Small Cap Stock Per­for­mance

Dalal Street Investment Journal - - COVER STORY -

Out of to­tal 777 small-cap stocks, al­most 66 % stocks have de­liv­ered pos­i­tive re­turns over a one year pe­riod. At least 8.62 per cent of the 777 stocks, i.e 67 com­pa­nies have more than dou­bled in over one year.

More than 16 per cent of the small-cap stocks, i.e 125 com­pa­nies have de­liv­ered re­turns be­tween 50 to 100 per cent over the last one year. Al­most 134 com­pa­nies or more than 17 per cent of the small-cap com­pa­nies gen­er­ated re­turns be­tween 25 per cent and 50 per cent in the pe­riod un­der con­sid­er­a­tion.

Small-cap stocks con­tinue to out­per­form the ma­jor bench­mark in­dices. How long do you think this out­per­for­mance will con­tinue?

His­tor­i­cally, in the var­i­ous time pe­ri­ods lead­ing up to mar­ket peaks – 3, 6 and 12 months – the small-cap stocks have most of the time out­per­formed the large cap peers and un­der-per­for­mances have been mar­ginal. Dur­ing pe­ri­ods where small-caps have out­per­formed their larger coun­ter­parts (rep­re­sented by a wide mar­gin), the de­cline there­after has been just as sharp.

With the out­per­for­mance oc­cur­ring this time around as well, that too at a quick pace, it would be pru­dent to book some prof­its. Hav­ing said that, one key fac­tor that is dif­fer­ent this time around is the over­all im­prove­ment in the bal­ance sheets of the small-cap com­pa­nies, which has led to a broad-based re-rat­ing within stocks that form part of the in­dex that rep­re­sents small-caps. This is one fac­tor that makes a his­tor­i­cal com­par­i­son not so easy, and thus, tak­ing a stock-spe­cific call is the way to go about things.

What are the com­mon mis­con­cep­tions sur­round­ing small-caps?

In­vestors of­ten con­fuse ‘cheap’ with the ab­so­lute price of a stock. For ex­am­ple: a com­pany, whose stock trades at ₹5 would of­ten be con­sid­ered as a more at­trac­tive in­vest­ment than one whose stock is trad­ing at ₹1,000. One can­not be any more wrong. Let’s as­sume two com­pa­nies have the same an­nual profit fig­ure of ₹1 bil­lion. One com­pany has 1 mil­lion of shares out­stand­ing, while the other has 1 bil­lion shares out­stand­ing. The EPS thus is INR 1,000 in case of the for­mer and INR 1 for the lat­ter. If we as­sign both the com­pa­nies the same earn­ings mul­ti­ple (as­sum­ing all other things be­ing equal) of 14x, then their shares would trade at INR 14,000 and INR 14 re­spec­tively. One may be eas­ily fooled into think­ing that a stock trad­ing at ₹14 can rise to ₹18 much eas­ily than an in­vest­ment of INR 14,000 ris­ing to INR 18,000.

Promi­nent ex­am­ples of how large value stocks have out­per­formed in­clude MRF and Eicher Mo­tors. In­vestors should in­stead gauge at­trac­tive­ness in the form of the var­i­ous val­u­a­tion meth­ods – with the key ones be­ing, div­i­dend yield, price-to-eq­uity ra­tio, free cash yield, among oth­ers.

An­other com­mon mis­con­cep­tion is that small cap stocks are more risky be­cause of their size and sharp move­ment in stock prices. A com­pany earn­ing very strong and sta­ble ROCES and mar­gins with good op­er­at­ing cash flows and steady growth, but hav­ing a mar­ket cap of INR 300 cr could be a much more at­trac­tive in­vest­ment (i.e. when in­vested at a fair price) as com­pared to a lar­ge­sized be­he­moth with not so great fun­da­men­tals (hav­ing cycli­cal busi­ness and com­mod­ity-prod­uct busi­ness traits) trad­ing at sim­i­lar val­u­a­tions. Also, price volatil­ity in stocks can in fact be used to one’s ad­van­tage, rather than be­ing con­sid­ered as a risk.

At this mo­ment, would you pre­fer in­vest­ing in small-caps in­stead of mid-cap and large-cap stocks?

For an in­di­vid­ual to have a healthy in­vest­ment track record, it is equally im­por­tant to cap the de­cline as it is im­por­tant to get up­side calls right. Given the run up in stocks, val­u­a­tions have be­come a bit stretched when gauged from a broad per­spec­tive. To jus­tify the same, the earn­ings per­for­mance will have to match up.

