Investment

How to pick best smallcaps? Top PMS manager shares 3 solid tips

NEW DELHI: People who tell you smallcaps deliver mega returns do not say what it takes to earn them and what is the probability of success.

A seasoned smallcap fund manager on Dalal Street says it’s not everyone’s cup of tea, and definitely not the average retail investor’s!

“It is not wise for retail investors to invest in smallcaps directly. They do not have the bandwidth to be able to separate the grain from the chaff,” says Pramod Gubbi, who manages a smallcap-focussed fund for wealthy investors.

He says it involves researching a large number of companies in that basket, and that is not a mean task.

As per the Amfi categorisation list released at the end of June, 4,754 stocks fall in the smallcap category. However, less than half of them are traded regularly on the stock exchanges, which still make this basket too big for a retail investor to wade through efficiently.

“Smallcaps are a vast ocean; finding a handful of good names there is like finding a needle in a haystack,” says Gubbi, who manages a smallcap-focussed PMS fund at Marcellus Investment Managers.

In recent weeks, seasoned investors and market watchers have voiced concern over a frenzy among new retail investors and amateur traders to buy penny stocks in heaps, which sent shares of some loss-making and bankrupt companies soaring.

“It is a myth that smallcaps eventually outperform midcaps or largecaps. Data suggests otherwise. It is difficult to generate wealth in this space,” says Gubbi.

In the last 15 years, BSE Smallcap Index has risen 163 per cent compared with a 264 per cent jump in the midcap index and 376 per cent rise in the Sensex. In a 10-year period, smallcaps have risen 39 per cent, midcaps 82 per cent and Sensex 104 per cent.

“There is no evidence to say people can make more money by investing in smallcaps, compared with largecaps or midcaps,” he says.

Yet, Gubbi does run a smallcap fund, and is making money for his investors too. And how!

Gubbi says it is possible to pick a few quality stocks even from that basket that may outperform others, something that is also true for largecaps.

“It is pretty much clear that India is a stock picker’s market. This aspect of picking the good ones and avoiding the bad ones is even more accentuated at the smallcap level. While there are a handful of companies that can create immense amounts of wealth, there are a far greater number of them which can destroy your wealth,” says the seasoned fund manager.

How to screen smallcaps
What if one wants to manage his money on his own and pick a few smallcaps? How does he pick those stocks?

Gubbi says he screens thousands of stocks from the smallcap universe to pick 10-15 investable names.
“What we do is, we use a combination of quantitative and qualitative approaches. The quantitative screens are used to narrow the universe down to a small enough number, which can then get us through in-depth bottom-up research,” he said.

Step 1: Trend screen
Gubbi uses 12-15 financial and accounting ratios to screen and assign an accounting quality score to each of the 1,000 companies beyond the BSE500 basket. He takes the top 50 per cent of the top five deciles of these 1companies into the next set of filters. This selection process is inspired by Howard Schilit’s legendary book on forensic accounting called Financial Shenanigans. It is used to look at financial parameters like revenue growth, consistency in gross margin, consistency in interest coverage and improvement in working capital.

Step 2: Quantitative screen
The second screen is to assess the business quality. Gubbi picks those companies that have shown consistent improvement (say for 5-6 years) on parameters like operating margins, gross margins, revenue growth, working capital turnover, gross turnover, debt to equity ratios and return on capital employed.

Step 3: In-depth research
The second step usually results in a smaller sub-set of around 40-50 companies, which can then be put under strict scrutiny from a bottom-up perspective, says Gubbi. In the third step, it is mostly ground research, examining the quality of business, moats present and looking for the quality of corporate governance in the companies.

“It’s impossible to really do this (third step) sort of in-depth diligence on 1,000 companies. We can at best do it on 50 companies. The idea is to pick the best 15 companies that can give us a fairly diversified portfolio and a very high quality portfolio. So, that is the challenge in smallcaps,” Gubbi says.

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