While small-caps tend to outperform in a rising market, investors should watch for scrips riding on momentum rather than performance.
With the broader indices continuing to power ahead and valuations trading at a premium, investors tend to look at small and mid-cap companies for bargains.
While this is a normal part of the investing cycle, indices such as the BSE Small Cap have also been participating in the rally, giving returns of 34 per cent vis-à-vis the Sensex's 20 per cent in the past year.
Though a number of small-cap scrips ran up on news flow and improvement in operational parameters, a large number of stocks have been piggybacking on the market momentum, with little change in fundamentals.
"When markets are at fair valuations, some investors look at the absolute price of the small caps, which look cheaper, increasing speculative activity," says Sarabjit Kour Nangra, VP, Research, at Angel Broking.
To identify stocks which have appreciated significantly and where fundamentals are far from comforting, we crunched numbers.
We looked at companies that have market value below Rs 4,500 crore (Rs 45 billion) and had seen their share prices rise more than 100 per cent over the past year.
To filter out better businesses, we excluded most dividend-paying and cash flow-positive companies and chose those with lower return ratios on the capital employed (of less than 15 per cent), as well as poor profit track record. We further sorted out companies that had positive triggers on the business front.
While the table comprises of top scrips (by returns) that are riding more on momentum than performance, investors should also make their own independent analysis before deciding.
Many of these are also under-researched, with hardly a few analysts tracking them. We also spoke to experts, who highlight the parameters that investors should bear in mind before committing money to small caps. Read on to know more.
When to invest
In addition to the liquidity issues, costs and risks associated with investments in small and mid-cap stocks, fund managers feel it is better from the returns perspective to invest when the business cycle for the sector/stock is at its low rather than in the up-cycle.
Defensives like FMCG and pharmaceuticals are, of course, the exception, they opine.
Analysts say that small caps tend to scale new highs and retail investors get attracted to these, especially at the last leg of the bull-run.
Interestingly, a leading fund manager says the fund has actually gained by investing in small caps which have not shown spikes in trading volumes.
Stocks with excessive volumes do not give adequate returns, are costly to keep in the portfolio and, in most cases, are typically up due to speculation, he says.
Most money managers believe that for your investments in small caps to work, you need to hold your investments for at least three years.
What to look for
"It is better to look at price to book rather than price to earnings while picking up small caps, especially for cyclical sectors and companies," says Sankaran Naren, CIO, Equities, ICICI Prudential AMC.
Since lower profits could inflate the PE and distort valuations, assessing smaller stocks on the book value is more advisable. Naren believes the company should have a record of at least five years.
To avoid investing in businesses which are struggling or have gone up on speculation, it is better to stick to companies which have paid dividends over the past two-three years than those with no dividend record.
Anoop Bhaskar, head of equity at UTI AMC, believes that unlike large caps, the key criteria that investors should look at are operating cash flow, capital intensity of the business due to dilution concerns and broader parameters such as pricing power and, thus, ability to improve profitability.
Analysts such as Nangra that investors should avoid small caps which do not have a strong management, transparency, scalability of business and a credible record.
(With inputs from Sarath Chelluri)
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