My Watchlist of High Quality Smallcaps 

2022 was a big speed breaker for BAAP (buy at any price) and growth at any price investors.

With the cheap money out of the picture, a lot of high-flying stocks saw the wind beneath their sails disappear.

However, the sentiments are shifting again.

From a big sell off in March this year, the smallcaps have rebounded, and how.

The smallcap index is now flirting with all time highs.

For individual smallcaps, the upswing has been even higher.

You see, that's the nature of smallcaps. When sentiments are adverse, they take the hardest knock.

When markets are upbeat, a slightest nudge could send them soaring.

It's good to see smallcaps rallying. But this comes with a sense of caution.

For markets are cyclical. And there may be a point when the valuations run ahead of fundamentals. How close or far are we to that point?

While this point would be different for each business depending on their fundamentals and stock price, let me share my view on smallcaps in general.

Let's first check the general market sentiments. At present, Sensex is just 1% shy of its lifetime high. It Is trading at a PE of 23.2x, a level saner than the peak of 36 times in 2021, but at a premium to its long-term median of 20.2 times, and not too far from some of its previous peaks.

Here's a very simple conservative or base case prediction for Sensex in the next 5 years.

You see, the Sensex earnings have grown at a CAGR of around 13% over the last 2 decades.

If I expect the earnings to grow at the same rate over the next 5 years, and use the median PE multiple of 20.2 times, the Sensex could be close to 96 thousand. Let's assume one lac for the sake of simplicity.

Let's see what the implied upside could be for smallcaps from current levels.

Unlike Sensex or BSE 30, PE ratio for smallcaps does not make sense. That's because over 4000 stocks fall in this category, lot of which are loss making, junk stocks where earnings is a non meaningful concept. So, for the lack of a sensible PE number, let's use another metric - Smallcap to Sensex ratio.

The smallcap to sensex ratio at present stands at 0.49 times. This compares to the previous peaks ranging from 0.54 to 0.76 in the last two decades.

Which means that there is still room for smallcaps to rise before investors turn fearful.

Now if I have to make a projection for smallcap index, I'll use the median Smallcap to Sensex ratio and base case projection for Sensex. Since the base case prediction for Sensex is 1 lac in 5 years, the projection for Smallcap index comes at around 44,000. This compares to 31,000. So is upside in the individual smallcaps even in the base case

However, at the current level of 0.49 times, the smallcap to Sensex is at a premium to long term median of 0.44 times. You would not find enough low hanging fruits in smallcap space. If you are not diligent and selective while picking stocks in this space, your investment journey could be doomed.

That said, in my view, it does not make sense to wait on the sidelines yet but invest in quality smallcaps that offer enough comfort on sustainable growth over next 5 years.

At the same time, it's a good time to use this momentum for profit booking in some cases where the growth prospects and balance sheet do not support valuations.

Here's are few pointers I would recommend picking high potential smallcaps in these markets.

A few pointers that I pay attention to are...

Looking if cash flows are in alignment with earnings. While earnings can be manipulated easily, such as with depreciation policies, capitalizing recurring expenses, changing inventory policies and so on, it is difficult to manipulate cash. A consistent divergence deserves some digging in and due diligence.

While cash flow from operation could be a bit out of tune with earnings depending on the nature of the industry, a peer comparison and comparison with past trends could be very insightful. I prefer stocks with positive cash flow from operations.

For non banking stocks, I prefer businesses where debt to equity ratio is less than one. That's because I like the businesses that can carry growth in a self sustainable manner.

While a lot of investors pay attention to profits, few are conscious of returns generated by a business.

A business , let's say X, that requires an investment of Rs 100 and earns a revenue and profit of Rs 50 and Rs 20, is likely to have a better economics as compared to another business y that needs investment of Rs 500 , and generates revenue of Rs 50 and profit of Rs 25 .

For X, the profit margin is 40% and return on capital invested is 20%.

For Y, the profit margin is 50%, and ROCE of 5%.

So, it is not the profit margin but ROCE that is a better indication of returns you will make on an investment.

Lastly, check how the valuations fare as compared to long term median valuations, for instance PE of the same stock, as well as compared to peers in the industry. Do check out my video for Balaji Amines and Alkyl Amines where I spoke of a potential case of valuation arbitrage. You could check the link below this video only.

Next, long term investors should approach investing like business partnership.

