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Small Stocks… Big Profits:

4 Rules for Finding Multibagger Small Caps

Dear Readers,

Let’s face it.

As amazing as companies like Asian Paints and Hindustan Unilever are, you can’t expect
their share prices to go up 25% every year.

That would be nearly impossible. These companies already have a commanding market
share. Any more gains will be difficult to come by. Competition will fight tooth and nail.

These giants are more likely to grow in line with the industry - high single or low double
digits, give or take a few percentage points.

We are not disparaging them. Nor are we discouraging you from investing in them. In
fact, these well-established companies should be part of any well-balanced investment
portfolio. They provide stability and compound wealth at a decent enough rate.

However, if what you really want is speedy returns (and who doesn’t?), you need the power
of a small-cap engine.

A few good quality small caps in your portfolio can mean the difference between good
returns and great wealth.

But small caps come with their own set of challenges.

A tweak in regulations here…a shift in consumer preferences there…and the whole thing
could come crumbling down. 

Then there’s the question of the management.

A small cap could have a great runway ahead of it, but if the management is inept…or can’t
allocate capital properly…shareholders might suddenly find themselves staring into the
abyss of stagnation.

And that’s precisely why we prepared this guide for you. To help you navigate the small-
cap universe and pick only the most promising companies.

1 | Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps
Which industries to target…

How to zero-in on the most credible management teams…

How much to pay for a stock…

It’s all there.

I have crisscrossed the country tracking small caps for my premium recommendation
service, Hidden Treasure. And everything I’ve learned along the way is in this handy little
guide. I have made this guide as simple and comprehensive as possible to show you how
to potentially win big with small caps.

You may recall it was Hidden Treasure that recommended the 5,900%+ gainer Page
industries…

And the 2,500% eClerx pick…

And the 1,000%+ Balkrishna industries recommendation…

These are the multibaggers we all dream of.

Picks like these are extraordinary, of course, but all you need is one and you could make
twenty times your money…fifty even!

In this guide, I explain everything - the principles, the tools, the patterns - you need to know
for small-cap success.

If I were you, I’d read carefully. And then read it again.

Welcome to the wild and wonderful world of small caps!

Regards,

 
Richa Agarwal (Research Analyst)
Editor, Hidden Treasure

Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps | 2
An Asset Class That Could Make
Warren Buffett Jealous of You

5,920% in eight years eight months…

1,058% in six years eleven months…

550% in six years eight months…

489% in 6 years 8 months….

288% in 2 years 5 months

330% in 2 years

They are real-life returns from recommendations made by our ‘small-cap’ stock research
service Hidden Treasure… While these returns are extraordinary, in my view, no other asset
class is as powerful as small-cap stocks when it comes to earning huge returns.

Yet, many investors choose to avoid small-caps altogether. And never experience the thrill
of banking potential multibagger profits. But you don’t have to be one of them…

As you probably know, “small-cap” is investor lingo for a small, publicly traded company. So
we’re not talking about Tata or Infosys, here. In fact, most small-caps are unheard of—and
that’s the key to their mouthwatering profit potential...

Big companies have already seen most of their growth, but tiny companies are still sitting
on the runway, waiting for take-off.

Consider Maruti Suzuki, for example, over the last three years, the big Indian auto company
has handed shareholders a 153% gain.

Take a look:

3 | Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps
 Maruti Suzuki up 153% in 3 Years
9,000
Stock Price (Rs)

7,500

6,000

4,500

3,000
Nov-14 Nov-15 Nov-16 Nov-17
Source: Ace Equity : Not an Equitymaster recommendation.

Now, that’s actually quite an impressive return for a company the size of Maruti Suzuki.

But it’s still nothing compared to the potential of small-caps.

Over the same time-period, a small auto ancillary firm called Minda Industries Ltd soared
a staggering 864%, see for yourself…

Minda Industries up 864% in 3 Years

1,200
Stock Price (Rs)

900

600

300

0
Nov-14 Nov-15 Nov-16 Nov-17

Source: Ace Equity : Not an Equitymaster recommendation

Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps | 4
That’s enough to multiply Rs 1,000 investment by over ten times to Rs 9,640.

This is the power and promise of small caps.

In fact, the greatest investor of all time once wrote that if he was running $1 million today,
or $10 million for that matter, he’d be fully invested in small caps. But his size hurts him.

