How to approach risky, but rewarding small caps

In most equity portfolio constructs, the majority of holdings are large, well-known companies. Here, there is no joy of discovery except a steady and modest index-matching return over the years. But as a person’s investible surplus rises, one goes in search of smaller companies. This is a logical progression but not a rule. 

Small caps are always alluring to the investor. Everyone knows that it is difficult to make quick money in large well-known and well-researched stocks. We all want to find that small gem which turns a lakh of rupees into crores. The most money is made in such cases when we can spot a company that will turn out to be a market-leading name in five to ten years. Today, the investor population has increased dramatically. Besides, information is available to everyone. This makes small cap investing both interesting and risky.

How to approach risky, but rewarding small caps

Slim survival rates

If I go back to the eighties and nineties, of the many small cap companies that were around then, only a handful have gone on to become money multipliers. I can see names like SRF, Eicher, Enfield, Alkyl Amines, Hatsun, Page, TVS Motors that have rewarded investors handsomely. They were small cap companies that have gone on to become mid-caps and sometimes even large caps. But it needs to be recognised that most of the small cap companies of those days continue to remain small or don’t even exist any longer.

Once upon a time, we had companies like Century Textiles, Nirlon, Premier Automobiles, Orkay  that were small and promising. So, it was your skill and luck which determined whether you picked the right small caps that could grow your wealth.  

Today, information is easily available. Access to top management is a matter of public knowledge. Thus, spotting promising businesses ahead of everyone and getting in early into a sound small cap is not so easy. There are probably more analysts than the number of listed companies to track. Everyone is searching for the hidden gem. 

I am, however, a believer in this ‘small company’ philosophy. When in CRISIL, we all got employee stock options – ESOPS – as reward. Post listing, many people sold the stock promptly because it was not well known at the time and the rating business was nascent. But the credit rating boom is just beginning. There were 5000 plus companies in the listed space and many more in the unlisted space that would need ratings.

The business did not need fresh capital to scale up and was knowledge-driven. This was even before S&P took over. If we had put some numbers together as to how CRISIL would look in ten, twenty and thirty years ahead, the story would have been screaming in your face. 

But to me, CRISIL is a good illustration of how most of us get anchored to ‘current’ valuations and fail to see the long-term picture. CRISIL did its IPO at Rs.50 per share and never made a call on capital. It got acquired by global rating giant S&P at Rs.750 or so per share. Adjusted for splits, the share is now worth Rs.30,000!! Do the numbers. 

However, that is one success. I’ve also had many failures or companies that simply did not grow up. They remained juvenile or just wound up or vanished or got taken over. The fact that we still do not have that many companies with over Rs.5000 crore of market cap in the Indian universe. Take banks. Many private banks started around 1995. Today HDFC Bank and Kotak shares would have multiplied your wealth, whereas a Global Trust Bank would have decimated it. 

So how does one approach small cap investing? I have a few pointers, based on what I have seen thus far. I am not very good at the new fad of investing in companies that do not seem to be able to report a bottomline without using brackets. I still believe in looking at PAT, after ensuring that tax is being paid. Not for me the fancy numbers like EBITDA, EBITDA or other nomenclatures which are glamorous-sounding that give one simple message-  Boss, we do not know how to make a profit!

An investing approach

Here are my personal learnings on small cap investing.

#1 They shouldn’t be your first investment

Before venturing into this high-risk high-reward zone, it is best to plan one’s core portfolio around more stable investments. This should include fixed income, provident funds and equity mutual funds/ ETFs. Of course, if you are so wealthy that there is money sloshing round, then you can stop reading further and do as you wish.

#2 Commit amounts that are meaningful

To make a meaningful difference to your net worth, you need to commit a reasonable amount to small caps. I would think that a minimum of a couple of lakh per idea would be required. If you want to get invested in ten ideas over a time frame, then you need that much more.  I am taking ten as a number out of my hat. The money has to be in more than two or three concentrated bets.

