3 Smallcap Growth Stocks for Your Watchlist 

Dear viewers,

In today's video, I'm going to talk about how to assess valuations of growth companies, and three growth stocks that deserve to be on your watchlist.

But before that, I would like you to participate in a simple stock picking exercise with me.

Consider two companies - A and B.

A is a clear market leader in lubricant space, which is kind of mature industry.

B is a growing company in textile space - a highly competitive industry.

This is what the financial profiles and valuations of these two companies look like.

From a scale, return ratios, margins, dividend payouts, and balance sheet perspective, company A seems to be a better candidate than B.

Assuming that both the stocks are able to maintain these their respective dividend policies and high returns, if I ask you to consider a horizon period of 9 years, which stock would you choose.

It is obvious that despite healthy financials - be it their profit margins, return ratios or, none of the companies look cheap.

You can choose to not pick any. Or make a choice. And we will see how your selection has performed in next few minutes.

Well, if you are already feeling you have enough data to make a choice, you have a lot to learn in the field of investing.

At this stage, a diligent investor would want to know the competitive intensity, management track record in terms of execution, and potential growth rates that the businesses could witness.

Since lubricants is a mature industry, let's assume the earnings of company A, which is the market leader, to grow at a CAGR i.e. compound average annual growth rate of 6% in next 9 years, assuming this year as the base year.

For the textile company, the best case scenario could be 19%.

Does this info make any difference to the choice you made?

Well, you can still switch your selection.

Stay with your options.

And this is how you have fared in the real world.

If you picked company A, i.e. the market leader in lubricant space, you would have ended up with a loss of 21% over 9 years.

If you picked company B, i.e. a growing textile firm with in a high competition industry, your return would be 1,084% over nine years. That's a CAGR of 32% over 9 years.

If you picked none of these options, considering that a PE of 38 times was expensive for stock B despite its decent fundamentals, that 32% CAGR would be your opportunity loss too.

In case you have not guessed yet, the stock A is Castrol. The stock B is Page Industries.

In the table you see, the base year is 2012 - December 2012 for Castrol and March 2013 for Page Industries, as per their financial reporting for annual results.

As I'm recording this, the PE for Castrol has fallen from 31 to 15 times, while Page Industries' PE multiple has expanded from 38 to 81 times.

Case A (Lubricants industry)

The reason Page has done so well is it had a runway in an underpenetrated organised segment in India and a management team with strong execution capabilities.

Castrol, on the other hand, despite being a decent business, is severely limited by lack of growth opportunities in a mature market.

The example of Castrol underscores the importance of margin of safety in businesses with strong balance sheets and returns.

Page Industries, on the other hand, is a classic example that is proof of wisdom shared by Charlie Munger...

• That if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result.

It is also a case study that makes us see the moats in a new light. Moats are seen as some kind of competitive advantage that helps a business march ahead of its peers and allow high return on the capital employed over the long term.

While speaking of moats, most investors only consider the legacy moat. The concept of legacy moats applies to companies that enjoy leading market shares and earn strong returns on capital but are unable to find opportunities to deploy their incremental capital at similar high rates.

In other words, these businesses have a solid competitive position that provides healthy profits and strong returns on capital. But employing additional capital in their own business is not possible or provides poor returns.

As such, these companies tend to redistribute most of the profits earned in the form of dividends, buybacks, and so on. This is often the case with companies that have reached a mature phase.

Such companies like Castrol, that enjoy 20% market share in a mature lubricant market, a market that is hardly growing at 2% CAGR, can hardly help you grab multibagger stocks.

As a long term investor aiming to nail some of the best investment stocks, what you really need to assess in a business is reinvestment moat - something at which Page Industries has fared better.

Reinvestment moat applies to companies that find opportunities to deploy incremental capital at high rates, and hence their stocks are likely to compound at a higher rate.

The renowned value investor, Chuck Akre, uses a unique construct to identify potential compounding stocks - the three legged stool.

It evaluates business on three important aspects:

1. Business model
2. Management quality
3. Reinvestment prospects

Borrowing his explanation of this approach...

• The first leg has to do with the quality of the business enterprise. Look for businesses that earn high returns on the owner's capital. Spend time to understand what's causing that better-than-average return on capital, to occur, and is it getting better or worse.
  
  The second leg of the stool goes to the issue of the people who manage the business. They need to be not just competent managers, but are they honest, and do they have high integrity?
  
  Do they see that what's happening at the company level is happening identically at the per share level? Basically, do they treat minority shareholders fairly.
  
  And then lastly, the third leg is the issue of reinvestment. This is the glue that holds everything together. That is, is there an opportunity that exists because of the skill of the manager, the nature of the business to reinvest what we presume is excess cash. To reinvest that in a way to continue to earn these above-average rates of return.

Once you have found a great business run by an ethical management that has the potential to reinvest its own capital, compounding takes over.

Now as I promised in the beginning, I'll now talk about three smallcap companies where the managements expect the business growth to be 17% or above and where the ROCE is over 18%.

Before we go to the names, please note that these are not recommendations but companies to be kept on your watchlist.

The inclusion in this list does not imply any view. Further, the growth assumption is based on the management guidance, and is not my estimate, and needs to be taken with a pinch of salt.

The first is Tiger Logistics.

Tiger Logistics is a multi-vertical global logistics provider that operates on an asset light model, using the fleet of carriers it partners with. This is still a young company, handling an average of 4,500 TEU per month.

While it has exposure to 5 different industries, the biggest exposure is to auto segment that accounts for 79% of its revenue. The rest comes from commodities, yarns, cold chain logistics, defense logistics, and projects and heavy lifts.

Its clients include Balkrishna Tyres, Piaggio, Hero, HAL, Rites, Praj, Welspun, ABB, Ceat, TVS, Honda, Bajaj, and so on.

The business model is concentrated with top 5 clients accounting for 84% of revenues.

While the competition in logistics is intense, a low base and exposure to diverse industries and experienced management suggests a long runway for the company.

There are risks related to end industry slowdown, intense competition, and client concentration.

However, the management has shown execution capability, and the business has shown strong resilience in the recent years amid Covid disruption. The balance sheet is debt free, and return ratios look strong post the pandemic recovery.

The management has shared an ambitious vision to make it a Rs 20 bn company, through automation and digitisation, expanding geographies, acquisitions in related businesses, and complying to standards of MNCs by opting for green logistics, for instance use of EVs.

I believe this is a company that deserves to be on the watchlist.

The promoter stake in the business is 71%. There has been insider selling in the stock in last quarter. The pledging in the business is nil.

The second on the list is Heranba Industries. The company is in agrochem industry and manufactures insecticides, herbicides, and fungicides.

It is the market leader in India's Pyrethroids based agrochemical market, with over 20% market share.

Pyrethroids belong to insecticide group. These are synthetic chemical compounds that are used to control pests in farms, homes, communities, restaurants, hospitals, and schools.

42% of its revenue come from exports. Top 10 clients account for 25% of the revenue.

Its client base includes PI Industries, Sharda Cropchem, UPL, Rallis India, Dhanuka, Insecticides India, Tagros, Sumitomo Chemical. The company reported a 39% return on capital employed in FY22.

In the latest call, the management of Heranba has shared a revenue growth guidance of 15-17%, with 16-18% EBITDA margins for FY23. The long-term guidance for EBITDA is 18-20%.

Growth strategy includes launch of new products, entry into regulated markets of US and Europe, increased capacities and strengthening R&D. The company is working on 15 products at the R&D level. Further, for FY23 and FY24, the capex is expected at Rs 2.5 bn with turnover of 3.5 to 4 times.

The promoter stake in the business stands at 74.87%. The insiders have increased stake in the stock in this fiscal year.

The third company on the list is SJS Enterprises.

The company is a leading player in India's decorative aesthetics industry and operates from design to delivery stage.

Its end markets include auto, consumer durables, medical devices, sanitary ware, and farm equipment. Two wheelers contribute to around 45% of its sales. And the company's growth has been higher than the underlying industry's growth.

Its clients include Whirlpool, Stellantis, Continental, Mahindra, TVS, Samsung, Bajaj, Maruti Suzuki, to name a few. The company is also working with EV makers like Gravton.

The company has close to 6000 SKUs. It has supplied 123 m parts in FY22 and has export presence in 22 countries. Domestic sales in the first quarter comprised up to 90% of the revenue.

The management has shared organic growth guidance of 25% for FY23 and 30% growth in the net profit. This will be supported by new product development such as in-mold electronics, expansion in geographies, premiumisation or value addition, client addition and capacity expansions.

The company is in the process of acquiring a 7.5 acre land in Pune to expand chrome plating capacity. The target ROCE is 20%.

The promoters have 50.37% stake in the company. Despite it being a microcap, the stock is popular among the institutional investors with FIIs having a 5.3% stake and DIIs having 15.9% stake. The debt is almost nil. The return on capital employed is 20.7%.

I would like to remind again that this video does not attempt to make recommendations but to educate the viewers and make them aware of the opportunities that seem worth tracking.

With this, I have come to the end of this video. I hoped it offered some fresh insights on how to pick growth companies.

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Thank you for watching. Goodbye.