Small cap stocks: how to spot your multibagger

Small cap stocks never cease to generate interest with retail investors. Recently we had published an article titled “How to approach risky, but rewarding Smallcaps” where Mr Balakrishnan gave some valuable tips on how to approach this space. 

It had two important elements – One, how to choose companies and two, what approach to follow to make meaningful gains from them.

The article concludes with an extremely relevant point:

“On the NSE, there are approximately 200 companies with market capitalisation of more than Rs.25,000 crore and probably around 2000 companies that are less than Rs.5000 crore in market capitalisation.  This tells us that the odds of scaling up are very low.  More often, we will be left to dig for tiny sub-Rs.1000 crore market cap companies that can probably go up five to ten times.”

What this means is that in the long run, very few small companies grow in size and become mid-caps and large caps.  There is a good chance of Rs 1,000-crore market cap company becoming Rs 2,000 or even Rs. 5,000 crore. Or the odds may favour even a Rs 500 crore crore market cap company growing 3 to 5x to Rs 1,500 crore or Rs 2,500 crore. But the odds of small cap companies scaling up to become mid-and large caps are extremely low.

The article spoke of how very few companies like D Mart or a Page Industries or a KPR Mill, to cite some examples, scaled up to becoming mid or large caps. But those touted to become the next Page industries or the next D Mart haven’t survived.  Essentially, companies have significant challenges in scaling up.

Odds don’t favour smallcap winners

To share a data point to illustrate the challenge of scalability of companies from small caps to mid and large caps, as per the AMFI classification as on 30^th June 2022, the 100^th Company has a market capitalisation of Rs.47,500 crore while the 250^th company  has a market capitalisation of Rs.16,500 crore. Companies below 250 (by market cap) are considered small caps. In the AMFI list, we can see that the 500^th company has a market cap of Rs 5000 crore. That means there are 4,500 companies with a market cap below Rs 5,000 crore. 

And these 4,500 companies include names that were once touted as multi-baggers in the bull run between 2003 and 2013. 3,700 out of this 4,500 are below Rs 500 crore market cap  now, which also shows the extent of failures in this space.

Some of the popular names that couldn’t scale up to becoming even mid-caps include Arvind Mills, Bombay dyeing, BEML, Castrol, CEAT, Glenmark, GE Shipping, India Cements, Indiabulls housing, Karur Vysya Bank, Karnataka Bank, Raymond, Sun Pharma Advanced Research, Rallis India, NCC, Va Tech Wabag and Wockhardt. They have remained where they were in size for a long time now. 

And worse, many others washed away investors’ wealth. This includes names such as Aban offshore, Bajaj Hindustan, Coffee day, Future Retail, Reliance Power, Jain Irrigation, Jet Airways, Suzlon Energy, Sintex, Subex, Unitech, Punj Lloyd, Sadbhav Engineering, Gayatri Projects, Jaiprakash Associates, GVK Power, Manpasand beverages, Sunil Hi-tech engineering, 8K Miles software, Cox & Kings, Bartronics and Llyod electric.

This is just a sample. If we examine the long list of 3,700 companies below Rs 500 crore market cap, more of such wealth destructors would emerge.

We’re not saying this to entirely keep you away from small-cap stocks. We want to bring to your notice that the odds of small-caps scaling up to mid or large caps are very low and so the chance of striking that “big winner” from a lot of 10, maybe 1 or even none. Some deliver, some disappoint and some fade away into oblivion. In other words, the returns for the risk you took may not be great.

At PrimeInvestor we too acknowledge the difficulty and sometimes the futility of going behind such odd winners. But what we strive to do is to ensure that you can filter small-cap companies that show promise in performance and have a narrower list that allows you to then track them closer, before you take the final call. Otherwise, it can be akin to shooting in the dark, given the large size of this universe.  So, we have tried to build a mechanism that can help spot up-and-coming companies in the small cap space. This is done through our Stock Screener tool. 