Of course, if your cash flow permits, you are free to place large bets on some ideas.  It is based on your comfort zone. The way I look at this is, that in twenty years, some company shares would have gone up 100 to 200 times, some would have just about given you bank returns and maybe one or two would have perished. On the aggregate, this must give better returns than the broad indices. If not, there is no point in pursuing a small cap strategy.

#3 Bet for the long haul

Buy the shares of the company you’ve identified in two or three lots until you get to a sizeable position. You may end up buying on the rise, but that is better than averaging the price on the way down and sitting down for a mediocre return. Unless you think that your basic premise is flawed or there is fraud or a corporate action involving this company, do not sell the stock. I would not monitor daily prices. I would keep track of the annual reports and be alert on the lookout for any news on the company / promoter.

Choosing companies

This is the most difficult part. Today, if I look at the list of companies with market capitalisation below Rs.5000 crores that also have a ROCE of at least ten percent, I get about 700 companies, the smallest having a market cap of around Rs 2 crore! I also see in that group, some names that have been around for four decades and still remain small companies. 

I use a screening tool to create an initial shortlist (PrimeInvestor.in has a good one). To screen, work with a checklist. Say – potential to grow faster than GDP, Promoter quality, Accounting quality, Free Cash Flow, Past growth rates, Customer reviews and so on. You should be able to identify the key reason as to why the company makes money. And a conviction that it can make more money going forward because there’s a big market out there for its product or service. I also believe that commodity stocks will not fit the bill here. Commodity stocks are (to me) a value play.  

While choosing companies for early stage investing, I tend to look for the following characteristics:

  • The business has to be such that it can grow top line rapidly without constraints. When I say constraints, take a dedicated auto ancillary. It is limited by the size of the auto industry and can only scale to be a small part of it. It may remain small for longer than we think. At the same time, a retail business or a Dixon type of business has a huge growth runway ahead. The problem is to find enough such opportunities.
    Today, the deadly combination of Private Equity plus free pricing means that when promising small companies enter the public markets for the first time, they are already mid to large in terms of market cap and the valuation has skimmed off much of the return potential. But IPOs can still throw out winners, if reasonably priced. D-Mart was one such. HDFC AMC was not as attractive as Dixon. However, these are businesses which meet the requirements for early investing for big gains. 
  • Today, there are many small cap companies which have been around for a very long time but could still be good investments. Some auto ancillaries come to mind. Yes, they may not become large, but can give you above-index returns. This is what we have to focus on. These are typically high growth companies. They may have some debt, but enjoy high ROCE to take care of repayments. They have a USP in terms of niche or quality or customer fulfilment or a strategy that gives them the edge. Their execution is typically good. 
  • These stocks can often be priced more aggressively than the big and boring ‘solid’ names. The speciality chemicals sector threw up many such instances in the past 2-3 years. The Page Industries stock was never cheap but has been a great wealth creator. One example I can cite today is ACRYSIL (confession- I own the stock). They manufacture a product that is always going to be needed and they have the quality. The potential to grow is big.  I was lucky to spot this stock a bit early. It has been around for many years, but it is only in the last few years that it has gained traction.  
  • The wait for a small cap to be recognised by markets can often be painstaking and long. The rise in price happens in sudden bursts. It is never a linear graph. It can be a frustrating wait for a long time and then it suddenly jumps up in a vertical take-off. This is why the crucial quality in small cap investing is resisting the temptation to exit. 
  • When choosing companies, go for those which have a healthy ROCE (well above the cost of debt), manage their working capital cycle very well and are rarely seen in the corporate arena of M&A. I recall one hot potato stock named ‘Opto Circuits’. However, it had enough warning signals that helped me keep away. Financial inspection is an absolute must. If a business sounds too good and the stock hasn’t been re-rated by markets, think ten times about placing your bet. Most good investments are easy to understand businesses. We must understand how the company can make money. 
  • Trace the company’s equity history. In the early stages, the promoter holding should be as high as possible. This leaves some room for one or two rounds of dilution in case of need. While this is not a hard and fast rule, I like to see companies where the promoter has a large enough stake. Typically, a good company will not make a follow-on public offer. An IPO followed by one or two rounds of QIP is what the path should be. 
  • Governance is the biggest risk factor for small caps. Therefore, promoter quality has to be checked. Ask customers/vendors about the promoters. For a small cap company to scale up, good promoters with integrity and passion are a must. I am seeing many old companies that were dull and boring, now get a new lease of life with the next generation, who seem to understand the joys of the capital market, giving them the drive to grow business aggressively.

