In 14 points to keep in mind when buying small-cap stocks, I threw light on what one must look at specifically and diligently.
While, I am not undermining the importance that must be given to facets such as industry growth, company growth, return ratios, profitability, cash flows and debt, I would like to present a broader perspective too.
Experienced investors will not only scrutinise all of the above, but also look at potential trigger or what could provide a supportive growth environment.
Let’s look at some of them.
1. Next-Gen
Keep a track of when the next generation takes over. More often than not, the next-gen are educated from Ivy league institutes, work for renown investment banks/consultancies globally for a few years before heading back to join the family business in India. This is not just a formal transfer of responsibility, but the birthing of a culture that realizes the importance of clean corporate governance and the upside it gives to valuations.
You can see it evident during the recent past in some companies such as a leading tyre manufacturer, glassware producer and an iconic automobile player.
2. Entrepreneurs
Keep an eye out for entrepreneurs who take over a listed shell company or a very small operating company or a loss-making company. They buyout the existing promoters, make mandatory open offers to the public and once in control of the company, they come up with a strategy to turn it around.
This has recently been noticeable; a Harvard graduate taking over a forestry related company, a pipe company promoter taking over such companies to diversify in related fields.
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The heady Indian bull market was fueled by the liquidity rush post demonetization. But that was not the only reason propelling indices in India to new highs. Thanks to lower global interest rates, money was channelized into India in the hunt for better returns. A stable government at the center, lower crude prices and low inflation were other factors that contributed to the overall positive sentiment.
But many of us wanted more than what blue chips had to offer. We wanted to “beat the market”. Or, for that matter even the track records of legendary investors like Warren Buffet or Peter Lynch. Naturally, this led us to scenarios which offered potentially superior returns. And in the perpetual hunt for 10-baggers, we ended up investing in nano-, micro- and small-cap companies with questionable business models, corporate governance and promoter intentions.
We looked at:
- Turn around stories
- Hope stories
- High growth small cap names
- Formalization of informal sector across industries
- Commodity stocks
Many stocks that fell in the above categorizations turned out to be 10-20 baggers over the last 3-4 years. But once the music stopped, we witnessed a vertical decline in stock prices that has stunned even seasoned investors.
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Valuations are looked at through the prism of cash flows, earnings, corporate governance, return ratios, debt-equity proportion and so on. Within these, the most primary valuation tool used by investors is the Price Earnings (P/E) ratio.
The P/E ratio is arrived at by dividing the stock market price with the company’s Earning Per Share (EPS). For example, a Rs 200 share price divided by EPS of Rs 20 represents a PE ratio of 10. Theoretically, it translated into the assumption that if we were to buy this company today it would take 10 years to earn back our investment.
The Trailing P/E ratio uses the earnings of the last 12 months, while the Forward P/E uses the expected earnings for the next 12 months, which means it requires estimating the forward earnings.
At Mumbai’s Morningstar Investment Conference in October, equity market strategist Ridham Desai and head of Morgan Stanley’s Indian equity research team tackled the subject of India’s high P/E.
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