He can never invest in high-return small caps. They look enticing, but with a capital base
of over US$ 100 billion, investing small amounts does not move the needle much for him.
And he can’t invest big sums in illiquid small caps without distorting their prices. He writes…

… The universe I can’t play in has become more attractive than the universe I
can play in. I have to look for elephants. It may be that the elephants are not as
attractive as the mosquitoes. But that is the universe I must live in.”

The elephants here are big, stable, well-known businesses. The mosquitoes are small caps.

Buffett might have to stay away from small caps, but you certainly don’t.

5 | Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps
Small Caps: Your Best Competitive Edge
over Big Investors and Fund Managers

For once, your relative lack of capital gives you a competitive advantage over every big
investor out there. Because when you invest in the small-cap space, your odds of nabbing
a multibagger go way up.

The high returns are a result of the ‘small-firm’ effect. It works in three ways:

• Unlike big businesses that have already matured, small caps are at an early
phase in the business cycle. This makes the growth potential of quality
small caps enormous.

Lifecycle of a Business

Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps | 6
 • Small cap companies are relatively unknown and off-limits for big investors.
Less money is chasing them, so they are likely to be priced attractively. This
makes the small-cap space the best meeting point for a value and growth
investor.

• As these small businesses grow and prove themselves over time, big
investors and funds start paying attention. This offers a re-rating opportunity
(valuations going higher), which means huge gains for an astute early-stage
investor.

7 | Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps
4 Things One Should Look for
In Market-Beating Small Caps

1. A Strong Moat
What is common between Asian Paints, Facebook, and ITC?

All three companies enjoy strong moats.

Asian Paints has strong brand power.

Facebook enjoys a virtuous cycle (the high number of existing account holders ensures
more people sign up for it).

Cigarette regulations allow ITC to enjoy a monopoly.

A moat is a long-lasting competitive advantage that a company used to earn above average
returns.

Moat ensures longevity - that the company survives and thrives over the long run, and not
its competitors.

It may be the company has the lowest cost of production or service in the industry, exclusive
access to raw materials or technology, high switching cost (for clients), the network effect,
or so on.

When we met Page Industries at a non-descript office in Bangalore, it had an exclusive

license for the Jockey brand in India, Nepal, UAE, Bangladesh, and Sri Lanka along with a
strong distribution network. A solid moat.

For Astral Poly Technik, an Ahmedabad-based leading manufacturer of chlorinated polyvinyl

chloride (CPVC) and polyvinyl chloride (PVC) pipes, it was the first and only Indian licensee
of US-based Lubrizol Corporation, a 100% subsidiary of Berkshire Hathaway. And Lubrizol
is the leading global producer of CPVC resin (~85% global market share), the chief raw
material for manufacturing CPVC pipes. A wide, well-protected moat.

For Mold-Tek Packaging Ltd, a Hyderabad-based rigid packaging player that supplies
containers and packaging solutions to leading paint, lubricant, and food and FMCG

Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps | 8
companies, the moat lies in the company’s long-standing relationship with clients in the
paints and lubricant industries (ie a 100% supplier to Castrol). The fact that it is a pioneer of
in-house in-mould labelling (IML) in India, and the only domestic company in this industry
that makes in-house robots for IML decorations, considerably widens the moats.

No formula in finance tells you that moat is 28 feet wide and 16 feet deep. That's
what drives academics crazy. They can compute standard deviations and betas,
but they can't understand moats. - Warren Buffett

It was not just strong financials, net profit margins, or return on capital that gave us these
insights. After all, earnings can be manipulated, more so with small caps without much
analyst coverage.

What helped us understand the moat of these companies and gave us conviction to
recommend them was ‘boots-on-the-ground’ research - management meetings, plant
visits, a study of industry dynamics and competition. Once you have the moat, you have
your solid small cap.

2. A Long Runway
Most large companies are past their phase of exponential growth. Certain small companies,
on the other hand, starting from a low base, are yet to see the best growth phase of their
lives.

A packaging company that has entered the food and FMCG segment with unique hygienic
labelling is only likely to grow. The same is true for a company in the Indian hospitality
industry operating with an asset-light model (both these are open positions in Hidden
Treasure).

That said, not all small companies enjoy sustainable growth. Many borrow significant capital
to operate. And then lose badly in a downcycle. Income goes down while interest costs
remain the same, causing a downward spiral in earnings that leads to a vicious circle. Stock
prices take a plunge, and investors can only get out with significant losses. When picking
a small cap, avoid high-debt companies.

