experienced a correction, presenting investors with an opportunity to build their smallcap portfolios. In April, the inflows into equity mutual funds were primarily driven by steady investments in small-cap and mid-cap funds with an amount of ₹ 2,182 crore and ₹ 1,790 crore, respectively.
 

Small-Cap Outlook

India has emerged as a favoured destination for foreign portfolio investments (FPIs) when compared to the other emerging markets. Notably, FPIs have injected a substantial amount of USD 2.7 billion into the Indian market, surpassing the USD 1 billion inflows observed in both Indonesia and Brazil. Among the countries under consideration, including Indonesia, Brazil, South Africa, Philippines, Turkey and Thailand, India stands out as the only nation to consistently attract FPI inflows throughout the months of March, April, and up to the present in May. This trend highlights India’s appeal as an attractive investment opportunity for foreign investors in the current market landscape. Foreign institutional investors (FIIs) showed interest in acquiring high beta and value stocks, which were the same types of shares that mutual funds aimed to divest. FPIs primarily concentrated their buying activities in cyclical and capital-intensive sectors, including financials, industrials, discretionary consumption and metals. Interestingly, despite their aversion to risk associated with beta and value stocks, mutual fund data revealed significant buying in small-cap funds, indicating a willingness to take on size risk. Among mutual funds, the top sectoral preferences were financials, IT, materials, transportation and real estate. 

The premium associated with investing in India compared to other emerging markets has experienced a substantial decline. This development, combined with the reduction in the fiscal deficit and a decline in the current account deficit, the stability of the rupee and inflation remaining within the acceptable limits defined by the RBI, positions India favourably for outperforming in attracting foreign portfolio investments (FPIs). However, rising valuations pose a significant risk to FPI flows into India in the future. According to data from Prime Database, foreign institutional investors (FIIs) have increased their holdings in India’s small-cap companies to the highest level seen in at least five years. 

This surge in investments comes despite a decline in their holdings in large-cap and mid-cap companies. FPIs appear to be actively seeking opportunities to generate alpha, as evidenced by their heightened investments in specific small-cap companies during the March quarter. This inclination also demonstrates their confidence in the Indian micro story, whereby certain companies within their respective sectors have the potential to outperform regardless of the overall market direction. This trend could potentially be indicative of the participation of new foreign portfolio investors (FPIs) who have recently entered the market and possess a broader investment mandate encompassing companies across the market capitalisation spectrum.
 

Interview 

Vinay Jaising MD, Portfolio Management Services JM Financial Services Ltd 

The Margin of Error in Small-cap is far Larger than the Large-cap
 

What are the specific parameters you look for selecting small-cap companies? 
Is there a difference between the selection of a small-cap or a large-cap company? We think the answer is NO, however, the spade work for the selected stocks in small-cap is tougher than for large-cap. 

We use a two-prong approach for our portfolio construction: First, we focus on our Macro view of India; the key themes we think will play out in the current environment and which have longevity in earnings. Then we look at the bottom-up analysis on look at each company individually focusing on a) Industry and b) Company strengths. In industry, we focus on finding those which have a growing secular market, which is scalable and sustainable. The industry should be in the growth stage of the business cycle with pricing power and higher margins leading to the consistency of ROCE and high FCF and high-quality profits. 

On companies, we focus on their moats and competitive advantage which could be a Cost or Technology advantage. Management quality, Corporate Governance; Forensic analysis of its Balance Sheet. Valuation plays an important role along with the Margin of safety and earnings growth viability after we understand the business model of the company. For all our Companies under our portfolio we build business models which include Income statements, Cash flows and Balance Sheets; both on a yearly and quarterly basis. Our experience suggests the margin of error from the small-cap is far larger than the large cap and hence every quarter data point matters a lot. 

In the case of small-cap companies, our selection criterion remains the same; however, we prefer a small fish in a big pond to a big fish in an aquarium. The spade work for the small cap to gain these parameters is, however, tougher than for the large-cap. Many companies are just listed so have a limited history in the markets and some may have been incorporated less than 5 years, especially in the Sun Shine industries. Here we try and look at a lot of domestic industry and global peers to understand the company's journey from small-cap to large-cap. A simple Porters Model takes a long way in the analysis of these companies.

(Source- SEBI, JM Financial views)
 

What is the maximum drawdown you are comfortable with for small-cap stocks? 

We have time and again witnessed huge volatility in small cap. Individual stocks. Here we use 2 principles to guide us during drawdown a) Discipline and b) The Core thesis of our investment in the stock. 

