Catch Them Young

Small companies with robust financial performance could be multi-baggers of future

Equities can deliver flying returns in a matter of days or investors have to wait patiently for years. They have the ability to outperform other asset classes in the medium to long term. Among the different categories of stocks, the best returns are provided by small- and mid-cap companies. Small but well managed companies can graduate to the mid-cap category and become large-cap companies. The natural progression is based on robust financial performance on continual and sustainable basis.

Small companies are a must in the portfolio of investors looking to earn spectacular returns. Infosys Technologies, Cipla and Wipro started as small-cap stocks and graduated to the large-cap category over a decade. There are many such examples. More small-cap companies now have the potential to become big looking at the country's promising long-term future. An economic growth rate of over 6% is almost given in the coming decade, which means opportunities in abundant for Indian investors to profit from.

It is extremely difficult to discover the next big theme or multi-baggers. Capital Market, nevertheless, has made an attempt to discover companies that can make big in the medium to long term (see attached CSV file CatchThemYoung.csv). The criteria adopted were exhaustive and stringent. The sample base was over 2,500 companies listed on the Bombay Stock Exchange (BSE) with market cap under Rs 1000 crore. Subsequently, several filters were applied including

• positive net worth,
• dividend payout,
• compounded annual growth rate (CAGR) in net sales and profit after tax (PAT) of above 20%, and
• return on capital employed (ROCE) and return on equity (ROE) above 10% over the last five years.
• PAT was adjusted for extraordinary items while determining ROCE and RONW.
• Only those companies that outperformed the market were taken into consideration. For this, absolute change between 21 September 2011 and 21 September 2006 was considered. The BSE Sensex gained 39% in the period.
• At the end, there were 24 companies.
• From these, Balmer Lawrie Investments was removed as it holds 61.8% equity stake in Balmer Lawrie & Co Ltd (BLCL) and has only two sources of income: dividend from BLCL and interest on surplus funds. Thus, its revenue is capped.
• Thereafter, 23 companies were left. Several of these 23 companies are unexplored with nil mutual fund holdings.
• These 23 companies are from various industries such as chemicals, finance, pharmaceuticals, steel, engineering, aluminium and aluminium products, glass and glass products, breweries and distilleries, auto ancillaries, ceramics, software, automobiles, and agrochemicals. Thus, investors can have a diversified portfolio of small firms.
• Among these 23 companies, the top five with maximum appreciation in shareholders' wealth included Bliss GVS Pharma (717.6%), ABM ABM Knowledgeware (642.5%), VST Tillers Tractors (598.4%), Acrysil (490.6%), and Tilaknagar Industries (477.9%).
• Companies delivering superlative growth in turnover over the last five years comprised Bliss GVS Pharma (107.9%), Karuturi Global (104.6%), ABM ABM Knowledgeware (57.7%), Muthoot Capital Services (54.4%), Dhanuka Agritech (54.2%), and Parekh Aluminex (53.2%).
• Apart from Bliss GVS (102.9%), other companies to have reported robust growth in net profit consisted of ABM ABM Knowledgeware (113.1%), Tilaknagar Industries (100.8%), Karuturi Global (88.9%), Dhanuka Agritech (65%), IL&FS Investment Managers (57.3%), Muthoot Capital Services (55%), and Parekh Aluminex (54.1%). The figures in bracket represent five-year CAGR.

The filters that have been applied are by no means the best way to narrow down small firms that can make big tomorrow as this methodology ignores loss-making or negative networth companies. These counters could turn around and deliver superior returns in future. Ignoring such companies, thus, could mean losing on good investment opportunities.

However, the filters applied allow only well managed companies with fairly stable financials to appear in the shortlist. The various stipulations ensure that companies with fairly robust financial and operational performance emerge as top pickings. For instance,

• a good dividend track record means the profit reported is real and not merely a book entry.
• Consistency in profit is ensured through the criterion of net profit in each of the last five years.
• Stock-market outperformance enables to check if financial performance is driving the counter in the medium term.
• Outperformance over the medium to long term is a big deal.

There are several risks attached to investing in small firms. First, small companies can remain small forever. Investors even face the probability of losing capital. Many small caps create hype whenever a bull-run kicks in and vanish from the trading ring once bears attack. Focus on stable finances and robust operational performance could safeguard from this vulnerability.

