If you follow smart money and chase growth, now is a good time to go for bargain hunting in the small- and mid-cap stocks. Big companies are acquiring global scale, but it's the small companies that are playing a stellar role in the economy and where the true growth story is. They (the small companies) straddle a wide variety of growing and sometimes niche business that big companies usually don't get into. And these businesses are extremely profitable.
While the BSE Sensex companies recorded a solid revenue growth of 34 per cent in 2006-07 over the previous financial year, the growth in profits in the same period was 36 per cent. Profits were higher at 42 per cent in the companies that constitute the BSE's Mid-cap Index, despite a lower revenue growth of 22 per cent. But the biggest growth, by far, came in the BSE's small-cap companies that saw revenues increase by just 16 per cent, but profits zoom by an astounding 381 per cent. Little wonder then, the BSE's small- and mid-cap indices have been outperforming the dominant Sensex stocks since the beginning of this year (see Smaller Stocks Shining).
Now, smart money too is chasing these stocks. Mutual funds are increasingly launching new funds that are targeted purely at the small- and mid-cap space. ICICI Prudential, Reliance, Franklin, and HDFC have launched small- and mid-cap funds and are expected to invest about Rs 3,500-4,000 crore in these stocks. The flows will keep interest alive in this segment. Brokers, too, have begun to get bullish about the sector-and with good reason. Rajen Shah, Chief Investment Officer, Angel Broking, says he is "extremely bullish" on small- and mid-caps because there are dozens of such stocks that have been 'under-owned' and have underperformed the market despite great potential.
On Attractive Grounds
The time has come
For a long time, the markets focussed on large companies. Foreign institutional investors were investing in big companies because they could buy and sell large quantities of these stocks without disrupting the daily trading. As a result, small companies underperformed the markets. "Since October 2005, the BSE Sensex moved from a level of about 7,500 to around 14,500, but these smaller stocks have barely grown by 5-10 per cent. Many currently trade at P-E multiples of only 7-10, represent fast growing businesses, and are also attractively priced. In the next few months, there's about 20-30 per cent upside to their valuations," says Shah.
Among his favourites are Ballarpur Industries, Coromandel Fertilisers, Atlas Cycles Haryana, Finolex Industries and VST Tillers. Some small-caps are in booming segments and also own undervalued assets. Bangalore-based farm equipment company VST Tillers, for example, has a market cap of about Rs 80 crore (in early June), but its land holding in Bangalore alone is worth Rs 160 crore, notes Shah. The company, which posted a net profit of Rs 3.6 crore on gross sales of Rs 40.73 crore in Q3 of 2006-07, is also expected to gain from the government's increased investment in the farm sector.
"Small- or mid-sized companies are the ones that represent great investment opportunity"
Head (Research), Emkay Share and Stock Brokers
AIA Engineering, Elecon Engineering, Everest Kanto, Garware Offshore and Great Offshore
"The value driver of a stock is its business scalability. This requires a lot of commitment from the company"
Head (Research), Motilal Oswal Securities
Ashapura Minechem, Dena Bank, Sasken Comm. Technologies, Shasun Chemicals & Drugs, and Shriram Transport
"You must do your homework in picking the stocks with strong fundamentals. Accurate stock selection is very important"
BOC, Hind Dorr Oliver, India Glycols, Jupiter Bioscience and Tayo Rolls
"Poor liquidity of smaller stock has been a concern, particularly among institutional investors, who for that reason prefer large-cap stocks"
Chambal Fertilisers, Greenply Industries, Indo Asian Fusegear, Oriental Hotels and Sirpur Paper Mills
"If the stock is good, money has to chase it. Liquidity takes care of itself"
Chief Investment Officer, Angel Broking
Atlas Cycles, Ballarpur Industries, Coromandel Fertilisers, Escorts and Finolex Industries
Shah's investment principles are based on under-owned companies, compelling p-e multiples (in the range of 7-11), a good management, and significantly underperforming stocks. Others in the market concur with his views. Says Rajat Rajgarhia, Head (Research), Motilal Oswal Securities: "With robust growth in the economy, there are many companies that have made large investments in their businesses. Their business models are also sound and scalable. These companies can offer very good return on the stock market." The valuations of many of these companies are already increasing. Rajgarhia prefers stocks such as Shriram Transport, Dena Bank, Sasken Communication Technologies and Ashapura Minechem. He looks in a stock for a sound business model, its scalability, management's vision, expected earnings, and a reasonable price.