What to watch for

Small cap companies need more frequent and diligent tracking than established bluechips. 

Once you have invested, keep a watch on any corporate action. If the company you own has a penchant for acquisitions, be cautious. If the company is being acquired, it makes sense most of the time to sell and get out. Keep tabs on the headline growth numbers and on cash flow. For how long? Frankly, I do not know. I would think that if I have gone in with a ten year view, I should not change my mind. Once the stock becomes large enough for many institutional investors and promoter stakes to start to come off, I will probably think of exit.

The risks to execution are many.  Just look at the retail space. When Future Retail started, we all thought that it was an early mover in a space that is bound to grow by leaps and bounds. Sadly, execution was poor. D-Mart, though a late entrant, did brilliantly in the same space and is still growing. So many others have come and gone or are simply mediocre. The gig economy threw up so many opportunities. However, the absence of a profit makes them poor candidates. The presence of PE and VC Funds also denies most of us the opportunity to get in time to make some money.

It is not easy to discover new picks today. In this age of information overload and high density of equity ‘experts’ virtually every small stock seems like a winner. You will need to take time to pick up a good quality business. Once you find out two or more candidates, buy in gradually. Bad markets are generally the best time to pick up such stocks. A SIP in small stocks is difficult given the high impact costs. Therefore, one has to time the buying price. Small cap stocks are easy to buy and tough to sell. Assume that you will give up five to ten percent of your paper gains when you actually sell. 

On the NSE, there are approximately 200 companies with market capitalisation of more than Rs.25,000 crore and probably around 2000 companies that are less than Rs.5000 crore in market capitalisation.  This tells us that the odds of scaling up are very low.  More often, we will be left to dig for tiny sub-Rs.1000 crore market cap companies that can probably go up five to ten times. 

This is a minefield and one has to be prepared to lose money. But this is where many of the investors I know spend their time and money. Some of them get it right. Most of them do not. Choose wisely, depending upon your stomach lining. Remember, as you venture from small to micro caps, there is no information that can be considered authentic. You are on your own.

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5 thoughts on “How to approach risky, but rewarding small caps”

  1. emailsubcriptions9

    No doubt a good article
    But..
    how about including small cap investing directly in stocks vis-a-vis small cap mutual funds? That would have given a more comprehensive article and addressed more completely the requirements of Investors

    Also how about having a premium screener made, saved and directly available in your Premium Screeners section covering all that you have to say and once has to consier?

    Thanks

  2. Small caps are a minefield rightly said, and small investors are the last in line to know what is happening on ground.
    Held Nirlon Orkay,RIL it’s just odds some survive, it’s lucky if you are still holding it

  3. Informative Article. I am not into direct stocks. Investments in Small caps is through Mutual Funds

  4. Very Nice Article… You told virtually everything without telling specifics… Specifics are indeed to be learnt case to case basis by individual investors… I am still to learn DIY Stock Investment n still to learn reading balance sheets.. Hence stay away fm it.

    I think, most of the retail investors can stay away fm Small Caps if they want to save time n money… Proper Asset Allocation, Risk Profiling, Diversification, Goal based Investing, Timely Review n Rebalancing etc. are more than enough for most of us..

    If at all needed then one can invest 10% of Equity in 1-2 Small Cap MFs with differentiated strategies and low overlapping portfolio. Tag it to real long term goals which are 15-20 years away.

    Ur Article was Bang On Target for those who wants to experience Magic of Small Caps.

  5. Thank you. As usual, excellent article from Bala sir. Please make sure he writes more often for PrimeInvestor.

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Unless the client notifies us before the end of his/her subscription period, or the client cancels the auto-renewal mandate within the period specified by law, that the client does not wish to renew his/her subscription, the client’s subscription will renew for the period defined by the client’s subscription plan. We will charge the subscription using the same payment method that you previously used.

