How to Find Smallcap Multibagger Stocks

A well-known financial institutional recently released an update that caused quite a stir in the market

In one fell swoop, it dropped it's recommended midcap portfolio.

The tone of the update was mixed - honest and frustrated.

It suggested there is no point in trying to find value in midcap or small-cap stocks after the recent rally.

It suggested that their assessment of fair value is lower than the price the smallcap and mid-cap stocks are commanding.

The sentiment mirrors the mutual funds' that have paused the lumpsum inflows in the smallcap category.

I can empathise with all of them. In fact, in Hidden Treasure, we have had the highest number of Sell views in the current month, along with one smallcap stock recommendation.

While the fundamentals of India Inc., including that in the smallcap space, have shown an improvement, a top-down view suggests most of it is priced in.

At 38,000, the BSE Smallcap index is at a level where Sensex was in 2019. This was the year pre Covid, so I'm not factoring in any special case scenario here.

The Smallcap to Sensex ratio is at 0.56x, perilously close to the level at which it peaked in January 2018.

What followed was a 40% correction in the smallcap index by August 2019.

It was brutal. Having lived through that correction, I can say that it was not for the weak hearted.

If I had not the conviction in the businesses I recommended, I would have panicked too.

But amid this din of smallcaps look frothy and risky, here is a finer point getting lost.

The listed universe has over 4,000 stocks. Barring the top 250, everything is categorically a smallcap.

The smart investors and big fund houses are right in being nervous. That's because their access to this 'smallcap' universe is quite limited.

You see, having to invest huge funds at one go, they are restricted by liquidity. Liquidity of a stock is indicated by overall traded volumes and value in a particular time frame.

For a given smallcap to qualify for their universe, it has to be higher than a certain liquidity that minimises impact cost.

Impact cost can be seen as the extent of rise in a stock price just because someone is buying it in bulk. Or the sharp drop in the stock price because a big sell order is placed.

When the impact cost is high (or liquidity is low), it's almost impossible for big and institutional investors to buy or sell at desired levels.

Here's the thing. The universe of liquid enough stocks is small, actually way smaller than the universe of less liquid stocks.

And I'm not even making a drastic comparison here, not comparing the bigger smallcaps with penny illiquid stocks, where you should be overcautious.

So where does that leave you dear investor?

It means that if you are relying on big investors to find the next smallcap multibagger for you, there is a high possibility of two scenarios.

• They will not accept it, at least not in lumpsum.
• If they do, there is a high chance they will invest in the highly chased - liquid set of smallcap stocks, where margin of safety is thin, and valuations are not attractive.

Don't be disappointed. These are not your only options.

In fact, in markets like these, you have a significant edge over these big and institutional investors. The odds are indeed in the small investor's favour.

This is an edge that even Warren Buffett envies.

If I was running $1 million today, or $10 million for that matter, I'd be fully invested. It's a huge structural advantage not to have a lot of money.

The universe I can't play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in."

The elephants here refers to the universe of liquid stocks.

The mosquitoes are the smallcap stocks, that do not make the cut for big investors.

This is not because they don't have solid managements, not because their business fundamentals are not great. And not because they are overpriced.

The reason they do not make the cut for big investors is because they are not liquid enough.

Good for you, isn't it?

In this age of information overload and digitisation, when you have the access to management call transcripts, screeners, annual reports, financial presentations, the information asymmetry that gave big investors a huge edge is already getting narrowed.

On the top of that, you have the liquidity advantage that they don't.

So stay cautious amid the euphoria, but make sure you use do not let this edge go waste.

Wondering where to look for the potential watchlist?

How about looking for insider buying data i.e., looking for smallcap stocks that are market leaders where the insiders are buying the stock from the open market?

Here are a few other pointers to you pay attention to:

• Are the cash flows in alignment with earnings?
  
  While earnings can be manipulated easily, such as with depreciation policies, capitalising recurring expenses, changing inventory policies and so on, it is difficult to manipulate cash.
  
  A consistent divergence deserves some digging in and due diligence.
  
  While cash flow from operations could be a bit out of tune with earnings depending on the nature of the industry, a peer comparison and comparison with past trends could be very insightful.
  
  I prefer stocks with positive cash flow from operations.
• For non-banking stocks, prefer businesses where debt to equity ratio is less than one. That's because a great business is one that can carry growth in a self sustainable manner.
• Focus beyond profit margins. Are the return ratios strong enough?
  
  While a lot of investors pay attention to profits, few are conscious of returns generated by a business.
  
  A business, let's say X, that requires an investment of Rs 100 and earns a revenue and profit of Rs 50 and Rs 20, is likely to have a better economics as compared to another business Y that needs investment of Rs 500, and generates revenue of Rs 50 and profit of Rs 25.
  
  For X, the profit margin is 40% and return on invested capital (ROIC) is 20%.
  
  For Y, the profit margin is 50% and ROIC is 5%.
  
  So, it is not the profit margin but ROIC that is a better indication of returns you will make on an investment.
• Check how the valuations fare as compared to long term median valuations.
  
  For instance, compare current price to earnings (PE ratio) of the same stock to its long term median, as well as to peers in the industry.
  
  Do check out my video on Balaji Amines vs Alkyl Amines where I spoke of a potential case of valuation arbitrage.

Lastly, long term investors should approach investing like business partnership.

The stocks as such are to be treated not just as price tickers moving up or down, but real businesses the prospects of which would be made or marred not just by the competence of the management, but also by their integrity and focus.

Avoid stocks with very high promoter pledging. As this weakens the management control on the business and could lead to selling pressure amid bearish sentiments on the stock.

I hope this helps you make the most of your competitive advantage in the smallcap space.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure