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| Bearish conditions might be the right window of opportunity to step into the world of small caps. This particular space is highly risky but can deliver mouth-watering gains |
The political environment, even compared with the days of coalition governments, was never so chaotic as it is today. Hopes of an accelerated pace of reforms with the formation of a stable government at the Center with a clear majority in the Lok Sabha have been dashed. Instead, India is losing crucial time to legislate to move the economy to a higher growth trajectory.
As the political slugfest continues, it is more or less understood that the opposition parties will remain defiant and the budget session of the parliament will see another wash-out. Key legislations such as the Goods and Services Tax (GST) Act, which is considered as a mother of all tax reforms, is likely to remain in a limbo. The Indian economy is expected to report growth of 7.6%. This will be a five-year high. But the optimism associated with this number is lacking on the ground. Passage of GST can create a feel -good factor that is very much needed to boost the market’s morale.
Questions are being raised over the methodology used for the calculation of economic growth. The doubts have a solid base. India’s exports declined 13.6% to US$ 21.07 billion in January 2016 over a year ago. Ironically, exports have fallen for the 14th straight month. Sluggish exports depict a grossly disappointing picture as the figure is based on the lower base of January 2015. Moreover, the dip in exports is on account of poor performance by a variety of sectors, be it petroleum, engineering, leather, chemicals and marine products and readymade garments.
Aggregate net sales of around 4,000 companies slipped 5.2% and net profit plunged at an accelerated pace of 7.8% in the December 2015 quarter. This is in contrast with the economic growth of 7.3% reported in the December 2015 quarter. Poor corporate earnings over the last few quarters show a divergent trend from the growth in the gross domestic product (GDP). In fact, mounting bad loans is one of the prime indicators of economic sluggishness. Lately, non-performing assets (NPAs) in the books of public sector banks have spooked the market.
The performance of the banking system has turned out to be a sore point for the market. The S&P BSE Bankex is down 31.4% from the 52-week high and 16.1% to 16,221 in the current calendar year (CY) till 18 February 2016. In February 2016, banking stocks dragged down the broader indices. Apart from crony capitalism, the record NPAs is to an extent a reflection of the poor state of the economy and challenging business conditions.
Subdued prices of crude oil have emerged as one of the global concerns. Crude oil plunged below US$ 30 a barrel in January 2016. This is a 12-year low. Mid February 2016, Saudi Arabia, Russia, Qatar and Venezula announced their intention to bring discipline in production to support prices of crude oil. The plan is to freeze crude output at the January 2016 levels. This is one big positive news for global markets. The market requires easy money generated through high crude oil prices to sustain asset valuations across the world. Countries such as Saudi Arabia, Russia and several African countries are facing fiscal crunch owing to the slump in crude oil prices.
Iran ,which has entered international markets after lifting of sanctions, might play the spoil-sport. It might prefer to regain share in the crude market. However, after initial hiccups and concerns, the country seems to be game for market discipline. With a new lobby in the making to control supply, crude bounced back to around US$ 35 per barrel mid February 2015. But uncertainty remains whether the new lobby will see the light of the day.
On 16 February 2016, negative interest rates came into effect in Japan. The negative interest rates were announced in January 2016. The Bank of Japan, the country’s central bank, will charge banks 0.10% for parking additional reserves with it. Whether this move will revive the Japanese economy remains doubtful but will ensure easy liquidity. The US Federal Reserve in February 2016 raised concerns over increased uncertainty in global markets. Now the possibility of interest hike by the Federal Reserve has diminished. In addition, the European Central Bank might opt for further monetary easing. In short, the liquidity taps might remain wide open across the developed world. This is another positive news for the market.
Foreign portfolio investors (FPI) continue to dump Indian equities. The trend might reverse with clarity on global liquidity. FPI offloading is a matter of grave concern. Unless and until this section of investors resumes buying, domestic equities will remain under severe pressure. This is despite buying by domestic institutional investors.
FPIs net sold equities worth Rs 14356 crore in January 2016 and net offloaded equities worth Rs 6465 crore in the month till 18 February 2016. Domestic institutional investors invested Rs 12875 crore in equities in January 2016 and Rs 5977 crore in the month till 18 February 2016. But this is no match for the prowess of FPIs.
In this gloom, global weather agencies have indicated overall weakening of the El Niño phenomenon in their initial predictions. This is another positive for India that faced two consecutive droughts in CY 2014 and CY 2015. Weather forecaster India Meteorological Department will be coming out with first official forecast for 2016 southwest monsoon in April 2016.
The S&P BSE Sensex, the benchmark, slid 2,468 points, or 9.5%, in CY 2016 till 18 February 2016. The S&P BSE Mid-Cap was down 11.9% and the S&P BSE Small-Cap index 16.7% in this period. The Sensex is off 21.2% from its 52-week high, the Mid-Cap index 15.9% and the Small-Cap index 19.2%.
In terms of technical analysis, with over 20% decline from the yearly high, the Indian market is already in a bear territory just as several other global indices. This information is numbing and might make nervous even shrewd and seasoned investors. Talk is already on about the possible bottom. Again this is a never-ending guessing game.
Bearish conditions are expected to prevail for some more time. This might be the right window of opportunity to step into the world of small caps. This particular space is highly risky as investors can practically lose their entire capital. But, at the same time, it is probably the only category that can deliver mouth-watering gains. Further, assessing small-cap stocks for investment is a gigantic task. There are several hundred small-cap stocks to be scanned and appraised.
To de-risk, investors can focus on small caps with a sound business model that has chances of survival in future. This critical for long-term investment. The stature of a company within its industry can provide better insights about its sustainability and prosperity.
In this context, investors can pick small-cap companies that are among the leading players within their industries. These small-cap leaders might be worth a look in the present market carnage. Importantly, investors should be extremely choosy while taking the ultimate investment call.
Capital Market picked companies with market capitalization of less than Rs 1000 crore and also from the lower strata of mid-cap firms with market value below Rs 2000 crore. Additionally, companies with some amount of mutual fund investment were shortlisted. Last, and important, companies commanding leadership position or are among the leading players in their industries were selected (see table: When size does not matter).
Everest Industries is a classic example. With a Rs 1268-crore turnover in the fiscal ended March 2015 (FY 2015), the market share is 14-15% in the fiber-cement roofing. The two distinct business segments of operations comprise building products and steel buildings. The building products segment contributes around 75% to the top line. Established eight decades ago, the portfolio includes a complete range of building solutions for roofing, ceiling, wall, flooring and cladding and steel buildings for industrial, commercial and residential applications.
Building products and solutions are available in over one lakh villages and 600 cities in India. The products and solutions are distributed through 38 sales depots and 6,000 dealer outlets. Over 1,500 pre-engineered steel buildings have been designed and erected across 275 cities. Also, exports go to around 25 countries. Building products are manufactured across six units, with aggregate capacity of 8.10 lakh tonnes per annum (tpa), while the steel building division, in aggregate, has capacity of 72,000 tpa.
Initiatives such as Make in India, Swachh Bharat and development of smart cities will be beneficial. Further, to reach the objective of housing for all by 2022, the government is aiming to build four- crore affordable houses in the urban areas and two crore in rural areas.
The new unit for steel building and metal roofing at Narmada in Gujarat was commissioned in FY 2015. Built with a capital outlay of Rs 50 crore, the plant, with a manufacturing capacity of 30,000 tpa, will cater to projects in the western, central and southern regions and save freight cost and ensure faster deliveries. Commercial production of fibre-cement roofing sheets at the manufacturing facility at Somnathpur in Odisha started in May 2015. The plant, with installed capacity of 8,000 t per month, achieved 100% utilization in FY 2015. A 72,000-tpa fibre-cement board plant is being set up in the UAE through a wholly owned subsidiary in Mauritius to cater to the Middle East market.
With debt of Rs 300.8 crore, the debt-to-equity ratio stood at 0.89 times end FY 2015. Consistently making profit and paying dividends over the last decade, mutual funds held 15.54% stake end December 2015. The stock reported an all-time high of Rs 430 in July 2015 and is now available at Rs 201.9.