Although the client may notify to us his/her intention to his/her subscription, such notice will only take effect at the end of his/her then current subscription period, and he/she will not receive a refund other than as set out under Clause 8 in these Terms.

The client may notify us of his/her wish to cancel his/her subscription by sending an email to [email protected]. The client must provide at least 5 business days advance notice for this to be implemented.

Refunds: There can be no cancellation and refund of subscription fee paid once the subscription is active, other than as stated in Clause 8 of these Terms. If the client is entitled to a refund as specified under Clause 8 of these Terms, the RA will credit that refund to the card or other payment method used by the client to submit payment, unless it has expired - in which case the RA will contact the client to proceed with the refund. If we do issue a refund or credit due to circumstances outside the obligations specified under Clause 8, we are under no obligation to issue the same or a similar refund in the future.

General disclaimers: The recommendations made herein in the Research Services are expression of views and/or opinions and should not be deemed or construed to be advice for the purpose of purchase or sale of any security, nor a solicitation or offering on any investment/ trading opportunity on behalf of the company, AMC, insurance company, or issuer of security referred to herein.

The content and research reports generated by the RA does not constitute or is not intended to constitute an offer to buy or sell, or a solicitation to an offer to buy or sell financial products, units or securities.

The information/ opinion/ views mentioned in research reports or by the RA are not meant to serve as a professional guide to the client or recipients of this Report. The research report, recommendation, or any other content published by the RA do not assure or guarantee any minimum or fixed returns to the client or recipients of the reports/ recommendations/ content.

Use of this information is at the client’s own risk. The client must make his/ her own investment decisions based on his/her specific investment objective and financial position and using such independent advisors as he/she believes necessary. The services rendered by the RA are on a best-effort basis. All information in the content or research report of the RA is provided on an as is basis. Information is believed to be reliable but the RA does not warrant its completeness or accuracy and expressly disclaim all warranties and conditions of any kind, whether express or implied.

While due care has been taken to ensure that the disclosures, information, and opinions given are fair and reasonable, PrimeInvestor Financial Research Pvt Ltd and/or none of its officers, directors, partners, employees, agents, subsidiaries, affiliates or business associates shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way whatsoever from the information/ opinions/ views contained in the research report and recommendations that form part of the Research Service, and/or mails, social media or notifications issued by PrimeInvestor Financial Research Pvt Ltd or any other agency appointed/authorised by PrimeInvestor Financial Research Pvt Ltd. Returns and performance figures mentioned in the research report represent past performance and should not be constituted to be future returns or guaranteed returns.

Any agreements, transactions or other arrangements made between the client and any third party named on (or linked to from) the Website are at your own responsibility and entered into at your own risk. Any information that you receive via the Website, whether or not it is classified as “real time”, may have stopped being current by the time it reaches you. Market price information may be rounded up/down and therefore may not be entirely accurate.

The purpose of these disclosures is to provide essential information about the Research Services in a manner to assist and enable the prospective client/client in making an informed decision for engaging in Research Services before onboarding.

History, present business and background: PrimeInvestor Financial Research Private Limited is registered with SEBI as Research Analyst with registration no. INH200008653. The Research Analyst got its registration on August 19, 2021 and is engaged in offering research and recommendation services.

Disciplinary history: There are no pending material litigations or legal proceedings against the Research Analyst. As on date, no penalties / directions have been issued by SEBI under the SEBI Act or Regulations made thereunder against the Research Analyst relating to Research Analyst services.

Details of the RA's associates: No associates.

Usage of Website Content: This Website is controlled and operated by the RA. All material, including research reports, recommendations, portfolios, ratings, lists of financial products, illustrations, statements, opinions, views, photographs, products, images, artwork, designs, text, graphics, logos, button icons, images, audio and video clips and software (collectively, “Content”) are protected by copyrights, trademarks and other intellectual property rights that are owned and controlled by the RA or by other parties that have licensed their material to us.

