14 points to keep in mind when buying small-cap stocks

By Morningstar |  02-07-18 | 

While there may be various approaches to identifying a good small-cap stock, we can be fairly unanimous that the holy grail of investing is to unearth one early in the game. But the small/micro/nano-cap arena is treacherous ground.

Shagun Jain, vice president at Kotak Mahindra Bank, elucidated it extremely well in Capitulation of the small-cap investor.

Over here, he lays placeholders as to what to look at specifically, and very diligently, while investing in smaller fare.

  1. Related party transactions

Don’t shrug this off. Numerous instances of sales and purchases are routed through group entities. Further, loans or guarantees given/taken from such parties should also be looked at carefully.

Loans (given or taken) are done for a reason. Simply put, money is moving out from the company to promoter entities at more favorable terms than the market. That’s what needs to be checked. And how much money you are losing is something you should worry.

  1. Group entities/promoter entities

They might be carrying on the similar business. This is an easy way to book income outside the main company being considered. There are instances where joint ventures have been created wherein the promoter holds a substantial stake which houses the profitable business. You need to be wary of this since you never know how much your company actually makes. 

  1. Change in name of the company

Promoters are notorious for changing the names of their companies multiple times every few years. Primarily to disassociate any negative references to the original sins committed in the earlier avatar. 

  1. Management remuneration and employment numbers

There have been instances of companies with hundreds of crores by way of revenues, while the CFO gets a miniscule salary in comparison, probably single digits. The low-cost-of-living explanation is simply a hogwash. Have a look at the median salary levels, as well as the number of employees, and compare it with peers.

  1. Promoter remuneration

Salaries, commissions and perquisites have to be seen in context with peers. Is the compensation too high or too low? Does the company declare dividends regularly? Else, do they have any other sources of income? This points to whether or not the promoter has skin in the game.

  1. Pledging of shares

If the promoter does this, it’s a very strong indication that all is not well. This takes on all the more significance if it is a smaller company in question. Funds are usually raised for illiquid, small-cap names at least 2x cover. A drop in the stock price triggers margin calls which might lead to a cascading effect on share prices due to relentless selling by the lenders.

  1. Statutory dues including taxes

These need to be paid off on time. Any discrepancy can be observed from the cash flow statements, if all taxes which have been provided for have been paid or not. The taxman will eventually catch up with non-payment of taxes and it will be ugly; a corporate governance nightmare.

  1. Receivables

This is one of the first places where accounting jugglery can be caught many a time. If the growth of the same is disproportionate to other parameters, including sales, there is a high probability of mischief. A large number of companies which have gone belly up could have been identified earlier by looking at the trends of receivables only.

  1. Cash flow from operations, or CFO

This one is top of the ladder when listing parameters to look at while pursuing an investment opportunity. It’s a red flag if the company has not generated sufficient or generated negligible free CFO during the last few years. Or, if the company has not able to service its interest/debt via CFO, sooner or later the balloon will burst.

  1. Capex

Capex data provides insights into what the company is into. A little bit of online search can give a fair idea of comparable capex done by other firms in the same industry and will give a guidance as to the genuineness of the investments or if the project has been gold plated or not. 

  1. Goodwill and other intangible assets

This provides a perfect excuse to create and write off assets. It generally leads to outflow of money to assets acquired at relatively higher prices than they are tangibly worth, to be written of slowly over the years. It is generally used by large corporations in M&A transactions. But many Indian promoters have found a way to use the same to acquire group entities. 

  1. One of a kind of business

This narrative gets thrown around quite a bit. No other company does it or this company has some exclusive technology or technical tie-ups in place. There could be truth to it if it’s a monopoly product that no one sells, or the margins are so abysmal that no one wants to enter this business. If there’s money to be made, there are bound to be competitors. 

  1. NCLT cases

The chances of winning are virtually NIL when the company is subject to the proceedings of the National Company Law Tribunal. A good analogy will be a roulette game. If the lenders or operational creditors are facing a hair-cut, there is no way the shareholders will walk away with anything. The value of equity is practically NIL for listed shareholders in such cases. 

  1. Criminal proceedings

Check if the promoter is involved in any civil, criminal or any other legal case or is under investigation by any authority or regulator in India. Of course, it need not automatically translate into a touch-me-not investment since each such case deserves to analyzed based on its individual merit. 

Dig deep

All that I have listed above can be obtained by reading the annual reports of the specific company over the last few years. It will also give you a perspective as to how the business has progressed on various fronts.

Investing in small- and micro-cap companies is tedious and demanding. But the rewards on owning a 10 or 20 bagger make it worth one’s while.

If you are serious about enhancing your investing knowledge, a book I recommend is Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports by Howard Schilit.

Shagun Jain blogs at liberatedsoul.com and tweets at @liberatedsoul3

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subhrajyoti saha
Aug 12 2018 11:32 AM
 A good read @Shagun jain
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