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The basic starter guide to effective 'stock-picking' by Anuj Jain & Abhay Agarwal

Investors must have a good risk appetite and limitless patience. After all it is some of the Small and Mid-cap stocks that grow out to be large-cap stocks in the future.

March 30, 2021 / 10:35 AM IST
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‘Stock-Picking’ isn't easy, and that is why retail investors put their faith in professionals such as Investment Advisers (IA), Portfolio Managers, etc. But, that doesn't mean one can’t learn stock picking, and here’s a basic starter’s guide to ‘Stock-Picking’. The tips provided here are in reference to smallcases.

Smallcases are model portfolios of stocks/ETFs based on a theme, idea or strategy. It is a modern investment instrument for investors to build long-term diversified portfolios.

Smallcases are created by SEBI-registered professionals. Smallcases have brought a lot of flavour to investing as they are created across various strategies, market segments, sectors, and risk profiles.

According to Anuj Jain who is a co-founder/research head at Green Portfolio, a short-term approach to investment can’t actually be considered as an investment but rather a speculation.

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“An investor invests in shares to build wealth in the long run, whereas, in my view, the short-term approach is not investment, its rather speculation. Reason being, during a short period (less than one year), the market tends to overreact and can remain irrational,” he said.

Jain further added that the volatility, kindled by everything from an abrupt escalation of border tensions to a sudden spike in COVID cases is impossible to gauge or hedge against.

Hence, in my standpoint, selecting and allocating funds to the right shares with a long-term investment horizon, ranging from 3 to 5 years, can be more lucrative than returns derived from investing in other asset classes – especially real estate or fixed-income assets.

Now, when you start off as an investor, there may be many terminologies revolving around the equity space that you will have to be familiar with such as CMP, PE Ratio, EPS, CAGR etc.

There are thousands of these terms but worry not. As your knowledge widens, so will your exposure and understanding to such terms.

Stock-picking isn't a simple task that can be fit into a list. But, the basic guiding principles that one has to adhere to during stock-pick and investment can be a combination of factors listed below.

Anuj Jain of Green Portfolio has compiled a list of basic guidelines to follow while investing:

• The management integrity, capability, and history should be good
• The company should have survived for a reasonably long period of time

• The company should be profitable with Return on Equity of at least 15%,


* The Debt-to-Equity ratio should be below 1
• Growth in revenue
• Strong balance sheet
• The company should be paying regular and reasonable dividends,

* Operating margins should be above 15%
• The company should be spending on product innovation and brand building,
* The taxes paid should be near the rate prescribed by the Government.These some broad pointers which investors can look at but there are some qualitative factors as well which investors should keep in mind:“Although the performance of a company can be measured and be plotted against a graph, INTEGRITY of a company cannot be measured. A lot of firms have been the centre of major scams recently such as YES BANK and DHFL just to name a few,” says Jain of Green Portfolio.

So how can you spot Integrity within a company?Anuj has a solution to this as well. Though Integrity can't be measured it can definitely be gauged by using various indicators.Promoters’ spending money on a multimillion-dollar penthouse when their company is navigating with a heavy debt on their books.Management remuneration is increasing despite the falling performance of the company.

Handsome profits are generated by the company but nothing goes into buybacks, dividends nor for Capex plans.

Promoters' involvement in illicit acts or acts that are condemned by its stakeholders is another red flag. If a company is spearheaded by promoters belonging to this class, it would be rather impossible to expect performance as flaws like these are difficult to overcome.

Again, if these factors exist, it does not necessarily mean avoiding the stock, but you should look for counter-evidence. For example, a company that does not pay a dividend each year (RISK) yet comes up with a buyback (RISK MITIGATION), at a premium price and for a decent quantity, every 3-5 years.

All in all, an investor must consider the history and activity of promoters before investing in a stock. A simple google search will prove useful.

You can find Green Portfolio’s “High-Quality Right Price” smallcase right here

"High Quality Right Price" Multi-bagger Portfolio smallcase by Green Portfolio


Now, let’s dive into a different territory, that is, small and mid-cap stocks.

Before we go to the basics of stock-picking for small and mid-cap stocks, let’s first try to understand what they are and why it would potentially be a good idea to invest in them.

According to SEBI definition, the 251st company onwards in terms of market capitalisation is defined as small-cap, and mid-cap stocks are companies with a market capitalisation between 5,000 and 20,000 crore.

Thyrocare Technologies Ltd, Cummins India, Heidelberg Cement India Ltd are a few of the Small and Mid-cap stocks falling within the market cap of 20,000 Crores.

There is a general misconception that small-cap stocks refer to start-ups or newly formed entities. But, this couldn’t be further from the truth as many of these small caps are like their larger peers in terms of financial and performance track record.

Newbie investors must appreciate that SEBI has stringent financial and litigation prerequisites for IPO’s which is in contrast to the UK/US where they can list a company directly or through a SPAC or special purpose acquisition company while meeting minimum requirements.

They confer high risk due to their volatility compared to large-cap blue-chip stocks, and more often than not it takes several years for gains to materialise.

Hence, investors must have a good risk appetite and limitless patience. After all it is some of these Small and Mid-cap stocks that grow out to be large-cap stocks in the future.

For novice investors looking to earn a stable income alongside consistent capital appreciation -- small and mid-cap stocks are recommended to be avoided as these are usually fast growers who tend to reinvest their profits back into the business than pay dividends.

