Introducing the Quality Smallcap – Smart Beta smallcase

Investors use different investing strategies to align their investment performance with their financial goals. These strategies and investment philosophies are dictated by a variety of metrics like age, risk appetite, family obligations, etc.

Among a variety of different investing styles, smallcap investing is quite popular, especially among those who have a comparatively higher risk tolerance — as smallcap stocks are more volatile as compared to large/midcap stocks.

Investing in Small-cap stocks

Smallcap stocks are those that have a market cap of less than around ₹5,000 crores. It should be noted that this is a rough approximation and is subject to change. These are small companies that are either new or operate in a relatively nascent industry — which is why their market cap is less when compared with some of the big and famous names in the market.

An interesting thing to note about smallcap stocks is that even the big names of today started out by once being small-scale firms. Hence, identifying quality smallcap stocks with good potential can be an extremely rewarding investment. Why? Let’s answer that question with a question — Do you think it’s easier to double your money when you have ₹1,000 or when you have ₹1,00,000? Well, the answer is obvious. It’s ₹1,000 — because a low base effect makes it easier to generate higher returns.

However, this very trend should not be the reason to conclude that investing in small-cap stocks is better than investing in large-cap stocks. You see, investing in small-cap companies is a risky affair. These are small, not-so-well-known companies that are away from the limelight of the market. There have been numerous cases of fraud and scams in these companies — which once brought to light, often resulted in the share price tanking to 0.

Investing in small-cap stocks — the smart way

You know, they say that there is opportunity in adversity, right? Smallcap investing is a good analogy to that statement. The reason why the market and most analysts stay away from smallcap stocks is because of their inherent riskiness and vague inner workings of the company. But, that’s also where the big bucks can be made! If there was a way to identify quality smallcap stocks that have a very promising future, smallcap investing can potentially consistently outperform large/midcap investing.

That’s when the ‘Quality Smallcap — Smart Beta’ smallcase came into the picture. We figured that if we could figure a way out to identify good quality smallcap stocks with massive future potential, we could offer our investors a very efficient and reliable way to get exposure to smallcap stocks.

Hence, we started building this smallcase. We started out by finding a way to smartly identify quality smallcap companies. How? By assigning smallcap companies a ‘Quality Score’. Essentially, our team quantified financial data associated with consistent & healthy profits, cash flows, and business stability, to come up with the Quality Score.

Essentially, the calculation of the Quality Score stands on 4 pillars of financial information —

• 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.

The small-cap companies went through 3 layers of the selection process to finally be eligible to be included in the smallcase. The first was laid out as a Quality Score.

Step 2 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 smallcap index by quantitatively selecting smallcap stocks exhibiting strong quality fundamentals with positive momentum trends. The smallcase offers a much better risk-reward ratio compared to the Nifty Smallcap Index and Nifty Smallcap ETFs. It is best suited for investors looking to take exposure through quality small-cap stocks for passive long-term investing.

Check out the offering, here.

Take care, and happy investing! 🙂

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_{Windmill Capital TeamWindmill 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.}