Except where otherwise agreed in writing with the RA, material on the Website is solely for the client’s personal, non-commercial use. Except as provided below, the client must not copy, reproduce, republish, upload, post, transmit or distribute such material in any way, including by e-mail or other electronic means and whether directly or indirectly and the client must not assist any other person to do so.

Without the prior written consent of the RA, modification of the materials, use of the materials on any other web site or networked computer environment or use of the materials for any purpose other than personal, non-commercial use is a violation of the copyrights, trademarks and other proprietary rights, and is prohibited. Any use for which the client receives any remuneration, whether in money or otherwise, is a commercial use for the purposes of these Terms.

The client may occasionally distribute a copy of a research report, or a portion of the same, from the Website in non-electronic form to a few individuals without charge, provided the client includes all copyright and other proprietary rights notices in the same form in which the notices appear, original source attribution, and the phrase “Used with permission from PrimeInvestor Financial Research Pvt. Ltd.”

While the client may occasionally download and store research reports or information from the Website for his/her personal use, he/she may not otherwise provide others with access to the same. The foregoing does not apply to any sharing functionality we provide through the Website that expressly allows the client to share Content or links to Content with others. In addition, the client may not use Content he/she has downloaded for personal use to develop or operate an automated trading system or for data or text mining.

The client agrees not to rearrange or modify the Content available through the Website. The client agrees not to display, post, frame, or scrape the Content for use on another website, app, blog, product or service, except as otherwise expressly permitted by these Terms. You agree not to create any derivative work based on or containing the research products and Content. The framing or scraping of or in-line linking to the Services or any Content contained thereon and/or the use of webcrawler, spidering or other automated means to access, copy, index, process and/or store any Content made available on or through the Services other than as expressly authorized by us is prohibited.

The client further agrees to abide by exclusionary protocols (e.g., Robots.txt, Automated Content Access Protocol (ACAP), etc.) that may be used in connection with the Research Services. The client may not access parts of the Research Services to which he/she is not authorized, or attempt to circumvent any restrictions imposed on your use or access of the Services.

As a general rule, the client may not use the Content, including without limitation, any Content made available through one of our RSS Feeds, in any commercial product or service, without our express written consent.

The client may not create apps, extensions, or other products and services that use our Content without our permission. The client may not aggregate or otherwise use our Content in a manner that could reasonably serve as a substitute for a subscription to the Website.

The client may not access or view the Services with the use of any scripts, extensions, or programs that alter the way the Services are displayed, rendered, or transmitted to you without our written consent.

The client agrees not to use the Services for any unlawful purpose. We reserve the right to terminate or restrict the client's access to the Website if, in our opinion, the client's use of the Services may violate any laws, regulations or rulings, infringe upon another person's rights or violate these Terms.

Prohibited content: The Website includes comments sections, blogs and other interactive features that allow interaction among clients and between clients and the RA. We call the information posted by or contributed by users “Contributed Content.” In the course of availing of the Research Services or uploading any post or comment on the Website, the client shall not post any Contributed Content that (i) contains nude, semi-nude, sexually suggestive photos, (ii) tends or is likely to abuse, harass, threaten, impersonate or intimidate other users of the Website and/or Research Services, (iii) is lascivious or appeals to the prurient interest or if its effect is such as to tend to deprave and corrupt persons who are likely to use or have access to the Website and/or Services, or (iv) otherwise violates, is prohibited or restricted by applicable law, rule or regulation, is offensive or illegal or violates the rights of, harms or threatens the safety of other users of the Website and/or Services (collectively “Prohibited Content”).

We reserve the right to cease to provide the client with the Research Services or access to the Website, or terminate your subscription, with immediate effect and without notice and liability, for violating these Terms, applicable law, rules or regulations and reserves the right to remove Prohibited Content which is in violation of these Terms, or is otherwise abusive, illegal or disruptive. The determination of whether any content constitutes Prohibited Content, violates these Terms, or is otherwise abusive illegal or disruptive, is subject to the sole determination of the Firm.

