The Best Small-cap Stocks to Buy

Smallcaps are fascinating.

Highly volatile, but also highly profitable.

With all their up and downs, these are the stocks that interests me the most.

I have seen ordinary men becoming millionaires and living life king size, all thanks to one multibagger small-cap stock.

And that too as an investor, without taking any of the pains that promoters of these businesses go through.

What Gives Smallcaps the Big Edge?

Why invest in smallcaps when there are big stable businesses that have been there forever?

Here's the reason I prefer smallcaps over Tatas and Infosys of the world...

You see, big companies are already past their prime. The days of fast growth and glory are behind them.

It does not help that most of the big money in the market is already chasing them. This makes them expensive. It shrinks the upside potential in these stocks.

Both these factors combined, means you can't expect multibagger returns from well-established large cap stocks.

A case in point is HUL. This stock offered almost no returns for a decade.

A Bluechip's Journey to Nowhere Over a Decade

Small companies, on the other hand, are sitting on the runway, waiting to take-off.

Further, in large caps, you are investing along with big investors who are better informed about these companies.

In other words, your competitive edge is low.

But that's not the case when you invest in smallcaps.

You see, most big players have to stay away from smallcaps due to regulations, liquidity issues, or because playing in this space just doesn't move the needle for them given the huge amounts they deal in.

Investing legend, Warren Buffett, had this to say about his inability to investing in small companies, when his capital became too big.

The universe I can't play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.

You need not be confined to that universe!

How to Find Multibagger Smallcaps

Among the thousands of companies on the BSE Smallcap index, only a few smallcaps become big winners. Most get lost in oblivion.

Amid the survivors, a few companies are first among equals.

These small cap companies witness spectacular growth. Their stocks become the talk of the town.

Vinati Organics, Astral Polytechnik, Pi Industries, Balkrishna Industries...

These are just some such fascinating stories that have made millionaires out of ordinary folks...in just a few years.

All they had to do was to enter these stock at the right time and hold on to them. All the hard work was being done by the management.

What edge did these companies have?

It could be the network effect that strengthens as the company grows in size, such as in case of Naukri.com. It benefits from the virtuous effect of more employers bringing more traffic of job seekers, which in turn leads to more recruiters to come to the website.

Or it could be a strong and robust sales and distribution network and economies of scale. Page Industries was one such recommendation that went on breaking all records and became our first hundred bagger.

Or it could be access to an exclusive technology, something that Astral enjoyed a few years ago as the first and only Indian licensee of US-based Lubrizol Corporation, a 100% subsidiary of Berkshire Hathaway.

But it's not so easy...If it were this smooth, smallcaps would not be an ignored lot. There would not be so much fear around them.

For every Vinati Organics or Astral Ltd, there are tens of stocks that never take off.

And if you play in this space without a strategy, or look for short cuts to get rich, you might end up losing your capital.

You need a roadmap to invest in them...

A RoadMap to Make it Big in Smallcaps

Over the years, my experience with small caps has taught me that things are not always as they seem. Stock prices can double overnight, riding not on fundamentals, but hyperbole...only to crash later. It's a slippery ground indeed.

It's critical to avoid unnecessary risks and speculative bets. As Warren Buffett once said, in the market, we does not get paid for activity, just for being right.

It's not enough to go by financials and track records, and market news.

Here are some broad guidelines to pick multibagger stocks in smallcap space.

• Economic Moat

  The dictionary defines a moat as a deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defence against attack.

  In investing, it refers to a business's ability to maintain its competitive advantage over its peers to protect market share and ensure sustained profits. It is what allows a business to earn high returns on capital over time.

  The wider the moat, the stronger the business. If the moat is weak, ultimately, competition will spoil the game, erode returns, and take away market share and profits overtime.

  Moats could come from having a cost advantage (being the lowest cost producer), brands (such as Castrol), exclusive licensing or patents (Astral Polytechnik and its tie up with Lubrizol a few years ago), network effects (as in the case of Alphabet), higher switching costs (like in case of private banks).

  But remember, the presence of one or many of these do not ensure great returns.

  Kodak, Orkut, many Indian utility companies are some examples of companies with moats that failed.

  A true moat needs to stand the test of the time.

  In the absence of that, one might end up with companies like Kodak that used to be the market leader but could not stand up to the technological disruption from digital cameras. The moat did not just get eroded, it was completely wiped away.

  So, what does true moat look like?

  A true moat gives a business scalability, and with every growth milestone crossed, it gets strengthened further.

  Think about Coca Cola. The company has been around for decades.

  There are businesses that compete with it. Yet Coca Cola has not just survived but expanded its market share multifold.

  The more it grows, the more difficult it becomes for new or existing players to compete with its distribution network.

• Circle of Competence

  Warren Buffett said...

  Everybody's got a different circle of competence. The important thing is not how big the circle is. The important thing is staying inside the circle.

  Stick to investing in businesses that you understand and be okay with ignoring what you don't.

• Management Quality

  Investing in a stock is not buying a share with a price tag. It's like owning a part of the business. The management are your business partners.

  Unlike largecaps, which run on auto pilot mode, managements can make or break a smallcap company.

  In smallcaps, you need to be highly discerning about who you want to partner with.

  So what kind of partners should you look for?

  You're looking for three things, generally, in a person," says Buffett. "Intelligence, energy, and integrity. And if they don't have the last one, don't even bother with the first two."

  That is as succinct an advice that could ever be given while assessing the management quality of the businesses you may want to invest in.

  The quality of management does not get captured in quarterly or even year on year profit growth numbers. You need to look deeper.

  A good quality management is passionate and transparent. It is honest about admitting mistakes when they are committed rather than justifying them.

  It creates long-term value for minority shareholders, sometimes at the cost of letting short-term or quick profits go. I'll share more on this later.

• Margin of Safety

  Margin of safety is what differentiates a good business from a good investment.

  In case you're wondering about the difference, go back to the stock price chart of Hindustan Unilever Ltd.

  Despite being backed by a great story and fundamentals, its stock remained stuck at around Rs 220 for around 10 years.

  Always ask how much a company is worth and never overpay. Margin of safety ensures that you buy a stock only when it trades at a reasonable discount to its true value.

  Further, have a balanced asset allocation strategy to take care of the potential downsides.

Our Approach

For smallcaps, I think what works the best is growth at reasonable price (GARP), which I believe is a variation of value investing.

My approach for smallcaps is bottom up i.e. I focus on the business fundamentals, growth prospects, management, and valuations. I do so with a time frame of 3 to 5 years.

There are cases when the stock prices meet true value well within the horizon period of 3 to 5 years.

However, that's the time frame I have in mind while recommending smallcaps because sometimes markets can be moody. It may take a while before valuations reflect true fundamentals.

This approach varies from the mainstream approach, which is more top down, focused on the short-term, and chases stocks which are expected to gain from macro themes.

The problem I have with the mainstream approach is that macro-economic variables are complex in nature.

They are interlinked and difficult to predict. If you make these variables the center piece of investment thesis, there is a high probability of going wrong.

I, on the other hand, focus on the intrinsic value of the business. This is the true value or present value of all the cash flows that the business generates during its lifetime. I perform fundamental analysis on these stocks and recommend those which trade at a discount to this value (which we call margin of safety).

Now this does not mean I don't give macro factors due regard. I try to be conservative on macro front and do factor this in to our estimates and valuations.

A Quantitative versus Qualitative Analysis

My approach uses both quantitative and qualitative factors.

Getting the former right is relatively easy in my view. It requires knowledge of financial basics, analytical skill, and works with a lot of data.

It is important but it's okay if you don't get your estimates 100% on the mark, as long as you don't go directionally wrong or differ by a wide margin.

On the other hand, getting qualitative aspects right is critical. These points include management quality, regulatory aspects, demand and supply dynamics, consumer behavior, understanding the competition, industry disruption and sector dynamics etc.,

The Most Critical Aspect of Investing in Smallcaps

Berkshire Hathaway was once a struggling textile company. No moat. No rosy financials. Just a bleak future.

That is, until Warren Buffett took it over.

Or take Apple, Microsoft, Alphabet, and Amazon...

These companies wouldn't be where they are without Steve Jobs, Bill Gates, Mark Zuckerberg, and Jeff Bezos.

Ultimately, the people running the business determine the fate of a company. It's the legendary investors' judgement of competence and character, that separates them from the rest.

Buffett's ability to spot good managers has long been critical to Berkshire's smooth functioning as a mammoth holding company.

Every great investor I can think of shares this trait.

They know how to separate good managers from mediocre and bad ones.

They don't confuse business tailwinds and headwinds with management quality.

They are wary of the halo effect. They look beyond the financials. They place no emphasis on headlines. They are the first to spot successful turnaround stories.

They value intelligence, energy, and integrity. They understand that without the third, the first two could be fatal.

Unfortunately, CVs and credentials don't help us spot this critical quality.

This conviction comes from deep interactions with the management and promoters

Knowing a management is not just about listening to their talks. Great investors look for little details that give real insight.

Warren Buffett likes to tell a story about Tom Murphy, CEO of Capital Cities Communications. Before I tell you that story, you must know who Mr. Murphy is.

In his letter in the year 1981 to shareholders, Buffett praised this gentleman. He called him a real managerial 'twofer'.

I'll come to what this term actually stands for, but first let's see what exactly Mr. Murphy achieved to deserve the praise from Warren Buffett.

Mr. Murphy has gone down in US corporate history as one of the greatest capital allocators ever. An investment in his firm yielded 13 times more money compared to investing in the benchmark index.

This record was achieved through a mix of shrewd, well timed acquisitions and also running the business with ruthless efficiency.

When the former didn't happen, he would simply buy back his own company's stock at sensible valuations. In a fitting finale to his illustrious career, Murphy finally sold his business to Disney for a valuation as high as 28 times earnings!

Little wonder, Buffett called Murphy a real managerial 'twofer'. These people excel at being both great operators of businesses as well as great capital allocators...and hence are the kind of managements you would want to associate with.

But how could one have identified a manager like Tom Murphy long before he made that sale?

Perhaps an early visit to his office might have helped.

As per the story Warren Buffett shares, Murphy was cost-conscious. When asked to repaint the old convent building the station was housed in to appeal to advertisers, he painted only the two road-facing walls (just enough cost to appeal to advertisers) and ignored the others that no one would notice.

He kept a picture of the station throughout his career.

There was that little detail that could have offered insight about his cost consciousness or shrewd capital allocation skills, had someone visited his office.

The media is too busy to notice such small gestures or traits, especially when the companies involved are smallcaps. This is where an investor can generate alpha.

The key lies in knowing the business and management well.

Now, given the limited coverage in the media and fewer disclosures in such companies as compared to large caps, getting this information is hardly easy.

Sure there are annual reports and other disclosures.

And if you're lucky, some companies might add presentations too!

You may come across ideas by observing sectoral trends, talking to people and so on. There are always tools with all the financial information and stock screeners neatly organised in one place.

But could that be enough?

I don't think so. I think it needs a 'boots on the ground' approach - speaking to or meeting the management in person.

Assessing Managements - Questions that Matter

Given that every business is different, there can be no standard list of questions for the managements. It all boils down to aspects you must know:

• Management's passion and commitment towards business - This is reflected in how managements talk about the business, not just what they say but their gestures. To assess this, we always ask managements to talk about their business rather than shooting business specific questions first. Sometimes, in the first few minutes it is clear whether the stock makes the cut. Be wary of the managements who talk more about stock price than the actual business.
• The competitive edge of the business. Can it survive and stay ahead of the competition in the long run? - Here, assess how the business is positioned vis a vis competition. What are the factors that offer it a moat and whether that moat is sustainable.
• The runway - This is basically the opportunity size. After all, it might not be a great idea to be stuck with a business which is the market leader, but the scope of growth is almost negligible, such as in case of Castrol (unless it's just a valuation play).
• The management's attitude towards mistakes or negative developments - Sometimes good managements take decisions that do not yield results as expected. The only worse thing than that would be to not admit it or not learn any lessons from it. We like managements that are transparent in this regard.
• Key risks, disruptions or threats to the business - The biggest risk sometimes is not understanding the risks that might exist. Every business has some inherent risks. We prefer managements that acknowledge them and have a survival plan rather than managements who like to brush away such questions. For instance, the threat from electric vehicles to auto OEMs and auto ancillary. It's even better if the company is a disruptor itself.
• The growth strategy in the long-term - Higher growth does not always return in higher returns. Assess whether the management is too conservative or too aggressive. For instance, we would avoid an NBFC that grows aggressively by taking on more debt and without having in place enough controls when it comes to maintaining asset quality.
• Attitude towards minority shareholders - This includes aspects like management compensation, pledging of shares for personal reasons, what the management plans to do with excess cash when growth opportunities are not there, and so on.

No checklist is complete without getting a sense of the value chain, including suppliers and end clients.

This includes aspects like concentration and pricing power. Sometimes, answers to these questions could lead to another investment idea (a monopoly supplier or end client with a better bargaining power for example). It also helps in checking and verifying the management claims.

Some Personal Experiences of Meeting Managements

Like I mentioned before, to get a real understanding of the potential in the business, it is crucial to get one's boots on the ground

It's also what I like the most about my work. My team and I have travelled the length and the breadth of the country to meet the managements in person.

In case of most smallcaps, the management is also the owner of the company. This is unlike big companies where a lot of people with no skin in the game hold crucial positions.

Most of these promoters are first generation entrepreneurs with humble backgrounds, and with inspiring journeys and visions.

Meeting them and speaking to them directly, gives an insight into the business that no number of interviews on financial channels or magazines could offer.

