There is no disputing the fact that there was more wealth at the bottom of the pyramid over the last two years. Large-cap stocks, which rallied in an impressive manner prior to the Lok Sabha elections in 2014 and for a few months following the event, turned lukewarm from 2015, hit by poor earnings, slow pace of reforms, global commodity melt-down and growing global risk-aversion.
Small-cap stocks have, however, continued to sizzle and the S&P BSE Smallcap Index is currently close to its life-time high. This index has returned 26 per cent annually since the beginning of 2014 while the Sensex grew at less that half this rate, at just 12 per cent.
The performance of individual stocks has been even more spectacular. If we consider the movement of the actively traded stocks forming the S&P BSE Smallcap Index between January 1, 2014 and now, more than 73 per cent of the 730 stocks have gained more than 30 per cent. What is more, 380 stocks have more than doubled their price over the last two-and-a-half years and 135 stocks have given more than three-fold return. The multi-bagger list contains some well-known names such as ITD Cement, TVS Srichakra, Century Ply and NBCC.
So, why are these small-caps rallying? Are they backed by fundamentals?
Supported by numbers A look at the earnings of the companies in the small-cap index shows that many of these companies have managed to improve their performance over the last two years. Four out of every 10 stocks in the BSE Smallcap Index have recorded more than 30 per cent increase in their net profits between FY14 and FY16. About a third of the basket has recorded more than 50 per cent increase in profits in this period and almost 18 per cent have recorded earnings growth of over 100 per cent. Some stocks such as Rico Auto, BEML and Tube Investments have recorded five-fold growth in their earnings in the last two fiscals. Presence in niche segments and smaller size appears to have worked in the favour of many companies.
The improvement in earnings has come in difficult conditions. This is reflected in the revenue growth; about a third of the companies recorded less that 5 per cent growth in sales between FY14 and FY16.
Not too burdened by interest It is true that some of the smaller stocks in the infrastructure, steel and real estate space such as ABG Shipyard, Indiabulls Real Estate and GVK Power have taken on too much debt and are struggling to service it, but small-caps on the whole have not taken up too much debt. Interest cost as a proportion of revenue is less that 4 per cent for 40 per cent of the small-cap universe.
Unlike their larger counterparts, the small-caps appear less leveraged. While this does mean that they could be cutting back on capex, it is apparent that the smaller companies are more intent on reining expenses to get through this tough phase.
Getting pricey The biggest risk with small-caps is, low liquidity. Low floating stock and high promoter holding tends to increase impact costs in small-cap stocks. So, once a large institutional investor starts buying, prices tend to rise steeply, making these stocks pricey. Similarly, if a large investor offloads stocks, prices can crash. These sharp price movements are absent in large-caps where participation and hence volumes are higher.
The BSE Smallcap Index is currently trading at a price-earning multiple of 68 times, far above the earning multiple of 20 at which the Sensex trades currently. Many of the stocks in the index have been re-rated since January 2014; almost 60 per cent of the stocks in the index have seen their PE expand more than 20 per cent in this period and almost a third of the stocks trade at multiple of over 30.
It is obvious that with investors chasing smaller stocks, they have turned quite pricey. So should you buy at these levels?
It is true that the risk is higher at such elevated valuations due to the higher impact cost associated with these stocks. Again, information about smaller companies tends to be scanty. Many of these companies also have poor governance, making it difficult to judge a company’s prospects accurately. Not everyone can devote enough time to equity investment to enable entry and exit at the right time either.
While the risk averse can steer clear of small-caps, those with a stomach for risk can allocate a small portion of their portfolio to these stocks; for there are good growth stories in this space.
For those who want to take the plunge, here are five stocks you could consider.