There are many small companies in it, auto, pharma and the entertainment industries with good potential to grow. Says Ajay Parmar, Head (Research), Emkay Share and Stock Brokers: "Today, money is not a problem for talent and enterprise in India. Many pharma companies in India, for example, are still small- or mid-sized companies, but have excellent managements and growing businesses. Companies of this kind are the ones that represent great investment opportunity." He also looks for a unique business model where the companies have a profitable niche. His picks include AIA Engineering, Everest Kanto, Nucleus Software Exports, Panacea Biotech and NIIT Technologies.
Next up: Micro-caps
They have market capitalisations of less than Rs 1,500 crore, according to the recently concluded DSP Merrill Lynch Mutual Fund's Micro-cap Fund. "Within this criteria (of micro-cap), we will focus on those companies that have had a consistent record of net profit and have shown a tendency towards going after good quality management," says Soumendranath Lahiri, Senior VP & Co-head (Equities), DSP Merrill Lynch Mutual Fund. "The businesses of these companies should obviously be scalable and show a strong possibility of getting re-rated."
Companies, whose net profits have consistently grown by over 30 per cent, stand a good chance of getting re-rated. However, micro-cap companies are typically ones that are open to higher risks as compared to mid- or large-cap companies. Says Lahiri: "Largely, micro-cap companies are promoter-driven and have shown erratic growth. The risk associated with this segment is greater. There are chances that some of these companies may fail to make the transition."
Micro-caps are likely to be a big area of activity, believes Lahiri, and companies within this category will also offer the opportunity for multi-fold increase in investments. Large-cap companies (market cap over Rs 5,500 crore) have seen a net profit growth of only 20 per cent on average. Mid-caps (market cap of up to Rs 2,500 crore) have seen an average net profit growth of 25 per cent, while the small- and micro-caps are likely to witness a profit growth in excess of 30 per cent, feels Lahiri.
Select stocks only
Sometimes the going may get tough in the middle. Smaller stocks could be volatile over the short-to-middle term. In a market downturn, they tend to get battered more than the large-cap stocks. Their returns also may be poor over small-to-medium-term because of low liquidity. So, a time horizon of less than three years could prove to be disastrous. Says D.D. Sharma, Senior Vice President (Research), Anand Rathi Securities: "Mid-cap stocks tend to offer good returns in the time horizon of at least 3-5 years. So, you have to be patient." Sharma, too, is bullish on the segment with a long view; some of his great investments include Elecon Engineering, Moser Baer, and Balaji Telefilms.
If you invest during peaks and things don't go as expected, you may end up losing money; so have a careful look at the entry price. "Poor liquidity (tradability) of smaller stocks has been a concern, particularly among institutional investors, who for that reason prefer large-cap stocks. But things are already changing," says Pranav Parekh, Analyst, Edelweiss Securities, who likes Sirpur Paper Mills, Chambal Fertilisers, Oriental Hotels, and Indo Asian Fusegear, among others. "Of late, institutional investors are increasingly showing interest in these stocks, some of which can give pretty good returns," he adds. Shah says mutual funds and FIIs are already "rediscovering" small- and mid-cap stocks, infusing money into them and boosting their valuations and liquidity. That's good news for the retail investors who worry that their investments in smaller stocks risk poor liquidity. "The next six months will see unlocking of a lot of value in these stocks. If the stock is good, money has to chase it. Liquidity takes care of itself," adds Shah.
It's not that the entire small- and mid-cap space will do well. So, investors need to tread carefully. Many companies in this segment are family-run businesses that tend to compromise on corporate governance and disclosures. "Don't think that the entire mid-cap segment is worth investing; you must do your homework in picking the stocks with strong fundamentals. Accurate stock selection becomes more important in a well-priced market like we have currently," says Sharma. There are also risks in scaling up a business. Only those companies that can add capacities and expand their businesses deliver handsome shareholder returns. "The value driver of a stock is its business scalability. This requires a lot of commitment on the part of the company, which is not easy to assess," says Rajgarhia.
Don't just invest in a stock here or there. The key is to get a decent mix in your portfolio. "Start with the right sector and drill down to good-quality companies with competent management. Have a portfolio of at least 10 stocks, not just 2-3. It's the whole basket that will give you returns. Two-three stocks could become multi-baggers, 3-4 could go up modestly, and the rest could just fail," says Sharma. Parekh, on the other hand, advises a bottom-up approach to building a portfolio, starting from the right company rather than the right sector. "There can't be any hard and fast rules in picking the stocks. You could start with a fast growing sector of the industry. Or you could treat an individual stock on its own merit," says Rajgarhia.
"In building my portfolio, I won't allot more than 10 per cent to any one industry and more than 7 per cent to any one company," says Shah. With the broader markets meandering, now's the time to accumulate smaller stocks at lower prices. They are well poised to pay back.