Small-caps outperforming large-caps; how you can make your smart bet
While small-cap stocks have potential to yield higher returns than large-caps, they also carry higher risks. Here's a road map for investing in these stocks.
Advantages of small-caps
Many small-cap stocks are undiscovered gems. If you manage to identify a good company in the early stages of its growth cycle and ride it all the way till it enters the ranks of mid-cap stocks, your gains could be considerable.
Moreover, on a low base, growth rates in these stocks tend to be very high. Since the returns from stocks are a function of earnings growth, such high growth can translate into high returns for investors.
A recovery in the Indian economy is widely expected. "In a stable or improving economy, as is the case at present, small-caps tend to outperform large-caps," says Vinit Sambre, fund manager and VP, DSP Black-Rock Investment Managers.
Small-cap stocks are not as widely researched as large-caps. Therefore, your chances of discovering stocks where a wide discrepancy between price and intrinsic value exists are quite high. You can often pick these stocks at very low prices. If the stock later catches the fancy of institutional investors, you could have a multi-bagger.
While offering the potential for higher returns than large-caps, small-caps also carry higher risks. The most significant one pertains to management quality. Since not much is known about these companies, it is difficult to assess the quality of the management and promoters. If the quality of the management is not high, the company is often not able to sustain its growth.
Corporate governance is another issue.
"What you see in the balance sheet and the profit and loss statement may be very different from the actuals," warns Raghvendra Nath, MD, Ladderup Wealth Management.
Thus, one can't be sure whether the aggressive growth displayed by the company is the result of performance or cooked books.
The business model of small-caps is also untested. It is difficult to tell whether today's fast grower will be able to scale up, and stay profitable while doing so. The earnings growth witnessed over the past five years may not get replicated over the next five.
Small-cap stocks also have a low level of liquidity. Typically, the amount of floating stock is very low. "Their price can be easily manipulated," says Nath. Even a small amount of buying can send prices soaring, and vice versa. Moreover, when the economic climate worsens, investors flee to the safety of blue chips. Offloading a large position in small-caps can then become difficult, or only be possible at a steep discount.
How much should you allocate?
Given small-caps' potential to outperform, investors should always have an allocation to them. Depending on the risk appetite, they could constitute 10-20% of their equity portfolio. Moreover, small-caps tend to outperform during an upswing and underperform in a downturn. "If your financial adviser can identify such cycles in advance, you may make some tactical modifications to your long-term allocation," says Sambre.
Tips to contain risk
Since small-caps are more risky, they should be selected with a lot of caution. Prior to investing in them, you should do a lot of research.
"Only invest in companies with sound fundamentals—a high-quality business run by a high-quality management offering quality growth," says Nath. According to Sambre, in order to reduce risk in his small-cap portfolio, he interacts regularly with the management, the competition and other stakeholders to ensure the business is on track. While you may not be able to do track so intensively, at least read the annual report, reports issued by brokerage house analysts, and stories about the company that appear in the media.
While assessing a business, make sure that the company has a competitive advantage in its field. Also, the area that it operates in should offer a lot of opportunity. Only then will the company be able to scale up.
The management must also possess the necessary vision and drive to be able to take the company to a higher level. Check what the management had said about its intentions three-four years earlier and see whether this has come about. It will give you an insight into its execution capabilities.
Instead of investing in just a couple of small-caps, bet on a basket of these stocks spread across sectors. Finally, don't enter smallcaps when the market is near its peak.
All the three stocks selected have received investments from mutual funds. They are fast growers, whose revenue as well as profit after tax has grown at a compounded annual rate of above 15%. They boast an average return on capital employed (RoCE) of above 15% over the past three years, and their debt equity ratio is below one.
Siyaram Silk Mills: Siyaram Silk Mills (SSM) is the largest manufacturer of blended fabrics in India with a 4% share of the organised market. It has strong brands, such as Siyaram's, Mistair, MSD, J. Hampstead and Oxemberg. Its distribution network comprises 1,600 dealers and 500 agents who supply to 40,000 outlets. It has around 160 franchised stores and it plans to increase these to 500 by 2016-17.
According to a report from Angel Broking, Siyaram's growth will be driven by rising demand for blended fabrics and shift in preference towards branded fabrics. The company's brands enjoy high recognition. Access to a large number of retail stores allows it to launch new brands at a low cost and with a high degree of success. The company is also trying to change its product mix towards premium offerings enjoying higher margins.
SSM faces competition from unorganised players who sell at lower prices. The price of polyviscose, the company's key input, is susceptible to spikes in the price of crude oil. In the third quarter, the company had posted lower-than-expected numbers amid poor consumer sentiment. However, its longterm prospects remain sound and its current valuation is also not high.
Lovable Lingerie: Lovable Lingerie (LL) manufactures and sells women's innerwear products. It possesses strong brands, such as Lovable (premium segment), Daisy Dee (mid-segment) and College Style. The women's innerwear market is smaller than men's, but is expected to grow at a faster pace of 12-13% annually.
LL is expected to gain from the growing preference for recognised brands and the growing penetration of organised retail, which sells branded products. The attractiveness of the Indian innerwear market has led to most leading multinational brands entering the country. While this has increased competition, their advertising initiatives have also expanded the market.
The multinationals are positioned in the premium and super-premium segments, while LL has focused on the fashion-at-areasonable-price segment.
Weak consumer sentiment has affected LL too. According to a note from ICICI Direct, the company aims to maintain its margins through price hikes and lower ad spend. It also plans to foray into the men's innerwear market via an acquisition. Its strong position in the women's segment and attractive valuation make LL a sound pick.
Solar Industries India: Solar Industries India (SOIL) is India's largest manufacturer of industrial explosives and explosive-initiating systems. It has a licensed capacity of 2,50,000 MT per annum and 30% market share. It is the largest supplier of explosives to Coal India and also exports to over 20 countries in the Middle East, Africa and Southeast Asia, accounting for 65% of India's explosives exports. Besides 16 manufacturing units in India, it has also set up plants in Nigeria, Zambia and Turkey.
Since SOIL's business requires licensing, the company enjoys an economic moat—a competitive advantage that is hard to overcome.
The company is now entering the defence business and has obtained the licence for manufacturing new-generation explosives and propellants.
The current slowdown in the mining and infrastructure sectors is the key concern for SOIL. A sharp upswing of the rupee also has the potential to affect its export earnings. It also faces concentration risk: its top three customers account for 30% of its revenue.
The company's stock has a price-earnings to growth (PEG) ratio of above one, and its current PE is also above the five-year average.
According to an analyst at Edelweiss, the commencement of the defence facility, expected in late 2014-15 or early 2015-16, will be the next trigger for the stock. While its prospects are sound, investors should buy this stock only on corrections.