Have you of late looked at stocks of small companies for investing? Though they are rarely on the top of investors' priority list, they can give very good returns, provided they are chosen with care.

Consider this. Nine small-cap stocks more than doubled between January 1 and June 3. Global Infratel and Finance led the pack by rising nearly 10-fold; it rose 960% from Rs 6.93 to Rs 73.4. Among the other gainers were Westlife Development, which rose 491% from Rs 187.35 to Rs 1,107.25, Turbotech Engineering (Rs 153 to Rs 448.95, a 193% rise), Radford Global (Rs 37.87 to Rs 84.25, a 149% rise), and Ajanta Pharmaceuticals (Rs 385 to Rs 950.90, a 147% rise).

The Bombay Stock Exchange (BSE) small-cap index fell over 20% from 7,452 to 5,936 during the period. However, the benchmark, the BSE Sensex, rose 0.15%.

While small-cap stocks can give big gains, the losses, too, can be huge. For instance, nearly the entire value of Chromatic India and Sudar Industries was wiped out between January 1 and June 3. While Chromatic Industries fell 97% from Rs 124.75 to Rs 4.21, Sudar Industries fell 93% to Rs 11.07 from Rs 159 on January 1. The other top losers were Aanjaneya Lifecare (down 92% from Rs 752 to Rs 60.15), Tuni Textiles (down 91% from Rs 127.40 to Rs 10.34) and Orient Paper and Industries (down 91% from Rs 79.65 to Rs 6.71).


PROS AND CONS

Small-cap stocks are not tracked closely by market analysts and that is why the real value of good smallcap stocks can remain undiscovered for long. This makes investing in them risky. But the rewards of finding a hidden gem are huge too, for such a stock may become a midcap or even a large-cap stock over time, giving superlative returns.

"Small-cap stocks are like trees that have just been planted. Obviously, they will take a few years to grow and blossom. They can be good bets for the long term," says Gokul Raj P, executive director and head, investments, HBJ Capital Services.

On the flip side, small-cap stocks have a low equity base, which is why selling/buying can take time. If one buys a wrong stock, a prompt exit is difficult. Also, many small companies are young, with a very short track record. Hence, judging their performance is difficult.

"Small companies are relatively weak in terms of governance, dividend policies and professionalism of the board. This makes them risky. When times are tough, large companies sail through, but the smaller ones are at the receiving end," says Vishal Jajoo, senior research analyst, Nirmal Bang.

FACTORS TO WATCH

Small companies are struggling with high borrowing costs, low demand, power shortage, and high wages and commodity prices.

"Most companies are being forced to either sell assets to pay off loans or pledge shares to raise funds. Higher imports from China and currency volatility are also putting pressure on margins," says Alex Mathews, head of research, Geojit BNP Paribas Financial Services.

Between January and March this year, Cinemax India promoters pledged 93% shares held by them. Essar Shipping, AGC Networks, Asian Hotels (North) and Plethico Pharmaceuticals promoters pledged 75%, 72%, 72% and 67% shares held by them, respectively.

Now, let's look at some aspects that need to be looked at while buying small-caps stocks.

Track record of promoters:
The first thing one must check is for how long the promoters have been in the business and whether they are backed by a strong team. "Usually, we have a face-to-face talk with the management and visit the facilities of the company before recommending a penny or small-cap stock," says Gokul Raj P of HBJ Capital Services.

However, retail investors have no option but to rely on research reports on this count.

Promoters' stake:
A high promoter stake shows his confidence in the business. You should also ask if the promoter plans to increase his stake. "One has to be extremely cautious while investing in smallcap companies. Attributes such as promoter holding, shares pledged, return on equity and debt-to-equity ratio should be considered carefully," says Jajoo of Nirmal Bang.

Business model:
A unique and robust business model augurs well for the company in the long run. If a small company is present in areas dominated by those with deep pockets, then chances are that it will close shop sooner than later.

Debt figures:
High debt means the interest outgo is huge, which can be a big drag.

Institutional holding:
Experts say institutions avoid buying shares of small companies due to lack of liquidity. But if you come across a small company in which institutions have bought stakes, you need to take the stock seriously. But be careful, as institutions can also take wrong calls.

INVESTMENT OPTIONS

There are 509 stocks available for trading in the BSE Small Cap index. Out of them, 11% are from the capital goods sector, followed by finance (10.7%), housing (9.75%), metal and mining (5.73%) and health care (5.39%).

"Small-cap pharmaceutical, FMCG, information technology and banking stocks can give good returns," says Mathews of Geojit BNP Paribas Financial Services.

However, Gaurav Dua, head of research, ShareKhan, advises caution. "Identifying small-cap stocks is more of a bottom-up exercise (being stock-specific) rather than a sector-specific call."

Here are a few small-cap stocks that market analysts feel can give good returns in the next few quarters.