Salzer Electronics is another example of a small-cap leader. The largest manufacturer of Cam- operated rotary switches (market share 25%) and wire ducts (20%) in the country, a wide range of products are manufactured at five facilities located in Tamil Nadu and Himachal Pradesh. Incorporated in 1985, total and customized electrical solutions are offered in the switchgears, wires and cables and energy management business through a portfolio of over 15 products. The industrial switchgear business is the largest revenue segment, with a share of 50%, followed by copper (34%), energy management (12%) and building products (4%).
Auto component maker LG Balakrishnan & Bros is the largest supplier of drive chains to original equipment manufacturers, with a market share of 70%. The share is around 50% in the replacement market. Founded in 1937, the transport company evolved as a major manufacturer of chains, sprockets and metal-formed parts for automotive applications. There is a consistent track record of profit and dividends over the last decade.
Business segments include transmission, metal forming and others. Transmission products include chains, sprockets, tensioners, belts and brake shoe. Offers also comprise metal-forming products consisting of fine blanking for precision sheet metal parts, machined components and wire-drawing products for internal use as well as for other chain-manufacturing plants, spring-steel suppliers and umbrella manufacturers. Products are marketed under the Rolon brand. Manufacturing units are spread across Tamil Nadu, Maharashtra, Uttrakhand, Karnataka and Haryana.
There is a 25:75 joint venture with Renold Holding PLC of the United Kingdom, Renold Chain India, manufacturing industrial chains. The small cap is moderately leveraged, with a debt-to-equity ratio of 0.49 times. Mutual funds held 13.38% equity end September 2015.
Kaya is a leading specialty skin-care solutions provider in the country and Middle East, either directly or through subsidiaries. Incorporated in 2003 as wholly owned subsidiary of Marico, the demerger came in September 2013. Holistic skincare solutions are delivered through a range of Kaya Skin Clinics. Nearly 107 Kaya Skin Clinics are owned and operated in India and 20 in the Middle East.
Also, a product retail format, Kaya Skin Bar, is operated with 104 outlets in the country. Kaya Skin Clinic, the chain of specialized skincare clinics, offers customized solutions by expert dermatologists and are backed by skincare technologies. One clinic and 37 Kaya Skin Bars across formats were added in the country and one clinic acquired in the Middle East in the third quarter of FY 2016.
Services are offered in the areas of acne reduction, acne-scar reduction, pigmentation, anti-ageing, and laser-focused permanent hair reduction along with regular beauty enhancement and maintenance services. Also, there are over 50 skincare and haircare products, ranging from daily skin care to specific skin concerns such as acne, pigmentation and ageing. Mutual funds held 5.38% stake end December 2015 in the debt-free company.
The Anand group company, Gabriel India, was listed in 1978 and commands 80% market share of ride-control products such as shock absorbers in the commercial vehicle segment and 45% share in the passenger-car segment. There are technical collaborations with KYB Corporation of Japan, KYBSE of Spain and Yamaha Motor Hydraulic Systems of Japan. Lately, a technology license agreement was signed with Koni Shock Absorbers of the Netherlands.
The manufacturer of front forks and rear shock absorbers for two-wheelers, McPherson struts and shock absorbers for passenger cars, axle, cabin and seat dampers, suspension shock absorbers for commercial vehicles and shock absorbers for railway coaches is headquartered in Pune and owns six manufacturing facilities and three satellite plants located close to originial equipment manufacturers (OEMs), with an aggregate manufacturing capacity of 28 million units per annum.
A significant 86% of the total revenues is derived from the domestic market and remaining 4% from exports. Clientele includes almost all the prominent two- and three-wheeler, passenger-vehicle and commercial-vehicle manufacturers (OEMs). The balance sheet is strong, with negligible debt. Mutual funds owned 6.32% equity end December 2015.
Incorporated in 1973, Dynamatic Technologies is one of the world’s largest manufacturers of hydraulic gear pumps and automotive turbochargers. The global tier I supplier to major global aerospace OEMs such as Airbus, Boeing and Bell Helicopters designs and makes highly engineered products and operates in the three segments of automotive and metallurgy (revenue contribution of 66%), hydraulics (18%) and aerospace and defence (16%).
