Quality Smallcap – Smart Beta

All About Smallcaps

SEBI defines smallcap companies as those whose market cap rank, based on average market capitalization over the previous 6 months, is greater than 250. Most large-cap stocks started as small businesses. For example, Infosys started in 1981 with an initial capital of just Rs.10,000. As of Oct’22, its market cap is more than Rs.6.23 lakh crore. Since these companies are small, they can grow at a faster pace compared to their larger counterparts. Higher business growth usually results in higher stock price growth, especially during bull markets. Hence investors seeking to generate higher returns tend to prefer small-cap stocks.

Performance during market uptrend:

It is also important to consider the risks associated with investing in smallcap stocks.

• Stock prices of small-cap companies tend to be more volatile. The volatility of the Nifty smallcap 100 over the past 1 year is 23.7% compared to 18.1% of the Nifty 100. 
• Small companies usually tend to have a lower customer base and ambiguous business models. Hence their business suffers more when compared to larger companies during times of economic crisis. This is reflected in their stock price performance during bear phases.   

Performance during market downtrend:

It is important to remember that smallcap companies offer significant upside growth potential that large cap companies cannot match. However this potential can manifest only over the medium to long term. Hence investors in smallcap stocks must be patient and invest in smallcap stocks only with a long term view.  

What is factor investing?

A factor is a broad and persistent driver of stock returns.

Let’s start right at the beginning. In the 1960’s William Sharpe and his friends introduced the Capital Asset Pricing Model (CAPM), to explain stock market returns.

The model states that the beta or returns of markets drives stock returns. So here market return is the factor. Subsequent research indicated that this was not always true. 

In 1992, Eugene Fama and Kenneth French built on the original CAPM and came up with the Fama French 3 factor model.

In addition to stock market returns, the model attributed stock returns to 2 additional factors:

• Size (SMB) : smallcap companies provide greater returns compared to large cap ones.
• Value (HML) : Value stocks provide excess returns compared to growth stocks

In 2014, Fama and French further refined the model and came up with a 5 factor model. In addition to market returns, size and value, this model stated that profitability and investment patterns also affect stock returns.

All this seems familiar right? In the above section we had just discussed small cap stocks. Further, the idea of picking up value stocks usually represented via low PE and more profitable companies is common knowledge even among novice investors. 

So which factors actually work? It depends on the asset manager’s research. The table provides a board list of factors that are usually accepted by all asset managers.

More about quality factor

The “Quality” factor has its root in fundamental analysis and has been around for some time. In recent times, issues such as the Enron scandal, revived interest in it. A major drawback of this factor is that there is no consistent definition of what is considered quality.  

The Windmill Capital team, after intense research, created the proprietary quality score. We used 4 pieces of financial information to calculate the score :    

• Management Effectiveness is determined using Return on Equity (ROE)%
• Financial Strength is evaluated using the Debt/Equity ratio
• Earnings quality is estimated using an accrual ratio ((Net income – Free Operating Cash Flow) / Total Assets)
• Consistency in performance is gauged through earnings variability over the past 5 years.

When calculating quality scores for banks and NBFCs we use capital adequacy ratio instead of gearing ratio. In case of insurance companies, gearing ratio is substituted by insurance leverage ratio. 

Based on the quality score, companies can be assigned to any of the 4 quartiles. Companies in quartile 1 (Q1) are the best and so on.

What is Quality Smallcap – Smart Beta smallcase?

A major reason for investors to be hesitant about investing in smallcap stocks is their higher riskiness due to ambiguous business models. The Quality Smallcap – Smart Beta smallcase seeks to mitigate this risk by selecting only those small cap stocks with high quality scores. Additionally the smallcase only selects those quality smallcap companies whose price is experiencing a positive momentum trend. This improves the chances of the smallcase giving outsized returns. The smallcase attempts to shortlist at least 10 such stocks and will invest in Gold Bees if the requisite numbers are not available.  

The ‘Quality smallcap — Smart Beta’ smallcase aims to systematically beat the smallcap universe of stocks by quantitatively selecting smallcap stocks exhibiting strong quality fundamentals with positive momentum trends. It is best suited for investors looking to take exposure to quality smallcap stocks for passive long-term investing.

Disclaimer: Investment in securities market are subject to market risks. Read all the related documents carefully before investing. 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. For more information and disclosures, visit our disclosures page here –https://windmillcapital.smallcase.com/#disclosures