Small cap mania - ready to join?

Is bungee jumping or a thrill-a-minute roller-coaster ride your idea of having a good time? If it is, then small-cap investing may be your preferred route to stock market riches. Unlike sedate blue-chip stocks that need to be held for several years to turn in a three-digit return, small-cap stocks can turn multi-baggers in a matter of months, especially if aided by a raging bull market (needless to say, small-caps are equally prone to nose-diving at the first sign of a ma rket reversal).

If you have the risk appetite to invest in them, take note that the party in small-cap stocks is already well underway. You may have to act quickly to capitalise on the recent wave of optimism towards the less-known names of India Inc.

Small-caps were barely ahead of their larger counterparts in the stock market rally between June 2006 and August 2007 that saw the Sensex surge by 42 per cent. But they have been the life and soul of the party in the most recent phase of the rally.

Since August 2007, the BSE Small-cap Index, with a return of 60 per cent, has easily trounced the Sensex (44 per cent). These index returns actually understate the case. Over 50 stocks in the BSE Small-cap index have doubled in this three-month span, while 12 have gone up three-fold or more.

As with large-caps, multi-baggers within the small-cap space feature several stocks with astronomical PE multiples.

This is a clear sign that gains in some cases have been driven by speculative froth rather than by hard fundamentals. Reliance Industrial Infrastructure, Nalwa Sons, Marksans Pharma and Walchandanagar Industries are some of the chart-toppers that fall into this category.

Another unusual trend in the recent small-cap rally is that stocks with high institutional interest haven’t delivered better gains than those with low institutional holdings.

Many of the stocks from the top performers list (State Trading Corp, Reliance Industrial Infrastructure, Lloyd Steel) have marginal or nil stakes held by FIIs.

This reinforces the belief that the recent rally in small-cap stocks has been driven largely by individual investors, whether of the retail or high-net-worth variety, rather than by institutional buying.


Fundamentals do work

But this is not to say that selecting small-cap stocks based on their fundamentals has not been a rewarding proposition. Investors who did buy into small-caps with good businesses would have pocketed hefty gains in the past three months.

Companies in niche businesses such as equipment finance company — SREI Infrastructure Finance (154 per cent return), earth-moving equipment maker-TIL (149 per cent), Alphageo — a provider of seismic survey services (145 per cent) and investment bank IL&FS Investmart (128 per cent) are such examples.

These companies owe much of their gains to a re-rating (expansion) in their PE multiple, as investors recognised and priced in bright growth prospects for their business.

It is also a misconception that the small-cap basket consists only of obscure companies with an uncertain pedigree. The small-cap index is home to some companies that do occupy leading positions in their respective businesses — ICRA (rating services), Gokaldas Exports (garment exports), Rallis India (crop protection) and PVR (multiplexes) are cases in point.

The small-cap space also features several “sunrise” businesses — multiplexes, construction equipment, logistics, financing and broking, seen as having a high linkage to the India growth story. Some of these sectors don’t find a representation in large-caps. This makes for rich pickings in this segment of the market. Companies in businesses such as metals, capital goods and financial services have been the frontrunners in the recent small-cap rally. The trend is now showing signs of expanding to engulf companies in businesses such as logistics, realty and media.
FIIs deepen exposures

Research apart, how can investors identify sound small-cap stocks to add to their portfolio? If safety of capital is your prime concern, institutional interest in the stock may be a good filter to apply (despite recent market trends).

Eight out of every ten stocks in the BSE Small-cap index featured at least a marginal holding by FIIs or mutual funds, based on their latest shareholding pattern. This suggests that only a few stocks in the small-cap space are yet to be unearthed by FIIs or domestic mutual funds. Should investors take exposures to the under-owned stocks, in the hope that they would attract institutional interest at a later date?

While this strategy may work quite well for large-cap stocks (which are high on the shopping list for institutions), this may not be a good approach to take to investing in small caps, for two reasons.

For one, institutional investors haven’t sharply expanded their investment universe within the small-cap basket over the past year, despite ample opportunity; instead they have chosen to increase exposure to their existing holdings.

The markets have swung from 10,000 levels last June to over 20K in recent weeks. Yet, the number of small-cap stocks that have FIIs/mutual funds on board has registered a relatively small change in this period.

Domestic mutual funds, if anything have been even more circumspect than the FIIs, not at all entering any new small-caps in this period. On the other hand, there are several instances of companies where institutions have significantly increased their stakes.

These trends suggest that both FIIs and mutual funds have been cautious about adding new small-cap names to their portfolio. Instead, they have preferred to stick to businesses and stocks they are familiar with.

Given that the rally in small-caps has been underway for some time now and that valuations of these stocks have climbed considerably, it may be best for retail investors to stick to safe ground, when it comes to small-cap investing.

At this juncture, stocks that have seen a significant increase in institutional interest, either from FIIs or domestic funds, may be a good hunting ground. Logix Microsystems, Lloyd Electric, South Indian Bank, SREI Infrastructure Finance and Nitco Tiles are some of the stocks that have seen a significant accretion to FII holdings over the past year. Madhucon Projects, McNally Bharat, Subros, TV Today, Greenply Industries and TV Today have seen domestic fund managers hike their stakes significantly between last June and this September.
No pain no gain

While the return potential offered by small-cap stocks cannot be gainsaid, those keen to enter such stocks should also bear the following in mind:

Earnings disappointments from small-cap companies can lead to sharper declines in their prices than would be the case with large-caps.

As such, companies are typically under-researched and there are uncertainties about their prospects; their ability to sustain earnings growth from quarter to quarter thus becomes an important reference point for investors in such stocks.

That the recent rally in small-caps has been driven largely by re-rating (expanding PE multiple), rather than by earnings growth, makes the gainers particularly vulnerable to any disappointment.

As a reversal in a small-cap stock can be quite swift and accompanied by thinning volumes, investors should probably adopt a target price-based approach to taking profits in small-caps.

If small-cap stocks can deliver manifold returns in a matter of months, the downside can be equally swift.

On every occasion when the Sensex has suffered a sharp setback over the past five years, the BSE Small-cap index has taken a much sharper plunge.

In the stock market correction of May-June 2006 the BSE Small-cap index nose-dived by 27 per cent, when the Sensex corrected by 12 per cent.

Investors keen to shelter from such storms should set aside a fixed portion of their portfolio for small-cap stocks. Re-balancing at periodic intervals, to contain small-cap exposures, may be necessary.

Finally, the current valuation levels enjoyed by small-cap stocks as a class, also raise flags of caution. The rally between August and now has ramped up the PE multiple of the BSE Small-cap index from 16 to 25 times (on past earnings), in a matter of three months. This has substantially narrowed the valuation gap between the large caps, as represented by the Sensex, and the small-caps.

Given that small-caps do deserve to trade at a discount to the large-caps, this leaves limited room for further ‘re-rating’ of the former. This suggests that the action may now be restricted more to “value” picks among small-caps.

It is also worth noting that the last major corrective phase in the markets (in May 2006) came about when the BSE Midcap and Smallcap indices moved into a valuation premium to the Sensex.

The rapid rise of some of the small-caps, heightened speculative activity, and the fact that the PE multiple of the BSE Smallcap index is now at a new high, should all be considered as warning signs by investors tempted to go overboard with small-cap investments