Deciding on “which stock to analyse” should be given serious consideration.
The Indian market regular, SEBI, classifies listed Indian stocks – based on their market capitalisation – into three categories: large-cap stocks, mid-cap stocks, and small-cap stocks. Stocks ranked between 1 and 100 by market capitalisation are the ‘large caps’; those ranked between 101 and 250 are the ‘mid-caps’; and those ranked above 250 are the ‘small caps’. There are around 5,000 listed stocks on the Bombay Stock Exchange (BSE) – which means 95 percent of listed stocks belong to the ‘small cap’ category.
Of this 95 percent… only 5 percent receive any serious coverage by major institutions… like mutual funds, foreign investors, pension funds, and insurance companies. This indicates that the stock market is akin to ocean exploration or space exploration… where even though stupendous progress has been made over the last century… a vast majority remain unexplored.
In Indian equity markets, stocks with a market capitalisation of less than ₹5,000 crores receive little coverage from the mainstream investment community. They don’t receive enough attention. And the lower we move down in market capitalisation; the scale of coverage diminishes further.
Consider mutual funds: Quant Small Cap Fund, SBI Small Cap Fund, DSP Small Cap Fund, and Kodak Small Cap Fund are a few top-performing small-cap Equity Mutual funds – funds that invest at least 65 percent in small-cap stocks.
Consider DSP Small Cap Fund with net assets of ₹9,231 crores. The Fund holds a total of 70 stocks with an average market capitalisation of ₹6,561 crores. Its biggest holding Suprajit Engineering has a market capitalisation of ₹5,547 crores.
Kotak Small Cap Fund – another top-performing small cap fund – with net assets of ₹8,498 crores – holds 74 stocks in its portfolio with an average market capitalisation of ₹11,685 crores. The biggest holding – Carborundum Universal has a market capitalisation of ₹22,367 crores.
SBI Small Cap Fund – with net assets of ₹15,335 crores – holds 52 stocks in its portfolio with an average market capitalisation of ₹10,259 crores: the biggest holding – Blue Star has a market capitalisation of ₹17,352 crores.
This pattern is a boon for us – the retail investor.
To achieve superior returns, it isn’t enough to find quality stocks; additionally, the stock must be available at an attractive valuation. For this, the stock should be outside the purview of the mainstream investment community. The stock should be undiscovered. Discovered ideas attract large capital driving its price higher and diminishing its expected future returns. From a return perspective, we need to find and invest in the stock before it gets discovered.
In 2015, Garware Technical Fibres was trading at ₹200 per share at a market capitalisation of ₹437 crores with a price-earnings (PE) multiple of 10.15: relatively, a very low market capitalisation and a cheap valuation. Presently, the stock trades at ₹3,200 per share at a market capitalisation of ₹6,520 crores and a PE multiple of 38.3: in between the stock got discovered and became a multibagger. During the 8 years, earnings per share (EPS) grew at a CAGR of 19.80 percent; however, the stock price grew at a much higher CAGR of 41.42 percent.
Both earnings and earnings multiple (PE ratio) should expand to achieve superior returns. However, a lower valuation is a precondition for earnings multiple expansion. Mostly, it is stocks with a lower market capitalisation that are available at a lower valuation – and this advantage (lower valuation) diminishes as we go up higher in market capitalisation.
The point I intend to convey is – it would be more fruitful to focus your investment analysis on low market capitalisation stocks trading at a low valuation. In coherence with this policy, we confine our analysis to stocks with – market capitalisation ranging from ₹100 to ₹2,000 crores – and price-earnings multiple ranging from 10 to 25.
AMN CAPITAL 