Building a Robust Small-Cap Portfolio with 3 Factors
The allure of small-cap stocks is undeniable. These companies, often characterized by rapid growth and disruptive innovation, can offer significant returns. However, investing in small caps can be a double-edged sword. While the potential for high returns is enticing, the risks associated with this asset class are equally substantial. To navigate this complex landscape effectively, a well-crafted strategy is essential. This is where the Quality Smallcap Smart Beta smallcase comes into play. It’s created using three factors: size, quality & momentum.
Understanding the Three Factors
Size: Small-cap stocks, by definition, are companies ranked beyond the top 250 companies in terms of market capitalization. The average market capitalization of listed companies during a specific 6 month period is used to rank the companies. Small-cap companies have more room to grow compared to large-cap companies. This potential for significant growth can lead to substantial capital appreciation over time. Small-cap stocks are often less followed by analysts and institutional investors, which can create opportunities to find undervalued stocks. Smaller companies are often more innovative and agile, allowing them to adapt quickly to market changes and capitalize on new opportunities.
Quality: While growth is crucial, the sustainability of that growth is equally important. Focusing on high-quality small-cap companies can significantly enhance investment outcomes. Key indicators of quality include strong balance sheets, consistent earnings growth, efficient management, and a sustainable competitive advantage.
Momentum: Identifying stocks that are already on an upward trajectory can be a powerful strategy. Momentum investing suggests that stocks that have performed well in the past are likely to continue performing well in the future. This factor can amplify returns and help investors capitalize on market trends.
Why These Factors Create a Strong Strategy
The magic lies in the synergy of these three factors. Size provides growth potential, quality ensures stability and resilience, and momentum acts as a catalyst for sustained performance. This combination creates a balanced and dynamic investment approach that can help investors navigate the complexities of the small-cap market.
Moreover, this trifecta of factors can serve as a robust risk management tool. By focusing on high-quality companies with strong fundamentals, investors can mitigate the risk of business failures. Additionally, momentum can help avoid value traps – companies with deteriorating fundamentals.
Historical data suggests that strategies combining size, quality, and momentum have the potential to outperform traditional market-cap-weighted indices. While past performance is not indicative of future results, it does provide a glimpse into the potential benefits of this approach.
An Anecdote on small-cap investing from the Manager
They say there is opportunity in adversity, and small-cap investing is a good analogy to that statement. Small-cap stocks are more sensitive to market sentiment and broader economic trends, which can lead to rapid and sometimes irrational price movements based on market perception rather than fundamentals. Small-cap companies generally have fewer financial and operational resources compared to large-cap companies. This can limit their ability to withstand economic downturns or industry-specific challenges. Smaller firms might lack experienced management teams or robust operational infrastructures, leading to higher risks of mismanagement and operational failures.
But that’s also where the big bucks can be made! If there was a way to identify quality small-cap stocks with a very promising future, small-cap investing could potentially consistently outperform large/mid-cap investing.
That’s when the ‘Quality Smallcap — Smart Beta’ smallcase came into the picture. We figured that if we could find a way to identify good quality small-cap stocks with massive future potential, we could offer our investors a very efficient and reliable way to get exposure to small-cap stocks.
Hence, we started building this smallcase by finding a way to identify quality small-cap companies smartly. How? By assigning small-cap companies a ‘Quality Score’. Essentially, our team quantified financial data associated with consistent and healthy profits, cash flows, and business stability to develop the Quality Score.
The calculation of the Quality Score stands on four pillars of financial information:
- Management Effectiveness: Determined using Return on Equity (ROE)%
- Financial Strength: Evaluated using the Debt/Equity ratio
- Earnings Quality: Estimated using an accrual ratio ((Net income – Free Operating Cash Flow)/Total Assets)
- Consistency in Performance: Gauged through earnings variability over the past five years.
