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The Best Small-cap Stocks to Buy

Free Access: A guide to generating potentially colossal long-term wealth

You have been told a lie!

You need to have big capital to become rich in stock markets.

You need to associate with a financial adviser or big fund manager to help you in your journey to riches.

Making it big in investing is beyond the reach of a common man.

For us, the unveiling of this lie started almost a decade ago, at this place...

Map

In 2009, our research team was tracking a small business based out of Varthur Hobli.

It's an overcrowded, congested suburb of the Silicon Plateau of India, Bangalore, this small company could easily be mistaken for 'just another small business'.

This wasn't an IT company, but a textile firm, hardly popular among the investing circles.

It's headquarters had no glass facades...or intimidating security levels. It could easily pass as an ordinary building.

As our research team dug further, this seemingly ordinary textile business had lot of extra ordinary things going for it.

It was the 'Sole Licensee' in India for a global brand that (at that time) enjoyed a 30% market share in the industry worldwide.

When we recommended it, the stock was priced at Rs 300. At a market cap of Rs 3.4 billion, it was just one among more than three thousand listed smallcaps.

As I'm writing this, the company is a part of S&P BSE 100. It's marketcap is Rs 228 billion.

The textile company that we found a decade ago is Page Industries, well known today for its 'Jockey' brand. It is also the first stock to give us a taste of a 100-bagger.

That's the beauty of the smallcaps. The professionals in the industry don't want you to know this.

This is an attempt to dispel all the myths around smallcap investing. I want to show you how to make the most of huge wealth-creating opportunity.

The Biggest Myth - Smallcaps Are Risky

Risk only comes from not knowing what you are doing, and that's irrespective of marketcap.

Yes Bank, Ranbaxy, Lehman Brothers, Satyam, Enron...

Cases like this underscore what I have always believed -

  • Safety or stability has little to do with the size of the business.
  • Big Size is no substitute to ethical and competent management.
  • And an ethical and competent management is not guaranteed in big businesses.

Having dispelled this myth, let's now consider the unique and exclusive advantages of smallcaps for a common investor.

Your Big 'Edge' in Smallcaps

There are over three thousand listed stocks in Indian smallcap space.

This compares to just 30 in the Sensex, fifty stocks in the Nifty, top 100 by market cap in the largecap space and next 150 in midcaps.

Over 90% of the listed entities belong to the small cap space.

The playground for most big investors is limited to the mid and large cap space. The low liquidity in smallcaps keeps them under their radar, and out of fashion. This is why you hear and know less about them.

And what do you think happens when a huge money chases a limited number of large and midcaps?

They become expensive. It shrinks the upside potential in these stocks.

Further, the big and well-known companies are already past their prime. The days of fast growth and glory are behind them. They are in a mature stage.

No wonder than the so-called active managers in this space fail miserably in beating even the index returns.

I consider it an occupational hazard.

Warren Buffett, had this to say about his inability to investing in small companies, when size became his bane.

    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 and mosquitoes here are the well-known stocks and small-cap stocks respectively.

The good news is you can look beyond elephants! This is your strongest, and perhaps the only edge you have over the fund managers.

Small companies, unlike their large peers, are sitting on the runway, waiting to take-off.

This is the space from where the future Infosys, and Bajaj Finance will emerge. It's a space where you can generate strong 'alpha' i.e. outperformance.

That said, among the thousands of companies on the BSE Smallcap index, only a few smallcaps become big winners. Most get lost in oblivion.

Amid the survivors, a few companies are first among equals.

These companies witness spectacular growth. Their stocks become the talk of the town.

Vinati Organics, Astral Polytechnik, Pi Industries, Balkrishna Industries...

All you have to do is to enter these stocks at the right time and hold on to them. All the hard work was being done by the management.

But it's not so easy...

If it were this smooth, smallcaps would not be an ignored lot. There would not be so much fear around them.

For every Vinati Organics, Page Industries or Astral Polytechnik, there are tens of stocks that never take off.

And if you play in this space without a strategy, or look for short cuts to get rich, you might end up losing your capital.

A RoadMap to Make it Big in Smallcaps

Over the years, my experience with small caps has taught me that things are not always as they seem. Stock prices can double overnight, riding not on fundamentals, but hyperbole...only to crash later. It's a slippery ground indeed.

It's critical to avoid unnecessary risks and speculative bets. As Warren Buffett once said, in the market, we do not get paid for activity, just for being right.

It's not enough to go by financials and track records, and market news.

Here are some broad guidelines to pick multibagger stocks in smallcap space.

  • Economic Moat

    The dictionary defines a moat as a deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defence against attack.

    In investing, it refers to a business's ability to maintain its competitive advantage over its peers to protect market share and ensure sustained profits. It is what allows a business to earn high returns on capital over time.

    The wider the moat, the stronger the business. If the moat is weak, ultimately, competition will spoil the game, erode returns, and take away market share and profits overtime.

    Moats could come from having a cost advantage (being the lowest cost producer), brands (such as Castrol), exclusive licensing or patents (Astral Polytechnik and its tie up with Lubrizol), network effects (as in the case of Facebook), higher switching costs (like in case of private banks).

