Small Caps: The Invisible Grass

VP- Equity & Institutional Sales. Bonanza Portfolio Ltd. As the sun was rising; I was walking through a small forest, there was huge bamboo tree in front of me and I have always been fascinated by grasses especially the largest of the grasses and bamboos. There are over 1600 species of bamboos; 64percent of which are native to Southeast Asia. The most fascinating thing about this grass is for the first 4 years they grow a little. But then, suddenly in the 5th year, they grow 80-90 feet tall! Mother Nature is the worlds best university; her lessons are always free, but only for the people- who are ready to listen to her. Let us learn the lessons and go ahead. David and Goliath The biblical story states that, a small teenage boy called David defeated a giant soldier in the philistine army with few stones. In the world of sports there has been few Davids, who can forget India-winning the first prudential World Cup way back in 1983; under the leadership of Kapil Dev and the young Dhoni winning the 20/20 World Cup. From there, he (David) has made Winning his habit. In the world of stocks, Small Cap - Davids historically defeated Large cap Goliaths; few Davids have the strength and ability to fight the raising cost and interest and to grow fastest when the interest rate falls. In the different phases of market cycle; not limited to bull or bear markets, there could be some smart Davids significantly outperforming Goliath with their own unique strength.

The "Small Cap Effect" in Emerging Markets: The Small Cap effect in the U.S. markets is well-known though underappreciated. David Swensen, the manager of the Yale Endowment, once observed that if you put a dollar into small stocks in June of 1932, by the end of 2006, you would have had 1,59,000 times your money. The comparable number for the Dow Jones Industrial average is 266. By all accounts, the same effect is seen in emerging markets. The S&P Emerging Small Cap Index returned an average of 16.6% per year, and the S&P Emerging Large Mid-Cap Index returned 13.2% over the past decade. This outperformance held everywhere on the planet in Asia, Europe, Latin America, the Middle East and Africa, as well as in - 9 out of the 10 main industry sectors. By all measures, this outperformance by Small Caps was the "real deal." So why do Small Caps tend to outperform? First, their small size makes them nimble and quicker to react to changing market conditions. Its also much easier for a $10-million firm to double in size than a $1-billion firm. Then there is the "pig in the poke" effect. The small stocks that dont make it are by definition knocked out of the index and replaced by other, fast-growing companies and the bigger companies whose growth likely has slowed get kicked upstairs to Mid or Large-Cap indexes. Why India in the emerging pack? India has the second-fastest growing GDP in the world behind China and the good news India might overtake China as the fastest growing economy by 2015, and could reach a growth rate of 9.5 percent between 2011 and 2015. This South Asian country is expected to double infrastructure and add six times more workers than China over the next 5 years. India will add 136 million workers by 2020, compared to China's 23 million workers. Dr. Manmohan Singh, our Prime Minister has said that the government has plans to double its spending on ports, roads, and power plants between 2012 and 2017. This will most likely lead to an increase in workers and salaries, which will help boost growth in the economy. With India's growth rate accelerating so fast, it's worth looking at Small Cap investment opportunities in this country. After all, Indias Small Cap market has the potential to double and even triple over the next few years. Ours is the fastest growing economy, in the fastest growing democracy. We will look into few themes which will grow faster in the next decade! The following table illustrates that Sensex has gained ~448% in July 2011 since last decade. Whereas, BSE Small Cap Index has gained ~504% in 8 yrs (prior data not available).

Examples: Following are some of the stocks which have grown multifold since last one decade. 1) 2) 3) 4) Bharti Airtel has gained ~770% (from Rs 44 to Rs 383) Shriram Transport has gained ~6,784% (from Rs 9.5 to Rs 654) Praj Industries has gained ~1,150% (from Rs 6 to Rs 75) Vijaya Bank has gained ~ 800% (from Rs 8 to Rs 72)

Investment Implications: Market movements and global risk appetite is always difficult to forecast in short term. Small & MidCap stocks will face difficult times going forward on account of high inflation and higher cost of bank credit; High inflation in India (>7%) is likely to persist until the end of FY11. High inflation hammers returns for the Small & Mid-Cap indices more profoundly than it does for the rest of the market. Secondly, rising policy rates will translate into higher cost of bank credit a development which will impact Small & Mid-Cap companies which are dependent on banks for growth. In light of the above, only selective Indian Small and Mid-Cap stocks will exhibit outperformance in the rest of FY11. Still we will highlight few companies, where investors can start accumulating the shares at various price levels; as we feel the policy rates are already higher and will peak in the coming months. Investment in Small Caps always-as high risk and high return and one should have right Portfolio allocation for Small Cap and investment should always be made in phases. Going forward will cover one Small Cap idea every month which has a story behind it and likely to emerge as multi bagger. Kindly note that, the ideas- are for two year investment horizon only.

Wealth from Waste!!! Ganesh Polytex ltd. (BSE Code 514167) is India's Largest PET Waste Recycling company with dynamic and investor friendly management. The Company has achieved prestigious ICAI Award from Institute of Chartered accountants for transpiracy in financial reporting. Business model GPL has a very unique and interesting business model. It has a number of waste collection centres to collect the PET bottle waste from the rag pickers and convert it into Polyester Staple Fiber which has multiple uses in stuffing in pillows, quilts, mattresses, furniture, etc., Yarn Spinning for fabric, Medical Textiles, Geo textiles, Automotive Textile and other technical and non-woven textile. GPL recycles around five million pet bottles daily. Performance GPL is a consistent performer and is a dividend paying company, growing at 30%+ CAGR since last 5 years. The company has achieved a turnover of Rs 291 Cr in 2011 with EBITDA of Rs 26 Cr and PAT of Rs 17 Cr. Valuations GPL is a low beta stock and has stood firm during the meltdown of other Small Cap stocks. With an EPS of Rs.13.5, scrip is currently trading at the multiple of around 5 xs, whereas other companies related to waste management and recycling are enjoying a PE of around 25 xs. Target As depict by its name, currently GPL is termed as a textile company and not as a waste recycling company by BSE and other portals, which seems to be the major reason of its under visibility. The company has started its visibility campaign to get proper valuations. The re-rating of the stock seems to be inevitable. The company is all set to enjoy higher multiples. With improving performance and extended PE, we recommend buying the scrip for an 18 months target of Rs. 162. Risks and Concerns The PET recycling business doesn't require niche technology or huge Capex, which results in the absence of an entry barrier, to avoid competitors from entering this field. To counter this, the company is focused on building the raw material procurement network which would provide a major competitive advantage to the company. GPL is a Small cap company and has the normal execution risks associated with any Small Cap. Even though the company has a significant depth in its business, scalability is a risk nevertheless -By RL Narayanan

VP- Equity & Institutional Sales. Bonanza Portfolio Ltd.