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 scrutinize 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.
3. High insider ownership
Look for ESOPs, the holy grail for job seekers and a magnificent source of wealth for its employees. This is now fairly prevalent in all listed companies. Keep an eye out for such a programme that could crop up in a company you are tracking. They may be used to reward old hands or the new professionals who have joined in, such as bankers joining listed NBFCs.
A hotshot foreign banker taking a stake in a leading forex player; retail banker taking over an NBFC with the help of a decorated private equity player are two examples that immediately come to mind.
A high promoter holding is also most welcome at it displays skin in the game. There are also instances wherein some promoters hold more than the mandatory 75% mandated by SEBI. A crawler of Ministry of Corporate Affairs will help you understand who are the directors/partners of top 10-20 public shareholders of any company and if they are in anyway related to the promoters.
4. Exclusive tie-ups/technology partnerships
Some companies have a tie up for a global recognized brand or technology which is exclusive. In fact, it could also be the case that the Indian franchise is valued more than the parent/owner of the brand worldwide. This is due to the size of the Indian market, the monopolistic nature of that specific market, huge growth prospects, high margins and other such factors.
You would find instances in fast food, inner wear and automobiles.
5. Look beyond the obvious when it comes to shareholding patters and subsidiaries.
a) Small listed entities of large groups
There are many listed companies which do minimal or no business at all and are part of large corporate groups. Essentially, these are companies kept by promoters to house any new business which they intend to do in the future. Alternatively, if they intend to hive off a business from one of their main operating companies.
Think of a housing finance and real estate player venturing into other areas of the financial services industry.
b) Valuable subsidiaries or joint ventures
There are many companies whose performance is lousy but have subsidiaries or hold substantial stakes in companies which show superlative performance. More often than not, these valuable subsidiaries essentially contribute to the main value of the company. Focus on subs in annual reports should be a routine now.
For instance, a chemical company having a highly profitable diagnostic subsidiary or a manufacturer running a subsidiary in luxury retail.
c) Holding or investment companies
There are plenty of listed and discovered companies in this space and many companies which are not yet known widely. Yes, identification is a problem, but a fair amount of diligence like looking at the shareholding pattern or top 10 shareholders of large listed entities do sometimes carry names of smaller/shell/holding companies listed on the exchanges.
Some listed entities holding stakes in a paints company, a cement manufacturer and a highly valuable unlisted housing product company are some examples.
6. Analyst coverage
Limited or no analyst coverage is what should get you excited.
An undiscovered stock is the best bet. It lets the management perform unhindered without any distractions or pressure from the investor community. It may be tough to believe, but many companies are rarely spoken about in the media, until they have already become multibaggers.
There are plenty of examples in agricultural inputs and chemicals, animal feeds and processing etc
When investing in small caps, it pays to be alone. You get to buy the stock at your price and convenience. Take your position and wait for your investment to perform. When (and if) the performance begins to pick up and the stock price rises, it starts getting noticed. That’s when the analyst reports come out and larger investors start getting in. By that time you would have already had your 3/5/10 bagger.
But……
It all sounds so beckoning. But remember, these investments are fraught with a higher risk.
Many of them don’t have proven business models or have been badly mis-managed. There is a risk of franchise or royalty agreements being re-drawn. Also, professionals who have performed spectacularly in large institutions may not necessarily have a repeat performance when they take over a company. But if the blocks all fall into place, the payoff is huge.
Higher the risk, Higher the return.
It is so true.
Shagun Jain is vice president at Kotak Mahindra Bank. He blogs at liberatedsoul.com and tweets at @liberatedsoul3.
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