5 parameters that you should consider before buying small & midcap stocks

Brokerage houses have come out with their preferred picks in the small and midcap space that makes it easier for investors to make their decision but they should do their homework as well.

Also read: SEBI’s diktat on multi-cap funds: Why investors must resist the urge to act immediately  

“Post the SEBI circular and the clarification, buying in smallcap and midcap is expected by traders in anticipation of fund buying that can come later once they finalise their strategies. This buying can sustain for a couple of days and then if the institutions don't turn up to buy, traders can get impatient and start to unload their positions,” Deepak Jasani, Head of Retail Research, HDFC Securities told Moneycontrol.

“A lot will depend on how reasonable the valuation of these stocks remains to attract long-term buying from institutions. Mutual funds have expressed their hesitation in buying small and midcaps just to meet the SEBI requirements without getting convinced about the stocks or their entry valuations,” he said.

Also read: Sebi's multi-cap fund norms may see Rs 25-35K crore move from largecaps to mid and smallcaps

Here are five factors that experts want investors to keep in mind before pressing the buy button:

Low liquidity

Many mid and most small-caps don’t have adequate liquidity in terms of daily turnover in the exchanges, say experts.

“The average daily turnover of many smallcaps below Rs 5,000 crore market cap is around Rs 2-3 crore only and hence the impact cost in most of them is high,” Rusmik Oza, Executive Vice President, Head of Fundamental Research at Kotak Securities told Moneycontrol.

“Analysts’ coverage is also another important factor to keep in mind when it comes to midcaps. Companies having regular post-result conference calls, analysts meet and widely covered by brokerages are preferred by both FIIs and DIIs,” he said.

Oza added that in the case of smallcaps, one should ideally prefer companies falling in the Nifty smallcap index as these are known and actively covered.

Also read: SEBI move on multi-cap funds: Schemes may have to majorly re-allocate holdings

Avoid herd mentality

Mutual funds have expressed their hesitation in buying small and midcaps just to meet the SEBI requirements and a similar checklist should be followed by retail investors.

“Joining the herd on the buying side without having enough conviction in the story could bring pain for investors,” Jasani of HDFC Securities said.

The SEBI prescription could have lifted the P/E ratio that one ascribes to good mid and smallcaps by a few percentage points; even then if the run-up is too sharp and the story is not convincing, the runup in stocks prices could fizzle out soon, he said.

Do your own research

Investors could take cues from what mutual-fund managers are buying or selling but the final decision should be based on their research about the company and management as well as the firm’s product basket.

“Smart investors who understand balance sheets, financials and have been analysing companies can venture on their own in smaller unknown companies,” said Oza.

“One must do some basic homework on the hygiene factors like promoter holding, pledged shares, ratios, cashflows, debt-equity ratio and valuations before taking higher exposure in any mid or smallcap company.” he said.

Focus on 5GCPM framework

The change in multicap allocation policy for mutual funds will see some shift towards smallcaps and a little bit towards midcaps. To make a high conviction bet, the earnings growth of the company should continue for some quarters, experts said.

“An investor should focus more on the size of the opportunity, high earnings growth sustenance and management’s execution capability, which is what our 5GCPM framework focuses upon,” Pritam Deuskar, Founder of Wealthyvia.com told Moneycontrol.

“When your small or midcap stock becomes a largecap then only substantial wealth is created.  Forbes list changes many people every five-seven years. Many companies grow,” he said.

5GCPM is a method developed by Arthavruddhi Research Analysis that includes:

- 5 types of growth in a company business
- Corporate governance check
- Practicability of investment becoming fruitful and
- Magic parameters that tell about fundamental and technical long term trend.

Focus on earnings

Most smallcap companies are not covered by analyst community, hence investors would have to do their due diligence before putting in the money.

The expected inflow in the broader market is likely to draw investor interest in small and midcap stocks as fund managers begin to align with new guidelines.

“A retail investor planning to put money in broader stocks should remain mindful of basic factors like considering fundamentals of the business, credibility of the management, and past track record in terms of relation with other stakeholders of the company,” Dinesh Rohira, Founder, CEO - 5nance.com said.

“It should be remembered that the strong business fundamental drives the price of the company and not the market-cap classification. It is also equally important to check the liquidity of stocks in a market while buying companies,” he said.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.