Thread by @Equitymaster

Smallcaps have a reputation of being risky, unlike their bigger peers. However, Richa Agarwal, Editor of Hidden Treasure (Equitymaster's smallcap recommendation service) and her team, have broken this myth. #smallcapstocks

Since inception in Feb 2008 until September 22, the verified IRR (Internal rate of return) for Hidden Treasureis at 26.9%, beating benchmark indices by almost 3x.Here's is what I expect for smallcaps in 2023. #SmallcapMultibaggers #topsmallcapsfor2023

Some reflections first…2022 was a challenging year with Russia Ukraine war, supply chain disruptions, inflationary pressures, tech meltdown, slowdown in global economies and locks downs in China. And the rough ride is not over.

While deglobalization is the flavour of current times, there is not a complete decoupling. Given the uncertain macro scenario, it is best to be prepared for the developments that could influence the smallcap space.

In 2022, while the Sensex gained 3% during the year, Smallcap index lost 3%. In 2021, Smallcap index witnessed a gain of 63%, vs just 24% gains in the Sensex. Since the Covid crash, total gains in the smallcap index stand at 207% vs 130% in the Sensex. So, will 2023 mirror 2022?

Let’s first check the general market sentiments. At present, Sensex is trading at a PE of 23.6x, a level saner than the peak of 36 times in 2021 , but at a premium to its long term median of 20.2 times, and not too far from some of its previous peaks.

Here’s a simple base case prediction for Sensex in next 5 years. The Sensex earnings have grown at a CAGR of around 13% over last 2 decades. If I expect the earnings to grow at same rate over next 5 years, and use the median PE multiple of 20.2, the Sensex could be close 1 lac.

Let's see what this means for smallcaps. PE ratio for smallcaps does not make sense. Over 4000 stocks fall in this category, lot of which are loss making. So, for the lack of a sensible PE number, let’s use another metric - Smallcap to Sensex ratio. #peratio

The smallcap to sensex ratio at present stands at 0.48 times. This is against a long term median of 0.44 x, and against the previous peaks ranging from 0.54 to 0.76 in the last two decades. So, there is still room for smallcaps to rise before investors turn fearful.

For projection of smallcap index, I’ll use the median Smallcap to Sensex ratio (0.44x) & base case projection for Sensex(1Lac). If Sensex could touch 1lac in 5 years, Smallcap could be at 44,000. That’s a ~9% CAGR from the current levels over next 5years in a base case scenario

So even a base case scenario suggests better returns than a lot of other alternatives out there. As such, I believe it makes sense to not wait on the sidelines but invest in quality smallcaps that offer enough comfort on sustainable growth over next 5 years.

That said, you will have to be highly selective while picking stocks in the space, as low hanging fruits are rare. Here are a few filters I would recommend you to ensure.

1) Positive Cash flow from operations: A huge gap between cash flow from operations and earnings is a red flag that needs deeper analysis. If you are only looking at earnings growth, you could be a victim of #accounting gimmicks where profits are only on paper.

2) Debt to Equity ratio < 1x. Growth is good, provided it is sustainable. While high debt companies can perform well now and then, they are quite fragile. For any ladder you climb, another event like Covid or downturn in the industry cycle could be the snake to bring you down.

3) Median or average ROCE > 15%. This reflects some prudence on the behalf of the management when it comes to capital allocation decision. If the business fails to offer a decent return on the capital invested, chances of a good return on the amount invested in its stock are slim

4) Low promoter pledging. Be cautious of the stocks where #pledging is above 15% and has been increasing. And even more cautious with stocks where pledging is high along with low promoter stake. These stocks could be a victim of bulk selling in case of a market downturn

5) Avoid managements with shady history or the ones that have treated minority shareholders unfairly in the past. A tiger does not change its stripes. Be careful with the companies that are changing names frequently, hoping to white wash the past reputations.

6) Look for companies where there is comfort on growth aspect. It would help to focus on industries and themes that are witnessing tailwinds. For 2023, my favourite is #capex #infrastructure revival theme

To know more about why I believe this theme could play well and the stocks that I believe deserve to be on your watchlist, watch my Youtube video