The stocks as such are to be treated not just as price tickers moving up or down, but real businesses the prospects of which would be made or marred not just by the competence of the management, but also by their integrity and focus. Avoid stocks with very high promoter pledging. As this weakens the management control on the business and could lead to selling pressure amid bearish sentiments on the stock.

Now based on the criteria I have shared with you so far, I will now share a watchlist of stocks. These stocks have also witnessed insider buying in the month of. By the way, do check my video on insider buying to further filter stocks on this parameter.

So moving on to today's watchlist.

The first on this list is Anup Engineering.

Hived off from Arvind Ltd in 2018, the company's product portfolio includes Heat Exchangers, Reactors, Pressure Vessels, Columns & Towers, Industrial Centrifuges and Formed Components. Heat exchangers alone account for over 70% of revenues.

These products find applications in diverse industries such as Oil & Gas, Petrochemicals, LNG, Fertilizers, Chemicals, Pharmaceuticals, Power, Water, Paper & Pulp and Aerospace in India and export markets, with domestic contribution to sales at 81%.

Given the nature of its products, the business is likely to be beneficiary of capex revival. To capitalize on this, the company has expanded capacities, while keeping the balance sheet debt light. As compared to a revenue of Rs 4 bn with operating profit margin at 20%, the order book for the company stands at Rs 5.3 bn

The management guidance is 25%-30% growth for 2 to 3 years, with annualized EBITDA of 22%, with share of exports expected at 30% from 19%.

The debt to equity is well within comfort zone and three year average RoE or return on equity is at 15%. The dividend payoput stood at 29% in FY23. The stock is trading at a PE of 28 times and a price of Rs 1460 as I record this. The insiders have bought the stock in the month of May at Rs 1400.

The second is PSP Projects, a Gujarat based construction company offering a diversified range of construction and allied services across industrial, institutional, government, government residential and residential projects. It is associated with the Surat Diamond Bouse project which is the world's largest building on a single basement, and Kashi Wishwanath project, The management is tech savvy and has been fast in adapting new and faster ways of construction like precast facility.

From just Gujarat, the company has successfully diversified into other states such as, Rajasthan, Karnataka, Uttar Pradesh, Maharashtra and New Delhi

With a robust balance sheet and access to capital, along with strong track record of executing signature projects, the company is well placed to gain market share in its industry especially as weaker and unorganized players get shunted out of the market.

The debt to equity is at 0.2 times. The average return on equity over 5 years is above 20%. Over last five years, the company's revenue and net profits have grown at 21% and 16% CAGR respectively. With the completion of Surat Diamond Bourse, the company is now eligible to bid for high value projects of upto Rs 25 bn. In FY23, its order book stood at Rs 51 bn, with an almost 90% jump in order inflows. This orderbook of Rs 51 bn compares to a revenue of Rs 19 bn in FY23, thus giving a good visibility of revenues in the near future.

The company's balance sheet is robust and return ratios too look attractive. It has one of the best working capital cycle of 41 days. The stock is available at a PE of 19 times. The insiders have bought the stock at Rs 747 in the month of May 2023.

The third is GNA Axle. It has a market share of over 50% in supplying rear axle shafts, spindles, and drive shaft to domestic tractor and CV segments. Over 50% of its revenue come from exports markets like US, Europe, S America, Japan, UK, France, China and Australia

The business has shown strong resilience amid challenges like lockdown, and steep increase in raw material price such as steel. Historically, the fortunes of the company were linked to tractors and CVs.

It has recently entered categories like LCVs and SUVs. Within India, from a mere 15% share of the domestic passenger vehicle industry, the share of SUVs has jumped to 40% in FY22. The share of SUV segment is expected to continue to grow as customer preferences tilt towards compact SUVs from sedans. Hence, entry into this space is not just positive for profitability, but also de-risks the business from an over dependence on a specific category of vehicles.

The business is also likely to benefit from scrappage policy in 2021 due to replacement demand. Within India, tractors are also likely to be in demand with uptick in infra and capex cycle. As a key supplier, GNA Axles is likely to benefit from the same.

However, the key risks to watch out for are client concentration and a downcycle in the CV and tractor industry.

The return ratios of the company are above 20%. The stock is trading at a PE of 12 times. The insiders have bought stock at a price of over Rs 800 in 2023.

Do note that inclusion in this list does not imply a view on the stock. For that, you will need to conduct your own due diligence.

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Thank you for watching. Goodbye.