The automotive and metallurgy division supplies engine, transmission, turbocharger and chassis parts to leading global OEMs. Also, high precision, complex metallurgical ferrous castings are made for automobile engines and turbochargers. The division supplies critical engine and transmission products to around 50% of the passenger cars made in the country.
Asia’s largest producer of hydraulic gear pumps is also one of the largest in the world. There is 65% of market share of the organised tractor market in India. The aerospace and defence division supplies airframe structures and precision aerospace components.
Among the popular stocks with mutual funds, with holding of 10.22% end December 2015, the high balance-sheet leverage, with a debt-to-equity ratio of 2.81 times, end March 2015 is a matter of concern. However, the ratio had been declining consistently over the last two years.
Gulshan Polyols is one of the largest manufacturers of precipitated calcium carbonate (PCC) and sorbitol in the country. The first Indian producer of rice-based dextrose mono-hydrate (DMH), maltro-dextrin powder (MDP) and liquid glucose, for which a manufacturing unit has been set up at Muzaffarnagar in Uttar Pradesh (UP), has undertaken capacity expansion of starch sugar: liquid glucose, MDP, DMH and glucose powder.
The business portfolio covers starch sugars, calcium carbonate, alcohol, agro based animal feed and on-site PCC plants with production facilities at Muzaffarnagar, Bharuch in Gujarat, Dhaula Kuan in Himachal Pradesh, Abu Road in Rajasthan, Patiala in Punjab and Tribeni in West Bengal. Products are offered to several industries including pharmaceuticals, personal care products, footwear, tyres, rubber, plastics, paints, alcohol, value-added paper, agrochemicals, food and agro products. Key clients are Colgate-Palmolive, Hindustan Unilever, Dabur, Asian Paints and ITC.
The star export house is setting up new projects in UP and Madhya Pradesh to manufacture agro- based animal feed, DMH, MDP, liquid glucose and green-field grain-based distillery unit to produce extra neutral alcohol. Both the projects are expected to go commercial by March 2016. Additional revenues of Rs 250 crore are expected from these two projects in FY 2017.
Transport Corporation of India (TCI) is among the leading integrated supply chain and logistics solutions provider. The infrastructure boosts of an extensive network of owned offices and 10.5 million square feet of warehousing. Product offerings include TCI Freight, TCI XPS, supply chain solutions, TCI Global and TCI Seaways.
The TCI Freight division provides total transport solutions for cargo across dimension and product segment. The TCI XPS division offers door-to-door and time definite solution for customer’s express requirements. Services are provided at 13,000 locations in India and 200 countries globally.
TCI Global offers freight forwarding and customs clearance activities across boundaries largely serves industries like pharmaceuticals, commodities, retail, fast moving consumer goods and auto. Real estate arm TCI Developers looks into the development of commercial properties. Investment of Rs 275 crore has been made to create capacities in FY 2016. Debt was Rs 320 crore and the debt- to-equity ratio stood at 0.61 times end March 2015.
In October 2015, the board approved the demerger of the TCI XPS business into TCI Express. The demerged business will be listed after securing requisite necessary approval. Equity shareholders will receive one share of TCI Express for every two shares held in TCI. This business has tremendous growth potential, specifically in the e-commerce space, requiring focused leadership and management attention.
MPS is among the leading publishing services outsourcing companies offering end-to-end publishing solutions across the author-to-reader value chain. Services include content development, printing and digital publishing services, technology solutions, media products and customer services for educational, trade and scholarly publishers. The one-stop destination for some of the largest publishing companies in the world has a team of around 2,850 employees. There are offices in Bengaluru, Chennai, Delhi, Gurgaon, Noida, and Dehradun and at Portland, Orlando, Durham, Effingham and Champaign in the US.
The zero-debt company had cash and cash equivalents of Rs 179.6 crore end December 2015. This is significant quantum of cash taking into account the market value of Rs 1204.5 crore and net worth of Rs 256.1 crore. Considering the book value (BV) of Rs 137.6 per share, the stock is available at a price to BV of 4.7 times. Around 52% of the revenue are from North America, followed by 46% from Europe and theUK and the remaining 2% from the rest of the world. Client concentration is high, with top five accounting for 64% and top 10 about 82% of the revenues. This is a matter of concern.
