"How many millionaires do you know who have become wealthy by investing in savings accounts or a safer asset class?”

This quote by Robert Allen is, in fact, a proven fact... the relationship between risk & reward. In their quest to earn higher returns than the index, investors often go for risker avenues like Small Cap Stocks, but the reality is little do they know how to do that properly. So, here’s help.

In this blog, we shall understand how to analyze small-cap stocks and come up with the 5 best small-cap stocks that investors can consider for their watchlist based upon diverse metrics. 

But before jumping onto the number crunching part let's understand what are small-cap stocks and some of their inherent characteristics. Shall we?

What are Small-Cap Stocks?

A small-cap stock is one whose market capitalization is less than Rs. 5000 crores. Such companies are usually smaller in size and have rapid growth potential. This is also why such companies are exposed to high volatility.

SEBI, the custodian and watchdog of our financial markets in the year 2017 reclassified/ redefined the categories of stocks for Mutual Funds, according to which -

• Large Cap Stocks: Firms ranked between 1-100 based on Market Capitalization

• Mid-Cap Stocks: Firms ranked between 101-250 based on Market Capitalization

• Small-Cap Stocks: Firms ranked beyond 250TH rank based on Market Capitalization

This reclassification was done to safeguard the interest of mutual fund investors because portfolio managers earlier used to invest a high proportion of their holdings in small-cap stocks to spike their fund returns. However, such a reclassification had consequences for the small-cap stock category which can be noticed in the image below. Post the release of the circular by SEBI (Sept. 2017) stock market witnessed a bloodbath in terms of forced selling by such portfolio managers to comply with the norms of SEBI.

(Source: Bloomberg)

How to analyze Small Cap stocks?

Lucrative growth multiples

Smallcap entities are generally accompanied by low working capital, hence their fortune is highly dependent on their revenue from operations. Thus, higher growth multiples are expected which can turn the tables across for both the internal and external stakeholders of the business. Fundamentally strong small caps shall portray a sales growth of at least  25-30% CAGR over a 3-5 years horizon.

Low debt

A smallcap buy would be one having high growth multiples and low debt, this further implies high addition to the wealth of its equity shareholders. Debt financing in a company’s capital structure is a double-edged sword; having its limitations and its advantages as well, but in the hour of crisis, high debt financing and financial leverage is the nail in the coffin.

High Promoter holdings and low promoter pledging

High promoter holdings at the cost of high promoter pledging is a sin and the same is explained in detail in our previous blog. Smallcaps with high promoter holdings and low promoter pledging seem lucrative in the light of the fact that the promoters have faith in their vision. Moreover, their actions will have a personal impact on their net worth as well.

Improving operating margins

As and when small-caps expand their legacy over a period of time their operating margins should show signs of improvement, hence they should rise over a period of time. Improving operating margins comes with either improvement in operational efficiency or reduced cost of production. Cost of production is a grey area for these small caps i.e. with economies of scale coming into the picture. As and when their operations progress, the cost of production is deemed to reduce, thereby ensuring high operating margins.

High capital appreciation

A good smallcap stock will have a low dividend yield because the firm might still be in its growth phases. Paying high dividends will imply high funding requirements during the need of the hour, which shall further increase the cost of capital and decrease the value of the firm (share price). Retained Earnings is the cheapest source of financing business needs; hence history has provided enough evidence that premier small-cap stocks are the ones with low dividend yield and high capital appreciation.

Now that we have learned the art of scouting out fundamentally sound small-cap stocks, let's do that practically, and analyze some of the fundamentally viable and healthy small-cap stocks that we have shortlisted out of the entire universe of small-cap stocks based on the metrics mentioned above -:

Gujarat Themis Biosyn Ltd

This company is from the most buzzing sector of the year, yes you guessed it right... Pharma!

It is a biotech and synthetic product manufacturing company, having plants at Vapi, Hyderabad, with a group turnover of over $ 40 million. The company’s principal activity is to manufacture and distribute pharmaceutical bulk drugs called rifampicin produced by the fermentation process.

Metrics for Analysis	Data Point	Comments
PE Ratio	19.81	Average
Sales Growth	33.61%	High and Attractive
Dividend Yield	0.4%	Low and Attractive
ROE (Return on Equity)	52.63%	Healthy and Attractive

(Source: Gujarat Themis Biosyn Ltd)

The company has shown a good profit growth of around 270% and 75.5% in the past 1 and 3 years respectively, which is one of the main highlights in the company’s financials.

Indian Energy Exchange Ltd

Indian Energy Exchange Limited (IEX) is the first and largest energy exchange in India providing a nationwide, automated trading platform for physical delivery of electricity, renewable energy certificates, and energy Saving Certificates. Recently on 23rd July, the company presented its Q1 results whereby it reported a 49% increase in consolidated net profits.

Metrics for Analysis	Data Point	Comments
PE Ratio	55.42	High and slightly Overvalued
Sales Growth	8.97%	Fair
Dividend Yield	0.58%	Low and Attractive
ROE (Return on Equity)	48.6%	Healthy and Attractive

(Source: Indian Energy Exchange Ltd)

IEX boasts a super healthy interest coverage ratio and a good CFO/PAT ratio, which makes the stock all the more enticing.

Heidelberg Cement India Ltd

Heidelberg Cement India is a subsidiary of Heidelberg Cement Group, Germany (the world’s largest integrated manufacturer of building material). Heidelberg Cement India has its operations in Central India at Damoh (Madhya Pradesh), Jhansi (Uttar Pradesh), and in Southern India at Ammasandra (Karnataka).

Metrics for Analysis	Data Point	Comments
PE Ratio	17.94	Fair and Reasonable
Sales Growth	8.1	Fair and Attractive
Dividend Yield	3.02%	Fair and Attractive
ROE (Return on Equity)	18.23%	Fair and Attractive

 

(Source: Heidelberg Cement India Ltd)

The company has shown a good profit growth of 52.08% for the past 3 years. The company also has an efficient cash conversion cycle of -29.30 days (the company sells inventory and receives cash faster than it pays to creditors). All these parameters make Heidelberg an interesting stock within the intensely competitive cement and construction manufacturing sector.

JK Paper Ltd

JK Paper Limited is a leading player in Office papers, Coated papers, and Packaging boards. From being the pioneer of branded paper in India, the company today is a leading exporter of Branded Copier Papers and Packaging Boards, and exports to many countries like the USA, Middle-East, Southeast Asia, SAARC, and various African countries. It enjoys a rich experience of many decades, which has enabled it to emerge as one of the biggest wood-based paper companies in India as well as a leader in the branded office paper segment.

Metrics for Analysis	Data Point	Comments
PE Ratio	13.71	Low and Undervalued
Sales Growth	5.2	Fair
Dividend Yield	1.53%	Low and Attractive
ROE (Return on Equity)	20.65%	Fair and Attractive

(Source: JK Paper Ltd)

JK Paper Ltd has high promoter holdings and low promoter pledging, which adds weight to it being a fundamentally sound company.

Bhansali Engineering Polymers Ltd

This small-cap stock is operating in the petrochemical sector in India. BEPL is a vertically integrated petrochemical company that is into the manufacturing of ABS (Acrylonitrile Butadiene Styrene) -- a raw material used extensively across industries like automobiles, home appliances, telecommunications, luggage, and other sectors. 

BEPL has taken a step for a big expansion leap towards 200 KTPA (Kilo-Tonnes Per Annum) in near future. Moreover, the basic layout for 400 KTPA and 600 KTPA expansion has been finalized. This takes us to the fact that  Bhansali Engineering Polymers Ltd is enhancing its operational capabilities which is another positive aspect apart from its lucrative fundamentals.

Metrics for Analysis	Data Point	Comments
PE Ratio	8.1	Low and Undervalued
Sales Growth	7.79%	Fair
Dividend Yield	0.49%	Low and Attractive
ROE (Return on Equity)	33.8%	Fair and Attractive

(Source: Bhansali Engineering Polymers Ltd)

The company is debt-free, and with a PE of 7.57, it seems to be a real treasure.

Conclusion

"Given a 10% chance of a 100 times payoff, you should take that bet every time." — Jeff Bezos.

His saying holds true for small-cap stocks because these stocks have the potential to become future large caps and multi-baggers. Hence, one can choose to have a specific percentage of his portfolio invested in small-cap stocks, for the reason being that these little champs can be future legends. However, because these are riskier avenues, you must do in depth research before investing.

Invest carefully!

*Disclaimer: This should not be construed as investment advice. Invest only after proper research.