Identify valuable small-cap companies using these techniques!

Picking the right small-cap companies can help you to amass wealth in the long run.

Selecting Small-Cap stocks requires a comprehensive approach that involves research, analysis, and risk management. According to SEBI’s classification, companies ranking after 250 in terms of market capitalization are known as Small-Cap companies. Market capitalization is the result of multiplying the current share price by the total number of shares.  

Small-cap companies can be riskier than larger companies because they are less established and have less financial stability. However, their probability of exponential company growth is much higher than large and midcap companies if they work in the right direction, therefore investors are much more engaged in a growing enterprise which results in higher volatility and they also have a very high potential for higher returns.  

Some examples of small-cap companies are Bikaji Foods International, Force Motors, Central Bank of India, JK Lakshmi Cement and Dollar Industries.  

Following are the factors to be considered:  

Fundamentals of the company: This includes factors such as revenue growth, earnings growth, profitability, and cash flow. The company should have a solid business model, a competitive advantage, and a capable management team.  

Valuation of the company: Company's price-to-earnings, price-to-book value, and other valuation metrics should be less to the broader market. The company should not be overvalued.  

Financial health: The company's balance sheet and income statement should have a healthy debt-to-equity ratio and sufficient cash reserves. Sales should not be manipulated by related party transactions. A related party transaction is a commercial agreement or deals between two parties who already have a link or relationship. The exchange of products, services, or properties may be part of the deal. i.e., Satyam Computers inflated their sales by showing fake transactions. Credit ratings are also a good way to understand a company’s health.  

Industry and market trends: Companies that operate in industries with strong growth potential or that are poised to benefit from macroeconomic trends are a good choice. Overall market conditions should be favourable.  

Scalability: Company’s business has the potential to grow its revenues significantly over time. Companies that do well, in the long run, have huge opportunities for external growth compared to their current revenue. A business is considered scalable if it can attract new customers for its products and generate volume growth. The scalability of a business depends on the growth of the overall market. For instance, a company can grow at 25 per cent if the underlying market grows at 20 per cent, but it will struggle to grow even at 20 per cent if the market expands only at 10 per cent. Hence, it becomes important to understand this factor while investing in small-cap stocks.  

Promoters and Management: The company’s management should have skin in the game, they should have a strong shareholding in their business.  

Liquidity: There should be a sufficient quantity of shares in the market to prevent someone from simply manipulating its price, such as by pumping or dumping.  

Diversification of portfolio: There is a famous quote on diversification ‘Don’t put all your eggs in one basket’. Investing in a diverse range of Small-cap stocks can help spread risk and potentially maximize returns. For more diversification, you can put 20 to 25 per cent of the total portfolio value in small-cap or increase/decrease according to your own risk appetite.