Smallcap stocks: Don't overlook this critical question before investing

Understanding smallcaps requires more than numbers. Harini Dedhia shares the single most important question to ask a smallcap company, to understand if it can truly scale and win market share

Another quarterly earnings season has ended, and so have the plethora of messages, emails and tweets on all sorts of number crunching. While it is easy to build screens to parse through financial data of the past, past returns do not guarantee future return.  In smallcaps, the future is dependent on the company's ability to scale and continue gaining market share. Our ability to determine the probability of that occurring as an investor is dependent on asking "the most important question" of a business, that sheds light on the qualitative aspects of their business. This question changes depending of who the customer is; i.e. B2B or B2C.  

The most important question to ask of a B2B business is, "Why can your company manufacture this (or deliver this service) more efficiently than anyone else?" If the company is not an efficient producer vs. its peers, the company is unlikely to scale as there is no right to win. A simple turn in the business cycle, will lead to competitors waging a price war to grab client wallet share and the company in question will be left to bleed or simply give up.  

This efficiency can either be a product of innovation (using materials or a new method of manufacturing) or just better project engineering leading to lower requirements of capital in order to achieve similar production levels. While the earlier is rare to see in the ecosystem, the latter isn't as uncommon.   ALSO READ | Neuland, Lupin, Divi's lead domestic, CDMO surge amid US generics headwinds 

  I will share a few examples to exemplify this. In the pharmaceutical ingredients space, the leader specialises not in chemistry or bio-chemistry but in their ability to design their own equipment resulting in much higher yields compared to peers. This has allowed them to take on Chinese competitors head on and therefore consistently scale. Their strong market position is demonstrated by the narrow band their gross margins operate in.  

 

A niche oleo-chemistry based additives player has a similar strength. Their excellence stems from their internal department of project engineering and not chemistry. While still a small cap, their excellence is demonstrated by higher return on capital employed vs. peers.  

 

Both of these companies have demonstrated engineering excellence leading them to have dramatically lower capex costs versus peers. This capital efficiency therefore allows them a right to dominate their respective product segments. 

  This question however is ineffective when one tries to understand the ability of a B2C business to scale as most of them tend to be asset light and opex heavy. The question to ask here is, "How do you sell better than the next guy on the street?" Neither capital nor a hero product alone can solve for a lacklustre sales effort.  

The paints industry recently witnessed significant disruption with a large conglomerate investing 10,000cr in order to gain a foothold in the industry. Despite this capital being spent, as the dust settles, market shares are again trending in favor of the dominant industry player that has always had a right to win with their distributors. 

  The most recent success story of a new protein brand making it to 150cr ARR at the end of year 1 showcases a differentiated go to market strategy. A powerful brand ambassador/ co-founder was backed with instant gratification of ordering the product at a great price point via quick commerce. The moment the social media marketing campaign dropped, so did the product on quick commerce, inducting a paid trial from customers instantaneously. A differentiated ability to sell is what makes a hero scalable B2C brand. 

  With everyone overanalysing reported numbers, focusing on these most important questions help understand businesses and their ability to scale better.       ===============  Disclaimer: Harini Dedhia is Fund Manager at Tamohara Investment Managers. Views are her own.