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For the Brave Hearts

Stocks that can make a fortune for you, or lose the one you invested in them.K nowing you are in the company of institutional investors is some comfort.

By Devangshu Datta | Print Edition: December 28, 2006

In absolute terms, just over 10% of the total corpus of diversified equity funds is parked in small-caps. However, an individual investor would not go wrong if he focused 90% of his attention on that 10% of fund-holdings. The reason is simple: small caps "filtered" for your benefit by fund houses are more likely to produce extraordinary returns. This is often where the "ten-baggers" or, stocks that produce four-figure returns emerge.

There are literally thousands of small stocks - the exchanges are awash with them. Many exist only on paper and don't comply with the basics of filing returns. Most have no analyst-coverage at all.

 

Risk Profile
 Most Volatile Least Volatile
Orient Paper
Infotech Enterprises
KEC Infrastructures
IPCA Labs
Gujarat Mineral Dev Corp
Federal-Mogul Goetze
Dishman Pharma
KSB Pumps
TNNewsprint & Papers
Trent 

 Volatility is the difference between 52-week high and low as % of average share price

A select few are high-growth businesses with excellent prospects. It is likely to produce a higher return than a large-cap if only because of the favourable maths. Small stocks tend to be low-priced and closely held.

For example, the top 10 largecaps have an average market capitalisation of over Rs 80,000 crore, while the top 10 mid-caps have an average market capitalisation of Rs 5,100 crore and the top 10 smallcaps have average market capitalisation of about Rs 1,000 crore.

If the same amount of money is pumped into the three categories, a small-cap rises disproportionately faster than a large-cap or mid-cap. When a fund takes a small-cap position, the price of the stock usually jumps because it has a big position relative to the equity base. Inevitably the stock also receives a certain amount of attention the moment a fund entry is disclosed. Other people discover its virtues and, as they enter, the price maintains its northward journey.

Most sought-after small-caps
Most sought-after small-caps

There is, however, more risk in piggy-back riding a small stock. The fund managers who find it first are usually taking minor risks because they are deploying negligible portions of their corpus (though UTI Software has 11% of its corpus in Infotech Enterprises).

Retail investors who enter in their wake are substantially more exposed. Higher relative exposure has its good and bad sides. Let's take the example of Orient Paper. It has offered returns of 103% over the past five years - roughly a compounded return of 14.5% over that time. The average fund would have deployed perhaps 0.2-0.5% of corpus in the stock whereas an individual investor would probably have parked a far larger proportion of his investible surplus. So the small investor would receive a proportionately larger benefit. On the downside, when small-caps slide, they can also lose 90% of value and small investors can be driven into bankruptcy.

We've listed the 10 small-caps in which funds have the largest exposures. Each of these top 10 stocks has at least five funds invested in it (most have 20 or more) and the lowest consolidated mutual fund exposure (Dishman Pharma) is over 11% of the equity. But the coverage is still patchy - four of these companiesappear to have never been subjected to the third-degree of investment analysis at all. Of the other six, only Trent has ever suffered a "sell" re-commendation.

What's special about these companies? At first glance, little except that the smart money is flowing into them. None are cheap in terms of price-earnings ratio.

KEC Infrastructures is in the middle of a complex restructuring that makes it tough to meaningfully track the business. Gujarat Mineral Development Corporation (GMDC) suffered drastic profit shrinkage in 2005-6 as did IPCA Laboratories. Information on KSB Pumps is sparse. Federal-Mogul Goetze actually lost money in 2005-6 due to a high debt burden. The other six have reasonable financials though Trent is very expensive in terms of both PE and PEG (terms explained on page 52). Orient Papers' EPS growth of 687% in 2005-6 over 2004- 5 is an aberration caused by a turnaround.

Looking deeper, KEC had a reasonable track record before the merger-restructuring (and incidentally, renaming - it used to be KEC International while its listed group company was KEC Infrastructures). GMDC has ambitious plans to expand beyond its home state and perhaps, become an international coal explorer and manager.

Its first half 2006-7 results show a strong financial recovery and the predictions are, the second half will see roughly 250% improvement in EPS over the first half when the EPS improved 93% over the first half of 2005-6. IPCA Labs also had a 2006-7
first-half turnaround as did Goetze after its US parent bought out the Nanda stake and sorted out the debt servicing burden.

Could you make a fortune if you bought any or all of these 10 stocks? Perhaps - it's a high-risk, highreturn strategy. This basket has produced an average return of 50% in the past year and over 63% in a three-year timeframe. You would also need to manage your investment allocations actively because these stocks are all fairly volatile.And best of luck!

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