Mayur Uniquoters is one of the largest manufacturers of synthetic leather in the country, with an installed capacity of 3.05 million linear meters (mlm) per month. Production was 23.07 mlm in FY 2015 as against 21.16 mlm in FY 2014. Mainly products are sold to the footwear, furnishing, automotive and automotive replacement segments. Marquee customers include Ford and Chrysler in the USA and Ford India, General Motors India, Mahindra, Maruti, Honda Motorcycles and Scooters, Tata Motors and Eicher Motors. Bata, Action, Lancer, Relaxo, Paragon, VKC group are the key clients in the footwear segment. Around 26% of the revenue come from exports.
Operational performance has been on a dream run, with 8.7 times jump in turnover and 22 times in net profit over the last decade. Forays are being made into new geographical markets and new segments to keep up the growth momentum. There are plans to increase capacity to 3.6 mlm per month. Importantly, the company is almost debt free considering cash and investments. A third interim dividend of Rs 0.85 per share, or 17%, on face value of Rs 5 was declared in February 2016.
Eveready Industries is the market leader in the domestic battery and flashlight market, with sales of over 1.2 billion batteries and nearly 25 million flashlights. There is a share of 50% in the battery and 75% in the organised flashlight markets. This apart, the basket of products consist of light emitting diode (Led) bulbs, compact fluorescent lamps, incandescent bulbs and other lighting products and packet tea.
There is an extensive network consisting of 15 sales offices, 44 nationwide distribution centres and 3,000 distributors, giving a reach to villages with population of 5,000 and more. Products are available with around 3.2 million outlets. Besides the flagship brand, Eveready, other brands include PowerCell, Jaago, Eveready digiLed, Tez and Lava. The debt-to-equity ratio declined consistently over the last three years to 0.37 times in FY 2015.
The domestic Led market is expected to grow at a compounded annual growth rate of 35.9% from CY 2014 to CY 2020 to reach Rs 21600 crore. This is an alluring business opportunity. An order worth Rs 48.3 crore was bagged mid February 2016 from Energy Efficiency Services for design, supply and maintenance of self-ballasted 9W Led lamps for Madhya Pradesh.
APL Apollo Tubes is the largest producer of electric-resistance welded (ERW) steel tubes in the country, with capacity to produce over 1,050,000 tpa. There are six manufacturing facilities located at Sikandarabad in Uttar Pradesh, Hosur in Tamil Nadu, Bengaluru in Karnataka and Murbad in Maharashtra. Key product categories include over 300 varieties of mild steel black pipes, galvanized tubes, pre galvanized tubes and hollow sections. The main focus is on producing structural ERW steel tubes.
Largely, products are sold in tier 2 and tier 3 cities with adistribution network comprising of more than 500 dealers. Exports are to Europe, the US, the UAE, Australia and Asia. There is confidence about future demand and plan to double the capacity to 20 lakh tonnes over the next three-four years with a capital outlay of Rs 400 crore. There has been a consistent and robust rise in turnover over the decade.
The plunge in commodity prices has proved to be boon, resulting in margins expansion in recent times. Debt stood at Rs 483.2 crore, with the debt-to-equity ratio of 1.1 times, end FY 2015. Mutual fund owned 16.53% of paid-up capital end December 2015.
Conclusion
India is a geographically vast and diverse market. It is difficult to determine market share of several industries, particularly where the unorganized sector is dominant. Largely, investors have to rely on what companies have to say about themselves.
Investors should focus on the growth dynamics and drivers along with risks while assessing these small caps for investment. There should be enough business opportunities for them to grow their business and create shareholder wealth in future. This is very important and indeed a pre-requisite while assessing small caps for investment.
Assessing the credentials of promoters is another important task. This exercise is a must. Equity investment is all about handing over hard-earned money to the management that, in turn, deploys it to nurture and grow the business. Considering this fact, it is essential to pay adequate attention to the track record of the management.
The small-cap world is difficult to navigate. Picking industry leaders is one of the qualitative approaches for investment in this space. This is anytime better than exploring single-digit small caps at the bottom. The recent market correction can be used as an entry point to search for quality stocks that can appreciate rapidly in the medium to long term.
