• JUNE 2, 2009

10 dangerous small cap stocks

The markets have run up tremendously over the past three months. To be precise, it was March 9 that was the turning point. While the BSE-Sensex has moved up 82% since then, the BSE Midcap and BSE Small cap indices have run up by 104% and 116% respectively! And within these indices, we find several stocks that have trebled or even quadrupled in price during this period. Some might call these the star performers of this bull-run!

Instead, we believe these are now the most dangerous stocks to be in. See, you might think of us as party-poopers, but given the value investing principles we follow, these stocks are indeed dangerous.Have a look.

10 dangerous small-caps to be in
Company NameLatest P/EReturns#Avg. ROE*D/E Ratio$
Sanwaria Agro Oils Ltd.27.1411%14.82.2
Reliance Industrial Infrastructure Ltd.78.3392%15.10.5
Orbit Corporation Ltd.63.2347%47.60.8
State Trading Corpn. Of India Ltd.24.5243%25.82.1
Nagarjuna Fertilizers & Chemicals Ltd.57.2215%-1.31.6
Bombay Burmah Trdg. Corpn. Ltd.-18.7210%11.73.1
Ruby Mills Ltd.36.3189%8.53.0
Vardhman Textiles Ltd.26.7174%8.92.0
Rico Auto Inds. Ltd.55.8164%5.51.4
Firstsource Solutions Ltd.84.9156%8.12.2
$ - As of March 2008; # - Since March 9, 2009; * - Last five years
Data Source: Prowess

There are several reasons these stocks have surged. Among the key are:

  • Relatively stable political environment,
  • Improving economic sentiment (not fundamentals!),
  • A gush of cheap global money looking to earn superior returns, and of course,
  • Speculation.

And the result - these stocks currently trade at expensive to ultra-expensive valuations (commonly measured by the price-to-earnings or the P/E ratio). What is more, these companies have nothing spectacular to showcase in terms of their core financial performance. Almost all of these:

  • Are highly leveraged (have large debt on their books), and
  • Have weak return on equity (ultimately that is what shareholders need to look at).

Being a reader of Equitymaster, you know how important are these metrics when it comes to separating the right kind of companies from the wrong ones.

So there we are. Some wrong kind of companies getting valuations they probably do not deserve. But that is what speculation is all about. As for you, the decision to be taken is either to stay away from all the noise that is predicting even higher levels for stocks like these, or to repeat the mistakes that caused you to lose sleep over your damaged portfolio till about a few months back.

So, how do you know which small companies to look at?

You know for a fact that given the relatively poor disclosure levels and information dissemination issues, researching a small-cap stock is a tedious task. As Warren Buffett once said - "You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map. You may find local companies that have nothing wrong with them at all. You can't do that with big blue chips."

What we do in our identification process for quality small companies is to follow a defined set of parameters. While the process is not entirely insulated from errors of judgement, what it does is minimises such errors.

In finalising companies from the small-cap space, you need to give a lot of weight to the company's management for its competencies, execution skills and honesty.

The company's standing in the industry also deserves a lot of attention given the fact that small size companies are the first to buckle under pressure in case of a downturn. A solid financial performance history is another factor that you need to use as guides for small cap stock selection. In terms of the financial performance, you need to look at long term averages pertaining to the company's sales and profits, operating margins, debt to equity, return in equity, and finally the stock's valuations.

Through our Hidden Treasure service, these are precisely the parameters we look at while deciding on quality small cap stocks to recommend to our subscribers. After all, a few bad decisions can be the difference between a wonderfully crafted portfolio and the other that can be created by simply throwing darts at stock tables.

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