There have also been cases when we were extremely impressed with financials or influenced by stories floating around in the markets, but after meeting the management, realised that the optimism was not justified or found the managements' claims to be wrong.

Such meetings have been a revelation, where we have realised that numbers (which led us to meeting them in the first place) don't tell the real story. We never recommended these companies. Nonetheless, the work done has left us wiser.

A case in point is a company we met a few years ago. The stock was widely in the news on the buzz of some patents and innovative packaging products. While the management spoke about some interesting patents, during the interaction we realised that the company had no clear roadmap for monetising them and the stock was already pricing in the upside from such monetisation.

We decided to not go ahead for the lack of clarity. Today, it is trading at a fraction of the price when we met the management. Our concerns about the business were validated. Hardly any new products were introduced that could make big difference to the business.

In another case, my meeting with a textile company took me to Coimbatore (Tamil Nadu) a few years ago. It was the first time I had to take shoes off before entering in the office, as the latter happens to be a room in the house in which the promoter resides with his family.

In times like these when most companies squander money over swanky offices (that does little to promote the business), this was a welcome change. While this is hardly an investing argument, frugality is certainly a quality that we appreciate.

The extravagance of any corporate office is directly proportional to management's

reluctance to reward shareholders. Excellent companies are thrifty. - Peter Lynch

Later on, the same promoter willingly decided to not draw the commission (variable compensation based on profits) saying that what he gets in dividends is enough for him and his lifestyle.

When asked why he did so, his reply was: 'The shareholders of my company have reposed faith in me while investing in my company and I should live up to their expectations. While they receive only dividends, I felt it should be the same for me as well.'

In short, simple gestures and observations during meetings can give us a clue about the kind of management subscribers would be partnering with.

Conclusion

I hope you won't mistake the size of a business for its ability to survive and grow.

Borrowing from Darwin's theory of evolution, I believe that it won't be the biggest who will survive but those who can best manage the change.

As conventional moats get disintegrated, and disruptions frequent, I believe some of the deftest change managers amid this upheaval would be agile and well run smallcap companies.

And if you pick these smallcap stocks well, you could be on the fastest road to generational wealth.

However, while the above-mentioned reasons are compelling, one must view smallcap stocks with the same amount of caution as one would view other stocks.

Sustained research must not be compromised despite the positive odds.

Since the Covid-19 crash, the total gains in the smallcap index until FY22 stood at 223% versus 128% in the Sensex. In FY21, the smallcap index had surged 122% versus 77% gains in the Sensex.

Will FY23 be yet another year when Smallcaps will outperform? Check out this video -

Happy Smallcap Investing!

Warm regards,


Richa Agarwal
Editor, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)

FAQs on The Best Small-cap Stocks to Buy

1. How do I find the best small-cap stock?

The BSE and NSE index have a list of of all the small-cap stocks listed on the exchange. You can go through that and look for companies that have the following characteristics:

• dominant players with a strong competitive advantage
• fundamentally strong balance sheet low debt to equity ratio and high liquidity ratios
• run by quality management

Alternatively, you can browse through the Equitymaster screener to access an exhaustive list of small-cap stocks using a variety of filters like low debt to equity, high growth, high ROE, low PE ratio.

2. Are small-cap stocks riskier?

Small-cap stocks are usually niche businesses that carry a great growth potential. Since their market cap is less than the midcaps and large caps, they can generate a higher return, but also carry more risks. Top of the list, is volatility.

Volatility is the rate at which the stock price increases or decreases over a particular period. This volatility rises as you move down the capitalization ladder.

This is where your small caps lie. Sure, they offer better returns than large caps, but they also come with higher volatility since they are priced lower than large caps or mid-caps.

This means that as markets move, they swing a lot more than their safer counterparts. This is because smaller companies don't have the financial strength to withstand slowdowns.

This risk of greater losses along with more volatile returns keeps investors away from small-cap stocks.

3. What do the best Smallcap stocks have in common?

A cursory glance at history tells us that most of the best small-caps have these characteristics in common:

• dominant players with a strong competitive business advantage
• sport a fundamentally strong balance sheet with low or reducing debt
• run by proficient and high quality management
• sporting robust sales growth with an equally strong potential

4. How to identify Multibagger Smallcap stocks?

While there is no guranteed method of identifying a multibaggers, you can look for the following characteristics most of them have in common:

• dominant players with a strong competitive business advantage
• sport a fundamentally strong balance sheet with low or reducing debt
• run by proficient and high quality management
• sporting robust sales growth with an equally strong potential

So either you can pull out the data from the annual report or use the Equitymaster screener which can help you find high growth companies.