10 things to check before buying a small cap stock…

Investment | Published on 24th July 2018 | 525

Mid cap stocks and small cap stocks have had a dream run in the last 3 years. To be more precise, the run in mid caps and small caps began with the crash in oil prices beginning 2014. For 3 consecutive years, the mid caps and the small caps vastly outperformed the large caps. There were 3 reasons for the same. Firstly, the dividends of cheap oil and commodities led to a sharp fall in input costs. The small and mid-sized companies benefited the most from this trend. Secondly, the mid caps and small caps have traditionally been companies with a narrow product or service focus. That has made them less vulnerable to an overload of equity and debt. Hence they have been able to maintain their ROE and ROCE at more attractive levels. Lastly, it is these mid caps that hold potential to become large caps in future. Stocks like Lupin, Britannia, and Titan are all cases in point where small and mid cap stocks metamorphosed into large cap stocks

The performance of the mid caps and small caps has been quite disconcerting since January 2018. While the Nifty is by 4.8% since Jan 2018, the Mid-cap index is down nearly (-15%) in the same period. Small caps have done even worse. This is partly due to the reversal in the oil price fall and also due to the impact of tax on LTCG as well as special margins imposed by exchanges on these stocks. But the fact is that they are the stocks that can provide the alpha. However, here are 10 points to keep in mind while investing in small and mid caps.

10-point checklist before investing in small and mid cap stocks…

  • Past performance is the acid test of any mid-cap or small cap. We are talking of a consistent performance over the last 4-5 years and the consistently should be exhibited quarter after quarter.
  • Small and mid caps are extremely heterogeneous. Hence, they are less vulnerable to economic cycles and hence a bottom-up stock selection approach works better in this case. But always ensure that the mid cap or small company question is adequately capitalized.
  • Be very clear on why you are investing in the mid caps. You are there to make above average returns (alpha) so focus on the company’s financial performance. In case you are looking at just beta (market returns), then large caps can do the job. Your core purpose in buying small cap stocks is to get outperformance and participate in the next big story.
  • How does the company manage its working capital? Most small and mid cap stocks tend to take a hit on the working capital management front. Either they are able to get proper credit terms from suppliers and vendors or they are not able to get adequate bank financing. Hence focus on working capital is a must.
  • Stability of the management team is critical! Investing in mid-cap and small-cap is an art that is perfected over a period of time. Avoid small and mid caps where the core management team has been going through consistent churn. Also be cautious of companies that see a string of senior level exits in a short span of time. That is not good news for a small company.
  • What is the risk in the business model of the company? For example, an NBFC or MFI may be taking on undue risk when they are operating on the spread between cost of funds and yield on funds. Such stocks can be vulnerable in a down turn. Focus on stocks that are able to give performance in a de-risked manner.
  • Check how the company has done in bad times. That is the real test of the soundness of the business of the company. A small that can do well in bad times will also have the ability to leverage its core strengths in good times. The bad time index is also called the semi-variance capacity of the small company. That matters a lot in uncertain markets.
  • Look at margins. In fact, you must look at efficiency margins and profitability margins and also look at the trend over 3-4 years. Consistency and the ability to improve is what will determine the future trajectory of the stock price. Growth with profitability becomes all the more important in the case of small caps and mid caps.
  • Does the company have too much equity in its books? That is not a good sign. When Tata Tele was formed in 2001, the first challenge was that the company had an equity base of 500 crore shares. So the company had to earn a profit of Rs.500 crore to earn just Rs.1 EPS. We all know what happened to the company subsequently.

Lastly, focus on stock liquidity in the market and the basis risk. You surely do not want to get into a stock and then realize that you are stuck for good. That is best avoided. Focus on spreads, basis risk and also the available liquidity. Above all, ensure that the impact cost of your transactions on the stock is minimal.