Cera Sanitaryware:
The company has been registering strong growth over the last four years. Its net profit has been rising 24% on an annual basis since March 2010. For the year ended March 2013, the company posted a net profit of Rs 46 crore as against Rs 19.6 crore in 2009-10, Rs 26.54 crore in 2010-11 and Rs 32.04 crore in 2011-12.

Since the start of the year, the stock has risen over 25%; it was at Rs 516 on June 3 as against Rs 405 on January 1. "Cera Sanitaryware is a debt-free company with strong brands. It is strategically placed to repeat the performance over the next couple of years. The stock can touch Rs 700 in the next few years," says Jajoo of Nirmal Bang.

Development Credit Bank:
It is an emerging new-generation private sector bank with 94 branches and 272 ATMs. Its unique selling proposition is the promoter background. The promoter, the Aga Khan Fund for Economic Development, is present in 16 countries and employs over 30,000 people. It holds 18.47% in the bank.

In 2012-13, the company reported 85% growth in net profit due to lower provisioning and higher margins. It posted 25% growth in advances, which it is expected to maintain in the near future. "With improvement in book quality and return on assets, the bank is likely to see a re-rating of its valuation multiple. The stock can touch Rs 60 in the next 12 to 18 months," says Siddharth Rajpurohit, senior research analyst, Tathastu Advisory. On June 3, it was at Rs 44.

Rajiv Mehta, assistant vice president, research, India Infoline, is also positive on the bank. "Improvement in asset quality is likely to continue backed by secured lending and effective monitoring. Net interest margins will remain healthy at 3.25-3.30%," he says.



Deepak Nitrite:
One of the oldest chemical makers in India with a vast experience of handling hazardous chemicals, Deepak Nitrite is an industry leader with 62% share of sodium nitrate and nitrite markets. With its new plant in Dahej, it will be the world's first fully-integrated optical brightening agent manufacturer. "The brownfield expansion at Nandesari will enable the company to maintain market share amid rising global demand for sodium nitrite and nitrate. The new unit can produce enhanced solar salts which are under research for use in solar panels. The stock can touch Rs 330 in the next 12 months," says Rajpurohit of Tathastu Advisory. On June 3, it was at Rs 268.

VA Tech Wabag:
VA Tech is the largest player in the water management space and therefore will be a key beneficiary of the huge investments that are expected to be made to tide over the rising water scarcity.

"Margins are expected to expand over the next two years and earnings are likely to grow by 18-20% per annum. Current valuations do not reflect the robust financials of the company. We think the stock can touch Rs 668 in the next 12-15 months," says Mehta of India Infoline. On June 3, it was at Rs 467.

For the year ended March 2013, the company posted a net profit of Rs 90.11 crore, up 20% from Rs 75.12 crore in the financial year ended March 2012.



HSIL:
Hindware is the undisputed leader in sanitary ware with over 40% market share. The company's 1,600-strong dealer network gives it an edge over peers.

"Since the company is a market leader with significant competitive advantages and a lot of pricing power, investors don't need to watch input price volatility. We think the stock can touch Rs 300 in the next two years," says Gokul Raj P of HBJ. On June 3, it was at Rs 103.15.

Sun Pharma Advanced Research Company:
The company makes advanced pharmaceutical ingredients and generic drugs. It reported a net profit of Rs 44 crore for the quarter ended March 2013 as compared to a loss of Rs 21.58 crore in a year-ago period on the back of a sharp rise in operational income. The promoters hold 67.13% in the company, which recently received the US FDA response on "Levetiracetam NDA". Mathews of Geojit is upbeat on the company. "The stock can touch Rs 250 in the next few quarters," he says. On June 4, it was at Rs 159.95.



New Delhi Television:
NDTV reported better-than-expected numbers in the fourth quarter of 2012-13. It booked a consolidated net profit of Rs 29.87 crore compared to a loss of Rs 44.68 crore in the corresponding quarter a year ago. The reason for this sharp turnaround is cost-cutting and digitisation. The latter helps in checking underreporting of subscriber numbers and enables broadcasters to command a premium on ad rates.

"Digitisation is expected to increase revenue and bring down carriage charges. The stock can touch Rs 140," says Mathews. On June 3, it was at Rs 91.50.

JK Lakshmi Cement:
For financial year ended March 2013, the company posted a net profit of Rs 175.74 crore in 2012-13 as against Rs 108.78 crore in 2011-12. Nimit Shah, analyst, ICICI Securities, says, "A favourable market mix (60% North and 40% West) and capacity expansion (from 5.3 million tonnes to 10 million tonnes by 2014-15) will lead to higher-thanindustry growth and margin expansion. We expect revenue, operating profit and annualised net profit growth of 17%, 20% and 18%, respectively, over 2014-15. The target price for the stock is Rs 140." On June 3, it was at Rs 109.25.