There are more than 5000 companies listed on Bombay Stock Exchange (BSE). Out of this, large cap are typically the first 100, mid cap comprises of next 300-400 odd stocks, the rest of the universe of around 4500 companies belong to small caps (though all are not actively traded). Most research houses track and focus on 200 to 400 stocks at maximum stretch which leaves huge number of small caps (around 4500) under-researched and under-represented to investors. If you look at it, this is almost 90% of stocks not covered by research. This leaves a huge opportunity for common public to research and unearth multibagger gems from this lot. The problem is that it is easier said than done. Since we specialize in small caps, we are going to spill beans on our secret sauce of what we look into before identifying potential multibagger from the world of small caps.
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Why research houses don’t cover enough small caps?
I met a neighbor during Holi vacation and we were discussing about small cap advisory services in the market. He told me that typically most folks love to join subscriptions from big advisory firms believing they have the best talent and often some insider information. This is not the first time, I heard it. I know that this is a common perception. I asked him to think about the businesses of big firms. Their main target clients are HNIs and big investors who are a good source of revenue for them. Sadly, big investors can not invest in small caps because they invest in crores. Now if a small cap stock has total market cap of a few crores, there is no chance a big investor can buy such stock no matter how good it is. He will be stuck during buy and sell due to low liquidity. Even Warren Buffet admitted to this as he famously said that “I can make more money from mosquito but elephant is the universe I must live in”. He was referring to the big size of his investment portfolio which runs into billions of dollars. So clearly, big research houses or even mutual funds are never going to cover rest of 4500 stocks as it does not match with their investment size.
You are the lucky one: Ordinary Investor
Since big research houses and big investors are out of the game, 90% of stock market is yours. This is an advantage but world of small cap is uncharted territory with a lot of unknowns. Not to forget the mortality rate of small caps is quite higher. If you get a stock right, there should be enough people who think like you for stock price to move up. From my personal experience, I have seen many great small caps gathering dust for years until the time they are in limelight which is essential for upward movement. So it is also a test of patience for normal investor.
Spilling the Beans: What is AI’s checklist?
There are a couple of things that we look into before start believing in a stock as potential multibagger. Years of experience and reading has made us to develop our own set of framework to gauge future potential of a stock. Here are our top criteria:
- EPS Growth Rate: Number 1. Everything ultimately boils down to it. If a stock has to become multibagger, EPS has to grow. You can have various mis-leading scenarios where there is good revenue growth but fueled by loans, or even low debt company but with bad management who diverts money into their own pocket. So the bottom line is, for stock price to move up, money has to funnel down into the hands of ordinary stakeholders. If this does not happen, stock will fall apart sooner or later. Now for many companies dealing in commodity sector, business cycles can impact profitability and using this parameter, you will not be able to judge them in a downtrend. For such stocks, you have to forecast future EPS growth potential and look at how company is surviving during the downtrend (EV/EBITA ratio).
- Positive Free Cash Flow from Operations: Company has to produce cash from its business operations. If cash flow is negative then most likely it is another Kingfisher in making. Business should be self sustainable from its operations. There should be no loan requirements for running day-to-day operations.
- Manageable Debts: Typically debt/equity ratio should be less than one. However there can be some variation from industry to industry. For software companies, you will find D/E ratio very low even for bad firms. On the other hand for manufacturing or real estate companies, this ratio will be higher as they are capital intensive industries. Financial companies can not be judged by this parameter at all as they take loans to raise money which is further given to customers at a higher rate. So for financial companies, look out for net interest margin (NIM) & asset quality (ability of people to pay back).
- First generation Entrepreneurs (Management Pedigree): Again you have an edge in small caps since many promising small caps are actually entrepreneurship ventures turned into companies. Look for first generation entrepreneurs as they have built company from the scratch and have more survival instincts than the rest. If they are not first generation entrepreneurs, then they should have their heart and soul in the business.
- One quick way to check this – You can easily cross verify what management promised in last two or three years and are they really walking the talk. From past data and previous annual reports, you can easily find this out. I have seen many management painting rosy pictures in media and they default on their promises time & again (Suzlon). Review it with a reasonable time frame and if you find it not worthy, stay away from such companies.
- High Profit Margin & Business Scalability: This goes hand in hand. A company with higher margins but operating in niche segment does not have to be really scalable. For example, Boeing or Airbus caters to only airline operators offering niche products, aircrafts. They do not have to sell aircraft to every human being in this world. Their target client is a small groups of companies but margins are high which covers up to generate enough revenue. On the other hand for a company operating on wafer thin margins (less than 5%), it has to be scalable and have appeal to masses to generate enough profit. Like a superstore, D-MART or V-MART, they intend to sell their products to larger public and thereby generating bigger revenue.
- Market Capital vs Sales vs Net Profit: Since small caps are under-researched, many a times we find stocks having a revenue of ₹1000 crores but having a market capital of ₹500 crores while the competitor is having a revenue of ₹500 crores on a market capital of ₹1000cr. Such anomalies exist even today and we should keep an eye for this. Typically, this phenomenon is over displayed in a bear market or if industry is in a downward curve of the business cycle.
We have tried to cover top five or six aspects of evaluating a business from a small cap point of view. While this list is indicative, it is not exhaustive. Stock market is one of the oldest trade which has seen many great investors with their own ways to evaluate a business opportunity. Lots of great books have been written on it. You can develop and have your own evaluation mechanism which differs on parameters in paper but remains same in spirit with time-tested sucessful theories.
Having said all this, investment in stock market remains inherently risky and if you are in a full-time job and do not have enough time, please do not jump into a researcher’s role as it will backfire in future. Invest into professional services, not necessary the big research houses but the ones who are more aligned to your requirements.
At AI, we interact with a human touch and not with system generated emails. We specialize in small caps. Our clients are in regular touch with us on whatsapp to enable healthy discussions. This leads to a mutually rewarding relationship (see customer testimonials on home page). In long term, you are bound to make money with us but this journey is equally important to us.
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