Three high-potential smallcaps for 2024 watchlist

While the fundamentals of companies in the smallcap space have shown a recovery, it’s the liquidity and valuation expansion that is driving the gains. (Image: Pixabay)
While the fundamentals of companies in the smallcap space have shown a recovery, it’s the liquidity and valuation expansion that is driving the gains. (Image: Pixabay)

Summary

  • Caution, and not greed should be the sentiment while investing in smallcaps in the ongoing rally.

Have smallcap stocks run up too high? Is this rally in smallcaps going to continue further? Or are we going to witness a brutal crash?

If you are an investor, then these questions must be bothering you right now. Let us help clear these doubts. 

Here’s a quick summary of what’s driving this rally.

AMFI data suggests that inflow in smallcap funds has trumped the inflows in mid and largecaps. A staggering 372 bn from funds have found their way to smallcaps, as compared to an outflow of 27 bn in largecaps and 215 bn inflow in midcaps.

We have mentioned dedicated buckets here, and not multicap, thematic, or flexicap schemes here.

While the fundamentals of companies in the smallcap space have shown a recovery, it’s the liquidity and valuation expansion that is driving the gains. This is evident from the rise in Smallcap-to- Sensex ratio.

At the start of 2023, the ratio was at 0.46 times, as compared to a long-term median of 0.43 times. In February 2024, the ratio is way past that average. At 0.63 times, the Smallcap to Sensex ratio has already breached the previous peak of 0.58 in 2018.

The earlier corrections from the peak have been in the range of 50% to 70%. The recovery from the last crash in smallcaps took three years. That pales in comparison to 9 years post-2008 crash. As such, caution and not greed would be the right sentiment to approach smallcaps at present.

While Smallcap-to- Sensex ratio is flashing ‘caution’ sign, insider activity in Indian stock markets is not comforting either.

At 1.1 trillion, insider selling this year has been almost 2x of insider selling in 2020. And almost six times higher than 2018.

Opposite trends in insider activity and institutional activity, in the context of high valuations, has led to a dilemma of whether to stay put or get out.

We believe the answer is none of this.

The right strategy to play in smallcap space would be to be highly selective.

That would mean booking gains where earnings don’t support valuation expansion.

And looking for undiscovered players that big investors are yet to get a whiff of. It is here that you are likely to find the rare combination of growth and margin of safety in the current market.

Sticking to a selective approach has led investors to ride over a thousand percent gains in stocks like Hawkins, Page Industries, Persistent Sytems and Balkrishna Industries in the past cycles for smallcaps. While these stocks are considered junior bluechips now, there was a time they were ignored.

There is no dearth of high-potential businesses in smallcaps that are still in the ‘ignored’ bucket, even in the current rally. Being under the radar of big investors, these stocks offer relatively a lot more margin of safety as compared to a highly chased and overvalued set of smallcaps that institutions are buying.

Here is a list of three stocks that we believe you should keep on your smallcap watchlist for 2024.

#1 Pix Transmission Ltd

PIX Transmissions Ltd. is the leading manufacturer of belts and related mechanical power transmission products in India. It has an automated rubber mixing facility and a centralized logistics hub in Nagpur.

Its application areas include automotive including EVs, agri, ceramic, cold storage, mining, food processing, machine tools, cement, paper, oil and gas, steel, pharma, paper, and construction industry.

The company has a global presence with support infrastructure in countries including the UK, Germany, and UAE, and channel partners in over 100 countries. Exports comprise 60% of its revenue.

The customer concentration risk is low with top ten customers contributing about 36% (41%) towards total sales.

In FY23, the company increased its capacities to cater to growing demand for its products. It was also the year when the company reported its highest-ever revenue despite challenges in the global economy.

For the trailing 12 months, the growth in the operating profits stands at 22.8% with EBITDA (earnings before interest depreciation and amortization) margins at 24.4% vs 20.8% (YoY).

The company has minimal debt on its balance sheet. With a return on equity of 16.6% and return on capital employed at 19.5%, it is currently trading at a PE of 22.8 times and PEG (Price earnings to growth) ratio of less than 1 time.

The key monitorables for the company are ability to sustain margin in case of raw material price fluctuations (mainly rubber) and working capital cycle.

The institutional stake in the stock is less than 5%, while promoters hold 61.82% stake in the company.

#2 RACL Geartech Ltd

RACL Geartech Ltd core competencies include gear cutting, precision machining, aluminium machining, process R&D and concurrent engineering, exports logistics handling.

Its products include transmission gears and shafts, sub- assemblies, precision machined parts, chassis parts and industrial gears.

With over 900 SKUs, it caters to 22 active customers in the auto and industrial segment - two wheelers, three wheelers, premium e bikes, passenger cars, commercial vehicles, ATVs, agricultural equipment and industrial gears.

Its clients include BMW Motorrad (Germany), Kubota Corporation, IT Switzerland, KTM AG, Schneider Electric, Dana, MAN, ZF. Top 5 customers accounted for ~60% of revenue in FY23.

Over last few years, the company has witnessed expansion in operating profit margins (25% in FY24) with value added products, and as a supplier to premium segment export customers. Exports comprised 76% of revenue in FY23.

Its turnover for FY23 stood at 3.7 bn.

The return ratios remain healthy at over 20%. While the debt is on the higher side (over 1x debt to equity), the interest coverage ratio stands at 3.5 times. The management is comfortable with the debt levels for now and doesn’t wish to dilute equity. The business is working capital intensive.

It has undertaken a capex for increasing capacities and upgrading existing facilities. For FY24, the budgeted capex is at 800 m. While the auto industry itself in cyclical in nature, exposure to premium segment mitigates this risk to some extent.

The growth guidance for FY24 is in the range of 15%-20%. The management expects margins to be sustainable in the range of 22%-24%. The institutional stake in the company is less than 1%. The stock is trading at a PE of 31 times and a PEG of less than one.

#3 MPS Ltd

MPS Ltd is one of the leading players globally in the publishing outsourcing space. It’s a B2B model with end clients being scholarly and research community, education community, edtech, corporate learning space.

Its clients include Macmillan, Cengage Learning, McGraw-Hill, Elsevier, Wolters and Kluwer. 

The company has multiple segments – Content solutions that deals with content creation and delivery across different channels, platform business that offers a complete range of configurable platform solutions throughout the entire content lifecycle, delivered as SaaS and e-learning segment.

The management has shared a vision of a revenue base of 15 bn by FY28, almost 5x of current topline, with significant contribution (60%) from acquisitions. The operating profit margins for the company are north of 40%. The balance sheet is almost debt-free.

The return ratios stand above 25%. The institutional stake in the company is less than 4%. The stock is trading at a trailing 12-month PE (price-to-earnings ratio) of 25x.

Do note that none of the stocks mentioned above reflect a view on the stock. Any investment decision should be based on due diligence and keeping in mind the asset allocation guidelines.

Happy Investing,

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com

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