Changes to Research Services: We are constantly endeavouring to improve the quality of Research Services provided to our clients. Due to this, the form and nature of the Research Services provided may change from time to time without any prior notice to the client. We reserve the right to introduce and initiate new features, functionalities, components to the Website and/or Research Services and/or change, alter, modify, or discontinue existing ones without any prior notice to the client.

Warranty and liability disclaimer: The Website, Research Services, and all the materials and services, included on or otherwise made available to the client through this Website is provided by the RA on an “as is” and “as available” basis without any representation or warranties, express or implied except otherwise specified in writing. Without prejudice to the foregoing paragraph, the RA does not warrant that:

  • This Website and/or Research Services will be constantly available, or available at all;
  • The information on this Website or provided through the Research Services is complete, true, accurate or not misleading; or
  • The quality of any products, services, information, or other material that you obtain through the Website or Services will meet your expectations.

The RA, to the fullest extent permitted by law, disclaims all warranties, whether express or implied, including the warranty of merchantability, fitness for particular purpose and non-infringement. The RA makes no warranties about the accuracy, reliability, completeness, or timeliness of the Website, Research Services, Content, Contributed Content, Services, software, text, graphics and links.

The RA does not warrant that this Website, Research Services, information, content, materials, or any other material included on or otherwise made available to you through this Website, their servers, or electronic communication sent by the RA are free of viruses or other harmful components.

Nothing on this Website constitutes, or is meant to constitute, advice of any kind.

Indemnification: The client:

  1. Represents, warrants and covenants that no materials of any kind provided by him/her will:
    1. Violate, plagiarise, or infringe upon the rights of any third party, including copyright, trademark, privacy or other personal or proprietary rights; or
    2. Contain libellous, Prohibited Content or other unlawful material;
  2. Hereby agree to indemnify, defend and hold harmless the RA and all of the RA’s officers, directors, owners, agents, customers/clients, information providers, affiliates, licensors and licensees (collectively, the “Indemnified Parties”) from and against any and all liability and costs, including, without limitation, reasonable advocate’s fees, incurred by the Indemnified Parties in connection with any claim arising out of any breach by the client of these Terms or the foregoing representations, warranties and covenants. The client shall cooperate as fully as reasonably required in the defence of any such claim. The RA reserves the right, at its own expense, to assume the exclusive defence and control of any matter subject to indemnification by the client.

Applicable law: This Website, including the Content and Contributed Content and information contained herein, and the provision of Research Services shall be governed by the Securities and Exchange Board of India, laws of the Republic of India and the courts of Chennai, India which shall retain exclusive jurisdiction to entertain any proceedings in relation to any disputes arising out of the same. As such, the laws of India shall govern any transaction completed using this Website.

Information gathered and tracked: Information submitted or collected on the Website or pursuant to the use of the Services is stored in a database. Specifically, we store the username, name, e-mail address, contact number, as submitted or collected on our Website or through the provision of the Research Services. We may use such information to send out occasional promotional materials, including alerts on new Services available, or other promotional and marketing material relating to our clients and customers.

In accordance with the Information Technology Act 2000, the name and the details of the Grievance Officer at PrimeInvestor is provided below:

Mr. Srikanth Meenakshi
PrimeInvestor Financial Research Pvt. Ltd., Registered office: 659, 4th Avenue, D-Sector, Anna Nagar Western Extension, Chennai 600 101.
Email: [email protected]

11. Mandatory notice:

Clients shall be requested to go through Do’s and Don’ts while dealing with RA as specified in SEBI master circular no. SEBI/HO/MIRSD-POD-1/P/CIR/2024/49 dated May 21, 2024 or as may be specified by SEBI from time to time.

12. Optional Centralised Fee Collection Mechanism:

SEBI has operationalized a centralized fee collection mechanism for IA and RA. Under this mechanism, clients shall pay fees to IAs/RAs through a designated platform/portal administered by a recognized Administration and Supervision body. This is an optional mechanism for the registered entities. At this time, PrimeInvestor has opted out of this fee collection mechanism. Therefore, all subscription payments for the Research Services will be through the modes as specified in Clause 5 of these Terms.

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