Saturday, April 4, 2009

Small-cap Stocks: Analysis of Risk-Reward Ratio


Quote of the Day: "A small-cap stock may bloom into a multi-bagger, but all multi-baggers need not necessarily be from small-cap space" (by Myself).

Like, for example, if you buy a mid-cap or for that matter even a large-cap stock at the fag end of the bear market and sell it at the peak of the next bull phase, the stock can give as astonishing a returns as any small-cap, albeit with an assured degree of certainty. But is it possible to time market entry and exit in such a manner? Not really!

Small Cap stocks are nothing but stocks with small market capitalization levels, say, for example, stocks with Market cap of Rs.500 crore & lower than that. Though, this can not serve as a strict reference for classifying stocks on the basis of current market capitalization levels, as market capitalization levels of such stocks tend to depict sharp changes in different phases of stock markets. Like, for example, a small-cap stock can soar into a mid-cap during a scorching bull phase. Likewise, even a good mid-cap stock can meltdown into small market capitalization levels during times of extreme distress like the current bear phase.

So, some times such classification references serve only as a ‘relative’ factor based on market conditions. But, one can carry on with the classification of stocks based on the size (or net worth)of their business and market capitalization both, to arrive at a clearer market position of the company.



PECULIAR FEATURE OF SMALL-CAP STOCKS:

One peculiar feature about stocks from small-cap category is that they tend to provide multi-bagger returns over a period of time, especially, during bull phases. On the other hand, it takes a relatively very long period of time for such buzzing returns from large-cap counters unless such stocks are bought at depressingly low valuations at the fag end of the bear phase and are held until the peak of the next bull phase, which is very tough to do as it amounts to accurately predicting and attempting to TIME the market entry and exit.

But, the selection of such multi-bagger stocks is one of the toughest decisions to make as it involves researching and studying hard into various factors like fundamentals of the company, virginity level of the stock visibility, liquidity levels of the stock on the bourses, coverage of the stocks by the analyst fraternity, prospects of the company fundamentals in the light of globalizing economy and fiercely competitive business scenario, financial position of the company and adaptability of constantly changing business environment among various other analyzing aspects.

SAILING AGAINST THE TIDE:

Smaller companies can be classified into two categories viz. one which has established new business venture having dynamic growth prospects and the other one being those who are involved in niche business operations with some degree of monopoly in market share. But, they may not be financially as sound and strong as large-caps. Most of such small companies, often, face one or multiple set of problems like weak cash flow, low market reach, talent crunch, intense competition, lower linkages to sources of funds, etc.

The real test of such small-cap companies come during such extreme periods of slowdown and recession. Liquidity crunch, high attrition levels, high cost of borrowing, drying of order flow and lower credit rating among other aspects are a true test of sustainability for such companies in such times.

STORY OF HIGH RISK & HIGH RETURNS:

Small–caps are often considered as virgin stocks with little visibility among general investors and most of the other market participants. Due to this very reason, these stocks largely trade at lower valuations and sometimes even under-valued with respect to their business potential. But, at the same time, Investments in small-cap stocks are fraught with HIGH RISK and corresponding high returns if your bet falls true.Prices of such stocks sometimes tend to swing irrespective of fundamentals & news flow, especially, during bullish times. Similarly, these stocks are the first on the boat to witness a sharp meltdown during times of distress.

LACK OF INTEREST FROM INSTITUTIONS:

Small-Cap stocks are often characterized by lower levels of interest & indulgence of markets participants in it, especially, QIB & Institutional investors. Even mutual funds have certain limitations in holding stakes in Small-cap stocks. Usually, fund houses concentrate on highly liquid large-cap & Mid-cap stocks in their portfolio. Retail investors are, often, the scapegoat of holding this kind of high risk investments. But, on the other hand, if the bet holds out fruitful, that there is every likely possibility that the retail investor also acquires the first mover advantage of buying this stock at its nascent stage of evolution

Such investors from bulge bracket category often resort to bulk trading which demands high liquidity in the counter so as to allow them swift entry and exit at their convenience. Suppose, a fund house has researched into a small-cap stock and based on its fundamentals want to buy a stake in a small-cap company for as much as 3-4% of its own portfolio, they may have to defer their purchasing transactions over a period of few weeks due to dearth of sellers.