9 | Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps
3. Ethical and Competent Management
I once met the promoter of a niche textile company we recommended. The promoter
declined the commission (a percentage of net profits) that he was entitled to. His reason:

I intend to live a simple life and the expenditure for that is very limited. The dividend
that I receive from my company is excess for my expenditure. The shareholders of
my company have reposed faith in me while investing in my company and I should
live up to their expectations. While they receive only dividends, I felt it should be
the same for me as well.
He operates his office from a simple room at his residence and scores perfect on ethics. As
far as competence is concerned, he dominated a niche segment and offered investors up
to 21% returns with negligible debt, a rare feat for a textile company.

Unlike a stable business that is on autopilot and can survive with even an idiot running the
company, small caps are in the formative stage. The importance of intelligence, energy,
and integrity in the management of a small cap cannot be overemphasised.

Conversely, a lack of integrity, intelligence and energy could be fatal.

You can’t draw such insights from armchair financial analysis, con-calls, or management
interviews, where the one who sells the story the best steals the show.

Nothing gives a sense of the commitment, passion, and integrity (or lack thereof) of the
management as clearly as personal meetings…and some ‘scuttlebutting’ with competitors
and suppliers and distributors.

Competent, ethical managers tend not to be much bothered about media attention,
meaning they often go unnoticed. Which is why management meetings are an integral part
of our process. Not a single small-cap stock is recommended without it. We are believers
in super investor Peter Lynch’s philosophy…

The extravagance of any corporate office is directly proportional to management’s

reluctance to reward shareholders. Excellent companies are thrifty. - Peter Lynch

Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps | 10
4. Margin of Safety
Many confuse ‘cheap’ with high margin of safety. And forget the stock investing mantra that
it’s better to buy a wonderful company at a fair price than a fair company at a wonderful
price.

For us, margin of safety starts with company selection.

We don’t recommend arcane business models that can’t be understood in simple language.
We avoid companies with overambitious projections.

We use a proprietary tool to assess risks related to industry, management, business, and
performance.

And we ensure there is enough gap between stock price and true value so investors can
grab the upside. So even when the stock falls, we see a buying opportunity rather than a
panic button.

11 | Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps
 But What About the Risks?

Ever heard of Hindustan Motors, Nocil, Premier, Mukand, Indian Rayon?

They were Sensex companies once. Today, they aren’t.

Small-cap companies like Cera Sanitaryware, Hawkins, and traded at Rs 74, Rs 135, and Rs
6 a decade ago. Today, they are trading at Rs 3626, Rs 2,801 and, Rs 835.

Size alone does not ensure longevity, stability, or security.

In the small-cap universe, losers always outnumber winners. But with due diligence, a solid
investment process in place, and discipline, you can ensure gains that far outweigh losses.

A common mistake people make is to confuse small caps with penny stocks. And they
equate the sharp price swings of small caps with risk. But volatility does not necessarily
indicate risk. While volatility refers to price swings, risk leads to permanent loss of capital.

In fact, for a shrewd small-cap investor, volatility is your best friend, offering many mispriced
opportunities. With smart asset allocation and diversification (more on this later), a small
cap investor can totally deal with volatility without losing sleep.

A Solid Process That Leads to Profitable Investments

Page Industries, Astral Poly Technik, Pi Industries, Balkrishna Industries, eClerx Services,
and City Union Bank are companies we recommended when they were completely unnoticed by
the market.

Today, they are market darlings that have made their investors, especially those who spotted them
early, very rich.

While small-cap stocks comprise more than 90% of the BSE universe, only a few will make it big,
the rest will vanish.

So how do you separate the wheat from the chaff in this market?

Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps | 12
You need a well-designed process. Let me show the one we use that has helped us beat the
markets nearly three times over the long term.

The process has been refined over nine years. We have travelled thousands of kilometers to meet
hundreds of small-cap managements and ask them tough questions to help us identify hidden
small-cap gems.

Your Investing Approach and Temperament

Investing should be more like watching paint dry or watching grass grow.
If you want excitement, take $800 and go to Las Vegas. - Paul Samuelson

In my interactions with small-cap investors over the years, I have realised their biggest
weakness.

Impatience.

Small caps need time to bloom. Low liquidity and high volatility may lead to price swings
or long intervals where price doesn’t move. But checking stock prices daily will make the
situation seem bad. It’ll make you lose patience and sell at the wrong time.

