Small-caps a ‘double-edged sword’: 7 things to watch before investing in heap of 5,250 small stocks

By Aishvarya Dadheech

In India, there are more than 5,500 listed companies, which is the highest in the world. In terms of market cap, all companies, apart from the Top-250 companies, fall in the Small-Cap category. This means that there are roughly 5,250 listed small-cap companies (Market cap of <INR 8,000Cr) in India today.

Over the years, treasure hunters have spent a lot of time and energy to find gold in mullock heaps. It is quite a difficult task to find a decent amount of gold amidst that difficult terrain. Similarly, finding the right small-cap businesses, which have the ability to eventually become the mid/large-cap companies of tomorrow, in this heap of 5,250 companies, is not an easy task.

Small-cap investing is a double-edged sword with high risk-reward. Biggest wealth is created when one invests in the right business much ahead of the curve. One should look out for the following traits when investing in small-cap companies:

Consistency: This is what separates the men from the boys. Consistency in operational performance is an important trait, which helps small companies turn into big businesses. One must look out for consistency in revenue, margin and return ratio, across different time frames.

Scalability: One must try to find businesses that are scalable. Scalability is one of the key factors for high earnings growth in the future. Businesses with lower scalability seldom create wealth.

Promoter/ Management integrity: This is all the more important when investing in small-cap companies, which are relatively lesser-known. One must be cautious of promoter/management that has a sketchy past and have overlooked minority shareholder interests. Look out for corporate governance loopholes and stay away, wherever there is even an iota of doubt.

Float/liquidity: This risk is unique to small-cap investments. Lower liquidity should always be taken into consideration before investment. A company with very little float and low liquidity can be detrimental to your portfolio. Liquidity is generally low in small-cap companies and it increases over a period of time with better price discovery and broader stock ownership.   

Leverage: Small businesses are relatively more vulnerable to the vagaries of the economic cycle. Small companies with high leverage are more likely to go belly-up in black-swan events like GFC, Covid-19 etc., which severely impact the economy. Any company with a Debt/Equity ratio of greater than 1.5 times should be carefully assessed.

Capital allocation: Look for a business with efficient capital allocation. Historical trends of Capex, working capital and dividend payout should help one assess the same. A minimum ROE of 14%, which helps businesses cover their cost of capital should be an important filter. Try to identify companies with RoE of more than 20%.

Leadership position: Invest in a business that has leadership in a niche segment or where it has a technological lead over its peers, or a strong brand pull. These factors provide a strong pricing power, which would eventually fuel earnings growth.  

All in all, an investment portfolio should have exposure to small-cap businesses, which should clear the above-mentioned criteria or other attributes which fit the individual’s risk profile. One should be very choosy in identifying small-cap businesses to invest in, out of the 5,250 small-cap listed companies. Filtering out companies on attributes like inconsistency, low standard of corporate governance, weak business moat, incompetent management, high leverage, inefficient capital allocation, etc. goes a long way in wealth creation.

(Aishvarya Dadheech is the fund manager at Ambit Asset Management. Views expressed are the author’s own.)