Liquidity is another headache for investors. A small equity capital means lesser number of shares available for trading. Lack of volumes could turn small firms volatile on the trading floor. This could impact price discovery. Veljan Denison is a case in point. The manufacturer of hydraulic and pneumatic products has equity capital of a mere Rs 1.8 crore since 2006, with promoter holding over 73%. One can imagine what volumes Veljan Dension can attract on the trading floor. Its volumes seldom exceed double digits. Institutional investors like mutual funds, insurance companies and foreign institutional investors avoid small companies due to illiquidity. Banks do not lend against shares of small caps. This curtails interest in small firms. These factors make it difficult for small companies to attract attention. This should not be a big concern for long-term investors, who believe in the story. Volumes generally increase as the growth story becomes evident to the market.

A critical issue is inconsistent financial performance. Wild ups and downs in the top and bottom lines could scare investors during intermediate periods. Such movements are common as small companies are among the first to be affected by business and economic cycles. Investors need to overcome their fear and stay put during such challenging periods. That is the reason Capital Market has looked at CAGR growth in net sales and PAT instead of consistent year on year growth. CAGR provides point to point change without any emphasis on intermediate ups and downs.

Nectar Lifesciencereported a decline in PAT to Rs 52.9 crore in the fiscal ended March 2009 (FY 2009) from Rs 74.7 crore in FY 2008 on increased interest and depreciation due to enhanced capacities and fall of the rupee against the US dollar, which pushed up its import bill by 34.26%. Its phytochemicals business shrank 44% due to lower demand from China. Nonetheless, the company did well subsequently, with PAT bouncing back to Rs 92.2 crore in FY 2010 and Rs 102.8 crore in FY 2011. Nectar is planning to enter the US market with a number of (Anda) filings for its cephalosporins range this fiscal. Further, it intends to explore the European market, particularly France, Germany, the UK, Italy, Spain, Poland and Hungary next fiscal.

A striking feature is that several of these firms have strong balance sheets and are cash rich. This could add to the comfort level of investors as cash-rich firms are in a better position to weather economic and industry downturn. For example, Tata Sponge Iron had cash balance of Rs 188 crore end March 2011. This is 40% of its current market cap of Rs 466 crore. Similarly, ABM Knowledgeware, a company with almost zero debt, had cash balance of Rs 13.6 crore as against its present market cap of Rs 70 crore.

One of the biggest advantages of small companies is that they can focus on their businesses owing to the small scale of their operations. They can utilise their resources in a far better way compared with large companies. The management bandwidth dedicated to small companies could be on the higher side. Judging the promoters' commitment, passion and efforts is a difficult task as limited information is available about small companies. But these limitations provide hidden opportunities not known to the market at large. Hence, these stocks could deliver superior results in the medium to long term.

Many small companies have expressed their optimism about the future in the annual reports. Based on its progressive investments and initiatives, Parekh Aluminex has set a target of Rs 2000-crore top line by 2014. The company reported a turnover of over Rs 900 crore in FY 2011. Sanco Trans is planning to increase warehousing facilities by constructing additional multi-storied warehousing capacity of 1.2 lakh square feet, with a capital outlay of Rs 12 crore. The company expects to improve its capability to meet anticipated increase in the volumes of business and also reduce operating costs. Considering its net worth of Rs 34 crore on 31 March 2011 and market cap of Rs 46 crore, this particular investment is significant for the company. If one looks at its humble beginning, Sanco Trans is a ragsto- riches story that could grow bigger and better in future.

The scale of the opportunity, that is the industry size, is important as firms should have enough space to grow. A small- sized industry would limit the scope for growth. Tata Sponge Iron achieved capacity utilisation level of 98.2%, with production of 3.83 lakh tonnes FY 2011. This is a record production for the zero-debt company. With manufacturing capacity of 3.9 lakh tonnes, it is addressing a big market, which stood at 2.3 crore tonnes of hot briquetting iron and sponge iron in FY 2011. The company is in the process of installing a boiler-based power plant, with capacity of 25 MW, to utilise the solid waste. The project would be financed through internal generation and borrowings. Tata Sponge currently has installed capacity of 26 MW and sells surplus power, which is over two-thirds of its output. The new plant would further add to the bottom line.

Strategies that would drive growth are also an important qualitative factor to look at while picking the right small-cap stock. Bliss GVS Pharma, deriving 90% of its business from export of anti-malarial products, plans to set up local manufacturing units and a joint venture (JV) abroad to increase the growth momentum. It incorporated a 100% subsidiary, Bliss GVS International PTE, in Singapore in FY 2011 to oversee exports and entered into a JV in Kuwait to establish a suppository manufacturing facility. The firm reported a five-year CAGR of 108% in the top line and 103% in PAT.