Unless you have a minimum time horizon of three to five years and stony patience, I would
not recommend you play in this space.

Quality small caps always win in the long term, irrespective of market cycles.

Quality matters more than quantity. You just need a few small caps to ensure great returns.
You just need to find stocks you’d be perfectly happy to hold even if the market shut down
for ten years.

That said, we don’t suggest allocating more than 2%-3% of a portfolio to a single small cap.

We also suggest limiting small caps to 10% of the portfolio.

However, this allocation will vary from person to person. For something that works best for
you, talk to your investment advisor. In fact, get all the advice you can and need…

13 | Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps
 But Don’t Ignore That
Retirement-Boosting Small Cap Space

You could work your entire life and still struggle for financial security. Or you could keep
aside some funds for quality small-cap stocks and plan an early and wealthy retirement.

You see, the road to big returns passes through the small-cap universe. A meticulous
selection and disciplined approach can land some multibaggers in your portfolio. As a
retail investor, this is unique competitive advantage you have over big investors.

This is the big picture idea behind starting Hidden Treasure in 2008, dedicated exclusively
for picking small cap stocks. Since inception, our research team has scoured through
hundreds of small companies and met over a hundred managements. Meeting the senior
management of companies, understanding their business vision, and putting before them
the tough questions has been the most enriching experience in our research work. This
extensive journey within the small cap universe not only helped us pick winning investment
ideas but also enabled us to build a solid repository of knowledge on small companies.

Every once in a while, we would lay our hands on lesser known value compounding
machines that would deliver manifold returns on investments... 4 times... 10 times... even
50 times!

With a strong process in place and help from a proprietary risk assessment tool, the
service has offered 30.1% average annual returns (CAGR) and has beaten benchmark
indices nearly three times. And we hope to continue to outperform.

So far, the journey has been quite fulfilling.

During this journey, one thing became crystal clear to us. You could invest in the known
large cap bluechips and earn better returns than most other investment assets. But if you
want to transform your fortunes and build serious wealth, the key is to spot the right small
companies that have the potential to grow multi-fold.

If you’re interested in unlocking the huge potential of select small-cap companies, we

recommend you start here…

Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps | 14
Richa Agarwal

Richa Agarwal, Research Analyst, is the editor of Hidden

Treasure and Phase One Alert.

After getting her MBA in Finance from Symbiosis

International University in Pune, Richa went to work for
HSBC group (HSBC is the largest bank in Europe).

Though based in India, Richa was tasked with providing

analysis for Europe based companies.

But she always questioned whether she could provide effective analysis of a company from
7,000km away…

This led her to Equitymaster, where she could focus solely on Indian companies. It also let
Richa deploy her favorite investment strategy…

Boots on the ground research.

While most stock analysts do all their research from a stuffy office, Richa goes the extra
mile…

She’s travelled hundreds of thousands of kilometres in search of new investment ideas for
Equitymaster subscribers.

One week, you might find her in Bangalore, interviewing the management team of a small
IT startup…

And the next, she’ll be on the factory floor of a cotton mill in Delhi.

This is the kind of due diligence that’s led Hidden Treasure, Equitymaster’s small cap
recommendation service, to some spectacular recommendations for its subscribers. Some
of Hidden Treasure’s superhits are1:

• 5,920% in 8 years and 8 months with Page Industries

• 2,500% in 8.5 years with e-Clerx Services

• 1,058% in 6 years and 11 months with Balkrishna industries

15 | Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps
Click here for a 30-day, risk-free trial of Richa Agarwal’s Hidden Treasure.

When not traveling for work, Richa travels for adventure. When not ‘scuttlebutting’
companies for her research, she immerses herself in reading fiction.

1 Returns as of Sep 30 2017 for stocks under coverage

For stocks not under coverage, returns as on 23 Nov, 2017.

Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps | 16
 About Equitymaster

Equitymaster, India's leading independent equity research initiative, is the

preferred destination of the thinking, long-term investor. Our research
coverage extends to over 700 companies and 23 sectors. We provide in-
depth analysis on the stocks and sectors under coverage. We also offer live
stock market commentary and free newsletters.

Do post your feedback on this guide to us at info@equitymaster.com. Or on

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To know more about us, please visit www.equitymaster.com or

call +91 22 6143 4055.

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17 | Small Stocks… Big Profits: 4 Rules for Finding Multibagger Small Caps