But, again retail investors holding such stocks with low on supply volumes provides opportunity of gaining returns circuit on circuit on the bourses for such small counters with high demand. Though, the same theory also works on the downside when there is over-shoot in supply of paper and there are no buyers willing to buy during times of crisis or bear phases.

ONLY FOR STRONG HEARTED:

It is highly recommendable for Low risk and medium risk investors to stay away from these sort of volatile investment destinations. In fact, even High risk investors should not indulge in such small-cap stocks with uncertain future for more than 10-15% of one's over-all portfolio.

Many a times, it so happens that even after critical evaluation some small-cap stock remain dwarfed and are never able to graduate into mid-cap category. During such times, even the critical analysis and research of the past goes haywire as some of the analyzing aspect does not bear expected fruits. Even management of the company plays a vital role in seeing the company at the next stage which may not fructify in case of low ambitious & autocratic top management views and thoughts.

PIECEMEAL APPROACH FOR DIVERSIFICATION OF SMALL-CAP PORTFOLIO:

While investing in small-cap stocks do not rely or bet on concentrated list of companies. The future prospects of small-caps are fraught with uncertainty and fragile in nature. The stock price movement may not necessarily move in synch with market condition unless there is a certain degree of confirmation of the business potential of the company. So, it is always better to diversify the small-cap sector portfolio to ride through the volatility of the stocks in the sector more swiftly.

Spread the small-cap portfolio amongst 3-6 companies depending upon the amount you are willing to invest in such stocks. Even if a couple of stocks are stagnant or under-performing the markets, the other rising stocks can make up for the loss of opportunity in the former couple of stocks. Small-cap stocks need not necessarily provide returns in a short span of time. A long wait out may be needed, even during the bull phases. Sometimes, the fortunes of some small-cap stocks may turn at the last stage of bull phase and hence it often depends on your patience, perseverance and confidence in the company’s ability and prospects to determine the potential returns for your hard earned money.

MULTI-BAGGER RETURNS DURING BULL PHASE:

At the same time, the chances of finding multi-baggers in one of these stocks can also not be ruled out. Such stocks may provide regarding returns in terms of 'Number of Times' instead of 'Small Percentage Gains'. The only requisite being your bet should fall true & you should have patience to remain invested in them & wait for the next bull run to see sharp rallies in such stocks.I've recommended a few stocks under the section of 'DARK HORSES' most of which are Small-caps or even little bigger in size. Hence these stocks can not be strictly termed as Small-cap stocks. But, it is better to bet on such smaller stocks, with some sort of known & clear fundamentals, business prospect and operations in Niche segments of their respective industry, rather than relying completely on absolutely unknown & fragile stocks.

DARK HORSE LIST:

1) Kalindee Rail
2) Bartronics
3) Time Technoplast
4) Ess-Dee Alluminium

All the above stocks can not be clipped strictly under Small-cap category. But some of these small companies operating in Niche businesses have potential to graduate into big mid-caps stocks over a period of time.

SOME MORE SMALL-CAP STOCKS:

Below is the list of some other companies from Small-cap category. These lists of stocks are not recommendation by any means. So, do not fall in to it without your own sound research and due diligence:

1) SREI Infra
2) MIC Electronics
3) Rajesh Exports
4) Spice Jet
5) Mysore Cements
6) Electrotherm (India)
7) Suven Life Sciences
8) Aegis Logistics
9) Venky's India
10) Hitachi Home
11) Manugraph India
12) Zicom Electronic
13) Compact Disc
14) Piramal Life Sciences

15) Temptation Foods


WHETHER TO INVEST IN SMALL-CAPS AT THE PREVAILING STAGE OF BEAR PHASE:

There is also another side to the story of high risk attached with small-caps. History suggests that small-cap investments are subject to high risk and volatility. But, some analysts of small-cap counters suggest that even most of large-caps have melted down by over 50% in current bear phase and not to mention 80-90% slump in the stock prices of some of the most prominent and favourite mid-caps of investor fraternity.

