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Wednesday, July 17, 2013

How to Choose Small Cap Stock for Investing?

Dear Reader,

Have you of late looked at stocks of small companies for investing? Though they are rarely on the top of investors' priority list, they can give very good returns, provided they are chosen with care.

Nine small-cap stocks more than doubled between January and June 2013. Global Infratel and Finance led the pack by rising nearly 10-fold; it rose 960% from Rs 6.93 to Rs 73.4. Among the other gainers were Westlife Development, which rose 491% from Rs 187.35 to Rs 1,107.25, Turbotech Engineering (Rs 153 to Rs 448.95, a 193% rise), Radford Global (Rs 37.87 to Rs 84.25, a 149% rise), and Ajanta Pharmaceuticals (Rs 385 to Rs 950.90, a 147% rise).

The Bombay Stock Exchange (BSE) small-cap index fell over 20% from 7,452 to 5,936 during the period. However, the benchmark, the BSE Sensex, rose 0.15%.

While small-cap stocks can give big gains, the losses, too, can be huge. For instance, nearly the entire value of Chromatic India and Sudar Industries was wiped out between January and June 2013. While Chromatic Industries fell 97% from Rs 124.75 to Rs 4.21, Sudar Industries fell 93% to Rs 11.07 from Rs 159 on January 1. The other top losers were Aanjaneya Lifecare (down 92% from Rs 752 to Rs 60.15), Tuni Textiles (down 91% from Rs 127.40 to Rs 10.34) and Orient Paper and Industries (down 91% from Rs 79.65 to Rs 6.71).

Some Positives & Negatives of Investing in Small Caps

1. Small-cap stocks are not tracked closely by market analysts and that is why the real value of good smallcap stocks can remain undiscovered for long. This makes investing in them risky. But the rewards of finding a hidden gem are huge too, for such a stock may become a midcap or even a large-cap stock over time, giving superlative returns.

2. Small-cap stocks are like trees that have just been planted. Obviously, they will take a few years to grow and blossom. They can be good bets for the long term.

3. On the flip side, small-cap stocks have a low equity base, which is why selling/buying can take time. If one buys a wrong stock, a prompt exit is difficult. Also, many small companies are young, with a very short track record. Hence, judging their performance is difficult.

4. Small companies are relatively weak in terms of governance, dividend policies and professionalism of the board. This makes them risky. When times are tough, large companies sail through, but the smaller ones are at the receiving end.

Important Factors to Watch

1. Small companies with high borrowing costs, low demand, power shortage, and high wages and commodity prices would be highly risky bets.

2. Companies with high debt on books are being forced to either sell assets to pay off loans or pledge shares to raise funds.

Hence, its important to look at total debt on books, debt to equity ratio and no. of pledge shares of small cap companies.

Between January and March this year, Cinemax India promoters pledged 93% shares held by them. Essar Shipping, AGC Networks, Asian Hotels (North) and Plethico Pharmaceuticals promoters pledged 75%, 72%, 72% and 67% shares held by them, respectively.

Now, let's look at some aspects that need to be looked at while buying small-caps stocks.

1. Track record of promoters: The first thing one must check is for how long the promoters have been in the business and whether they are backed by a strong team.

2. Promoters' stake: A high promoter stake shows his confidence in the business. You should also ask if the promoter plans to increase his stake.

3. Business model: A unique and robust business model augurs well for the company in the long run. If a small company is present in areas dominated by those with deep pockets, then chances are that it will close shop sooner than later.

4. Debt figures: High debt means the interest outgo is huge, which can be a big drag.

5. Institutional holding: Experts say institutions avoid buying shares of small companies due to lack of liquidity. It does not mean that one should not invest in small companies. Over a period of time when small companies grows in terms of market cap and business, Institution buying can bring huge price appreciation as well as rerating of the stock.

There are 509 stocks available for trading in the BSE Small Cap index. Out of them, 11% are from the capital goods sector, followed by finance (10.7%), housing (9.75%), metal and mining (5.73%) and health care (5.39%).

Are you investing in Hidden Gems? If you find it difficult to perform above quality checks before investing in small caps, leave it to us. You can rest assured that we are committed to offering you authentic and unbiased research reports of fundamentally strong small cap companies. Simply subscribe to Hidden Gems and start receiving one small cap stock research report on monthly basis to make educated investment decisions. 

It’s  dedication & passion of our team that even during bearish phase of equity market since last 2.5 years, 8 out of 28 Saral Gyan Hidden Gems gave more than 100% returns to our members. Hidden Gems have given maximum returns of +78.2% whereas small cap index has given negative returns of -22.7% in last 2.5 years.