In this article, we will explain how to use our Stock Screener to pick potential small caps that can climb to becoming mid and large caps. 

You can also read our earlier article on how to use our Stock Screener to pick Growth Stocks, the filters from which we are going to apply here.  For this purpose, we took companies below the 250^th company in terms of marketcap but those with above Rs 1000 crore of market cap. This came to 1,060 companies. You may also use companies above Rs 500 crore in terms of market cap but below the 250^th company (as defined by AMFI), if you wish to explore very small companies.

Growth Stocks

If we apply the various filters to find out growth stocks in the market cap range of Rs 1,000 to Rs. 5,000 crore, we end up with a set of 29 stocks from the universe of almost 500 NSE listed stocks as below:

From this list of 29, you will need to now do more qualitative analysis on growth, scalability and financial performance to figure potential small caps that can mature to mid and large caps. Don’t miss out on the governance aspect!

The key here is scalability combined with capital efficiency which few will be able to achieve. This is what takes them from being a small cap to a mid or large cap stock.

You can refer to our articles on “magic formula to identify multi-baggers” as well as “3 ratios to pick winning stocks in manufacturing space” to get a glimpse of the key qualitative and quantitative factors to look at.

To pick and discuss briefly on a few stocks from the list, the 5^th one in our list is Astec Life Sciences which is a subsidiary of Godrej Agrovet. From starting off as an agrochemical company, it is now becoming a serious player in the contract research and manufacturing space, following the footsteps of companies such as PI Industries and Rallis.  It is noteworthy that the chemicals industry, as such, has seen a lot of companies scaling up. That means the industry itself offers potential for companies to scale, if they get everything else right internally. 

On the other hand, the 10^th one in the above list (Hindware Home) is a consumer play that owns the Hindware brand. The 21^st company is Acrysil, another one in the home improvement space, that manufactures and exports quartz kitchen sinks.  This is a space where the largest player is still a mid-cap while the 2^nd largest player is a small cap. But then there is potential to grow because the consumer space offers much bigger scalability compared to any other space. As per-capita income rises, the mid and small cap players can graduate to large and mid-sized players.

So essentially, the stocks mentioned above have seen the size of their industry either grow large (like chemicals) or the sector itself is growing in size (such the home consumer discretionary mentioned above). So choosing quality stocks from such sectors can help ride the sector expansion.

Emerging plays and turnarounds

Let us also try other ways of using our stock screener to expand our list of candidates. Having discussed “growth stocks” with quality metrics, let us also use our Premium Screeners such as “Rising RoE” and “Debt reduction” to pick more from the small cap space.

#1 Rising ROE

Return on Equity or RoE is the ultimate measure of shareholder returns. And only companies that generate shareholder returns consistently above cost of capital (say 15%) generate returns for shareholders. This is particularly important in case of small caps because most of them generate poor RoE which in turn explains why they remain small caps for long. In such a scenario, the ones showing rising RoE, above the cost of capital, deserve attention.

This Premium Screener picks companies where RoE has been increasing for 3 consecutive years.  Apply a quality filter again to input the lower end of RoE ( we are taking 15% here) to weed out the ones with poor RoE and refine the list further. Since we used a more stiff screener earlier with growth metrics, some stocks may have been left out. This list will have more companies in its fold. We got a list of 55 stocks with rising RoE from among 500 stocks in the Rs. 1,000 – Rs. 5,000 crore market cap segment. See the result in the excel download here.

The excel list features companies such as Astec Life and Hindware that we have discussed above.  Among others, companies such as Suprajit Engineering, Sharda Cropchem and Globus spirits have been growing at a faster pace through both expansions and acquisitions. 

On the other hand, you will find companies like Swaraj Engines and Kalyani Steels belonging to big groups, and with established financial track record, but their scalability seems to be constrained despite having a large parent.  There are also companies like Ambika Cotton that has decided to stay small while competition and technology seem to have arrested growth of players like Geojit. 

