Small Caps that pass the 'One Rupee' test

According to Warren Buffett, a stock is considered a good investment candidate if the business earns at least one dollar for every dollar invested in the business throughout its lifetime. In other words, he says that as investors, we should consider businesses with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.

Simply put, it means that a stock is a worth considering as long as it its business generates a higher return on equity (ROE) than the cost of capital for a sustained period of time. Thus, if the business reinvests most of its earnings, those earnings should also generate return on equity that is higher than the cost of capital. If that is not the case, the total return on equity will eventually come down and the stock will stop being a good investment.
Let's take a look at an example to understand this well. For instance, a business has a net worth of Rs 100 and an ROE of 20%. Also, let's assume the opportunity cost of capital to be 15%. Thus, if this business keeps on generating ROE of 20% forever and does not invest a single rupee back into the business but rather pays out as dividends to shareholders then the intrinsic value of this business is said to be Rs 133.3 (Rs 20 divided by 15% which is the cost of capital). Therefore, as can be seen, every rupee in the business is worth Rs 1.33. Naturally, this is a good investment as per Buffett because one rupee has created a market value of Rs 1.33.
Now, assume that the same business does not choose to pay back all its profits but wants to invest some money back into the business. We as investors would welcome the same, considering that the reinvested amount is expected to earn returns higher than the opportunity cost of capital. In other words, as long as the profits which are invested back into the business generate an ROE of at least 15%, they should be allowed to be reinvested. However, one should be cautioned if the ROE on this incremental capital is expected to be less than 15%. Then the sustained reinvestment of such sort can eventually take down the total ROE to less than 15%. Thus, in this case, in the long run, one rupee of money invested as equity back into the business may not eventually translate into at least one rupee of market value.
The above explanation can have profound implications for the way we invest. Investors are often lured into believing that companies that witness the highest earnings growth are considered to be good investments. But if the profit growth takes the overall return on equity of the business down to less than the cost of capital, then that business has destroyed market value and not created it.
Also, doubling of share price is no proof that the investment is a good business. What needs to be found out is the fact that how much money has been added to company's net worth to bring about the doubling of share price. If net worth has increased by Rs 150 and market value by Rs 100 then it is no use.
Thus, one can consider the 'one rupee' test as highlighted above to be a very important factor while analysing companies. And not the growth in earnings per share! Only if the business generates more than one rupee of market value for every rupee invested over a long period of time, it should be considered as a potential investment candidate.
Now, let us try and perform this so called 'one rupee test' on the BSE Small Cap universe. We will have a look at those small caps that have provided the maximum bang for the buck in the last ten years. This is to gauge the market value that the investors have assigned to them for every one rupee increase in the net worth of these companies. It is important to add here that we have considered only those stocks where the average Debt to equity ratio (D/E) has been less than 0.5 times in the last five years. This is because increasing debt could be the best way to increase ROE but increase beyond a certain debt to equity ratio makes the stock a speculation rather than an investment and we are only concerned with the latter.
Out of the more than 530 stocks that we have considered from the BSE Smallcap index for our study, only about 76 managed to pass the 'one rupee test' i.e. not only did these stocks generate more than one rupee of market value for every rupee increase in net worth but they managed to do it by keeping the average D/E ratio less than 0.5 times (average D/E of past five years). It must be noted that we have not included companies whose historical data was not available. Below is the list of top twenty such stocks.
 

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