With that being stated, here are 4 reasons why investors gravitate towards small and mid-cap stocks over large caps according to Anuj:

Immense growth potential:

With the right research and identification of a small or a mid-cap stock, investors can expect multi-bagger returns, in the long run, the time horizon can vary from 5-10 years.

Under the radar:

Historically, these mid and small caps are neglected by brokerages and would fly under the radar for many years despite strong financial performance and the manifestation of growth opportunities.

Since mutual funds when investing acquire a biblical number of shares, they tend to cold-shoulder small-cap stocks as the number of shares they offer is limited.

Large-cap stocks are acclaimed to already have had their good days and their stock growth tends to be aligned with the market growth.

Undervalued:

Owing to the prior reasons, these categories of stocks tend to be undervalued and unnoticed for a prolonged period of time and trade below its intrinsic or real value.

But eventually, the stock will catch praise of the markets, and investors would be able to book handsome gains.

Diversification:

Exposes investors to stocks with aggressive growth rates as compared to large-caps where growth is usually conservative.

With the IMF and large financial institutions forecasting robust recovery for the Indian economy, we expect to witness a greater allocation of foreign institutions and mutual funds to small and mid-cap stocks this season.

All in all, the relatively new investors having a good risk appetite and willing to show patience shall incline towards individual Small and Mid-caps instead of just investing in the relative indexes for exponential returns.

Well, if small and mid-cap stocks are a good choice for investors with such risk appetites then how should they be stock picked?

Well, according to Abhay Agarwal who is a Founder at Piper Serica Advisors -- it is always rewarding for an investor to be able to identify stocks that can become a part of a benchmark index, especially the Nifty50.

The Nifty50 is the most followed benchmark index for domestic and international investors, especially large passive funds. Therefore, inclusion in the index is not only financially rewarding it is also a matter of great pride for the company and its investors.

“There are 4 industries where the Nifty is severely under-represented - consumer Internet, healthcare, real estate and general insurance. The benchmark indices of most developed countries, especially the US, have substantial representation of these industries,” says Agarwal.

“For instance, 2 of China’s largest Internet companies, Tencent and Alibaba have a combined market cap of almost USD 1.5 trillion while the market cap of Info Edge, India’s largest Consumer Internet company, with leading properties like Naukri.com and majority stakes in Zomato and PolicyBazaar, has a market cap of less than USD 8.5 billion,” he said.

Abhay finds a contrasting difference of misrepresentation of industries within the benchmarks.

“Almost all leading indices have 1-2 real estate developers since real estate is a significant part of any developed economy. Similarly, domestic healthcare service providers (not to be confused with generic pharma exporters) are also part of leading indices. Lastly, general insurance, covering auto, health, fire etc. is a large part of a developed economy and is well represented in leading indices,” he said.

Abhay is confident that these industries will be represented in the Nifty benchmark by 2025 to 2030. By then, these industries will scale up rapidly and their leading players will qualify to be part of Nifty.

For an investor, it would be quite safe to bet on the existing leaders in each of these spaces rather than take the risk of identifying outliers that may or may not make it to Nifty.

To give us more clarity of this particular circumstance, Abhay gave us a few examples for comprehension. For instance, if Info Edge is a good proxy for India’s rapidly expanding Internet industry. Apollo Hospitals, with its unique integrated business model of hospitals, pharmacy, diagnostics and telemedicine is the best bet on India’s domestic healthcare services.

Likewise, Godrej Properties is a clear leader in real estate development with an unmatched national level footprint and a very well-defined business model. In case of general insurance, ICICI Lombard is a leader in the private space and has a good chance of getting into Nifty.

Abhay made it quite clear that the scalability of the business is very critical as it needs to accommodate the required market gap to get into Nifty. The current average market cap of Nifty is Rs. 2.3 lakh crore and the average market cap of even the 5 smallest Nifty companies is Rs. 63 thousand crores.

And so to scale up to this level of market cap, the current small and mid-cap contenders will need to have the following characteristics –

Substantial focus and investment on digitisation of the entire business model across customer acquisition, delivery, collection, and servicing. The millennial and GenZ consumers are extremely tech-savvy. They will prefer to consume products and services from companies that have mastered technology.

Ability to attract talent along with strong human resources processes. Scalability is not possible without having a HR system that takes care of hiring, training, compensating and career management.

National level presence of brand and distribution. India is made up of hundreds of unique mini markets. That is the reason that many companies stay strong and competitive within their regional market but are not able to grow beyond it.

However, companies that are able to build a presence across the country are handsomely rewarded by investors.

Buying growth by acquiring weaker companies through borrowed funds has rarely worked as a long-term value creation strategy. Compare that to companies that are extremely sensitive to any dilution in the quality of their balance sheet.

They will still look for inorganic growth but only with their own funds and only where the quality of the acquisition is highly accretive to earnings and therefore shareholder value.

The above list of requirements is what can help guide you in picking up small and mid-cap stocks that can make it into the Nifty.

On a closing note Abhay says “Again, this is not an exhaustive list, rather, it is a list of minimum qualifying criteria. There will always be those break-out stories that will come out of nowhere and scale up rapidly. However, investors need to make sure that they are backing long-term trends and not getting carried away by flavor-of-the-month fleeting trends. Whenever the temptation arises please once again have a look at the names of stocks that have been removed from Nifty to make sure you are allocating your hard-earned funds to the right candidates.”

You can find Piper Serica’s “Emerging Dominator’s Plus (ED+)” smallcase here:

Emerging Dominators plus (ED+) by Piper Serica smallcase by Piper Serica

(This is a partnered post)

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.

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