    But remember, the presence of one or many of these do not ensure great returns.

    A true moat needs to stand the test of the time.

    In the absence of that, one might end up with companies like Kodak. It used to be the market leader but could not stand up to the technological disruption from digital cameras. The moat did not just get eroded, it was completely wiped away.

    A true moat gives a business scalability, and with every growth milestone crossed, it gets strengthened further.

    Think about Coca Cola. The company has been around for decades.

    There are businesses that compete with it. Yet Coca Cola has not just survived but expanded its market share multifold.

    The more it grows, the more difficult it becomes for new or existing players to compete with its distribution network.

  • Circle of Competence

    Warren Buffett said...

      Everybody's got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle.

    Stick to investing in businesses that you understand and be okay with ignoring what you don't. Remember, you need only a few smallcaps to win big.

  • Management Quality

    Investing in a stock is not buying a share with a price tag. It's like owning a part of the business. The management are your business partners.

    Unlike largecaps, which run on auto pilot mode, managements in smallcaps can make or break a smallcap company.

    You need to be highly discerning about who you want to partner with.

    So, what kind of partners should you look for?

      You're looking for three things, generally, in a person," says Buffett. "Intelligence, energy, and integrity. And if they don't have the last one, don't even bother with the first two."

    That is as succinct an advice that could ever be given while assessing the management quality of the businesses you may want to invest in.

    The quality of management does not get captured in quarterly or even year on year profit growth numbers. You need to look deeper. I'll come to it later.

  • Margin of Safety

    Margin of safety is what differentiates a good business from a good investment.

    In case you're wondering about the difference, see the stock price chart of Hindustan Unilever Ltd. returns for a decade.

    A Bluechip's Journey to Nowhere Over a Decade

    A Bluechip's Journey to Nowhere Over a Decade

    Despite being backed by a great story and fundamentals, its stock remained stuck at around Rs 220 for around 10 years. That's because all the positives were already factored in the stock price.

    Always ask how much a company is worth and never overpay. Margin of safety ensures that you buy a stock only when it trades at a reasonable discount to its true value.

    Further, have a balanced asset allocation strategy to take care of the potential downsides.

Our Approach

For smallcaps, I think what works the best is growth at reasonable price (GARP), a variation of value investing.

My approach for smallcaps is bottom up i.e. I focus on the business fundamentals, growth prospects, management, and valuations. I do so with a time frame of 3 to 5 years.

This approach varies from the mainstream, which is more top down, focused on the short-term, and chases stocks which are expected to gain from macro themes.

The problem I have with the mainstream approach is that macro-economic variables are complex in nature.

They are interlinked and difficult to predict. If you make these variables the center piece of investment thesis, there is a high probability of going wrong.

A Quantitative versus Qualitative Analysis

My approach uses both quantitative and qualitative factors.

Getting the former right is relatively easy in my view. All you need is a basics in place, such as different financial ratios and their implications and an internet connection that can offer you free access to financial screeners.

These are important, but not enough.

In investing, getting qualitative aspects right is critical. These include management quality, regulatory aspects, demand and supply dynamics, consumer behavior, understanding the competition, industry disruption, and sector dynamics etc.,

The Most Critical Aspect of Investing in Smallcaps

Berkshire Hathaway was once a struggling textile company. No moat. No rosy financials. Just a bleak future.

That is, until Warren Buffett took it over.

Or consider Apple, Microsoft, Facebook, and Amazon...

These companies wouldn't be where they are without Steve Jobs, Bill Gates, Mark Zuckerberg, and Jeff Bezos.

Ultimately, the people running the business determine the fate of a company. It's the legendary investors' judgement of competence and character, that separates them from the rest.

They know how to separate good managers from mediocre and bad ones.

They don't confuse business tailwinds and headwinds with management quality.

They are wary of the halo effect. They look beyond the financials. They place no emphasis on headlines. They are the first to spot successful turnaround stories.

Unfortunately, CVs and credentials don't help us spot this critical quality.

This conviction comes from interactions with the management and promoters

But how could one identify such managements?

Given the limited coverage in the media and fewer disclosures in smallcaps, getting this information is hardly easy.

Sure, there are annual reports and other disclosures.

And if you're lucky, some companies might add presentations too!

You may come across ideas by observing sectoral trends, talking to people and so on. There are always tools with all the financial information and stock screeners neatly organized in one place.

But could that be enough?

I don't think so. I think it needs a 'boots on the ground' approach - speaking to or meeting not just the management in person, but suppliers, consumers and competitors.

This helps to validate the management talk or find disconfirming evidence.

Some Personal Experiences of Meeting Managements

Like I just shared, to get a real understanding of the potential in the business, it is crucial to get one's boots on the ground.

It's also what I like the most about my work. My team and I have travelled the length and the breadth of the country to meet the managements in person.

In case of most smallcaps, the management is also the owner of the company. This is unlike big companies where a lot of people with no skin in the game hold crucial positions.