At the end of the day, val­u­a­tions are de­ter­mined by fac­tors such as the qual­ity of earn­ings, the pre­dictabil­ity of those earn­ings and the stay­ing power of com­pa­nies. In­stead of clas­si­fy­ing stocks as mid, small or large cap in na­ture, one would do bet­ter to look at the qual­i­ta­tive fac­tors like fi­nan­cial ra­tios, bal­ance sheet strength, stance in in­dus­try, the chang­ing in­dus­try dy­nam­ics, com­pet­i­tive pres­sures, amongst oth­ers. An in­vest­ment in a com­pany with good eco­nomics and growth prospects is bound to fare well over the long run, even if not pur­chased at the cheap­est of val­u­a­tions.

❝Tak­ing a stock-spe­cific call is the way to go❞ Ni­tasha Shankar Sr. Vice Pres­i­dent and Head of Re­search YES Se­cu­ri­ties (I) Ltd.

❝Cre­at­ing value for all stake­hold­ers is the ful­crum of our busi­ness❞ N Srini­vasan Ex­ec­u­tive Vice Chair­man & Man­ag­ing Di­rec­tor Cho­la­man­dalam Fi­nance Ini­tially, we were con­cen­trated in South and our oper­a­tions were lim­ited to few prod­ucts and ge­ogra­phies. De­pen­dence on banks for fund­ing and lim­ited ac­cess to cap­i­tal mar­ket was also a hur­dle.

How has been your jour­ney from be­ing a rel­a­tive small player in equip­ment fi­nance player in 1978 to a large di­ver­si­fied fi­nan­cial ser­vice provider cur­rently?

It has been an amaz­ing jour­ney so far and we have been able to touch so many peo­ple’s life. In our jour­ney cov­er­ing four decades, we have grown our clien­tele to over eight lakhs. The growth of Chola can be at­trib­uted to our ground level un­der­stand­ing of the cus­tomer’s pro­file and their credit needs, which helped us to in­no­vate and cus­tom­ize prod­ucts to suit their needs. With bet­ter prod­uct lines, lower cost, wider and ef­fec­tive reach, strong risk man­age­ment ca­pa­bil­i­ties to check and con­trol bad debts and bet­ter un­der­stand­ing of our cus­tomer seg­ments helped us not only achieve suc­cess in ve­hi­cle fi­nance busi­ness, but we have also man­aged to build sub­stan­tial as­sets un­der man­age­ment (AUM) in the hous­ing fi­nance sec­tor. At Chola, in­tegrity, pas­sion, qual­ity, re­spect and re­spon­si­bil­ity are our five lights and all our ac­tions are gov­erned by th­ese guid­ing prin­ci­ples. All the above have en­abled us to grow from an equip­ment fi­nanc­ing com­pany to a com­pre­hen­sive and full-fledged fi­nan­cial ser­vices provider.

In your opin­ion, which fac­tors were the ab­so­lute driv­ers of growth for the com­pany?

Strong pan-in­dia pres­ence, key fo­cus on ru­ral and semi-ur­ban sec­tors, well-di­ver­si­fied port­fo­lio of as­set fi­nanc­ing prod­ucts, ex­pe­ri­enced man­age­ment team with un­ri­valled in­dus­try ex­pe­ri­ence, strong back­ing and ex­cep­tional lin­eage from the Mu­ru­gappa Group.

What were the key growth chal­lenges faced by your com­pany at the ini­tial stages?

Ini­tially, we were con­cen­trated in South and our oper­a­tions were lim­ited to few prod­ucts and ge­ogra­phies. De­pen­dence on banks for fund­ing and lim­ited ac­cess to cap­i­tal mar­ket was also a hur­dle. The fi­nan­cial sec­tor re­forms in the early 90s, lib­er­al­i­sa­tion of reg­u­la­tory con­trol over mar­kets, in­sti­tu­tions and in­stru­ments, along with ra­tio­nalised reg­u­la­tory frame­work in 2000s en­abled NBFCS to func­tion as a cat­a­lyst to eco­nomic de­vel­op­ment of the coun­try.

What are the ma­jor strate­gies of the com­pany that have helped it grow over the years?