So, isn’t investment in small-caps more fruitful as they have capability to provide multi-bagger returns, whereas the difference between risk ratios involved in small-caps & mid-caps being almost negligible?

Indian stock market indices have corrected more than 50% from its peak levels of Sensex 21000 during the last 1 year. There is a global recession going on led by leading western countries and slowdown in most of the fast emerging Asian countries led by China and India.

Usually, markets tend to factor in the worst way before the economy bottoms out. Indian markets have also witnessed a sharp slowdown and a substantial slump in its leading stock indices. Same is the fate for all categories of counters right from small-caps to large-caps. Though, stock prices of large-caps have depreciated lesser as compared to mid-caps and small-caps based on their sound fundamentals and market leadership.

If investors feel that the worst for the Indian markets may have been somewhat factored in, they can proceed further with investing their money in small-caps subject to proper understanding of the risk-reward ratio in such counters and their own investment and income profile. The above is just a list of indicative stocks from small-cap category from my side. Investors should carry out their own due-diligence and research analysis before investing in any of the above stocks.

NOTE FOR SMALL-CAP INVESTORS: As per past trends in equity markets, small-caps usually bloom somewhat during the peak of the bull markets. As the bear market phase is up for wraps, the rally is largely led by large-cap counters only to be followed by mid-cap space. Small-caps take part of the rally, only if the sanguine market scenario is sustainable for a longer duration.

Going by that, we are still somewhat at the bottom or the fag end of the bear phase. Markets will certainly show lots of consolidation and range bound movements marked by profit booking at regular interval. This would mean, investing in small-caps at current juncture would not provide an instant opportunity of making quick and smart gains in near to medium term. But, most of such stocks may be quoting at attractive valuations. So, only long investors are recommendable to indulge in small-cap counters who have stomach to ride out the volatility and fluctuation (or rather stagnation) in such space for times to come.



A Request to Readers:
Readers are requested to post their views on Small-cap stocks in the below given 'Comments' section. They can also share their list of favourite small-cap stocks which they feel can provide Multi-bagger returns going forward. Make this topic on small-caps more interactive and interesting by sharing your thoughts on stocks from small-cap category.

Disclaimer: All data, content and/or reports posted by Viral Rajnikant Dholakia on this site are only for information and educational purpose of visitor/readers of this blog. It does not constitute to be a recommendation/offer/advice to buy or sell assets/securities in any form. Individuals/organizations are requested to take an informed call by consulting their Financial Advisor before acting on any matter/data published on this blog. This blog does not warrant of any kind of accuracy, adequacy and completeness of data, ideas or thoughts published in it. This site and Viral Rajnikant Dholakia assumes no responsibility or liability or loss or damage of any nature for your trading and investment decisions and its consequent results.

15 comments:

Shabu's said...

Dear Bulls,

Marvelous... I am in more love with Small-Mid Cap stocks and I feel more confident after reading your post. As you said, the selection process of such stocks are very much thorny, but the returns are also very high.

Followign are few of my considerations under study.

Assam Company
Nectar Life
Taneja Aerospace
Avon Weighing
Alok Industries
Western India Shipyard
Guj State Fert Corp
Global Vectra
TVS Motors
Kolte Patil

Please comment..

Faisal Humayun said...

One note on the small caps in the current economic scenario...

The small caps usually have little of negative cash flow...Some large caps on the other hand have huge cash inflows...So what happens is that if we have a 2-3 year slowdown then the cash position of small caps even goes from bad to worst...for large caps the cash position somewhat weakens but its still good...

now when the economic recovery comes the large caps still have enough cash to fund their day to day business and also expansions while the small caps struggle...in this scenario the large caps will be the ones who will be outperformers in my opinion in the current markets and also during the economic recovery stage...