Most of these promoters are first generation entrepreneurs with humble backgrounds, and with inspiring journeys and visions.

Meeting them and speaking to them directly, gives an insight into the business that no number of interviews on financial channels or magazines could offer.

There have been cases when we were extremely impressed with financials or influenced by stories floating around in the markets, but after meeting the management, realised the optimism was not justified or found the managements' claims to be wrong.

Such meetings have been a revelation, where we have realised that numbers (which led us to meeting them in the first place) don't tell the real story. We never recommended these companies. Nonetheless, the work done has left us wiser.

A case in point is a company we met a few years ago. The stock was widely in the news on the buzz of some patents. The management too went on and on about this. On digging further, we realised that there was no clear roadmap for monetizing these patents.

We decided to not go ahead for the lack of clarity. Today, the stock is trading at a fraction of the price when we met the management.

Our concerns about the business were validated. Hardly any new products were introduced that could make big difference to the business.

In another case, my meeting with a textile company took me to Coimbatore (Tamil Nadu) a few years ago. It was the first time I had to take shoes off before entering in the office, as the latter happens to be a room in the house in which the promoter resides with his family.

In times like these when most companies squander money over swanky offices (that does little to promote the business), frugality was a welcome change.

    The extravagance of any corporate office is directly proportional to management's reluctance to reward shareholders. Excellent companies are thrifty. - Peter Lynch

Later, the same promoter willingly decided to not draw the commission (variable compensation based on profits) saying that what he gets in dividends is enough for him and his lifestyle.

When asked why he did so, his reply was:

    'The shareholders of my company have reposed faith in me while investing in my company and I should live up to their expectations. While they receive only dividends, I felt it should be the same for me as well.'

In short, simple gestures and observations can offer big insights.

How Much Should One Invest in Smallcaps?

Smallcaps are inherently more vulnerable to market sentiments and speculations, and hence volatile as compared to bluechips or midcaps.

Further, the success ratio in smallcaps is lower as compared to bigger businesses. Not all smallcaps turn out to be multibaggers. It's not unusual to see sharp declines in a short time frame when bears take grip of the markets.

That limitation is more then compensated when one picks quality smallcaps for the long term, with strong margin of safety in valuations.

With an optimum asset allocation, one can use smallcaps to the best advantage- making asymmetric payoffs from the upside, while not losing much in case of a downside.

According to us, in a scenario of ideal allocation of funds, small cap stocks should not comprise more than 10% of one's total equity portfolio. Further, we believe that a single small cap stock should ideally not form more than 2-3% of the total portfolio. Please note that this allocation will vary from person to person. For something that works best for you, we recommend you talk to your investment advisor.

Which Are the Best Smallcaps to Buy Now?

Well, we can't make any stock recommendations through this article.

However, had you followed the roadmap as shared in the article, you would have come across stocks CDSL, Persistent Systems, KRBL, Fiem Industries etc that have seen a spectacular return over last few months.

In a post Covid world, one needs to focus a lot on balance sheet and cash flows along with profit and loss statement.

There are some sectors where the road to recovery is long, and the business casualties will be high. And at this point, given the drastic change in the macro situation, arriving at intrinsic values with high degree of conviction for sectors such as airlines, retail, hotels, real estate, tourism and hospitality, NBFCs and capital goods is difficult.

Then there are others such as food and FMCG stocks, businesses in agriculture and allied activities, packaging, pharma and healthcare, software, companies providing services in digital space, and ecommerce, where the pain will last for a shorter duration.

We believe it will be good to focus on businesses that enjoy market leadership in their niche segments and where the balance sheet is lean.

To Conclude

I hope you won't mistake the size of a business for its ability to survive and grow.

Borrowing from Darwin's theory of evolution, I believe that it won't be the biggest who will survive but those who can best manage the change.

Conventional moats are getting disintegrated, and disruptions are more frequent. I believe some of the best change managers amid this upheaval will be agile and well run small cap companies.

If you pick small cap stocks well, you could be on the fastest road to generational wealth.

Happy Smallcap Investing!

Warm regards,

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

Here are Links to Some Insightful Equitymaster Articles and Videos on Smallcaps

Articles:

How We Beat the Index Nearly 3X

You Should Be looking for Small-cap Stocks that Will Rebound Strongly

Ignore the Media Headlines and Focus on High Quality Small-Cap Stocks

Here's How to Ride a Rebound in this Volatile Market

From a 57% Fall to Gains of 168%. This is What a Small cap Rebound Really Looks Like

Your Top 10 Days to Get Rich in the Smallcap Rebound

Videos

A Zero Loss Strategy that Also Maximizes Returns in Volatile Stock Markets

How to Ride the Rebound Amid Market Flip-Flop

Smallcap Investing in the Times of Covid-19

Stocks to Ride the Covid-19 Rebound

External Links

https://www.oaktreecapital.com/insights/howard-marks-memos

https://jasonzweig.com/blog/

https://fundooprofessor.wordpress.com/

http://aswathdamodaran.blogspot.com/

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