Home / Money / Personal Finance /  Meet the young small-cap investors picking multibagger stocks

Sahil Sharma, a software engineer from Delhi, who sees himself as a multi-tasker, analyse small-cap companies in his spare time. But volatile and sometimes irrational movements in such stocks present a challenge. “Coming from a science background, solving a mathematical question or writing a program is very deterministic. But investing, especially in small-caps, is a probabilistic game, where things change rapidly," he said.

For India’s small but growing tribe of small-cap investors, the hunt for small-cap multi-baggers comes with the expectation of great rewards. “With small-caps, we will be able to get the highest return for the invested time, which we will never be able to generate by investing in large-cap companies even if we analyse them extensively," says Sharma.

According to Mint’s research of the NSE data from QED Capital Advisors, about 6% of listed small-cap stocks turned multi-baggers in the past 5 years – delivering 5 times or more returns in 5 years. However, investing in such companies is also highly risky. One in every seven stocks in the small-cap space on the National Stock Exchange (NSE) has either been suspended or delisted in the last 5 years, while only one in 16 turned into a multi-bagger (went up 5 times or more in the past 5 years).

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Those who spend extra hours poring through company annual reports and stock exchange filings also need to ensure their stock picks outperform small-cap mutual funds, so as to justify their efforts. These mutual funds have delivered 2-3x returns over the past 5 years. As for ordinary investors, they can put money into a small-cap MFs and let the fund manager generate returns for them.

Filtering small cap stocks

Filtering and analysing a small-cap company from a myriad of more than 1,000 stocks is a tough task given the limited disclosures and information available in the public domain. Serious investors who directly invest in small-cap stocks often resort to the ‘scuttlebutt’ technique, which involves obtaining information from various sources including vendors, customers, and former employees, etc., to understand the business.

 

 

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Sharma is self-taught when it comes to investing. He learned the basics of investing from platforms like Varsity by Zerodha, online courses and by putting it into practice every day. For him, ValuePickr - a forum for discussions on Indian mid-and-small-cap companies, is the starting point to select a stock to analyse. “I take cues from those whose investing style I admire. But that’s just the starting point. I will do my own groundwork before buying a stock."

Yashika Narang, a resident of Surat, was taught to save and invest by her parents in childhood. She started her investment journey with mutual funds but now has an exposure of almost 30% to small-cap stocks. Narang approaches small cap investing systematically. “I follow a top-down approach and focus on finding the industries that have tailwinds. Then I look for companies that are potential beneficiaries in the value chain; I map the full value chain of the industry starting from the manufacturer of the product, distributors, customers, to the middle-men who are marketing the product," she said.

According to Mumbai-based finance content creator Aryan Mulchandani, 21, when it comes to screening small cap companies, “I first filter out stocks that have a price-to-earnings ratio of more than 50. This is just a quick way to remove operator-manipulated stocks or those that could have garnered a lot of interest in the last 6-12 months."

Mulchandani, who is also a member of Multipie, a social network for investors, follows a contrarian style of investing where he looks for companies that are facing headwinds but are in a turnaround phase. He believes that the right small-cap stock is not correlated with the market and acts as a different asset class.

Narang backs up her initial filters with some more checks. “I look at financial ratios such as profitability, asset turnover and leverage. If I think that a company can balance three of these levers and expand ROE (return on equity), I will consider investing in it," she added.

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How much time to devote

A few of the direct small-cap investors thatMintspoke to said that they spend a minimum of 20-25 hours researching a small cap stock before they invest. This process can sometimes stretch to a few months. Investing in small-cap stocks is not just about earning supernormal returns for many young investors; it is also about passion, zeal for learning and the thrill of finding a multi-bagger.

For Ankit Gupta, 35, an engineering graduate from Ahmedabad in Gujarat, it was an extremely difficult decision to resign from his job in 2018 to become a full-time investor.Gupta,who is now a CFA (Chartered Financial Analyst) charter holder now believes that small-cap investing is not very risky, provided investments are backed by thorough research. “I significantly invest in companies with a market capitalisation of less than 10,000 crore. I study the company for about three to four weeks and go through their past 10-12 years of annual reports," he said.