These are factors that you will understand only when you dig into the company/industry and not by merely looking at financial metrics. The metrics will give you key performance trends. Whether those are growth stories that are scalable, or are sustainable is something you would need to investigate. This may often be contingent on the nature of the management team as well as the opportunity size itself.

#2 Reducing debt

This Premium Screener picks companies that have been reducing debt for the last 3 years. Apply a cap on debt to equity* at 2 and base RoE at 10% to weed out poor ones using the quality filter. (Tip: add 0.1 as the lower end of debt equity ratio to eliminate companies with negligible debt. The idea here is to see the debt reducing companies and not those with already negligible or no debt). 

We got a list of 59 stocks from the universe of 500 stocks. See the result in the excel sheet link here.

You will also  find a lot of companies from the auto ancillary and capital goods space in the excel  list given above, apart from cyclical sectors such as sugar, textiles and metals. All of these sectors have seen a trend of reducing debt. 

In the auto ancillaries space, you will find interesting candidates such as Suprajit engineering, LG Balakrishnan and Fiem Industries. On the other hand, Tega Industries, a recent IPO, is a niche player in the capital goods space.

While this metric also captures a lot of textile companies, you will see companies like Gokaldas Exports which is a garment exporter (value added player) rather than a yarn or fabric manufacturer. It may well be a scalable business if India can emerge as a key player in garment exports.

You will also find a niche construction player such as Ahluwalia Contracts which emerged as a survivor from a troubled sector. If you look at top 250 companies by market cap, you can rarely find any company from the construction space. This raises the question on whether the segment is undervalued and offers opportunity or whether it is simply not a scalable sector. So, here again, a good dose of qualitative assessment of the sector and the company comes into play.

Half-way winners

If doing down the marketcap list is not something you are comfortable with, you can then look at companies that have already made their way – at least half way up! You can explore the space between the 250^th and 500^th companies with market capitalisation between Rs 5,000 crore to Rs 16,000 crore. This space may also offer some companies with demonstrated scalability as compared with the much smaller ones discussed above.

Applying the same growth parameters as discussed earlier, it throws a list of 26 growth companies in the market cap range mentioned above.

Few of the companies here are part of our recommendation as well while we have a review on Godrej Agrovet. In this slightly higher market cap segment, you can also find leading companies from diagnostics and logistics segments which are smaller sectors but offer scalability in a growing economy.  

Even in this space, one has to do all the qualitative, quantitative and governance checks as some of the companies such as Lux Industries have seen sudden dip in stock prices despite being owned by institutions, owing to corporate governance issues.

Summary

Essentially, there are 3 things that you need to keep in mind while hunting for small caps:

• If you are a new investor, it is hard to assess the size of the industry and opportunity and scalability of the company within such an industry. In such cases, it is better to pick a higher market cap range, like we did in the section ‘Half-way winners’ to ensure your call does not go too wrong, even if it means you participated in a growth story midway. Our Stock screener will help you figure this is a structured way. 
• Go back to the approaches mentioned in the small cap article earlier, on how to place your bets to benefit out of it.  Commit amounts that are meaningful” and “bet for the long haul” are the two important messages out there. 
• But the meaningful sum should not get too concentrated. The odds of scaling up a company from small cap to mid cap and large caps is so low that you need to place your bets across a few stocks. It is also important to bet for the long haul as the stocks may not do anything for years and suddenly go up multifold in a year or two. 

To end, the only way to increase the odds of a winner in your portfolio is to make the initial research process and screening stringent while weeding out the under performers a few quarters down the line.  

Disclaimer: Stocks discussed here are for illustrative and explanation purposes and should not be taken as our recommendation.  

Our Screener is a dynamic tool and the stock metrics will change over time with quarterly and annual financial results. So, keep using the Screeners periodically to get an updated list as well as to find new companies that fit your criteria.

For our recommendations, visit Prime Stocks

Disclosers and disclaimers.