It will be somewhat later the small caps will also join the good phase...So in my opinion while small caps create the biggest multibaggers for individual portfolios its better to be in large caps with good cash for now...

DARK KNIGHT ABHAY said...

great post viral ji..

so can one consider penny stocks and small caps as the same..
because penny stocks are usually small caps.


abhay

Viral Rajnikant Dholakia said...

Mr Shabu... Thank you for the comments & your nice little list of small caps. As such, Alok Industries is a mid-cap stock. But since the stock is out of favour it seems a small-cap stock right now.

Thats what i meant to say in the introduction of this posting on small-caps, that sometimes situations are not favourable & stocks tend to provide wrong signal as to which category of Market Cap do they belong to.

Mr Faisal... Thank you for the analytical comment & i almost agree with your views on small-caps.

Mr Dark Knight Abhay... There is a small line of differentiation between 'Penny Stocks' and 'Small-cap Stock'.

Penny stocks are usually those which trade at very small stock values like stocks trading below Rs.10 or Rs.5 or sometime even below Re.1.

Whereas small-caps are the ones with Lower Market Capitalization. They need not necessarily quote at lower stock values.

All penny stocks are small-cap stocks, but all small-cap stocks need not necessarily be Penny stocks.

Mohit said...

Thanks for great article bulls,

Can you put some more light on prospects of Suven Life Sciences

Thanks

MOhit

Shalu said...

Dear Viral, thanks again for your post. Although I'm now confused, which small cap to go for? I think I should stick to large cap, mid cap.....

Viral Rajnikant Dholakia said...

Dear Mohit,

Suven Life Sciences is the Hyderabad-based drug company involved in manufacture of bulk drugs and drug intermediates. The company derives a major part of its revenues from exports to the extent of 2/3rd of total revenues.

Suven Life Sciences is leading company involved in Contract Research and Manufacturing Services (CRAMS). The company is involved in alliances with many big pharma companies and partnering various research initiatives in the Life Sciences space.

The company main area of specialization remains R&D on Central Nervous System disorders like Alhzeimers, Depression, etc.

Currently Suven Life Sciences is quoting at an approximate Market Cap of Rs.155 crore. The stock had touched the high of Rs.70 odd during the peak of the bull phase a little more than a year ago. Currently the stock is quoting at Rs.13 after forming a trough of Rs.9.

A major problem with this small-cap company being lower EPS since past many years. Though, the sales of the company have witnessed a nice year-on-year growth during the past 5 years. However, the Net Profits of the company have remained almost stagnant in spite of growing sales, which seems to be an area of concern pointing towards depressing Margins for the company's operations.

This company operates in a Niche space of Life sciences which is moving well ahead to be the next emerging sector on the horizon. High Risk Investors interested in Small-Cap investments with a long-term view of 3-5 years can buy stakes in this company with a staggered approach.

NOTE: Investment in this small-cap stock should not cross more that 3% of the over-all portfolio. This implies even for investors with high risk appetite.

Ashish said...

Hi Viral,
Can you give the rationale behind Temptations foods. In my opinion this company should be strictly avoided because of it's suspicious activities especially in case of Kohinoor foods. In fact SEBI had given warning and some investigation is still going on. Though this company had given astounding returns during the last bull run(from some 10 rs to 200 something) but after Kohinoor incident this stock has been heavilly battered down. This clearly raises some doubts over managements intentions.

let me know your thought on this.

-Ashish

Viral Rajnikant Dholakia said...

Dear Ashish,

Temptation Foods:

Temptation Foods is the largest Indian company in the space of frozen foods & Vegetable business. The company also has substantial sales in overseas countries like US, Europe & Middle East. The company is a major gainer from the booming domestic retail sector business.