Not all small cap investors devote themselves full-time to this activity. Aryan Mulchandani, who started reading finance-related books when he was 14, figured out that his risk profile is moderate and invests in small-caps only to enhance the returns of his overall portfolio, which is significantly invested in index funds.

Promoter matters

“My first filter for stocks is based on management’s honesty, its capital allocation decisions and willingness to share the returns with minority shareholders. I don’t want to compromise on that," said Gupta.

“One of the biggest risks in small-cap investing is the promoter risk. There has been a transformation from family-owned to professionally managed businesses in the small-cap space. If one can identify such a company in its early stage of transformation and if the business (products/services) are future relevant, that can be a potential multi-bagger. However, spotting them is the most challenging part," said Porinju Veliyath who is popularly known as the small-cap Czar in India.

Gupta, who started investing for almost a decade, said that the first and foremost criterion to invest in small-cap companies is to assess management integrity.

According to Mulchandani, we must resist falling in love with small-cap stock. “If an accounting fraud or a governance issue is discovered after investing, we need to cut our losses faster. Conviction is important, but that shouldn’t be misplaced. Businesses in this space are not like large-cap companies where the brand name is bigger than the person," he added.

Buy and hold, or time the market?

Equity delivers returns over the long term, but not all small cap investors believe in the ‘buy and hold’ technique of equity investing popularized by Warren Buffet. Gupta tries to book profits during good times in the market because he believes that mid and small-cap companies cannot sustain higher valuations witnessed during bull markets in the long run. This can be emotionally taxing. Gupta recalled a saying by the late Rakesh Jhunjhunwala, that markets are supreme and said that the investing journey will always be full of regrets - for not buying a stock that went up and for not selling a stock that corrected.

Final words

The biggest challenge with investing in small-cap companies is evaluating the corporate governance of the company. “It helps to start with a governance checklist to see areas where companies might be faltering. A good majority of companies in this space have some governance issues. Hence one needs to take a judgment call on the management’s intentions and actions and decide accordingly. It is not completely black and white there," said Ganesh Nagarsekar, a research analyst tracking small-cap companies.

The low liquidity of small-cap stocks on the stock exchange is another issue. The illiquid nature is a double-edged sword. Due to a lack of investor interest in this space, one might get a stock at a very attractive valuation. On the other hand, a small trade can fluctuate the price of the stock significantly and investors may not be able to buy or sell the stock at the desired share price. Jiten Parmar, the co-founder of Aurum Capital suggested that one must stagger the investments over a period of time to reduce the impact cost of buying small-cap stocks. “One can also consider checking if the trading volume of the stock on any particular day is at least 10 times the amount which is intended to be invested," he added.

It’s a no-brainer that investing in a small-cap is a time-consuming process. If one cannot allocate adequate time for research, one would be better off investing in actively-managed small-cap mutual funds than direct investing to have the exposure. Going passive in this space has so far not proved rewarding. Active funds, on an average, beat their benchmarks over the long run because the market is still relatively inefficient and careful analysis can help fund managers spot opportunities.

Elsewhere in Mint

In Opinion, V. Anantha Nageswaran & Gurwinder Kaur tell why MSMEs survived the pandemic. Are we axiomatically immune to a global recession? Madan Sabnavis answers. Rajani Sinha tells what can anchor Indian economy amid a global shake-up. Long Story lays bare an ambitious plan to speed up India.

ABOUT THE AUTHOR

Satya Sontanam

Satya Sontanam is a senior content creator at Mint with a keen interest on data crunching, analysis and the story behind trends. She writes on personal finance including investments, regulations and data stories. Before joining Mint in December 2021, Satya worked as research analyst and also a personal finance writer at The Hindu BusinessLine. Satya is a qualified chartered accountant. In her free time, she enjoys doing yoga and listening to podcasts.
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