A 10-Point Checklist to Pick a Small Cap Stock

How exactly do you define a small cap stock in the Indian context? There are various definitions but largely small cap is a term used to classify companies with a relatively small market capitalization. To be on the safer side, you can just consider stocks between Rs 2000 crore – Rs 5000 crore market cap.

Of course, you need to do your homework before you invest online in these stocks, but here are 10 things to check when you buy small caps in the stock market.

Look at past performance

You often see safe harbour statements that past performance is not indicative of future potential. While that is correct technically, the closest you can get to comfort in the case of these small cap stocks is the past performance of the company over the last 5 years. Ideally, avoid investing in small caps which do not have a five-year track record.

Focus on consistency of performance

More than the absolute performance, it is the consistency that matters. Prefer companies that have shown growth over the last five years and avoid companies that show violent fluctuations in financial performance. These can be quite tricky when it comes to projecting cash flows. Also consistent small caps get better valuations in the market.

Focus on market size and positioning

Typically, small cap companies are single product or single service line companies. They neither have the capital nor the management bandwidth to spread too thin. Hence the size of the market matters. But more than that, it is the positioning in the industry that matters. A niche positioning or some entry barriers created can make a significant difference to the company valuations.

Check volumes in the market

That is the golden test. While there are no hard and fast rules for volumes, the thumb rule is that the average daily stock market volumes are at least 5% of the market cap. So if the market cap is Rs2,000 crore then the daily turnover in the stock market should be closer to Rs.100 crore.  When you invest online, you can check this data in the trading platform itself.

Bid ask spreads are an important signal

Bid ask spread is the gap between the best buy price and the best sell price. The former is the price at which sellers can sell and the latter is the best price at which buyers can buy. The benchmark tick spread is 5 paisa or 0.05 on the trading screen. Normally, liquid stocks have bid-ask spreads of around 5 paisa but as you go lower in the market stakes, the spread keeps widening. When you select small cap stocks ensure that the bid-ask spread in normal trading conditions does not cross 10 paisa. The moment you allow that, it adds to your risk when you invest online.

Check the bulk deals for intraday deals and promoter deals

Why are bulk deals so important for small cap stocks? There are two reasons. Firstly, bulk deals report all deals above 0.5% of the outstanding shares, irrespective of delivery or intraday. If you look at the bulk deals of small cap stocks, you normally find a flurry of intraday trades in some stocks indicating that the stock is highly speculative and could be potentially volatile. Also check if promoters are too active in selling the stock, details of which are there in the SAST disclosures.

Check for management quality and commentary

These are two different aspects but equally important in small cap stocks. Stay away from small caps where the management has shown serious lapses in corporate governance, disclosure practices etc. Also avoid managements that have failed to deliver on past promises. Small caps are overly dependent on management commitment. In fact, reading the MDA in the annual report gives you the sharpest picture.

Stay away from small caps with legal / regulatory charges

Before buying any small cap stock, do a quick system check on any pending issues with SEBI, any regulatory issues raised by SEBI / RBI, any pending investigations etc. If these are of a serious nature, it is best to keep away from such stocks. Normally, small cap stocks tend to get overwhelmed by such regulatory challenges and it is best to avoid such cases. Such cases are regularly reported on the website of SEBI.

Don’t ignore contingent liabilities and auditor qualifications

Contingent liabilities are potential liabilities like pending legal cases, open derivative exposures etc. Small caps in the stock market are extremely vulnerable to the negative impact of contingent liabilities. This gives you a quick idea of whether the business model has disproportionate risks built into it. Also be cautious if the auditor is not qualified or when auditors resign.

Check the cash flow statements

Of course, we are assuming that you have done your due diligence on the financials but the importance of cash flow statement is special in case of small cap stocks. Often, small cap stocks are under liquidity constraints as they are not able to churn their working capital effectively. Such credit pressures are visible in the cash flow statement.

Indian stock markets have been extremely successful in converting small caps stories into large cap winners. A quick check can go a long way.