Scared of small-cap investing? Here’s how one can avoid landmines in small-caps

Published: March 24, 2020 3:08:42 PM

There are two ways to look at small-cap investing. One, take a very conventional view that it is a highly risky space and avoid it all-together. The other is to take a more contrarian, but an objective approach.

stock market, stock market investment, how to survive a volatile market, coronavirus, Covid-19, Sun-Tzu, survival guide 2020, mutual funds, SIPThere is a twin side to the debt story. The same debt that is greeted with cheers in the bull market, turns into a dreaded one in the bear market.
  • By ArunaGiri N

There are two ways to look at small-cap investing. One, take a very conventional view that it is a highly risky space and avoid it all-together. Goes with that, is all the potential reward as well, as one says no to the alpha generation (higher returns that come from small-cap space). The other is to take a more contrarian, but an objective approach. That is, take the pain to understand the various risks in that space and build a process to mitigate those risks. This is more demanding, but rewarding in the long-run, as the whole game in small-caps investing is all about weeding out bad apples. This piece is an attempt to cover the critical steps that are required to be taken in the stock selection process to mitigate the risks in the small-cap space. 

Nature of risks in small-caps:

Small-cap is not a sexy space, notwithstanding the seduction of spicy returns it promises to lay investors. It is a space which is infested with a lot of risks. The prominent ones are,

  • Sub-scale and unproven business model
  • Poor governance
  • Key man and succession risks
  • Leverage and balance sheet risks
  • Management depth
  • Client concentration risks

These are mighty risks and the process to mitigate them may seem herculean at the first look. But the good news is, it can be distilled with few basic hygiene filters which, surprisingly, can surmount much of the risks in this murky space. Though these filters are simple, sticking to them in a disciplined manner when spirits run high (bullish time), is not easy. That is what makes this process fascinating. 

Let us look at some of the most crucial ones.

Debt: The great derailer:

There is a twin side to the debt story. The same debt that is greeted with cheers in the bull market, turns into a dreaded one in the bear market. While it can spruce up returns in the upturn, it has the lethal power to turn a liquidity issue into a solvency crisis in the down-turn. In that sense, it is a dangerous beast. This much is well understood. But, what is not that understood and appreciated is the extraordinary influence debt has on the overall governance standard. One thing that constantly pops out from our extensive 

experience in small-cap investing is this – if the business doesn’t need debt to grow, there is less likelihood of mis-governance in that business.  At the first sight, this correlation may seem odd, but every down-cycle has shown that the real catalyst for corporate mis-governance is rooted in debt. When debt puts additional pressure on the management in a down-cycle when the business is already under duress, there is extra-ordinary incentive for the management to pursue the sub-standard governance practices. In this case, the debt pushes the otherwise okay management into below-board practices (Zee Entertainment is a classic example – group debt in the promoter entities). What about managements/promoters who are inherently unclean and with bad motives. For such managements, debt is a convenient alibi for siphoning money out. Hence one will find such managements loading up debt more than what the business might need as debts are taken with the intent of not repaying. In both the cases, debt is a very accurate indicator of potential governance issues that may be lurking under the radar. It leads to a surprising simple filter, that is, avoid excessive debt to avoid much of the risks in small-caps. To put it differently, look for businesses that hardly require debt to grow or more ambitiously, look for those that have the ability to throw free cash-flow after funding its growth capital.

Long operating history:

This is another critical metric to weed out the bad ones. Longer operating history essentially means that the business model is tested under many down-cycles and hence more robust. If it has survived down-cycles without facing liquidity issues, it also reflects stronger long-term financial position. 

Sticking to Knitting (Focus):

In this era of mega expansion and diversification, talking about focus may seem odd. But, hardly anyone can overestimate its importance, especially when it comes to its impact on both quality of business and also on quality of management. As we have seen from our extensive research, sticking-to-knitting in a given segment over a long period of time leads to solid specialisation which in turn builds a durable moat in the underlying business. Focused management has less need to expand the empire. With that comes less risk of unrelated diversification, either through’ promoter pledging or through’ diluting balance sheets (loading up with debt). Both such actions have always led to deteriorating governance standards in addition to solvency risks as many examples have shown in the current down-cycle (many reputed groups like Eveready, Zee, Emami etc come to mind).

Conclusion:

The list of filters can go on. But what is explained above covers most part of the requirement. If one adds the other hygiene factors such as, management compensation, related party transaction, capital allocation track record, capital efficiency (high return metrics like ROCE/ROE) and skin in the game etc. along-with bit of scuttle-butt work on management’s quality/track record (channel checks in analyst’s parlance), one pretty much gets to size the overall management and business risks. Small-cap investing is much like “road-less travelled” poem by Robert Lee Frost – “Two roads diverged in a wood, and I – I took the one less travelled by, 

And that has made all the difference”.  

Happy Value Investing!!

(ArunaGiri N, Founder CEO & Fund Manager, TrustLine Holdings Pvt Ltd. The views expressed are the author’s own)

Get live Stock Prices from BSE and NSE and latest NAV, portfolio of Mutual Funds, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.

Next Stories
1How to handle rupee volatility as coronavirus hits global market
2Nifty may see more weakness in near term; here’s what to expect
3Why protecting your money against the US Dollar is important?