My Favourite Smallcap Investing Theme for 2022

Jan 11, 2022

Most of the time when I interact with you in real time, dear reader, it's usually a one way conversation.

Last weekend was different.

On 8th and 9th January 2022, Equitymaster held its annual conference.

Until a few years ago, this annual event used to be held, at one of the most iconic buildings in Mumbai, The Taj Mahal Palace, Colaba. And it indeed had its own charm.

The pandemic has forced us to go virtual. While I miss meeting in a three dimensional world, our online reach has been expanded greatly.

This weekend, more than 700 attendees, from nine countries, and over 66 cities joined us, leading to very rich discussions.

As a regular speaker at the annual conference, I spend a lot of time to decide the topic that attendees might find interesting. Sometimes, it's a struggle. This time, it was easy.

The overarching theme for 2022 conference was, 'Disruption', for both the internal and external speakers.

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And this is not surprising. Disruption is one word that captures the essence of last 2 years.

In the last 2 years, the real and virtual worlds have blended. The internet revolution has taken over the concept of money, work, socialising, shopping, consumption of goods or knowledge or services...and even investing.

Everything is online, available at finger tips. All you need to navigate the world these days is a smartphone and an internet connection.

Even revolution of the future are related to the internet and the digital world. Think of the metaverse and Web3.0.

So when I was asked to pick a theme, my choice was obvious.

Disruption is not just one isolated theme. It's omnipresent, irrespective of what sector or niche you're thinking of investing in.

From hard core bottom up style of investing, we are evolving to be disruption analysts. It's not just a matter of choice but the need of the hour.

You see, until a few decades ago, the biggest companies globally were from sectors like Auto, telecom, and retail. Of the top 10 list, there was just tech company - IBM - that made it to the list.

Currently, nine out of top 10 belong to the tech space, with companies like Apple, Amazon, Facebook, Alphabet, and Microsoft dominating the list.

The single non tech company, Berkshire Hathaway, in the top 10 list, has 45% of its investments in the tech space.

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At a late age, Warren Buffett pivoted from being a tech averse to tech proponent. He was lucky to get in just in time when disruption was happening at a linear pace.

Today, it's happening at an exponential pace. I don't think people who remain complacent now with regards to the potential of disruption and tech will have time to catch up.

Zomato, Byju's, matrimonial portals, Zerodha, Ola, Uber, Netflix, Airbnb, Paytm, Policybazaar... these companies, barely a decade in existence, are more integrated in our day to day lives than any of the conventional companies.

While the opportunity is big, so are the risks. The tech and unicorn revolution in India has come riding on the liquidity drug.

For investors, visibility of profits is another challenge, with most of front runners of disruption opportunities getting listed at the cash burning stage.

Company Name EBITDA Margin (%) Net Profit Margin (%) Net Sales Growth(%) Marketcap (Rs bn)
FSN E-Commerce Ventures Ltd. (Nykaa) 7 3 38 951
One97 Communications Ltd. (Paytm) -49 -58 -15 776
Zomato Ltd. -17 -41 -23 1022
Policybazaar -18% -17% 15% 403
Data Source: Ace Equity

Now, I don't mean to undermine the power of these trends.

Be it food delivery, digital payments, financialisation of savings, e-commerce, almost everything is getting digitised and is being consumed through internet. The change is irreversible and these trends will only expand at scorching rates.

However, this doesn't imply that every participant in the trend will grow. Most businesses in this space work on winner takes all principle. There will be no second Amazon, Facebook or Google.

However, for these new age businesses, especially the ones getting listed in India, the road to profitability seems longer than the road for their disruption. All it needs to disrupt them is a few crores from different investors and some code.

For instance, Paytm has lost its first mover advantage to Google Pay and Phonepe in retail payments in a very short time. The winner of electric vehicle (EV) revolution in India could be Ola Electric, a conventional auto company, a batter maker or companies making hydrogen fuel cells.

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You can be so right in predicting the disruptive trend, and wrong with stock specific bets. Especially since at these valuations, there is no scope for any dent in the narrative that justifies any price for them.

So how can you invest in tech and disruption theme and ensure you are remain on the winning side?

There is more to India's disruption and tech revolution than meets the eye. You need not settle for loss making firms or highly valued stocks to participate in the disruption theme.

Consider this:

If I had headquartered StAR MF as a separate company in Bangalore, it would be worth probably a few tens of millions of dollars because that is where you value things differently. But we are in Mumbai and so we try to be profitable, we do not burn money at all and that is why we do not even spend money on marketing. - Ashish Chauhan, MD & CEO, BSE

StAR MF a mutual fund distribution platform - an incubation of the BSE- that itself is more than one and a half decade old.

And by the way, there are many other such blue ocean businesses the BSE has invested into with non-linear pay offs.

And this is just one example.

There are many smallcaps plugging themselves into the disruption theme, which could offer a strong boost to their earnings and re-rate them.

For instance...

  • An agrochem company that has invested in a drone making startup
  • A machinery maker investing in green technology
  • A paper manufacturing company signing a deal to make anti-leak packaging products for the food delivery industry
  • A packaging company moving up in the value curve and incubating a pet care venture, to capitalise on an industry growing at 25% every year
  • Profitable smallcap companies that are sole suppliers to leading EV makers

and so on.

You may not have heard much about of them as the main stream media is infatuated with loss making unicorns making bumper listings.

How are these companies different from listed front runners?

They are profitable.

These companies are not betting the farm on a single trend. They will benefit from non-linear pay offs without losing much in case the trends do not materialise as expected.

Not only they have the potential to grow profits from disruption, but they are also likely to be strong rerating candidates.

What more, while winners will be one or may be two as far as front runners are concerned, these companies will benefit from the disruption, irrespective of which front runner wins.

The bottomline

2022 and the rest of this decade will be all about disruption. And you will have to look beyond front runners to be on the winning side of this trend.

Warm regards,

Richa Agarwal
Editor and Research Analyst, Hidden Treasure

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