Getting big returns from small stocks

These are currently rising faster than their large-cap counterparts. Yet, tread carefully and invest only in sound companies

What do stocks like Atul Auto, Ceat and VST Tillers have in common? They all are small-caps and have made multi-bagger-like returns in the past year.

One of the biggest movers of this bull rally has been the rise of small-cap stocks, especially in the past four months. They have defied gravity, beating large-caps and mid-caps handsomely this past year (the term cap is an abbreviation for market capitalisation of companies). The BSE Small-cap index returned 25 per cent the past year, while the benchmark BSE Sensex and BSE Mid-cap surged 18 per cent.

Lately, the strong up-move in small-caps has prompted big brokerages and analysts to do deeper research and coverage on these stocks. Analysts usually avoid small-cap research because of low liquidity and lower participation of foreign institutions. The trend is changing.

However, has the huge outperformance made the small-cap universe more vulnerable to a price correction? Should investors be wary about investing in this segment?

Still undervalued

For now, small-caps are still reasonably priced and have lower valuations than large-caps. Currently, large-caps trade at a price to earnings ratio (PE) of 16 times trailing earnings; mid-caps at a PE of 12-13 times. Says Vinit Sambre, vice-president, investments, DSP BlackRock Mutual Fund, who manages the DSP micro-cap fund: "This is giving some comfort on valuations. But if you have a positive view on the markets for three to four years, this category will outerperform and one should remain exposed to this category for the long haul."

Small-cap investing is, however, challenging. The companies that can gradually grow into large-caps and provide consistent earnings are among the ones that give the highest possible returns. But it is not very easy to find these companies. When the economy is down, small stocks see pressures on their balance sheet. Says Vishal Jajoo, senior research analyst, Nirmal Bang Securities: "Economic turbulence can be very hard on small-cap companies. Big companies can manage the risk due to the strength of their balance sheet but it gets very hard for small companies."

However, experts reckon the economy should recover in the next two years and there is a huge opportunity in the small-cap space, as these companies can grow faster than large-caps. Says Sambre: "Leave aside the top 300 companies and the rest is the small and micro-cap universe. Indian entrepreneurship culture is enormous and investors can participate by investing with the right promoters. One has to be very careful, though, about the credibility of the business and cash flows."

The big upside for small stocks comes from above average growth, as well as a re-rating in valuations. Sambre says a large-cap's PE of, say, 20 times leaves little room for a re-rating. So, the growth of these stocks is only through that in earnings. For small companies, investor returns can come from an upside in both earnings and valuation.

Jajoo points to VST Tillers as an example. It is a small company that manufactures tillers and is seeing robust demand for its products, posting consistent earnings growth. The stock was quoting at Rs 340 and around six times its earnings last year. It is now quoting at Rs 1,062 and at about 12 times earnings. Investors have made more than 300 per cent return in a short while.

Another big positive in small-caps is that these are usually under-researched but this works both ways. It might mean not having enough data to take the right investment call. But if you are able to spot an opportunity, it will help your portfolio. This leaves room for higher appreciation as their business growth stories get more visibility. Market watchers reckon it's important to identify an opportunity before other market players. If a small-stock story plays out well and the brokerages and big investors pick up after that, this gives you additional gains.

Says Jajoo: "Alpha returns are possible in small stocks but you have identify such opportunities early and be convinced about their growth potential." Among automobile companies, for instance, growth has been tough for Bajaj Auto and Hero Honda. But Atul Auto, a company making autorickshaws, has been seeing 18 per cent annual volume growth consistently for four to five years. Its stock has gone up from Rs 170 to Rs 361 in one year and valuations have improved from seven times to around 13.

Watch the risk

Nevertheless, the going isn't always hunky-dory for small-caps. Experts say it requires a lot of high conviction to buy small-cap stocks and only a careful selection strategy could pay in the long run. Says Sambre: "The cost of going wrong is very high. For instance, if you invest in a company and you realise the promoters have siphoned off money. It can have a big impact on your portfolio."

Also, small-caps stocks tend to move in waves. From January 2009 till August 2010, the BSE small-cap index outperformed the BSE Sensex. Since then, the small-cap space has underperformed and still has to catch up with large-cap stocks. As small-caps move in cycles, investors might see longer periods of under-performance.

Many unknown and illiquid stocks can show exceptional returns in the short run and drive up the indices. Says Sambre: "If you have got yourself into a badly managed company, have not given much thought to the credentials of a company, about the management, that is a big risk."

On the other hand, if you invested in a good management and good business, and the cycle turns low, there is a chance the cycle will recover and whenever it does, these good companies will bounce back in a big way.

Investors will have to assess their risk profile, to see how much exposure they can give to the small-cap and mid-cap space. One can reduce risk here by going for good cash flow companies, available at a reasonably attractive price.

Experts say one will not be able to take a short-term call. The way to look at this is to see the long cycle, stay invested and give the company time to grow and increase its earnings. As earnings grow and the market recognises the potential of the company, valuation multiples will also re-rate and investors will make above-average returns.

UNDERSTANDING THE WINNERS

* Small stocks have the potential to provide above-average returns but are vulnerable during an economic slowdown

* Consistent growth in earnings and business opportunity could see these stocks re-rated in the market

* These stocks are often thinly traded and avoided by investors; therefore, stock prices can swing faster

* Being a less liquid counter also makes it difficult to buy and sell in large quantities

* Look for companies that show consistent earnings growth, sound business prospects and wait for the investing story to play out