On discipline every 15 per cent move of the stock downwards or upwards we reassess our investment rationale including our assumptions to our models. In case our thesis is playing out however stock is falling for some technical reason which is not a governance issue we build up our scale. And the other way around if our thesis is getting weaker and the price is correcting, we do not shy away from selling. Normally we give in some time to analyse why our decision is having a drawdown; however, if the drawdown is 25 per cent or higher it could trigger our stop-loss policy if we are not convinced with our thesis. To us it is important to do something with massive drawdowns; i.e. Buy more to average or sell due to a lack of conviction. Taking NO ACTION is something we rarely do.

(Source- Bloomberg, NSE India, JM Financial) 

After underperforming in the last one and half years, what is your outlook on the performance of the small-cap stocks compared to large-cap stocks in FY2024? 

Firstly; let us look at data: in the last 18 months the large-cap has moved up 7 per cent and small and mid by 6 per cent each; so really there is nothing to differentiate. In a 3-year horizon however small cap at a CAGR of 41 per cent has outperformed large cap which has grown 25 per cent. In a 20-year horizon again all the caps have surprisingly given similar returns of 16-18 per cent. 

Hence, we believe one should not look at a Company based on its current capitalisation but more so at its future prospects which makes it a large-cap company. Industry selection is key to success along with a positive Macro environment. 

The Indian economy is vibrant for growth for all kinds of Companies – HDFC the Country’s largest bank has grown at 20 per cent CAGR in profits for the last 8 years. During the same time, the profitability of the small-cap index has gone up by 14 per cent and 11 per cent for the largecap index. The P/E for large-cap and small-cap is around 20x and 19x respectively.

(Source- Bloomberg, JM Financial)
 

Conclusion 

According to Raghvendra Nath, Managing Director, Ladderup Wealth Management – “"The small-cap market is currently in an intriguing phase in terms of valuations as well as new business opportunities. Starting with valuations, the small-cap index is presently trading at 20 times earnings, which is significantly lower than its 5-year average of 33.4 times. This presents a promising opportunity for investors to gradually add small-cap stocks to their portfolios. 

Moving on to the business opportunities, small-cap companies have demonstrated resilience amidst global turmoil, thanks to their local economic strength. The government's emphasis on capital expenditure (capex) and the revival of private capex bode well for small-cap companies, as they can anticipate increased business visibility through order inflows." 

The recent increase in buying activity within small-cap firms can be attributed to the notable financial resilience displayed by the companies. Besides, during the past 18 months, mid-cap and small-cap segments have encountered substantial declines. Consequently, these segments appear to be increasingly appealing from a value standpoint. The recent price corrections observed in small-cap and mid-cap stocks, coupled with the consolidation phase and lower valuations, have created longterm opportunities for small-cap investors. These opportunities hold the potential to outperform the returns generated by large-cap stocks. 

The small-cap index level reached its peak around January 2022 and has subsequently undergone a phase of consolidation or slight correction. Valuations for both categories are now nearly in line with, or slightly below, their 10-year averages based on a one-year forward price-to-earnings ratio. This consolidation can be attributed to global macro uncertainties, as well as a moderation in growth within India, coupled with the high valuations these stocks had previously commanded. Notwithstanding the aforementioned factors, the current valuations present an opportune moment to initiate the construction of a long-term portfolio.

It is crucial to acknowledge that there might still be some short-term disruptions as the effects of growth moderation on earnings become apparent. Consequently, individuals contemplating investments in this category should be prepared to adopt a long-term perspective spanning at least five years. Moreover, they should be open to increasing their positions during periods of volatility that may arise over the next few quarters. Investors should be mindful of the relatively higher volatility associated with small-cap and mid-cap stocks compared to large-caps.

However, this should not dissuade long-term investors from exploring opportunities in this category, as volatility tends to diminish over time. In fact, small-cap and mid-cap stocks have the potential to outperform large-caps, making them an essential component of asset allocation for many investors seeking a balanced portfolio that aligns with their goals. When selecting sectors or individual stocks, it is advisable to aim for a diversified portfolio as opportunities are available across various sectors within the small-cap and mid-cap space.
 

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 and their growth in last few years. We have also taken into consideration the efficiency of the companies by analysing 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 FY21 into profits in FY22.
 

◼ Improving Financials: Although these companies still reported losses in FY22 as they did in FY21, 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 FY22. 

All the raw financial data is sourced from Ace Equity and price-related information is as of April 28, 2023.
 

Download the complete financial data of 487 small cap companies by scanning this QR code. 

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