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  • JUNE 4, 2008

Hidden Treasure or Tragedy?

...asked one of our long time subscribers seeing the decline in market price of one of the stocks we had recently recommended through our small-cap service - Hidden Treasure. There have been several more queries like these where our subscribers have raised concerns with respect to the falling prices of some stocks we have recommended over the past few months. This article has been written with a purpose of addressing these queries and concerns, as also to clear the air about how to go about identifying stocks from the small-cap space.

A breed called 'small-caps'
There are around 5,600 companies listed on the BSE-Sensex. Out of these, a sizeable number - 4,000 - are those that have market capitalisation of less than Rs 10 bn and around 2,700 out of these have market cap even lower than Rs 500 m. These (companies with market cap less than Rs 10 bn) can be categorised as 'small-caps' and the very small ones as 'micro-caps'. In fact, the smallest of these has a market cap of just about Rs 10 m.

While some of these companies are successful businesses despite their small size and market cap, there are numerous (actually, a majority) that are mediocre. So how does one go about selecting quality stocks from this varied space - stocks that will be winners/multi-baggers in the long run?

What we look at in small companies?
Given the relatively poor disclosure levels and information dissemination issues, researching a small-cap stock is a tedious task. However, we have defined a set of parameters for our internal use that makes our task a lot easier and 'less' prone to mistakes.

In finalising companies from the small-cap space, we 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 and high levels of insider ownership are two other factors that we use as guides for small cap stock selection. In terms of the financial performance, we look at long term averages pertaining to -

  1. Sales and volume growth - To determine whether the company has grown larger is size as compared to its past.

  2. Operating margins - To determine whether it has not increased its topline at the cost of profitability.

  3. Interest coverage - A large amount of debt can seriously impact a small company's financial performance owing to the fact that large portion of operating profits are needed to pay out interest.

  4. Net debt to equity/Net debt to market cap - This factor also plays an important role in the company's financial stability. Higher the ratio, riskier the business.

  5. Cash generation capabilities - Small companies are in consistent requirements of cash and the same, if not available, can impact performance to a great deal. Quick and sustainable cash generation abilities will separate winners with the 'also-rans'.

  6. Returns on equity and invested capital - To ascertain whether the company is utilising shareholders' funds and assets in productive purposes and generating more than commensurate returns year after year.

And finally, we consider the price at which the stock is trading. There is a peculiar thing about small cap stocks that make them (the good ones) multi-baggers in the long run. Unlike large cap stocks that are more driven by growth of the underlying companies, in case of small cap stocks, not just growth but the expansion in valuation multiples (like price to earnings) also play a major role in turning them into multi-baggers over a long period of time. And the expansion in multiple happens due to a greater though gradual unfolding of the 'story' behind these stocks.

So, what should you do?
Before we say more, here is what Ajit Dayal has to say on stock market investing in the current market turmoil - "No one has a clue when the foreign investors will come in. Or what will make them jump back into India. Just like no one has any idea why they pumped in USD 6 billion into the Indian stock markets in September/October 2007. Or sold USD 3 billion in January 2008. And no one has any idea when India will no longer be the worst performing market in someone's global stock portfolio. You should not worry about it. Don't brood on it. Keep on buying into shares you like or mutual funds you like. Don't borrow money to invest. Don't try to hit 'sixers' - or you will be bowled out. Just go for the steady batting. A regular rhythm of strokes, taking every ball as it comes."

He further states, "India is on sale. And it may be for some more time, who knows. But we were on sale in March 2003 when the BSE-30 Index was at 3,000 levels then. And in June 2006 when the BSE-30 Index was at 9,000 levels. So even at these 'low' levels of 16,500 on the BSE-30 Index there was a lot of profit to be had if you had invested - and continued to invest - in the stock market."

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    The ability to ignore short-term market sentiment and keeping focus on a company's underlying fundamentals is what separates investors from speculators. It is also what propels long-term market-beating returns and wealth creation.

    When you buy quality companies, be it from the small-cap, mid-cap or large-cap space, that trade at discount to intrinsic value, you do not have to worry about timing the market or buying at the bottom. All you have to do is sit back, relax, and wait for the markets to award your stocks more reasonable valuations.

    One is required to continue to invest by understanding the businesses of companies, quality of managements, and with a strict regard to valuations. Leave speculation to speculators! If the job is done correctly when a common stock is purchased, the time to sell it is - never! Not even in panic situations like the one we are witnessing these days.

    Though thanks to the recent volatility, one can find quite a number of attractive opportunities out there. So do not try to predict where the market is headed next, as doing the same is nearly impossible as also immaterial to your long term investment returns. Rather, utilise your time in looking out for quality companies whose stocks are trading at discount to their intrinsic value. That is exactly what we are doing in the big universe of small-cap stocks.

  • Buffett asks you to 'think small'

    "Be fearful when others are greedy and greedy when others are fearful," said Warren Buffett. Here is a chart that explains the quote.

    After a Buffett quote, here is a Buffett quiz, which the legendary investor once asked his shareholders to answer.

    A short quiz: "If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves."

    But now for the final exam: "If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the 'hamburgers' they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

    Do we need to say any more?

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