Po­si­tion­ing Chola as a strong as­set fi­nanc­ing com­pany, cre­at­ing busi­ness value through tech­nol­ogy in­no­va­tion, strong dealer and man­u­fac­turer re­la­tion­ship, highly ex­pe­ri­enced and sta­ble team and cus­tom­ized prod­uct of­fer­ings for our tar­get cus­tomers.

How do you com­pare the busi­ness en­vi­ron­ment to­day to the en­vi­ron­ment in 1980s when it was early days for your com­pany?

The busi­ness en­vi­ron­ment in the 1980s was very re­stric­tive for NBFCS be­cause of the non-avail­abil­ity of in­stant credit and reg­u­la­tory re­stric­tions, while the cur­rent busi­ness en­vi­ron­ment and the In­dus­try out­look is very en­cour­ag­ing. NBFCS play an im­por­tant role in nation-build­ing and fi­nan­cial in­clu­sion by com­ple­ment­ing the bank­ing sec­tor and reach­ing out credit to un­banked seg­ments of the so­ci­ety. Go­ing for­ward, the la­tent credit de­mand of an emerg­ing In­dia will al­low NBFCS to fill the gap, es­pe­cially where tra­di­tional banks have been wary to serve.

Ad­di­tion­ally, im­prov­ing macroe­co­nomic con­di­tions, higher credit pen­e­tra­tion, in­creased con­sump­tion and dis­rup­tive dig­i­tal trends will al­low NBFCS' credit to grow at a healthy rate. The RBI is con­stantly striv­ing to bring nec­es­sary changes in the NBFC reg­u­la­tory space to proac­tively pro­vide reg­u­la­tory sup­port to the seg­ment and also to en­sure fi­nan­cial sta­bil­ity in the long run.

In the cur­rent en­vi­ron­ment, al­ter­na­tive credit scor­ing meth­ods are used on mul­ti­ple data sources, which en­ables in­formed un­der­writ­ing, thereby re­duc­ing de­fault rate and pro­vid­ing in­stant de­ci­sion-mak­ing. This im­proved un­der­writ­ing prac­tice en­ables in fi­nan­cial in­clu­sion and has the abil­ity to reach a di­verse and wide­spread au­di­ence. This was not the sce­nario in the 1980s as the credit man­ager had lim­ited data for eval­u­at­ing the credit wor­thi­ness of the cus­tomer.

In the jour­ney so far, has there been any shift in vi­sion and mis­sion of the com­pany?

There has never been any shift in vi­sion and mis­sion of the com­pany. The vi­sion of Chola is to en­able cus­tomers en­ter a bet­ter life. Ever since its in­cep­tion and all through its growth, the com­pany has kept a clear sight of its val­ues. The ba­sic tenet of th­ese val­ues is a strict ad­her­ence to ethics and a re­spon­si­bil­ity to all those who come within its cor­po­rate am­bit - cus­tomers, share­hold­ers, em­ploy­ees and so­ci­ety.


A good stock is a good stock to buy, not­with­stand­ing its mar­ket cap­i­tal­i­sa­tion. In­vestors should not get car­ried away by the re­cent run in small-cap stocks. Small-cap stocks seem to be ex­tremely popular with the in­vest­ing com­mu­nity lately due to their re­cent per­for­mance. Also, due to ta­per­ing of growth in large-caps, in­vestors find rel­a­tive higher growth in small-caps at­trac­tive. It is widely per­ceived that small-cap in­vest­ing is risky. The fear of small-caps be­ing ex­tremely volatile may be overblown, as our re­search sug­gests that small-caps in the long run are not as volatile as they are per­ceived to be. With the global fund man­agers look­ing pos­i­tively at emerg­ing mar­ket small-cap stocks as an as­set class within eq­uity, chances are that there will be no dearth of liq­uid­ity in small-cap stocks.

With lot of in­vestors' at­ten­tion, both re­tail and in­sti­tu­tional, on small-cap stocks, one needs to only avoid highly lever­aged stocks with poor earn­ings out­look. In the cur­rent mar­ket sce­nario, with slow­down in GDP and ex­pen­sive val­u­a­tions, the ex­pec­ta­tion on small-cap stock re­turns need to be re­al­is­tic. We be­lieve that small-cap stocks as a cat­e­gory may still out­per­form their peers in large-cap space. How­ever, the re­turns in the com­ing years may not be as high as we have seen in the pre­vi­ous three to five years.

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