A Stock Watchlist Amid the Correction in Smallcaps

Editor's note: Equitymaster invites you to join our exclusive WhatsApp channel. Be in constant touch with our editors and get regular updates on their most profitable ideas and research. Join Equitymaster's WhatsApp channel here.

---

This has been a scary month for smallcap investors.

I have been warning for some time now about the unfavourable valuations in the smallcap space.

Smallcap to Sensex ratio has touched 0.6 times as compared to a long-term median of 0.43 times. However, that did not deter inflows into smallcaps.

That might have changed with the regulator coming into the picture.

The BSE Smallcap index is down by over 10% from its peak.

The demand for stress tests and steps to protect investors' interests in case of a meltdown has put a temporary break on the rally.

Just to be clear, the stress test suggests the time it will take to liquidate and recover investment in case investors rush for redemptions amid a market correction.

The stress test results are not as bad as one would have imagined.

However, I wonder if these will hold true in real time, when everyone wants to sell, and the buyers would be rare.

The real question is: Are smallcaps really in a bubble, waiting to burst?

I don't think so.

It's true that the margin of safety is not as wide as one would want in a lot of smallcaps, especially in the much hyped themes.

However, the earnings data for the smallcap index (over 900 stocks in smallcap space) suggests a compounded annual growth rate (CAGR) of more than 20% over the last four years.

This comparison is for trailing 12 months from 31 December 2019 to 31 December 2023. It does not consider the Covid phase as its base.

Now that's a pretty impressive growth rate.

Along with the improvement of corporate balance sheets, and pick up in the capex cycle, it's a valid ground for rerating in smallcaps.

So, stay cautious, but do not write off this space.

I believe that even in these markets, there are pockets of opportunity.

With prudent asset allocation, long term horizon and margin of safety in buy price, you could make the most as an investor without getting butchered in case there is a smallcap correction.

As I have shared in the past, a good place to start this search where one can find well priced candidates is tracking insider activity.

These include the stocks which insiders and promoters are buying.

To be sure, in the recent times, the selling activity trumps buying activity by a wide margin.

The selling is driven by valuations and promoters wanting to monetize some of this opportunity.

But that's not the only reason.

Promoters in smallcaps are also considering selling to accommodate more institutional investors. This I believe is not a negative, and good for price discovery in the stock.

And then there are stocks where promoters are buying in this market. The same market that another set of business owners are using to exchange their ownership in a company for the sake of public money and listing (read IPOs).

Access Now: Our 'Value for Money' Stocks Research at 60% OFF

Nassim Nicholas Taleb, in one of his books -'Skin in the Game' has said that no person in a transaction should have certainty about the outcome while the other one has uncertainty.

If you consider insider activities and public listing of a stock, the entities are markets and insiders.

Like it or not, the insiders are likely to have more clarity on business direction and potential as compared to market participants.

So, if I have to choose a starting point for looking for value and potential in stocks, I will look at already listed stocks that insiders are buying.

On the other hand, most of the IPOs where promoters are making an offer for sale are likely to be in the avoid zone for me.

Here are a few smallcaps that deserve special mention and deserve to be on your watchlist based on recent insider buying in March:

1. Gokul Agro Resources Ltd

   The company is mainly into making and processing edible oils and non-edible.

   Apart from selling under its own brands, the company caters to clients like Parle, Britannia, ITC, Amul, leading paint companies, Godrej, and Nirma.

   The return ratios are above 20% while debt to equity is well below one.

   The stock has corrected by over 20% from its peak and has seen insider buying at an average price of Rs 104, in line with the current price.

2. R K Forgings

   It is the second largest in India and largest in Eastern India in the forging segment with over 75% share from auto market.

   The company makes and supplies highly engineered, mission critical automotive and non-automotive components (railway wagons & coach and engineering parts) with complete one-stop integrated solutions.

   Exports are 37-41% of its revenue. The return ratios are healthy and debt to equity is about 1.

   The stock is down about 20% from its peak and has seen insider buying in price range of Rs 630- 725. The stock is trading at Rs 645 currently.

3. Man Infraconstruction

   It is primarily an EPC player with experience and execution capabilities in port, residential, commercial & Industrial and road construction segments.

   The company stands to benefit from the infra cycle. The return ratios of the company are well above 25% and debt to equity is minimal.

   The stock is down 20% from its peak. Insiders have bought the stock at an average price of Rs 190 in March, close to the current stock price.

Access Now: Our 'Value for Money' Stocks Research at 60% OFF

Other stocks where insiders have bought in March include Nuvoco Vistas, Mangalam Cement, Star Cement, Elin Electronics and PG Electroplast (both operate in the EMS/Electronic Manufacturing Services industry), Satin Creditcare, and Rajratan Global Trades.

To know more about emerging opportunities in the smallcap space, stay tuned...

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)