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.

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