The small-cap companies went through three layers of the selection process to finally be eligible to be included in the smallcase. The first was laid out as the Quality Score. Step two was to further screen down stocks to those that are experiencing positive momentum trends in their price. Momentum trends help align the portfolio with the market trend.
If a certain number of stocks fail to exhibit the mentioned traits, the portfolio is tilted towards gold until the situation normalizes.
The ‘Quality Smallcap — Smart Beta’ smallcase aims to systematically beat the small-cap index by quantitatively selecting small-cap stocks exhibiting strong quality fundamentals with positive momentum trends. It is best suited for investors looking to take exposure to quality small-cap stocks for passive long-term investing.
Spotlight on Top-Performing Stocks
To illustrate the power of this strategy, let’s examine a few standout performers from our small-cap portfolio:
- Exide Industries: Added to the basket in April 2023, Exide Industries is engaged in manufacturing and selling acid batteries and storage solutions. The company has recently forayed into manufacturing lithium-ion (Li-ion) cells in partnership with China’s S-Volt at a total investment of ₹6,000 cr. Exide acquired Hyundai-Kia as a customer for its Passenger Vehicles Li-ion cell business. Since its addition, the stock has run up ~186%.
- Blue Star Limited: This consumer electronics company, known for air conditioning and commercial refrigeration, launched a range of heavy-duty ACs ideal for extremely hot markets and hired Virat Kohli as a brand ambassador. The stock was added to the basket in July 2023 and has surged by 125% since.
- Cochin Shipyard: A PSU shipbuilding and repair services company specializing in the construction and maintenance of ships for the Indian Navy and Coast Guard. The company had an order book of ₹19,963 cr as of May ’24, with ₹15,225 cr from defense services. Added to the basket in Feb ’24, the stock has run up ~190%.
Performance in various market conditions
Our small-cap strategy, underpinned by size, quality, and momentum, may not be bullet-proof (no portfolio is) but has demonstrated resilience across various market conditions. By carefully selecting stocks that align with these criteria, we aim to deliver superior risk-adjusted returns to our investors. Numerous investors have benefited from this approach, experiencing capital appreciation and portfolio diversification.
Note: Risk-adjusted return measures how much return you get compared to the amount of risk you take. Higher risk-adjusted returns mean better returns for each unit of risk taken, making it potentially more suitable for risk-averse investors.
| Name | CAGR Returns | Risk-Adjusted Returns | Volatility | Max Drawdown |
|---|---|---|---|---|
| Quality Smallcap – Smart Beta | 42.2% | 2.0 | 21.1% | -22.6% |
| Equity Smallcap | 33.5% | 1.7 | 19.6% | -33.4% |
*Data set is between Dec ‘20 to July ‘24.
Conclusion
The combination of size, quality, and momentum creates a powerful framework for investing in small-cap stocks. By harnessing the growth potential of small caps, emphasizing the importance of quality, and capitalizing on market momentum, investors can position themselves for long-term success. While no investment strategy is guaranteed, our focus on these three factors provides a solid foundation for navigating the dynamic small-cap landscape.
Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. Registration granted by SEBI, membership of a SEBI recognized supervisory body (if any) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.
The content in these posts/articles is for informational and educational purposes only and should not be construed as professional financial advice and nor to be construed as an offer to buy /sell or the solicitation of an offer to buy/sell any security or financial products.Users must make their own investment decisions based on their specific investment objective and financial position and using such independent advisors as they believe necessary.
Windmill Capital Team: Windmill Capital Private Limited is a SEBI registered research analyst (Regn. No. INH200007645) based in Bengaluru at No 51 Le Parc Richmonde, Richmond Road, Shanthala Nagar, Bangalore, Karnataka – 560025 creating Thematic & Quantamental curated stock/ETF portfolios. Data analysis is the heart and soul behind our portfolio construction & with 50+ offerings, we have something for everyone. CIN of the company is U74999KA2020PTC132398. For more information and disclosures, visit our disclosures page here.
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