The company has recently made some useful acquisitions which would help it in enhancing its market share and reach. The company has more recently also ventured into Marine food business.

Mr Ashish...
Coming to your point of contention:

Recently Kohinoor Foods Ltd. had placed complaint with SEBI for alleging that Temptation Foods had mis-declared to the bourses the stake it holds in Kohinoor Food.

With regard to the above, the company has given clarification that it holds 11.98% stake in Kohinoor Foods & 1.71% being held by Venture Business Advisors Pvt. Ltd., the Promoter of the company.

NOTE: The promoters have pledged 90.33% of the total number of shares held by them in the company (Temptation Foods).

santy said...

Hi Viral,

In your small cap stocks, there are couple whihc belong to the packaging industry , namely , Time technoplast and Ess dee aluminium. Time technoplast is more diversifed play while Ess dee ia mainly into packaging. What would your pick be among these two?

Thanks,
Santy

Viral Rajnikant Dholakia said...

Dear Santy,

Time Technoplast is involved in sale of Packaging products & solutions with Polymer base. The company's products cater to various industries like consumer packaging solutions, Life style products, auto components among various other industries.

Whereas, Ess-Dee Alluminium is involved in manufacture of Aluminium Foils and Poly Vinyl Films based packaging products. The company's packaging products cater to various different industries like Pharmaceuticals, FMCG, etc.

Going by above, there is little to choose from between the 2 companies. Though, i prefer Time Technoplast over Ess Dee. Stock of Ess Dee Alluminium may be more volatile & dependent on the fortunes of ALLUMINIUM prices as a Commodity which is the basic raw-material for the company's products.

On the other hand, Time Technoplast provides products & solutions to various diversified industries like like consumer packaging solutions, Life style products, auto components whereas Ess Dee main focus of area is Pharmaceutical industry.

Ashish said...

There are 2 more companies I can think of in packaging space. Parekh Aluminex and Radha Madhav corporation ltd. Both with tremendous potential and excellent past track record. Best thing is that these are available at very low price (P/E 2.9 and 1.9 respectively) and candidate to have a look for long term investment.

-Ashish

Antriksh Patel said...

Dear Viral,

You have been posting wonderful articles, and they are a great help to me and hope the same for all others who are here as well. I think now the bottoms of the majority of large caps like Larsen and Tubro, RIL, Tata Steel, Sterlite Industries and Sesa Goa will change. How about predicting them. I tried to do that but could not.

Moreover the stocks where FII holding is quite high viz. Jain Irrigation, Educomp, Financial Technologies they might revisit to the same (earlier) bottoms. I would like to have some insight onto this.

What is your say Viral.

Regards.

jamesvaikom said...

Sir,
Please share the dis advantages of srei infra. My broker is bullish on this stock. Srei imports infrastructure equipments and provide financing for buyers of these equipments. When I checked the cash flow I found that they are getting money through financing activities. I thought that they are getting money through debt. But actually they are getting money through re-payment of loans they give. Their loans and advances are much greater than total debt. Please share your view on this stock.

Viral Rajnikant Dholakia said...

Dear Jamesvaikom,

SREI Infrastructure Finance is one of the leading Non Banking Finance Institution in the private sector. Government is taking concerted efforts to strengthen the Indian infrastructure and this company is involved in financing companies in the infrastructure related businesses. The company is engaged in financing infrastructure equipments, infrastructure projects & advisory services in the infrastructure arena.

With reference to your query on cash flows, the cash flows are positive. This year during the December 2008 quarter, the company has witnessed a significant drop in Sales and profits on the back of severe slowdown in infrastructure spending on the back of recessionary environment across the globe. Lower EPS remains a problem for the company.

Over-all, it’s a good small-cap stock to own from long-term perspective. But, if u can resist, I would rather recommend you to go for another Infrastructure stock from NBFC space – IDFC. It is a much bigger and well-managed company but from mid-cap space. Buy IDFC in the range of Rs.45-55.