10-Point Checklist for picking a small-cap stock

Checklist for picking Small cap Stock 1 10 Point Checklist for picking a small cap stockIn the Indian context, a precise definition for a small-cap stock might sound like, “ Smallcap is the term used to label the companies with a comparably small market capitalization.” Let’s not take any chances and consider the stocks between Rs 2000 crore and Rs 5000 crore market cap. Generally, these companies will have remarkable growth potential and are somewhat smaller in size. The risk factor that comes with these stocks is the lower probability of these stocks becoming successful over a period of time. 

Because of this quality, the stocks of these companies turn out to be volatile. Generally, Small-cap companies are well known for their underperformance in general, nevertheless, these companies have outperformed in many circumstances such as the time in which an economy is emerging out of a downturn. However, you need to brush up on your knowledge before investing online in these stocks. This article reminds you of 10 things to be on your checklist while buying small caps in the stock market. 

Get to know the past performance

Safe harbor affirmations often state that past performance cannot be a sign of future potential. As you can say that is practically a correct statement, the past performance of a company over the last five years will be in close proximity to confirm when it comes to the small-cap stocks. It is best not to invest in the small-caps which does not have a track record of five years.

Anchor on the consistency of performance

Consistency is what matters than the out-and-out performance. Be more partial towards the companies that have displayed growth over the last five years and it is important to steer clear of companies that have shown frenzied fluctuations in their financial performance. Projecting cash flows can be quite problematic in such instances. On top of that, consistent small caps get better evaluations in the market.

Emphasize the market positioning and size

The small-cap companies are mostly single product or single service line companies. The size of the market matters because small caps lack the capital and the management bandwidth needed for these companies to spread too thin. Nevertheless, the positioning of the industry in the market is what matters the most. Few entry barriers and a niche positioning can help a company to have a notable difference in its valuations.

Risk Management 10 Point Checklist for picking a small cap stock

Explore volumes in the market 

There are no quick and impenetrable and rules for the volumes, but the thumb rule is that the average volume of a daily stock market must be at least 5% of the market cap. Therefore if the market cap is RS 2000 crore then the daily turnover in the stock market should be around Rs 100 crore. Trading platforms help you to check these data by themselves.

Bid-ask spreads are an important signal

The gap between the best buy price and the best sell prices is known as the Bid-ask spread. The first mentioned is the price at which sellers are able to sell and the other one is the best price at which the buyers can buy. 5 paisa or 0.05 on the trading screen denotes the benchmark tick spread. Typically it is the liquid stocks, that have bid-ask spreads of around 5 paisa but once you go lower in the market skates, the spread keeps extending. Make sure that the bid-ask spread in normal trading conditions does not cross 10 paisa while selecting small-cap stocks. If you let it cross over then, it adds up to your risk when you invest online.

Inquire into the bulk deals for the intraday deals and promoter deals

The bulk deals are quite important for small-cap stocks for two reasons. First of all the bulk deals gives an account of all deals above 0.5% of the outstanding shares, regardless of intraday or delivery. When you look into the bulk deals of small-cap stocks, generally there will be a flurry of intraday trades in some stocks stipulating that the stock to be highly speculative and can be potentially volatile. Not to mention, check if the promoters are agitated in selling the stock, for which the details are given in the disclosures of SAST.

Examine the management quality and commentary

Commentary and the management quality are the two different but equally important aspects of small-cap stocks. Do not indulge with the small caps, which has the management with a record of significant lapses in corporate governance, disclosure practices, etc. You have to avoid managements that have failed to carry out past promises. Small caps are unduly dependent on management commitment. You can get a clear picture of this through reading the MDA in the annual report.

Break loose of small caps with legal/regulatory charges

Before buying any small-cap stock, it is advisable to do a quick system check on any pending predicaments with SEBI, any pending investigations, and any regulatory issues escalated by SEBI / RBI. If you find these problems to be serious of nature, it is better not to engage with such small caps. Generally, small-cap stocks will swamp under such regulatory challenges and it will be best to avoid these circumstances. You will be able to find such cases on the website of SEBI. 

Never ignore contingent liabilities and auditor qualifications

Contingent liabilities are potential liabilities that might be experienced by a business concern based on the outcome of an undetermined future event such as the outcome of a pending legal case, open derivative, etc. small caps in the stock market are extremely ill-protected towards the negative impacts of contingent liabilities. This will give you a quick picture of whether the business model has inordinate risks incorporated into it. Also, it is important not to forget to check whether the auditor is qualified or not and when they resign.

Research the cash flow statements

Let us conclude that you have done all your due diligence on the financials, but when it comes to small-caps the importance of a cash flow statement is always exceptional. Many a time, small-cap stocks are unable to effectively churn their working capital, as a result, these small-cap stocks are under liquidity constraints for most of the time. Such credit pressures are noticeable in the cash flow statements.

Still, to our surprise, the Indian stock markets have been tremendously successful in converting the small-cap stories into large-cap champions.

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