Acrysil, the maker of quartz kitchen sinks, claims to be the largest sink manufacturer in the non-steel category in the domestic market and aims to be the number one across categories. The company is forming subsidiaries and establishing branches in the overseas market. It has incorporated a subsidiary in Germany, which has already begun supplies. Acrysil is in the process of ramping up its annual production capacity to 2.5 lakh units from 2.2 lakh units and increasing the reach and penetration in the domestic market. It has floated a subsidiary, Acrysil Steel Pvt Ltd, to manufacture stainless steel kitchen sinks to cater to domestic and export markets.

A small-cap quality stock operating in a niche market could be looked at based on future growth projections for the industry and the market share commanded by the firm. ABM Knowledgeware is mainly into egovernance software and has several state governments apart from the Central government as its clients. It is an almost debt-free company. Nesco owns Bombay Convention & Exhibition Centre (BCEC), which is the largest and permanent exhibition centre in the private sector in the country. BCEC is the cash cow for the company, with revenue contribution of 45% in FY 2011. The remaining revenue comes from engineering and realty businesses. Nesco is in the process of finalising expansion plans of BCEC. An architect firm has been appointed. The construction of the first new convention and exhibition hall is expected to start before the end of FY 2012. Further, its IT park's third building is nearing completion and it would start contributing to the top line in this financial year and achieve full occupancy in FY 2013. The firm has appointed an architect for the fourth IT building and work is expected to start in December 2011. These plans provide reasonable visibility about incremental revenue.

There is risk associated with expansion as failure to garner forecasted volumes could put companies in trouble. But what matters is the commitment and vigour of management to overcome difficulties. Equity is inherently risk capital and wealth is created by taking risk on a continuous basis. One of the most important criteria for investors, therefore, is to check the quality of the management and promoters. Good credentials are a must. This is something difficult to quantify. Stable financials, sound record of dividend payment and readiness to walk the talk could be some of the parameters to test promoters' credibility. A critical study of annual reports and every announcement by the company is important to fill the information lacuna.

While running a check on the promoters, investors should also search for any linkages with other group companies with dubious records. With over 2,500 companies traded on the BSE, establishing such a nexus could be difficult but an essential task. Companies with a muddy record move into the silence zone for a couple of years after being caught in the act. Such companies try to re-enter with a reinvented face once market memory feds. Investors should stay away from stocks with even the slightest doubt about their past.

Last, investors should put in money with long-term commitment as the story needs to be told and retold to grab market attention. The market should appreciate the financial performance of the company for it to become investors' favourite. This could take years and, thus, funds not needed by investors in the immediate future should be invested in small companies.

How long to hold or when to sell a small cap? The ideal answer is never, except in unavoidable situations like family emergency. But investors can liquidate in case of serious corporate governance lacuna. Another strategy would be to offload to the extent of original investment after capital appreciation. Investors who sold during intermediate periods of uncertainty have missed out the mouthwatering returns generated by Infosys, Cipla and Wipro.

A sharp appreciation in few of the small stocks shortlisted over the last five years should not act as a deterrent. The focus should be on valuation rather than appreciation in stock price. Out of these 23 stocks, only two stocks are commanding price to earning (P/E) in double digits. The rest are available at P/E in single digits. The dividend yields of IL&FS Investment Managers (4.8%), Banco Products (4.1%), Acrysil (3%) and Sukhjit Starch (3%) work out to be on the higher side and, thus, offer reasonably decent protection from sharp dips. Five stocks among these 23 are available below their book values: Gulshan Polyols (0.49), A.K.Capital Services (0.66), Nectar Lifesciences (0.75), Karuturi Global (0.87) and Tata Sponge Iron (0.92).

Investors have to look at their existing equity portfolio while exploring the option of investing in small companies. A mix of large, mid and small caps is must depending on the age-profile, risk appetite, objective of investing and duration of investment. Investment in small caps should be with long-term commitment. This is essential as small companies could witness sharp plunge owing to bear assault and may remain at low levels for years.

Investing in a basket of small companies from diverse industries could help to reduce risk and also increase the probability of unearthing real gems. But too many small companies could spoil the quality of the portfolio and would look more like a game of chance rather than investment based on research.



(source: CM mag Vol 26 Issue 16 Oct 3 - Oct 16, 2011)